Asset allocation strategies are based on simulations of past performance. The theory is that the future will mirror the past. If only that were so, life would be so much more simple. The world is changing and if one is to be a successful investor one is going to have to change with it. In the past a conservative allocation strategy has been to allocate about one half of ones assets to fixed income investments and about one half to equities. The assets allocated to equities have generally been recommended as being 75% invested in US equities mostly to large cap equities and perhaps 25% to foreign equities or perhaps even less. The logic behind this distribution is that fixed income is a more stable investment than equities tend to be and US equities are more understandable than foreign equities and better regulated.
Of course no one can predict with any certainty what the future will hold, but one can certainly make some reasonable postulates based on trends that are apparent.
Trend #1 US budget deficits are increasing rapidly with virtually no end in site requiring the government to borrow more and more money.
Trend #2 Production is leaving the US for less expensive economies.
Trend #3 Economic development is shifting from the western world to the countries of the east.
Trend #4 Many US corporate CEOs are more interested in feathering their nests than in managing a thriving business.
These trends suggest that interest rates will rise dramatically in the future as the world's largest borrower runs out of people willing to risk lending money that most likely will not be repaid. The world economic shift taking place suggests that future investment options should also shift with them. And finally they suggest that one should avoid investing in companies paying their CEOs extravagant salaries and bonuses. They do not have their investors' best interests at heart. They have their own best interests at heart.
Although these trends appear almost self evident, nothing in this world is deterministic. Everything is probabilistic. There is always a chance that things might not be as they seem. And there is always the chance that things might change. Supposing for example that the US government were to pass a new tax law taxing incomes of over $1,000,000 at a 90% tax rate. Such a change might also change the management styles of many US corporations.
So the question is what should an asset allocation look like for the future world economy. To me it seems that one should allocate more assets to equity investments than has previously been recommended. For a conservative investor that would suggest no more than 20 to 30% in debt instruments if that much. Looking towards the future debt instruments seem to be an investment that will not fare very well. For a less conservative investor they might be avoided all together. One might ask why as much as 30% for a conservative investor if in fact interest rates are expected to rise. Why not avoid them all together? Well, the problem is that during periods of rising interest rates equities tend to perform even worse than debt instruments. Most corporations run on borrowed money, not all but most; and if borrowing costs increase their profits suffer as a result. Banks will be especially vulnerable because they borrow short term to lend long term and if they have lent a lot of long term money at 5% interest and they have to pay 6% short term, one can imagine what the impact will be. Another consideration is if one is investing in debt instruments one should avoid the longer term instruments--those over about 5 years in duration. The longer term debt instruments will be the ones that suffer the most during a rising interest rate environment.
The remaining question becomes how should one invest ones equity allocation. Certain companies in the US will do much better than others in the future. Companies with a strong balance sheet will be at a distinct advantage over those loaded with bank loans and short term debt. Those that had borrowed long term at previously low interest rates will also be at a distinct advantage. Companies with a large amount of foreign sales will also be at an advantage as they convert foreign currencies back into US currencies and as they service economies growing more rapidly than the US economy.
What are some examples of these types of companies? Coca-Cola is one such example. More than 75% of sales is outside of the US. Long term debt of the company is less than 20% of total capital. 3M is another such company. 64% of sales is outside of the US. Long term debt is less than 30% of capital. Multinational companies should be relatively safe investments if not exciting. A non-US company of this type is Nestle, a Swiss company. The question of what percentage of ones assets should be invested in these types of companies is open to some speculation. Perhaps 50% of ones equity portion, perhaps more or less. Despite what the future holds these type of companies should do well provided they continue to have good management.
The Asian countries, Latin American countries and Australia are those where future growth is most likely to occur. Some companies in these countries are traded in the US. Another option is to invest in an index fund or mutual fund that invests in these countries. There are many to choose from.
