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Thursday January 8, 2015

How To Simplify Your Portfolio

In my year end newsletter to clients I talked about simplifying the financial planning process as well as reducing the number of investments in client portfolios. In this blog post I’ll be discussing why “less is better” if done correctly in an investment portfolio. First we’ll talk about why simplifying your investment portfolio is advantageous, then I’ll give you specific examples on how to simplify your portfolio.

Wait, Don’t I Need A Lot Of “Stuff” In My Portfolio?

No! When I speak with investors not currently working with my company, more often than not two themes appear with regular consistency. First, investors believe having a larger number of investments represents safety (that diversity thing). Second, when you look under the hood of their investment portfolio, I find people investing in a lot of the same stuff.

Challenging The Belief That More Investments Are Better

Most folks believe investing is complicated (maybe it is, but just a little). Therefore, they tend to feel more comfortable owning a portfolio of 12 mutual funds, 7 ETFs, and 15 stocks versus a portfolio of just 3 or 4 funds. While it’s possible to obtain fairly broad diversify with only a few funds, many people would feel they’re missing out on something. It’s easy to see why our investment behavioral bias would leave us feeling this way. What I’ve found is that when I explain the breadth of diversity they could achieve with fewer investments, most folks tend to relax their attitude that more is better. When I further show that reducing the amount of investments can maintain (and in many cases improve) diversification, reduce risk, improve tax efficiency, reduce trading costs, and lower fund expenses they really start to get on board. Once an investor has a basic education on proper portfolio design, they can usually let go of their old school thinking. They end up with that same “ahhhh” feeling you get after cleaning out your basement and dropping off all your unused stuff off at the thrift store. Investors who reduce portfolio clutter either on their own or by hiring me feel in control. When an investor feels in control, they become better equipped to be disciplined investors committed to the long term. How powerful!

When You Buy A Lot Of Stuff, Overlap Happens

When you have investment overlap, the portfolio you think you own isn’t the portfolio you actually own. Simply said, you may think you are investing in a balanced portfolio, but duplication in stocks or bonds can skew the portfolio more aggressively or more conservatively than your liking. Not good. It’s rare a portfolio actually represents what the investor believes it represents. To give you an example of overlap, you may own Apple stock, but it may also appear in your large cap growth fund, your S&P 500 index fund, your tech fund, and your world stock fund. With that kind of exposure, APPL stock could easily climb to 10 or 15% of your entire portfolio. Such concentration doesn’t align with diversification, does it?

Ok I’m Convinced I Need To Look Into This, What Do I Do?

Well, without trying to come across like the typical salesman, call me! I can quickly create an analysis showing your stock, sector, and country overlap. Without even ever becoming a client a my company, we can discuss which investments can be eliminated, as well as asset classes you may be lacking (adding diversity). If you prefer, you can create a free account at Morningstar.com, and use their Portfolio Manager. Even in their free version, the analysis is fairly robust, giving you insight on where and what you’re invested in. Here’s a sample of part of the output you can generate.

If you’re not familiar with the style box analysis, or if you get bogged down trying to figure out which holdings can be eliminated, just let me know. I’ll get you back on track.

Putting All The Pieces Together

Once an investor determines what portfolio sprawl can be eliminated, they need to find differentiating investments to capture all parts of the investable universe. I accomplish this using index funds and exchange traded funds (ETFs), but you can also use mutual funds if that’s what you’re comfortable with. If you’re unsure what investments to buy, Morningstar offers free fund screeners for both ETFs and mutual funds. To give you an idea of what your new, refreshingly simple portfolio could look like, the portfolios I use with clients have 8 funds, contains over 20,00o individual stocks and bonds, invest in over 40 countries, and on average cost 0.26% in fund expenses. The returns aren’t too shabby either.

Remember, I’m here to help. I genuinely care about building inexpensive, globally diversified portfolios. It’s pretty easy to get bogged down with portfolio design. I can help you take the guess work out of it. Together we can raise your portfolio confidence and free up time so you can focus on other stuff in life. Thanks for reading and have a great day!

Greg Lessard, CRPC
Founder & President

Tuesday October 28, 2014

When Mutual Fund Managers Mimic An Index, Investors Lose.

If investors are going to pay significantly higher fees than an index fund, shouldn’t they expect significantly different holdings than the appropriate benchmark index? If a mutual fund holds similar holdings as its underlying benchmark, after expenses the mutual fund typically underperforms the index.

The Trend

In a 2009 study, Antti Petajisto suggests that mutual funds that hold at least 40% different holdings than their benchmarks are statistically truly active. Taking data from Morningstar, we can see that the 25 largest mutual funds barely constitute “actively” managed. This is measured by a relatively new statistic called Active Share. On a scale of 0 to 100, a score of 0 equals perfect correlation to an index whereas a score 100 equals an entire deviation from the index. Statistically, anything below an Active Share score of 60 means the mutual fund manager is a closet indexer.

