Active Versus Passive Investing

There exists a long-running debate regarding whether it is possible for individual investors to outperform the broader stock market consistently over time. On one side are those who believe that there are investors who have an inherent ability to outperform, add "alpha" is the expression, through shrewd stock picking and correct forecasting of future market trends. This camp believes in "active" management.

There is another group, led by academics such as Eugene Fama and Kenneth French, who believe in a "passive" investment approach. They feel that market data extending back to the 1800's shows that active management is not able to consistently outperform over time, especially when the real world costs of taxes and investment fees are considered. The passive camp argues for a "buy and hold" strategy and believes that owning a highly diversified portfolio designed to track the performance of the overall market is the most rational approach and the one that has been shown to outperform active managers even over shorter periods of time.

I am firmly in the camp of passive investing.

Buying into an active manager based on past positive performance is no different than buying high and selling low. The likelihood is that the manager will revert to the mean or even under perform. In reality, your likelihood of identifying a manager BEFORE THE FACT who will outperform the overall market over time is low to nil. And the percentage of managers who outperform over time is no more than what one would expect in a standard distribution of total performance. It is therefore hard to say that these manager's results were the result of inherent skill as opposed to luck.

Even if we assume that there are gifted managers out there like Peter Lynch and Warren Buffett, it is impossible to identify these managers before hand. Peter Lynch could not pick his successor at Magellan Fund to continue his own successful run (remember Jeff Vinik?). What chance does any of us have of doing better?

In my opinion, the matter has been settled. A passive investment strategy is the only one that makes sense and that is consistent with a fiduciary standard. It is the approach that I take with my own investments and adhere to when managing the assets entrusted to me by my clients. This approach also recognizes that the main value that I provide comes from a comprehensive approach to financial planning and a focus on enabling clients to achieve their key life goals. In my opinion, that is the only kind of "alpha" worth pursuing.

Energy Tax Credits and Misleading Ads

You’ve seen the ads for “huge savings” on central air conditioning systems touting a $1,500 federal tax credit.  What these ads are referring to is the expansion of tax credits for heating and air conditioning equipment in The American Recovery and Reinvestment Act of 2009 (ARRA) signed into law on February 16 of this year.  What these same ads do not state, however, is that not all systems qualify for the credit, nor do all taxpayers. 

Only systems that meet certain efficiency ratings are eligible.  Also, the credit itself is actually a credit for 30% of the cost of the installed system up to a maximum of $1,500.  If the system costs less than $5,000, the credit will be less than the $1,500 maximum.  Last but not least, the credit is “non-refundable”, which means that it is capped at the amount a taxpayer actually owes in taxes, reduced by other available credits.   Lower income taxpayers who qualify for the Earned Income and other credits may see their energy credit limited. 
 
Putting aside taxes, it seems dealers are inflating the cost of these systems to $5,000 or more in order to be able to claim that their products qualify for the maximum $1,500 credit.  Overpaying for a product just to qualify for a tax credit which may itself be limited is not smart.  Many dealers seem to be cynically using the tax laws to mislead buyers.  Unless and until greater regulatory scrutiny is placed on these dealers, this is clearly an area where the buyer needs to be aware in order to avoid being ripped off.

IRA to Roth Conversions in 2010

As you probably already know, the tax law is changing in 2010 to remove the current restriction for making traditional IRA to Roth conversions. Currently, individuals with modified adjusted gross incomes in excess of $100,000 cannot do a conversion without incurring a 10% penalty if they are younger than 59 1/2 years old. Additionally, taxes are due in the year of conversion on any pretax savings and accumulated growth. In 2010, the income limitation is being removed allowing anyone to make a Roth conversion without incurring the 10% penalty. Taxes would still be due as before however there will be an option to pay these in equal installments over the two years following the year of conversion.

Already, financial product salespeople are touting the advantages of Roth conversions in anticipation of 2010 by emphasizing the tax advantages Roth IRAs have over traditional IRAs. Unlike withdrawals from traditional IRAs, Roth withdrawals in retirement are tax-free. Another key advantage of the Roth is that there is no requirement to begin taking withdrawals after one reaches the age of 70 and 1/2, as is the case with traditional IRAs. This "required minimum distribution" (RMD) feature of the traditional IRA forces taxpayers to make taxable withdrawals from their accounts regardless of actual income need. Roth IRAs do not require RMDs, thereby allowing the taxpayer the option of leaving assets in the Roth to potentially appreciate over a longer period of time.

Unfortunately, financial product salespeople often do a better job promoting the potential advantages of Roth conversions than they do the more important job of assessing whether a Roth conversion is appropriate for an individual client. The answer is not clear-cut by any means and a careful analysis must be performed to make an informed decision. Factors that must be considered are current and anticipated future income tax brackets, the source of assets available to pay the tax due on the conversion, and projected income needs in retirement. This is not a straightforward analysis. Additionally, there is the element of the unknown with regard to future tax law changes that further complicates matters.

In many cases, the result of a careful analysis will be that a partial conversion is the optimal course of action, both for empirical reasons as well as a hedge against future tax law changes. The ability of a client to pay the taxes due upon conversion may also weigh in favor of the partial conversion strategy.

Clearly, this is an area fraught with traps for the unwary and no one-size-fits-all solution exists. Advisors seeking to maximize the business opportunity presented by this tax law change while failing to properly assess the appropriateness of a Roth conversion on a case by case basis do their clients a disservice. Undoubtedly, a tax planning opportunity exists for some in 2010. Advisors who truly put their client's interests ahead of their own, however, need to be prepared to tell some of these clients that a Roth conversion is not appropriate in their particular case. Those of us who understand that providing good advice, and not selling products, is the best value we can offer clients will be more likely to engage in the thoughtful analysis required by the Roth conversion opportunity in 2010.