Strategies For Uncertain Times: Municipal bond update

The two major muni bond closed end fund (CEF) companies are Blackrock and Nuveen. I’ve written previously about my preference for insured-only investments because it reduces default risk and raises the certainty of your returns. My previous post about munis is here: https://knowledgecapitalist.wordpress.com/2009/12/15/strategies-for-uncertain-times-municipal-bonds-munis/

Here’s the link to the Blackrock funds list (munis listed and sortable by state so you can find the one that applies to your location).

http://www1.blackrock.com/Default.aspx?cmty=ind&m=ind_2&m1=ind_2_1&lo=9&appname=wsod_perf&appurl=http://www.blackrock.wallst.com/public/performanceCenter.asp?fundSwitch=CE

Here’s the link to the Nuveen funds list (munis listed and sortable by state so you can find the one that applies to your location).

http://www.nuveen.com/CEF/DailyPricing.aspx

Taxable vs. tax-free accounts: where do you hold your investments?

First, let’s just assume that you have two investment accounts: a personal investment account and a tax-advantaged (tax free) IRA

Hold in a taxable account:

Commodity funds: If they invest in the actual commodities they won’t pay significant distributions/dividends like natural resource / commodity funds that buy equities of companies whose operations are based on the actual commodities. Since there are low distributions, and presumably you’re holding commodities as a core investment holding for asset allocation purposes and as a hedge against inflation, you probably plan on keeping your commodity holdings for longer than one year. If so, that means your sales will be classified as long-term capital gains, so the tax hit is only about 15%

Biotechnology funds: Biotech companies have little or no dividends, in general, so there’s little to no current income. Assuming again that this is a long-term holding, you probably hold it for over a year, which again means the long-term capital gains tax hit is only about 15%.

Covered call funds: Since covered call funds have long-equity exposure, I prefer to hold them in my taxable account because, should they decline, I can take tax losses against other long-equity positions b/c that’s where I hold single stock and other equity positions (like emerging market equity ETFs). I try to hold all my long-equity positions over one year to get long-term capital gains tax treatment, but if you’re a short-term trader then you should probably do so in your tax-free account to avoid the higher short-term tax impact. Keep in mind that you can’t take tax losses on your investments in a tax free account, so if you do lose money you can’t sell your losers to offset taxes on your winners.

Long/short equity funds: I hold them in either my taxable or tax free accounts, but at the moment I prefer to hold them in my taxable account because they don’t really distribute investment gains or dividends with frequency or meaningful size. If you have a long/short equity fund in your tax free account, and the tax free account allows you to sell after time without realizing any capital gains taxes at all, then it makes sense to keep it there if you’re willing to hold on for a long time horizon.

Private equity ETFs: They distribute some dividends, depending on the holdings of the ETF (some PE firms that are listed pay dividends and some don’t). I personally look at the PE sector as a unique investment at the moment because of their unusual volatility over the last two years or so, so I don’t think I’ll sit on my private equity ETF holdings indefinitely, so I keep it in my taxable account.

Buyback / repurchase ETFs: Companies that have large repurchases have opted to allocate their capital towards returning it to investors and doing so via buyback and not dividend, hence the dividend income is pretty small. As a result, it’s basically a capital appreciation investment, and since I hold that type of investment longer than a year to qualify for long-term capital gains tax rates, I keep it in my taxable account.

MUNICIPAL BONDS / MUNI BOND FUNDS: THESE SHOULD ALWAYS BE HELD IN YOUR TAXABLE ACCOUNT BECAUSE YOU DON’T PAY TAXES ON THEM ALREADY. That’s the point of holding munis, so there’s little logic in holding a tax free investment in a tax free account, because it’s redundant.

Hold in a tax-free account:

Real estate funds: Most real estate funds generate significant current income via dividends, and REIT dividends actually do NOT qualify for the lower qualified dividend tax rate. Additionally, most real estate funds have high turnover (though not all do) so you avoid their short-term capital gains exposure by holding it in a tax-free account.

Emerging market debt: They pay out non-qualified interest income frequently and a good portion of their capital gains tend to be short-term, so I hold them in my tax free account.

Merger arbitrage funds: They have VERY high turnover because most deals get closed in less than a year, so they have significant short term capital gains issues, hence I hold it in a tax free account.

Closed end fund (CEF) fund of funds (FoF) CEF FoF: They pay out a ton of distributions that usually do not qualify for lower dividend tax rates.

Currency funds: Their distributions need to be shielded from taxes, but not all pay significant or frequent distributions, so you need to look at the history of the actual funds themselves before you decide.

Floating-rate /variable rate debt funds: The vast majority of them invest in senior bank loans that are not tax exempt, so you try to shield the taxable income by keeping them in a tax free account.

Strategies For Uncertain Times: Municipal Bonds (Munis)

Overview: I list this separately from “debt” because I view munis as a tax-avoidance strategy, and also because unique characteristics about the munis I look at like pre-refunded status and insurance mean they have different risks than other types of fixed income. Additionally, because I only look at New York muni bond closed end funds (CEFs) trading at a discount that are both insured and New York City tax-exempt, the long-CEF strategy is effectively a strategy by itself. The best way to pick muni CEFs based on  your location is to find them on CEFConnect and then go to the actual fund manager websites for additional detail and the most recent data.

