Actively Managed Mutual Funds

In the “efficient markets” hypothesis, all available information is factored into the stock price, making attempts to “beat the market” by selecting your own stocks a fool’s errand. Index funds, which were originally stock mutual funds, such as those at Vanguard, not only attempt to mimic rather than beat the index, they also sport much lower expenses. Thus even if the performance was the same for an index as a stock picker, the index would win with costs as low as 0.2% / year as opposed to 1% – 2% / year for managed funds. One advantage that remained of a stock selection methodology over mutual funds was related to taxes – individual stocks were definitely more tax efficient if handled correctly; now index ETF’s have erased that lead.

Of course, theories don’t always work in the real world, as the recent financial meltdown attests, when AAA rated financial instruments took significant losses. In a similar vein, those in favor of active stock selection could always point to a few candidates to make their cases. One candidate was Bill Miller, head of the Legg Mason Value Trust, who beat the S&P 500 for 15 consecutive years.

 

While Bill Miller may have been the “poster boy” for those that point to active stock pickers, he was a reticent candidate. He even said that a lot of his “streak” was due to timing on the calendar and didn’t strut around like a world-beater. Thus I didn’t take much pleasure in the this article…

Bill Miller, whose Legg Mason Value Trust achieved the unlikely feat of beating the S&P 500-stock index for 15 consecutive years, has become the fund world’s punching bag. So far this year, the fund is down a devastating 56 percent on account of bad bets on stocks including AIG, Washington Mutual, and Freddie Mac. This horrific year (combined with lackluster results in 2006 and 2007) has banished Legg Mason’s crown jewel to the ranks of the worst-performing mutual funds not only for the year, but for all standard periods of measurement.

Actively managed funds did terribly in the current stock market environment, and index funds also fared poorly. The delta between the two is the “negative alpha” of active management (sorry, not everyone will get that, but I find it a bit funny) as well as the increased expenses of the actively managed fund over the index (it may be up to 6x bigger, as they say in the Vanguard adds, but unfortunately that is only a small percentage of the overall loss).

Due to the way that ETF’s are structured, there are basically no “actively managed” ETF’s. And ETF’s are more tax efficient than mutual funds. Thus when you pick an “actively managed” mutual fund, you are losing three times:

1) you probably are going to come in worse than your index performance
2) you will almost certainly pay higher fees
3) by selecting a mutual fund over an ETF, you are sacrificing tax efficiency

Bill Miller is among the last of the “index beaters”. The marketing departments for actively managed mutual funds are going to have to think hard to make this one shine…

Cross posted at LITGM

Larger Investment Topics

This blog is focused on practical advice for someone starting out in investing, setting up a smaller trust fund for a relative, or wanting to manage their own performance of a reasonably sized portfolio.

The author of this site also writes on larger topics, really ones that aren’t “actionable”.  Here are a couple that you might find interesting.

Here at Chicago Boyz I write about “Private Equity“, which mainly consists of 1) leverage buyout funds that take public companies private 2) venture capital funds that invest in early stage enterprises in hopes of taking them public for a big profit (those few that typically make it).  The general gist is that these types of financial professionals are supremely well-compensated for their efforts which haven’t warranted these big paychecks recently.

Here at Chicago Boyz I wrote about “Hedge Funds“, which also discusses their relatively vanilla strategies that seem to be easily replicable (note the pages and pages of hedge fund performance statistics in a recent issues of Barrons’) and also not worthy of the big 2% / 20% cuts.

I will try to focus this site on practical tips on a smaller scale that are actionable.

Re-Directing To This Site

For several years I have run a site at http://www.certificationhelp.net called “Trust Funds For Kids”.  Over time I have been moving from that web site to a word press blog run at this address http://www.certificationhelp.net/blog.

I re-directed the URL “Trustfundsforkids.com” to this site but as it turns out very few people got here through that URL; they got here because the text had been embedded in the search engines and they found it through search words.

Just today I changed the code at the Front Page site so that everyone who goes there, searching for something that was in a search engine, gets redirected to this blog, instead.

SO WELCOME!

