Adding Value in Down Markets
There is no way to sugarcoat it, this has been a difficult year with both the stock and bond markets down significantly year-to-date. As clients and friends know PMA takes a long-view on the markets and strongly believes that, over longer periods of time, markets go up more than they go down. But, that said, it raises a question — “how is PMA adding value in managing accounts at a time when the markets are down?” Fair question. I would like to highlight just a few of the things we have been working on over the past year to optimize portfolio construction and performance returns. And while it has been a challenging year, when markets trend downward there are several strategies we employ to ensure that we are properly positioning portfolios during these market downturns.
One of the first things we will do when the markets are down is to look for tax loss harvesting opportunities. By realizing losses we take advantage of a potentially small window where we can actually take some benefit from a down market. By utilizing this type of tax planning strategy, we optimize our clients’ outcomes and help to offset potentially large embedded capital gains. 1 Realized losses can be used to offset gains in the current year, but also in future years. For example, a $5,000 capital loss can be used to offset a $5,000 gain in the current year. But, if there are no capital gains, the tax code allows $3000 to be used to deduct against ordinary income, and the remaining $2,000 loss may be carried forward to the next tax year.
While harvesting losses during a down market, PMA also looks to rebalance portfolios back to their target weights, as needed, and in accordance with guidelines set forth by PMA’s Investment Committee. Rebalancing while the market is in a downward trend allows us to return to target weights with less of a tax bite from capital gains in taxable accounts. And even for tax-sheltered accounts it is a good time to reposition portfolios back to their asset allocation targets.
In terms of portfolio positioning, within our fixed income allocations PMA has kept a short duration profile and recently added a further tilt towards short-maturity bonds in response to our assessment of rising inflation and interest rate risk. A bond’s duration is a measurement of its sensitivity to changes in interest rates. More specifically, this change has helped cushion our clients’ bond portfolios to make them less sensitive to potential increases in interest rates.
Inflation is of course a hot topic. PMA’s Investment Committee continues to spend a good deal of time discussing inflation and how best to address it within our portfolios. PMA’s Investment Committee reviewed various inflation-hedging strategies before ultimately deciding upon an allocation to Treasury Inflation Protected Securities (TIPS) in client accounts which hold taxable bonds, and a Real Asset fund for accounts invested in tax-free municipal bonds. PMA has thereby sought to alleviate, to some degree, the adverse impact of inflation on our bond portfolios. Since our Investment Committee’s approval of the initial TIPS allocation in taxable accounts in the fall of 2021, inflation readings have continued to trend upward while inflation breakeven rates have declined. We have increased our allocations to these inflation hedges in 2022 as well. 2 TIPS provide direct inflation protection via an adjustment to the principal of the bonds, which increases with inflation (and decreases with deflation). The inflation metric used is the headline Consumer Price Index. Also, TIPS can be purchased through low-cost, open-end mutual funds, and represent our investment option of choice for client portfolios. The DFA Municipal Real Return fund was created to serve as a TIPS-like product option designed for tax sensitive investors.
PMA has also sought to optimize portfolio construction during this difficult year by rebalancing within our Conservative equity sleeve with a modest shift towards Large Cap Value. Adding a Value tilt in our portfolios was prudent because, among other reasons, there is a large valuation gap between growth and value securities. In other words, with value-based funds reaching historically cheap levels as compared to so called “growth” funds, PMA concluded that it made sense to make a small “tilt” towards value stocks and boost our Conservative sleeve’s value orientation.
Finally, at the start of the conflict initiated by Russia in Ukraine, we received several inquiries about our holdings and the extent of any approved fund’s underlying holdings in Russian and Ukrainian companies. So, several months back, as part of our investment process due diligence, PMA went through a review of our portfolios’ exposure to Russian and Ukrainian equities and fixed income. We found that with our strategic underweight to emerging markets, any positions held in either of these two countries was very small and warranted no action at the mutual fund level.
So, in sum, while we navigate the ebb and flow of the markets, PMA continues to seek to add value in our clients’ accounts through all of the strategies and techniques outlined above. Of course, we wish we had a “magic wand” that would shield all of our clients from ever having to experience any of the pain caused by market downturns, but we don’t have such a wand, and anyone who claims to be able to wave one, should also be asked if they have magic beans for sale. As always, should you have any specific questions about these topics discussed here or any other items you would like to discuss please do not hesitate to contact us.
