Part 1: The Long and Short on Tax-Aware, Long-Short (TALS) Investing

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The Hosts:

Kevin Kroskey, CFP®, MBA – About – Contact

Tyler Emrick, CFA®, CFP® – About – Contact

Episode Transcript:

Walter Storholt:

It is another episode of Retire Smarter. Walter Storholt with you once again, but Tyler is on break today. Ladies and gentlemen, we have the great wealth advisor, Certified Financial Planner, Kevin Kroskey, the OG, as the kids say. Kevin, the original host of the show and certainly still present in many different ways here on the program, but welcome back my friend. It’s great to talk to you. It’s been few months since your last appearance, I believe.

Kevin Kroskey:

It has been. It’s been quite a while, and I’m happy to be back and happy to be talking to you and our listeners today. I definitely don’t know about OG or the original gangster, maybe, OH, for Ohio and for the original host.

Walter Storholt:

I like that. I like that better. That’s more age-appropriate, probably the Oh, the original host. Has life been well the last few months? Give us a quick catch up before we dive into today’s topic.

Kevin Kroskey:

Yeah, absolutely. The Krosky family are doing great. I have two girls. My girls are in first and fifth grade and completely objectively me saying this, but they’re absolutely wonderful and little darlings do no wrong. Say that with a little bit of… Sorry, [inaudible 00:01:19].

Walter Storholt:

A little bit of a smile creeping in there.

Kevin Kroskey:

But yeah, no, the Kroskey family is great and business has been good too. It’s candidly part of the reason why I haven’t been on that much over the last few months. True Wealth continues to grow and be able to help and serve more families. And we’ve also had the growing tax and accounting division and we have another, I guess, growth announcement that I wasn’t thinking of the share, but now that you mention it, we’ll be adding about another five people to our team here by the end of the year, and they’ll be all in our tax and accounting division, bringing it up to 10 people. And we’ll also be adding another location, kind of brick-and-mortar location in the Canton Ohio area. So continue spread out throughout Northeast, Ohio in Western, PA from our brick-and-mortar locations. Also, still have offices down in Southwest, Florida, but of course we serve clients all around the country.

Walter Storholt:

That’s wonderful to hear. Congrats to adding some new team members and bringing more families into the fold at True Wealth Design. So that is really cool to hear that update and progress for you personally and the company. So thanks for sharing a little bit of that with us. Shall we turn the page to financial matters at hand today?

Kevin Kroskey:

Yeah, absolutely. And one reason why I wanted to jump on the podcast here was to really talk about some Q4 things that are pretty typical for us at True Wealth, even before we added the tax and accounting division. It’s really been in our nature to make sure that we’re forward-looking in regards to tax matters and planning. It could be a tax-smart distribution plan for somebody entering retirement or just making sure that we’re being strategic about our tax plan even while we’re working. And of course with business owners, there’s often more tax planning to do in terms of whether they’re going to reinvest in the business, benefits that they may go ahead and provide for their employees and for themselves tax strategies that we can use and so forth. So we’ve always done that. But I guess I would say the overarching thing that has struck me to be quite different over the last several years is just a lot of the innovation that’s been out there.

If I look back when I first got into the industry and I remember reading and just kind of being a very beloved fan of Vanguard and the low-cost, well-diversified, more index-typed approach, and I would take it to another level making sure that we’re being very tax-aware. But that’s evolved quite a bit over the last couple of decades and as have the markets, when you think about even just some of the products that are out there, you really move from mutual funds to ETFs by and large. And there’s certainly nothing wrong with mutual funds, in fact, there’s many asset classes that are better owned through mutual fund or other vehicle than an ETF, but an ETF has inherent tax advantages that are pretty attractive. And there was something called the ETF roll about, it was 2018, so five, six years ago at this point that just made some of the strategies that you can do within that ETF wrapper even more robust.

And I would say really taking some investments that traditionally had been in more private spaces, more alternative spaces, and not only making them available to the public, but also bringing the cost down significantly too. All of these have been really positive innovations over time. So it’s one of those things when you’re looking as a practitioner, you kind of have your core of what works and you always have to measure against that before you consider any change. If I’m going ahead and add this ingredient to the portfolio to say what am I going to take out or how does it relate to the other ingredients that I already have in there, what’s the net expected benefit that I’m getting in terms of return enhancement or risk reduction or both, which is kind of the icing on the cake if you can get both of those. So those have been taking quite a bit of my time in leading those efforts for True Wealth.

