Essential Guide to Your Employee Stock Purchase Plan

Employee Stock Purchase Plan

What is ESPP

Employee Stock Purchase Plan (ESPP) is a popular tool for companies to allow their employees to participate in the company’s growth and success by becoming shareholders. ESPP gives you the option to buy shares of your employer at a discount price. Most companies set a discount between 10% and 15%. Unlike RSUs and restricted stocks, the shares you purchase through an ESPP are not subject to any vesting schedule restrictions. That means you own the shares immediately after purchase. There are two types of ESPP – qualified and non-qualified. Qualified ESPP generally meets the requirements under Section 423 of the Internal Revenue Code and receive a more favorable tax treatment. Since most ESPP are qualified, I will only talk about them in this article.

How ESPP works

Your company will typically provide you with information about enrollment and offering dates, contribution limits, discounts, and purchasing schedule. There will be specific periods throughout the year when employees can enroll in the plan. During that time, you are required to decide if you want to participate and set a percentage of your salary to be deducted every month to contribute to the stock purchase plan. The IRS allows up to $25,000 limit for ESPP contributions. Make sure you set your percentage, so you don’t cross over this limit.

At this point, you are all set. Your employer will withhold your selected percentage every paycheck. The contributions will accumulate over time and will be used to buy the company stock on the purchase date.

Offering period and look-back provision

Offering periods of most ESPPs are ranging from 6 to 24 months. The longer periods could have multiple six-month periods for purchase. Your employer will use your salary contributions that accrue over time to buy shares from the company stock on your behalf.

Most ESPP offer a look-back provision will allow you to purchase the shares at a discount from the lowest of the beginning and ending price of the offering period.

ESPP Example

For example, let’s assume that on January 2nd, your company stock traded at $100 per share. The stock price had a nice run and ended the six-month period on June 30 at 120. Your ESPP will allow you to buy the stock at 15% of the lowest price, which is $00. You will end up paying $85 for a stock worth $120.

The price discount is what makes the ESPP attractive to employees of high growth companies. By acquiring your company stock at a discount, the ESPP lowers your investment risk, provides you a buffer from future price declines, and sets a more significant upside if the price goes up further.

Selling your ESPP shares

Some ESPPs allow you to sell your shares immediately after the purchase date, realizing an instant gain of 17.65%. Others may have a holding period restriction during which you cannot sell your shares. Find out from your HR.

Taxation

An ESPP plan has its own unique set of tax rules. All contributions are pretax and subject to federal, state and local taxes.

Keeping your stock will not a create a tax event. In other words, you don’t owe any taxes to IRS if you never sell your shares. However, the moment you decide to sell is when things get tricky.

The discount is treated as ordinary income

The first to remember is that the price discount is always treated as ordinary income. You will add the value of the discount to your regular annual income and pay taxes according to your tax bracket.

Capital gains

The difference between the selling price and the purchase price is considered a realized capital gain. There are two types of capital gains – short-term and long-term. Short-term gains are triggered if you sell your stocks in less than one year after the purchase date. You will pay taxes on short-term capital gains as an ordinary income according to your tax bracket.

Long-term capital gains vary between 0%, 15% and 20% depending on your income. In order to get preferential this lower rate from the IRS, you need to keep your shares for more than 2 years from the offer date and 1 year from the purchase date.

Investment risk

Being a shareholder in a solid high growth company could offer a significant boost to your personal finances. In some cases, it could make you an overnight millionaire.

However, here is the other side of the story. Owning too much stock of a company in bad financial health could impose a significant risk to your overall investment portfolio and retirement goals. Participating in the ESPP of a company with a constantly dropping or volatile stock price is like a catching a falling knife. The discount price could give you some downside protection, but you can continue to lose money if the price continues to go down. The price of General Electric, one of the longest Dow Jones members, went down more than 65% in one year.

Remember Enron and Lehman

Many of you remember or heard of Enron and Lehman Brothers. If your company seizes to exist for whatever reason, you could not only lose your job but all your investments in the firm could be wiped out.

You are already earning a salary from your employer. Concentrating your wealth and income from the same source could jeopardize your financial health if your company fails to succeed in its business ventures.

As a fiduciary advisor, I always recommend diversification and caution. Try to limit your exposure to your company stock and sell your shares periodically. Sometimes paying taxes is worth the peace of mind and safety. 

Conclusion

Participating in your employer’s ESPP is an excellent way to acquire company stock at a discount and get involved in your company’s future. While risky, owning company stock often comes with a huge financial upside. Realizing some of these gains could help you build a strong foundation for retirement and financial freedom. When managed properly, it can help you achieve your financial goals, whether they are buying a home, taking your kids to college or early retirement.

Reach out

Keep in many that most ESPPs have different rules. Therefore, this article may not address the specific features of your plan. If you’d like to discuss how to make the most out of your ESPP, please feel free to reach out and learn more about our fee-only financial advisory services. I will meet you in one of our offices in San Francisco, Oakland, Walnut Creek, and Pleasant Hill areas. As a CFA® Charterholder with an MBA degree in Finance and 15+ years in the financial industry, I am ready to answer your questions.

Stoyan Panayotov, CFA 
Founder|Babylon Wealth Management

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All you need to know about Restricted Stock Units (RSUs)

RSUs

Employers, especially many startups, use different compensation options to attract and keep top performing employees. A common alternative is equity compensation, which allows employees to share in the ownership and the profits of the company. Equity compensation takes different forms such as stock options, restricted stocks, and deferred comp. Today, most companies are resorting to the use of restricted stock unit (RSU) as a significant compensation package. If you are fortunate to receive RSUs from your employer, you should understand the basics of this corporate perk. Here is all you need to know about Restricted Stock Units (RSUs) and some essential tips on how to manage them.