Personally, I am not in favor of many index funds as investment vehicles. They have one glaring flaw. That is that most are capitalization weighted which means that they are not a diversified investment option. Index funds concentrate most of ones investment in a few very large capitalized companies. But they are an option. On the other hand mutual funds also have one glaring flaw. They have to pay realized capital gains annually on which one is taxed. Index funds generally do not suffer greatly from that flaw.
Sunday, February 21, 2010
Sunday, January 31, 2010
Investing for Retirement--401k asset allocation
If you have a 401k account you also most likely have mutual funds. But which mutual funds are the right ones to incorporate as part of your retirement account?
Opinions on these questions are probably as varied as there are persons who have opinions to express.
One of the precepts of mutual fund investing is that future performance can be predicated based on past performance. Virtually all mutual fund investment advisers and the mutual fund families themselves provide volumes of statistics relating to the past performance of the particular mutual fund and the rating agencies rate them based on past performance. Although this seems like a logical approach to evaluating a mutual fund, it is based partly on a fallacy. Not completely but partly. The fallacy obviously is that future performance can be based on past performance. The universe just does not work that way. So then what is one to do?
Some of the answer was provided by Harry Markowitz in a paper written in 1952 entitled "Portfolio Selection." His ideas have become known as Modern Portfolio Theory--MPT. Without going into the gory details, the idea basically is that one can reduce risk and increase returns by diversifying ones investments across a wide range of asset classes and rebalancing ones investments periodically. Easier said than done but that is the idea. Mutual funds can play a role.
The role that mutual funds plays in ones portfolio is not and should not be a set and predefined function. It should vary with ones risk acceptance, financial goals, and assets.
Someone risk adverse should not allocate his/her assets into the same mix of mutual funds as someone not risk adverse.
Someone young with his/her future ahead should not invest in the same types of assets as one who is retired.
These concepts should be evident but many times seem not to be. The role mutual funds play in ones portfolio should vary with all the above criteria and more besides.
Generally speaking one has very few other options than mutual funds for ones 401k portfolio other than possibly company stock. The challenge is in determining which mutual funds one should invest in. Recently, the mutual fund industry has attempted to make this decision a no brainer by devising target date retirement funds that reallocate ones investments based on how near one is to retirement. They universally change the asset allocation to a more conservative allocation as one approaches retirement. They also attempt somewhat to rebalance periodically ones assets at least in theory. Among the different mutual fund companies the investments in these target date retirement funds varies, but with 401k accounts one usually does not have a choice among the different families. There generally is only one choice for a particular target retirement date, but one does not specifically have to choose his/her particular retirement date. One can choose a markedly different retirement date which would change the asset allocation mix.
It has been stated as a truism that a younger person should choose a more aggressive asset mix than one nearing retirement. What has not been stated though is how much more aggressive that asset mix should be. Many found in 2000 and again in 2009 that they might have chosen a much too aggressive asset mix as their 401k accounts lost perhaps half of their value and perhaps even more. What seems to be overlooked is that investing for retirement is not a sprint. It is a long distance race. One should invest with that in mind. One should also invest with the future in mind and not specifically based on what happened last year or the last decade. No one really knows for sure what the future might hold. But one can be pretty sure it will not be as the past was. This is where choosing a variety of different asset classes to invest in comes in extremely handy. By spreading ones bets around at least one is not going to suffer a major calamity. Many if not all target date retirement funds tend to concentrate ones investments in what is perceived to be suitable investments but not particularly diversified investments. To illustrate my argument this is the allocation of the Vanguard 2040 retirement fund:
72% Total stock market index fund
10% Total bond market index fund
9% European stock market index fund
4.6% Asian stock market index fund
4.3% Emerging markets index fund
The total stock market index fund consists of over 3400 different stocks. That would seem to be well diversified, wouldn't it? No, it is not. 15.6% of the assets are invested in only 10 stocks. The total bond market index fund is 38% US treasury bonds and 33% US mortgage backed bonds. The same can be said about the other 3 portions of the portfolio. In my opinion this is not as diversified a portfolio as one should have in ones retirement account nor is it as riskless as one might strive for. In other words ones assets might be much much less diversified than one might expect if one is not very careful.
