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3rd Quarter Market Update

15 October 2019

Geremy van Arkel, CFA® | Principal


Geremy van Arkel, CFA | Principal

It’s October 1st, and you know exactly what that means. It’s mutual fund distribution season! I know, I know. That wasn’t at all what you were thinking, but for us at Frontier and especially for our traders, this is the busiest time of the year.

In the 4th quarter of every year, most mutual funds pay distributions to allocate any capital gains or income to investors that have accrued during the year. These distributions are akin to a dividend: the shareholder receives a distribution, which is a cash payout of income and capital gains, and the price of the fund is reduced by the distribution. The distribution is an advancement of the client’s return, thus advancing the taxes. In other words, you either pay now as a distribution, or you pay later as a capital gain. In effect, this is exactly how stock dividends work.

Why is it that investors love stock dividends, but hate mutual fund distributions?

Unlike stock dividends, though, investors hate receiving distributions or income from their mutual funds. This is because, in theory, investors could be receiving someone else’s payout. A mutual fund could lose 10% over any given year, but still pay a distribution of capital gains from stocks that were sold in that year. This is, of course, the same thing as a stock paying a dividend the year when the stock price fell. Although this happens all the time, I never hear any investors complaining about it.

Consider this: If some investors are receiving tax bills that they technically didn’t earn, then – by the nature of the universe – some other investors must be experiencing earnings for which they are not paying enough tax.  What if we could be those investors?

The default mode in the industry for taxable clients is to invest in strategic allocation portfolios implemented with either indexes (mutual funds or ETFs) or with mutual funds that seek to minimize distributions. But is the tax tail wagging the investment dog?

Of course, index product providers make a big deal about this. Low expenses and low taxes go straight to the core of investors’ sensibilities. Indexes naturally come by low distributions, they are market cap-weighted, and they move with markets without having to trade. If you are not concerned about the return or risk of your investments, I agree that indexes are an effective way to reduce distributions.

A second option for investors is what I call ZDP mutual funds (Zero Distribution Policy). These are actively managed mutual funds that are specifically designed to be tax-efficient, and where a primary goal of the fund is to minimize distributions. These are a subset of mutual funds that seek to perform well and pay out a minimal distribution. And what’s not to like: the hope of excess return with very little distributions, and you only pay taxes when you sell.

While the hope for ZDP funds to be able to deliver excess returns and to experience almost no distributions sounds great, I am skeptical. To eliminate capital gains distributions (not considering income and dividend distributions), fund managers need to either sell most of their losers and keep their winners or not make any money. If making no money isn’t the goal, fund managers would soon end up with a portfolio of securities that they don’t want to own, can’t sell, and pent up potential capital gains. The older the fund, the worse the problem, as new investors would buy into an ever more askew portfolio with bigger and bigger potential capital gains. Under these circumstances, it would be very difficult for fund managers to provide excess return, or for investors to avoid looming potential taxes.

The rule that taxable clients should only invest in indexes or ZDP funds has become a law that needs to be rewritten. Minimizing distributions is only a byline in an effective tax management process – there is so much more to the story.

Let’s start at the beginning.  We must remember one simple fact: it’s a marginal tax rate. If you make $10,000 and the tax-effective tax rate is 25%, you keep $7,500. The logic is straightforward: you make more, you keep more. Thus, the goal of tax management is not just to minimize distributions, but to maximize after-tax returns. Period.

After decades of managing investment strategies, we at Frontier know that most of the excess return to be had in the portfolio management process occurs at the security selection level. There is very little evidence to prove that anyone is adding significant excess returns at the asset allocation level. This is probably because, in order to add significant returns, managers must make large and abrupt allocation moves. But the bigger you bet, the more you risk losing if you are wrong – which, sooner or later, seems to happen. Alternately, a static allocation forces investors to be risk-takers and to simply accept what the market gives them, which is often more risk than investors had originally imagined. The effective answer, then, is utilizing asset allocation as a risk management tool, and relying on security selection for excess return. When done right, this approach can produce a meaningful, more consistent return stream.

In short, the best way to improve returns is to get better at risk management and security selection – or, as in Frontier’s case, to get better at manager selection, because it is the manager who selects the securities.   Ironically, this is exactly the opposite of how most tax-managed portfolios are managed. Most of them are managed with static allocation strategies, implemented with index funds or ZDP funds.

The example below clarifies the concept. If you make more return by investing in very successful, actively managed mutual funds, you still keep more. If you could make excess returns of 2% a year, and if the tax drag from distributions was approximately 0.5% a year, investors would earn more.

