ETFS FOR SCAREDY-CATS

You want to get a piece of the bull mar­ket while elim­i­nat­ing cat­a­strophic losses? fol­low the lead of twenty-first se­cu­ri­ties.

Forbes - - CONTENTS - BY WIL­LIAM BALD­WIN

You want to get a piece of the bull mar­ket while elim­i­nat­ing cat­a­strophic losses? Fol­low the lead of Twenty-First Se­cu­ri­ties.

In a toppy mar­ket, in­vestors suf­fer ter­ri­ble men­tal tor­ment await­ing the next crash. Min­is­ter­ing to them is Robert N. Gor­don, port­fo­lio doc­tor. One pa­tient: a for­lorn tax­payer sit­ting on a highly ap­pre­ci­ated $51 mil­lion col­lec­tion of blue chips. Us­ing a deft com­bi­na­tion of put and call op­tions, Gor­don has all but locked in the gain while sidestep­ping tax rules de­signed to pun­ish peo­ple who hedge away their risk.

Gor­don works with a lot of in­vestors like this one. “The last thing they want to do is pay a cap­i­tal gain tax, but they want to lighten up,” he says.

Gor­don is pres­i­dent and owner of Twenty-First Se­cu­ri­ties, a bou­tique bro­ker in New York City that han­dles dif­fi­cult trades, the ones re­quir­ing a knowl­edge of both op­tion math and tax law. At one point his firm was over­see­ing $5 bil­lion in short sales against the box, which un­til 1997 was a way to de­fer cap­i­tal gains taxes by hold­ing long and short po­si­tions si­mul­ta­ne­ously. Congress ended that par­ticu-

lar tax dodge, but Gor­don has a lot more in his sur­gi­cal kit.

As a niche bro­ker spe­cial­iz­ing in ar­cane tax-avoid­ance tech­niques, Gor­don is like a Tal­mu­dic scholar when it comes to the tax code. For ex­am­ple, he knows, in­side and out, Reg. 1.246-5(c) (1)(iii)(B), which sets out when a tax-spar­ing hedge crosses the line into a for­bid­den strad­dle. But he is also adept at the glad-hand­ing side of the bro­ker­age busi­ness.

One lead came in from a course on in­vest­ment tax­a­tion that Gor­don teaches at New York Uni­ver­sity. A for­mer stu­dent got in touch, ask­ing whether a tech­nique he re­mem­bered from class would be help­ful when his fam­ily sold its hot-dog busi­ness. Twenty-First got that as­sign­ment. The value at stake ran to nine fig­ures.

If you don’t own a pri­vate jet you are prob­a­bly not cut out to be a cus­tomer of Twenty-First. But Gor­don is will­ing to share some of the tech­niques he uses on large ac­counts and to show in­vestors of more mod­est means how they can get sim­i­lar re­sults us­ing ex­change-traded funds.

Given the stock mar­ket’s qua­dru­pling from its 2009 low, would-be users of ETF-based hedges fall into one of two camps: Timid Bull and Pro­tect What I Have. The first group fear miss­ing out but also fear get­ting in­jured in a correction. Is there a way to be in the mar­ket while re­duc­ing or elim­i­nat­ing the pos­si­bil­ity of loss?

Banks have prod­ucts to ful­fill this need: cer­tifi­cates of de­posit with pay­offs tied to the S&P 500 in­dex. Gor­don picks up a re­cent of­fer­ing from J.P. Morgan and de­con­structs it. It’s not a par­tic­u­larly bad deal, he says, since the CD is priced at only 3.8% over its in­trin­sic value. But the seven-year CD has two big neg­a­tives: If you need to get out early you might have a hard time sell­ing it, and it de­liv­ers all its re­turn in the form of highly taxed in­ter­est in­come.

