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STA Weekly Report – What is the Best Way to Deploy Capital

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What is the Best Way to Deploy Capital
An Employee Stock Ownership Plan (ESOP) is a Tax-Smart Business Strategy
Weekly Snapshot of Global Asset Class Performance
401k Plan Manager

When investors want to put cash to work, they have to decide whether to invest all the cash at once (immediate implementation) or whether to invest the money in several installments over time (systematic implementation).  Many investors prefer the latter approach because it feels more comfortable. However, the question is whether this is truly the best approach.

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This week we highlight research from Vanguard1, in combination with our own research, to analyze this topic from a historical perspective. To do this, we compare two implementation approaches, cash is either immediately invested in a lump sum or in 12 equal monthly installments in a balanced 60% stock/40% bond portfolio. The investment performance is then evaluated across rolling 12-month historical periods (Figure 1).

The historical performance of immediate and systematic investing across three different markets — the United States, the United Kingdom, and Australia, are compared (Figure 2). In each market, immediate lump-sum investment has delivered better results two-thirds of the time. On average, immediate lump-sum investing has outperformed systematic investing by 1.45% in Australia and 2.39% in Unites States in the 12-month investment window. The outperformance is not specific to a 60%/40% model, as different asset allocation splits, show similar results.

So why does a systematic approach create a performance drag?

The systematic investment approach results in holding significant cash in the portfolio over the investment period, especially during early phases (Figure 3). Because stocks and bonds are riskier investments than cash, they historically generate higher returns than cash to compensate investors for the additional risk (Figure 4).

As a result, the longer it takes to deploy capital, the more drag cash has on performance.

Vanguard research shows outperformance of immediate lump-sum investment increased to 92% of the time over a 36-month rather than 12-month interval in the Unites States.

While immediate lump-sum investment outperforms on average, a risk-averse investor may be more concerned than most about major market correction events. In these scenarios, the systematic approach can provide short-term downside protection and ease investor fears of large losses.

What are the benefits and costs of this down-side protection and peace of mind? Looking at the chart below, we see the rolling 12-month performance of a balanced portfolio divided into deciles, ranging from top 10% to bottom 10% performance periods (Figure 5). The systematic approach did protect the portfolio by a wide margin in those worst-case scenarios (green box), which is 10% of the time. However, it also gives up large amounts of the upside during bull markets about 30% of the time.

There are two ways to implement a systematic approach: 1. divide a cash balance into monthly installments and invest in the portfolio in line with a target asset allocation (Figure 3); 2. immediately invest all cash in the less volatile fixed income portion of the portfolio and gradually invest into the more volatile equity portion. The second method reduces trading costs but also deviates the most from the target allocation and reduces diversification benefits of stocks, as demonstrated by the 2013 quantitative easing (QE) and tapering (Figure 6).

The pros and cons of each method are summarized in table 1. Obviously, there is no gold standard to adopt. It all depends on individual investor’s specific situation.

Powell Testimony Makes July Rate Cut More Likely

Last Friday’s strong jobs report raised concerns about a July rate cut later this month, which boosted interest rates and caused some profit-taking in stocks.

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Mr. Powell today put the July rate cut back on the table. Traders are now placing the odds for a July cut of 25 basis point at 80% (with only a 20% chance of a 50 basis point cut). But that was enough to restore upward momentum in stocks, with the three major U.S. stock indexes hitting record highs. Another record by the technology sector is making the Nasdaq the day’s leader. 

The 10-Year Treasury bond yield is showing little change, but backed off from its earlier gains. A bigger reaction came from the 2-Year Treasury yield which fell 7 basis points to 1.83%. The drop in yields helped push utilities to a record high, with staples and REITs right behind. Lower rates, however, weakened banks which are leading financials lower. Homebuilders are also having a strong day on expectations for lower mortgage rates. 