I realize that many people are skeptical about what people write on the Internet and rightly so.  This blog is run by someone who has financial experience in setting up a trust fund, with selecting stocks, and other financial areas.  You don’t see any links to other dubious sites or get rich quick schemes.  Also no ads (maybe someday, but not now).  The only two links are to other sites that I also post at (recommended, by me at least) and likely I will add some other useful sites to the blogroll (the IRS, etc…).

I will be posting about various investing topics and how to set up a trust fund, select stocks, and related taxation issues.  Hope you enjoy the site and find it useful.

iBonds

Recently I have been writing about investing in secure securities (i.e. where you can’t lose money, except in extremely unlikely scenarios). I focused on purchasing CD’s that are insured by the FDIC and constructing a “ladder” of varying maturities through your brokerage account. The return on these CD’s is much higher than is currently being offered by US Treasury securities and has other advantages such as convenience and simplification of statements.

There is another form of safe investing that is easy to do and risk-free (assuming the US Government does not collapse). This is called an “I Savings Bond” or “iBond”.

ABOUT IBONDS AND CALCULATING THE INTEREST RATE:

iBonds are issued by the US Government. iBonds can be purchased at www.treasurydirect.gov after you set up an account and provide appropriate information, at zero charge. The iBonds are issued electronically and the money moves electronically which makes them very convenient, as well.

Unlike virtually all other types of bonds, the iBond interest or “coupon” rate is tied to the inflation rate as measured by the US Government. Virtually all other bond instruments either adjust their coupon rate according to how interest rates move (short term rates mainly determined by the Federal Reserve, long term rates a combination of short term rates and market sentiment) or the price adjusts (i.e. if you have a bond paying 6% interest and the market price moves to 5%, you could sell that bond for a gain in the market and it would be priced “above par”), depending on the type of bond.

The iBond has 2 components; a “fixed” interest rate that has varied between 0% (low) to 3.4% (high) over the last several years and a semi-annual interest rate component tied to the rate of inflation that changes every six months. ONCE YOU BUY AN IBOND THE FIXED RATE NEVER CHANGES, but the semi-annual component tied to inflation adjusts every six months (thanks to an alert reader for catching this error in a previous post). iBonds have a thirty year maturity.

The “fixed” interest rate component has had different base rates since the iBond program was started in 1998. The “fixed” component was 3.4% in 1998 and then dipped as low as 0% for bonds purchased between May 1, 2008 and October 31, 2008. The current fixed rate component on iBonds is 0.7% for bonds purchased between November 1, 2008 and April 30, 2009. If you buy iBonds today that “fixed” component will stay the same until you cash them in or they mature, 30 years from now.

The “variable” interest rate component is determined by the inflation rate, divided by 2 (the semi-annual inflation rate). The current semi-annual inflation rate is 2.46%, or 4.92% for the year. Thus iBonds purchased between November1, 2008 and April 30, 2009 pay about 5.64% (it is slightly higher than 0.7% + (2.46% * 2) because of compounding interest).

Note that if you buy different issues (i.e. $5,000 / year) of iBonds, your fixed rate may vary by year, but the “variable” component will be the same for each issue over every six month period. I realize this is confusing (it confused me, for what that is worth) and here is a link to the government site where they try to explain it.

IBOND LIMITS AND REDEMPTIONS:

An individual can purchase up to $5,000 / year in iBonds. If you are married and want to go into details 2 individuals can purchase $10,000 / year in iBonds under 2 SSN’s, electronically. You can also go physically to a bank and buy “paper” iBonds up to that same limit (this can be done at a bank). You can also purchase iBonds for kids (i.e. for college or a trust account) under their SSN up to the same limits.

UPDATE – THE LIMITS HAVE BEEN REDUCED TO $5000 / YEAR AS OF 1/1/08.

You can’t sell back your iBonds in the first year after purchase (unless there is a natural disaster or some other unique circumstance in your area); thus they are not “cash and cash equivalents”.

If you sell back your iBond within 5 years of purchase, you lose one quarter of one years’ interest. After 5 years you can redeem your iBond with no penalty.