Gor­don has his big in­vestor clients repli­cat­ing CDs like this us­ing zero-coupon bonds and “flex” op­tions, which are cus­tom-made con­tracts that can be de­signed to de­liver a pre­cise du­ra­tion and pay­off pat­tern. Us­ing op­tions, he can turn more than half the re­turn into fa­vor­ably taxed long-term gains.

At Fidelity In­vest­ments you can or­der up a flex op­tion on State Street’s S&P 500 ETF (SPY)—but only if you’re look­ing for at least $13.6 mil­lion of mar­ket ex­po­sure. What if you’re a smaller player? You have to use off-the-shelf op­tions traded on the Chicago Board Op­tions Ex­change, where the ante is one con­tract con­trol­ling $27,100 of SPY.

Us­ing re­tail op­tions, you may wind up with a slightly dif­fer­ent mix of po­ten­tial pay­outs than what­ever your bank is ped­dling this week, but you will ac­com­plish your goal of get­ting some ac­tion from the stock mar­ket while in­sur­ing against a fi­nan­cial cri­sis. Your liq­uid­ity will be higher and your taxes lower than with the bank prod­uct.

You could, for ex­am­ple, buy Van­guard’s S&P 500 in­dex fund (VOO), then pro­tect it with put op­tions on SPY. Why buy the ETF from Van­guard? Be­cause it has lower ex­penses. Why buy put op­tions on the other S&P 500 ETF? Be­cause they are more liq­uid. SPY has 4,300 times as many op­tions out­stand­ing as VOO does.

With SPY trad­ing at $271, the put ex­pir­ing in June 2019 and ex­er­cis­able at $250 was re­cently priced at $12. This in­sur­ance is good only against crashes; in a correction smaller than 8% the put ex­pires worth­less.

There’s a booby trap here that your bro­ker may ne­glect to men­tion: If the ETF is held in a tax­able ac­count, the op­tions have to go in an IRA. Mess this up and you’ll get nailed by the strad­dle rule, killing the fa­vor­able tax treat­ment granted to the ETF’s div­i­dends and cap­i­tal gains.

What does Twenty-First do for Pro­tect What I Have cus­tomers? Roy Haya, 45, the firm’s chief de­riv­a­tives trader, runs re­gres­sions of clients’ port­fo­lios against dozens of ETFs. The game is to find op­tions on a fund that tracks an es­tab­lished port­fo­lio very closely, yet does not flunk the strad­dle test.

That game is sur­pris­ingly easy to win. The IRS as­sesses the sim­i­lar­ity be­tween two port­fo­lios not by cal­cu­lat­ing a cor­re­la­tion but by count­ing shares. You might feel a twinge of guilt tak­ing ad­van­tage of the agency’s naïvete, but the emo­tion will pass quickly.

A well-di­ver­si­fied col­lec­tion of highly ap­pre­ci­ated blue chips is likely to have a fairly high cor­re­la­tion to the S&P 500. If it does, puts on SPY are a way to sleep bet­ter at night. As for tax com­pli­ance, you can ei­ther go through with the share-count­ing rit­ual or just take Haya’s word for it that no port­fo­lio of fewer than 121 stocks cre­ates a strad­dle with SPY. All else fail­ing, hide the put in your IRA.

Gor­don, 65, re­cently wid­owed, has two kids, nei­ther par­tic­u­larly in­ter­ested in Wall Street. What’s go­ing to be­come of the firm? Gor­don says that Haya has an equity stake.

If that stumps you, given that Gor­don owns the whole thing, you don’t think like a de­riv­a­tives guy. Turns out Haya has a call op­tion on shares of Twen­tyFirst. Some kind of tax an­gle is in­volved. These guys don’t miss a beat.

fi­nal ThouGhT

“There are times when fear is good. It must keep its watch­ful place at the heart’s con­trols.” —Aeschy­lus

By wil­liam Bald­win Robert Gor­don with 19th- and 18th-cen­tury or­reries from his col­lec­tion. The so­lar sys­tem is not quite as com­pli­cated as tax rules.

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