Cost Basis: How not knowing can hurt you

Knowing the cost basis on your house or your investment portfolio is critical to building your wealth in a tax efficient manner. Without managing the cost basis in your portfolio you may inadvertently increase your tax liability. These last six months we’ve encountered a large number of cost basis issues so I’d like to enhance your understanding of how cost basis can impact your wealth.

What is cost basis? When you look at your investment statements you’ll see a column that states the cost basis for that investment. Simply stated, cost basis is the cost you incurred for that security. In reality, cost basis is more than the original cost. In fact, many securities change their cost basis annually and in other specific situations.

First let’s make sure that we’re clear on the types of accounts that we’re talking about. If your investment portfolio only consists of tax-advantaged accounts (401K, pension or any IRA) you can safely ignore cost basis. In such accounts your tax liability is governed by Federal and State tax rules and not impacted by the cost basis rules discussed here. If, on the other hand, you have a taxable account (a trust, individual, or transfer on death (TOD)), every year your personal tax liability will be dependent on what is in that account and how it is managed.

Just about everyone knows that gain from the sales of a security is taxed (short-term rates if held less than 12 months and long-term rates if held longer). This taxable gain, as you can imagine, is the difference between the sale price and the cost basis. It is to our tax advantage to keep this difference low but it is a better investment when it grows far higher than the basis.

What you may not realize is that without buying/selling you may still incur 1099 dividend and capital gain distributions that are taxable. These are distributions that flow to the shareholders from funds when they earn and “realize” gain. For high earners these distributions can add an unreasonable annual tax burden because the current tax code not only taxes the gain but adds the gain to inflate the Adjusted Gross Income (AGI). After all, it is the level of the AGI that will determine the phase out deductions and if higher taxes apply. If possible high earners need to reduce funds that yield large distributions from their taxable portfolio.

Up until 2012 we were each responsible for tracking cost basis on our taxable accounts and reporting cost basis and gains for our investments. If you have no actual evidence of the cost basis then your basis is considered to be zero – maximizing your gain and therefore your taxes. Not something any tax payer would want. In 2012 funds were required to report basis relieving us of this task by creating what are known as “covered shares” (those purchased after 2012 and for which the brokerage firm has records) and non-covered shares (those for which the brokerage firm has no record or were purchased prior to 2012). We help you track, recreate and manage cost basis for portfolios under our management.

If you were diligent enough to read this far, I want to alert you to one very important role of cost basis. On the death of the original owner of a security current rules allow for the basis to be elevated to the market value on the day of death. This is called a step-up in basis. Why is this important? If those securities have appreciated in value, the advantage is substantial. The gain in the securities is wiped out so that inherited assets are received at current value without paying capital gain tax. This process of step-up must follow required steps and careful monitoring of cost basis information.

When managing a portfolio whose goal is to be inherited there is little advantage to reducing any gains to the portfolio, particularly if the current owner already is subject to high taxes. The opposite might be true if the owner has low taxable earnings and is still young since they would benefit from keeping the gain of the portfolio low and therefore available for near term purchases (with minimal tax implications in any one year).

Considering the effort in managing cost basis, why do I consider a taxable account essential to your portfolio? A taxable account has at least two practical advantages that other types of accounts can’t provide. One is that it is available for short-term goals (for withdrawals prior to age 59½). The other is that in a retirement portfolio it often provides a means to reduce taxes during retirement. For example, most retirees have social security and tax deferred accounts to fund retirement. Withdrawals from such tax-deferred accounts are treated as having a zero cost basis and taxed as regular income. Whereas assets withdrawn from a taxable account with the cost basis carefully managed should see a lower tax liability. A taxable account is a key part in planning how the portfolio will support your needs.