For 401k investors though the task of choosing ones allocation can be a lot more complex than just choosing the no brainer approach. For one thing the company might not even offer a target date retirement account.
So what then would be a decent diversified portfolio for different types of retirement alternatives?
This is my opinion and might vary greatly from the opinion of others. The opinion is based on several premises. First, one should choose a more conservative strategy than a less conservative strategy because these are retirement funds one is investing. Second, one should have a well diversified portfolio because no one knows what the future might hold and it is better to cover the bases broadly unless one has a crystal ball. Third, as one does get closer to retirement the asset allocation certainly should become more conservative but perhaps not as conventional wisdom would suggest. Finally, although one does not know what the future holds, one can be pretty sure it will not be as the past.
For a person in his/her 20s with very little in retirement assets and the entire future in front of them.
A portfolio that is mostly equities certainly is appropriate, but relying entirely on equities (stocks) is not so appropriate as many would suggest. Those who did so during 2006 and 2007 suffered a world of hurt during 2008 and 2009.
A sample type portfolio might consist of the following.
20% 500 S&P index fund or broad market index fund or large cap US fund. These have performed really poorly during the last 10 years but we do not invest based on the past.
15% Europe stock fund
20% Developing market stock fund (remember we are looking towards the future)
15% Small cap stock fund. Small cap stocks tend to outperform large stock funds because they have the potential of faster growth. Again we are looking toward the future.
20% Money market funds. I said we should be conservative.
10% Bond funds.
You will note that the suggested allocation is distinctly different from that suggested by Vanguard. This is a more diversified approach to investment allocation than that suggested by virtually all mutual fund companies. I might also add a more conservative allocation.
A sample type portfolio for someone in his/her mid-earning years 30-45 would be just a tad more conservative.
5% less of option 1 and 5% more of option 5 or 6, preferably 5. Remember we are talking about the future and the US has serious debt problems.
A sample for someone 45-55 again would be more conservative still. 5% less of options 2 and 3 and 5% more each of options 5 and 6.
A sample for someone 55-65. This is where one either is on track for retirement or one is not on track. If one is not on track and does have close to 10 more years, then all is not yet lost, but if one only has 5 or fewer years then safety first regardless. If one of the retirement options is a mutual fund investing in resource stocks--oil stocks, copper stocks, gold stock--this might be a way to make up some lost ground. It would be worth a shot to divert allocations from 1 and 2 into a fund investing in resource stocks perhaps a total of 10%. That does entail some risks though. To become a tad more conservative one should increase ones allocation into money market funds to at least 35% taking from bond funds and small cap funds and emerging market funds.
Finally, how much should be invested in a 401k account. Most companies have a matching amount and one should certainly strive to get the entire match if possible. For many that might be out of reach but certainly get as much as you can. Beyond the match it is not an easy question to answer. A big concern is what the future tax rate might be. Remember that 401k contributions when they are removed are taxed at the full tax rate. It is deferred but not advantaged as it is if one invests in mutual funds outside of a 401k account. In that respect it might be appropriate to consider investments also outside of a 401k account especially with funds that do not have a company match.
Opinions on these questions are probably as varied as there are persons who have opinions to express.
One of the precepts of mutual fund investing is that future performance can be predicated based on past performance. Virtually all mutual fund investment advisers and the mutual fund families themselves provide volumes of statistics relating to the past performance of the particular mutual fund and the rating agencies rate them based on past performance. Although this seems like a logical approach to evaluating a mutual fund, it is based partly on a fallacy. Not completely but partly. The fallacy obviously is that future performance can be based on past performance. The universe just does not work that way. So then what is one to do?
Some of the answer was provided by Harry Markowitz in a paper written in 1952 entitled "Portfolio Selection." His ideas have become known as Modern Portfolio Theory--MPT. Without going into the gory details, the idea basically is that one can reduce risk and increase returns by diversifying ones investments across a wide range of asset classes and rebalancing ones investments periodically. Easier said than done but that is the idea. Mutual funds can play a role.
