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2014 could be a year of tough calls for investors

No big tax-law changes loom in 2014, but people may be surprised by higher capital gains and other taxes on 2013 returns.

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No big tax-law changes loom in 2014, but people may be surprised by higher capital gains and other taxes on 2013 returns.

For investors, this year is off to a mixed start. Stock market indexes maintained their gains from last year before dropping. Treasury bonds continued their losing streak in the weeks after the Federal Reserve announced it was reducing its bond-buying program — until the stock sell-off caused people to buy bonds. Interest in emerging markets has dropped.

On a positive note, politicians in Washington did nothing in January to cause jitters in the financial markets. But there are still 10 months to go, and another deadline to raise the debt ceiling.

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A variety of legislative actions and policy changes have gone into effect, are in effect but are being felt only now, or could come along later this year. What effect they could have on financial markets and investors’ psyches is hard to predict. Putting aside the unpredictability of the troubled health care overhaul, here is a look at some of the main policy events that could affect returns.

Federal reserve policy

One consequence of the end of the Fed’s bond-buying program, which it said it expected to decrease by $10 billion at each meeting, is that interest rates are expected to rise. If this happens, investors in existing Treasury bonds would face more losses.

What are the alternatives? The simple one is to invest in stocks, but many investors have a parallel fear — heightened, no doubt, in the last few weeks — that stocks are overvalued.

Anh Tran, a managing director at Modern Wealth Advisors in Irvine, Calif., had told clients to consider high-dividend-paying stocks and variable-rate high-yield bonds as alternatives to Treasurys. These two assets offer income and a hedge against rising inflation that fixed-rate bonds do not.

“They aren’t your Facebooks or tech companies,” she said. “These are large-cap companies that have remained consistent, like Johnson & Johnson, Procter & Gamble, and Coca-Cola.”

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For investors who prefer to hold bonds for income, there are products that can insulate them from rising rates and inflation. Steve Sachs, head of capital markets for ProShares, a provider of exchange-traded funds, said his firm had started two ETFs to hedge the risks for high-yield and investment-grade bonds.

Sachs said the ETFs were created to answer the question many investors have about Treasury bonds now: “What happens when the risk management tool you’ve been using to mitigate your risk becomes the source of your risk?”

There is a contrarian view of the Fed’s actions.

The Fed is tapering “at a time when the government is shrinking its deficit,” said Gary Ran, managing partner at Telemus Capital. But that “doesn’t mean rates are going to go higher.”

Still, he said his firm had advised clients not to go too far one way or another. He said his firm was mindful that the economy could improve more quickly, which would cause the Fed to raise rates sooner than expected.

Bank regulation

This is the year when rules with names like Volcker, Dodd-Frank, and Basel III are set to rein in how US banks do business. Their goal is to avoid a repeat of the 2008 financial collapse.

“They’ve been stated, postponed, somewhat implemented, but the end result is heightened regulation of banks is breaking the traditional business model,” said Greg Peterson, director of investment research at Ballentine Partners, an adviser to high-net-worth clients. “They can’t make the loans they used to.”

This is not great for businesses that need loans, but it is an opportunity for nontraditional lenders. Peterson said he had talked to clients about investing in funds that lend directly to smaller companies.

They are not without risks.

“In some sense, the systemic risks in the economy have been pushed out of the banks and onto the investors,” he said. “If one of these firms goes bankrupt, there’s no recourse. The investors have lost their investment.”

For this reason, he said, investors need to be vigilant in assessing managers and making sure their qualifications are not overstated.

Municipal bond worries

When a judge allowed Detroit to file for bankruptcy last year, it was hard on the city’s workers and pensioners. It also struck fear into the hearts of municipal bondholders, who were treated as unsecured creditors. Would this signal a way for struggling municipalities to not pay their debts?

For many analysts, a bigger concern is Puerto Rico, whose bonds are more widely owned because of the tax advantages. The island’s ability to pay on these bonds has been questioned for months, and last week two ratings agencies downgraded their ratings to “junk.”

Jim Cahn, chief investment officer at Wealth Enhancement Group, said the “Detroit effect” has caused investors to be more discerning, but he hasn’t lost faith. Higher taxes will continue to make municipal bonds attractive, he said, because the interest they pay is not taxed federally.

Broker rules

Standards governing brokers and advisers are a longstanding issue. The fiduciary standard requires advisers to adhere to a higher ethical standard when making investment decisions for clients. The suitability rule allows brokers to recommend investments they think are suitable, even if their firm created the product and will profit more if the client buys it.

This year, the Labor Department is expected to rule on whether a fiduciary standard is needed for the management of 401(k) plans and other investment vehicles under its purview. The ruling is expected to make anyone who offers advice on these plans adhere to the fiduciary standard.

But Knut A. Rostad, president of the Institute for the Fiduciary Standard, said how transformative the ruling is will depend on how advice and education are defined. A firm calling its advice education might not be bound by the fiduciary standard.

Many brokers work hard to provide a fiduciary level of service, though they’re not required to, Rostad said. “But there are many who don’t do that. From a regulatory point of view there is no way for a broker to be a fiduciary for retirement assets but not everything else.”

This is where any ruling from the Securities and Exchange Commission would have a broader effect. Advisers like Rostad worry an SEC requirement for brokers to be fiduciaries could be so vague it would be worse than no requirement at all. “Virtually overnight every single financial investment intermediary would call themselves a fiduciary, but they would be working under the same rules that they are now,” he said.

This is where investors need to be more vigilant about how their advisers or brokers are paid and whether they are given further incentives to sell products by their own firm or any other.

Your tax bill

While there is no big change set for federal tax policy in 2014, now is the time when people realize just how much their taxes went up last year. In many cases, they went up significantly.

In addition to higher taxes on earnings, taxes on capital gains went up. Couple that with a banner year for stocks and there are two immediate problems. First, investors may hesitate to sell a stock on which they will have to pay a large capital gains tax, even though the company behind that stock is no longer as strong. But at least those investors have a choice. The second problem is that people who owned stocks in mutual funds, which are required to distribute capital gains, had no choice but to pay taxes on the gains.

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