What are Restricted Stock Units (RSUs)?

A restricted stock unit (RSU) is a type of equity compensation given by an employer to an employee in the form of company stock. Employees receive RSUs through a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with their employer for a particular length of time. RSUs give an employee interest in company stock but they have no tangible value until vesting is complete.

Vesting Schedule

Companies issue restricted stock units according to a vesting schedule.
The vesting schedule outlines the rules by which employees receive full ownership of their company stock. The restricted stock units are assigned a fair market value when they vest. Upon vesting, they are considered income, and often a portion of the shares is withheld to pay income taxes. The employees receive the remaining shares and can sell them at their discretion.

Grant Date and Vesting Date

As an employee, you should be aware of these essential RSU dates. The grant date is the date when the company pledges the shares to you.

You only own the shares when the granted shares are ‘vested.’ The vesting date when the employer transfers the full ownership of the shares to you. At that point, the stock becomes fully vested, and they are owned by the employee.

Even though RSUs offer employees ownership in company stock, they usually don’t have a tangible value before vesting. When vesting is complete, the restricted stock units are valued according to the fair market value at that time.

Taxes on RSUs

The fair market value of your vested RSUs is considered personal income in the year of vesting. Typically, companies withhold part of the shares for federal and state income taxes. The remaining shares are given to the employees. At this point, you can decide to keep or sell them at your wish. If your employer doesn’t withhold taxes for your vested shares, you will be responsible for paying these taxes during the tax season.

Once the RSUs are converted to company stock, you become a shareholder in your firm. You will be able to sell some of these shares subject to companies’-imposed trading windows and executive limits. If the stock price goes up after vesting you will need to pay either short-term capital gain taxes for shares held less than a year from date or long-term capital gains taxes in shares held longer than one year.

Investment risk

Being a shareholder in your firm could be very exciting. If your company is in great health and growing solidly, this could be an enormous boost to your personal finances.

However, here is the other side of the story. Owning too much of your company stock could impose significant risks to your investment portfolio and retirement goals. You are already earning a salary from your employer. Concentrating your entire wealth and income from the same source could jeopardize your financial health if your employer fails to succeed in its business ventures. Many of you remember the fall of Enron and Lehman Brothers. Many of their employees lost not only their jobs but a significant portion of their retirement savings.  

As a fiduciary advisor, I always recommend diversification and caution. Try to limit your exposure to your employer and sell your shares periodically. Sometimes paying taxes is worth the peace of mind and safety.

Conclusion

Receiving RSUs is an excellent way to acquire company stock and become part of your company’s future. While risky owning RSUs often comes with a huge financial upside. Realizing some of these gains could help you build a strong foundation for retirement and financial freedom. When managed properly, they can help you achieve your financial goals, whether they are buying a home, taking your kids to college or early retirement.

Reach out

If you’d like to discuss how to make the most out of your RSUs, please feel free to reach out and learn more about our fee-only financial advisory services. We will meet you in one of our offices in San Francisco, Oakland, Walnut Creek, and Pleasant Hill areas. As a CFA® Charterholder with an MBA degree in Finance and 15+ years in the financial industry, I am ready to answer your questions.

Stoyan Panayotov, CFA
Founder|Babylon Wealth Management

CFA Charterholder. Let's build a better world for investing.

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A financial checklist for young families

A financial checklist for young families

I recently had the chance to work with several young families looking for help to build their wealth and improve their finances. We discussed a broad range of topics from buying a house, saving for retirement, savings for their kids’ college, budgeting and building legacy. As a financial advisor in the early 40s, I have personally gone through many of these questions and was happy to share my experience.

Some of my clients already had young children. Others are expecting a new family member. Being a dad of a nine-month-old boy, I could relate to many of their concerns. My experience helped me guide them through the web of financial and investment questions.  

While each family is unique, there are many common themes amongst all couples. While each topic of them deserves a separate post, I will try to summarize them for you.

Communicate

Successful couples always find a way to communicate effectively. I always advise my clients to discuss their financial priorities and concerns. When partners talk to each other, they often discover that they have entirely different objectives.  Having differences is normal as long as you have common goals. By building a strong partnership you will pursue your common goals while finding a common ground for your differences

Talking to each other will help you address any of the topics in this article.

If it helps, talk to an independent fiduciary financial advisor. We can help you get a more comprehensive and objective view of your finances. We often see blind spots that you haven’t recognized before.

Set your financial goals

Most life coaches will tell you that setting up specific goals is crucial in achieving success in life. It’s the same when it comes to your finances. Set specific short-term and long-term financial goals and stick to them. These milestones will guide you and help you make better financial decisions in the future.

Budget

There is nothing more important to any family wellbeing than budgeting. Many apps can help you budget your income and spending. You can also use an excel spreadsheet or an old fashion piece of paper. You can break down your expenses in various categories and groups similar to what I have below. Balance your budget and live within your means.

