Monday, September 28, 2009

What should one invest in during retirement?

Investing during retirement entails different criteria than investing during ones productive years. There are three paramount criteria that retirees need to consider when considering their investments--current income from their investments, safety of their capital, and protection against inflation.

If a person retires at age 65, that person can reasonably expect to live another 20 years. If we assume historic rates of inflation, in 20 years prices will be somewhere between 2 times and 3.5 times greater than they are today. Those are the previous 20 year inflation rates during the past 50 years in the United States. If one does not take inflation into account during ones retirement, the consequences could be considerably unpleasant as one approaches the grave.

Many investment advisers suggest a rather conservative investment philosophy for retired persons. Let's review a couple just to get a flavor of what conventional wisdom suggests. Vanguard Retirement Income Fund VTINX allocates 65% bonds, 29% stocks, and 5% short term investments. Its average return since inception is 3.39%. Its current yield is 2%. Fidelity Freedom Income Fund FFFAX allocates 60% bonds, 21% stocks, and 19% short term investments. Its average return since inception is 4.82%. Its current yield is 2.95%.

When one considers the current yield of these retirement funds, their asset allocations, and their returns one must question the wisdom of their philosophy. With historic inflation rates running at a minimum of 3.5% annually and as high as 6.5% annually over a 20 year period this investment philosophy is not going to yield sufficient returns nor yield sufficient income to last a 20 year term for the average retiree who is dependent on his retirement income and social security.

One of the common rules of thumb for retirees is that they can withdraw 4% of their retirement capital annually and have it last about 25 years. There are web based retirement tools to show the user the amount that can be withdrawn monthly assuming an initial amount at retirement and an expected life span. Unfortunately, many of these tools make assumptions that may not be correct and they do not allow the user to adjust the assumptions.

A simple calculator can be found at this link. Too simple.

I believe a better strategy is to allocate more to quality equities that have a history of increasing their dividends. Generally speaking that will accomplish two goals. It will provide over time an increasing income and the increasing dividends generally will support an increasing value of ones assets. Investing in bonds accomplishes neither. That is not to say that bonds have no place in ones retirement portfolio. They do add some stability to ones assets during market turmoil, which they did during these previous two years. Some of them did anyway. Some did not. Only the very highest quality bonds actually added to stability. The rest did very poorly.

Let's look at several examples of high quality stocks that have a history of increasing their dividends.

McDonalds Corp--MCD--10 years ago paid a dividend of 0.20 a share. Today it pays 1.63 a share. Ten years ago its average price was 42.50 a share. Today its price is 57.00 a share.

Procter & Gamble--PG--10 years ago paid a dividend of 0.64 a share. Today it pays 1.64 a share. Ten years ago its average price was 45.00 a share. Today its price is 58.00 a share.

Coca Cola--KO--10 years ago paid a dividend of 0.64 a share. Today it pays 1.52 a share. Ten years ago its average price was 60.00 a share. Today its price is 53.00 a share. But recall that 10 years ago we were at the peak of the bull market. KO has indeed during the last 10 years depreciated somewhat in value.

Chevron--CVX--10 years ago paid a dividend of 1.24 a share. Today it pays 2.53. Ten years ago its average price was 44.00 a share. Today its price is 71.00 a share.

Each of these companies pays a dividend of more than 3% annually, more than either of the two mentioned retirement income funds pay. They also each has a long history of raising their dividends annually.

This is not a full proof investment strategy. There are risks involved. One is that one of these companies that has had a history of raising its dividend might fall on hard times and not be able to do so. One might even have to cut its dividend. Bank of America recently was among companies that annually raised its dividend. But it recently had to drastically cut its dividend. A strategy to mitigate the impact of such an action is for one to invest in a diverse holding of stocks. It is generally suggested among asset allocation strategists that one should invest in no fewer than 20 different companies in a variety of industries.

One might ask why it would not be an appropriate alternative to invest in a blue chip mutual fund as such a fund should be composed of such stocks. One reason is that the term blue chip has been mis-applied by the investment communities in recent decades to include companies that have no claim to such a title. Another reason is that mutual funds feel themselves obligated to invest in a wide variety of companies. There are not that many companies that actually meet the qualification of quality companies that increase their dividends, maybe 50 to 100. Most mutual funds own many more than that number so they have to reduce their investment standard.