Municipal Bonds

Overview: Generate tax free current income (federal and state if you buy a fund for your state, and potentially no city taxes either). Risk from material state-level fiscal problems across the nation. Some muni funds invest in insured securities, some don’t. Hold in a taxable account b/c income is already tax-free. Almost always makes sense to buy muni bond CEFs at a discount.

• Open-end mutual funds: THERE ARE LOTS OF THEM, BUY CEFs INSTEAD
• CEFs: THERE ARE LOTS OF THEM, ONLY BUY AT DISCOUNT
  • MYN: BlackRock Muni NY Insured
  • NNF: Nuveen NYC Insured
  • MHN: BlackRock Muni NYC Insured
• ETFs:
  • PZT: PowerShares Insured New York Municipal Bond
  • INY: SPDR Barclays Capital New York Municipal Bond

Strategies For Uncertain Times: THE OVERVIEW

I believe that tremendous uncertainty supports the adoption of hedge fund replication strategies.

At the end of 2008 I felt very certain that, given the oversold levels of various equity markets around the world, a basket of China, India, and LatAm (Brazil) were extremely likely to experience very solid price appreciation. Multiples for their respective indexes were lower than they were in the US (which is rare) and I knew that emerging market economies will precede the US coming out of the trough of the macro cycle. Additionally, their macroeconomic situations were comparatively healthy versus the US. In retrospect, it was a no-brainer and a huge winner. I nearly bottom-ticked those equity markets and ended up doing extremely well on a percentage/relative basis as their TTM performance has been stellar.

This year I have the entirely opposite mindset: I have ZERO idea what will happen to equities over the next two years and I think anyone who says they do is selling a theory that they can’t realistically support as actually PROBABLE. Hence, I’ve put together a list of strategies/asset classes that, in aggregate, satisfy my desire to make money over the next year or two. Some ideas are targeted at generating current income, some ideas are targeted at capturing potential equity market appreciation, and some ideas are just uncorrelated strategies or asset classes that offer non-equity means of potentially increasing in value (income plus price appreciation).

Some people refer to compiling these strategies and/or adding non-equity  asset classes  as “hedge fund replication” whereas I just call it considering your alternatives (zing). I believe that, while unlikely to repeat the huge outperformance of my portfolio this over past 12 months, this strategy should produce sold tax-managed returns with favorable volatility over the next one to two years. This is really just a study I prepared for myself (AKA The Dan-Don’t-Be-Broke-Portfolio), but you might find some interesting info for yourself.

There is a considerable amount of disagreement about the definition of the term “hedge fund replication” but, to me at least, it means any combination of three things: 1) not being exclusively long equities (long only), 2) maintaining short exposure as a hedge against bearish moves in equities or the economy overall, and 3) looking at various asset classes and strategies that seek to generate uncorrelated or low-correlation returns with equities.

Clearly 2008 demonstrated that many “hedge funds” were not appropriately hedged, if at all. If the S&P was down 30%+ in 2008 and hedge fund XYZ was down roughly the same amount, then they did not come close to producing returns for their investors that were either 1) positive on an absolute basis (greater value at end-of-period than at beginning-of-period), or 2) positive on a relative basis (lost less value on a percentage basis than the S&P, which is admirable but still fails to increase investor wealth), and 3) most likely generated a return that was highly correlated with the performance of the S&P, which is not acceptable given that investors pay high fees to hedge funds in the expectation that they do NOT produce results similar to what the overall equity market does.

This list is not inherently “fully hedged” or “market neutral” but the list (when aggregated as a portfolio) has a correlation with the S&P of less than 1.0 and potentially has the ability to increase in value even if the S&P falls.  Obviously, my allocation to each of these strategies will vary greatly depending on changes in value, and I might not even currently employ any one of them at all.

Non equity asset classes:

-Commodities

-Debt (emerging market)

-Debt (floating or variable corporate)

-Muni bonds

-Closed end fund (CEFs) arbitrage

-Private equity and/or venture capital (PE and VC)

-Currencies

-Convertible bond arbitrage

Equity-based strategies:

-Merger arbitrage and special situations

-Closed end fund Fund-of-Funds (CEF FoF)

-Biotechnology

-Stock buyback funds

Covered call funds (buy-write strategy)

Real estate (US and/or international)

Long/short equity (partially hedged or market neutral equity)

Managed futures (this can mean several things)

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I have prepared my own investment guide that spans all of these strategies. You can download it by clicking here.

Strategies For Uncertain Times

I prepared it awhile back, so it may not reflect current market conditions, valuations, or discounts. It is based on my own financial situation, goals and objectives, risk profile, and tax considerations. My picks/selections are bolded, there may be two per strategy/asset class. In many cases I prefer closed-end mutual funds (CEFs) b/c they trade on an exchange like stocks, and frequently trade at discounts to their “net assets” per-share, which occasionally creates a built-in margin of safety. I will continue to hold a good portion of emerging market equities, which I trade in and out of depending on valuation on price changes. I hold HAO for China, GML for Latin America, RSX for Russia, and EPI for India. I just typed up my handwritten notes, so there are plenty of abbreviations, typos, and short-hand notes. The format isn’t meant to be anything more than acceptable, so just call me if you have a question about what something means or what I’m thinking.