The Benefits of using an Outsourced Chief Investment Officer

The Benefits of using an Outsourced Chief Investment Officer

In today’s insights, we will discuss some of the key benefits of using an Outsourced Chief Investment Officer.  Outsourced Chief Investment Officer (OCIO) is a growing service, where financial advisors, family offices, endowments, pension funds and other institutions seek an outside firm for help to manage their core assets. Employing an OCIO can be an essential step in improving the efficiency of the investment decision-making process by employing the resources and the expertise of an outside firm.

In fact, the 2016 NACUBO – Commonfund study of endowments revealed that 43 percent of the respondents had substantially outsourced their investment management function, up significantly from 2010’s report of 34 percent. Eighty-four percent of the study participants reported using a consultant for various services related to investment management

 

Managing growth

One of the most common reasons why clients seek our services is to manage their growing asset base. While fast growth is a good problem, it brings more responsibilities and higher investment and operational risk. For instance, one of our key clients increased their asset base 400% within 12 months. In that short period, we created an infrastructure to integrate new incoming accounts into the existing portfolio structure. While at the same time we worked on eliminating operational deficiencies and establishing an investment committee.

Asset complexity and customization

Organizations have unique investment goals and appetite for risk.  We regularly observe customer portfolios with significant investment concentration and need for diversification.  Additionally, we see that many organizations have specific tax or liquidity constraints that can hinder their investment decisions.  There is also a growing need for socially responsible and faith-based investing.  An outside CIOs can help clients efficiently navigate through the ever-growing complexity of customized investments and financial decisions.

Asset Liability management

As of December 31, 2017, the average endowment surveyed by NACUBO-Commondund Study has generated a 10-year return of +4.6%. This return is substantially lower than their long-term target rate of 7% which is necessary to support spending and operational cost. For a $10m foundation, this gap could result in a $3.9m asset shortfall in just 10 years and over $14m shortfall in 20-years.

Real-time oversight

Investment portfolios need real-time management.  Financial markets are risky and often move very fast. Our customers know that their complex portfolios require continuous supervision from experts who can monitor investment risks and take advantage of tactical opportunities.

Performance pressure

The rise of ETFs and low-cost index investing created enormous pressure on organizations to improve their returns. Our team of experts can establish a dynamic process for evaluating external managers and passive investment strategies. We are a firm believer of risk-adjusted performance. Therefore we continuously scan the investment universe for managers with an outstanding history of achieving risk-adjusted returns and recommend them to our clients.

Risk management

Identifying and understanding the risks in our clients’ portfolios is a critical element in our investment management process. A robust risk and trading system can make a huge difference in a volatile market environment. As OCIO, we can implement ongoing risk management using daily monitoring, hedge strategies, portfolio stress testing, and risk modeling.

Free up internal resources

Our clients often rely on an investment committee and small internal staff to operate and manage their assets.  Hiring a full-time portfolio manager can be a lengthy, challenging and often costly process. By engaging an external CIO, our clients can free up their already stretched internal resources and focus on their core services in a cost-effective way.

Accelerated investment process

In a dynamic market environment, many of our clients benefit massively from an accelerated investment process. Our OCIO service helps our clients make faster strategic and tactical investment decisions. We also assist in the timely implementation of portfolio infrastructure and operational tasks.

Fiduciary advice

Our clients highly appreciate the value of fiduciary advice aligned with their specific goals, needs, and objectives. As a fiduciary OCIO, we must provide advice, investment management and guidance in our clients’ best interest.

Open architecture

An outsourced CIO can implement an open architecture investment portfolio to allow for expanded investment options in all asset classes and categories. The open structure can lower cost and provide diversification.  With our ongoing investment due-diligence process, our customers can choose from a broad pool of investment options including index funds, factor-based ETFs, and top-ranked portfolio managers.

Cost control

As OCIO, we can help clients reduce their overall investment management and administration cost. We often see clients locked-in expensive investment management agreements or using high-cost mutual funds and fee-loaded strategies with lackluster performance. Our fiduciary client commitment allows us to evaluate a wide range of investment strategies and recommend those with the lower cost and higher risk-adjusted return.

 

 

About the author: Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm. Babylon Wealth Management offers highly customized Outsourced Chief Investment Officer services to professional advisors (RIAs), family offices, endowments, defined benefit plans and other institutional clients. To learn more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,

 

Investing in MLPs – Risks and benefits

What is an MLP?

Managed Limited Partnerships (MLPs) have grown in popularity in the past several years. Many U.S. energy firms have reorganized their slow-growing, but stable cash flow businesses, such as pipelines and storage terminals, into MLPs.

MLPs are very attractive to income-seeking investors. They must pass at least 90% of their income to their partners (investors). As a whole, the MLP sector offers on average 6% annual yield with some MLPs reaching over 15%.

Companies that operate as MLPs tend to be in very stable, slow-growing industries, such as pipelines and energy storage. The nature of their business offers few opportunities for price appreciation. On the other hand, cash distributions are relatively stable and predictable giving the MLPs features of both an equity and fixed income investment.

The number of public MLPs increased dramatically in the past 20 years. There were more than 18 IPOs in 2014 from almost zero in 1984.

MLP IPO History 1984 – 2015

MLP IPO History

 

Legal structure

There are two types of MLP owners – general and limited partners. General partners manage the day-to-day operations of the partnership. All other investors are limited partners and have no involvement in the company’s activities. MLPs technically have no employees.

MLP investors buy units of the partnership. Unlike shareholders of a corporation, they are known as “unitholders.”

Each unitholder is responsible for paying their share of the partnership’s income taxes. Unitholders are required to file K-1 forms in each state where the MLP operates, regardless of the size of revenue generated from that state. This filing requirement makes the direct MLP ownership.

Additionally, open-end funds like traditional ETFs are restricted from investing more than 25% of their portfolio in MLPs. Therefore most ETFs choose a C-corporation or ETN structure in order to track the MLP market.

 

Returns

In the past ten years, MLPs had outperformed S&P 500 and similar sectors like Utilities and REITs. MLP reported 9% average 10-year return versus 7.2% for S&P 500, 7.9% for Utilities and 6% for REITs.

Alerian MLP 10 year performance

Source: Alerian.com

Distributions

MLPs provide generous income to their investors. The average yield is around 6% as some small MLPs pay up to 15%. The distributions from MLP consists of non-qualified dividends, return on capital and capital gains.

Since MLPs pass through 90% of their income to unitholders, each type of distribution has different tax treatment.

Dividends are taxed at the ordinary income tax level, up to 39.6% plus 3.8% for Medicare surcharge.

Capital gains are taxable as either long-term or short-term. Long-term capital gains have favorable tax treatment with rates between 0, 15% and 20%. Short-term gains are taxed at the ordinary income level.

The largest portion of MLP distributions comes as a return on capital. The benefit comes from the MLPs use of depreciation allowances on capital equipment, pipelines, and storage tanks, to offset net income. Return on capital distributions are tax deferred. Instead of being immediately taxable, distributions decrease the cost basis of the investment. Taxes are only due to these distributions when investors sell their units. In fact, investors can defer paying taxes indefinitely by keeping their shares.

Tax Impact

MLP distributions are not sheltered from taxes in retirement accounts. According to the Unrelated business taxable income (UBTI) rule, unitholders will owe taxes on partnership income over $1,000 even if the units are held in a retirement account.

Individual MLP holdings, ETFs, mutual funds and CEFs are most suitable for long-term buy and hold investors in their taxable investment accounts. Those investors can benefit from the tax-deferred nature of the cost of capital distributions, which will decrease their cost basis over time. They will pay taxes only when they sell their units. Investors can avoid paying taxes indefinitely or until cost basis reaches zero. In that case, they will owe taxes on the return of capital distributions at the long-term capital gain rate.

Short-term investors may consider ETNs for their better index tracking. All distributions from ETNs are taxable as an ordinary income level and do not provide any preferential tax treatment.

Risk considerations

MLPs drive their revenue from the volume of transported energy products. Their business is less dependent on the fluctuations of the commodity prices compared to other oil & gas companies. Historically, MLPs as a group is less volatile than the broader energy sector. MLP price tends to have a direct correlation with the partnership distributions. Higher payouts drive higher prices while lowers distributions push the price down.

Between September 2010 and October 2016, the largest MLP ETF, AMLP had a standard deviation equal to 14.8%. As a comparison, the largest energy ETF, XLE, had a standard deviation of 19.61%.

MLPs are often treated as an alternative investment due to their considerable ownership of real assets. They also have a lower correlation with the broad equity and fixed income markets while simultaneously having characteristics of both. AMLP has 0.57 correlation with S&P 500 and -0.16 to the 20-year treasury.

 

Investing in MLPs

Direct ownership

As of March 31, 2016, 118 energy MLPs were totaling $304 billion in market capitalization.

The most popular index tracking the MLP space is Alerian MLP. The index has 44 constituents and $298 billion market capitalization.

There are ten companies dominating the sector. They make up close to two-thirds of the Alerian MLP Index. The remainder consists of hundreds of small and mid-size partnerships. 

Largest public MLPs

 

Direct MLP ownership is a popular strategy for yield-seeking investors. The direct investing also provides the most beneficial tax treatment of MLP distributions – tax deferral.

However, the biggest drawbacks of direct investing are the large tax filing cost and the exposure to a single company.

Investors interested in direct ownership in MLPs should consider buying a basket of partnerships to diversify their risk more efficiently. They should also weight the tax benefits of direct ownership versus the cost of year-end tax filing.

ETFs and ETNs

MLP ETFs and ETNs have the most complex legal and tax structure of any other ETFs. Due to these complexities, most funds are structured as ETNs.

There are 28 MLP ETFs and ETNs currently listed on the exchange. Their total Asset Under Management (AUM) is $17.7 billion with the top 4 ETFs dominating the space with total AUM equal to $15.9 billion.

 

List of MLP ETFs and ETNs

 

AMLP

AMLP is the most popular and liquid MLP ETF. It tracks the Alerian MLP index. AMLP is the first ETF to address the complexity of direct MLP ownership.  This ETF offers a broad diversification to the largest publicly traded MLPs.

AMLP offers simplified tax filing by issuing standard 1099 form. Because of its legal structure, AMLP can pass the tax-deferred treatment of MLP distributions to its investors.

To satisfy the legal restrictions on ownership, AMLP is structured as a corporation, not an actual ETF.  AMLP pays taxes at the corporate level. The structure requires the fund to accrue the future tax liabilities of unrealized gains in its portfolio. Doing this is causing the fund to trail its underlying Alerian Index during bull markets and beat it during down periods.

