MaineBusiness.com

Hype or Substance? Of Separately Managed Accounts and Hedge Funds

Wall Street makes a living off of selling prestige. And two of the more popular types of investment vehicles as of late have been Separately Managed Accounts (SMA’s) and Hedge Funds. These vehicles have been exclusive to the wealthy, but are becoming more main stream over the past few years. Are these vehicles really worth it or just a great conversation piece during a cocktail party. Let’s discuss SMA’s first:

SMA’s are investment vehicles where a professional money manager is hired to directly oversee the investment strategy of a specific account. It’s similar to a mutual fund, but you directly own the underlying securities instead of the shares of the fund. Available only to wealthy individuals in the past, now you can get into a SMA for as little as $50,000. The snob appeal with these funds is that you can hire a prestigious money manager without having to do it through a mutual fund. SMA’s are heavily promoted as a tax efficient alternative to mutual funds as the structure of the account allows the manager better capability to employ tax efficient strategies such as tax loss harvesting. Also SMA’s avoid the tax inefficient distribution requirements associated with mutual funds. SMA’s also are attractive as the individual investor can customize their portfolio. For example, the investor may want the portfolio to reflect their socially responsible beliefs such as avoiding tobacco, alcohol or focusing solely on only environmentally conscious companies.

Sounds appealing, doesn’t it? Unfortunately the benefits of SMA’s don’t live up to the hype. For example:

Access to the Marquee Manager & Customization Isn’t Always the Case: Unless you have a significant amount invested, it’s highly unlikely that you are going to get direct access to the prestigious money manager. More likely, the account will be managed by a subordinate of the team that will not make individual adjustments to your account, but rather will make block trades for a group of accounts. And if the junior manager is doing this, you better believe that you’re probably not going to get the personal customization and touch that these vehicles promote.

True Diversification: For the level of initial investment involved, most people would find it highly difficult to be able to develop a fully diversified portfolio consisting of SMA’s. You may be able to cover some aspects of a truly diversified portfolio by asset class and sub-classes, but I doubt that you can cover all the bases with this approach.

Tax Benefits More Hype than Substance: According to a study conducted by Cerulli Associates, only 30% of SMA’s receive specialized tax treatment. This doesn’t sound like the universally tax efficient character that is heavily promoted. Also mutual funds do have one advantage in a taxable account. Mutual fund management fees are deducted from investment income, which essentially reduces the investor’s income dollar for dollar for income tax purposes. SMA fees on the other hand are deductible only if they exceed 2% of the investor’s adjusted gross income as a miscellaneous itemized deduction, something that very few taxpayers can take full advantage of.

Will You End Up Beating the Market Anyway? I highly doubt that a separate account manager with an active strategy is going to provide market beating returns over their comparable benchmark in the long run. The probability is reduced when you get fees involved as SMA’s usually charge in between 1% to 3%. You would probably be better off with an index fund in the long haul from a before and after tax perspective; most of the efficiently managed active mutual funds would probably give SMA’s a run for their money as well.

In the end, an SMA might bring you some level of status, but there is a price to be paid. In the end, you want performance not status and most investors, even the wealthy ones would be better off in the end with mutual funds and ETF’s.

In my next entry I will discuss hedge funds.

Year End Planning: Five Things to Be Thinking About

The early fall is an opportune time to address your financial planning needs. The cooler weather and shorter days force us inside. The hustle and bustle of the holiday season is still a couple months away. And from a seasonal perspective, there are decisions that can or need to be made now that will affect your circumstances for next year. Here are some things to be thinking about as the year draws to a close:

Budgeting: This is a great time to refresh or establish a budget. For many, this is a lull period as summer vacation spending is behind you while holiday shopping is ahead of us. So it makes for a good time to get a grasp of your discretionary and non-discretionary spending and setting limits. It could help prevent you from going overboard in the upcoming months.