The role that mutual funds plays in ones portfolio is not and should not be a set and predefined function. It should vary with ones risk acceptance, financial goals, and assets.
Someone risk adverse should not allocate his/her assets into the same mix of mutual funds as someone not risk adverse.
Someone young with his/her future ahead should not invest in the same types of assets as one who is retired.
These concepts should be evident but many times seem not to be. The role mutual funds play in ones portfolio should vary with all the above criteria and more besides.
Generally speaking one has very few other options than mutual funds for ones 401k portfolio other than possibly company stock. The challenge is in determining which mutual funds one should invest in. Recently, the mutual fund industry has attempted to make this decision a no brainer by devising target date retirement funds that reallocate ones investments based on how near one is to retirement. They universally change the asset allocation to a more conservative allocation as one approaches retirement. They also attempt somewhat to rebalance periodically ones assets at least in theory. Among the different mutual fund companies the investments in these target date retirement funds varies, but with 401k accounts one usually does not have a choice among the different families. There generally is only one choice for a particular target retirement date, but one does not specifically have to choose his/her particular retirement date. One can choose a markedly different retirement date which would change the asset allocation mix.
It has been stated as a truism that a younger person should choose a more aggressive asset mix than one nearing retirement. What has not been stated though is how much more aggressive that asset mix should be. Many found in 2000 and again in 2009 that they might have chosen a much too aggressive asset mix as their 401k accounts lost perhaps half of their value and perhaps even more. What seems to be overlooked is that investing for retirement is not a sprint. It is a long distance race. One should invest with that in mind. One should also invest with the future in mind and not specifically based on what happened last year or the last decade. No one really knows for sure what the future might hold. But one can be pretty sure it will not be as the past was. This is where choosing a variety of different asset classes to invest in comes in extremely handy. By spreading ones bets around at least one is not going to suffer a major calamity. Many if not all target date retirement funds tend to concentrate ones investments in what is perceived to be suitable investments but not particularly diversified investments. To illustrate my argument this is the allocation of the Vanguard 2040 retirement fund:
72% Total stock market index fund
10% Total bond market index fund
9% European stock market index fund
4.6% Asian stock market index fund
4.3% Emerging markets index fund
The total stock market index fund consists of over 3400 different stocks. That would seem to be well diversified, wouldn't it? No, it is not. 15.6% of the assets are invested in only 10 stocks. The total bond market index fund is 38% US treasury bonds and 33% US mortgage backed bonds. The same can be said about the other 3 portions of the portfolio. In my opinion this is not as diversified a portfolio as one should have in ones retirement account nor is it as riskless as one might strive for. In other words ones assets might be much much less diversified than one might expect if one is not very careful.
For 401k investors though the task of choosing ones allocation can be a lot more complex than just choosing the no brainer approach. For one thing the company might not even offer a target date retirement account.
So what then would be a decent diversified portfolio for different types of retirement alternatives?
This is my opinion and might vary greatly from the opinion of others. The opinion is based on several premises. First, one should choose a more conservative strategy than a less conservative strategy because these are retirement funds one is investing. Second, one should have a well diversified portfolio because no one knows what the future might hold and it is better to cover the bases broadly unless one has a crystal ball. Third, as one does get closer to retirement the asset allocation certainly should become more conservative but perhaps not as conventional wisdom would suggest. Finally, although one does not know what the future holds, one can be pretty sure it will not be as the past.
For a person in his/her 20s with very little in retirement assets and the entire future in front of them.
A portfolio that is mostly equities certainly is appropriate, but relying entirely on equities (stocks) is not so appropriate as many would suggest. Those who did so during 2006 and 2007 suffered a world of hurt during 2008 and 2009.
A sample type portfolio might consist of the following.
20% 500 S&P index fund or broad market index fund or large cap US fund. These have performed really poorly during the last 10 years but we do not invest based on the past.