Sample budget

Gross Income?????
Taxes???
401k Contributions??
Net Income????
Fixed Expenses
Mortgage?
Property Taxes?
Utilities (Phone, Cable, Gas, Electric)?
Insurance?
Healthcare/Medical?
Car payment?
529 savings?
Daycare?
Non-Discretionary Flexible Expenses
Groceries?
Automotive (Fuel, Parking, Tolls)?
Home Improvement/Maintenance?
Personal Care?
Dues & Subscriptions?
Discretionary Expenses
Restaurants?
General Merchandise?
Travel?
Clothing/Shoes?
Gifts?
Entertainment?
Other Expenses?
Net Savings???

Consolidate your assets

One common issue I see amongst young couples is the dispersion of their assets. It’s very common for spouses to have multiple 401k, IRAs and savings accounts in various financial institutions and former employers. Consolidating your assets will help you get a more comprehensive view of your finances and manage them more efficiently.

Manage your debt

The US consumer debt has grown to record high levels. The relatively low-interest rates, rising real estate prices and the ever-growing college cost have pushed the total value of US household debt to $13.25 trillion. According to the New York Fed, here is how much Americans owe by age group.

  • Under 35: $67,400
  • 35–44: $133,100
  • 45–54: $134,600
  • 55–64: $108,300
  • 65–74: $66,000
  • 75 and up: $34,500

For many young families who are combining their finances, managing their debt becomes a key priority in achieving financial independence.

Manage your credit score

One way to lower your debt is having a high credit score. I always advise my clients to find out how much their credit score is.  The credit score, also known as the FICO score, is a measure between 300 and 850 points. Higher scores indicate lower credit risk and often help you get a lower interest rate on your mortgage or personal loan. Each of the three national credit bureaus, Equifax, Experian, and TransUnion, provides an individual FICO score.  All three companies have a proprietary database, methodology, and scoring system. You can sometimes see 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 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.

Own a house or rent

Owning your first home is a common theme among my clients. However, the price of real estate in the Bay area, where I live, has skyrocketed in the past 10 years. The average home price in San Francisco according to Zillow is $1.3 million. The average home price in Palo Alto is $3.1 million. (Source: https://www.zillow.com/san-francisco-ca/home-values/ ). While not at this magnitude, home prices have risen in all major metropolitan areas around the country. Buying a home has become an impossible dream for many young families. Not surprisingly a recent survey by the Bank of the West has revealed that 46% of millennials have chosen to rent over buying a home, while another 11% are staying with their parents.  

Buying a home in today’s market conditions is a big commitment and a highly personal decision. It depends on a range of factors including how long you are planning to live in the new home, available cash for a downpayment, job prospects, willingness to maintain your property, size of your family and so on.

Maximize your retirement contributions

Did you know that in 2019 you can contribute up to $19,000 in your 401k? If you are in your 50s or older, you can add another $6,000 as a catch-up contribution. Maximizing your retirement savings will help you grow your wealth and build a cushion of solid retirement savings. Not to mention the fact that 401k contributions are tax-deferred and lower your current tax bill.

Unfortunately, many Americans are not saving aggressively for retirement. According to Fidelity, the average person in their 30’s have $42.7k in their 401k plan. people in their 40s own on average 103k.

If your 401k balance is higher than your age group you are already better off than the average American.

Here is how much Americans own in their 401 plan by age group

  • 20 to 29 age: $11,500
  • 30 to 39 age: $42,700
  • 40 to 49 age: $103,500
  • 50 to 59 age: $174,200
  • 60 to 69 age: $192,800

For those serious about their retirement goals, Fidelity recommends having ten times your final salary in savings if you want to retire by age 67. They are also suggesting how to achieve this goal by age group.

  • By the age of 30: Have the equivalent of your starting salary saved
  • 35 years old: Have two times your salary saved
  • 40 years old: Have three times your salary saved
  • 45 years old: Have four times your salary saved
  • 50 years old: Have six times your salary saved
  • 55 years old: Have seven times your salary saved
  • 60 years old: Have eight times your salary saved
  • By age 67: Have 10 times your salary saved

Keep in mind that these are general guidelines. Everybody is different. Your family retirement goal is highly dependent on your individual circumstances, your lifestyle, spending habits, family size and alternative sources of income.

Know your risk tolerance level

One common issue I see with young families is the substantial gap between their risk tolerance and the actual risk they take in their retirement and investment accounts.  Risk tolerance is your emotional ability to accept risk as an investor.

I have seen clients who are conservative by nature but have a very aggressive portfolio. Or the opposite, there are aggressive investors with a large amount of cash or a large bond portfolio. Talking to a fiduciary financial advisor can help you understand your risk tolerance. You will be able to narrow that gap between your emotions and real-life needs and then connect them to your financial goals and milestones.

Diversify your investments

Diversification is the only free lunch you will get in investing. Diversifying your investments can reduce the overall risk of your portfolio. Without going into detail, owning a mix of uncorrelated assets will lower the long-term risk of your portfolio. I always recommend that you have a portion of your portfolio in US Large Cap Blue Chip Stocks and add some exposure to Small Cap, International, and Emerging Market Stocks, Bonds and Alternative Assets such as Gold and Real Estate.

Invest your idle cash

One common issue I have seen amongst some of my clients is holding a significant amount of cash in their investment and retirement accounts. The way I explain it is that most millennials are conservative investors. Many of them observed their parents’ negative experience during the financial crisis of 2008 and 2009. As a result, they became more risk-averse than their parents.

However, keeping ample cash in your retirement account in your 30s will not boost your wealth in the long run. You are probably losing money as inflation is deteriorating the purchasing power of your idle cash. Even if you are a very conservative investor, there are ways to invest in your retirement portfolio without taking on too much risk.

