Issues, Exchange Traded Funds, Taxes

Issues

Issues are background to decision making for your portfolio management. Each month DIYPMS will feature an issue. Most of the monthly issues are discussed more completely in DIY Portfolio Management. However, the discussion here might have a slightly different slant than in the book.

April— 2006

What's Working Now?

I’ve been increasingly enthused about ETFs, Exchange Traded Funds. In DIY Portfolio Management, I recommend SPY* or a mix of a few large ETFs as good strategies for those who don’t want to invest a lot of time or assume a lot of risk. The appeal of holding ETFs comes from low expense ratios, diversification, and tradability. ETFs trade all day long, like stock equities.

Lately, I’d been paper trading various Trend Regression Portfolio Strategies using models with 50 ETFs. I switched one of my real money accounts to a traded ETF strategy in March 2005, and expanded to a second account in November.

The graph below compares funded ETF model performance against SPY. SPY is the horizontal green line at 100%. Using SPY as our market benchmark, lines above SPY indicate market beating performance.

Fund		RETURNS		Fund B(W)	Years from Inception	Annualized Return		Annual B(W) S&P 500
Symbol	Inception	S&P500	Fund	S&P500	Years from Inception	S&P500	Fund	Annual B(W) S&P 500
etf	3/28/05	13%	29%	16%	1.0	13%	28%	15.8%
etf index	11/7/05	7%	12%	5%	0.4	19%	32%	13.3%

Both these strategies are funded on FOLIOfn. The oldest one is a mix of a daily price and a weekly price model using the same 50 ETFs. The ETFs were picked primarily based on length of trading history. The newer account adds continuous holding of 6 large ETFs. The total number of ETFs held varies week to week, from 9 to 12. Both accounts are always 100% invested. The newer account blends ‘buy and hold’ and Trend Regression Portfolio Strategies in a single account.

The performance of these strategies has been impressive. I don’t know how long it will last. My experience has been that models work for a while then fade. I’m not sure yet whether it is because the models just stop working or because my focus shifts.

For more performance statistics see performance tables.

The six large ETFs are SPY (for broadness), DIA (for tradition), QQQQ (for tech), EFA (for globalness), EWJ (because my wife is Japanese), and EWC (because I’m Canadian).

*SPY is the ticker for S&P Depositary Receipts the ETF that tracks, mirrors the S&P 500 index. SPY is the oldest and biggest ETF.

Lyle Wilkinson

June— 2005

Retirement Planning Wars

Through our working lifetime, saving forces battle the ‘live life’ forces. In our family sometimes saving won and sometimes spending won. As retirement approached we had equity in our home, a small nest egg, and no consumer debt.

Through our working lifetime, the conservative asset allocation forces battled the aggressive asset allocation forces. In our family, we mostly allocated and diversified with random financial transactions. There was no written or even spoken plan. Individual transactions were analyzed as discrete events loomed, not as part of a total plan. Thankfully we weren’t living beyond our means or wildly aggressive investors. As retirement approached our nest egg was split 50/50 between common stock and money market funds.

Finally, I retired and only then began studying our financial life from a big picture point of view.

Most of my early reading reinforced the common perception that asset allocation between asset classes reduces risk. The theory is that prices in different asset classes inflate and deflate at different rates. Rising bond prices might offset falling stock prices. Rising real estate prices might offset falling commodity prices. One of the champions of asset allocation is Burton G. Malkiel, PhD. In A Random Walk Down Wall Street he popularized a life-cycle approach to asset allocation. He proposed that retirees should shift more of their nest egg into bonds or other fixed income securities. The theory is that when salaries/wages stop and projected years to live decrease we can tolerate less risk.

Along the way I started looking at ways to access the equity in our home. I looked at reverse mortgages and discovered what reverses is the mortgage balance. In a conventional mortgage the balance decreases with each payment you make to the bank. With a reverse mortgage the balance increases with each payment the bank makes to you. The balance grows, but at some point the bank has to be paid off. Often cash is raised to pay the bank by selling the home.

