A smarter way to rebalance

As advisers begin midyear rebalancing of client portfolios, they face a dilemma.

While investors have enjoyed the fruits of a nine-year bull market — including a 19% gain by the S&P 500 in 2017 alone — they’ve also seen a significant shift in the risk profile of their investment portfolios. It’s likely that over the past few years clients have seen such significant equity gains that the standard 60/40 portfolio may now resemble a 75/25 model.

With these sizable gains, many clients are reticent to rebalance portfolios because that likely means paying a big tax bill to Uncle Sam.

So how can advisers and their clients rebalance portfolios without incurring capital gains? Some are turning to a buy-write option strategy to provide the market exposure or beta reduction clients want without the need to sell equities and trigger taxes from capital gains. Used systematically, this approach can “rebalance” the risk of portfolios, in a much more tax-efficient manner.

Buy-Write/Four Steps

A buy-write strategy, according to the Cboe, is “an investment strategy in which an investor buys a stock or a basket of stocks, and also writes covered call options that correspond to the stock or basket of stocks. Buy-write strategies have an added attraction to some investors in that buy-writes can help lessen the overall volatility in many portfolios.”

One approach to this strategy is through the CBOE S&P 500 Buy-Write Index, a benchmark index designed to illustrate the performance of a portfolio that engages in a buy-write strategy using S&P 500 index call options over a long S&P 500 stock portfolio.

By adding a specific amount of “write” to the client’s existing “buy” (i.e. long equity position), the buy-write tax-efficient rebalancing strategy can be used to achieve the target risk exposure without triggering cap gains on the underlying equities. In order to do this, advisers need to:

• Determine equity beta for all holdings in a portfolio: In layman’s terms, this simply means advisers need to calculate the amount of market exposure inherent in the specific underlying holdings in the client’s portfolio.

• Determine the difference between current and target exposure: This will be the amount of adjustment to the portfolio achieved by layering on the buy-write strategy

• Implement option overlay: Sell call options on the S&P 500 or other indices in the appropriate amount to bring current exposures back in line with a client’s risk tolerance

• Monitor: Manage the option component in the existing account, monitoring positions in real time and making adjustments as markets move.

An illustrative example

The following scenario is familiar to many advisers. Thanks to strong equity markets, a client who just a few years ago had a $700,000 taxable account with a 60% equity and 40% fixed income portfolio now has a $1 million nest egg, and the portfolio has jumped to 75% equity and 25% fixed income.

To rebalance the portfolio to reflect the client’s risk profile and portfolio strategy, an adviser would need to reduce the portfolio’s equity exposure by $150,000, or 15% of the total portfolio value. Selling means a big tax hit, upwards of $20,000, and clients are often behaviorally wired to avoid such actions.

With a well-diversified equity portion of the portfolio with an overall profile similar to the S&P 500, adding the “write” part of the buy-write strategy is a relatively safe, simple and tax-efficient way to bring a portfolio back in line with client objectives.

Implementing the buy-write, an adviser would write, or sell, a call option on the S&P 500 Index (SPX) in relation to the client’s equity overweight. In this case, implementing a 30% overlay of at-the-money calls would bring the portfolio’s risk profile back to its original 60/40 mandate. This is appropriate since a 1% reduction of beta exposure requires approximately 2% of the equity portfolio to be covered by options.

Conclusion

With volatility returning to the market, clients are getting more and more nervous about stock market performance after watching nine years of positive returns. The hesitancy to rebalance due to tax consequences is ultimately a distraction that needs to be overcome. The buy-write strategy enables advisers to realign client portfolios and brings clients back to focusing on their individual plan and strategy. With the potential for more volatility ahead, a rebalanced investment portfolio with no capital gains can go a long way to calming client fears.

(More: How investors can leverage tax alpha to increase returns and savings)​

Dave Donnelly is head of client portfolio management at SpiderRock Advisors.