And also too, I mean, tax strategies and tax laws are always changing. We are getting through an election here and no doubt there’s going to be some changes on the horizon if for no other reason, inaction. Tax laws are going to change come 2026 if no action is taken and tax laws that are currently on the books do sunset. But as part of that too, one of the things we’re going to talk about today is what I’ll call tax-aware long-short investing. That’s a mouthful. I know I don’t have a really snazzy acronym for something like that just yet, Walt, but-

Walter Storholt:

Do you want the egghead alert? Just for old time sake.

Kevin Kroskey:

Let me take a little tangent here. I did listen to the last podcast and you did not give Tyler an egghead alert when he came up with that. I don’t even know. It was like decouple, but he was pronouncing it wrong. He was trying to describe-

Walter Storholt:

Oh yes, the decouple or whatever.

Kevin Kroskey:

Decouple. I was like, “What the heck is going on?” Truthfully, as part of the reason why I backwired too, I just had to call him out on that. [inaudible 00:06:34].

Walter Storholt:

I think I was busy Googling that I forgot to trigger the sounder.

Kevin Kroskey:

It’s certainly not my intent to go ahead and trigger the egghead alert or [inaudible 00:06:45].

Walter Storholt:

Okay, I’ll hold off for now. We’ll see.

Kevin Kroskey:

I don’t want to make this more complex than it needs to be, but candidly, this is quite complex and over the last six months I’ve really been embroiled with it. I’m always the guinea pig for things in the firm and eat my own cooking, so to say. So I usually do for myself and then work out any kinks in the process with clients that also are generally close friends that will give us maybe a little bit more leeway as we make things nice and fine tuned and then we roll it out more broadly to our clients and then also to prospective clients. So that’s really what I’ve been doing.

There’s been a lot of that in the innovation and I’m here to talk about it today. And in part too, the word is starting to get out. So if you do a Google search and Walt, I know you’re a good Googler as you talk, but if you just type in Bloomberg tax-aware long-short, and there was an article that came out less than two weeks ago, and we’ve actually received about five calls resulting from this article for people all over the country that are interested in these strategies. Now was True Wealth named in the article? No. I wish, it would’ve been some nice publicity. Bloomberg’s quite a good outlet for news and investment news specifically, but I’ve been writing about these tax-aware long-short strategies over the last couple months. So the first time I’m talking about it on the podcast and apparently we’re ranking pretty well for them. There’s not a lot of content that’s out there it seems, or at least we’re showing up on some search results for people.

And I would say it’s quite atypical that we would get that number of calls in such a short period of time about some topics such as this. Usually our calls come in from people that have been listening to the podcast for a while that have an inflection point. Maybe they’re getting serious about retirement or we just got an inquiry today from somebody that has an early retirement buyout offer that they have to work through. Usually there’s something in your life that changes and you want to get a second opinion or it’s time to get serious and get some good trustworthy and competent help. And hopefully we consistently demonstrate that on the podcast. But this one was different for sure, and I think it’s definitely got a pizzazz to it. So that’s what we’re going to dive into today, Walt.

Walter Storholt:

Perfect. And it looks like it’s tax-aware with a hyphen in between and then long-short with a hyphen between, so a tax-aware long-short, is that correct?

Kevin Kroskey:

Yeah, or T-A-L-S.

Walter Storholt:

TALS.

Kevin Kroskey:

I don’t love the acronym, but it’s quite a mouthful to say. Maybe I’ll just synthesize it down to just say the strategy. How’s that?

Walter Storholt:

There you go. Ooh, the strategy. I like that. All right, so yeah, I love innovation, love hearing about things that we can be keeping our eye on going forward and the fact that you’ve been able to already kind of get your hands dirty working with this kind of from a personal perspective. So looking forward to your takeaways.

Kevin Kroskey:

So let’s start talking about first who this applies to because these strategies, again, they are more complex and sometimes when you get into more complex investments, there’s certain requirements that the SEC imposes on people whether they can use them or not. And some of that is kind of strange. You have these ETFs that are out there that are like, “Hey, you can get two or three times the return of the NASDAQ index or Tesla stock.” You’re seeing single stock ETFs just loaded up with leverage. It’s like giving somebody a loaded investment gun and they’re pointing at their head and the SEC says, “That’s fine.” But the stuff that I’m talking about today is a little bit different in terms of who can do it. So I’ll broadly say who does it apply to, successful investors. Think about people that maybe have owned stocks for a long time.