IBONDS AND TAXES:

The advantage of iBonds is that you can defer Federal taxes on iBonds until they are redeemed, and they are immune from state and local taxes. Deferring taxes in this manner is useful because the interest that would have been taxable grows at a compound rate for the life of the bonds. In some circumstances (using them for education), the interest isn’t taxed at all when the bonds are redeemed (you should read about these at the government site, I am not an expert on the various criteria, but they seem pretty generous). Overall, iBonds receive very favorable tax treatment. IBonds might be considered as part of your college savings solution; they essentially have the same treatment as 529 accounts (you aren’t taxed on your earnings, assuming they are used for qualified education purposes). If you wanted a guaranteed portion for college you could use IBonds and get a guaranteed (albiet low, if the markets are booming) return.

IBONDS AND INFLATION:

iBonds provide protection against future inflation. If you own a bond with a fixed coupon at, say 6%, and inflation moves from 3% (current rate) to 5%, it will significantly erode the value of your bond (the price in the market will be lower if you want to sell it prior to maturity; you will receive your same coupon payments in the meantime). For iBonds, however, they automatically adjust to the inflation rate, and thus they provide a “hedge” against changes in inflation. For this reason it may be good to have them in your portfolio, because they are not correlated with your other investments (this is a good thing in “portfolio theory” terms).

Note that inflation as computed by the Treasury may not match actual inflation; they measure a basket of goods and don’t count services like college costs nor do they count real estate (an asset). Thus YOUR rate of inflation could be much higher (or potentially lower) than the rate quoted for your iBond.

SUMMARY:

You may want to look into iBonds, especially if you are in a high tax bracket or the AMT. iBonds have very favorable tax treatment, more so if your state has a high tax rate. iBonds are also attractive if you are saving for college for yourself or your children; the interest may be non-taxable if used for certain purposes.

iBonds don’t come with any expenses and are easy to buy and sell. You don’t have to deal with a broker, you can just do it all online at the Federal government site.

IBonds are currently paying VERY competitive rates – 5% – 6% depending on when you made your initial purchase – but this could easily go down if inflation slows with the cooling economy. CD’s are paying 4% or so for a couple year maturity. The brokerage CD’s have an advantage in that they can be sold in the open market while the iBonds are “stuck” for one year. Money market (which is paying below 2%) is immediately available (but less well protected, in extreme cases).

The 1 year “lock up” and 5 year “interest penalty” of one quarter means that you shouldn’t use this for your emergency fund. They might be a good component of a balanced investment program, especially if inflation rises which will erode your other bond and fixed rate investments.

Cross posted at LITGM

Treasuries vs. Certificates of Deposit

PURCHASING CD’S THROUGH YOUR BROKERAGE ACCOUNT

Recently I wrote a post about how CD’s can be purchased through your brokerage account (Fidelity, Schwab, Vanguard, etc…) and how easy that it is to do so.

Recently I built a “ladder” by taking the amount that I wanted to invest and breaking it into 4 equal groups and buying CD’s as follows:

one year interest rate 2.75%
two year interest rate 3.95%
three year interest rate 3.9%
four year interest rate 4.1%

I called my brokerage account and they read the rates & banks over the phone and I was able to make these purchases in about 15 minutes. The process is simple because they only offer FDIC insured CD’s, so there really isn’t much to differentiate each issue except for the frequency of payments (my 1 year CD paid out at maturity, the rest pay out either semi-annually or monthly, as I noted in my other article all things being equal the more pay outs you get each year, the higher the “real” return).

These CD’s are very easy to administer because they were purchased at face value (no discount or premium) and when the interest payments are made they will just show up in my brokerage account rather than compounding with the CD, which makes taxes (a bit) more complex later.

The reason I built a ladder is because I am not smart enough to “guess” the yield curve and which way interest rates are going. As each component of the ladder matures (i.e. a year from now), I will repurchase a CD at the “far” end of the maturity level. For instance a year from now my 1 year CD paying 2.75% will mature and at that time I will buy a 4 year CD at prevailing rates (which could be higher or lower than the 4.1% I received today).