15% Europe stock fund
20% Developing market stock fund (remember we are looking towards the future)
15% Small cap stock fund. Small cap stocks tend to outperform large stock funds because they have the potential of faster growth. Again we are looking toward the future.
20% Money market funds. I said we should be conservative.
10% Bond funds.
You will note that the suggested allocation is distinctly different from that suggested by Vanguard. This is a more diversified approach to investment allocation than that suggested by virtually all mutual fund companies. I might also add a more conservative allocation.
A sample type portfolio for someone in his/her mid-earning years 30-45 would be just a tad more conservative.
5% less of option 1 and 5% more of option 5 or 6, preferably 5. Remember we are talking about the future and the US has serious debt problems.
A sample for someone 45-55 again would be more conservative still. 5% less of options 2 and 3 and 5% more each of options 5 and 6.
A sample for someone 55-65. This is where one either is on track for retirement or one is not on track. If one is not on track and does have close to 10 more years, then all is not yet lost, but if one only has 5 or fewer years then safety first regardless. If one of the retirement options is a mutual fund investing in resource stocks--oil stocks, copper stocks, gold stock--this might be a way to make up some lost ground. It would be worth a shot to divert allocations from 1 and 2 into a fund investing in resource stocks perhaps a total of 10%. That does entail some risks though. To become a tad more conservative one should increase ones allocation into money market funds to at least 35% taking from bond funds and small cap funds and emerging market funds.
Finally, how much should be invested in a 401k account. Most companies have a matching amount and one should certainly strive to get the entire match if possible. For many that might be out of reach but certainly get as much as you can. Beyond the match it is not an easy question to answer. A big concern is what the future tax rate might be. Remember that 401k contributions when they are removed are taxed at the full tax rate. It is deferred but not advantaged as it is if one invests in mutual funds outside of a 401k account. In that respect it might be appropriate to consider investments also outside of a 401k account especially with funds that do not have a company match.
Thursday, January 7, 2010
Investing in 2010
Caution should be the name of the game in 2010, I think. The market has recovered more than fundamentals seem to indicate is warranted. If and when the government stops printing money to 'stimulate the economy' what is going to be the economic driver? I am at a loss to find one. I suppose that if the health care bill were to be passed it might be an economic stimulus for the insurance companies and quite possibly for other health care related industries. It will however take a while for the effect to filter through the system. Unfortunately, the health insurance companies are not investor friendly. Their dividends are worse than poor. They prefer to spend investors' money buying back their overvalued stock. I can not recommend investing in such poorly managed companies.
A healthy cash reserve would not be inappropriate for a conservative investor. I know it will earn squat in interest but squat is a whole lot better than a negative return as we all learned during the first part of 2009.
If you have some profits, take a few of them now while the taking is good. Put the proceeds into your money market account and grin and bear it. Remember though that investments are based on probabilities. Even though I think the probabilities favor sitting on cash, there is a probability that I could be sadly mistaken.
A healthy cash reserve would not be inappropriate for a conservative investor. I know it will earn squat in interest but squat is a whole lot better than a negative return as we all learned during the first part of 2009.
If you have some profits, take a few of them now while the taking is good. Put the proceeds into your money market account and grin and bear it. Remember though that investments are based on probabilities. Even though I think the probabilities favor sitting on cash, there is a probability that I could be sadly mistaken.
Tuesday, November 24, 2009
Trip to Uganda
I spent 19 days in Uganda in November looking for birds. This is a brief description of the trip for those who might be interested in visiting Uganda.
Uganda is a great place to visit if you are a nature lover. I visited six national parks while I was there and several other nature areas also. It was an adventure of a life time. I tallied about 420 different bird species, 5 chimpanzees, one Puff Adder, and many monkeys, antelope, elephants, giraffes, hipos, Cape Buffalo, dragon flies, butter flies, but very few mosquitos. November is part of the 2nd rainy season of the year which begins in October. It did rain about every day while I was there but only for about one or two hours. While it is raining, that is a great time to drive to the nearest bar and have a Nile Special if there is a bar handy. Much of the time there is not. It is best therefore to take a couple along to enjoy during the lunch break. Uganda has excellent beer, but hands down Nile Special was my favorite.