Early retirement

I talk about early retirement a lot often than one might imagine. The media and online bloggers have boosted the image of retiring early and made it sound a lot easier than it is. I am not saying that early retirement is an illusion, but it requires a great deal of personal and financial sacrifice. Unless you are born rich or rely on a huge payout, most people who retire early are very frugal and highly resourceful. If your goal is to retire early, you need to pay off your debt now, cut down spending and save, save and save.

Build-in tax diversification

While most of the time we talk about our 401k plans, there are other investment and retirement vehicles out there such as Roth IRA, Traditional IRA and even your brokerage account. They all have their own tax advantages and disadvantages. Even if you save a million bucks in your 401k plan, not all of it is yours. You must pay a cut to the IRS and your state treasury. Not to mention the fact that you can only withdraw your savings penalty-free after reaching 59 ½. Roth IRA and brokerage account do not lower your taxes when you make contributions, but they offer a lot more flexibility, liquidity, and some significant future tax advantages. In the case of Roth IRA, all your withdrawals can be tax-free when you retire. Your brokerage account provides you with immediate liquidity and lower long-term capital gains tax on realized gains.

Plan for child’s expenses

Most parents will do anything for their children. But having kids is expensive. Whether a parent will stay at home and not earn a salary, or you decide to hire a nanny or pay for daycare, children will add an extra burden to your budget. Not to mention the extra money for clothes, food, entertainment (Disneyland) and even another seat on the plane.

Plan for college with a 529 Plan

Many parents want to help their children pay for college or at least cover some of the expenses. 529 plan is a convenient, relatively inexpensive and tax-advantageous way to save for qualified college expenses. Sadly, only 29% of US families are familiar with the plan. Most states have their own state-run 529 plan. Some states even allow state tax deductions for 529 contributions. Most 529 plans have various active, passive and age-based investment options. You can link your checking account to your 529 plan and set-up regular monthly contributions. There are plentiful resources about 529 plans in your state. I am happy to answer questions if you contact me directly.

Protect your legacy

Many young families want to protect their children in case of sudden death or a medical emergency. However, many others don’t want to talk about it at all. I agree it’s not a pleasant conversation. Here in California, unless you have an established estate, in case of your death all your assets will go to probate and will have to be distributed by the court. The probate is a public, lengthy and expensive process. When my son was born my wife and I set up an estate, created our wills and assigned guardians, and trustees to our newly established trust.

The process of protecting your legacy is called estate planning. Like everything else, it’s highly personalized depending on the size of your family, the variety of assets you own, your income sources, your charitable aptitude, and so on. Talking to an experienced estate attorney can help you find the best decision for yourself and your family.

I never sell insurance to my clients. However, if you are in a situation where you are the sole bread earner in the household, it makes a lot of sense to consider term life and disability insurance, which can cover your loved ones if something were to happen to you.

Plan ahead

I realize that this is a very general, kind of catch-all checkpoint but let me give it a try. No matter what happens in your life right now, I guarantee you a year or two from now things will be different. Life changes all the time – you get a new job, you have a baby, you need to buy a new car, or your company goes public, and your stock options make you a millionaire. Whatever that is, think ahead. Proper planning could save you a lot of money and frustration in the long run.

Conclusion

I realize that this checklist is not complete. Every family is unique. Each one of you has very different circumstances, financial priorities, and life goals. There is never a one-size-fits-all solution for any family out there. If you contact me directly, I will be happy to address your questions.

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 investment 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), family offices, endowments, defined benefit plans, and other institutional clients. To find out more visit our OCIO page here.

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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,

Will Emerging Markets Continue to Rally

Will Emerging Markets Continue to Rally

Will Emerging Markets Continue to Rally

Emerging Markets are up 26% so far year. But can they sustain the rally?

If you invested in one of the large EM ETFs like EEM (iShares MSCI Emerging Markets ETF) or VWO (Vanguard FTSE Emerging Markets Index Fund ETF Shares) ten years ago, you would have earned nearly zero as of September 29, 2017. At the same time, you would have doubled your money if you invested in S&P 500 (SPY) as long as you stayed put during the market crisis of 2008 – 2009.

So is this just a fluke? Or maybe after a lost decade of volatile price swings, EM stocks are finally ready to turn the page. While we recognize the long-term opportunity in EM, we also understand this could be a bumpy ride.

Learn more about our Private Wealth Management services

 

What is an Emerging Market?

In the investment world, the countries are divided into three main categories – developed, emerging and frontier. Developed countries include countries with developed capital markets and relatively high GDP per capita. The list consists of USA, Canada, Japan, UK, Australia, Germany, Italy, France and several others. Emerging markets have some similarities with the developed economies including functioning capital markets and a banking system, but they lack certain characteristics including lower market liquidity and transparency. They also have more political influence and less strict accounting standards.

The list of Emerging economies includes Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and UAE.

Just to make things a little more complicated, FTSE  indices classify Korea as a developed economy. However, other index providers such as MSCI and Dow Jones include Korea in the EM group.

What makes the emerging markets an attractive investment?

Economic growth

EM has been characterized by higher growth than most developed economies. According to IMF, emerging markets GDP is expected to grow by an average of 4.7% in 2017. Furthermore, despite the recent slowdown, next year projections are the first time in six years when we see an acceleration in the growth forecast.

For comparison, US GDP is expected to grow at 2.6% in the next two years, while EU is projected at 1.7%.

