Portfolio 2 has a value of $31,055.The beneficiary contributed $7000 and the trustee $14,000 for a total of $21,000. This portfolio has a $10,000 CD to provide stable value and 2 core ETF’s. This year a biotech ETF was added, as well.
Investing has changed significantly during the 25 or so years that I have been following both the market and also the tools available for an investor to participate within the market. The following trends are key:
- The cost of trading and investing has declined significantly. Trades used to cost more than $25 and now are essentially free in many cases. Mutual funds used to have “loads” of 5% or more standard when you made an investment, meaning that $100 invested only went to work for you as $95. These sorts of up-front costs have almost totally been eliminated
- ETF’s have (mostly) replaced mutual funds. ETF’s “trade like stocks”, meaning that you can buy and sell anytime (mutual funds traded once a day, after being priced with that days’ activity) and they don’t have income tax gains and losses unless you actually make a trade (mutual funds often had gains due to changes in the portfolio that you had to pay taxes on even if you were just holding the fund)
- CD’s and Government Debt are all electronic. You used to have to go to a bank for various governmental bond products or to buy a CD. Now you not only can buy all of this online, you can choose from myriad banks instantly rather than settle for whatever your main bank (Chase, Wells Fargo, etc…) offers up to you
- Interest Rates are Near Zero. One of the key concepts in investing is “compound interest”, where interest is re-invested and even small, continuous investments held for a long time can end up amounting to large sums (in nominal terms, because inflation often eats away at “real” returns). However, with interest rates basically near zero, you need to earn dividend income or take on more risk (i.e. “junk bonds”) in order to receive any sort of interest income. There is no “safe” way to earn income any more
- Currency Fluctuations Matter. When the Euro initially came out it was $1.30 for each US dollar, and then it went to 70 cents per dollar, and now it is about $1.10 per dollar. At one point the dollar fell 30-40% against many currencies world wide (when “commodity” currencies like the Canadian and Australian dollar were surging). For many years currencies were relatively stable against one another but that era seems to be ending, and thus the change in relationship between the US dollar and their currency can be much greater than the return that is earned on the international investments
- Active Trading Has Mostly Been Beaten By Passive Trading. While there are many exceptions, initially the majority of investments were “active”, but over the years many of the “active” managers have substantially under-performed the market, wilst charging investors more in fees (it is cheaper to run a “passive” index). As a result, there has been a massive shift away from active investors to passive investors like Vanguard
- Correlation Among Stocks and Investment Classes Is Much Higher. Correlation means that stocks or asset classes tend to “move up” together or “move down” together. It is not unusual for me to look at a portfolio of 20 stocks and 19 or 20 of them have all gone up or down on a single day. This is related to active managers being unable to “beat” the market (see above)
- The “Risk Premium” for Lower Quality Debt is Small. The amount of extra interest required for low quality borrowers over the US Treasury benchmark is very small. Investors are taking on a lot of risk to just earn a few more percentage points of return. If there is a downturn in the economy (such as what happened only recently in US oil companies), there are likely to be significant declines in junk bond values that wouldn’t justify the modest risk premium you receive for holding these types of assets
- ETF’s Provide an Easy Way to Participate in Commodity Markets. It was more difficult to buy and invest in commodities like gold and crude in the past, and it was often limited to relatively sophisticated investors or those willing to hold on to physical commodities like gold (which can be risky since they need to be stored and protected due to high value and inability to trace once stolen). Today you can easily buy a liquid ETF to participate in the commodity markets for key areas like precious metals (gold and silver) and crude oil / natural gas
- Fewer Companies are Going Public and the Market is Shrinking (in terms of issuers, not total value) – It is easy for start up companies to access private capital (venture funds) and they tend to “go IPO” at high values, making a further upside (after the initial IPO) more difficult. The total market is shrinking in terms of listings due to M&A (companies buying other companies) faster than the new IPO’s and many companies are “buying back” shares which also reduces the total value of the public markets