And we are talking about really stocks here. I mean, there could be some other, I suppose it could mutual funds too, something that has really increased in value over time and has an unrealized capital gain. And again, just for context here, we have a lot of smart listeners. I’m always impressed by the people that reach out and talk to us from the podcast. I’m sure this is pretty much old [inaudible 00:11:09] for most. But let me just mention one of the key things that we’ll talk about today is just the difference in tax rates. So your ordinary income rate is your highest rate, and then you have these preferential rates for things like long-term capital gains, qualified dividends. So we will talk more about that, but just keep that in mind as we go through here. So you have some highly appreciated asset with unrealized capital gains.

It could be real estate, it could be stocks, could be mutual funds, it could be art, but anything that has those traits, mostly I would think the people that are listening with the applications would be stocks, funds, and then probably real estate, thirdly. So who would have this? Again, you could be a successful investor and you just have owned it for a long term. Or maybe you are an early investor in Nvidia and you predicted the future and that has certainly skyrocketed over the last couple of years. Or perhaps you inherited stocks. We have several clients that inherited stocks from a trust years and years and years ago from their parents and they inherited those stocks from bypass trust or what they would call the family trust and for estate planning that was done, call it back pre-2010, those stocks that went into that bypass trust. Well, it’s still today, but the strategy is just used less frequently with funding the bypass trust.

But if you inherited stocks from a bypass trust, they have carryover basis. So what your folks bought them for is what you inherit as your basis. So in those cases, it does not get a step up at the second death. So we have several clients that have thousand percent gains in holdings because their parents bought them back in the ’80s or the early ’90s or something like that. So those are some things that you would see executives too, if you have stock compensation could be options and incentive stock or you could have some grants or restricted stock that you don’t sell, but hold on for a period of time and the company does well and that results in that unrealized capital gain. So those successful investors, this certainly applies to, and also I will just call it high-income earners.

So here could be business owners, it works particularly well for business owners or it could just be high-income professional, sales professional, doctors, attorneys, what have you. We have a few couples, families that are couples where both are doctors and their earnings or ordinary income earnings are significant and these strategies are being applied for them too. So that’s the who. Now if I get into the SEC part of it, for the definitional aspects, you have to be an accredited investor. So generally you have to have a million dollars in net worth. There are income requirements that you can meet to depending on, and they vary based on whether you’re single or married. You can look into that with a simple search. Or SEC qualified purchasers. Walt, I’m guessing you’ve heard of an accredited investor before, have you heard of a qualified purchaser? Do you know what that is?

Walter Storholt:

No. So I’d heard of the first but not the second.

Kevin Kroskey:

So here’s where you’re getting into some big bucks. So the qualified purchaser is somebody, and there’s different definitions, but generally you have to have $5 million more of investment assets. So here you’re really not looking at net worth or anything. It’s really just investments. And so we have several clients that are over that level, but that’s certainly some pretty rarefied air. But if you’re in that category, there’s a multitude of additional investments including one that we’ll touch on if not today, in the next episode depending on how time goes. But everybody that is an accredited investor, and candidly, even if you’re not a credit investor, part of the strategy that we’re going to talk about today can definitely still apply to you. It’s just going to be done in a different form and the tax benefits that we’ll talk about will be limited. So I guess in thinking about this, it really does apply to everybody because this long-short strategy is out there.

That’s kind of the core of what we’re going to be talking about. But the applications of it, it could be in a mutual fund where it could apply to everybody or it could be for an accredited investor directly applied to their account in an SMA, which we’ll talk about. Or for the qualified purchaser, it could apply there too. And there you’re getting into generally a limited partnership or hedge fund. So kind of setting the table here, but let me just check in for a moment. Hopefully no egghead alerts just yet Walt, but how are we doing so far?

Walter Storholt:

A good amount of acronyms there at the last second, but we’re good. We’re good. You brought back just kind of the memory of The Big Short when the two young guys walk into the office to try and start trading with the big boys and they don’t know the minimum qualifications for the ISDA and there’s something like 1.4.7 billion short of needing the ISDA so they can do the high level trading that they want to do. So that’s like one level above the accredited investor, and then the additional wins that you mentioned. So I guess that would be… They just brought back that memory for me. So [inaudible 00:16:31].

