Market Update. Volatility Index (VIX) 2

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1 Market Update Decanting Trusts Final Thoughts Market Update The first quarter of 2018 can be characterized as the start of a return to normalcy. Asset prices began to retreat from their expensive price levels and volatility rose from historic lows, thus creating a long-awaited opportunity to trade the market. This marked the first such opportunity we have experienced in more than two years. While the complacent conditions of the past several quarters have undoubtedly been disturbed, it is important to note that volatility is still below and asset prices are still above historical averages. Figure 1 and Figure 2 illustrate the beginning of this return to normalcy as well as the current levels relative to historical levels. S&P 500 P/E Ratio 1 Figure 1 BEYOND MANAGING MONEY Volatility Index (VIX) 2 Figure 2 The materialization of much-anticipated increases in interest rates, which resulted in lower bond prices, as well as political turmoil shaped much of the landscape over the last several months. The US Federal Reserve ( The Fed ) is continuing its monetary tightening program on the back of a strengthening economic outlook. President Trump introduced tariffs on particular foreign imports, igniting worries about a trade war with China. Products that bet on continued low volatility, none of which are owned by West Capital, plummeted dramatically, accelerating the move lower and introducing concern about some of the investment Ycharts.com 1

2 products in the market (more on this later). The unfolding of these developments will spill over into the coming months and should continue to dominate the narrative and drive market behavior and investor sentiment. The general decline in equity and bond prices coupled with heightened volatility is reminding investors of the risk associated with investing and the importance of adhering to a diversified, strategic asset allocation appropriate for their risk tolerance. Tier 1 and 2 Cash and Fixed Income Investments Interest rates were a big story over the last few months. An often reliable, although not foolproof, leading indicator of a market correction (see Figure 3), the 10-2 year treasury yield spread (10-year treasury yield minus 2-year treasury yield) tightened to its narrowest level in 10 years just before the equity selloff in early February Year Treasury Yield Spread (As leading indicator of selloffs) 3 Figure 3 Once trouble surfaced in equity markets, investors fled to safety, purchasing short-term treasuries and widening out the spread. Figure 4 below illustrates this story Year Treasury Yield Spread (10-2 Spread) 4 Figure 4 Short-term rates climbed higher as the quarter progressed, with the US Federal reserve raising the Federal Funds rate another 25 basis points as the Fed continues to tighten monetary policy. New Fed Chairman Jerome Powell commented on the strength of the economy and the committee s more positive inflation and growth outlook. As a result, the 10-year yield temporarily surpassed 2.9% for the first time since early It is important to note that the last time the 10-year tested this 3% level roughly four years ago, there was a subsequent drop in the yield to below 2%, begging the question whether this will be the time the 10-year will see a sustained breakout above this level. Regardless, the strong outlook and bullish comments by the Fed foreshadow a more hawkish agenda in regard to rate increases. 3 Ycharts.com 4 Ycharts.com 2

3 The volatility and general increase in rates caused the forewarned possibility of interest-rate risk to materialize. Rising rates make existing fixed-income securities relatively less attractive, causing their values to decline. However, they are also necessary for increased yields on future securities and presents the opportunity for active bond managers to add additional value. West Capital has been aware of this possibility and positioned clients in a way that attempts to reduce interest-rate exposure and take advantage of the cheaper fixed-income environment. By allocating to actively-managed short duration and managed duration fixed-income managers, we have seen our managers and clients both generally outperform broad fixed-income indexes. grade fixed income is tied more closely to changes in interest rates, whereas Tier 3 fixed-income is more responsive to the credit quality of its issuers. While High-Yield spreads did widen during the quarter (see Figure 5), they did not blow out to the degree they did in other relatively recent sell-offs, signaling investors confidence in companies ability to pay back debt. High Yield Spread (Now vs early 2016) 5 Tier 3 Other Fixed Income/Alternatives At West Capital Management we discuss Tier 3 investments with our investors when there is an appetite for lower credit quality (i.e. junk bonds) or other alternative investments that seek higher returns than those available in Tier 1 and Tier 2, but not necessarily as risky as Tier 4 equity investments. Tier 3 can be seen as a diversifier to the main asset classes of investment grade bonds and stocks. Higher-yielding credit performed slightly better than higher-quality investment grade fixed-income. Strength in the economy, as demonstrated by strong employment numbers and other indicators, persuaded investors that the relatively higher credit risk and lower interest rate risk of this portion of the fixed-income market was a worthwhile tradeoff in order to earn relatively higher yields. Investment- Figure 5 An interesting development in credit markets is the sharp climb in LIBOR, the London Inter-Bank Offered Rate, up from an extended period of near-zero rates. LIBOR is the rate at which London banks are willing to lend to each other and serves as a measure of credit risk, or the extent to which these institutions feel confident that they will receive their loan payments as agreed upon. It is also the benchmark rate used for many mortgages, floating rate debt and loans, as well as a variety of other financial vehicles. A higher LIBOR rate also puts pressure on entities that depend on higher-interest loans to fund their capital needs and are sensitive to changes in credit risk. These types of borrowers and 5 Ycharts.com 3