There are mutual funds that have a strategy of investing in dividend paying stocks. Several index funds come to mind. One is Wisdom Tree Large Cap Dividend--DLN. Its current yield is 3.3%. Unfortunately, the quality of some of its holdings leaves a great deal to be desired. One of its largest holdings is Bank of America, not a stock that one might choose to invest in. It currently holds stock in about 288 different companies. Considering there are only about 315 large cap companies, they are not all that selective in which ones they choose.

It would be a mistake to invest all of ones assets in only this type of companies. Indeed one should choose some bonds and also some other types of equities also. A diversified portfolio has a greater chance of limiting risk than one that is not. But I believe that for someone in retirement it is a better strategy to allocate a larger portion of ones assets to these types of stocks than to invest a large portion in bonds or in other types of equities.

Saturday, September 19, 2009

Closed end mutual funds

There currently are three different types of mutual funds one can invest in--open end mutual funds, exchange traded index funds, and closed end funds. This is a discussion of closed end funds.

Closed end funds are bought and sold on stock exchanges very much like exchange traded index funds. As of this posting there are about 630 different closed end funds available. Very similarly to open end mutual funds they come in a wide variety of different types. Some are municipal bond funds, some taxable bond funds, and others covering a wide variety of equity investment categories.

There are several specific differences between closed end funds and open end funds however.

First they are traded on the stock exchanges. As a result they do not necessarily trade at net asset value. In fact sometimes the price at which they do trade varies greatly from the value of the net assets. At the time of this posting, one astonishingly sells at a premium of 73% to net assets. Back in March 2009 it sold at a slight discount. It is not all that uncommon for a closed end fund to sell at a premium to net assets but the vast majority do not. Currently about 160 do and 470 do not. Occasionally, some closed end funds will trade at a substantial discount to net assets especially during market panics. During the March 2009 market panic there were many closed end funds selling at 20+% discounts to net assets. There are currently about 15 or so trading at such a discount perhaps for some good reason. However, if one can purchase a mutual fund at a substantial discount to net assets, one might give such a fund careful consideration.

A second difference is that most closed end funds are considerably smaller than most open end funds. the largest has $3.3 billion in assets. The median about $200 million in assets. The number of shares outstanding is generally a fixed number of shares. Unlike an open end fund, they do not issue new shares at public demand and they do not redeem shares at public demand. They do occasionally issue new shares to cover dividend reinvestment. And they do occasionally liquidate. There is one ramification of this aspect. That is that in general it is a great deal easier to manage a small mutual fund than it is to manage a larger mutual fund. Fidelity Contrafund has $51 billion in assets. American Funds Capital Income Builder has $75 billion in assets. With such a large asset base it is also more difficult to diverge from the market average. They are the market average. The two specifically mentioned have managed to diverge positively from the market average, but most have not.

A third difference is that many closed end funds employ leverage, which can work for them in a rising market but against them in a falling market. Not all do but many do. The leverage is in the form of preferred stock and usually represents 30-40% of capital. Many of these closed end funds had issued auction rate preferred stock. A result of the banking crisis was that virtually all of this type of preferred stock became untradable. This led to some difficulties for several closed end funds. Another difficulty many closed end funds encountered was that as the value of their assets decreased during the market collapse of 2008-9, their leverage ratios increased beyond the regulatory limits for their particular funds--33% for debt leverage and 50% for equity leverage. The drop in asset values ment that they had to reduce their leverage, which ment selling assets at distressed prices. Not a particularly good position to be in.

During more normal market conditions there is about $20-30 billion in new closed end funds issued on an annual basis. Recently there have been virtually none issued. Buying a closed end fund IPO is a loosing proposition in general. The IPO is generally issued at a premium of about 5% to net assets. Once the fund begins trading there is about a 80% probability that the market price will fall to about a 6-10% discount to net assets. There are certain exceptions to this generality. In 2006 Morgan Stanley China A Share Fund came to market. This particular fund invested in a market that virtually no other mutual fund invested in and a market closed to individual foreign investors--China A shares. The fund immediatedly soared to a premium and during 2007 returned 100%. It now sells at a very small premium of 3% but as resently as April 2009 sold at a premium of 30%.

There are two web sites that give a good statistical analysis of closed end funds.