- Bonds have had a Gigantic Bull Market that is Nearing It’s End – Bond prices move inversely to yield; thus if you held on to a 5% low risk bond (which would have been available everywhere in the early 2000’s), that bond would currently be priced at much more than 100 cents on the dollar today. Interest rates peaked around 20% near 1980 and now are not far from zero; in this sense bonds are part of an enormous “bubble market” that has not yet peaked. But given how low rates are (they are even negative), it seems like this bull run is about to come to an end
- Ensure That You Include Dividends and Total Return. A common mistake is to look at performance just in terms of stock or asset prices, and avoid including the compounding impact of dividends received, especially since dividends often rise each year. Dividend income can make up a significant portion (25% and up) of total return, so selecting assets that provide dividend income is critical. Finally, dividends provide favorable tax rates when compared to interest income
What does all of this mean? I would sum it up in two ways:
- It is easy for individual investors to set up a simple and low cost way to track the market – the “basic plan” that I set up as a simple example can be used by anyone and it does what it says. Here is a second plan that also includes some hedging of the non-US investment
- You will need to save much more (or take on more risk) because interest rates are low – with near zero interest rates, you can’t make much money on low risk interest bearing products (like CD’s, savings accounts, and simple government debt). If you are earning risk income, you likely are taking on substantial risk of default because there is no “free lunch”. As a result, you need to put more cash into stocks in order to earn dividends or see real returns, but this also could lead to significant losses if there is a market crash like 2008-9.
I try to promote financial literacy and have helped many friends and some family members when they ask questions. Ideally we would actually drive financial literacy through school and into the university. Even those who have a degree in finance or accounting often lack practical advice on personal finance and don’t know how to approach these issues.
One key concept is “net worth”. Net worth isn’t how much you earn in salary, it is what remains in savings after taxes (or through long term deferral of taxes). The only “assets” that count are those that you can turn into cash if needed, and they are “net” of the debt (such as on your house). Most people have a negative or near-zero net worth, which is also linked to the concept that they are essentially a couple of missed paychecks away from very bad outcomes such as having to take out a payday loan or borrow money from relatives.
Another key concept is trying to avoid excessive student debt. Unlike all other forms of debt (loans on your house, your car, or credit card debt) your student debt cannot be discharged through bankruptcy. You essentially have no options except to repay your loans, and if you miss payments or fall behind the fees and penalties will greatly increase your balance due. Student financial literacy is critical because they are making decisions that will impact themselves and their families for the rest of their lives and they must be made thoughtfully and with the end in mind (if you are taking out all of this debt, you must be driven in your career to make money in order to pay it off and get on with building net worth).
Cross posted at Chicago Boyz
Portfolio Two is our second longest lived portfolio, at 11 1/2 years old. The beneficiary contributed $6500 and the trustee $13,000 for a total of $19,500. The current value is $27,814 for a gain of $8,314 or 43%, for a rate of return of 5.2% adjusted for the timing of cash flows. You can see the detail here or on the link on the right side of the page.
Portfolio Two is now unlike all the other portfolios. Our goal is to have about 1/3 of the value in interest rate products (CD’s), about 1/3 in US stocks (VTI) and 1/3 in international stocks (VEU and HEFA). This portfolio will invest only in CD’s and ETF’s going forward. This is similar to the “basic investing plan” listed on the site header.
In 2015 we sold all the individual stocks in the portfolio, for a net long term gain of approximately $7300. In the past, figuring out the cost basis for your stocks was difficult but today the brokerage firm put the cost basis on each of the sales along with the trade date (to determine whether it is a short or long term trade) which makes it easy to calculate (if a little bit tedious, unless you can download your brokerage account directly to your tax software). It depends on how it comes out but we are hoping that this goes under the tax rate at 15% or about $1100 but it will depend on the net calculation and other earnings of the beneficiary and the parent.