Jeremy Siegel, PhD. studied more than 200 years of US stock market data. He determined on average the stock market returns a real return of 6.8% per year. He found that on average the stock market out yields other equity classes, and says “stocks remain the best bet in the long run for US investors.”

In mid 2002, these ideas were swirling around in my retired head. Diversifying asset classes reduces risk. Stock market has greatest average return. Interest rates, mortgage rates are at a fifty year low. I also knew from financial theory that pursuit of greater return requires acceptance of more risk. Conversely, avoidance of risk limits return. Some Excel spreadsheets with random number generators convinced me that the average annual draw from a retirement nestegg 100% in equities would exceed that of any mix of bonds and equities. Average draw would be more, but in individual years the draws possible for a bond portfolio are sometimes greater.

In July of 2002, we refinanced our mortgage and invested the proceeds in the stock market. The account is also my checking account. The plan was to keep the account balance at about the mortgage balance. The balance would be maintained by spending less if the account fell below the mortgage, and spending more if the account climbed above the mortgage. The account started with $128,175.86. Since then I’ve withdrawn $34,921.17 more than I have deposited, the investment value has grown by $35,782.19 and the account is at $129,036.87. The withdrawals include all interest and principle payments and closing cost for the first refinance and for a second refinance along the way. The mortgage balance is $127,766.97.

This strategy is working for us. I like the idea of staying flexible, slowing spending when the market is down and spending more when the market is up. Last year I spent $10,000 on reflooring and painting our condo. This year I’m spending the same on a 1990 Mustang Convertible. These are flexible projects. The market gave a little extra so we spent it. This strategy is probably not appropriate for everyone. There is always the chance that a bad year in the market will coincide with large inflexible expense.

In retrospect, I wish I had figured out at the start of my working life that diligent investment into a diversified equity portfolio would have made me wealthy. I wish I’d figured out borrowing for an investment was probably a better use of credit than borrowing for a new car. But, when you are in your twenties, who thinks deferred consumption is good. I’m happy now with more than 100% of my equity in the stock market.

In a future article I’ll discuss my Excel retirement draw models, and point out a website that goes far beyond. The website lets you play with asset allocation, funding amounts, and your expected longevity to see what your monthly withdrawal will be.

May — 2005

Top 3 Wealth Building Mistakes

— Do You Make Any of Them?

Do you procrastinate? Investing mistake #1 is waiting too long to begin. The wealth building formula needs time to work.

Do you invest too little? Investing mistake #2 is putting too little money into your investments. Living beneath your means is not easy, but it is essential to building wealth.

Do you accept too low a compound interest rate? Investing mistake #3 is accepting too low a return on your investment. Rate of return, compound interest rate, is a key determinant for growing wealth. Compound interest is powerful in both directions. Positive compound interest builds wealth. Negative compound interest shrinks wealth. Bank savings accounts may eliminate negative compounding, but are not a good place for investing because of low returns.

These 3 mistakes link in the wealth formula:

Wealth = ($ invested)*(1+(compound interest rate)) (time $ invested)

Wealth is a function of the amount of money invested, the interest rate it grows at, and the amount of time it is left to grow.

Okay the wealth formula is really just the compound interest formula with new labels. You know the compound interest formula and how it works. You know what to do to increase your wealth. Save more, defer consumption longer and get a better return on your investment.

It is one thing to know the wealth formula; it is another to live it.

What are you going to do to increase the amount you are saving and the time you are letting your investment work? Saving is synonymous with amount of money going into investments, not amount going into a bank savings account. Get rich slow gurus pitch tips like: “save 10% of your income” or “pay yourself first.” There are books aimed at helping you save, about changing your lifestyle. I recommend:

How To Live Without A Salary is by Charles Long, he promotes what he calls a Conserver Lifestyle
The Tightwad Gazette is by Amy Dacyczyn, she promotes thrift as a viable alternative lifestyle

Both books, give tips about saving money and pitch living frugally as a superior, or at least acceptable, lifestyle. Amy Dacyczyn points out there is a difference between being wealthy and looking wealthy. In the short term, an affluent lifestyle can be financed by debt. What are you about substance or image?