The real lesson here is that growth in a taxable account is a double edge sword. To avoid paying unnecessary taxes and take full advantage of the account, it needs to be managed and, moreover, requires that you provide your advisor with updates on your past taxes and current year tax plan. The key is to choose the right investments and to manage the cost basis based on your specific goals and tax situation.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Fostering Financial Peace of Mind

According to a study (conducted by the Research Intelligence Group) we struggle with regret over financial decisions, argue over spending, feel pressure to keep up with friends or colleagues, and bend the truth to friends and family about our financial situation in order to save face. In many cases, the primary response of stress is denial. Unfortunately, putting off these financial conversations can affect mental and physical well-being and the quality of our lives. The longer we stay silent about challenging financial situations, the bigger the problem is likely to become. Often this leads to regret for not having created a financial plan (and good financial habits) early in our lives – but is it ever too late?

Without a financial plan in place it is difficult to know if you’re making the most of the resources you have. It is also difficult to establish financial habits that will support you regardless of what life throws your way. Moreover, it is difficult to annually monitor and adjust the various competing demands for your finances in a way that allows you to sleep well at night.

According to many studies women are significantly more likely than men to lose sleep over financial worries. Fifty percent of women admit losing sleep over financial worries and forty percent of men. It is these issues that bring out some of the differences in how women handle financial adversity. For women, financial planning is inclusive, focused on building and maintaining the family, community and even beyond, well into the future. For men (on average) it seems that the focus is less on the relationship and more on the short-term transaction. According to financial author Kelley Keehn, in the face of considerable stress, men release higher doses of adrenaline, activating a “flight or flight” response, while women produce higher levels of oxytocin, activating a “tend and befriend” response.

Keeping in mind how we tend to react to financial stress, a clear well-defined financial path and a trusted financial professional with whom you can maintain a sincere collaborative and communicative relationship can go a long way toward building confidence, and hence, peace of mind.

Here are a few things you can do to ensure that you’re not the one losing sleep over finances:

  1. Do your due diligence. Demand that those giving you advice have your best interest at heart and have the qualifications and experience to provide this advice (especially if you have very specific needs). Moreover, find out if your advisor has any real or potential conflicts of interest.
  2. Understand what fees you pay and what value they add to your ongoing and future financial needs.
  3. Be prepared when you meet with your advisor. Do your part, keeping track of your finances and letting your advisor know in advance of your meeting of any items that you would like clarified as part of the agenda.
  4. Get to know your financial and personal goals intimately and be sure that they are reflected in all your financial decisions.
  5. Seek opportunities to enhance your financial education. Keeping abreast of valuable (not hyped) financial news. Stay away from pundits and financial hype.
  6. Include your partner and your adviser in your process. Don’t try to “go it alone.”

At Aikapa, we choose our clients carefully to be sure that we have the greatest chance to add value to their financial lives and their portfolio. Our clients tend to be high achieving professionals/business owners with an interest in building solid financial habits that will lead them to a life they will enjoy.

Sleeping well is essential to good solid decisions and enjoying life. If you find yourself losing sleep over your finances or getting overly anxious, give us a call or drop us an email. It is our mission to educate and help you build a stress reduced financial life while maximizing your wealth. Let’s continue to remain in touch and let us know if we can help you with any financial issue.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Empowering yourself through financial education

After six years of annual editions, we have decided to retire the Aikapa Financial Planning Calendar. Once this decision was made, it became clear that I needed to find some new way to address financial education since it is a fundamental aspect of our (AIKAPA’s) mission.

But what was it to be?

I explored tools that help build healthier financial habits. I listened to several clients describe how difficult it is to evaluate media stories about the market and investments. This led me to recognize that the financial media and the internet tend to hype products and encourage quick (‘easy’) financial decisions without providing any fundamentals. What was needed, I realized, was a tool to help you educate yourself and build your confidence regarding investments.

In the coming week I’ll be sending our clients a well written book that I feel best describes the fundamental behavior and considerations of a successful long term investor (let me know if you wish me to send it to a different address). To encourage you to read the book and truly absorb the most important principles of investing I’ve taken the liberty of personalizing it–tabbing and annotating the sections that I think will be of most value.

