We know from years of experience that the consistent implementation of the five practices of our Active Wealth strategy – investing, borrowing, spending, managing costs, and protecting wealth for future generations – can provide meaningful long-term financial benefits to investors willing to apply them over time.
Having lived through the market mayhem wrought by 2020’s pandemic, we can now also demonstrate how investors can use these same practices tactically, to protect and even grow portfolio value during bouts of extreme market volatility.
As much as we all want to leave 2020 behind us, it was the perfect example of a year where investors could have left considerable value on the table if they focused only on their market investments and failed to view all Active Wealth practices as viable levers of wealth creation and protection.
With the benefit of hindsight, we’re able to illustrate the benefits of tactically implementing Active Wealth in ways that minimized downside participation in 2020’s market rout in March, yet also allowed portfolios to participate fully in the equity market rebound that began in April.
By rebalancing portfolios, staying invested, using credit to cover non-recurring expenses, adjusting spending to account for market conditions, harvesting tax losses and utilizing gifting strategies, we show how an Active Wealth investor with a $20 million portfolio could have ended 2020 with about $3.5 million more than an investor who took a more passive approach.1
We also calculate the value of implementing advice in each Active Wealth practice – or “Advice Alpha"2 as we call it – by measuring the increased dollar value and growth rate of a fictitious $20 million portfolio with a standard 60/40 equity/debt allocation.
Equity market weakness can provide portfolio rebalancing opportunities, which involve selling appreciated bonds to buy depreciated equities. Portfolio rebalancing can increase the future return potential of an investor’s portfolio, as well as keep an investor’s risk profile aligned with long-term goals and objectives.
At the end of March 2020, a $20 million buy-and-hold portfolio that began the year with a 60/40 allocation would have sustained a 12.5% drawdown, with equities dropping to around 55% of the portfolio’s value. Opportunistically rebalancing back to a 60/40 at this time would have increased investor exposure to the market’s rebound in April, which turned out to be the strongest month for equities since 1987.
If an investor didn’t rebalance a $20 million portfolio, they would have ended 2020 with a return of 13% and a value of $22.6 million. However, rebalancing it back to a 60/40 target at the end of March could have boosted return to 15%, resulting in a portfolio value of $23 million. In other words, rebalancing provided a benefit of $400,000 versus a buy and hold approach, which equates to an Advice Alpha of 1.9%.
The speed and depth of March 2020’s selloff prompted many investors to exit the equity markets rather than expose themselves to the possibility of further declines. Yet, making reactionary moves in the face of extreme volatility can undermine years of well-thought-out financial planning.
Consider an investor who withstood March 2020’s volatility and remained fully invested. Doing so would have reaped a 13% return for the year and increased a $20 million portfolio’s value to $22.6 million. However, bailing out of the market in March and missing the market rebound in April would have dropped returns to 5% for 2020, leaving an investor with a portfolio value of $21 million at year-end. Staying out of the market for the remainder of 2020 would have eroded calendar year returns even further, to -9.7%, and reduced portfolio value to $18.1 million.
Staying the course, however, resulted in a benefit of between $1.6 million and $4.5 million, or an Advice Alpha of 8.1% or 22.8% respectively.
Tax-loss harvesting involves selling securities at a loss and reinvesting the proceeds in an investment that provides similar market exposure. It’s a way to participate in market upside while offsetting future tax liabilities. Equities suffered a 35% selloff in the first quarter of 2020, but ended the year up more than 18%, making 2020 a perfect case study to examine how effective this strategy can be.
A $20 million portfolio with 60% in equities and 40% in bonds would have been carrying a short-term equity loss of about $2.35 million at the end of March 2020, having recovered somewhat from the market nadir of March 23rd. By year-end, that same portfolio would have grown to a value of $22.6 million. That’s a gain of $2.6 million, which if realized would have been almost entirely offset by the losses harvested in March.