What are you doing to improve your rate of return? How are you balancing return and risk? Generally to improve your rate of return you will have to accept more risk. The textbooks calculate risk as variability. A bank savings account has low calculated risk because it grows but never shrinks below the starting point. However, if inflation is 2% and your bank is paying .5% your buying power is falling. The inflation adjusted return is -1.5%. The probability that you will lose buying power is 100%. Equity investments have variability, calculated risk. Their prices go up and down. Given an S&P 500 return of 7%, standard deviation of 10%, and inflation of 2% there is 31% chance that buying power will go down. This 31% compares to 100% chance that buying power of bank savings will go down. Think about risk.

There are lots of books about increasing your rate of return. Please, stay away from strategies that “sound too good to be true.” Read up on some of the strategies that promise a conservative get rich slow approach. I recommend High-Return Low-Risk Investment by Thomas J. Herzfeld and Robert F. Drach or DIY Portfolio Management . I’ve read other books, but my money is in Drach strategies and Trend Regression Portfolio Strategies now. These are the only ones that made it thru back-testing and paper-trading to funded accounts.

Individuals can and should manage their own stock portfolios. They gain more control over their investment results by doing it themselves. They reduce investing expense by eliminating management fees and reducing commissions. Recent mutual fund scandals and other Wall Street news is making it harder to accept that pros treat small clients fairly. Besides, there is no empirical evidence that professionals deliver better returns than individuals can attain for themselves.

Remember to grow wealth save more, defer consumption longer and get a better return on your investment. It sounds easy, but many can’t live the wealth formula. It takes desire and discipline. It takes deferring consumption and embracing risk.

April — 2005

Exchange Traded Funds Are Good for Investors

Exchange Traded Funds (ETFs) are growing. Investors are choosing low annual expense and market return over high annual expense and promised performance.

Total ETF inflow is growing faster than Mutual Fund inflow. ETF inflow grew from $42.5 billion in 2000 to $54.4 billion in 2004. In contrast, mutual fund inflow fell from $309.4 billion in 2000 to $180.3 billion in 2004. Standard & Poors Depositary Receipts Trust (SPY) is the largest and oldest ETF. From the one fund SPY started in 1993 the number of ETFs has grown to 150 in 2004.

Growth of ETFs is fueled by investors searching for market performance. About 20% of conventional mutual funds do beat the market. The puzzle is which funds will win, in the future. ETFs, on the other hand, have a reasonably good record of matching the performance of their underlying index. For instance, in 2004, SPY value grew 10.92% and the value of the underlying S&P 500 index grew at 10.88%. The promise of the conventional mutual fund is that it will deliver superior results. The promise of the ETF is that it will match the performance of its underlying index.

Expense for ETFs is less than for conventional mutual funds. A prime reason for the mutual funds’ higher expense is that pros perceived capable of superior results are more expensive than technicians paid to duplicate the holdings of an index. ETFs are passive investments and don’t require the active management of pros. Investors moving money from mutual funds to ETFs are trading promised performance and high expense for market returns and low annual expense. ETFs generally have expense ratios below 1. SPY’s expense ratio is .12. Expense ratio is percent of assets consumed by fees annually.

Investors sticking with mutual funds have a couple of things going for them. Eliot Spitzer has used his New York State Office of Attorney General to scare/shame mutual funds into minding fiduciary duties to their investors. The growth of ETFs is pressuring mutual funds to reduce their expenses and to introduce ETFs mimicking mutual funds. Investors sticking with mutual funds might benefit from the growth of ETFs. However, mutual funds might have a hard time delivering. Slowing growth or actual decline in fund size will make it difficult to reduce their expenses enough to keep investors happy. The more investors defect the fewer left to share the expense.

ETFs trade like stock equities. They can be bought and sold whenever the market is open. They can be shorted, purchased on margin, and optioned. Most brokers charge a commission for every buy and sell transaction. This can be a problem for small investors building a portfolio with monthly contributions. There is at least one broker that charges an annual fee rather than per trade commissions.

