Many people entered 2020 fully-invested in their investment portfolios. Fully invested does not necessarily mean 100% allocated to stocks. It means that you had an asset allocation mix that did not leave you with more than 5-10% cash. But fear not; you don’t need to be sitting on a pile of cash to take advantage of the massive moves in the market. Here are three moves you can make to take advantage of the recent decline in financial assets:
Switch From Mutual Funds to ETFs
There are many ways to get exposure to an asset class, such as buying individual securities, investing in a mutual fund, or purchasing an exchange-traded fund or a closed-end fund. Each of these structures has different liquidity, so when investors head to the exit door, the selling pressure can temporarily distort prices between the various vehicles. For example, recent panic selling in the investment-grade credit and municipal bond markets created large discrepancies between ETFs and mutual funds. Banks and broker-dealers were reluctant to bid on individual bonds, so investors turned to the ETF market to find liquidity. The overwhelming selling pressure in the ETF market created a situation where ETFs were trading significantly lower than their net asset value. In other words, the ETF was trading below the portfolio “fair value,” determined using end-of-day closing prices for individual cash bonds.
The net asset value (“NAV”) of a bond mutual fund, unlike an ETF that is traded intra-day, is determined using the mid-market closing level of the cash bonds in the portfolio. The bid-side, or where an investor could actually sell a bond, may be significantly lower than mid-market, especially during times of extreme illiquidity like we have seen over the last couple of weeks. Nonetheless, when you place a sell order for a mutual fund, you receive the NAV established at the close of business calculated using the mid-market levels. ETF.com details the differences between the two structures in this article.Today In: Hedge Funds & Private Equity
Why does this matter? If you hold shares in a mutual fund that consists of investment-grade municipal bonds, for example, you can sell that fund at its NAV and buy an ETF that has very similar characteristics and is trading below its NAV. Usually, ETFs trade close to fair value, but for some investment-grade municipal bond funds, the discount recently got as wide as 16%. True, you may end up in a more volatile investment by switching from a mutual fund to an ETF due to these fluctuations. In exchange for that added potential volatility, you could end up with a very similar portfolio of bonds at a much better price. Some of the discounts have normalized in the last few days as the market has rebounded, however, there still may be opportunities to switch from mutual funds to ETFs to take advantage of a discount to NAV if aggressive selling returns to the market.
Take Advantage of Tax-loss Harvesting
The stock market has plunged, and you have your full equity allocation in place. Sorry, there is nothing you can do about that now. Still, there is a way to turn the decline into an opportunity. There is a decent chance that some of the stocks, mutual funds or ETFs in your portfolio are currently worth less than what you paid for them. Investors can use the drop in prices to switch to a lower-cost fund or ETF that provides similar market exposure, locking in a loss for tax purposes. Holders of individual stocks can make sales and switch into an index or other companies in the same industry. Make sure you speak to your advisor or broker before doing this. Rick Ferri does an excellent job highlighting the nuances of strategy in a recent Forbes article.
Adjust Your Asset Allocation
Even if your portfolio cash balance is low, you can still take advantage of the gyrations in the market. It may be a great time to adjust your asset allocation. Maybe you avoided high-yield bonds because of tight credit spreads? High-yield spreads have blown out, and junk bonds are now offering yields close to 10%. If you held a position in US Treasury Bills, you can probably sell them at a negative yield and buy other short-term investment-grade bonds and pick up a couple of hundred basis points in tax-exempt yield. If your equity portfolio lacks diversification across sectors and geographies, it could be a fantastic time to take advantage of the under-performance of specific markets and re-balance stale allocations.
The downturn in asset prices caught most investors by surprise — if not by the correction in prices, then by the speed and severity by which it occurred. Sometimes the best advice is to avoid opening your brokerage statement at the end of the month, pretend it never happened, and wait for a recovery. Just because you have a full-invested long term strategic asset allocation doesn’t mean that you can’t take advantage of once-in-a-decade opportunities. Tweaking your portfolio to take advantage of market dislocations and utilizing effective tax-loss harvesting strategies is not panic behavior. It’s smart.
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