Whether you choose to read the entire book or just the highlighted sections, it is my hope that you will understand why your portfolio is made up of low cost, quality investment funds, why they are diversified, and why we don’t buy the latest gimmick or sell only based on a poor annual performance. I think you will see that the role of a long term investor is to preserve purchasing power while holding on to a margin of safety so that we can build our wealth. Each component in your portfolio has a role. If we want to change them we can, but never as an emotional response (or as the book states – never in response to the bipolar reactions of “Mr Market”). If you do buy and sell based on Mr Market’s reaction then you’ve entered in the realm of speculation.

As markets go up and down there will be times when a diversified portfolio will not perform as well as those focused in one sector. Unlike a single sector portfolio, it is a diversified portfolio that provides a long term margin of safety while allowing for growth opportunities. If you fully understand where you are going and how your portfolio will get you there then you’ll embrace market gyrations.

I hope this book and future discussions will help you filter out the investment media and help you better understand your own portfolio.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Uncloaking Investment Sales Pitches – Dig beyond the pitch

Two weeks ago a client brought promotional material from a stock-picking service and asked if it was “too good to be true”. In October we had a client bring in a booklet titled “Banned in America” providing an opportunity to obtain a “Death of Cash Survival Kit”. These types of sales pitches, along with the advertising practices of some firms, increase anxiety and misunderstanding, contributing little if anything to consumer education. I thought I’d share some of the sales tactics we’ve encountered this year.

Example 1: The Stock Picking Service

Consider this claim “84% of our stock picks are winners … gained more than 300% in less than eight years’ time … An investment of $100,000 in our portfolio recommendations would be worth $389,414 today. In comparison, the same investment in the S&P 500 index would be worth only $149,970 … outperformed the S&P by 165%”.

Sounds fabulous, doesn’t it?! So, what’s wrong? There is no portfolio. There are only stock picks at the beginning of the 8 year period and no indication of how you would buy the next picks. Since there is no portfolio, they don’t address buy/sell timing, costs, or performance. Usually they have a large number of purchases (beyond the $100K) that must be made before there is a sell order. If you sold any of the original stocks (to make the recommended buys) you would not have the gains quoted. What about the recommendations that didn’t perform? Any picks that do not work may disappear in future reports. In some cases, they might even be “pump and dump” schemes to raise the price of particular stocks before the owners sell them.

But how can they be allowed to make these claims? Most of these offerings are made through “educational subscriptions” that fall short of the definition of investment advice. In fact, they are not required or accountable to any investment regulatory agency.

Example 2: Selection of “hand-picked” Managers

This year we had a new experience with a prospective client who compared our real portfolio performance with a portfolio of investment managers selected specifically for them by another advisory firm. I found it difficult to explain (without appearing self-serving) that the portfolio of ‘hand-picked’ managers with an impressive portfolio return (well above all averages) was a new creation not a proven selection. There was no evidence to indicate that the advisory firm had any talent for selecting managers in the past or that this outstanding performance was not the result of survivorship bias (that is, ignoring under performers and only reporting returns for well performing advisors).

Sometimes it can be difficult to understand or explain the problem of survivorship bias in a ‘hand-picked’ portfolio. At Aikapa, all positions in our portfolio are publicly reported and there is no survivorship bias.

Example 3: Modeled Mutual Fund Portfolio

Some large investment firms love to create model portfolios that have little relevance to a client’s actual (real) portfolio. By model portfolios we mean portfolios in which the securities aren’t specifically identified. Since the securities included in the portfolio are unidentified, there is no way for an independent evaluator to verify if the calculated return provided by the model has any relevance to attainable returns or past history. There is the potential in model portfolios for survivorship bias (any under performing fund can be eliminated and no one the wiser). In addition, the models do not include front, back and ongoing fees. A model portfolio that doesn’t include real large costs obfuscates the performance that the client can expect from their portfolio now and in retirement.