AMJ

AMJ is the next most popular fund in this category. It i
s structured as an exchange-traded note.

ETNs are an unsecured debt instrument structured to track an underlying index’s return, minus management fees. Unlike exchange-traded funds, ETNs do not buy and hold any the underlying assets in the indexes they track. They represent a promise by the issuing bank to match the performance of the index.

AMJ is issued by JP Morgan and capped at the market value of $3.885 billion. Investors in AMJ have credit exposure to JP Morgan in case they are not able to pay the performance of the index.

Due to the lack of actual MLP ownership, AMJ can replicate the performance of the Alerian MLP index much closer than AMLP.

AMJ also issues single 1099 tax form. However, all its distributions are taxable as ordinary income, for up to 39.6% plus 3.8% of Medicare surcharge. AMJ distributions do not have the preferential tax treatment of AMLP and individual MLP ownership.

This ETF is suitable for short term investors willing to bet on the MLP sector and not interested in any potential income and tax benefits.

EMLP

EMLP is the only traditional ETF in this group. Because of the regulatory restrictions, EMLP holds only 25% stake in MLPs and the remaining 32% in Energy, 40% in Utilities and 2% in Basic Materials. Unlike the other funds, EMLP has a broader exposure to companies in the energy infrastructure sector. According to the prospectus, the fund invests in publicly traded master limited partnerships and limited liability Canadian income trusts,, pipeline companies, utilities, and other companies that derive at least 50% of their revenues from operating or providing services in support of infrastructure assets such as pipelines, power transmission and petroleum and natural gas storage in the petroleum, natural gas and power generation industries.

Mutual Funds

The three Oppenheimer mutual funds are dominating this niche. They manage almost 50% of the $20b AUM by MLP mutual funds.

A list of the most popular mutual funds by AUM.

MLP Mutual Funds

 

The MLP mutual funds tend to have higher fees than most ETFs. They utilize the corporate structure which allows them to transfer the majority of the income and tax advantages to their shareholders.

Closed-End Funds

Closed-End funds (CEF) are another alternative for investing in the MLP sector. Similarly to mutual funds,  CEFs are actively managed. The difference is that they only issue a limited number of publicly traded shares.

Most MLP closed-end funds use leverage between 24% to 40%  to boost their income. These funds borrow money in order to increase their investments.

MLP Closed End Funds

CEFs shares often trade at premium or discount from the NAV of their holdings. When purchased at a discount they can offer potential long-term gains to interested investors.

MLP CEFs also use the c-corp structure. They issue a 1099 form and pass current income and return on capital to their investors allowing for tax-deferral benefits on the distributions.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,  Image Copyright: <a href=’http://www.123rf.com/profile_kodda’>kodda / 123RF Stock Photo</a>

 

 

 

 

 

 

Investing in Small Cap Stocks

A Guide to Investing in Small cap stocks

Small cap stocks are an important part of a diversified investment portfolio. They had provided high historical return and diversification, which are key factors in the portfolio management process.

Many flagship companies started as small businesses in a local market and evolved to large multinational corporations. Some of these success stories include McDonalds, which opened its first restaurant in Des Plaines, Illinois to become one of the biggest food chains in the world.

Research has shown that small-cap stocks overperformed a large cap over an extended period.

The below chart shows 15-year performance between IWM, Russell 2000 Small Cap ETF and SPY, S&P 500 Large Cap ETF. For that period IWM surged by 164% while SPY rose by 67%.

Small versus large cap 15 year performance

Once we include dividends, the 15-year annualized return of a small cap blend strategy becomes 8.66% versus 6.71% for a large cap strategy.

If we extend our period to 40 years (1975 – 2015), the small cap generated 14.25% annualized return while large cap produced 11.66%.

Investing in small companies comes with many caveats.  Even though they bring potentially high returns, they also impose high risk and uncertainty.

Market capitalization

Small cap companies have a market capitalization between $300 million and $2 billion dollars. Overall, the small size market is very fragmented. There are thousands of publicly traded small-size companies, but they only make 10-15% of the total market. The definition of a small-cap company varies widely among index providers and portfolio managers. Standard & Poor’s tracks their own S&P 600 Small Cap Index while FTSE Russell tracks the Russell 2000 Small Cap Index.

Very often, small companies are managed by their original founders.  They are usually new and innovative companies with competitive strengths in a particular local market or a specific product. It is not uncommon for companies to go back and forth between small, mid and large-cap rankings depending on their business cycle.

Niche market

Small cap companies often operate in a niche market where they have a distinct competitive advantage. Small businesses have a unique product or service, which they offer on either national or local level.  Unlike their bigger counterparts, which offer a variety of products in different geographies, small size companies tend to be more focused, with one or two flagship products. A particular example can be Coca Cola versus Red Bull. Coca-Cola offers hundreds of varieties of beverages worldwide while Red Bull offers only one type of energy drink.

Regularly small companies will start from a local market and grow nationwide.  Starbucks is a great example of a local coffee shop that moved up the ranks and became one of the top 100 large company in the USA and the world.

Small businesses with a unique product will often become an acquisition target for a larger corporation that wants to gain a presence in a growing higher margin market. Great example for that is PepsiCo acquiring Gatorade. PepsiCo wanted to get access to the fast growing market of sports drinks and instead of developing their own line; they decided to purchase an already established brand.

Growth potential

Small cap companies often have higher revenue growth than large size ones. Their competitive advantages, innovative strategy, flexibility and market positioning allows them to grow faster. It is easier to increase 25% when you start at $10 million of revenue versus $25% at $ 1 billion of revenue. Many times small companies do not even have a competition in their market niche. Think of Facebook before they went public. It is common for small firms to grow their revenue between 25% and 50% annually for several consecutive years.

Volatile prices

Investing in small cap stocks is risky. The high potential return of small caps comes with greater risk. The share price of small companies is more volatile and subject to larger swings than those of bigger companies.

IWM, the biggest small-cap ETF, has a beta of 1.22 to the equity market. As the comparison, the beta of SPY, the most traded large-cap ETF, is equal to 1. Beta measures the volatility of a security compared to the market as a whole. IWM beta of 1.22 shows that the ETF is historically 22% more volatile than the overall market.

Another measure of volatility is a standard deviation. It illustrates how spread out are the historical returns compared to the average annualized return of the investments. In our case, the 15-year standard deviation of IWM is 19.73% versus 14.14% for SPY.

As I mentioned earlier, the average 15-year return for a small cap stock is 8.66%. With a standard deviation equal to 19.73%, an average annual return can go between -11.07% and 28.39%. For SPY the average range is between -7.43% and +20.85% with annualized return of 5.25%. Based on this historical data we can claim that the small cap market has a much wider probability of returns. The high upside comes with a bigger downside.

Limited access

Small cap stocks lack the liquidity and trading volume of the large public corporations. This makes them more vulnerable to large price swings in short periods.

In times of economic recession, small companies can take a bigger hit in their earnings and may take a longer time to recover. Ten or fifteen percent decline in revenues can have a much more adverse impact on a small company than a larger one.

Due to their limited access to equity markets and loan financing, small size companies have a higher risk to go into bankruptcy if they run out of money.

Many small firms are start-ups with one innovative product and untested business models. Their dependency on just one product or service puts them in a very high-risk category in cases when the product or service does not appeal to their target customer base.

Inefficient market

Traders and portfolio managers often ignore small-cap companies. The focus is usually on large size companies, which frequently have 5 to 10 analysts following their earnings.  In fact, research analysts cover very few of the 2,000 stocks in the Russell 2000 index. Therefore, it is common that a small company does not have a full coverage by any industry analysts. This lack of interest and publicity produces conditions for inefficient pricing.   Active investors with a focus on the small cap market can scan the universe for undervalued and mispriced stocks and generate higher returns based on their valuation techniques and knowledge of the market.

Diversification

Investing in small cap companies can significantly contribute to the diversification of your portfolio.  Even though small stocks have a higher risk than larger ones, their correlation to the overall market is lower. A small blend strategy has 0.86 correlation to the overall US stock market and 0.56 to the broader international stock market.

A correlation equal to 1 shows the highest strength of the relationship between two asset categories. In the case of small cap, the correlation of 0.86 shows a weaker link with the overall market. Small cap prices does not fluctuate in the same magnitude and pace as the large cap companies.  While there is some influence by S&P 500, they follow an independent path.

 

How to invest in small cap companies

Stocks

You can invest in small size companies by buying them directly on the open market. There are over 2,000 listed small size companies in various industries and stages of their business cycle. Naturally, you cannot invest in all 2,000 stocks. You have to find a way to narrow down your criteria and select stocks based on certain factors. Very few small companies have analyst coverage. Therefore investing in small caps stocks will require doing your own research, analysis, and valuation.

When you invest in any company directly, being that a small or large size, you have to keep in mind that concentrated positions can adversely affect your portfolio performance if that company has a bad year or goes bankrupt. While everyone’s risk sensitivity is different, I would recommend limiting the range of each individual stock investment to 1% – 2% of your portfolio.

Tax Impact

For the best tax impact, I recommend putting small cap stocks either in taxable or Roth IRA accounts. Small cap companies have higher expected return combined with a higher expected volatility. If you hold your stocks in a taxable account, you can take advantage of tax loss harvesting opportunities if a particular stock in your portfolio is trading at lower levels than original purchase price. Tax loss harvesting is not available in Roth IRA, Traditional IRA, and 401k accounts. I

If you have small-cap stocks with solid long-term return prospects, keeping them in a taxable account will also allow you to pay the favorable long-term capital gain tax when you decide to sell them.

Having stocks in a Roth IRA account will have even better tax treatment – zero tax at the time of sale.