Portfolio Two is transitioning to ETF’s and CD’s. This is aligned with the “basic plan” that I refer to here. The portfolio has $28,781 (all in cash) as of December, 2015.
At a high level our investments will consist of:
- $10,000 in the lowest risk interest rate products (Federally insured CD’s bought through a brokerage, go here if you want to learn more)
- $9000 low-cost ETF tracking the US stock market
- $4500 low-cost ETF tracking the non-US stock market, unhedged
- $4500 low-cost ETF tracking the non-US stock market, hedged
In the old days you used to need to call a broker to buy a CD or physically visit a bank. Now you can buy CD’s online through your brokerage account. To avoid more complicated tax issues with gains and losses I am sticking to “new issue” CD’s which are always issued at par (100 cents on the dollar). When you are buying existing CD’s (the secondary market) they have gains or losses implied as they do not sell for 100 cents on the dollar and this causes additional tax issues that aren’t significant but I want to keep this simple and at this purchase level it is easier just to buy new issues. For each CD there is a minimum bid quantity – for the highest yielding 2-3 year CD selected below, the minimum bid quantity is 10 at $1000 or $10,000.
Goldman Sachs bank USA CD 1.55% due 7/6/2018 paid out semi annual (audited by PWC). Thus it is a CD that will pay back the $10,000 in 2 1/2 years from now. Here is the link to a page that shows which external firm audits each entity.
The CD is semi-annual so it pays 1.55% * 10,000 / 2 = $78 every 6 months, or $155 / year.
There are no expenses (on buy, sell) and no fees with this holding. By contrast a money market fund pays about 0.2% (or $20) after fees.
If we need cash we can sell this in the secondary market and there will be a small gain or loss depending on how interest rates have moved since the purchase date, and likely a bit of slippage in the buy / sell. If for some reason the bank goes bankrupt (highly unlikely since this is Goldman Sachs) the government will pay back our $10,000 and accrued interest through the last date. This did happen to me back in the 2008-9 time frame when a number of banks were taken over by FDIC as they became insolvent and deposits were guaranteed.
We will put half the remaining in US stocks and half in foreign stocks. The US stock will be in the Vanguard ETF VTI. Vanguard is audited by PWC.
VTI has a yield of 1.91% (dividends). We will invest $9000 in this fund. It has an expense ratio of 0.05%.
We will put half the remaining in an overseas stock fund. We will put $4500 in VEU which is the Vanguard all-world index except the USA. It is not hedged. The yield is 2.96% and fees are 0.14%.
Will put the other $4500 remaining in a hedged overseas stock fund. We will put put $4500 in HEFA which is an overseas ETF that is owned by Blackrock (iShares). It has a yield of 2.35% and fees of 0.36%.
Blackjack (iShares) is audited by Deloitte and Touche.
Recently the US dollar has strengthened against most foreign currencies. This means that you could buy foreign stocks and they could do well in their local markets (for example, the Japanese stocks were generally up for a time) and yet you would have losses when your ADR or ETF was valued in US dollar terms.
While you cannot generally hedge the currency risk in a single stock ADR (for example, Toyota), they now offer ETF’s that give exposure to foreign markets but also hedge those currencies against the US dollar, so you receive their “actual” return (good or bad) rather than their actual return PLUS the impact of the rising or falling US dollar.
For instance, let’s look at the VEU Vanguard ETF (one of my favorites, the Red line below) against a new ETF I started looking at, HEFA (the Blue line), over the last two years. You can see that the total return was 1.1% positive in HEFA and 14.2% negative for VEU over that time span. This difference is due almost totally to the rise in the US dollar against foreign currencies that make up the bulk of those stock indexes (the Euro, the Japanese Yen, the Australian Dollar, and the Canadian Dollar). You can see that the peaks and valleys of the blue and red lines track together (they move in the same direction) but the red line sinks as the US dollar rises over the last two years.