Kevin Kroskey:

Hey, kudos to you for pulling out ISDA agreements. That’s good, Walt. Kudos to you. That actually is going to be part of kind of where we’re going to wrap up. Not talking about those agreements specifically, but that limited partnership that I mentioned, certainly they do have to have those ISDA agreements to execute these strategies that we’re going to talk about. And what’s important to remember here too, again, every investment involves risk. We’re not going to speak about specific investments, we’re just going to talk about some general traits here, but just because they’re more complex, it doesn’t necessarily mean that they’re more risky or riskier. I think both are commonly accepted. So just keep that in mind. I think that’s important.

Walter Storholt:

That’s important though, right? Because there is probably an inherent assumption that if something’s hard to understand, the hard to understand part of it is what feels risky, but it doesn’t necessarily mean that the investment or the thing that you’re trying to do is any more risky. It’s just harder to understand. So it takes a little more work to know the ins and outs.

Kevin Kroskey:

No doubt. And literally I probably have, I don’t know, conservatively 60 hours into this at this point, maybe significantly more than that. Just kind of taking a number off the top of my head, even though I’m bringing to the table a pretty good background experience and knowledge, there’s quite a bit of this that it’s not necessarily new, but the application of it is different. And certainly when you’re going to do something, you want to understand it. So our clients rely on us to make sure that we understand it. And part of the reason why they work with us is even if they have the aptitude, maybe they don’t have the time. And heck, you think about specialization, I mean, a lot of the physicians that we work with, it’s commonplace in their environment like, “Hey, I’m really good at this particular specialty,” or it could be a general practitioner, but I don’t get into this depth, that’s more of a specialist and they refer that out.

Same thing in law, in many cases, you have a generalist or you have a specialist. So I make a joke about my engineers, i got plenty in my family including my sister, but they’re the ones that can figure out everything. They’re smart for sure, but then they can… “I’ll figure it out.” We actually have, from what I’m told, a disproportionate amount of engineers in our client base because I think of our detail orientation. So I’m belovedly joking with you, our engineer clients, and I’m sure your spouses will get the joke if you don’t. So when we think of this [inaudible 00:19:07].

Walter Storholt:

That was a joke layered within the joke, that was really well done.

Kevin Kroskey:

I don’t know, hey, sometimes you swing at the ball and you miss, Walt.

Walter Storholt:

That was good. I even picked up on that little tail end piece of the joke, so that was good.

Kevin Kroskey:

All right, so why would we even consider adding this complexity? Well, we better as heck be getting some expected benefits for it, otherwise just keep it nice and simple. So just for some context and Walt, I know you’ve been getting kind of a pass here with Tyler. He doesn’t ask you the questions that I asked you, put you on the spot.

Walter Storholt:

That’s true.

Kevin Kroskey:

You’re probably lamenting my return right now, Walt.

Walter Storholt:

Like, “Oh man, the pressure’s back on.”

Kevin Kroskey:

All right, so let me ask you, a guess here, how many stocks are listed on the US stock exchanges? How many stocks make up the stock market?

Walter Storholt:

5,000.

Kevin Kroskey:

Okay, what about-

Walter Storholt:

How badly did I miss?

Kevin Kroskey:

Hold on, I’m coming back. So pretty good guess, I’ll say that. Actually, very good guess.

Walter Storholt:

Okay.

Kevin Kroskey:

Have there been any changes in the amount of companies that have been listed over time? Has it increased as companies continue to form or has it decreased or has stayed about the same?

Walter Storholt:

Interesting. I mean, I would imagine after probably initially increasing, I’m going to guess there’s just as many that fail and go away as there are added. So I would say relatively even over time compared to maybe just right at the beginning, obviously with everyone getting in.

Kevin Kroskey:

So excellent guess on the 5,000, it’s actually about 4,000 publicly traded stocks. So to give you some really broad question like that and kudos to you for answering that, I would give that one definitely an A there. And I think your reasoning is sound on the second part, but most I think would be very surprised to hear that if you just look back over the last couple of decades, and the stat that I have is in 1996 there was 8,000 publicly traded stocks in the US and so it’s decreased by half down to 4,000 over that timeframe. But you think about it, Walt, I mean, the economy keeps growing over time, stock market returns have been good, companies keep forming and the net formation is actually more than the losses. So I don’t think that’s a bad guess. There certainly is a lot of companies that do go out of business, but net formation of businesses has been positive.