Also, according to World Bank consumption growth per capita in emerging is expected to grow by an average of 5.5% versus 1.5% for developed markets.

This growth differential provides an opportunity for companies with strong presence in these markets to benefit and increase their revenues as a result of the expected economic growth.

Population trends

According to Euromonitor, developing countries account for 90% of the world population under 30.  For instance, the average age of the Philippines is 24, India is 26, Mexico is 27, and Brazil is 31. For comparison, the median age in the USA is 37.2. Japan and Germany are at 46.1.  Emerging economies have a young population base which will help them support future economic and consumption growth. In fact, developing markets now account for more than 75% of global growth in output and consumption, almost double their share in just two decades.

Attractive Valuations

With US stocks equities almost fully priced, investors are starting to look for better opportunities abroad. At 16x current price-to-earnings, emerging market equities (EEM) are considerably cheaper than US large cap-equities.  For comparison, SPY currently trades at 23.7 times price-to-earnings. Furthermore, Emerging Market price-to-book ratio is 1.63x versus 2.85 for SPY.

Even with the 25% return so far this year, EM stocks are still trading at nearly 50% discount to US large cap stocks. This valuation gap creates opportunities for investors to transfer some of their assets to less expensive assets.

Diversification

For investors looking to diversify some of their risks, EM represents a compelling alternative. EM stocks traditionally have a lower correlation to the US equity markets.

For instance, a broad EM ETF such as EEM has a correlation of 0.80 to the S&P 500, while its R-squared (explained returns) ratio is 62.7%. As a comparison, a US Small Cap stocks (IJR) have a 0.92 correlation ratio and 78.7% R-squared to the large US cap index.

 

What are some of the risks?

Volatility of returns

Owning EM stocks comes with a lot of risks. The EM equity performance has been inconsistent for the past ten years. $1,000,000 invested in EEM ETF in Jan 1, 2007 would have produced $ 1,005,620 by Dec 2015 and $1,433,727 by Sep 2017. This is the equivalent of 0.06% and 3.45% annualized rate of return. As a comparison, the same one million invested in SPY would have made 1,735,171 in 2015 and 2,215,383 in Sep 2017 or an average of 6.31% and 7.68% respectively.

This return volatility shows the unpredictability and large swings of returns in EM stocks, which brings us to the next point.

Furthermore, investors who are willing to invest in EM have to stomach the higher volatility associated with these stock. To illustrate, EEM has a beta of 1.29 vs. 1 for S&P 500 and 10-year Standard deviation of 24.59% vs. 15.74% for S&P 500. The maximum drawdown of EEM was -60.44% versus -50% for SPY.

Company concentration

A handful of large corporations and conglomerates are consistently dominating all EM country indices. For example, the top 5 holdings in the China Large-Cap index make up 38% of the entire market. In Korea, top 5 companies make up 33%, with Samsung dominating the market with 20%. In India, top 5 companies’ weight is 36%, in Russia, 35% and Mexico, 40%.  As a comparison, top 5 stocks in the S&P 500 index (SPY) make up 11% of the total.

This high concentration leaves the Emerging markets exposed to the fortunes of the handful of companies dominating their markets.

Political instability

Another risk associated with emerging economies is their heavy dependence on local politics. Just in the past few years, we saw North Korea nuclear threats, political scandals in Brazil, sanctions against Russia, the war in Syria. Changes in political power or any geopolitical turmoil will significantly impact the emerging economies and their neighbors.

 

 

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, Copyright: www.123rf.com

 

6 Saving & Investment Practices All Business Owners Should Follow

6 Saving & Investment Practices All Business Owners Should Follow

In my practice, I often meet with small business owners who have the entire life savings and family fortune tied up to their company. For many of them, their business is the only way out to retirement. With this post, I would like to offer 6 saving & investment practices all business owners should follow.

Having all your eggs in one basket, however, may not be the best way to manage your finances and family fortune. Think about bookstores. If you owned one 20-30 years ago, you probably earned a decent living. Now, bookstores are luxuries even in the major cities like New York and San Francisco. Technology, markets, consumer sentiments, and laws change all the time. And that is why it is vital that you build healthy saving and investment routines to grow your wealth, protect your loved ones and prepare yourself for the years during retirement.

Learn more about our Private Client Services

Start Early

I always advise my clients to start saving early and make it a habit. Saving 10-20 percent of your monthly income will help you build and grow your wealth. For instance, by starting with $20,000 today, with an average stock market return of 6 percent, your investments can potentially accumulate to $115,000 in 30 years or even $205,000 in 40 years.

Saving and investing early in your career can build a buffer to correct for any sidesteps or slip-ups. Starting to build your wealth early will provide the necessary protection against market drops and economic recessions and prepare you for large purchases like a new home, college tuition, a new car or even expanding your business.

Build a Safety Net

Life can often be unpredictable in good and bad ways. Having an emergency fund is the best way to guard your wealth and maintain liquidity for your business. I typically recommend keeping 6 to 12 months of basic living expenses in your savings account.

Even though my firm does not offer insurance, I often advise my clients especially those who are sole bread earners or work in industries prone to accidents to consider getting life and disability insurance. A good insurance will guarantee a protection and supplemental income for yourself and your loved ones in case of unexpected work or life events.

Manage Your Debt

The last eight years of friendly interest environment has brought record levels of debt in almost every single category. Americans now owe more than $8.26 trillion in mortgages, $1.14 trillion in auto loans, and $747 billion in credit cards debt. If you are like me, you probably don’t like owing money to anyone.