Example 4: Cumulative Return

Although cumulative return presentations are ubiquitous I have been spared seeing client portfolio reports with only cumulative returns – until this year. Cumulative returns are calculated using total earnings without regard for time. Cumulative returns (on their own) are intrinsically deceptive. For example, a 20% return is a good return over two years but a dismal return over 20. If two cumulative returns start at different times then the returns can’t be compared. It is much more useful to report rolling annualized compounded returns for each year than to show only the cumulative return.

Example 5: Purchase of illiquid assets as core investments

Many investment advertisements show private real estate investments as an excellent way for a small investor to quickly grow their entire retirement asset. The presentations illustrate the very high upside potential but often fail to point out the significant change in liquidity and risks compared to a publicly traded diversified portfolio. Unfortunately, several of our new clients experienced the real impact of the downside when the market took a downturn and their real estate projects couldn’t obtain necessary financing. It is during such a crises that a client learns the real meaning of downside risk and how lack of liquidity prevents them from recovering any of their investment. In addition, these sales pitches often forget to outline the increased costs and administration associated with managing such investments.

In short, a sales pitch should never be the sole basis for evaluating how to invest your hard earned money particularly assets already earmarked for your retirement. Do your homework and explore the strategies behind the sales pitches. In all investment decisions let your goals (not the sales pitch) define your target return.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Role of Bonds in a Portfolio – Bonds and a rising interest rate

In an age when data can be churned out for hungry consumers in the blink of an eye (in fact, much faster than it can be studied and the underlying meaning accurately assessed) there is never a shortage of pundits ready to point the way to a new and better ways to invest. With all that hype, it is understandable how you might sometimes feel like abandoning your current investment plan for on recommended by the latest ‘experts’.

In the last quarter of 2013, the bond gurus accepted that it was time to exit bonds and to move to equity assets. The evidence was clear that bonds were ready to collapse since rising interest rate and the end of QE3 would not support bond investments in early 2014.

What actually came to pass was quite different. The first quarter of 2014 was one of the best for US bonds, much better than most equity asset classes. In addition, this last month when all asset classes swooned for about 3-4 weeks, the bond assets of your portfolio remained unchanged or grew. But when have bonds been useful in a real portfolio? I want to draw your attention to the role that bonds played in these specific years between 1997 and 2013: Below, I’ve selected years when large company equity (in developed markets) was down while bonds were up. Note that in each of these year it is the bonds that help a well-diversified portfolio retain its value.

The applicable percentage for US Large Cap, then Non-US Large Cap, then US Bonds, then Global Bonds follow after each listed year from 2000 to 2011:

2000 -9% -14% 11% 9%

2001 -12% -21% 8% 6%

2002 -22% -15% 8% 11%

2007 5% 12% 7% 7%

2008 -37% -41% 5% 1%

2011 2% -12% 8% 9%

This is an example of how bonds play an important role in a diversified portfolio. It is also a reminder of the value that rebalancing plays between asset classes.

In summary, we must not forget the importance of bonds as diversifiers of equity risk in a balanced portfolio, even during low-interest rate periods.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

SEC charges former CalPers CEO in Agent Fee Scheme

SEC Charges Former CalPERS CEO and Friend With Falsifying Letters in $20 Million Placement Agent Fee Scheme

According to http://www.sec.gov/news/press/2012/2012-73.htm website Buenrostro (former CalPers CEO) directed placement agent fees to Villalobos through falsification of documents with CalPers logo.  The placement fees paid were at least $20 million dollars.

The letter was a new requirement by this fund company for fees paid to placement agents that assisted in raising funds.

There seems to be no end of leading executives who continue to cross ethical lines to enrich themselves and their friends.  Kudos to the SEC for identifying this action and hopefully, if found guilty, will apply a sufficient deterrence to discourage others from crossing over this very clear ethical line.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Introduction to the hazards of nontraded REITs as a real estate proxy

Nontraded REIT (real estate investment trusts (REITs))

Nontraded real estate investment trust are having difficulty based primarily on debt load and poor occupancy. A sharp decline in tenant occupancy has hammered this REIT: Tenant occupancy of the REIT’s retail properties was 69% at the end of last year, compared with 92% at the end of 2008. Investors in this Cornerstone Core Properties REIT Inc. were told this month by the company that the shares, once valued at $8, are now worth $2.25 – plunging nearly 72%.