Passive indexing

ETFs and index mutual funds are the top choice for passive small cap investing. They provide a low-cost alternative for investors seeking a broader exposure to the small cap market. Small cap ETFs come in different shapes and forms. The table below shows a list of the most traded small cap ETFs with AUM above $500 million:

List of Small Cap ETFs

TICKER

FUND NAMEEXPENSE RATIOAUMSPREAD %1 YEAR5 YEAR10 YEARSEGMENT

AS OF

IWMiShares Russell 2000 ETF0.20%$27.79B0.01%5.69%12.28%6.01%Equity: U.S. – Small Cap10/26/2016
IJRiShares Core S&P Small Cap ETF0.07%$20.83B0.03%7.35%14.16%7.56%Equity: U.S. – Small Cap10/26/2016
VBVanguard Small-Cap Index Fund0.08%$13.94B0.03%5.59%13.14%7.40%Equity: U.S. – Small Cap10/26/2016
VBRVanguard Small Cap Value Index Fund0.08%$8.16B0.04%7.31%14.20%6.77%Equity: U.S. – Small Cap Value10/26/2016
IWNiShares Russell 2000 Value ETF0.25%$6.72B0.01%9.39%12.17%4.82%Equity: U.S. – Small Cap Value10/26/2016
IWOiShares Russell 2000 Growth ETF0.25%$6.35B0.02%1.92%12.31%7.01%Equity: U.S. – Small Cap Growth10/26/2016
VBKVanguard Small-Cap Growth Index Fund0.08%$4.93B0.04%3.50%11.36%7.25%Equity: U.S. – Small Cap Growth10/26/2016
IJSiShares S&P Small-Cap 600 Value ETF0.25%$3.85B0.03%10.26%14.31%6.57%Equity: U.S. – Small Cap Value10/26/2016
SCHASchwab U.S. Small-Cap ETF0.06%$3.78B0.04%5.46%13.03%Equity: U.S. – Small Cap10/26/2016
IJTiShares S&P Small-Cap 600 Growth ETF0.25%$3.47B0.08%4.41%13.74%8.42%Equity: U.S. – Small Cap Growth10/26/2016
DESWisdomTree SmallCap Dividend Fund0.38%$1.59B0.12%11.96%14.36%6.35%Equity: U.S. – Small Cap10/26/2016
FNDASchwab Fundamental US Small Co. Index ETF0.32%$1.04B0.06%6.38%Equity: U.S. – Small Cap10/26/2016
SLYGSPDR S&P 600 Small Cap Growth ETF0.15%$807.64M0.27%4.61%13.74%9.00%Equity: U.S. – Small Cap Growth10/26/2016
VTWOVanguard Russell 2000 Index Fund0.15%$675.74M0.06%5.67%12.19%Equity: U.S. – Small Cap10/26/2016
XSLVPowerShares S&P SmallCap Low Volatility Portfolio0.25%$651.46M0.09%12.43%Equity: U.S. – Small Cap10/26/2016
SLYVSPDR S&P 600 Small Cap Value ETF0.15%$610.42M0.21%10.46%14.43%7.38%Equity: U.S. – Small Cap Value10/26/2016
SLYSPDR S&P 600 Small Cap ETF0.15%$512.80M0.25%7.10%13.99%8.19%Equity: U.S. – Small Cap10/26/2016

Benchmark

One of the main differences between small-cap ETFs is the index they track. Each of the three main Small Cap Indexes is constructed differently.

Russell 2000 (IWM) includes the bottom 2,000 of the largest 3,000 publicly traded companies. The average market cap of the constituents of Russell 2000 is equal to $1.9 billion. The median is 698 million. And the largest stock has a market cap of $6 billion.

S&P 600 Index (IJR) tracks a smaller subset of the market. It includes only 600 companies.  As of April 2016, the market capitalization of companies included in the Index ranged from US$ 400 million to US$ 1.8 billion. S&P 600 also sets additional requirements for liquidity, public float, sector and financial viability.

CRSP SmallCap index (VB) tracks the 2%-15% percentile of the total market. It has 1,462 companies. The smallest company has a market capitalization of $21 million; the largest has $7.9 billion. The average size is $1.85 billion. The median is $1.44 billion. It is worth noting that VB tracked Russell 2000 Index through May 16, 2003; MSCI US Small Cap 1750 Index through January 30, 2013; CRSP US Small Cap Index thereafter

Focus

Another big difference between Small Cap ETFs is their segment focus. There are three main segments – small cap blend, growth, and value. The blend strategy invests in the wide universe of small caps, which mechanically tracks the designated index. The value strategy tracks a specific group of companies that have a  certain level of Price to Earnings, Price to Sales, Price to Book, dividend yield, and other fundamental ratios. Growth strategy invests in a group of stocks that meet certain criteria for price, revenue and earnings growth.

Tax Impact

ETFs and index funds have more favorable tax treatment than actively traded mutual funds. Due to their passive nature and legal structure, these funds rarely release capital gains and losses to their shareholders. Therefore, investors looking to optimize taxes in their investment portfolio should consider these type of funds.

Active investing

This strategy includes investing in actively managed mutual funds. These funds are run by management teams. They normally charge higher fees than comparable ETF to cover for the trading, administrative, marketing and research expenses.  Mutual funds follow a benchmark, which is usually one of the three main indices described earlier – S&P 600, Russell 2000 or CSRP Small Cap Index. Because of their higher fees than comparable ETFs, fund managers are often expected to outperform their benchmark.

Active funds normally focus in one of the three main segments – blend, growth or value. The fund managers utilize a formal selection process that identifies a number of companies, which meet certain proprietary criteria. The end goal is to select those companies that will achieve a higher return than the undying benchmark. Since the characteristics of value vs. growth strategy can be subjective, it is not an unusual that the same company is owned by both value and growth oriented funds.

In the past 7-8 years, many of the active managers have been criticized for underperforming the market. Part of the reason is that we experienced a very long market rally driven by a small number of flagship companies.

Tax Impact

Actively managed mutual funds have a more complex tax structure. They must transfer most of their dividends and capital gains and losses to their shareholders. Mutual funds will often have large amounts of long or short-term gains and losses released in December regardless how long you had kept in your portfolio, to avoid paying additional taxes I recommend placing your actively managed mutual funds in tax deferred and tax exempt accounts. Another alternative is to look for tax-managed funds. They tend to have a low turnover ratio and tend to report long-term gain and losses less frequently.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

 

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing, Copyright: <a href=’http://www.123rf.com/profile_nonwarit’>nonwarit / 123RF Stock Photo</a>

7 Proven practices to handle your credit card debt

The average US family owes $15,675 in credit card debt.  An increasing number of Americans many of which millennials are facing the unbearable burden of owing money. Hence, I would like to share some ideas how to handle your credit card debt better. Whether you have maxed out on credit cards or planning to take on credit card debt, you may find the following steps critical in becoming debt free.

1. Know your credit score

As a first step, you need to understand your credit score also known as FICO. The FICO score is a measure between 300 and 850 points. Higher scores indicate lower credit risk. Each of the three national credit bureaus, Equifax, Experian, and TransUnion provide an individual FICO score.  All three companies have a proprietary database, methodology, and scoring system. Many times you may find small or even substantial differences in your credit score issued by those agencies.

Your FICO score is a sum of 64 different measurements. And each agency calculates it slightly differently. As a general rule, your credit score depends mainly on the actual dollar amount of your debt, the debt to credit ratio and your payment history. Being late on or missing your credit card payments, maximizing your credit limits and applying for too many cards at once will hurt your credit score.

The good news is that you can get your score for free from each of the three agencies once a year. Additionally, many credit cards include the value of your credit score for free.

Keep in mind that the FICO score provided by your credit card will come from one of these three agencies. So if you have a second credit card from a different bank that also offers free FICO score, it might be using a different agency and the score most likely will be different.

 

2. Know the interest on your credit card

When you apply for a credit card, you should always verify the interest rate if you don’t pay off your dues at the end of the month. This interest rate can also change over time, and your credit card provider is required to notify you. However, the chance of you not paying attention to the mail notification is pretty high. If you are not sure, call your bank and verify it with them.

 

3, Know the due dates on your credit card

Make sure you know when your credit card monthly payments are due. Forgetting to pay the monthly minimum on time can cause you a lot of grief, high penalties and significant amount of time on the phone with your credit card provider. Most reputable banks will waive the penalty if this is your first late payment. However, doing it more than once will raise a big red flag in your relationship with them. At a very minimum you can set up an automatic payment for the minimum amount due each month.

 

4. Set-up a budget

Before taking any further steps in managing your credit card debt, you need to have a balanced budget. To begin, make sure you know all your monthly income and pay days.  List all your expenses in broad categories. If you spend more than you earn, you may have to decrease your discretionary expenses until you balance out your budget. As a rule of thumb, try to leave 10-15% of your income aside for emergencies and unexpected expenses.

 

5. Open a saving account

In your pursuit of financial independence, one crucial step is opening a saving account. Most major banks will give you an extremely low, close to 0% saving rate. However, some of the online lenders like Discover Bank, Capital One, Ally Bank, and Synchrony Bank offer rates around 1%. Bankrate.com is an excellent source of  various saving account options.

 

6. Consolidate your debt to one or two cards with lower interest

Consolidating credit card debt is most effective when it’s a part of your bigger financial strategy.

If you decide to continue on that route, pay very close attention to the fine print in your cards offers. A lot of times the small print will contain critical information about interest rates, promotional periods, credit limits, due dates, and penalties.  Some banks offer credit cards with a promotional 0% rate for a specified period. Other banks will try to entice you with cash back or other rewards programs.

If you decide to transfer your debt, be aware that banks often charge upfront 3% to 5% fee on transfer amount. In that case, you will have to do the math to see if it’s worth making the switch.

Also, keep in mind that opening too many credit cards can abruptly impact your credit score. The general rule is opening one credit card per 3 months.

Once you pay off a credit card, put it aside. Lock it away and keep it open.  Closing a credit card lowers the amount of available credit and decreases your credit score.

 

7. Look for alternatives

Two of the main alternative options are taking a personal loan from local credit unions and a home equity line of credit if you own house. A lot of times local credit unions and banks can give you much lower rate and will work with you to pay off your debt.

 

Conclusion

Having a solid plan where you monitor your monthly income and expenses is the best path to financial independence and debt free life.  Be responsible with your finances and stay on top of your credit cards and loans. Many times you can do it on your own or ask a friend or a family member for help.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing. Image Copyright: <a href=’http://www.123rf.com/profile_logo3in1′>logo3in1 / 123RF Stock Photo</a>

 

Sources: 

https://www.nerdwallet.com/blog/credit-card-data/average-credit-card-debt-household/

 

10 Questions to ask when choosing your financial advisor

Seeking a financial advice is a major step in achieving your personal and financial goals. Financial advisors have been instrumental in helping clients maintain well balanced, disciplined, long-term focused approach towards their personal finances and retirement planning. Finding a good financial advisor is like finding a personal doctor. The chances are you will stick with that the person for a long time. In this article, we will give you several suggestions how to choose a financial advisor.

Lately, financial advisors have been under increasing pressure from clients, various regulatory bodies and new fintech competition. Furthermore, many financial advisors are facing questions about fee structure, legal organization, and fiduciary duties.