So do you want to take a gander? Well if those things are true, which they are economies grown, stock market returns have been good, what’s going on here?

Walter Storholt:

I don’t know. Does it have to do with qualifications or does fact that people can… Well let me read the tea leaves. If people can win betting stocks going down in addition to up, does that incentivize maybe stocks to stay on longer than they otherwise would’ve naturally appreciate? I’m looking a little too ahead.

Kevin Kroskey:

I don’t believe so for that, and this will be another podcast episode, I’m actually writing an article on it this week, but there’s really after Sarbanes-Oxley. So if you go all the way back to the early 2000s and you had the tech bubble burst and then you had all these accounting scandals with Enron, WorldCom, you had that famous party with Dennis Kozlowski of Tyco and the Roman theme and he had a golden toilet or shower rod or something and all these loans, there was a lot of crackdown on accounting standards and Sarbanes-Oxley, which are I believe two, I don’t know if they’re both senators, but two Congress people came out with that law and it was really designed to have more transparency and better quality in the accounting records. And also what it did by proxy is go ahead and increase the compliance costs for companies.

Part of that, you had private markets that were growing and as public markets or I would say the number of stocks in the stock market, public markets certainly have kept growing from an overall market capitalization, but the number of companies has gone down. Private markets, so private equity, venture capital, even private debt and a slew of others have increased really in lockstep as those public company listings have decreased. So you can just think about companies like Facebook. When Facebook went public, they were already a very large company. If you think about Uber, Uber was a very large company. If you go back a while ago, Amazon became public and was a small company and had significant growth in the public markets. So there’s a lot of investing ramifications from that. I’m not going to get into it in detail today, but nonetheless, you think of your opportunity set in the public markets and it’s basically decreased by half over almost the last 30 years. So just purely from the number of stocks.

Coincident with that over the last several years, we’ve had a lot more concentration in the stock market and the largest of the companies. So I know you’ve talked about this with Tyler and just some of the concentration that we’ve had with whatever acronym that you want to use, but with the Microsofts, with the NVIDIAs, with the Facebook… With the Facebook, that sounded weird, but you get the idea here. A lot of those big stocks just have a larger percentage of the market cap. And those indices, like the S&P 500 or the NASDAQ and the total U.S market in general are significantly less diversified than they used to be. So whenever you’re building that portfolio, like I said, you really want to have good diversification and you want to have a high expected return for the level of diversification that you have.

So it doesn’t make sense to add more risk if you can’t get some additional enhanced return and you really want to optimize both of them. It’s kind of the modern portfolio theory at its core, hearkening back now 60-so years. So going with this long and short approach, really can enhance and open up that opportunity set because now you can not only go long, 4,000-ish publicly traded stocks, you could also go short 4,000-ish publicly traded stocks. And Walt, just describe what shorting a stock means in plain English.

Walter Storholt:

Shorting a stock in plain English. Let’s see. So that would be when you are betting the stock to go down in value.

Kevin Kroskey:

Yes, you got it. These strategies have been around for a long time, The Big Short, there you go. That wasn’t really shorting stocks but really kind of shorting the mortgage market or certain parts of it I guess I should say. [inaudible 00:26:27].

Walter Storholt:

And you’re also borrowing rather than sort of buying a stock, isn’t that kind of the other difference?

Kevin Kroskey:

You are. And so there’s a cost of borrowing as well. So we will see how much we get into those intricacies today, but there’s a lot to this. My goal is to give a really good high level and start coming down towards the runway, but particularly giving some applications of it, some potential benefits and then certainly we can always talk with our clients or prospective clients that have an interest and see if it makes sense to do it. We’re obviously reaching out proactively to our clients who we think it makes sense to do these sorts of things. So candidly, most of them have already been reached out to. So if we think about shorting, you’re absolutely right. Some people may think un-American, I wouldn’t say that. If you don’t have a market where you can go short, inherently it’s going to be less efficient and you’re going to have more issues in clearing the market and just having it functioning well, it’s really a good thing to have some people that provide those other inputs to prices so they can just inherently function better.