Many of the biggest and most popular mutual funds exhibit Active Share scores close to the 60% mark. This means that many of these funds mostly hold the same exact stocks that an index fund representing the benchmark would hold.

A Closer Look At Closet Benchmarking

I wanted to illustrate closet benchmarking on a graph but when I began looking at the funds above, I couldn’t find one that actually outperformed its benchmark (I gave up after analyzing 14 of them). Instead of visually demonstrating this, let’s explore why a fund manager would choose to do this. Fund managers are under a lot of financial pressure to outperform. Since much of a fund manager’s compensation is tied to assets under management (AUM), they may do whatever it takes to bring in as much AUM as possible. One of the best ways to increase AUM is to advertise outperformance. The only way a fund manager is going to outperform the index is to take a risk and make a bet on a particular stock or sector. If they’re correct on their bet, then their financial incentives dictate they should do anything possible to continue that outperformance. Since this is practically impossible to do in the long term, once they’ve had a success (whether due to luck or skill is highly debatable), they’ll invest very similar to the index to “milk” the outperformance as long as possible. The problem with this is the investors that bought into the outperformance usually do so after the fund manager had their heyday. In effect, all the investor is doing is paying a high price a fund that mimics an index with little incentive to ever outperform again.

The Alternative

Instead of chasing returns where you probably won’t experience the outperformance you thought you were paying for, simply buy the index. You’ll forgo the allure of beating the market, but at least you won’t underperform. An investor can construct a highly diversified portfolio of index funds to achieve their long term financial goals, while adhering to a risk appropriate asset allocation. You can read more how to do this HERE.

Thanks for checking out my blog. If you have questions, please reach out to me!

Tuesday September 16, 2014

How To Reduce Taxes Using Exchange Traded Funds

You Can’t Control The Stock Market, But You Can Influence The Taxes You Pay On Investments

Ok sort of… The reality is there’s very little you can control when investing, but you can definitely influence a few important things. One strategy you have control over is what investments you use to manage your taxes. This post will focus exclusively on how using exchange traded funds (ETFs) versus mutual funds can help lower your current tax bill, especially capital gains tax. For any of the following to matter, it helps if you are in a tax bracket that actually taxes investment dividends, interest, and capital gains. Let’s begin with an overview of tax rates and brackets. In 2014, a married filing jointly taxpayer earning less than $73,800 will reside in the 15% tax bracket. If you’re a single taxpayer, your number is $36,900. If you think you’ll fly under these thresholds, then stop reading now since none of this applies to you as you’ll pay 0% tax on investment capital gains, dividends, and interest. Wait, there’s more tax jargon we have to pay attention to first… If you end up with a Modified Adjusted Gross Income of more than $250,000 in 2014, then you’ll likely have to pay an additional 3.8% in addition to your 15% capital gains rate. This extra 3.8% is called Net Investment Income Tax, and it’s levied to help pay for the subsidies available within the Affordable Care Act. If you are married filing jointly and end up in the top tax bracket (making over $457,601), then you’ll pay a capital gains rate of 20% plus the additional 3.8%. Next, we have to understand whether or not ETF dividends are qualified (underlying shares in the ETF held by the ETF for more than 60 days) or non-qualified dividends (those that don’t qualify for qualified status, duh). Most domestic ETFs are structured so that the dividends they pay out to shareholders are qualified, and if you’re married filing jointly making between $73,800 and $457,601, you’ll pay 15% on qualified dividends. Remember that if you’re married filing jointly and have a Modified Adjusted Gross Income over $250,000, you’ll pay that pesky 3.8% Net Investment Income Tax on top of the 15%. Last, we have to account for dividends that bond ETFs pay. These dividends ultimately come from the bond’s interest income within the ETF, and although its called a dividend, it’s technically taxed as interest and ordinary income tax rates apply.

Let’s Examine The Capital Gains Scenarios Between An ETF Investor Versus A Mutual Fund Investor

One investor holds $100,000 in a stock based mutual fund and the other holds $100,000 in a stock based ETF. Let’s assume the mutual fund is similar to the ETF in holdings, and therefore the dividends and interest are the same. However, an ETF investor can come out significantly ahead of the mutual fund on the amount of internal capital gains the funds pass onto to investors. This fund mechanic is called “turnover”. Fund turnover can be defined as the total amount of new stocks bought, or amount of stocks sold (whichever is less), over a 12 month period divided by the share price of the fund. Let’s assume both investors are married filing jointly and have a Modified Adjusted Gross Income of $200,000 (15% long term capital gains rates apply with no other IRS tax monkey business). We’ll also assume the mutual fund manager has a turnover percentage of 0.85% since this is probably close to the average. I’ll use the ETF ticker symbol (IVV) and it’s turnover of 5% as a comparison. Although a few of the stocks making up the index are swapped out each year, an investor has not seen a long or short term capital gain distribution because the small amount of capital gains resulting from sells within the ETF and its underlying index were passed onto the investor as dividend income. Last, we’ll assume each investment returned 9.5% (average stock return since 1928) last year. Check out the difference in the capital gains tax liability passed on to the investor:

So in this example representing the averages, the investor ended up paying an extra $1,211 in capital gain taxes just by owning an actively managed mutual fund. The investor didn’t even sell any of the fund, yet they still got clobbered with capital gains! I even did the mutual fund in the example a favor by assuming 100% of the capital gains were long term (15% tax rate), versus short term (ordinary income tax rate). Realize that the 5% turnover of the ETF did transfer away from capital gains to dividend income, but because the percentage is so low, the investor didn’t realize a considerably higher amount of taxable dividend income compared to the mutual fund. We’ll tie all this confusing dividend and capital gain taxability together next.