CD’S VS. TREASURIES

Recently Treasuries have been in the news since the yield on government debt has fallen to extremely low levels. This article describes the situation:

“Due to stampeding demand for safe short-term investments, the US Treasury’s four-week and three-month bills on Friday yielded an effective rate of 0.01 percent — down sharply from 1.515 percent and 1.785 percent, respectively, in early September… the 10-year bond yield fell as low as 2.505 percent and the 30-year bond yield slid to 3.005 percent at one point on Friday. The six-month bond yielded a mere 0.20 percent. The low yields reflect a surge in demand for these instruments, seen as the safest in the world during times of turmoil. Analysts say the fear factor has pushed up demand for Treasuries, since investors are virtually certain the US government will not default. The panic in global financial markets has sparked an unprecedented rush into safe US Treasury securities, driving yields on short-term government notes down to almost zero…”

To an individual investor, Treasuries and CD’s insured by the FDIC should be viewed roughly as equal in terms of risk. It would have to be near “end of days” when the US Government defaulted on Treasuries, but the situation would have to be almost equally as dire when the government would consider letting FDIC insured bank deposits fail.

For large investors, CD’s aren’t really a substitute for Treasuries because of the limits on government insurance coverage and the comparatively il-liquidity of the CD market. Large investors, who are demanding access to low risk places to put their cash, are driving down the yields on Treasuries as noted above. The ten year bond per above is around 2.5% and presumably 2-4 year yields would be closer to 2%, so you are almost doubling your rate of return on CD’s vs. Treasuries.

For smaller investors it is pretty clear that you are better off with brokerage CD’s than with US Treasury securities for money that you wish to have some return and as close to zero risk as possible.

If you are interested in more information about FDIC insurance here is the official FDIC site and here is a link to Treasury Direct where individuals can purchase US government securities.

Cross posted at LITGM

Certificates of Deposit

If you are looking for zero risk alternatives for cash the only options essentially are US Government securities (Treasury bonds, etc…) and FDIC secured cash which consists of bank deposits (up to the limit) and certificates of deposit (CD’s). The third option is a money market account which only rarely “break the buck” lose money but it did happen recently with a fund that invested heavily in Lehman Brothers paper (other money market funds, such as those at Vanguard, state that they invest only in the highest quality paper and the likelihood of any sort of loss is very remote).

For the purposes of this post I am going to summarize up CD’s and the basics for investing in this type of zero risk security, which has changed recently. Key elements are as follows:

Principal – amount that you are investing with a financial institution – generally ranges from a few thousand dollars up to $250,000 (you can invest more but you start to go past the limits of FDIC insurance with a single institution)
Duration – CD’s range from a month to 10 years. Most common durations are 6 months, 1 year, 18 months, then 2 years, 3 years, and 5 years
Interest Rate – interest rate paid on your investment – for example 4% on $50,000 principal gives you $2000 interest / year (yes, I know it is more complicated than that). This is typically called the “nominal” rate
Payment Frequency – the most common payment frequency is monthly, quarterly, semi-annually, or annually. If two CD’s offer the same interest rate (say 4%) and one makes payments monthly and the other annually, the “effective” rate will be higher on the monthly payment because you can re-invest your interest. At the relatively low rates of interest that we are talking about (4% or so) and short durations (up to 5 years or so) and principal amounts ($100,000 or less) the difference between an annual payout and a semi-annual payout is insignificant over the life of a CD. All things being equal, if rates are the same go for the more frequent payouts
Penalty – for CD’s bought directly from institutions (i.e. your existing bank) typically there is a penalty for early withdrawal. For instance, if you have a 5 year CD and you pull out your money before the 5 year mark, then you would forfeit 3 months of interest (as an example). This process is different for CD’s bought through your brokerage account, see below.

FDIC Insurance has been changed recently. FDIC Insurance coverage has been raised from $100,000 (per individual) up to $250,000 (per individual) through December 31, 2009. This change was probably done because banks are acquiring other banks with all of the mergers and without raising this cap investors would have to pull funds out of banks in order to stay within the FDIC insurance guidelines (which would reduce the incentive for banks to acquire their weaker competitors in the first place).

Note that this change in insurance only goes through December 31, 2009 – thus if you are buying a CD in the near term with a duration longer than 12 months you should assume that this cap will go back down to $100,000 and you want to plan accordingly (i.e. don’t have CD’s > $100,000 in value with a duration past 12/31/09 in the same bank).