My trip was arranged through Birduganda.com. They handled everything. My itinerary was custom designed to my specification with some suggestions from Herbert the director of Birduganda. I was presented with two options for accommodations--luxury and utilitarian. I chose the latter. To my surprise utilitarian was not all that utilitarian. At QE national park I ate my meals at the lodge where Queen Elizabeth stayed in 1954. It is first class. However, I did have my room down the road about 300 yards at a very nice hostel that was suitable for my needs.
My birding guide was Robert Byarugaba who lives in Buhoma. He is a top notch guide. You can find him on the internet at robertbirdguide@yahoo.com. Telephone is 256-782-029-054. My driver was Gordon Gongo. He lives in Kampala and is on the internet at gordon.gongo@yahoo.com. I suppose that a very adventurist person might attempt driving in Uganda himself. But the roads are not what one might be accustomed to and road signs are not something one generally sees in Uganda. Gordon also makes a really great beef stew, one of the best meals I had while in Uganda and great vegetable soup also. Uganda is not a large country and most of the interesting places are in the west and southwest. But the roads are in many places rutted dirt and I do not think we averaged more than 20 mph, so distances seem at least three times longer than in the US.
The money situation in Uganda is somewhat interesting. The currency is the Uganda shilling which exchanges at about 1900 to the dollar at this writing. A beer costs about 3000 shillings at the better establishments. But that is not what is interesting. What is is that national park entrance fees are for foreigners are in dollars not shillings. They average is about $30 a day but does vary by park, so when you arrive at Entebbe do not covert all of your currency into shillings. You will need a substantial amount of U S dollars also. Another interesting situation is that one is not allowed to walk any trails in a national park unless one has either a local park guide or an armed guard. A tip is expected for these functionaries at the end of the trip. A guard might expect 10,000 shillings. A local guide who is knowledgeable maybe 20,000 shillings for a full day. The guards carry AK47s but I am suspicious that they may not carry any ammunition.
Of the total time I was in Uganda, there was only one day which was a disappointment. That was the trip to Kaniyo Pabidi which is part of Budongo Forest Reserve. Birding there was extremely disappointing with only one new species seen. We did see a Chimpanzee there however and Robert also saw two Blue Duikers, an extremely small antelope of the forest. I missed both. There are several species that are supposed to be easy to see there but we had no luck at all attempting to call them in. My personal recommendation is to spend ones time at more productive locations such as Murchison Falls just north of Budongo. The Royal Mile at Budongo is an exceptional birding site and should not be missed.
One of the national parks that I visited is Semliki. It is somewhat off of the beaten path and receives only about 2000 visitors a year. That is somewhat unfortunate because it is one of the more interesting national parks and encompusses an environment not encountered elsewhere in Uganda--very tropical. One of the highlights of the Semliki trip was seeing a Puff Adder close up. It was brought to our attention by the commotion that the birds were making. Robert showed it to me and I thought it was a log lying on the ground. Then the log began to move--very slowly. Puff Adders are not fast snakes. The snake we did not see at Semliki but which is supposed to be common there is the Black Momba.
The other place worth some note is Mabamba Swamp on Lake Victoria a couple of hours from Entebbe. This is the home to the Shoebill and many other water and swamp birds. The Shoebill is one of the prize birds of a Uganda bird trip. Uganda is the only easy place to see this bird, easy being a relative term. There are two places in Uganda where it is usually seen--Mabamba and Murchison Falls NP. We saw four Shoebills there and many other birds besides.
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.
https://personal.vanguard.com/us/planningeducation/retirement/PEdRetTapDetermineWDContent.jsp
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.
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.
https://personal.vanguard.com/us/planningeducation/retirement/PEdRetTapDetermineWDContent.jsp
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.
http://www.etfconnect.com/
http://www.closed-endfunds.com/
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.
http://www.etfconnect.com/
http://www.closed-endfunds.com/
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.
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.
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