It’s really been around for decades now, I would say more than two decades, probably significantly longer than that, but I guess the strategy itself. Morningstar has a long-short category, it has that’s in there and there’s more than a hundred funds that are in that category today. So it’s been there. It’s typically been thought of probably more relegated to the area of hedge funds. We’ve been doing it longer and with more leverage and with higher costs, but there’s been a lot of innovations over time. You think about just all the technological innovations that we’ve had with computing power and what have you over the last couple decades. Again, there’s always tax law changes. So really some of the things that have made this strategy I think more attractive today is because of those technological advancements, you’re not really doing what most hedge funds did where they would go ahead and maybe go long certain stocks but go short other stocks and the total number of stocks would be fairly limited.

They’d be more so making a stock selection bet, really thinking company X was going to go down or company Y was going to go up and those sorts of things. Definitely more concentrated. What we’re talking about here and what we always believe in is maintaining diversification not only within a certain strategy but also within the greater portfolio. So this is very complex trading that you’re doing here, but I’ll give you an example of some things that you would go long and others that you’ll go short. If you think about it, we want to go long stocks with certain positive attributes, say that they have high profitability, increasing profitability, low debt levels, steady earnings, that all sounds good, a very quality type company. On the other hand, what’s the opposite of quality? Well, you got junk, you have companies…

Walter Storholt:

Put it more bluntly please.

Kevin Kroskey:

It’s actually what the academic literature calls it. I mean, and this is consistent with our investment philosophy through and through. I mean, candidly, this is just another, I would say iteration of it. We’ve always believed in going long stocks with certain positive attributes, but it was generally long only, even though the academic literature is really long-short. Here we’re talking about getting a fuller factor exposure, not only going along the stocks with certain attributes we like, but shorting the ones that we don’t like. And those junkie companies, some of the attributes that they would typically have, again, maybe very volatile earnings, lower profitability, decreasing profitability, higher or increasing debt levels, things like that. And usually when you see a big market decline, you’ll see that those junkie stocks have more of a way to go down than the quality stocks do. So that’s one example.

Another example could be there’s clearly some demonstrable momentum effects in the market. So you have stocks that are trending up, you’ll think of a lot of the technology names more recent, and then you can think of the ones that are maybe have negative momentum, think of catching a falling knife. So if you go along the stocks with positive momentum, say increasing prices over the last three to 12 months for example, and you’re going short the other ones, then you’re kind of getting exposure to that momentum factor or to the quality factor. So there’s plenty more to it than that, but I think those are in fact two core, the strategies within the investing component of this that do tend to add value over time.

And again, that’s very different. You’re doing it with a whole basket of stocks. I can think of some of the strategies that we’re currently using for clients. They may have 2,000 stocks in their portfolio depending on the size of their account with about half of those long and half of those short. So let me pause there, Walt. Making sense so far? Any questions?

Walter Storholt:

Yeah, I’m tracking you. I realize there’s other layers and we’ve got more depth here in terms of how the strings are getting pulled and what’s actually happening, but I get the idea of how we’re taking kind of a finite number of possibilities and by being able to, I don’t know, row in the other direction or let the river flow in either direction, we’re doubling the amount of things we can manipulate and use to our advantage.

Kevin Kroskey:

You got it. Well said. So I want to talk about, say three key building blocks of the strategy and then I will talk about just some applications of it and I can just tell from time right now, this is definitely going to become a two-part series, so we’ll try to wrap this up in about the next seven minutes or so.

Walter Storholt:

I was going to say we haven’t really gotten to the tax-aware part of the tax-aware long-short.

Kevin Kroskey:

You got it. So let me do the three building blocks and then it’ll fall into place and I’ll do the example about who it applies to and some of the tax savings. So again, we’re talking about, and when you think of your core return, well think about it this way, let’s take a step back. So think about your portfolio, just say that you own the S&P 500 in an ETF and so that’s your portfolio. A hundred percent of your money is in that. And so when you think about this long and short, you still own the S&P 500, but now you may add what I would call an overlay to it where you would go say 30% long additional companies and 30% short as well. So your net exposure or your net equity exposure, I’m not trying to get the egghead alert here, but this is what they call equity beta, to use the acronym I might need it just this…

Automated:

One egghead alert. Let’s be honest.

Kevin Kroskey:

You [inaudible 00:33:30] just trigger figure. You’ve just been waiting for that since we started this call Walt, which is fine.

Walter Storholt:

Just looking for the opportunity.