So how to pick your financial advisor? The financial industry has done a great job confusing the public with various titles and role functions. Financial advisors call themselves investment advisors, wealth advisors, financial coaches, wealth managers, and brokers. Additionally, insurance agents, accountants, and lawyers provide some type of financial advice to their clients.

So let’s breakdown several questions you need to ask yourself and your new financial advisor before you move forward.

1. Business model

There are two main models under which financial advisors offer their services – Registered investment advisor (RIA) and broker-dealers.

RIAs are independent fee-only investment companies that often provide both financial planning and investment management services. They charge a flat fee or a percentage of the client’s assets under management. RIAs are usually boutique companies run by their founders. Moreover, independent advisors have a fiduciary duty to work in their customers’ best interest. Most RIAs provide a holistic goal based financial advice based on their clients’ particular economic circumstances, lifestyle, and risk tolerance. If you prefer to receive personalized fiduciary financial services, then the RIA model is probably the best fit for you.

Brokers offer commission based financial services. They receive compensation based on the number of trades placed in their client accounts. The agents often belong to large banking institutions like Wells Fargo and JP Morgan Chase. Other times they are independent houses offering a wider range of services including insurance, accounting, tax, and estate planning. Brokers do not have a legal fiduciary duty to work in their clients’ best interest. However, with the new Department of Labor rule, brokers must perform fiduciary duties in retirement accounts like 401k plans and IRA. Nevertheless, the new law does not cover taxable investments accounts. If you favor an established relationship with a large financial institution with access to multiple services, then the broker model might be a better fit for you.

 

2. Education

What is your financial advisor education? Make sure that you are comfortable with your new advisor’s credentials and educational background.  Many financial professionals hold at least bachelor or master degrees in Finance or Accounting. For those that that lack the financial education or work experience, regulators require passing series 65 for RIAs and series 7 and 63 for brokers. Additionally, there are three popular financial certificates – CFA, CFP, and CPA, Advisors that hold any of the certificates have gone through a significant training and learning process.

 

Chartered Financial Analyst

CFA is a professional designation given by the CFA Institute. The exam measures the competence and integrity of financial analysts. Candidates have to pass three levels of exams covering areas such as accounting, economics, ethics, money management and security analysis.

CFA is considered the highest ranked financial certificate and widely recognized across the globe. CFA program takes at least three years and requires passing three level exam. Level 1 exam is offered twice a year in June and December. Level 2 and 3 are offered only once a year in June. Candidates also need to pass strict work requirements regarding their work experience in investment decision-making process.

 

Certified Financial Planner

CFP refers to the certification owned and awarded by the Certified Financial Planner Board of Standards, Inc. The CFP designation is awarded to individuals who complete the CFP Board’s initial and ongoing certification requirements. Individuals desiring to become a CFP professional must take extensive exams in the areas of financial planning, taxes, insurance, estate planning, and retirement. The exam is computer-based taken over a three-day period.  Attaining the CFP designation takes experience and a substantial amount of work. CFP professionals must also complete continuing education programs each year to maintain their certification status.

 

Certified Public Accountant

CPA is a designation given by the American Institute of Certified Public Accountants to those who pass an exam and meet work experience requirements. CPA designation ensures that professional standards for the industry are enforced. CPAs are required to get a bachelor’s degree in business administration, finance or accounting. They are also required to complete 150 hours of education and have no less than two years of public accounting experience. CPAs must pass a certification exam, and certification requirements vary by state. Additionally, they must complete a specific number of continuing hours of education yearly.

 

While receiving a degree in Finance, Accounting or Economics or passing a test doesn’t always guarantee that the person has the right set of skills to be an advisor, the lack of any of these credentials should be a warning sign for you.

There are many professionals with engineering, medical, legal or other degrees that pursue a financial career. Many of them build relationships with clients from their particular field. If this is something that you are comfortable with, at least make sure your advisor works with people who have solid financial credentials.

 

3. Experience

If you are planning to give your retirement savings in the hands of a financial advisor, make sure that this person has prior financial experience. Some of you may remember the commercial with the DJ who was imposing as a financial advisor. Would you want to work with this guy? He might be a great person, but it’s your money after all. Do your due-diligence before you meet them for the first time? LinkedIn is a great place to start your search.

 

4. Investment Style

Do you know your advisor’s investment style? Does your advisor regularly trade in your account or is more conservative and rebalance once or twice a year? It is important to understand your advisor’s investment style. Frequent trading can increase your trading cost substantially. On the other hand, not trading at all will bring your portfolio away from your target allocation and risk tolerance.

 

5. Investment options

What are the investment options provided by your financial advisor? Some advisors prefer to work only with ETFs. Others like using actively managed mutual funds. A third group favors trading single name stocks and bonds. All strategies have their benefits and shortcomings. ETFs come with lower fees and broad diversification. Active mutual funds seek to beat their benchmark and lower risk. However, they may lack tax-efficiency if sitting in investment accounts. Finally,  trading single name stocks provides very high upside but also a large downside.

  

6. Custodian

Who is your advisor’s custodian? Custodians are the financial companies that actually hold your assets. Most RIAs will use a custodian like Pershing, Fidelity, TD, Schwab or Interactive Brokers. Your advisor’s custodian to a large extent will determine (or limit) the selection of ETFs and funds available for investing. Additionally, custodians may have different rules, document requirements, technology platform and transaction fees.

 

7. Size

How large is the company that your advisor works for?

Some advisors are one-man-shop. They consist of their founder and potentially one or two assistants or paraplanners. Other advisors including RIAs could be a part of much larger regional or national network. Smaller companies have more flexibility but less capacity. Bigger companies have more bureaucracy but may have more resources.

 

8. Coaching

What have you learned from your advisor in the past few years or even at the last meeting?

Advisor’s role is not only to manage investments but also to coach and educate clients about best financial practices, tax changes, market developments, estate planning, college savings and such.

Additionally, many advisors offer workshops to clients and prospect where they talk about the economy, retirement planning, tax strategies and other financial topics.

 

9. Communication and customer service

How is your financial advisor communicating to you? Is your advisor responsive? Communication is an essential part of the advisor-client relationship. Good advisors always stay in touch with their clients. Remember what I said earlier, advisors are like doctors. You need to meet them at least once a year. So during your meeting, talk to them about your progress to achieving your goals. Also get updates on your portfolio performance. And finally, update them regarding any changes in your life.

Also, financial advisors have a duty to protect their clients’ privacy. Make sure your advisor uses secured channels to send and receive sensitive information.

How is your advisor handling client queries? Can you speak to your advisor personally if you have an urgent question or unexpected life event? Or do you need to call 1-800 number and wait for your turn in line?

 

10. Technology

Is your financial advisor tech savvy or old school? The current environment of constant tech innovations provides a broad range of tools and services to financial advisors and their clients.

New sophisticated financial planning software lets advisors change plan inputs just with one click of the mouse. This software allows clients to have access to their personal financial plans to amend their financial goals and personal information. Therefore, clients can see in real-time the progress of their financial plans and make better financial decisions.

Account aggregation tools allow clients to pull different accounts from various financial providers under one view. The aggregated view helps both advisors and customers to see a comprehensive picture of the client’s finances with only one login.

Additionally, services like DocuSign and LazerApp let financial advisors go completely paperless. Thus clients can receive and sign documents online.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing.Copyright: <a href=’http://www.123rf.com/profile_olegdudko’>olegdudko / 123RF Stock Photo</a> 

5 Ways to increase the impact of charitable donations

Traditional Charitable Strategies

Charitable contributions are an excellent way to help your favorite cause, your church, a foundation, a school or any other registered charitable institution of your choice. Americans made $373.25 billion of charitable donations in 2015, which was 4.1% higher than 2014. The average annual household contribution was $2,974. In 2015, the majority of charitable dollars went to religious institutions (32%), educational organizations (15%), human services (12%), grantmaking foundations (11%), and health organizations (8%).

Charitable donations are also a powerful tool to reduce your overall tax liability to IRS. By carefully following the tax law and IRS rules you can substantially increase the impact of donations. Here is what you can do.

1. Meet the requirements

In order to receive tax deductions for your gift, donations need to meet certain requirements. Some of the most important rules are:

  • You have to give to qualified charitable organizations approved by IRS. The charity can be public or private. Usually, the public charities receive more favorable tax treatment.
  • You need to have a receipt for your gift.
  • You need to itemize your tax return.
  • Donations apply for the same tax year when you make them. For most individuals the tax year and calendar year are the same. For some companies, their tax year may end on a different date during the calendar year (for example, November 1 to October 31)
  • All gifts are valued at fair market value. Depending on your donation, the fair market value may not be equal to the initial cash value.
  • You have to transfer the actual economic benefit or ownership to the receiver of your gift.

 

There are many ways to give. Some are straightforward, others are more complex and require professional help. Each one of them has its rules, which you need to understand and follow strictly to receive the highest tax benefit.

2. Give Cash

Giving money is by far the easiest way to make contributions to your favorite charitable cause. IRS allows for charitable donations for as much as 50% of your aggregated gross income. Any amounts more than 50% can be carried over in future years. However, it’s imperative that you keep a record of your cash donations.

 

3. Give Household goods

You can donate clothes, appliances, furniture, cars and other household items in good condition. The items will be priced at fair value, In most cases, the value will be lower than what you paid for them. This category is also subject to the 50% limit of the AGI.

Donating household items is a perfect way to clean your closet from old clothes and shoes that you haven’t worn for years. You can even donate your old car that has been collecting dust in the garage. Moreover, if you plan to do a kitchen remodel, you can give your old cabinets and appliances to charities like the Salvation Army. Remember to keep the receipts of these items in case IRS asks you for them.

 

4. Donate Appreciated assets

One of the most popular tax-saving strategies is donating appreciated assets directly to charitable organizations. This approach is subject to 30% of AGI for donations given to qualified public charities. Appreciated assets can include publicly traded stocks, restricted stocks, real estate, privately help companies, collectibles, and artwork. The main caveat to receive the highest tax benefit is to give the appreciated asset directly to the charitable donations instead of selling it and gifting the remaining cash amount.  This way you will avoid paying a capital gain tax on the sale of your asset and deduct the full fair value of your asset.

 Let’s look at an example. An investor at 28% tax bracket is considering donating an appreciating stock to her favorite charity. She can sell the stock and give the proceeds or donate the shares directly. The current market value of the stock is $100,000. She purchased it more than one year ago for $20,000. The total capital gain is $80,000.