Another way you can measure how tax (in)efficient a fund is with a metric called the tax cost ratio. Morningstar currently makes this available, and it’s free. Just type in the fund name or ticker symbol on their website, then click the “Tax” tab. Here’s a screenshot.

Sometimes I pick on the Growth Fund of America because my wife and I owned it for years without questioning tax efficiency. In the summary above, you can see the fund had a 1 year tax ratio of 1.59. This means that on average, over the last year an investor paying 15% capital gains taxes would have lost 1.59% of their return to taxes! For example, if your mutual fund returned 10% last year and have a tax cost ratio of 1.59%, then your real return after taxes was actually 8.41%. Using the same ETF (IVV) as a comparison, it has a tax cost ratio of 0.45%. Clearly, the ETF investment structure proved advantageous by over 1% to the investor. 1% over time can add up!

The bottom line here is risk, return, and cost are all important factors when selecting an investment, but as we’ve seen it isn’t wise to disregard the tax cost of a mutual fund in a taxable account. If you have a taxable account full of actively managed funds, please don’t just go sell all of them and buy ETFs without doing a bit of homework. There are several assumptions built into my scenarios above, so check your tax records for your cost basis or check in with your tax advisor to see what the impact of selling your funds would be. You may find it’s worth it to spread out the sells over a few years so you don’t feel blown up with capital gains. Everyone’s investment and tax scenarios are different, and most likely not exactly the same as the hypothetical investor above. If you’d like me to help you better understand your specific situation, please leave a comment or visit the Contact page of my firm’s website.

Monday September 8, 2014

Why I Use Index Funds To Build Better Portfolios

It’s been a while since my last blog post, and yes I’m alive, functioning (sort of), and healthy. It was a busy summer with family and mountain bike racing. If family time is as important to you as it is for me, you’ll understand why I took a break from blogging. If you don’t understand, tough!

Years ago while I was working at my former brokerage firm, it was drilled into us all that mutual funds were the best investments in town. If you recommended anything else, you were an outcast! It also helped that they paid quite a bit, but that was often left out of the training. What always confused me was how I was supposed to select various funds for clients, and more important, how was I supposed to build a proper asset allocation. Although very interested in doing both well, my former employer taught me neither. I was also overwhelmed with keeping up with the service that 276 client households required, I simply didn’t have time. I chose the path of least resistance and invested client’s money into pre-built investment models. I wish I knew knew back then what I know now.

Starting my own company left me with lots of time to research new ideas and prospect for new clients. I’m not sure I’ll ever be great at marketing, but I’m quite confident I’ve spent enough time reading on how to solve the asset allocation puzzle and investment selection dilemma. I’ll focus on specific investment selection for this blog post.

I’ll start with a bold statement; mutual fund managers can’t consistently beat their benchmarks over the long term. There, I even put it in bold to show I mean business!

Here’s some evidence to back this up. The New York Times summarized the results of a study where academics (read: Not Wall Street) wanted to test whether or not fund managers had any skill in stock selection. The study built a database of every actively managed mutual fund that operated with at least a 5-year track record from 1975-2006. Of the nearly 2100 funds analyzed, only 0.6% of fund managers had any genuine stock picking ability. Statistical conclusion: 0.6% is indistinguishable from 0%.

Ok, but maybe some fund managers are good in the short term? S&P Indices just released the mid-year 2014 report, and if you skip ahead to the top of page 3, you’ll see that over the last 1, 3, and 5 years at no time did even 50% of fund managers outperform their benchmarks.

So if mutual fund managers can’t reliably beat their benchmarks, what are the alternatives? The first index fund was created in 1975 by John Bogle (founder of Vanguard) to solve this problem. Index funds on the surface look like mutual funds, but unlike mutual funds that trade in and out of stocks and bonds, index funds are designed to replicate a pre-determined basket of stocks or bonds, without all market timing and trading. Index funds were designed truly as buy and hold investments.

Compared to mutual funds, index funds enjoy extremely low costs, force investors to stick with an investing style (versus the latest investment media fad that’s already lost its luster by the time your broker sells it to you), and generally exhibit more favorable tax consequences. Best of all, we can use a variety of index funds to build a smart asset allocation for a globally diversified portfolio. I’ll touch on all these topics in greater detail in upcoming posts!