Kevin Kroskey:

My point being is you still own market exposure, you still own the S&P 500 or whatever sort of benchmark or index that we’re targeting. You’re just adding this overlay to it. So when you think of the building block, you just have your equity return. Again, let’s just think of the S&P 500 and then you would have what I’ll call your access return or the expected benefit from going along those quality companies, going along those momentum companies or other companies with attributes that we like and shorting those with opposing attributes and characteristics. So that’s the access return from the overlay strategy. So let’s just use some examples, and these are purely hypothetical. They’re not any sort of, hey, this is a return expectation, but let’s just theoretically say you can expect 8% from the S&P 500 say over the next five years, and then you have this excess return component.

When you net out the costs in the long-short, maybe it’s going to add a half a percent hypothetically. So rather than 8%, maybe we’re increasing the return expectation to eight and a half at the same time that we’re adding diversification, more reliability to the overall strategy because we are now expanding our opportunity set going long and short. So kind of base of the pyramid, equity return. Next level up is the access return for the long and short overlay, I’ll just call it overlay. And then thirdly, the frosting on top or the icing on top is really the tax benefits. And again, you’re not going to get this so much through a mutual fund strategy that is operating the long and short. There’ll be some there, but it’s not going to be as beneficial as if you use something called a separately managed account or SMA.

These have been increasing in popularity over time. We’ve talked about these on the podcast before. We have several clients that have utilized them in their own planning, maybe because they wanted to exclude certain types of stocks for environmental reasons or their social beliefs, things like that. That’s pretty a common area where you see the application of SMAs and you open an account at a Schwab or at Fidelity and basically just appoint an external manager to go ahead and execute the strategy. The costs oftentimes are not too dissimilar from a mutual fund or an ETF, it’s just you’re breaking down the structure.

So one example of this could be take our S&P 500 rather than owning it in an ETF. If you wanted to own the S&P 500 exposure in the SMA, you could go out and buy the S&P 500 stocks and replicate the index. Now why would you want to do that? Yes, it’s more complex, but that’s what people would call a direct indexing approach. And there’s a fundamental thing that’s happening here that’s very important. When you look at the volatility or what I would typically call the Wiggle Factor.

Walter Storholt:

Oh.

Kevin Kroskey:

Do you remember the Wiggle Factor?

Automated:

The Wiggle Factor.

Kevin Kroskey:

You got it. Nice.

Walter Storholt:

I had it queued up just in case.

Kevin Kroskey:

If you look at the S&P 500, the Wiggle Factor, volatility, standard deviation, all the same stuff is about 15 to 20% per year. If you look at an individual stock within the S&P 500, basically double that, I would say for at least those large companies, you’re probably talking 25 to 35% volatility. And if you go outside of large stocks into smaller stocks, you’ll see the volatility increase even more. That volatility when used properly could be your friend. So direct indexing would say like, “Hey, let’s go out and let’s capture the return from the S&P 500, but let’s do it by owning the stocks individually, by taking this direct indexing approach and then using the inherent individual stock volatility to go ahead and realize some losses as we do that.”

It’s actually a good thing to realize losses because you can harvest those and you can offset gains. You can offset ordinary income to a few thousand dollars per year. There’s benefit in that. And direct indexing has been around for quite a while now. Here, we’re taking it a step further. The problem with direct indexing is when you start doing this, guess what? This part isn’t a problem. But stocks tend to go up over time, at least in aggregate they do. We have the S&P 500 performing very well over time, and a lot of those individual stocks, you’re going to exceed the ability to realize losses within a few years. So your direct indexing tax benefits really are nullified after a few years of the strategy. But if you add in the long-short overlay to it, you’re not only going to be able to preserve those tax benefits, you’re going to be to enhance them.

To give you some very broad numbers, suppose that you invest a million dollars into the strategy, you meet the accredited investor definition. Now here you are in indirect indexing and maybe year one, depending if the market’s moving up or down or how volatile it is, but maybe you can realize, say $50,000 in net losses. You get the return of the S&P 500, but because of the individual stock volatility, you’ve realized 50,000 in net losses that you can use to help defray your tax costs elsewhere. Now, if you take that next step and now you use this tax-aware long-short strategy, now you can see those benefits going up, not being say 5%, but maybe being 10%, 20%, depends how you structured and how much leverage that you would utilize on it. But theoretically, that million dollar investment could have the S&P 500 return plus now rather than $50,000 in net losses, maybe a hundred, maybe 200, could be even more than that if the market is declining.

