In our previous article The Model Portfolio Approach to Investing, we illustrated how as Portfolio Managers we establish a uniform basket of securities for our clients referred to as “model portfolios.”
As part of this, we have two lists for our model portfolios. The first list is a watch list that contains securities we are considering investing in for the portfolio. The second list contains the stocks that are currently in our model portfolio that we are considering selling.
Both lists are important because while we still like the outlook of the names on this second list, to take a disciplined approach something must go when a new opportunity presents itself. We can use a trading tool referred to as a “switch trade” to develop and keep our model portfolios up to date. A switch trade occurs when a position is simultaneously sold from a model portfolio and another position is bought with the proceeds.
To illustrate how a switch trade works, we will look at Mrs. Smith, who is retiring and will begin requiring a monthly income from her portfolio.
Mrs. Smith’s portfolio of $1,250,000 is currently invested in mutual funds that are not generating any income, while also paying the embedded management expense ratio (MER) of $27,000 annually, which translates to 2.16% on average.
Mrs. Smith has been speaking to her friends who invest with a Portfolio Manager and pay 1.0% in investment counsel fees for a portfolio of a similar size, which would equal $12,500 annually. Mrs. Smith’s conversation with her friends spurred her to come to us for a second opinion.
Mrs. Smith provided her current statements for analysis. We suggested she sell these mutual funds and switch into a basket of direct holdings containing dividend-paying blue-chip equities that would provide consistent dividend income and long-term growth (capital gains).
Moreover, Mrs. Smith would save $14,500 annually ($27,000 MER - $12,500 investment counsel fees) since direct equity investments through the Managed Portfolio Program accounts we offer have lower investment costs than mutual funds.
A good portion of Mrs. Smith’s assets are in a non-registered account so she will be able to deduct the investment counsel fee on this portion for income tax purposes, reducing her after-tax cost of investing even further.
When an individual is fully invested, such as Mrs. Smith, switch trades are effectively the only way someone can purchase securities. Initially, Mrs. Smith will be executing switch trades on a macro level as she is completely remodelling her portfolio from entirely mutual funds to all direct holdings. Once her portfolio contains direct holdings, switch trades will be executed on a micro-level.
Essentially, you sell the weakest name to purchase what you feel is a stronger name. These switch trades can be done for many different reasons, some of which will be explained below.
Changing objectives
As your circumstances change, your investment objectives will often change, too. Certain securities may no longer be appropriate, depending on your current situation.
Switch trades can be used in these instances to better align the portfolio with your current needs, investment objectives and risk tolerance. For instance, a switch order could be placed to liquidate a higher risk holding for a lower risk holding and vice versa.
Asset mix rebalancing
Your asset mix is not static; rather, it is always fluctuating depending on the current state of the markets. With time, it’s not uncommon for an investor’s portfolio to stray from its prescribed ranges due to market movements. Switch trades can be used to rebalance your portfolio, keeping it consistent with your initial asset mix weightings and risk tolerance.
In other instances, switch trades can be done in a tactical asset allocation. Your strategic asset allocation is the target for each asset class. With a tactical asset allocation, you temporarily will underweight or overweight a certain asset class.
For example, Mrs. Smith’s portfolio has become unbalanced, and she is now overweight in equities and underweight in fixed income. Part of this is due to strong performance of the equity markets, and the other part is due to the underperformance of fixed income caused by rising interest rates.
In a normal interest rate environment, we would do a switch trade to trim equities that have outperformed and buy fixed income; however, with interest rates rising, bond prices have fallen and will continue to do so.
After discussing the current outlook for fixed income, Mrs. Smith did not want to trim her equities and allocate more to fixed income. We updated Mrs. Smith’s strategic asset mix in her Investment Policy Statement which meant that she was now underweight equities. A switch trade was conducted to sell all her fixed income and buy equities with a portion of the proceeds.
The other portion equalled her cash flow from the portfolio for the next 12 to 24 months and this was set aside in a cash equivalent so she would not be forced to sell an equity at the wrong point in the market cycle to meet her cash flow needs.
Sector rotation
Due to market variations, each of the different sectors may be either underperforming or outperforming others during any given period. As more amounts are allocated to equities, it’s important to look at which sector to put those funds into.
Switch trades can be useful in these instances for rebalancing a portfolio to overweight or underweight a specific sector. By using a switch trade, investors can rotate between sectors with relative ease, allowing them to overweight a sector that is expected to outperform and underweight a sector expected to underperform.
For example, the value of Mrs. Smith’s shares of company XYZ Inc. have appreciated nicely; however, we believe their sector will soon decline and are updating our model portfolio for all our clients by switching into a sector we believe will outperform in the future.
With the proceeds from our block trade sell of XYZ Inc., we buy shares of company ABC Ltd. This switch trade can be done to execute this order for all our clients in the model portfolio. Mrs. Smith holds 400 shares of XYZ Inc., currently trading at $100 a share. As XYZ Inc. is sold, the switch trade simultaneously buys ABC Ltd. with the proceeds. Since ABC Ltd. is currently trading at $50 a share, Mrs. Smith buys 800 shares.
As a result of this switch trade, Mrs. Smith is now overweight in a sector expected to outperform and has minimized her holdings in a sector expected to underperform.
Changing yield
To increase the overall yield of the portfolio, you may wish to substitute one position for another with a higher yield.
As stated above, if you are fully invested, you may not have funds available or the liquidity necessary to act on a trade quickly which could increase your portfolio’s yield. Therefore, by executing a switch trade, you will be able to purchase a new holding and increase your income.
On the other hand, if you have a net capital loss carry forward, or if you want to defer growth, a strategy could be implemented to focus on growth stocks with little dividends. Investors can benefit from switch trades both by changing to a lower or higher yield, depending on their unique situation.
For example, Mrs. Smith is trying to increase her yield to provide retirement income. She currently holds a growth stock with a yield of 1.544 per cent; however, she is looking for a higher yield and is interested in switch trading her growth stock for a value stock that pays 4.1 per cent.
If Mrs. Smith holds a position of $40,000 with the growth stock’s yield of 1.544 per cent, she will make $617.60 in dividend income annually. If Mrs. Smith switched to the value stock with a yield of 4.1 per cent, her annual dividend income would increase to $1,640 (a $1,022.40 increase) on that one holding of $40,000.
Tax planning
For tax planning purposes, switch trades are ideal for ensuring you are minimizing the amount of tax you pay.
As an illustration, Mrs. Smith has experienced a capital loss in a particular stock in the communications sector; however, she wishes to keep the same weighting of communications in her portfolio.
An option for Mrs. Smith in this situation is to place a switch order. By selling the communications stock she currently owns and simultaneously buying another similar communications stock, Mrs. Smith is able to use the capital loss to reduce her tax payable for that year while still maintaining the same weighting in that sector.
By keeping the same weighting in a sector, an investor will benefit from any sector recovery.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email [email protected], or visit .