Saturday, September 12, 2009

S&P 500 Index Funds

Index funds have become extremely popular during the past 10 years and the most popular of all are ones based on the S&P 500. As of this writing SPY, an S&P 500 index, is the most popular exchange traded index fund with $63 billion in assets. The next most popular is GLD with only $31 billion in assets. But that is only a small portion of the total amount invested in S&P 500 based index funds. Nearly every major fund company also offers one. The Vanguard S&P 500 index fund, the granddaddy of them all which started the trend on Oct 31, 1976, has $84 billion in assets.

There are basically three selling points proponents of the S&P 500 index funds use when advocating purchase. First is the low expense ratio. The Vanguard fund has an expense ratio of 0.18%. SPY has an expense ratio of 0.10%. The median expense ratio of mutual funds is about 1.5%. Second, is the tax advantage of index funds. Since these are unmanaged funds they are very tax efficient. There is very little realized year end capital gains with an S&P 500 index fund if any at all. Managed mutual funds very often have very large year end capital gains upon which taxes must be paid. Third is that 70% of all mutual funds have underperformed the S&P 500 index so it is better to just place ones money into that index fund than to invest in a managed fund.

What is not ever discussed are what the disadvantages of the S&P index funds might be. There are several that one needs to be aware of. First and perhaps formost is the fact that it is capitalization weighted. What that means to the investor is that even though one has an investment in 500 different companies, it is not an equal investment. The top 10 holdings account for 20% of the total assets of the fund. The top 50 holdings account for 48% of the assets. The other 450 the remaining 52%. One of the cornerstones of the theory of modern portfolio allocation, is the concept of rebalancing ones portfolio on a periodic basis normally annually or quarterly to increase ones return and decrease ones risk. Since the S&P 500 index is capitialization weighted, not only is it not rebalanced but one might argue that it is debalanced, if there is such a word. In other words as the price of stocks in the index rise, the index buys more of them relative to the ones that fall in price. That is the exact opposit of the concept of rebalancing. One can in fact visually see the difference to returns that rebalancing has in the past made. There is another index fund based on the S&P 500 that is equal weighted rather than capitalization weighted. It is RSP. It has not been in existance 10 years so we can not do a long term comparison. But over a 5 year period SPY has returned 0.44% and RSP has returned 2.23%. That is despite the fact that RSP has an expense ratio of 0.60% compared to an expense ratio of 0.10% for SPY.

The S&P 500 is based only on US based large company equities. It ignores foreign companies, most small capitalization companies, and investments in debt instruments. It actually does consist of a few small cap stocks, ones that are still in the index but have recently fallen on hard times. As of this posting these include Gannet, CIT, and KB Home to name a few.

Foreign equities as recently as 1970 accounted for about 30% of total world market capitalization. Currently they have risen to over 50% of total market capitalization probably closer to 60% currently. So in the past 40 years the U S equity market has declined by about 1/2 of the total world equity markets. That decline should be noted by investors. Another aspect that should be noted is that investor returns on foreign equities over the past 5 years have in many cases outpace returns of the S&P 500. 10 year comparisons can not be made because indexes of foreign equites have only recently existed. But here are a couple of comparisons. The 5 year return of the S&P 500 index is 0.44%. That of IEV based on the S&P Euro 350 index is 5.7% despite having an expense ratio of 0.60%. That of EAF based on the European, Far East, and Australian index is 5.4%. That of EEM based on an emerging market index is 16.4%.

When we compare the S&P 500 performance to that of the small cap index funds we again see a divergence in returns. For the five year period IWM based on the Russell 2000 had a return of 2.2%.

Another aspect of asset allocation that is ignored by many is that of investing in debt investments as opposed to equity investments. The classic concept is that equity investments will outperform debt investments over the long term mainly because one must expect a greater return for the greater risk of equity investments. Invariably investment professionals will advise young clients to invest most of their assets if not all in equities because even though there is a greater probability of suffering a loss over the short term over the long term equities will provide a greater return. Yet the results of portfolio allocation theory tend to somewhat refute this claim. And certainly over the last 10 years debt investments have outperformed equity investments. Almost every managed bond fund over the past 10 years has outperformed the S&P 500 index by a wide margin. Vanguard Long-term Investment Grade bond fund has yielded 8.5% annually on average since Sept 1973. The S&P 500 has returned 6.5% over the same period. Those returns are before taxes.

Another interesting comparison is that of the Vanguard Balanced Index fund to that of the S&P 500. The Balanced fund has returned 2.9% annually over the last 10 years opposed to - 0.86% for the Vanguard S&P 500 fund.