One negative impact of this, all else being equal, is that hedging costs money and this should be expected to drive up fees on your ETF. The ETF for Vanguard (VEU) is 0.14%, which should be considered somewhere near rock bottom. The HEFA ETF expense ratio is 0.35%, which is also very low, but higher than the Vanguard product. This isn’t a perfect comparison because generally the Vanguard ETF’s have the lowest expense ratios due to their member-owned structure. HEFA is part of iShares which is now owned by Blackrock, a major competitor of Vanguard.
It should be noted that the VEU and HEFA indexes aren’t exactly the same in terms of countries that they cover and weighting of markets but as you can see above they generally move closely in tandem and the majority of the difference is due to the impact of the US dollar against foreign currencies.
This is of interest because the US Federal Reserve is considering raising interest rates soon, which theoretically would cause the dollar to rise which would make holding shares in other currencies less profitable. Of course this is already priced into the dollars’ current level, which could mean in practice that if the Fed doesn’t move fast enough or make enough moves, the dollar would fall. If anyone ever tells you that they can predict interest rates or currency moves you should not believe them; there is no reliable way to predict either one although there are mass industries of pundits attempting to do so.
Thus for my “basic plan“, the question is, should you also consider adding currency-hedged ETF’s and not just the two basic ETF’s (VEU and VTI). The question is whether to replace part of your VEU allocation (how much you buy) with something like HEFA (there are other ETF’s, but this seems to be a pretty good one, with a large base of investors and from a company like Blackrock which isn’t going away any time soon). Here’s what would happen – if the US dollar falls against major foreign currencies, you are going to make less money than you would otherwise if you hedge it. If the US dollar rises, you will make more money than you would otherwise with the hedged product. Also note that the hedging may not be perfect, but would likely shield you from the vast majority of the impact, especially on major currencies like the Euro.
I think that this is getting a lot of play in the financial press right now and I predict that at some point these products will be mainstream. It took a long time to move from “active” to “passive” investing and it has taken many more years for ETF’s to begin to take a large share of new investments away from mutual funds. This is another long term trend that started on the margin (there were very few currency hedged funds a couple years ago when I looked, and they were expensive) but is now going mainstream, and the additional expenses for hedging seem quite modest (0.14% vs. 0.35%).
Portfolio Two is our second longest portfolio, at 11 years. The beneficiary contributed $6000 and the trustee contributed $12,000 for a total of $18,000. The current value is $28,334 for a gain of $10,334 or 57%, which works out to about 6.8% / year across the life of the portfolio. You can download the detail here or utilize the links on the right side of the page.
This portfolio has been buoyed by two star performers, Amazon (AMZN) and Facebook (FB). Both of those stocks have moved up substantially recently and account for half the total gain.
Poor performers are TransAlta (TAC), which was hammered by the drop in the Canadian dollar and the collapse of the commodity markets, and Wynn (WYNN) resorts which was hurt badly by changes in Chinese policy that limit gambling and especially “high roller” VIP gambling in Macau.
We will likely sell off all these stocks and move into cash and then ETF’s, likely following the approach listed in this post titled “Investing – Basic Plan” of low-cost ETF’s and CD’s purchased through a brokerage. At approximately $28,000, the portfolio would likely be about $10,000 5 year CD (at around 2% / year) and $9,000 of VTI (Vanguard total stock market) and $9,000 of VEU (Vanguard total stock market ex-USA). There would be about $6900 in net taxable gains that would need to be paid and the trustee / their parents need to decide who is going to pay this amount (if the rate was 15%, this would be about $1035 in taxes). If the taxes were paid out of this distribution, then we would be re-investing just under $27,000. This portfolio has unique reasons for doing the sell-off and re-investment into ETF’s that we don’t plan to repeat with other portfolios unless it is necessary.
If you want to invest on your own, there are some basic ways to approach it. Here is a simple model that you might want to consider using.