 Planning charitable donations

 

By giving the stock directly to her favorite, the investor is achieving three major goals. First, she is not paying a capital gain tax on the proceeds of the sale. Second, she can use the full fair value of the stock (instead of the proceeds from the sale) to reduce her tax liabilities. Third, the charitable organization receives an asset with a higher value, which they can sell tax-free.

 

5. Make direct IRA charitable rollover

Donations made directly from your IRA, and 401k accounts are another way of reducing your tax bill. If you reached 70 ½, you could make up to $100,000 a year in gifts to a charity directly from your IRA or 401k accounts. Those contributions count towards the required annual minimum distributions you must take once you reach 70 ½, They also reduce your adjusted gross income. To be compliant, you have to follow two simple rules.

Your plan administrator has to issue a check payable to your charity of choice. Therefore the funds have to transfer directly to the charitable organization. If the check is payable to you, this will automatically trigger a tax event for IRS. In that case, your IRA distribution will be taxable as ordinary income, and you will owe taxes on them. The second rule, you have to complete the transfer by December 31 of the same calendar year.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing. Image Copyright: <a href=’http://www.123rf.com/profile_dizanna’>dizanna / 123RF Stock Photo</a>

8 Financial planning tips for doctors

Introduction

Being married to a physician has allowed me to obtain a unique understanding of the costs and benefits of achieving a medical degree.   In this post, we will discuss several practices that can help physicians and other healthcare professionals achieve financial prosperity.

What sets physicians apart from other professions?

Doctors begin their careers and start earning an income much later than the average person.  If a physician is accepted to a medical school immediately following completion of an undergraduate degree, she will be in her mid-20s when she graduates medical school.   After medical school, physicians must continue clinical training in their chosen specialty.  The residency training period ranges from 3 to 7 years depending on the specialty.  During this time, new doctors make a modest salary, work long hours and cover overnight on-call shifts in exchange for clinical training.

Learn more about our Private Wealth Management services

Once launching their career, doctors receive above average compensation and have almost zero risks of unemployment. These privileges, however, come with some serious caveats.

As of 2015, graduating physicians start their career with an average student loan of $183,000. This is equal to $1,897 of monthly payments over ten years or $927 over thirty years, at 4.5% interest. If I remove the lowest 20% of the medical students that come out of school with zero or small loan amount, the average debt figure jumps to $230,000. Which is a total of $286,000 due on principal and interest on a 10-year loan and 420,000 on a 30-year one. Student loans become repayable after medical school graduation.

1. Start saving for retirement early.

Doctors have a shorter working life than the average person. They start their careers ten years after most people. During these ten years, doctors don’t earn a significant salary and accumulate a large amount of education-related debt.

It is critical that young doctors start saving for retirement while they are in residency. During residency, the new doctors receive a salary between $40,000 and $60,000. Many employers offer both tax-deferred 401k and after-tax Roth accounts. Depending on their financial situation physicians should consider maximizing both plans with priority on their After Tax Roth contributions first before adding money to their 401k account. As of 2019, Roth IRA contributions are limited to $6,000 per year at $122,000 of income. The amount phases out as the income reaches $137,000. Almost certainly this option won’t be available once they start their career and move to higher income levels.

2. Maximize your retirement contributions.

Doctors have to maximize their retirement contributions to catch up for the extra ten years of school and residency.

Physicians working in hospitals and large healthcare systems will very likely have the option to open a tax-deferred 401k plan. As of 2019, these programs allow their participants to contribute up to $19,000 a year. Most employers offer matching contributions for up to a certain amount.

Some health systems offer pension plans, which guarantee a pension after certain years of service. These plans are a great addition to your retirement savings if you are willing to commit to your employer for 10 or 20 years.

Moreover, some government and state-run hospitals even over 457 plans in conjunction with a 401k plan, allowing participants to super save and defer a double

Doctors who are self-employed, own a corporation or run a private practice should consider investing in solo 401k plans. These plans allow for up to $56,000 of pretax contributions, $19,000 as an employee and $37,000 as profit sharing by an employer.

Doctors earning significant cash flow in a private practice should also consider adding a defined benefit plan to their 401k. This combination is a powerful saving tool. However, it requires the help of an accredited actuary. Contact your financial advisor if you want to learn about this option.

In addition to contributing to employer-sponsored retirement plans, doctors should consider setting aside a portion of their earnings to taxable (brokerage or saving) accounts. The contributions to these accounts are made on after taxes basis. Taxes are due on all dividends, interest, and capital gains.   The most significant benefit of these funds will be their liquidity and flexibility with no income restrictions.

 3. Manage your taxes.

High earning doctors need to consider managing their tax bill as one of their top priorities. Tax implication can vary depending on income level, family size, and property ownership. Hiring a CPA, a tax attorney or a financial planner may help you reduce or optimize some of your tax dues.

A successful tax planning strategy will include a combination of retirement savings, asset allocation, tax deductions, and estate planning.

Feel free to check some of my previous postings about tax optimized financial planning.

4. Balance your budget.

After ten years of vigorous study, sleepless nights and no personal life, doctors are thrown back in the normal life where they can enjoy the perks of freedom and money. As much you are excited about your new life, do not start it with buying a Lamborghini or an expensive condo on South Beach. In other words, do not overspend. Even if you got a great job with an excellent salary and benefits, you need to remain disciplined in your spending habits. Stay focused on your long-term financial goals. Leave enough money aside for retirement savings, rent or mortgage payments, loan payments, living expenses, college savings for your children and an emergency fund.

5. Manage your student loans. 

How to best manage your student debt depends on a combination of factors including your credit score, federal or private loan, loan maturity, interest rates, monthly payments, and current income. Stay on top of your student debt. Do not lose track of due dates and interest rates.

For those looking for help reducing their debt, here are some options:

  • Loan repayment options from employers. Many private, federal, state and city health care organizations offer loan repayment options as an incentive to retain their doctors. Those options are frequently dependent on years of service and commitment to work for a certain number of years. These programs vary from employer to employer.
  • Loan forgiveness. Under the Public service loan forgiveness program (PSLF) launched in 2007, full-time employees at federal, state or local government agencies, as well as nonprofit workers at an organization with a 501(c)(3) designation, are eligible for loan forgiveness after paying 120 monthly payments. The first applicants will be able to benefit from this program in 2017.
  • Working in underserved areas. Some states offer loans forgiveness for doctors working in underserved areas. The conditions and benefits vary state by state but in essence, works similar to the PLSF program.
  • Loan consolidation and refinancing. If you have two or more private student loans, you may want to consider loan consolidation. If you pay high interest on your current loans, think about refinancing it at a lower rate. Your new loan availability depends on your credit history, income, and general macroeconomic factors.

Under the current tax law, all forgiven loans are subject to taxes as ordinary income. Take it into consideration when applying for loan forgiveness.

6. Watch your credit score.

Physicians need to monitor and understand their credit score. Known also as the FICO score, it is a measure that goes between 300 and 850 points. Higher scores indicate lower credit risk. Each of the three national credit bureaus, Equifax, Experian, and TransUnion, has a proprietary database, methodology, and scoring system. It is not uncommon to find small or even substantial differences in credit scores issued by three agencies. Many times, creditors will use the average of the three value to assess your creditworthiness.

Your FICO score is a sum of 64 different measurements. And each agency calculates it slightly differently. As a general rule, your FICO score depends mostly on the actual dollar amount of your debt, the debt to credit ratio and your payment history. Being late on or missing your loan payments and maximizing your credit limits can negatively impact your credit score.

You can get your score for free from each one of the bureaus once a year. Additionally, many credit cards provide it for free. Keep in mind that their FICO score will come from one of these three agencies. Don’t be surprised if your second credit card shows a different value.  Your other bank is probably using a different credit agency.

7. Take calculated risks.

Doctors are notorious for their high-risk tolerance and attitude toward investing in very uncertain endeavors. While this is not always a bad thing, make sure that your investments fit into your overall long-term financial plan. Do not bet all your savings on one risky venture. Use your best judgment in evaluating any risky investments presented to you. High returns always come with high risk for a loss.

8. Get insurance.

Having insurance should be your top priority to take care of yourself and your family in case of unforeseen events. There is an extensive list of risks you have to consider,  for instance – health, disability, life, unemployment, personal umbrella, and malpractice insurance.

Fortunately, some of them might be covered by your employer. A lot of organizations offer a basic package at no cost and premium package at added subsidized price. Take advantage of these insurance packages to buy yourself protection in times of emergency.

For instance, if you are a surgeon or dentist and get a hand injury, you may not be able to work for a long time. Having disability insurance can help you have an additional income while you recover.

If you run your practice, having malpractice insurance will help cover the cost if you get sued by your patients.

Final words

If you have any questions about your existing investment portfolio or how to start investing for retirement and other financial goals, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit our Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA is the founder and CEO of Babylon Wealth Management, a fee-only investment advisory firm based in Walnut Creek, CA. Babylon Wealth Management offers personalized wealth management and financial planning services to individuals and families.  To learn more visit our Private Client Services page here. Additionally, we offer Outsourced Chief Investment Officer services to professional advisors (RIAs) and other institutional clients. To find out more visit our OCIO page here.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,  Image copyright: 123RF.com

High Dividend ETF Strategies

Introduction

The market has been observing consistently declining yields ever since the start of the financial crisis in 2008. In the current low yield environment, 10-year Treasury bond pays a mere 1.6% in interest and S&P 500 yields just above 2% in dividends.

Furthermore, we observe negative interest rates in Japan, Switzerland, and Germany.

At the same time, saving account rates in the US are at a record low with no prospects to go higher anytime soon. Oil hit $30 per barrel, and many energy companies that traditionally pay high dividends cut their payout.

The recent UK vote to leave the EU, more concerning news from China and sluggish growth in the US are very likely to delay another rate hike for a long time.

Income-seeking investors are facing challenges in finding safe investments that can provide them with a supplemental income. In their quest for yield, many investors are exploring more exotic asset classes that they have neglected previously. Furthermore, each of these asset classes has specific economic risks and tax treatment. Subsequently, investors interested in higher yielding investments need to understand how each one fits within their risk tolerance and asset allocation target.

For all yield-seeking investors, ETFs represent a low-cost and tax efficient alternative. Therefore we have seen significant inflows into passive high-dividend ETFs in the past few years.  We will walk you through the major asset classes that drive that interest. Also, we will show the largest ETFs by Asset Under Management (AUM) in each category.