4 securities are ones that a Tier 3 manager can be expected to own. West Capital is aware of the rapid rise in LIBOR and is keeping an eye on how this development might affect client s Tier 3 exposure and is among the many reasons we are positioned extremely conservative in high yield bonds relative to benchmarks. 3-Month LIBOR based on US Dollar 6 its peak. While the drawdown may seem large relative to the recent calmness and uptrend of the market, it is important to recognize that most years experience an intra-year drawdown larger than what we have experienced so far this year (with the average year seeing a 13.8% drawdown), further evidencing the fact that recent market behavior is returning to a more normal state. Figure 7 shows the largest intra-year drawdowns of the S&P 500 over time. S&P 500 Intra-year drawdown 7 Figure 6 Tier 4 Equities As previously discussed, equities experienced their worst performing and most volatile quarter in quite some time, paving the way for active managers to outperform broad equity indexes during the period of sharp decline. After a strong January, markets sold off sharply in the early part of February, and then again in March, on rising interest rates and the fears of a trade war with China. This led many equity indexes into correction territory (down 10% from peak) before they eventually bounced back off these lows. Prior to this decline, the S&P had gone a record number of consecutive days falling 3% from Figure 7 For passive index investors that experienced a gradual and consistent climb in their equities over an extended period of time, this recent bout of volatility came as a wake-up call. Actively managed strategies give portfolio managers the ability to position defensively in anticipation of a decline, as well as take advantage of some of the oversold securities in the period following. Where appropriate, West Capital has positioned client portfolios towards actively managed strategies that have the ability to do just this. Our allocation to 6 Ycharts.com 7 JP Morgan Guide to the Markets Q

5 these managers proved rewarding to client portfolios, as long/short and global allocation strategies generally outperformed broad, domestic market indexes during the worst days of the decline. In addition to allocating to active strategies in preparation of a decline, where appropriate, West Capital was able to trade actively at the portfolio level. Generally speaking, we were able to increase risk opportunistically in client portfolios by buying equities when the market was down more than 5% or 10% from its peak. This was the first time the market presented this strategic opportunity in over two years. Additionally, clients who implemented protective put strategies in their portfolios benefitted from successful hedging of their equity exposure during the selloff through reduced downside. An interesting aspect of the selloff centered around the behavior of financial products that facilitated bets on continued lower volatility. A portion of these products, which derived their return from the inverse of the VIX index, were often levered up to 3x and dropped into free-fall once volatility surfaced. These products became worthless and many investors lost their initial investment. Figure 8 shows the plummet of these levered products. Inverse VIX Product 8 Figure 8 As a general rule, West Capital Management looks to avoid or minimize these strategies that use leverage in order to avoid the possibility of sharp declines and permanent loss of capital. Small Cap and International stocks (both Developed and Emerging Markets) also experienced a sharp decline during the quarter. Only Emerging Markets fully recovered and managed to post a positive return over the time period. Emerging Markets has proven particularly profitable, outpacing developed international markets by roughly 10% over the last year. West Capital continues to see value in allocating internationally and continues to like the prospects of Emerging Markets. Figure 9 on the next page shows the performance of various market indexes over the quarter. 8 Ycharts.com 5

6 S&P, EAFE, EM, SC Performance index 9 Figure 9 Any market decline can be a scary, unwelcomed event to investors. However the most recent one can be perceived as healthy and important. Previously high general market valuations have declined, though they are still not overly cheap from a historical standpoint. In addition, investors who have become complacent with passive index investing are reminded of the importance of maintaining a diversified portfolio and one that can provide protection when markets turn downward. As the market rally slowed in the New Year, correlations between sectors and the broad market weakened, leaving actively managed strategies to prove whether they could mitigate drawdown and effectively deploy capital. West Capital Management uses these opportunities to evaluate whether our expectations of manager performance during these time periods were met. If and when expectations are not met, investments will be sold from portfolios. There are always opportunities arising and we expect increased trading activity for some of our client portfolios in the coming months. Our recent effort to shorten duration has proven successful and continues to be a point of emphasis with the research team. We have also seen increased interest in implementing or increasing some of our long/short and global allocation strategies as investors seek to be opportunistic with volatility. The increase in volatility has benefitted the option strategies we implemented last year, and although they are more expensive now than they were, it may still be prudent for investors to utilize this hedge. We have positioned client portfolios for this market environment. If you have questions or are interested in learning more about what we are seeing across the investment landscape, please reach out to your West Capital Management Team. Decanting Trusts Over the past few newsletters West Capital Management has explained the tax, asset protection, and other benefits of irrevocable trusts. Indeed, many of our prospective and existing clients have assets in an irrevocable trust structure. However, some of these structures were created many years ago, and as a result of the passage of time, changing laws, and changing family circumstances, these trust terms can become outdated and overly burdensome. Accordingly, many investors have asked what remedies are available to modify unwanted trust terms. 9 Ycahrts.com 6