ETFs are passive. They only trade when changes are made to the composition of the underlying index. Fewer trades mean less tax consequence. Mutual funds often have taxable capital gains, sometimes even in years when the fund has declined in value (sell winners and hold losers).

That 20% of mutual funds beat the market is a premise. It assumes multiply years and a market defined as the S&P 500. Meg Richards writing for The Associated Press reported that for 2004:

The S&P500 bested 61.6% of actively managed large-cap funds.
The S&P400 bested 61.8% of actively managed mid-cap funds.
The S&P600 bested 85% of actively managed small-cap funds.

The probability of a mutual fund having beaten the market in 2004 is low. Of course, relative performance changes from year to year. Relative performance, of active versus passive management, changes. Relative performance, of individual actively managed funds, changes.

The best ETFs strategy for small, beginning, busy investors is to ‘buy and hold’ SPY. If you are bigger, experienced, or have time on your hands you can try a more active strategy. A strategy that beat the S&P500 over the last three years is to hold equal amounts of five large diversified ETFs and rebalance weekly. This strategy is in some ways just an expansion of our definition of ‘the market’ beyond the S&P500. This strategy since inception 3 years ago has beaten the S&P500 just over 1% annualized. This small gain means rebalancing weekly is only viable when it is without trading cost. A more aggressive strategy is to monitor 50 ETFs and hold the most oversold, rebalancing weekly. This strategy since inception 2/27/04 has beat the S&P500 by 16%.

Remember. ETFs’ popularity is on the rise. They trade like stocks. They have lower annual expense than mutual funds. Their objective is to mimic the performance of an index. They don’t beat or lose to the market, they are the market. It is usually best for low maintenance, ‘buy and hold’ investors to define the market as broadly as possible.

March — 2005

Taxes

We want to pay our fair share. However, we don't want to pay extra, or pay someone else's share.

Most people can minimize, or at least delay, taxes by growing their nest egg in 401k accounts and IRA accounts. Tax rates are based on year of draw, not on year of gains.

Most people can minimize taxes on taxable accounts by buying and holding Exchange Traded Funds (ETFs). Taxes are due when ETFs are sold, probably at long term capital gains rates. There is more about ETFs in DIY Portfolio Management, and in the Strategy section.

Active traders can minimize taxes and record-keeping by trading in their IRA accounts. Remember taxes are based on draws, not on gains. From a tax standpoint this may make sense, but speculative trading with a retirement nest egg is not a good idea. Conservative, do it yourself portfolio management of an IRA account is okay. Balancing portfolio management in an IRA account with buy and hold ETFs in a taxable account is a tax efficient, conservative strategy.

Active traders can minimize taxes on taxable accounts by getting the IRS to recognize your status as an active trader. Traders are taxed on gains in the year of the gain and mark-to-market at the end of the year. Traders can deduct more losses than investors. Traders have more latitude in what qualifies as an investment expense. Trader status can get a little tricky and consulting with an accountant who is familiar with trading tax rules is a good idea.

An advantage of trading in IRA accounts, and of trader status, is individual trades become a little less complex because tax consequence is not a consideration.

Using tax consequence as logic to delaying an individual trade is not always a good idea. For example—

Investor buys Yahoo in summer of 1999. Investor studies tax situation for year end and decides to hold until Yahoo qualifies for capital gains. Yahoo bought July 1 for $44.31. Yahoo runs up to $100.92 on December 29 ( a nice $56.61 128% gain). On the day after the trade's one year anniversary ( 7/2/2000) Yahoo is back to $63.94. Still a gain, but the drop from year end would need a $36.98 in tax savings for break even. Investor forgets to sell on July 2. As year end 2000 approaches. Investor reviews situation and finds he can now take an advantage of Yahoo's $15.50 price to offset some capital gains.

The Yahoo example may seem a little contrived, but stock prices do go up and down. The investor holding for capital gains is expecting the stock price to hold, or at least not fall more than the amount of expected tax savings. In the Yahoo example the investor is trading a sure profit with tax for a unknown profit(loss) with a smaller tax rate.