That’s great, however, taking loans is an essential part of any enterprise. Expanding your business, building a new facility or buying a competitor will often require external financing. Keeping track of your loans and prioritizing on paying off your high-interest debt can save you and your business a lot of money. It may also boost your credit score.

Set-up a Company Retirement Plan

The US Government provides a variety of options for businesses to create retirement plans for both employees and owners. Some of the most popular ones are employer-sponsored 401k, self-employed 401k, profit-sharing, SIMPLE IRA and SEP IRA.

Having a company retirement plan is an excellent way to save money in the long run. Plan contributions could reduce current taxes and boost your employees’ loyalty and morale.

Of the many alternatives, I am a big supporter of 401(k) plans. Although they are a little more expensive to establish and run, they provide the highest contribution allowance over all other options.

The maximum employee contribution to 401(k) plans for 2017 is $18,000. The employer can match up to $36,000 for a total of $54,000. Individuals over 50 can add a catch-up contribution of $6,000. Also, 401k and other ERISA Plans offer an added benefit. They have the highest protection to creditors.

Even if you already have an up-and-running 401k plan, your job is not done. Have your plan administrator or an independent advisor regularly review your investment options.

I frequently see old 401k plans that have been ignored and forgotten since they were first established. Some of these plans often contain high-fee mutual funds that have consistently underperformed their benchmarks for many consecutive years. I typically recommend replacing some of these funds with low-fee alternatives like index funds and ETFs. Paying low fees will keep more money in your pocket.

Diversify

Many business owners hold a substantial amount of their wealth locked in their business. By doing so, they expose themselves to what we call a concentrated risk. Any economic, legal and market developments that can adversely impact your industry can also hurt your personal wealth.

The best way to protect yourself is diversification. Investing in uncorrelated assets can decrease the overall risk of your portfolio. A typical diversified portfolio may include large-, mid-, small-cap, and international stocks, real estate, gold, government, and corporate fixed income.

Plan Your Exit

Whether you are planning to transfer your business to the next generation in your family or cash it in, this can have serious tax and legal consequences. Sometimes it pays off to speak to a pro.

Partnering with someone who understands your industry and your particular needs and circumstances, can offer substantial value to your business and build a robust plan to execute your future financial strategy.

 

The article was previously published in HVACR Business Magazine on March 1, 2017

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: www.123rf.com

End of Summer Market Review

End of Summer Market Review

Happy Labor Day!

Our hearts are with the people of Texas! I wish them to remain strong and resilient against the catastrophic damages of Hurricane Harvey. As someone who experienced Sandy, I can emphasize with their struggles and hope for a swift recovery.

 

I know that this newsletter has been long past due. However, as wise people say, it is better late than never.

It has been a wild year so far. Both Main and Wall Street kept us occupied in an electrifying thriller of election meddling scandals, health reforms, political battles, tax cuts, interest rate hikes and debt ceiling fights (that one still to unfold).

Between all that, the stock market is at an all-time high. S&P 500 is up 11.7% year-to-date. Dow Jones is up 12.8%, and NASDAQ is up to the whopping 24%. GDP growth went up by 3% in the second quarter of 2017. Unemployment is at a 10-year low. 4.3%.

Moreover, despite record levels, very few Americans are feeling the joy of the market gains and feel optimistic about the future. US families are steadily sitting on the sideline and continuing to pile cash. As of June 2007, the amount of money in cash and time deposits (M2) was 70.1% of the GDP, an upward trend that has continued since the credit crisis in 2008.

End of Summer Market Review

Source: US Fed, https://fred.stlouisfed.org/graph/?g=dZn

Given that the same ratio of M2 as % of GDP is 251% in Japan, 193% in China, 91% in Germany, and 89% in the UK, US is still on the low end of the developed world. However, this is a persistent trend that can reshape the US economy for the years to come.

 

The Winners

This year’s rally was all about mega-cap and tech stocks. Among the biggest winners so far this year we have Apple (AAPL), up 42%, Amazon (AMZN), 27%, NVIDIA (NVDA), 54%, Adobe, 48%, PayPal, 55%. Netflix, 36%, and Visa (V), 33%,

Probably the biggest story out there is Amazon and its quest to disrupt the way Americans buy things. Despite years of fluctuating earnings, Amazon is still getting full support from its shareholders who believe in its long-term strategy. The recent acquisition of Whole Foods and announcement of price drops, only shows that Amazon is here to stay, and all the key retail players from Costco, Wall-Mart, Target, and Walgreens to Kroger’s, Home Depot, Blue Apron and AutoZone will have to adjust to the new reality and learn how to compete with Amazon.

The Laggards

Costco, Walgreens, and Target are bleeding from the Amazon effect as they reported- 0.49%, -0.74% and -21% year-to-date respectively. Their investors are become increasingly unresponsive to earnings surprises and massively punishing to earnings disappointments.

Starbucks, -0.74%, is still reviving itself after the departure of its long-time CEO, Howard Shultz, and will have to discover new revenue channels and jump-start its growth.