Example #1[1]

No excess return, no distributions:   

$1,000,000 + 10% gain – $0 tax on no distributions = $1,100,000 ending value

2% excess return, 0.5% tax drag

$1,000,000 + 12% gain = $1,120,000

– 0.5% ($5,600) tax drag from distributions = $1,114,400 ending value

Most people would view the $5,600 in distributed gains added to their taxable income as a very real nuisance. Yet it is worth noting that you would still end up with $14,400 more – even after paying the $5,600 in tax.

The most powerful tool in the investors’ arsenal for combatting unwanted taxes from distributions, dividends, or income, is tax-loss selling. Imagine if each year, investors would sell the funds that experienced a loss in that year. Those tax losses could be used to offset the inevitable distributions that actively managed mutual funds may pay out. For example, what if we could sell one emerging market fund at a loss to buy another similar emerging market fund? With one clean trade, investors can considerably offset taxes owed on distributions, dividends, and income. While this may not be possible every year, there is often – with 10+ funds in a portfolio – an opportunity to capitalize on this.

Example #2

No excess return, no distributions:   

$1,000,000 + 10% gain – tax on no distributions = $1,100,000 ending value

2% excess return, 0.5% tax drag, 1 tax loss trade

$1,000,000 + 12% gain – 0.5% ($5,600) tax drag from distributions = $1,114,400

One 10% trade for a 20% loss = $20,000 loss, or approximately $5,000 in offset, which just so happens to be about the amount of the tax on distributions.

Approximate Ending Value = $1,120,000 or $20,000 after-tax excess return

External tax-loss selling of entire fund positions cannot be done with proprietary funds, as there is usually only one option for each asset class. Further, this is difficult with index funds, as many are considered materially like options that could represent a wash sale. Further, while mutual fund managers are able to tax loss sell individual positions within their portfolios, it would take 10s, if not 100s, of trades to add up to the impact of selling an entire fund position. Thus tax-loss selling of entire funds is, for the most part, limited to those firms that utilize an independent approach to selecting mutual funds.

There is a war of words surrounding the concept of mutual fund payouts. A distribution could be made to sound bad, and a dividend could be a good thing. Marketing departments and investment product designers are on to this problem of investors having to pay tax on distributions. But, as we all know, there is no way around paying some level of taxes.

The full(er) story here is that we operate under a marginal tax rate. The more an investor earns, the more they keep. Yet even if the marginal tax rate is 90% and you earn more, you still end up with more. Thus, the goal of any tax-managed portfolio is not to simply attempt to minimize distributions but rather to strive to maximize after-tax returns.


Gary A. Miller, CFA | Founding Principal

The third quarter of 2019 turned out to be a muted version of the second quarter: higher equities in the first and last month, lower equities in the middle month. Fortunately for nervous types, the ups and more importantly, the downs were noticeably smaller in the third quarter relative to the second. Interestingly, stocks were given the green light to rally since the Federal Reserve Board voted to cut the Fed funds rate by ¼% at the end of July – its first cut since 2008 – and again in September. However, in both cases, equity prices rose modestly in anticipation of the cut but fell back afterward. For the quarter, the S&P 500® used the up-down-up pattern to gain approximately 1.7%. US small-cap stocks and international stocks were not so lucky as higher prices in September did not erase earlier losses, and those asset classes ended the quarter down.

The big news continues to be in the bond market. The yield curve inverted in the second quarter and remained inverted throughout the third quarter (An inverted yield curve is when the yield of the 10-year Treasury note is below that of the 3-month T-bill). Bond investors may be worried about a recession coming to the US or may be just taking advantage of the US’s relatively high interest rates compared to the negative rates found elsewhere in the world, but in either case, the global economic environment is not looking particularly healthy. Even with the bounce back in rates in September, the 10-year Treasury note fell from 2.00% to 1.68% in the quarter, and the 30-year Treasury bond fell from 2.52% to 2.12%. That drove the Bloomberg Barclays long-term US Treasury index to a whopping gain of slightly over 7.9% in the quarter.