The Cornerstone REIT raised only $172.7 million between 2006 and 2009, making it a relatively small player in a marketplace in which the largest players have raised and deployed billions of dollars. Still, other nontraded REITs or real estate funds sold by REIT sponsors recently have seen dramatic declines in value, eating away at investors’ portfolios and making life difficult for the brokers who sold the products.

Another example at the end of December, when investors in the Behringer Harvard Short-Term Opportunity Fund I LP, which had about $130 million in total assets, saw its valuation drop to 40 cents a share, down drastically from $6.48 a share Dec. 31, 2010. And the Behringer Harvard Opportunity REIT I Inc. saw its estimated value decline to $4.12 a share at the end of last year, from $7.66 a year earlier.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

Wealth with meaning – Keys to building wealth

A healthy work ethic is necessary to becoming wealthy, managing cash flow and savings are at the core of this strategy. But it is an ability to change and adapt that are key to staying wealthy, according to a recent survey by wealth management firm SEI (1).

An overwhelming majority (80%) of wealthy families say hard work was either the most important quality or a very important quality in their achieving financial success. SEI’s report was based on a survey of 100 families with more than $20 million in assets.

An even larger percentage (95%) agreed that innovation—an ability to adapt to changing conditions and reinvent business or financial strategies—is important to staying wealthy from one generation to the next. The results clearly suggest that innovation is important to sustaining wealth over the long-term, but survey respondents were divided on where they expect innovation to come from.

Professional advisors were credited with being the most likely source of innovation by 41%, while 37% say innovation will come from those in business. Thirty-six percent

“Wealthy families are craving new ways of communicating and collaborating with their advisors and new strategies for building and sustaining wealth,” said Michael Farrell, managing director for SEI private wealth management. “After everything that has gone on in recent years, they understand that sometimes it takes a different approach to be successful.”

The most innovation has been in investment products, according to 11% of respondents. However, investment advice was named as the area of wealth management that has seen the least innovation by 14% of respondents, followed by reporting (12%) and education and family communications (11%).

Advice is being tailored to individuals and individual situations rather than being based on just a simple number calculation, and investments are being designed to meet specific lifestyle, retirement and charitable giving objectives. Also, reporting is becoming all-inclusive, including all investments, progress toward goals and any overlap that might exist between portfolios managed by different investment managers.

This is nothing new to a comprehensive, fiduciary wealth practice like Aikapa – this is what we believe in.  Our role is to align our clients with their goal so that they can build and retain wealth that they need for their specific goals.  Total wealth is not as important as sufficient wealth to meet their specific goals.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

How insiders can legally profit from insider information

 Insight on how company insiders can still profit from insider information

Despite efforts by the Senate and president to reduce profiting from inside information there remain loopholds for corporate insiders that may be useful to those who are observant. Corporate insiders whose companies are about to be bought by rivals are forbidden from buying shares ahead of time to profit from the price jumps that takeover announcements often bring. But they accumulate plenty of shares just the same.
That’s because company managers are often paid partly in stock. Many sell these shares at regular intervals, whether to use the cash for other purposes or to keep their personal assets from becoming too concentrated in a single stock.
For this reason, managers who decline to buy their companies’ shares ahead of takeovers may nonetheless accumulate them if they also halt their typical selling.

Anup Agrawal of the University of Alabama and Tareque Nasser of Kansas State University studied 3,700 takeovers announced between 1988 and 2006. They compared trading in the year before takeover announcements (the “informed period”) with the year before that (the “control period”).  They found that insiders tended to reduce their buying during the informed period, but they reduced their selling even more. The result was an increase in net buying. Over the six months prior to deal announcements, the dollar amount of net purchases for officers and directors at target firms rose 50% relative to ordinary net purchase levels.