The goals of this approach are as follows
- Build a simple, consistent approach that does not require a lot of re-balancing
- Minimize fees and expenses
The money you want to invest can be split into any grouping depending on your risk tolerance. For the sake of this discussion, let’s assume that you want to split evenly before the 4 categories that are listed below. If you were putting in $100,000, you might put $25,000 into each of the 4 categories below.
- 2 year new issue brokerage CD’s (bought at par, or 100 cents / dollar, no gain loss)
- 5 year new issue brokerage CD’s (bought at par, or 100 cents / dollar, no gain loss)
- Vanguard ETF total US stock market (ticker VTI)
- Vanguard ETF total world stock market except US (ticker VEU)
I wrote a lot of articles about buying CD’s from a brokerage. Some highlights include 1) you get better rates than you get through your bank (for instance I saw 2 year CD’s at my bank at 0.7% and was able to get 1.2% through my brokerage) 2) the CD’s are guaranteed against loss – worst case you get your principal and accrued interest back (many of my CD’s were tied to banks that failed in 2008-9, so I tested this theory) 3) when you buy the CD’s up front through your brokerage account you pay no expenses except for any per-trade charge your brokerage like eTrade or Vanguard or Schwab might add to the trade (i.e. no annual fee).
What are the CD’s accomplishing? They are your “safe money” in the portfolio. You effectively can’t lose money if you hold them to maturity. If you have to see early before they expire (i.e. you need the money to buy a house) your brokerage account can put them up for sale and you will have a small gain or loss depending on how interest rates have moved since the time you bought your CD.
There are other ways to do this (buying bonds, treasuries), but they are more complicated, and don’t offer significantly better returns than this. On the other hand, you may note that some bond funds have had big gains, but these are mainly bets on interest rates and on the riskiness of portfolio items and this is fine but you need to know what you are getting into. The CD’s should work fine for most investors.
Also note that many bond funds have fees in the 0.5% range (although some are more, and many are far less). At this point, the fees will eat up your entire return! We need to plan as if the low interest environment (ZIRP) that we are in will go out indefinitely, which means low returns and watching expenses is paramount unless you want to take on more risk in terms of your investments.
As far as the ETF’s, it is easy to buy them through your brokerage account, you just figure out how much you want to buy (say $25,000) and determine the current price (about $107 / share) which is 230 or so shares. Put in an order, which might be free or might cost you up to $25 (depending on your brokerage), and voila – you are done.
Both VTI and VEU have rock bottom expense rates – VTI is at 0.05% / year (meaning $25,000 costs you $12.50 / year) and VEU is at 0.15% / year (meaning $25,000 costs you $37.50 / year). Note that a typical financial advisor plus fees on ETF and mutual funds might cost 1.5% / year, which would mean $25,000 would cost you $375 / year. Of course they also give you expert advice, so that is the flip side of that transaction.
How do you manage money using this model and re-balance? Easy. Likely semi-annually you will receive interest on your CD’s – this is about 1.5% on average between both of them – so you’d have 1.5% times $50,000 = $750 / year in interest. That doesn’t sound like much, but that’s pretty much the best you can do nowadays.
For your stocks – you will receive the dividend yield every year as cash in your account – VEU yields about 3.5% and VTI yields 1.75%, so on average you’d probably get about 2.6% / year in dividends or $50,000 * 2.6% = $1300 in cash.
The interest income on CD’s is taxed at the highest marginal rate for you (likely 28% or higher) but the dividends will be taxed at a lower rate of about 15%.
Rebalancing? You shouldn’t need to. Just leave the assets where they are. The 2 year CD’s will come due and you can buy new 2 year CD’s, and later the 5 year CD’s will come due. Unless you need to buy a house or something I would just leave the ETF’s there forever – they are a bet on the stock markets in the US and around the world.
As your assets earn cash they will be deposited back in your cash brokerage account. Take that cash, plus new cash you’ve saved up, and then pick one of the 4 categories depending on your risk tolerance, and invest more.
That’s it. This is a super low cost plan that requires little re balancing and gives you a balanced portfolio.