Expectations for lower rates weakened the dollar, and gave a boost to gold and other commodities. A strong crude oil market is making energy the day’s strongest sector. Chart 1 shows the United States Oil Fund (USO) surging more than 4% today to the highest level since May, and back above its 200-day moving average. Chart 2 shows the Energy SPDR (XLE) in the process of testing its 200-day line. Gold and gold miners are also looking stronger. 

The combination of lower interest rates and a weaker dollar are giving another boost to gold. Chart 3 shows the Gold SPDR (GLD) trying to emerge from a small “pennant formation” which suggests that higher prices are in store. Chart 4 shows the VanEck Vectors Gold Miners ETF (GDX) on the verge of resuming its new uptrend.

Weaker Dollar Boosts Emerging Market Stocks

Expectations for lower U.S. rates are weakening the dollar. The green bars in the lower box in Chart 5 show the Dollar Index (UUP) gapping lower today in reaction to Mr. Powell’s dovish testimony before Congress. That’s having the predictable effect of boosting commodity prices like gold and oil — and stocks tied to them. A falling dollar is also giving a boost to emerging market stocks which are having a strong day. The red bars in the upper box in Chart 5 show Emerging Markets iShares (EEM) jumping today as the Dollar Index drops (see circles). Notice also that the EEM bottomed in late May as the dollar peaked; and has risen since then as the dollar has weakened. A weaker dollar is usually supportive to higher-yielding emerging markets. Especially those tied to rising commodities like Brazil and Russia which are leading the EEM higher. Rising Asian stocks in export-oriented South Korea and Taiwan may also be benefiting from the weaker dollar. And a lot of that is happening courtesy of a more dovish Fed.

Weekly Global Asset Class Performance

If you have any questions, please feel free to email me at


STA Investment Committee
Luke Patterson, CEO & Chief Investment Officer
Mike Smith, President
Andrei Costas, Senior Investment Analyst (Equity Strategies)
Nan Lu, Senior Investment Analyst (Fixed Income Strategies)

Source: Money Crashers

An Employee Stock Ownership Plan (ESOP) is a Tax-Smart Business Strategy
As Seen in the Houston Business Journal on December 12, 2005

Written by: Scott A. Bishop, MBA, CPA/PFS, CFP®

As the baby boom generation of business owners approaches retirement, more and more are interested in selling or otherwise cashing out of their businesses.

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In the 1990s this could have been accomplished through roll-ups, initial public offerings or sales to industry consolidators. However, in the post-9/11, post -Sarbanes Oxley, and “post-tech bubble” world, more business owners are turning to a time-tested strategy of selling their businesses by “going public, privately” through the use of an employee stock ownership plan (ESOP).

By utilizing an ESOP, business owners can create significant income tax advantages for both themselves and their companies while allowing them to diversify part or their entire stake in their company. All this and the doors stay open, the employees keep their jobs and the name stays on the door. ls it any wonder that ESOPs are enjoying a resurgence in usage?

Many business owners are unfamiliar with ESOPs, even though they’ve been around in essentially their current form for over 20 years. ESOPs are remarkably flexible plans that permit business owners to accomplish a variety of business and personal financial planning objectives.

For example, ESOPs may serve the company as a means of corporate finance to fuel growth, to increase capital available to purchase fixed assets such as buildings or equipment, or to acquire the stock from retiring or disinterested shareholders.

Since ESOP stock must be valued by an independent appraiser each year, disputes involving the valuation of the company’s stock may be minimized and firm values may be established for planning and financing purposes.

If the company’s objective is to minimize income taxes, an ESOP is an excellent tool that may be used to create tax deductions of up to 25 percent of the company’s payroll plus any interest incurred by the ESOP for the acquisition of the sponsor company’s stock.

Often, the objective of the business owner who is selling his business is to minimize the size of the check that he writes to the IRS for capital gains taxes upon the sale of the business. (Currently, the capital gains are taxed at a maximum of 15 percent of the gain, but the tax percentage increases back to 20 percent in 2009.) The sale to an ESOP, properly arranged, can result in postponing and potentially eliminating capital gains taxes on the entire transaction.