7 In fact, this is such a common sentiment that estate practitioners and state legislatures have created a process to take advantage of today s trust system. This process, known as decanting, allows trustees to move trust assets from an existing trust to another trust with more favorable terms. Decanting has become far more common in recent years and more state legislatures have enacted statutes permitting decanting by law. When decanting a trust, the trustee is most often able to make minor changes to the trust to best fit the needs of the beneficiaries and maintain the wishes of the grantor of the trust. Specific reasons for decanting are wide ranging. Below are some of the most common reasons to decant a trust: Correcting mistakes or ambiguities Accounting for a special needs beneficiary Updating provisions in accordance with changes in the law Combining or dividing trusts Changing trustee powers Bifurcating trustee powers to permit the hiring of an investment advisor Adapting to changed circumstances of the beneficiary, such as creditor or marital issues Modifying the distribution provisions to delay distribution of the trust assets Adding a spendthrift provision Extending the length of the trust Another major benefit of decanting is to gain added asset protection. In a recent case, Ferri v. Powell- Ferri a court held it was permissible when the trustee of a divorcing husband s trust decanted the existing trust into a new trust with more protective terms. The impact of this case remains to be seen, as it is a state case from Massachusetts that focused on a very narrow issue. Nevertheless, it indicates the benefits that trust decanting may provide and shows how powerful of a tool decanting can be. The process for decanting is fairly straightforward. First, the trustee must ascertain whether decanting is permissible under state law. To date, at least 25 states have enacted decanting statutes. In states without such a statute, the court will look to the trust document and to common law. Indeed, in the Ferri case, the court determined that even though Massachusetts did not have a statute permitting decanting, the trust document itself made decanting possible. The authority to decant will generally rest upon the amount of discretion given to the trustee under the trust document. If the trust cannot be decanted in the home state, the trustee may still be able to move the situs or location of the trust to a state with more amenable laws. Again, this ability can be derived from the terms of the trust, or through the laws of the home state. Once the trust is located in a state with permissible decanting, a new trust with favorable terms will be drafted to receive the assets of the existing trust. Each state has minor differences in decanting requirements, particularly in the administrative processes and timing. There are, however, a few common requirements, including notice to the beneficiaries (or in some cases written consent). In other words, many states (but not all) require the 7

8 trustee to notify, or receive consent from, the beneficiary before the governing trust can be changed in order to protect beneficiaries from being blindsided by unexpected changes. Additionally, some states do not allow decanting if it could result in a negative tax consequence for the beneficiaries. While decanting provides exceptional flexibility for beneficiaries, it does require serious consideration. First, there will be a legal cost involved for an attorney to draft a new trust and transfer the assets. Second, not all states are created equally. Each state s laws differ slightly providing different tax, asset protection, and flexibility implications. Prior to moving a trust from one state to another, an investor should carefully review the impact of the new state. Finally, decanting is done by the trustee, not the beneficiary. So the trustee must be in favor of the change. Indeed, decanting can create potential liability for the trustee. Consequently, many trustees require the beneficiaries to sign release and indemnity contracts to alleviate potential liabilities. Final Thoughts We are very excited to continue our educational workshops and seminars throughout 2018 and will be adding new events throughout the year. At West Capital Management we are always looking for ways to educate our clients and enhance our relationships. We look forward to continuing to build on our strength of resources to bring you the best ideas and services the industry has to offer. As a reminder, these webinars, workshops and dinners are open to all clients, their family and friends, and/or their legal and accounting professionals who may be interested in the material. Keep an eye out for those invitations in the coming months as we plan to host a few events in the very near future. We would also like to take this opportunity to thank you for your business and loyalty. As always, we remain committed to providing you with the highest level of service, financial planning and investment advice. Sincerely, Your West Capital Management Team This newsletter is provided by West Capital Management ( WCM or the Firm ) for informational purposes only. The discussion included in this newsletter may contain certain forward-looking statements about the factors that may affect performance of the markets in the future, including WCM s outlook regarding economic, market, political, and other factors relevant to investment performance. These statements are based on WCM s expectations concerning certain future events and their expected impact WCM s clients portfolios, and are current only through the date on the cover of the newsletter. Forwardlooking statements are inherently uncertain and are not intended to predict future performance. Actual events may cause adjustments in WCM s strategies from those currently expected to be employed, and WCM s outlook is subject to change. Any opinions of WCM s Management Team are intended as such and not as statements of fact requiring affirmation is subject to change. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. No portion of this commentary is to be construed as a solicitation to buy or sell a security or the provision of personalized investment, tax or legal advice. Certain information contained in this report is derived from sources that WCM believes to be reliable; however, the Firm does not guarantee the accuracy or timeliness of such information and assumes no liability for any resulting damages. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investment products, which otherwise have the effect of reducing the performance of an actual investment portfolio. WCM is the business name of WSFS Capital Management, LLC. It is an SEC registered investment adviser that maintains a principal place of business in the Commonwealth of Pennsylvania. The Firm may only transact business in those states in which it is notice filed or qualifies for a corresponding exemption from registration requirements. For information about WCM s registration status and business operations, please consult the Firm s Form ADV disclosure documents, the most recent versions of which are available on the SEC s Investment Adviser Public Disclosure website at WSFS Capital Management, LLC, is a wholly-owned subsidiary of WSFS Financial Corporation West Capital Management 8