Income Taxes: There are many things that can be done prior to year end to maximize tax efficiency, options diminish greatly afterwards. I recommend spending some time prior to year end determining your income tax projections. Doing this can reveal if you are subject to any potentially adverse tax circumstances (such as the AMT) or have any opportunities that you may want to act upon. It helps avoid any nasty tax surprises when you least expect it. It certainly makes sense for those with material change in their income circumstances during the year, but even those with little financial change can still find value is doing this.

Employee Benefits: It’s that time of the year when employers begin the annual enrollment period for their benefit plans. Some employers have limited options while others have multiple options. Regardless, start thinking about your benefit needs now rather than minutes before the deadline to file the paperwork. What are your insurance needs? Are there any options available that are worth considering? What are your retirement funding needs and do you need to make adjustments in your deferrals or go with the Roth option (if available)? Does it make sense to fund a health or dependant care reimbursement account or even a health savings account? These are all critically important to your financial well being. Take the time to think these things through and make wise elections.

Near Term College Planning: This can be a crucial time for financial aid eligibility. Some colleges require a Profile form and the deadline for this is on December 10th of the student’s senior year for the following school year. FASFA applications can not be submitted before January 1st, but filing early and accurately is critical. If you have a child that is a year away from their base year for determining financial aid (January of their junior year to December of their senior year), you may want to consider making any financial moves now that would adversely impact your aid eligibility if left until next year.

Retirement Planning: If eligible for a tax-advantaged retirement account, plan to fund it and haven’t funded it yet, time is running out. Depending on the type of plan, you have until the end of the year or the tax filing deadline to implement. Also this is a good time of the year to consider a Roth conversion. If eligible, this may be a great opportunity for someone under the right circumstances.

The time to be thinking about these things is now, not during the holiday season or once January comes. By taking the time to make sure your financial house is in order, you will be ahead of the game in 2007.

Quick Tip: Life Insurance & Investing Shouldn't Mix

Last week I was in a financial planning study group meeting with the topic being about analyzing insurance policies. Within the discussion the story was brought up concerning one insurance agent advising someone to stop making contributions to their 401(k); instead funneling the money into a permanent life insurance policy based on the premise that it made a better investment vehicle. It may be an effective angle for someone to sell a whole or universal life insurance policy, but it rarely makes sense.

Why do they make a lousy investing vehicle? Many permanent insurance policies carry significant costs with high fees and commissions. In the initial years, these costs are amplified as commissions are often front-loaded and if you terminate the policy, there is usually a hefty surrender charge. Then the underlying investing sub-accounts can carry high expenses as well. After taking this into consideration, it’s awful hard to justify the basis to forgo your 401(k) or other tax-advantaged savings vehicle for the investment benefits of an insurance policy. Even investing in index funds within a taxable account would probably be better off in the end.

The gist of the story here is the primary reason that you should buy insurance is based on your protection needs: to allow your family to maintain the same quality of life after you pass away. For many, term insurance is really all that one needs as the financial risk subsides as you get older with assets accumulating, debt subsiding, and the kids are done with college and now live on their own. Permanent insurance can be helpful if you are uncertain of your long-term needs, have family history of questionable health, or want to provide liquidity for your estate planning. All I’m saying is that the decision to buy based on a method of savings should be secondary. It’s the rare individual that would find this to be the optimal savings vehicle for their situation.

Under What Circumstances Does Buying Long Term Care Insurance Make Sense?

In my last entry, I discussed the potential risks of needing long-term care (LTC). When does it make sense to consider LTC insurance? Here are some of the circumstances where it may make sense:

-The Financial Middle: For those with few assets, it just doesn’t make sense because you would be eligible for Medicaid and the cost of insurance would be unaffordable. For the affluent, the care would be affordable. But it may make sense for those in the financial middle; ones who managed to build a decent nest egg, but not enough to sustain a prohibitive care need. Not sure if you are “in the middle”? For example, say that you have to enter a care facility that costs $65,000 a year, you receive Social Security and pensions totaling of $45,000 and you have a nest egg of $500,000. If your portfolio was positioned for long-term growth, you can reasonably expect to take out enough from your portfolio to meet your needs. If you have a gap, that’s when insurance should be used. Although each individual has their own unique set of circumstances, this is a simplistic way to at least initially approach this.