The energy giants, Chevron, -5%, Exxon, -12%, and Occidental Petroleum, -14.5% are still suffering from the low oil prices. With OPEC maintaining current production levels and surge in renewable energy, there is no light at the end of the tunnel. If these low levels continue, I will expect to see a wave of mergers and acquisitions in the sector. Those with a higher risk and yield appetite may want to look at some of the companies as they are paying a juicy dividend – Chevron, 4%, Exxon, 4%, and Occidental Petroleum, 5.4%

AT&T, -7% and Verizon, -5%, are coming out of big acquisitions, which down-the-road can potentially create new revenue channels and diversify away from the otherwise slow growing telecom business. In the near-term, they will continue to struggle in their effort to impress their investors. Currently, both companies are paying above average dividends, 5.15%, and 4.76%, respectively.

And finally, Wells Fargo, -4%. The bank is suffering from the account opening scandals last year and the departure of its CEO.  The stock has lagged its peers, which reported on average, 8% gains this year. While the long-term outlook remains positive, the short-term prospect remains uncertain.

 

Small Caps

Small Cap stocks as an asset class have not participated in this year’s market rally. Despite spectacular 2016 returns, small cap stocks have remained in the shadow of the uncertainty of the expected tax cuts and infrastructure program expansion. While I believe the Congress will come out with some tax reductions in the near term, the exact magnitude is still unclear. My long-term view of US small caps remains bullish with some near-term headwinds.

 

International Stocks

After several years of lagging behind US equity markets, international stocks are finally starting to catch up. The Eurozone reported 2% growth in GDP. MSCI EAFE is up 17.5% YTD, and MSCI Emerging Markets is up 28% YTD.

Despite the recent growth, International Developed and Emerging Market stocks remain cheap on a relative basis compared to US Stocks.  I maintain a long-term bullish view on international and EM stocks with some caution in the short-term.

Even though European Central Bank has kept the interest rates unchanged, I believe that its quantitative easing program will slow down towards the end of 2017 and beginning of 2018. The German bund rates will gradually rise above the negative levels. The EUR / USD will breach and remain above 1.20, a level not seen since 2014.

Interest Rates

I am expecting maximum one or may be even zero additional rate hikes this year. Under Janet Yellen, the Fed will continue to make extremely cautious and well-measured steps in raising short term rates and slowing down of its Quantitative Easing program. Bear in mind that the Fed has not achieved its 2% inflation target and any sharp rate hikes can ruin the already fragile balance in the fixed income space.

Real Estate

After eight years of undisrupted growth, US Real Estate has finally shown some signs of slow down. While demand for Real Estate in the primary markets like California and New York is still high, I expect to see some cooling off and normalization of year-over-year price growth

US REITs have reported 3.5% total return year-to-date, which is roughly the equivalent of -0.5% in price return and 4% in dividend yield.

Some retail REITs will continue to struggle in the near-term due to store closures and pressure from online retailers. I encourage investors to maintain a diversified REIT portfolio with a focus on strong management, sustainability of dividends and long-term growth prospects.

Gold

After several years of underperformance, Gold is making a quiet comeback. Gold was up 8% in 2016 and 14% year-to-date. Increasing market and political uncertainty and fear of inflation are driving many investors to safe havens such as gold. Traditionally, as an asset class, Gold has a minimal correlation to equities and fixed income. As such, I support a 1% to 5% exposure to Gold in a broadly diversified portfolio as a way to reduce long-term risk.

 

About the author: Stoyan Panayotov, CFA is a fee-only investment 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,

 

6 Essential steps to diversify your portfolio

6 Essential steps to diversify your portfolio

Diversification is often considered the only free lunch in investing. In one of my earlier blog posts, I talked about the practical benefits of diversification. I explained the concept of investing in uncorrelated asset classes and how it reduces the overall risk of the investments.  In this article, I will walk you through 6 essential steps to diversify your portfolio.

 

1. Know your risk tolerance

Risk tolerance is a measure of your emotional appetite to take on risk. It is the ability to endure volatility in the marketplace without making any emotional and spur of the moment investment decisions. Individual risk tolerance is often influenced by factors like age, investment experience, and various life circumstances.

Undoubtedly, your risk tolerance can change over time. Certain life events can affect your ability to bear market volatility. You should promptly reflect these changes in your portfolio risk profile as they happen.

 

2. Understand your risk capacity

Often your willingness and actual capacity to take on risk can be in conflict with each other. You may want to take more risk than you can afford. And inversely, you could be away too conservative while you need to be a bit more aggressive.

Factors like the size of savings and investment assets, investment horizon, and financial goals will determine the individual risk capacity

 

3. Set a target asset allocation

Achieving the right balance between your financial goals and risk tolerance will determine the target investment mix of your portfolio. Typically, investors with higher risk tolerance will invest in assets with a higher risk-return profile.

These asset classes often include small-cap, deep value, and emerging market stocks, high-yield bonds, REITs, commodities and various hedge fund and private equity strategies. Investors will lower risk tolerance will look for safer investments like government and corporate bonds, dividends and low volatility stocks.

In order to achieve the highest benefit from diversification, investors must allocate a portion of their portfolio to uncorrelated asset classes. These investments have a historical low dependence on each other’s returns.

The US Large Cap stocks and US Treasury Bonds are the classic examples of uncorrelated assets. Historically, they have a negative correlation of -0.21. Therefore, the pairs tend to move in opposite direction over time. US Treasuries are considered a safe haven during bear markets, while large cap stocks are the investors’ favorite during strong bull markets.

See the table below for correlation examples between various asset classes.

Asset Correlation Chart
Source: Portfoliovisualizer.com

4. Reduce your concentrated positions

There is a high chance that you already have an established investment portfolio, either in an employer-sponsored retirement plan, self-directed IRA or a brokerage account.