Beyond the company’s purely financial and tax motivations, an ESOP may be a cost-effective way to motivate employees and to boost productivity by giving each employee a stake in the future performance of the company through employee stock ownership. And this benefit is gained without surrendering the control of the day-to­ day decision making by the business owner.

Setting Up A Plan
An ESOP is a tax-qualified employee retirement benefit plan like a pension or a profit-sharing plan. The employer establishes a plan, names a trustee and funds the plan initially with cash.

What makes the ESOP unique is that the plan is designed to own stock in its sponsoring company. Therefore, future employer contributions may be in cash (which can be borrowed from a bank) with which the ESOP may use to acquire stock. Future contributions may also be in company stock.

Stock contributions have the effect of creating a tax deduction without expending the company’s cash.

The plan trustee holds the stock for the benefit of the employees who participate in the ESOP. As participating employees approach retirement age, they are given the right to convert their ownership of stock to investable securities or to receive their retirement benefits in stock.

Postponing Capital Gains Taxes
An owner of a C-corporation can defer capital gains taxes indefinitely on the sale of company stock to an ESOP by taking advantage of a Section 1042 rollover, Section 1042 of the Internal Revenue Code permits owners to defer capital gains taxes on the sale of company stock to an ESOP — if the sales proceeds are
reinvested in qualifying replacement securities within a set time frame (subject to several other technical requirements).

If the owner chooses to sell the replacement securities, substantial capital gains taxes may be incurred. However, if the replacement securities are still in the owner’s portfolio at the time of his death, the deferred gain escapes capital gains taxes permanently. (This tax break will be limited in 2010, the year the federal estate tax is repealed.)

Thus, by selling to an ESOP, the owner of a closely held business can obtain liquidity for all or a part of his ownership interest. Therefore, instead of having the bulk of his personal wealth tied up in the fortunes of just one company, the owner can use the proceeds from the sale to invest in a well-diversified portfolio of securities.

ESOPs are Not for Everyone
ESOPs are not a panacea. They do have some disadvantages.

The first is the expense of establishing and maintaining the ESOP. Because ESOPs are still a relatively unique form of retirement plan, the costs of creating the plan documents and the ongoing expenses are much more expensive than those of a traditional profit-sharing plan or pension. Adding to the administrative expense is the cost of an annual business valuation; these costs can be as much as $10,000 or more.

A second concern is financial. While the many advantages of ESOP transactions should facilitate the financing and acquisition of the owner’s stock, the ESOP structure may complicate critical negotiations with lenders who are unaware or are unfamiliar with the application and advantages of financing through an ESOP.

Lastly, ESOPs are often touted and wonderful tools to increase employee spirit and productivity. While several studies have indicated this to be true, it is almost impossible to conclude that increases in productivity were caused exclusively by the ESOP.

To know what is right for him, a person can contract with someone with ESOP expertise to conduct a
feasibility study to determine how an ESOP might apply in his given fact pattern. The study should consider the value of the company, the demographics of employees, the financial future of the company and its industry, the goals and objectives of both current and future ownership, the current and projected cash flow and the income tax situation of the company.

In reviewing the study, the owner should then be able to decide whether to implement or forgo the ESOP as a prudent solution.

When an ESOP is right, it is an incredibly tax efficient, financially sound tool that can help assure the timely, successful transition of business ownership.

© 2005 American City Business Journals Inc.

Important Disclosure:
Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by STA Wealth Management, LLC (“STA”), or any non-investment related content, made reference to directly or indirectly in this article / newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this article / newsletter serves as the receipt of, or as a substitute for, personalized investment advice from STA.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  STA is neither a law firm nor a certified public accounting firm and no portion of the article / newsletter content should be construed as legal or accounting advice.  A copy of the STA’s current written disclosure Brochure discussing our advisory services and fees is available upon request. Please Note: If you are a STA client, please remember to contact STA, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. STA shall continue to rely on the accuracy of information that you have provided.


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