We survey the headlines and the latest out of academia to help you be a more informed steward of wealth. This month we look at the so-called “Magnificent 7”, a comprehensive look at direct lending performance, incorporating taxes into the investment process, and poor investor timing in “thematic” funds.
The surge in popularity and valuations of the "Magnificent 7" stocks has drawn parallels to the dot-com bubble and Nifty Fifty craze of the early 70s. The table below from Apollo shows the individual and collective valuations of today’s high flying megacaps with prior speculative periods.
Flatrock’s Take: The typical equity portfolio of a Flatrock mid-career household has exposure to the Magnificent 7, albeit at a less concentrated combined weight.[i] While parallels exist to previous periods of concentration, we’re hesitant to call for an imminent correction, consistent with our approach of not trying to predict the next market environment.
What investors can do is take advantage of the substantial appreciation in the Magnificent 7 in a custom index and gift these stocks to charity in (lieu of cash.) Using the cash originally slated for charitable donations can then repurchase these stocks at a higher cost basis.[ii] No immediate charitable plans? No problem. The stocks can be transferred to a Donor Advised Fund to be granted down the road. In the meantime, the deduction can be taken this year.
This peer-reviewed paper in the Financial Analysts Journal evaluated the performance, fees, and risk exposures of 47 publicly traded business development companies (BDCs) over the period December 2009 to June 2022. BDC’s are funds that provide loans to small to middle market companies that usually cannot receive financing from major banks due to their credit quality, lack of earnings or leverage. The author found the BDCs had lower risk-adjusted market value returns than comparable credit strategies like high yield and bank loans. Further, the returns could be substantially explained by leveraged loan and small cap value ETFs (that are substantially more liquid and less expensive) over the time period studied.
Flatrock’s Take: Prudent stewards should demand evidence over anecdotes. So we love comprehensive, long-term surveys of investment strategies, especially when published in rigorous peer-reviewed journals. Most BDCs have floating rate loans that act as a hedge to rising rates, hence the intense interest. BDC’s often apply leverage and tend to have very high management fees. The author found leverage of 71% debt-to-equity and fees of 5.46% of net assets. (You read that right, that’s no typo!)
BDCs can be publicly traded with daily liquidity (like those studied in the paper) or in a private vehicle with limited to no liquidity. Also, the returns almost entirely come on the form of interest income, which means upwards of half the returns in high tax states like California would be eroded in taxes. Thus, they are an incredibly heterogeneous investment category with a wide variety of strategies, underlying leverage and vehicles as Kevin noted from his PIMCO days. Accordingly, perhaps more than any other asset class, BDCs and other forms of private credit require a thorough review. After fees, taxes and illiquidity, we’re skeptical.
The article from BlackRock discusses the importance of incorporating tax-efficient strategies in investment decisions, emphasizing the need to "think like a champion" in navigating tax implications. It underscores the impact of taxes on investment returns and provides insights into optimizing portfolios for tax efficiency.
Flatrock’s Take: Grant Williams is right. Gross wages aren’t the same as after-tax take home pay. What’s true in human capital is true in financial capital. We particularly appreciate the observation that endowment portfolios – the so-called smart money with heavy doses of private equity and hedge funds – aren’t necessarily suitable to taxable clients as we previously noted. The piece also highlights the considerable tax advantages of charitable giving of highly appreciated stock through direct indexes, a tactic unavailable in wrapped products like mutual funds and ETFs. Flatrock is currently with clients working on these exact year-end planning opportunities.
Morningstar discovered substantial return gaps – the difference between the fund’s return and the return of the fund’s underlying investors - in thematic exchange-traded funds (ETFs.) In the five years ended December 31, 2022, thematic ETFs compounded at a 7.4% annualized rate of return. Meanwhile, the investors in the thematic funds only received returns of 2.4% per annum, a full 5% annually less than the funds they invested in. This occurs due to investors having poor timing, essentially buying high and selling low.
Flatrock’s Take: John previously wrote the return gap as being the biggest failure in investment management. The boring, broad based S & P 500 returned 9.4%. over the same stretch. Compounded over five years, a $100 investment in the S & P 500 Index would have grown to $157 versus only $113 for the thematic ETF investor, a glaring shortfall. The investment and wealth management industry constantly bombards investors with short-term outperformance and exciting narratives, encouraging the aforementioned buying high. Thematic funds that concentrate on so-called “megatrends” like AI and electric vehicles only exacerbate this trend.
The frothiness that comes with a hot theme or megatrend reminds us of this classic Homer Simpson quote: “After years of disappointment with get rich quick schemes, I know I’m gonna get rich with this scheme. And quick.” If Homer had a brokerage account, he could have replaced “schemes” with “themes”. If an advisor pitches you on these, be very careful.
Let us know if you would like to dive a bit deeper on any of these topics. Markets fluctuate. Priorities change. We’re here to help.
Until next month…have a great Holiday Season!
Flatrock Wealth Partners LLC (“Flatrock”) is a registered investment advisor.
Information contained herein should not be considered investment advice or a recommendation to buy or sell any particular security. Flatrock renders investment advice on a personalized basis, only after gaining a full understanding of a client’s unique situation. While every effort has been made to verify the information herein, Flatrock Wealth Partners makes no representation as to its accuracy. It is not possible to invest directly in an index. Past performance is no guarantee of future investment results. Data referenced is not meant to communicate or signify past, future or hypothetical returns of an actual investment portfolio. Information is at a point in time and subject to change without notice. Information is derived from sources that are believed to be reliable, but are not audited by Flatrock.
External links may contain information concerning investments, products or other information. Flatrock is not responsible for the accuracy or completeness of information on non-affiliated websites and does not make any representation regarding the advisability of investing in any investment fund or other investment product or vehicle. The material available on non-affiliated websites has been produced by entities that are not affiliated with Flatrock. Descriptions of, references to, or links to products or publications within any non-affiliated linked website does not imply endorsement or recommendation of that product by Flatrock, LLC. Any opinions or recommendations from non-affiliated websites are solely those of the independent providers and are not the opinions or recommendations of Flatrock, which is not responsible for any inaccuracies or errors.
Please see our website https://www.flatrockwealth.com/disclosures
[i] Our 2nd Quarter Client Letter describes how we allocate to different stock market indexes for both trending and mean reverting market environments. 2023 is certainly the former!
[ii] Clients are advised to discuss the tax impact of investments with their tax advisor.