-The Conservative Investor: A stay at a long-term care facility may be affordable now, but for the low risk investor it may not be affordable later. This is primarily because LTC costs are growing at a higher rate than inflation. If you keep all of your assets stashed away in cash, fixed annuities/pensions and bonds, it is unlikely that your purchasing power will keep up to cover the cost.

-Qualitative Circumstances: If you have an unrelenting worry about how you may pay for potential care costs it may be worth the peace of mind to be insured if you can afford the premiums. Also if you don’t want to be a burden to your loved ones, this insurance can help alleviate this. You may simply not have any family members or loved ones you can fall back on in your immediate area, making LTC insurance more desirable. In addition, LTC insurance may provide the additional means to receive the quality of care you desire. Finally, women are more likely to be subject to an extended care facility than men.

-Desire to Leave a Legacy and Avoiding Medicaid Planning: You may be affluent enough to pay out of pocket, but have a desire to leave money to your heirs, charity or don’t want to disrupt your assets. It also may help avoid the ethical and logical issues surrounding Medicaid planning as it is certainly questionable to manipulate a welfare system if you have the means. Also many Medicaid strategies involve repositioning assets in a way that would defy logic for any other circumstance. Eligibility isn’t getting any easier either and with projected budget shortfalls; it’s going to become even more difficult in the years to come. And Medicaid isn’t a bed of roses. Being eligible for Medicaid doesn’t guarantee that you will receive the quality of care, the location, or a permanent spot if you have to spend time in the hospital. It may make a lot more sense to insure yourself and have the flexibility to find the level of care that you want for the rest of your life.

In the end, LTC insurance certainly makes sense to cover risk that you can’t afford to lose, but it also can go beyond the numbers logic and simply be worth it for the peace of mind that it provides. And with that, anyone who could afford to pay the premiums for LTC insurance should at least consider it.

Do You Need Long Term Care Insurance? Start By Assessing the Risk

Long term care insurance has been a hot product over the past decade. With American’s living longer, Medicaid tightening its rules, and many Baby Boomers seeing their parents need assisted living, it can be pretty scary. In the May edition of Kiplinger’s, Kimberly Lankford started her article, A Fresh Look at Long Term Care by writing, “Could you afford to withdraw $250,000 from your retirement savings to pay for one year in a nursing home?” Although she goes on to say that this is the projected cost 25 years from now, this kind of statement certainly provided a shock factor to some of those who read it. The fear has compelled many to buy this very expensive insurance. You certainly may need long term care insurance, but it’s not for everybody.

Considering long term care insurance? The best place to start is to understand the risk. Penn State University professor Peter Kemper, Georgetown University Professor Harriet Komisar, and Lewin Group Consultant Lisa Alecxih, recently conducted a study to determine the risk of a 65 year old needing long term care as well as the projected financial implications. This study, Long Term Care Over an Uncertain Future: What Can Current Retirees Expect? was published in the winter edition of Inquiry, a quarterly health care journal. Using a complex microsimulation model, they projected that 69% of all 65 year olds today will need long term care and the average length of care is three years. But most of the need was projected to be moderate in nature, with family members expected to provide most of this assistance. The biggest risk is an acute situation, the need for skilled care in a nursing home or assisted living facility for a prolonged period of time at a prohibitive cost. The study projected that 37% will need assistance in a facility, but only 8% will need care in excess of five years. And this is where the cost factor comes into place; it is projected that 11% of individuals will need an estimated $100K to $250K at age 65 to cover future long term care expenses, 5% will need over $250K.

Most individuals will never need long-term care insurance. But who’s to know if you are going to be part of the unlucky few subject to an extreme long term care need several decades from now? When does it make sense to buy long-term care insurance? I'll talk about this later this week.

*The information from the study is based on data appearing in the winter issue of INQUIRY journal. The full article is available at www.inquiryjournal.org or by e-mail at inquiry@hartleydata.com. Copyright 2006 Excellus Health Plan,