This “passive insider trading,” as the authors call it, is legal. But it is profitable? Agrawal and Nasser didn’t look at returns, but a study published a year ago in the Journal of Multinational Financial Management offers clues. Researchers from Australia’s Commonwealth Bank and Deakin University looked at U.S. takeovers between 2001 and 2006. They found that shares of target firms tended to outperform by nearly seven percentage points during the 50 trading days preceding deal announcements.

Nothing illegal in these situation just good old fashion financial planning can yield a net gain if properly structured.

*Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

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*Inspired by “An Insider Trading Loophole Congress Didn’t Close” by Jack Hough | SmartMoney | March 23, 2012

ETNs (as ETFs) are they a good idea in your portfolio?

ETNs (as ETFs) are they a good idea in your portfolio?

Unlike an exchange-traded fund (ETF), an ETN (exchange-traded note) is your uncollateralized loan to investment banks. The banks promise exposure to an index’s return, minus fees. The draw is that, many (but not all) ETNs are taxed like stocks, regardless of the ETN’s true exposure not as ordinary income. These benefits could be a godsend for a hard-to-implement, tax-unfriendly strategy. You might think that you can have your cake and eat it, too.  Did we learn nothing from the bail out?

In fact, ETNs are dangerous tools in the hands of ‘professionals’ and a disaster for the unsuspecting public. They are one of the easiest ways individual investors and advisors unwittingly enter into contract relationships with vastly more sophisticated investment banks. It is hard to believe that in the midst of ‘financial regulation’ that ETNs (unlike mutual funds and most exchange-traded funds) are not registered under the Investment Company Act of 1940, or the ’40 Act, which obliges funds to have a board of directors with fiduciary responsibility and to standardize their disclosures. ETNs, on the other hand, are weakly standardized contracts. Where an ETN investor should fear what s/he doesn’t know, s/he instead is gulled into thinking s/he understands the risks and costs s/he bears.  If you can’t get yourself to read the prospectus carefully and analyse the fee structure caveat emptor.

The ETN is a fantastic deal for banks. An ETN can’t help but be fabulously profitable to its issuer. Why? They’re dirt-cheap to run. They’re an extremely cheap source of funding. More important, this funding becomes more valuable the bleaker an investment bank’s health – they can have their cake and eat it too! Finally, investors pay hefty fees for the privilege of offering this benefit. Believe it or not this isn’t enough for some issuers. They’ve inserted egregious features in the terms of many ETNs. The worst appear to insert a fee calculation that shifts even more risk to the investor, earning banks fatter margins when their ETNs suddenly drop in value (examples include DJP and GSP but there are many more).

The above fees scratch the surface. Other examples of investor unfriendliness follow:  UBS’s ETRACS (AAVX and BBVX etc) have a 4% levy on top of the 1.35% fee called event risk hedge cost.  Barclays’ iPath (BCM, etc) add 0.1% fee futures execution cost.  Also an additional 0.5% index calculation fee charged for Credit Suisse’s Liquid Beta (CSLS, CSMA, etc).

When many players in the industry behave in ways that signal they can’t be trusted, it raises questions about all ETNs. What a shame. The best ETNs could be useful tools, fulfilling their promise of tax efficiency and perfect tracking but none of these do.

The ETN product creators have gotten away with such investor-unfriendly behavior by free-riding the goodwill conventional ETFs have created as simple, low-cost, transparent, tax-efficient products. Understandably, many investors have taken for granted that the ETNs’ headline fees are calculated just like expense ratios, that “gotcha” fees are not facts of life. Given how publicly accessible ETNs are I recommend that most stay away from them.

*Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

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*The above is my opinion based on readings and triggered by an excellent article in Seeking Alpha by By Samuel Lee  “Exchange-Traded Notes Are Worse Products Than You Think” March 23, 2012.