 

High Dividend US Equity

Dividends are a significant driver of total returns. Historically, dividend income has accounted for about 40% of the return from stocks, with the remainder coming from growth in earnings and inflation.

DVY, VYM, SDY, SCHD are the most popular ETFs investing in high dividend US equity. As of September 12, 2016, all four ETFs had outperformed SPY by a significant margin. DVY and SDY reported price return of 15.1% and 16.27% versus 6% for SPY.

List of US Equity High Dividend ETFs

Large Cap US Equity Dividends ETFs

Most ETFs tend to invest in companies with a history of consistent or increasing dividend payout. While all of them try to achieve the same goal, they have different ways of doing it. Some ETFs tilt towards large cap finance and utility stocks. Others lean towards mid and small size companies. Most of the ETFs on the list do not invest in REITs and MLPs. They pay qualified dividends which are taxable at the more favorable rate at 0%, 15% or 20% plus 3.8% Medicare surcharge.

The highest risk with this strategy is that companies can cut dividends upon company discretion. Instead of paying dividends, management can direct funds to cover operational expenses or expected losses. For instance, many of the financial companies cut their dividend significantly during the crisis of 2008-2009. Most recently, energy companies decreased their dividends as the price of oil reached $30 per barrel.

Sectors

Utilities and Energy are among the sectors with the highest dividend payout apart from REITs. There is the list of the largest ETFs invested in these two areas.

Utilities ETFs

Energy ETFs

 Energy ETFs

International Equity

International high dividend strategy seeks the highest dividend paying securities outside of US. Investments comprise of a wide range of companies from Europe to Asia and Australia and from large to small sizes.

Foreign stocks have underperformed US stocks consistently for the past ten years. On the other hand, high dividend international stocks have outperformed broad market foreign stock on both absolute and risk-adjusted basis. An additional benefit of investing in this strategy is the lower correlation to the US market which will decrease the risk in a diversified portfolio.

 International Equity High Dividend ETFs

REITs

Equity REITs

An equity real estate investment trust (REIT) is a company that owns and manages income-producing real estate. It represents a pool of properties bundled together and offered in the form of unit investment trusts. REITs must pay out 90% of its taxable income to shareholders as dividends.

Consequently, they can deduct dividends paid to shareholders from its taxable income. This income is exempt from corporate-level taxation and passes directly to investors. REITs invest in most major property types with nearly two-thirds of investment being in offices, apartments, shopping centers, regional malls, and industrial facilities. The remainder includes hotels, self-storage facilities, health-care properties,  prisons, theaters,  golf courses, and timberlands.

REITs invest in most major property types with nearly two-thirds of investment being in offices, apartments, shopping centers, regional malls, and industrial facilities. The remainder includes hotels, self-storage facilities, health-care properties,  prisons, theaters,  golf courses, and timberlands.

VNQ dominates the REITs ETF space with$34 billion of AUM.

REITs ETFs

 

Mortgage REITs

Mortgage REITs provide real estate financing through the purchase of mortgages and mortgage-backed securities (MBS). They profit by exploring the difference between long term and short-term financing rates. Mortgage REITs are among the highest dividend paying companies. They are also one of the riskiest. They are highly sensitive to interest rates and economic cycles.

There are only two mortgage REIT ETFs – tickers REM and MORT.

Mortgage REITs

Investors who are looking for more diversified exposure may also consider IYR. This ETF invests in a broader range of equity and specialty REITs including mortgage and timber REITs.

Tax Treatment of REITs distributions

REITs dividend distributions for tax purposes come as to ordinary income, capital gains and return on capital,  which have different treatment for tax purposes. REIT ETFs must provide shareholders with guidance on how to allocate their dividends in the various categories.  The average distribution breakdown for 2015 was approximately 66% ordinary income, 12% return on capital, and 22% capital gains.

The majority of REIT dividends are considered non-qualified dividends and taxed as ordinary income, up to the maximum rate of 39.6%, plus a separate 3.8% Medicare surtax on investment income.

Capital gains distribution is taxable at either 0, 15 or 20 % tax rate, plus the 3.8% surtax.

Return on capital distributions are tax-deferred. They decrease the cost basis of the investment. Investors owe taxes on these distributions only after they sell them.

MLPs

Another favorite dividend alternative for yield-hungry investors is the master limited partnership or MLP. MLPs resemble some of the features of the REITs. They are required to pass at least 90% of their income to their partners/investors. This structure is especially popular with energy companies that own and operate liquid and gas pipelines along with storage facilities and processing plants that bring energy products to market.

List of MLP ETFs and ETNs

MLP ETFs and ETNs

MLPs drive their revenue from the volume of transported energy products. Their business is less dependent on the fluctuations of the commodity prices. Therefore MLPs as a group is less volatile than the broader energy sector. Bear in mind that 2015 oil prices drop to $30 per barrel negatively impacted many MLPs. As a result, the Alerian MLP Index went down by -38%, triggering sustainability concerns about many of the smaller size MLPs.

Legal Status, Tax Treatment, and Placement

The largest portion of MLP distributions is in the form of return on capital. The benefit comes from the MLPs use of depreciation allowances on capital equipment, pipelines, and storage tanks, to offset net income.

Due to their legal structure, direct MLP ownership requires federal K-1 tax forms filing in every state in which each MLP operates. MLP ETFs and ETNs address the issues with the filing and provide broader diversification.

ETFs and ETNs have entirely different legal status. MLP ETFs are organized as a C-Corporation. As a result, most distributions are tax-deferred, similar to the underlying MLPs.

ETNs are unsecured debt instruments. MLP ETNs are not backed by underlying securities but by the issuing bank’s promise to pay. Because of that, MLP ETN distributions are treated as ordinary income.

Both structures can suit different types of investors. All tax, economic and legal issues need to be considered carefully before purchase.

 

 

Preferred Stocks

Preferred stocks are a hybrid between equity and fixed income. They trade on the stock exchange. These shares represent a special ownership in the equity of a company with a fixed dividend payout. Preferred stocks do not usually give voting rights, but offer a higher claim on assets and earnings than common stock.

PFF leads this segment with over $17 billion of AUM.

Preferred Stock ETFs

Risk Exposure

Preferred shares are less volatile than common stock. They have a lower downside risk but also smaller upward potential. They are suitable for investors seeking more reliable income and less interested in price return.

Traditionally the financial sector is the primary issuer of preferred stock. For that reason, these asset class was hurt very hard during the financial crisis in 2008-2009. Furthermore, many of the high-yielding preferred stocks currently available on the market were issued during or after that same recession.

Investors interested in preferred stock will face credit risk. The average credit rating of the issuances held by major ETFs is BBB, which is the lowest investment grade rating. The credit rating determines the ability and risk of the issuer to pay off its debt.

Preferred stock investors have exposure to interest rate risk. Preferred shares are inversely related to changes in interest rates. Therefore, their value will decrease as interest rates go up and increase as rates go down.

Preferred stocks are positively correlated with the equity market. Their seven-year correlation to US market is equal to 0.6. While their correlation with the broad bond market is 0.2.  Preferred shares are not as volatile as equity stocks and have more predictable returns.

In the current low-interest environment, the issuers of preferred stocks (such as like Wells Fargo, HSBC, Barclays, Citigroup, Deutsche Bank) can decide to call them back, convert them to ordinary stock or replace them with lower yielding alternatives.

Tax treatment

U.S. corporation can exclude up to 70 percent of the preferred dividend from their taxable income as long as they hold the shares at least 45 days.

This benefit is not available for individual investors. For them, the dividends are taxable on the full amount at the favorable rate for qualified dividends – 0%, 15%, and 20%.

Placement

Due to their high dividend, favorable tax rate, and low expected volatility, the preferred stock ETFs are a suitable option for all investment type accounts.

 

High Yield Bonds

High Yield Bonds are fixed income securities issued by companies with below investment grade rating.  To attract investors, high yield issuances offer a higher yield. Currently, an average high yield bond pays 2% more than comparable investment grade bond. Also known as junk bonds, they present a much higher credit risk compared to equivalent investment grade bonds. Their embedded credit risk rating ranges between BB and CCC.

HYG and JNK are the most popular ETFs in the High Yield space with AUM of $15 billion and $11 billion respectively.

High Yield ETFs

Risk Exposure

Similarly to preferred stocks, high yield bonds have a positive correlation with both equity and bond markets. They have much stronger correlation ratio to the US markets, 0.76, versus US bond markets, 0.2.  This relationship extends from the issuer’s ability to pay off the debt, which more often depends on the success of their business model rather than changes in interest rates.

High yields bonds over-perform comparable investment grade bonds during a stable economy cycle and a low-interest environment. Rising rates, increasing credit spreads, recession and spike in business defaults will negatively affect high yield bond markets. In these cases, the value of the bonds will decline driven by adverse factors that will lower the issuers’ ability to pay off current debt.

For individual investors, high yield bond ETFs provide much better diversification than holding individual bonds. The largest ETF, HYG, owns over 1,000 bonds.  Without significant investment in research, ETFs offer low-cost alternatives into the high yield bond segment versus mutual funds.

Tax treatment

Investors in high-yield bonds pay taxes on their interest at the high ordinary income level tax bracket, up to 39.6% plus 3.8% for Medicare surcharge.

Placement

Due to their high tax rate and greater volatility than other fixed-income instruments, high-yield bonds are more suitable for tax-exempt and tax-deferred accounts.

 

Emerging Market Bonds

Emerging market bonds are government and corporate bonds issued by states and companies from the group of emerging economies. Primary EM bond issuers come from countries like Mexico, Turkey, Philippines, Indonesia, Russian Federation, Hungary, Brazil, Poland, Colombia, South Africa, and few others.

EMB and PCY are the leading Emerging Market Bond ETFs. Their AUM is $9 billion and $3.9 billion respectively. Like other investment classes, ETFs investing in emerging market bonds offer diversified regional and industry exposure.

Emerging Market Bond ETFs

Risk Exposure

Frequently, emerging bank bonds receive a below investment grade rating, which shows the significant credit risk to bondholders. There have been many examples of emerging economies not being able to pay off their debt. The most recent case was Argentina and Brazil. In the not so distant future, Russia and Turkey had similar troubles. The International Monetary Fund (IMF) or the World Bank often intervene in a case of country debt default.

In addition to credit and interest rate risk, investors in these securities have exposure to currency risk. For instance, a significant depreciation of the local currency can significantly undermine the USD value of the bonds from that country.