Purchasing a CD used to involve physically visiting a bank, transferring the funds into the bank (if your savings or checking accounts weren’t with that institution), and then receiving a statement or piece of physical paper to document your purchase. While this process certainly worked, it could also be time consuming to compare different rates and terms and it could be a hassle to track interest statements from a number of financial institutions (plus all of the extra tax forms at year end).

Today, however, a good way to purchase CD’s is through your brokerage account. If you have an account with Fidelity, Vanguard, or Schwab (for instance, there are many more) they have the ability to purchase CD’s through their “bond desk”.

You can purchase newly issued CD’s or you can purchase secondary CD’s. New CD’s are usually issued at “par” or 100 cents on the dollar. Secondary CD’s can be purchased at either a discount or a premium. Generally the discount and premium cause more complications from a tax perspective so that if all else is relatively equal new CD issues are a better and simpler bet.

For example, here is the summary at Fidelity:

Benefits of a Brokerage CD
1 All new issue CD’s offered by Fidelity are fee free
2 The CD’s Fidelity offers come from multiple sources
3 All CD’s offered by Fidelity are FDIC-insured
4 Brokerage CDs have some important advantages over bank CD’s including the ability to avoid penalties if the CD is sold before maturity

Author’s note – 2) multiple sources are useful because this allows you to select the best rate for different maturities and buy more than $100,000 at a time while staying within the FDIC limits 4) by avoiding penalties, they mean that you can sell your CD at any time at “market” price, which may be higher or lower than the current price. For example, I have a 3.5% CD that currently is priced at a discount, and a 5.3% CD that is priced at a premium. The fact that an issue is at a premium or discount doesn’t matter unless you want to sell before maturity – since I intend to hold them until maturity I am not worried about the discount. However, if you need your money back before maturity and interest rates have fallen since you purchased the CD you could actually make money (nominally) rather than pay a penalty.

Creating a “Ladder”

At the Fidelity site, for example, the new issue CD’s have different rates at different maturities. Unless interest rates are “inverted”, typically a longer duration CD would pay a higher interest rate than a shorter duration CD. From the Fidelity site:

3 month 2.10%, 6 month 2.55%, 12 month 3.2%… all the way to 5% at 7 years (84 months).

By a ladder, you might split your dollars between 1 year, 2 year, 3 year and 4 year CD’s. As each CD matures, you repurchase it at current interest rates. This will give you some protection from changes in rates, and you can protect yourself from getting stuck for a long duration at low rates (if they rise) and you can benefit for some period of time if rates decline.

If you buy this from your brokerage house (like Fidelity, or Vanguard) it is easy to select new issue CD’s from different banks that do not exceed the FDIC limits and take advantage of the best interest rates offered by CD’s at different durations. In addition, all of these CD’s appear on your brokerage statement and you get simplified tax reporting, too.

You generally will need to call the “bond desk” which is where fixed income investments like bonds and CD’s are sold. You can tell them the duration that you are looking for (2 years, for instance) and the amount you want to invest and they will tell you a bank that is offering the best rate – you will want to not put too much in any single institution. The CD’s are usually sold without extra fees (beyond whatever spread the brokerage earns from the bank, which is transparent to you).

From a tax perspective, the interest is taxable and will appear on your brokerage statement. CD’s are not necessarily tax efficient vehicles, but they are risk free. Depending on your tax bracket, municipal bonds may be a good bet, but they are more complicated and there are more risks (although municipal bonds are generally low risk, especially compared to corporate debt).

From an investment perspective, CD’s are not going to make you rich, but they won’t lose money. The interest rate is typically a bit more than the current short term rate, and then they are taxed, and the impact of inflation needs to be factored in. From an “economic” perspective, the net of return – tax – inflation is probably about zero.

Sadly enough, zero has been kicking butt for the last decade or so…

Cross posted at Life At The Great Midwest

Tracking Your Investments

There are many ways to track your investments. I have used a number of free online portfolio tracking tools over the years including the one at the Wall Street Journal and Yahoo. I really like the tool from google because:

1) it is very easy to set up
2) it lets you add cash independently of creating a “cash” account and treating everything as a transaction
3) you can see at a glance, and hide / unhide right off your home page