In the last column I talked about model portfolios and how many advisors establish a uniform basket of stocks for their clients. Most advisors have two sets of lists for their model portfolios: one that has the stocks they are considering buying and another that has the stocks they are considering selling. One trading tool that advisors use in developing and keeping their model portfolio basket of stocks up to date is switch trades. A switch trade occurs when a position is simultaneously sold from a model portfolio and another position is bought.
Mr. Jones is retiring and now requires income from his portfolio. Mr. Jones came to us for a second opinion. Currently he holds $500,000 in mutual funds that are not generating any income, while also paying the management expense ratio that costs $12,000 annually. We suggested he sell these mutual funds and switch into a basket of direct holdings containing dividend paying blue chip equities that would pay him a minimum of $20,000 in dividends annually. This would increase his income substantially. Moreover, he would save $7,000 annually since direct equity investments through a fee-based account would have lower investment costs than mutual funds. His investment costs for the blue chip equities would bring his cost of investing down to $5,000 annually.
When an individual is fully invested, such as Mr. Jones, switch trades are effectively the only way someone can purchase securities. Initially, Mr. Jones will be executing switch trades on a macro level as he is completely remodeling his portfolio from entirely mutual funds to all direct holdings. Once his 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.
As your investment objectives change, certain securities may no longer be appropriate for your current situation. Switch trades can be used in these circumstances to better align the portfolio with your 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.
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 the 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 trading both by changing to a lower or higher yield, depending on their unique situation.
For example, Mr. Jones is trying to increase his yield to provide retirement income. He currently holds a growth stock with a yield of 1.2 per cent; however, he is looking for a higher yield and is interested in switch trading his growth stock for a value stock that pays 4.6 per cent. If Mr. Jones holds a position of $20,000 with the growth stock’s yield of 1.2 per cent, he will make $240 in dividend income. If Mr. Jones switched to the value stock with a yield of 4.6 per cent, his annual dividend income would increase to $920 (a $680 increase) on that one holding of $20,000.
Due to market variations, each of the different sectors may be either underperforming or outperforming others during any given period. Switch trades can be useful in these instances for re-balancing a portfolio to overweight or underweight a different sector. By using a switch trade, investors are able to 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 Mr. Jones’s stocks of company ABC have appreciated nicely; however, he believes their sector will soon decline and he is now looking to sell those stocks. With the proceeds, Mr. Jones is looking to invest in stocks of company DEF, which is in a sector that he believes will outperform in the future. A switch trade can be done to execute this order. Mr. Jones holds 200 shares of ABC, currently selling at $50 a share. As ABC is sold, the switch trade simultaneously buys DEF with the proceeds. Since DEF is currently selling at $25 a share, Mr. Jones is able to buy 400 shares. As a result of this switch trade, Mr. Jones is now overweight in a sector expected to outperform, and has minimized his holdings in a sector expected to underperform.
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. For example, over time Mr. Jones’s portfolio has become unbalanced, and he is now overweight in equities and requires more fixed income. To solve this, a switch trade can be executed selling equities and buying fixed income. Alternatively, if Mr. Jones was underweight equities, he would sell fixed income and buy equities through a switch trade.
For tax planning purposes, switch trades are ideal for ensuring you are minimizing the amount of tax you pay. As an illustration Mr. Jones has experienced a capital loss in a particular stock in the energy sector; however, he wishes to keep the same weighting of energy in his portfolio. An option for Mr. Jones in this situation is to place a switch order. By selling the energy stock he currently owns and simultaneously buying another similar energy stock, Mr. Jones is able to use the capital loss to reduce his 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.