So now again, you’re getting the base level return, you’re getting that second step, that excess return that we think that the positive attribute stocks will yield by going along those and shortening the ones with opposing characteristics. And thirdly, you’re harvesting these net capital losses to go ahead and defray your tax costs each and every year. So it’s really when you build the expected return model, it’s those three components. And when you look at that, it’s a heck of a lot better for many people just compared to owning the S&P 500 outright. I want to wrap it up, but before I go over just the example, I mean, hopefully people are seeing applications of this now. I’ll give you one. And again, there could be multitudes of them.

So we had a business owner client this year and had a very significant capital gain, nearly eight figures, had a very good liquidity event. It was best year ever and probably ever will be for him, very significant capital gains from that business sale. What we did was take a sizable portion of the money that he got with the proceeds and we put it into a strategy like this. And we have been generating not only returns from that base expectation of owning the market, but also we’ve been getting the second level with the additional excess return component and very significant net capital losses. So rather than him having to pay a 20% plus tax rate on the capital gain this year, we’re going to be able to defray a significant portion of it. Now, it’s not going to go away forever, but if we can defer it and we keep our money working for us, that’s a huge positive.

He’s also charitably inclined. So we can go ahead and donate some of these stocks that do appreciate over time and avoid those gains altogether. Or if you hold on to these assets until death, those assets will get stepped up cost basis before they go on to your beneficiaries under current law. So it could potentially go from tax avoidance and tax deferral to tax elimination if done right over the right holding period. That’s probably a pretty extreme example, but candidly, it can work for anybody that has a taxable investment, trust account, joint account, individual account with around a million dollars in investments and they’re going to need to invest this money for a while to realize those benefits. But if you have that and if you have a pool of money where that money is going to stay invested for a while, it is liquid, you can sell these. There’s just stocks when it comes down to it.

But the idea is that deferral benefit is realized over time, even though those net capital losses will start coming through quite quickly. So when you conceptualize this for the client that I mentioned having the significant amount of money that he does, the expected tax benefits are well over six figures in his case. So he is certainly happy as a clam and he’s really the one that has been propelling me to do a lot of this research over the last months, and myself and him were the first applicants, if you will, to go ahead and apply these strategies to people in our firm. And we have several others that are going through the process now. And in part two, there’s some other applications to this. We’re not only can we help with defraying or potentially avoiding and maybe even eliminating the capital gains, but for those high income earners that I mentioned with ordinary income that maybe aren’t business owners or could be business owners, you can actually use the strategy you talked about today with the second part of the strategy to go ahead and offset ordinary income and also realize significant tax savings.

Walter Storholt:

Excellent. Looking forward to diving in deeper on part number two, but what a wealth of information here in part one. You came back to the show just in full force today, Kevin.

Kevin Kroskey:

I had some pent-up, Walt, demand. I did.

Walter Storholt:

I love it.

Kevin Kroskey:

Pent-up podcast demand.

Walter Storholt:

You’re ready to go. I have to tell folks this before we wrap up here, Kevin, and it is that Kevin came on today and said, I don’t feel very prepared, and then he rips out that episode. You seemed pretty prepared to me, my friend. Well done.

Kevin Kroskey:

I appreciate it.

Walter Storholt:

If you’ve got questions, obviously you may have a few because we haven’t covered every detail yet, but if this is intriguing, if this is something you want to find out a little bit more about, if you want to talk to the True Wealth Design team, it’s very easy to do that. Truewealthdesign.com. You can click on the are we write for you button schedule a 15-minute call with an experienced advisor on the team that way. That’s Truewealthdesign.com. We’ve got that linked in the description of today’s show, as well as the phone number. You can still do it the old fashioned way, of course. 855 TWD plan is the number. And again, all that contact info listed in our show description so you can find it easily as well. Ask your questions and see if you’re a good fit to work with the team. You’ve got in-office, hot locations that we talked about in Northeast, Ohio and Western Pennsylvania. And of course you can also meet remotely from wherever you are. Kevin, thanks for the details. Looking forward to having you join us for part two of this conversation and diving in a little deeper

Kevin Kroskey:

Looking forward to it, Walt. Thanks very much.

Walter Storholt:

Take care my friend, and thanks for joining us, everybody. We’ll see you next time right back here on Retire Smarter.

Automated:

Information provided is for informational purposes only and does not constitute investment, tax or legal advice. Information is obtained from sources that are deemed to be reliable, but their accurateness and completeness cannot be guaranteed. All performance references, historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.