Similarly to high yield, emerging market bonds have ties to both equity and bond markets. They have an equal correlation to US equity and bond markets with correlation ratio equal to 0.48.

Tax treatment

Investors in Emerging market bond pay taxes on their interest at the high ordinary income level tax bracket, up to 39.6% plus 3.8% for Medicare surcharge.

Placement

Similarly to high yield, the emerging market bonds come with a high dividend, unfavorable tax rate, and higher expected volatility. Due to these factors, high-yield bonds are more suitable for tax-advantaged accounts such as Roth IRA, 401k, and Traditional IRA.

Muni Bonds

Municipal bonds are debt securities issued by municipal authorities like states, counties, cities and their related companies. The primary objectives of Municipal bonds are funding general activities or capital projects like building schools, roads, hospitals, and sewer systems.

The size of the muni bond market is equal to $3.7 trillion dollars. There are about 350 billion dollars of Muni bonds issuance every year.

MUB is the largest Muni ETF with AUM of 7.6 billion dollars. It holds a broad basket of national municipal bonds with intermediate maturities.

Muni ETFs

Risk Exposure

Municipal bonds are sensitive to interest rate fluctuations. There is an inverse relationship between bond prices and interest rates. As the rate goes up, muni bond prices will go down. And reversely, as the interest rates go decline, the bond prices will rise.

Individual municipal bonds and municipalities receive a credit rating by major credit agencies like Moody’s, S&P 500 and Fitch. The credit rating shows the ability of the issuer to pay off its debt.

Unlike corporations, which can go bankrupt and disappear, municipals can’t go away. They have to continue serving their constituents. History proves that municipal bonds have much lower default rates than comparable corporate bonds.

Tax Treatment

To encourage people to invest in Municipal Bonds US authorities had exempted the interest (coupon income) of the muni bonds from Federal taxes. Furthermore, when the bondholders reside in the same state as the bond issuer, they do not pay state taxes.

Therefore, the majority of the municipal bond issuances enjoy tax-free status. Bondholders do not pay federal taxes on the coupon received from these securities. Besides, investors residing in the same state enjoy a state tax-free status as well.

Particular Municipal bonds related to business activities can affect their owners’ AMT status and potentially increase annual taxes.

Also, there is a small but growing group of taxable municipal bonds. These issuances relate to activities that do not provide a significant benefit to the general public.

Placement

Tax Exempt Municipal Bonds are only suitable for taxable accounts where investors can take advantage of their tax-free status.

Finally, investors interested in taxable or AMT bonds can consider placing them in their tax-deferred accounts like IRA and 401k.

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing. Image copyright: 123RF.com

4 Steps to determine your target asset allocation

One of the financial advisors’ primary responsibilities is to determine and document their clients’ target asset allocation. The target allocation serves as a starting point and guideline in diversifying the client portfolio and building future wealth. Clients’ unique financial goals, lifestyle, investment horizon, current and expected income and emotional tolerance to market turbulence will impact their future asset allocation.

The target investment mix is not constant. It can shift from more aggressive to more conservative or vice versa with substantial changes in lifestyle, family status, personal wealth, employment, and age.

Assess your risk tolerance

Most advisors use questionnaires to evaluate their client’s risk tolerance. The length of these surveys varies from advisor to advisor. Furthermore, some assessments are available online for free. The idea behind all of them is to determine the investor’s tolerance to market volatility, and unpredictable macroeconomic and life events.

Individuals with high-risk tolerance have the emotional capacity to take on more risk. They can endure significant market swings in order to achieve a higher future return.

On the opposite side, investors with low-risk tolerance are willing to sacrifice higher returns for safer, low volatility assets which will have smaller swings during turbulent markets.

A free risk tolerance test is available here:

https://www.calcxml.com/calculators/inv01?skn=#top

Regardless of which test you take, if you answer all questions consistently, you should expect to get similar results.

Advisors, of course, should not rely solely on test results. They need to know and understand their clients. Advisors must have a holistic view of all aspects of client’s life and investment portfolio.

 

Set your financial goals

Your financial goals are another critical input to determine your target investment mix. Your goals can stretch anywhere from a couple of months to several decades. They can be anything from paying off your debt, buying a house, planning for a college fund, saving for a wedding, a trip or retirement, making a large charitable donation and so on.

Each one of your goals will require a different amount of money for completion.

Having your goals in place will define how much money you need to save in order to reach them. The range of your goals versus your current wealth and saving habits will determine your target asset allocation.

More aggressive goals will require more aggressive investment mix.

More balanced goals will call for more balanced investment portfolio.

Sometimes, investors can have a conflict between their financial goals and risk tolerance. An investor may have low to moderate risk tolerance but very aggressive financial goals. Such conflict will ultimately require certain sacrifices – either revising down the investor’s financial goals or adjusting his or her willingness to take on more risk.

Define your investment horizon

Your investment horizon and the time remaining to your next milestone will significantly impact your investment mix.

529 college fund plan is an excellent example of how the investment horizon changes the future asset mix. Traditional 529 plans offer age-based investment allocation. The fund is initially invested in a higher percentage of equity securities. This original investment relies on the equities’ higher expected return, which can potentially bring higher growth to the portfolio. Over time, as the primary beneficiary (the future student), approaches the first year in college, the money in the 529 plan will gradually be re-allocated to a broadly diversified portfolio with a large allocation to fixed income investments. The new target mix can provide more safety and predictable returns as the completion of the goal approaches.

The same example can apply for retirement and home purchase savings or any other time-sensitive goal. The further away in time is your goal; the stronger will be your ability to take on more risk. You will also have enough time to recover your losses in case of market turmoil. In that case, your portfolio will focus on capital growth.

As the completion time of your goal approaches, your affinity to risk will decrease substantially. You also won’t have enough time to recover your losses if the market goes down considerably. In this situation, you will need a broadly diversified portfolio with refocusing on capital preservation.

 

 Know your tax bracket

The investors’ tax bracket is sometimes a secondary but often crucial factor in determining asset allocation. The US Federal tax rate ranges from 10% to 39.6% depending on income level and filing status. In addition to Federal taxes, individuals may have to pay state and city taxes.

Investors can aim to build a tax-efficient asset allocation.  They can take advantage of preferential tax treatment of different financial securities among various investment account types – taxable, tax-deferred and tax-exempt accounts. 

For instance, they may want to allocate tax efficient investments like Municipal bonds, MLPs, ETFs and Index funds to taxable accounts and higher tax bearing investments like Gold, Bonds, and REITs into tax-advantaged accounts.

In any case, investors should attempt to achieve the highest possible return on an after-tax basis. Building a tax-efficient investment portfolio can add up to 1% or more in performance over an extended period.

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing. Image copyright: 123RF.com

A Guide to Investing in REITs

On August 31, 2016, S&P 500 will introduce a new sector – Real Estate. Up until now real estate companies, also known as REITs,  belonged to the Financial sector. They were in the company of large financial and insurance corporations. The new category will have 27 stocks, $567 billion of market capitalization and approximate weight of 3% of the total S&P 500 market value.

With the addition of Real Estate as a separate sector in S&P indices, many active managers will have to aline their current portfolios with the new segment structure. It is possible that we observe a higher demand for REITs in the first few weeks after the change.

The list of REITs included in S&P 500
List of REITs included in S&P 500

What is REIT?

A real estate investment trust (REIT) is a company that owns and manages income-producing real estate. It represents a pool of properties and mortgages bundled together and offered as a security in the form of unit investment trusts.

REITs invest in all the main property types with approximately two-thirds of the properties in offices, apartments, shopping centers, regional malls, and industrial facilities. The remainder one-third is divided among hotels, self-storage facilities, health-care properties, prisons, theaters,  golf courses and timber.

The total market capitalization of all publicly traded REITs is equal to $993 billion. The majority of it, $933 billion belongs to Equity REITs and the remainder to Mortgage and other financing REITs.

There are 219 REITs in the FTSE NAREIT All REITs Index. 193 of them trade on the New York Stock Exchange

Legal  Status

REITs are subject to several regulations. To qualify as a REIT, a real estate firm must pay out 90% of its taxable income to shareholders as dividends. The REIT can deduct the dividends paid to shareholders from its taxable income. Thus their income is exempt from corporate-level taxation and passes directly to investors. Other important regulations include:

  • Asset requirements: at least 75% of assets must be real estate, cash, and government securities.
  • Income requirements: at least 75% of gross income must come from rents, interest from mortgages, or other real estate investments.
  • Stock ownership requirements: shares in the REIT must be held by a minimum of 100 shareholders. Five or fewer individuals cannot (directly or indirectly) own more than 50% of the value of the REIT’s stock during the last half of the REIT’s taxable year.

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Distributions

Dividend distributions for tax purposes are allocated to ordinary income, capital gains, and return on capital, each of them having different tax treatment. REITs must provide shareholders with guidance how to treat their dividends for tax purposes.  The average distribution breakdown for 2015 was approximately 66% ordinary income, 12% return on capital, and 22% capital gains.

REITs distributions have grown substantially in the past 15 years. As the chart shows, the total REIT distributions in 2000 were under $8 billion dollar. Just between 2012 and 2015, REITs distribution rose up from $28.8 billion to $44.9 billion, or 44%.

REITs dividends growth, up to Q12016
REITs dividends growth, up to Q12016. Source: www.reit.com

Tax implications

The majority of REIT dividends are considered non-qualified dividends and taxed as ordinary income, up to the maximum rate of 39.6 percent, plus a separate 3.8 percent Medicare surtax on investment income.

Capital gains distributions are taxable at either 0, 15 or 20 percent tax rate, plus the 3.8 percent surtax.

Return-on-capital distributions are tax-deferred. They reduce the cost basis of the REIT investment.

When a REIT distributes dividends received from a taxable REIT subsidiary or other corporation, those distributions are taxed at the qualified dividend rate of 0, 15 or 20 percent, plus the 3.8 percent surtax.

Timber REITs

One REIT sector makes an exception from the above rule. Timber REITs have a favorable tax treatment from IRS. Distributions from timber REITs such as RYN, PCL, PCN & WY are considered long-term capital gains and therefore are taxable at the lower capital gain rate (0, 15% or 20% plus 3.8% Medicare surcharge).

 

Economic Cycle 

Individual REIT sectors have different sensitivity to cyclical factors.  Industrial, hotel, and retail REITs have the biggest exposure to economics cycles. Their occupancy and rental rates are extremely sensitive to economic conditions. Cyclical downturns in the economy, recession, and weak consumer spending, can significantly hurt the revenue stream of these REITs.