The third quarter was a mixed bag for Frontier’s Globally Diversified strategies. All strategies had positive returns in the quarter except Global Opportunities which is always heavily allocated to small US stocks and international stocks – the quarter’s losing asset classes.  In general, the strategies trailed in the two up months (July and September), and outperformed in the down month (August). The fixed income dominated strategies, Capital Preservation and Conservative, trailed their benchmarks as they continue to be very conservatively invested in both stocks and bonds.  The more aggressive strategies matched or exceeded their benchmarks except for Global Opportunities, but Global Opp actually did well considering the performance of its underlying asset classes. Asset allocation provides a boost for the strategies across the board since bonds did so well in the quarter. Unusually, though, fund performance was subpar, particularly for the conservative funds in the more conservative strategies.  Longer-term returns continue to be benchmark-beating for all strategies over nearly all time periods

Frontier Asset Management’s unconstrained Alternative Strategies had solid positive returns that were better across the board than the Globally Diversified strategies in the third quarter. The strategies’ returns pretty much matched the returns from hedge funds, which had a relatively good quarter compared to the world’s other asset classes. The heavy allocation to fixed income was a big help in the quarter, although the equity allocations, which are mostly small-cap US and international, hurt. The performance of the Alternatives Strategies continues to look favorable relative to the hedge fund universe and alternative strategies available in mutual fund formats over longer-term horizons.

Past performance is no guarantee of future returns.  Performance discussed represents total returns that include income, realized and unrealized gains and losses. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees and expenses. All calculations of performance are by Frontier.
Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice.  Frontier obtained some of the information provided herein from third party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Data sources for funds and indices are Morningstar, the Hedge Fund Research Institute and BarclayHedge. Other sources include: National Geographic.
Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance.  References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries or financial instruments of any kind.  This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice.
Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.
Hypothetical expected returns have certain limitations, are shown for illustrative purposes only and it should not be assumed that actual results will match the hypothetical expected returns shown. Unlike actual performance, hypothetical expected returns do not represent actual trading and since trades have not been executed, the results shown may have under or over compensated for the impact, if any, of certain unforeseen market factors. Hypothetical expected returns, whether back-tested or forecasted, have many inherent limitations and no representation is being made that any account will or is likely to achieve the results shown. In fact, there are frequently material differences between hypothetical expected results and actual results achieved. One of the limitations of hypothetical expected results is that they do not take into account that material market factors may have impacted the adviser’s decision making process if the firm were actually trading clients’ accounts.  Also, when calculating the hypothetical expected returns, the adviser has the ability to change certain assumptions and criteria in order to reflect better returns. There are numerous other factors related to the markets in general or to the implementation of any specific investment strategy that cannot be fully accounted for in the preparation of hypothetical expected results, all of which can adversely affect actual trading and performance. Importantly, it should not be assumed that investors who actually invest in this strategy will have positive returns, or returns that equal either the hypothetical expected results reflected or any corresponding benchmark presented.  In addition, performance can, and does, vary between individuals.
In reviewing the performance information presented here, we recommend that you consider both the returns generated and the level of risk that was assumed in generating those results. We believe that performance information cannot be properly assessed without understanding the amount of risk that was taken in delivering that performance. The performance information presented here covers different time periods. We present performance information for short time periods because we understand that clients and potential Investors are interested in this information, however, we recommend against making any investment decisions based on short-term performance information. For any investment products mentioned herein, a complete description of their investment objectives, along with details of the risks and fees involved is contained in their respective prospectus and statement of additional information, which is available on their websites and should be read fully.
It is generally not possible to invest directly in an index*. Exposure to an asset class or trading strategy or other category represented by an index is only available through third party investable instruments (if any) based on that index.
S&P 500®
Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ
Barclays Capital Long U.S. Treasury
Includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value
Benchmark Composition. The Benchmarks for the Long-Term Growth, Growth & Income, Balanced, Conservative and Capital Preservation strategies are combinations of the Wilshire 5000 Total Market Index, MSCI All Country World ex US Index, Bloomberg Commodity Index, HFRX Global HF Index, Barclays US Aggregate Bond Index and 3-Month T-Bills.
The blends of the indices are currently:
Capital Preservation Bench
Conservative Bench
Balanced Bench
Growth & Income Bench
Long-Term Growth Bench
Wilshire 5000
MSCI AC World ex US
Bloomberg Commodity
HFRX Global HF
Barclays US Agg
3M T-Bills
Benchmarks for the Global Opportunities, Focused Opportunities, Absolute Return Plus, Absolute Return and Short-Term Reserve strategies are the MSCI World, S&P500®, HFRX Global HF, HFRX Absolute Return and Barclays Capital 1-5 Year US Treasury Indices, respectively. In the case of indices that include foreign securities, index returns are still presented on a total return basis but will be net of foreign taxes on income generated by these securities.
Frontier’s ADV Brochure is available at no charge by request at or 307.673.5675.
[1] Neither example considers unavoidable income and dividends, which, all else being equal, would impact both in a similar manner.

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