Portfolio growth would have been 13.1% on a pre-tax basis, whether an investor harvested losses or not. But after-tax, the investor who didn’t harvest tax losses would have had an 8.2% portfolio return by year-end 2020, versus 12.6% for the investor who did. That equates to an additional $870,000 in portfolio value by year-end or an Advice Alpha of 4.4%.
Borrowing against artificially depressed asset values amid market downturns can provide tremendous benefits down the road. For example, taking out an Investment Credit Line (ICL) to pay for a considerable expense at the end of March 2020, rather than selling securities to pay for it, left assets in place to participate in the market’s subsequent rebound. 2020’s low-interest-rate environment further enhanced this strategy. Conversely, liquidating portfolio assets to cover the expense would have reduced the asset base that could recover its lost value.
Our analysis shows that an investor who liquidated assets to cover a $2 million expense in March 2020 realized 2020 portfolio growth of 0.7%. The investor who used an ICL to cover the expense and paid off the debt at the end of 2020 grew portfolio value by 3.5% to $20.7 million, versus $20.1 million for an investor who liquidated assets. That’s a one-year benefit of $600,000 or an Advice Alpha of 2.8%.
The goal of a dynamic spending plan is similar to borrowing during economic downturns: it insulates portfolio assets from further reductions in value during periods of market distress, so the investor participates more fully in a future recovery. While most effective when implemented over longer time horizons, the benefit is apparent even over one year. In this analysis, we assumed that an investor reduced spending in 2020 by 5% in a month that was preceded by a portfolio loss of 3% or more. Such a loss occurred in February and March before the recovery kicked into high gear. The investor who employed a dynamic spending approach had an additional $73,000 or a year-end portfolio value of $21.88 million, compared with a $21.81 million year-end portfolio value for an investor who left their spending unchanged. This equates to an annual Advice Alpha of 0.4%.
Depressed asset prices in March 2020 provided an opportunity to use a Grantor Retained Annuity Trust (GRAT) to transfer to heirs' assets with potential to benefit from a market rebound – and reduce future estate tax liabilities in the process. Starting 2020 with a $20 million portfolio and transferring $2 million of equities to a GRAT at the end of March would have removed $950,000 of future appreciation from an estate. That would have reduced estate tax liability by $380,000, while at the same time transferring assets to family. The $380,000 saved in taxes equates to an Advice Alpha of 2%.
In reality, not all investors may have had the opportunity or need to implement every one of the above Active Wealth strategies. But for the sake of argument, doing so could have resulted in a 4.4% portfolio growth rate during 2020, from $20 million to $20.8 million – after accounting for a typical 4% annual spend rate and an additional $2 million expense (which is an example of how much a client may spend on a home). An investor who started with the same $20 million portfolio, spent 4% of their portfolio on living expenses and covered a $2 million cost yet failed to incorporate these Active Wealth strategies, would have seen their portfolio shrink 13.4% to $17.3 million by the end of 2020. That means the Active Wealth investor would have ended the year $3.5 million richer than the “inactive” investor – an Advice Alpha of 17.8%.
In our view, investors can leave considerable value on the table if they only consider investment performance and can face challenges during periods of meagre or negative market returns. On the other hand, Active Wealth pulls all levers of portfolio growth available to investors and can provide value in any market environment.
1 The analysis spans calendar year 2020 and assumes a starting allocation of 60% S&P 500 and 40% S&P Intermediate Municipal Bonds.
2 Advice Alpha is defined as the value of comprehensive wealth management that leads to better wealth accumulation and greater success of achieving financial goals and objectives over the life cycle of a clients' relationship. For further information about how BNY Mellon adds value, including an explanation of how the value we add is quantified, please see "Leading With Advice Overview and Active Wealth Value Proposition Discussion" (December, 2019), a copy of which is available at HTTPS://WWW.BNYMELLONWEALTH.COM/ASSETS/DOCUMENTS/LWA/LEADING_WITH_ADVICE_OVERVIEW.PDF or from your BNY Mellon Wealth Manager or relationship contact.
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