On the other hand, health care REITs tend to have long-term rental agreements and are more sheltered from market volatility.

Interest Rates

Since many REITs use bank loans and other external financing to expand their business, they have benefitted significantly from the current low-interest rate environment. Furthermore, many yield-seeking investors turned to REITs for higher income. If low-interest rates remain, REITs will likely expand their base to a broader range of market participants.

Interest rates can impact REIT’s performance differently depending on two main factors – debt and lease duration.

Loan maturities

As a result of the current low rates, many REITs have increased their leverage and therefore have high sensitivity to interest changes. If interest rates rise, REITs with near-term loan maturities will need to refinance at higher rates. Thus their interest payments will go up, which will lead to less cash available for dividends. Therefore, REITs with higher levels of debt and short-term maturities will perform worse than REITs with less debt and long-dated maturity schedules.

At the same time, REITs with lower debt levels relative to their cash flows, all else equal, will perform better in a rising-rate environment.

Lease duration

While higher interest rates would affect all REITs, industry subsectors would be affected differently, depending on lease durations. REITs with shorter lease durations will perform relatively better in a rising-rate environment because they can seek higher rents from tenants as rates rise than could REITs with longer lease durations. The higher rents can offset the negative impact of higher interest expense. Hotel REITs usually have the shortest lease durations, followed by multifamily properties and self-storage.

Healthcare, office, and retail REITs usually sign long-term leases. Therefore rising interest rates will potentially hurt these REITs due to their inability to adjust rental contracts to offset rising costs.

Risk and return

Real Estate Investment Trusts historically have been more volatile than S&P 500. The 40-year standard deviation of the REIT’s sector is 17.16% versus 16.62% for S&P 500 and 10.07% for 10-year Treasury. During this 40-year period, REITs achieved 13.66% cumulative annual return versus 11.66% for S&P 500 and 7.39% for 10-year Treasury. (www.portfoliovisualizer.com)

Furthermore, the 10-year (2006-15) standard deviation of the REIT sector is 22.01% versus 18.02% for S&P 500 and 9.54% for 10-year Treasury. For the same period, REITs reported 7.83% cumulative annual return versus 6.96% for S&P 500 and 4.57% for 10-year Treasury. (www.portfoliovisualizer.com)

Among the best five-year REIT sector performers were Retail, Self-Storage, and Industrial. For the same period, worst performers were Mortgage, Hotel and Office REITs.

REIT Performance by Sector
Source: Lazard Asset Management

 

Valuations

In respect to pricing, REITs are reaching high valuations levels. The current Price to Fund to Operations ratio is hovering around 18, which is slightly above the historical average of 16. While the P/FFO ratio remain reasonable compared to historical figures, further price rally in REITs not supported by the increase in cash flows may impose a significant risk for sector overheating.

 

REITs Price to Funds From Operations
Source: Lazard Asset Management / SNL Financial

Diversification

Even though REITs are publicly traded companies, very often they are considered an alternative asset due to their weak relationship with the other asset classes – equities and fixed income. US REITs have relatively low correlation with the broader stock market. The 40-year correlation is equal to 0.51, while the 10-year correlation is  0.73. The correlation between REITs and 10-year Treasury is equal to -0.06, while that with Gold is 0.09.

This low correlation with other asset classes makes the REITs a solid candidate for a broadly diversified investment portfolio.

 

Investing Strategies

Directly

There are 219 publicly traded REITs. 27 of them are included in the S&P 500 index. If you decide to invest in a single REIT or basket of REITs, you need to consider company specific risk, management, sub-sector, regional or national market exposure, leverage, lease duration, history and distribution payments.

 

ETFs

Top 5 REITs ETFs

Top 5 REITs ETFs
Source: Morningstar.com

 

VNQ

VNQ dominates the REITs ETF space as the largest and second cheapest ETF. It includes a broad basket of 150 securities. The ETF tracks the MSCI US REIT Index, which includes all domestic REITs from the MSCI US Investable Market 2500 Index. This ETF doesn’t include any mortgage, timber, and tower REITs. It has an expense ratio of 0.12% (second lowest to SCHH). It has $32.4 billion of assets under management and Morningstar rating of 4. The fund holds a diversified portfolio across all property sectors. Retail REITs are the largest holding, at 25% of assets, Specialized REITs make up 16.50%, office, 12.6% residential, 15.7%, healthcare, 12.3%, diversified, 8%, hotel and resort, 5.3%, and industrial, 4.7% REITs.

IYR

IYR tracks the Dow Jones U.S. Real Estate Index. It is the most diversified REIT ETF. Unlike other ETFs which hold only equity REITs, IYR holds mortgage, timber, prison and tower REITs including companies like American Tower, Weyerhaeuser Co, Annaly Capital Management NLY and Crown Castle International Corp. IYR has three stars by Morningstar and has an expense ratio of 0.45%. IYR’s holdings are broken by Specialized REITs, (27.09%), Retail, 19.74%, Residential, 12.70%, Office, 10.00%, Health Care, 9.88%, Mortgage REITs, 4.90%, Industrial, 4.56%, Diversified, 4.51%, Hotel & Resort, 3.56%, Real Estate Services, 2.06%

ICF

ICF tracks an index of the 30 largest publicly traded REITs excluding mortgage and tower REITs. The design of this index capitalizes on the relative strength of the largest real estate firms and the conviction for consolidation in the real estate market. The ETF includes Retail REITs, 24.84%, Specialized REITs, 18.71%, Residential, 18.08%, Office, 15.23%, Health Care, 14.41%, Industrial, 5.79%, Hotel & Resort REITs, 2.56%.

 

RWR / SCHH

RWR / SCHH are the smallest of the five funds. They track Dow Jones US Select REIT Index. The index tracks US REITs with a minimum market cap of $200 million. The index also excludes mortgage REITs, timber REITs, net-lease REITs, real estate finance companies, mortgage brokers and bankers, commercial and residential real estate brokers and real estate agents, homebuilders, hybrid REITs, and large landowners of unimproved land. The funds’ portfolio holds a diversified range of REITs across property sectors similar to other ETFs.

SCHH has the lowest expense ratio of 0.07% all REITs ETFs while RWR has an expense ratio of 0.25%.

 

Performance 

Comparing the performance of the top ETFs in the past ten years, we can see a clear winner. VNQ is leading by price return, total return, and Sharpe Ratio.  Next in line are RWR and ICF. IYR takes the last spot.

Having the largest number of holdings, VNQ overweights small size REITs relative to the industry average. Hence it benefited from the smaller REITs outpacing the growth of their bigger competitors.

IYR did not benefit from being the most diversified REIT ETF. The mortgage and specialized REITs have lagged behind the performance of the traditional equity REITs.

 

 

Mutual Funds

Mutual funds are actively managed investment vehicles. They typically use an index as their benchmark.  The goal of the fund manager is to outperform their benchmark either on a risk adjusted or absolute return basis.  The fund manager can decide to overweight a particular REIT if he or she believes the company will outperform the benchmark. Many times the managers will look for mispricing opportunities of individual REITs.

Active funds usually charge higher fees than passively managed ETFs due to higher research, management, administrative and trading costs. However, many investors believe that after subtracting their fees, active managers cannot beat the market in the long run.

In my analysis, I selected a pool of five actively managed funds which are open to new investors and have an expense ratio less than 1% – VGSLX,  DFREX, TRREX, CSRSX and FRESX.

All five funds have high ratings from Morningstar and robust historical performance.

VGSLX and DFREX have the largest number of holdings, 150 and 149 respectively, and maintain the lowest expense ratio. Both funds lean more towards small and micro-cap REITs relative to the average in the category.

The other three funds, TRREX, CSRSX and FRESX manage smaller pools of REITs. CSRSX and FRESX have the highest turnover: 58% and 34% respectively.

Performance

While the 1-year returns are quite variable, the long-term performance among the five funds is relatively consistent. Vanguard REIT Index Fund, VGSLX,  has the lowest fee and the highest 10-year return of 7.6%. Cohen & Steers Realty Shares Fund, CSRSX, is second with 7.5% annual return. CSRSX has the lowest 10-year standard deviation of 25.2%. VGSLX edges slightly ahead with the highest Sharpe Ratio of 0.39. Vanguard and DFA funds benefitted from low expense ratio and larger exposure to mid and small size REITs, which had better 10-year performance than larger REITs.

REITs Mutual Funds
Source: Morningstar.com

 

 

 

 

 

 

 

 

 

It is worth noting that the 10-year Sharpe Ratio for all REITs sector is lower than the Sharpe Ratio of S&P 500. The Sharpe Ratio calculated the risk-adjusted returns of a particular investment. In this case, the risk-adjusted returns of REIT lag behind the overall equity market.

When you consider investing in REITs mutual funds,  pay attention to management style, expense ratio, turnover, dividends, the number of holdings, and their benchmark.

Where to allocate REITs investments?

REITs are often attractive for their high dividend income. As I mentioned earlier, the majority of the REITs distributions are treated as ordinary income and therefore taxed at the investors’ tax rate. Investors in high tax brackets can pay up to 39.6% rate plus 3.8% Medicare surplus tax on the investment income.

Because of their unfavorable tax status, most REITs may not be suitable for taxable investment accounts.  Tax-sensitive investors may want to consider placing REITs in Tax Advantage accounts like Roth IRA, Traditional IRA, and 401k.

Since timber REITs receive favorable tax treatment, they are an exception from the above rule. Investors may choose to hold them in taxable investment accounts.

There are two scenarios under which REITs could be an appropriate fit for a taxable account.

First, investors in lower tax bracket will be less impacted by the tax treatment of the REITs income.

Second, investing in REITs with a history of making significant capital gain and return on capital distributions. These type of payments have more favorable tax treatment at the lower long-term capital gains tax rate.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing. Image copyright: 123RF.com
Sources:

http://www.bloomberg.com/gadfly/articles/2016-05-09/reits-are-coming-of-age-for-investors

http://www.investopedia.com/articles/pf/08/reit-tax.asp#ixzz4BW5T8K6U

http://marketrealist.com/2015/08/reits-come-existence/

https://www.reit.com/sites/default/files/1099/HistoricalDividendAllocationSummary.pdf

www.morningstar.com

https://www.researchgate.net/publication/5151761_Seasonality_and_Size_Effects_The_Case_of_Real-Estate_Related_Investment

http://www.lazardnet.com/docs/sp0/4915/Lazard_USRealEstateIndicatorsReport_201403.pdf