If you own a security that represents more than 5% of your entire portfolio, then you have a concentrated position. Regularly, individuals and families may acquire these positions through employer 401k plan matching, stock awards, stock options, inheritance, gifts or just personal investing.

The risk of having a concentrated position is that it can drag your portfolio down significantly if the investment has a bad year or the company has a broken business model. Consequently, you can lose a substantial portion of your investments and retirement savings.

Managing concentrated positions can be complicated. Often, they have restrictions on insider trading. And other times, they sit on significant capital gains that can trigger large tax dues to IRS if sold.

 

5. Rebalance regularly

Portfolio rebalancing is the process of bringing your portfolio back to the original target allocation. As your investments grow at a different rate, they will start to deviate from their original target allocation. This is very normal. Sometimes certain investments can have a long run until they become significantly overweight in your portfolio. Other times an asset class might have a bad year, lose a lot of its value and become underweight.

Adjusting to your target mix will ensure that your portfolio fits your risk tolerance, investment horizon, and financial goals. Not adjusting it may lead to increasing the overall investment risk and exposure to certain asset classes.

 

6. Focus on your long-term goals

When managing a client portfolio, I apply a balanced, disciplined, long-term approach that focuses on the client’s long-term financial goals.

Sometimes we all get tempted to invest in the newest “hot” stock or the “best” investment strategy ignoring the fact that they may not fit with our financial goals and risk tolerance.

If you are about to retire, you probably don’t want to put all your investments in a new biotech company or tech startup. While these stocks offer great potential returns, they come with an extra level of volatility that your portfolio may not bear. And so regularly, taking a risk outside of your comfort zone is a recipe for disaster. Even if you are right the first time, there is no guarantee you will be right the second time.

Keeping your portfolio well diversified will let you endure through turbulent times and help your investments grow over time by reducing the overall risk of your investments.

 

 

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: www.123rf.com

Municipal Bond Investing

Municipal Bond Investing

What is a Municipal Bond?

Municipal bond investing is a popular income choice for many American.  The muni bonds are debt securities issued by municipal authorities like States, Counties, Cities and their related companies. Municipal bonds or “munis” are issued to fund general activities or capital projects like building schools, roads, hospitals and sewer systems. The size of the muni bond market reaches $3.7 trillion dollars. There are about $350 billion dollars of Muni bond issuance available every year.

In order to encourage Americans to invest in Municipal Bonds, US authorities had exempted the interest (coupon income) of the muni bonds from Federal taxes. In some cases when the bondholders reside in the same state where the bond was issued, they can be exempted from state taxes too.

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Types of Municipal Bonds

General obligation bonds are issued by municipal entities to finance various public projects like roads, bridges, and parks. General obligation bonds are backed by the full faith and credit of the issuing municipality.  Usually, they do not have a dedicated revenue source. The local authorities commit their abundant resources to pay off the bonds. Municipals rely on their unlimited power to tax residents to pay back bondholders.

Revenue bonds are backed by income from a particular project or source. There is a wide diversity of types of revenue bonds, each with unique credit characteristics. Municipal entities frequently issue securities on behalf of other borrowers such as water and sewer service, toll bridges, non-profit colleges or hospitals. These underlying borrowers typically agree to repay the issuer, who pays the interest and principal on the securities solely from the revenue provided by the conduit borrower.

Taxable Bonds. There is a smaller but growing niche of taxable municipal bonds. These bonds exist because the federal government will not subsidize the financing of certain activities, which do not provide a significant benefit to the general public. Investor-led housing, local sports facilities, refunding of a refunded issue and borrowing to replenish a municipality’s underfunded pension plan, Build America Bonds (BABs) are types of bond issues that are federally taxable. Taxable municipals offer higher yields comparable to those of other taxable sectors, such as corporate or government agency bonds.

 

Investment and Tax Considerations

Tax Exempt Status

With their tax-exempt status, muni bonds are a powerful tool to optimize your portfolio return on an after-tax basis.

Muni Tax Adjusted Yield

So why certain investors are flocking into buying muni bonds? Let’s have an example:

An individual investor with a 35% tax rate is considering between AA-rated corporate bond offering 4% annual yield and AA-rated municipal bond offering 3% annual yield. All else equal which investment will be more financially attractive?

Since the investors pays 35% on the received interest from the corporate bonds she will pay 1.4% of the 4% yield to taxes (4% x 0.35% = 1.4%) having an effective after-tax interest of 2.6% (4% – 1.4% = 2.6%). In other words, the investor will only be able to take 2.6% of the 4% as the remaining 1.4% will go for taxes. With the muni bond at 3% and no federal taxes, the investor will be better off buying the muni bond.

Another way to make the comparison is by adjusting the muni yield by the tax rate. Here is the formula.

Muni Tax Adjusted Yield = Muni Yield / (1 – tax rate) = 4% / (1 – 0.35%) = 4.615%

The result provides the tax adjusted interest of the muni bond as if it was a regular taxable bond. In this case, the muni bond has 4.615% tax adjusted interest which is higher than the 4% offered by the corporate bond.

 Effective state tax rate

Another consideration for municipal bond investors is the state tax rate. Most in-state municipal bonds are exempt from state taxes while out-of-state bonds are taxable at state tax level. Investors from states with higher state tax rates will be interested in comparing the yields of both in and out-of-state bonds to achieve the highest after-tax net return. Since under federal tax law, taxes paid at the state level are deductible on a federal income tax return, investors should, in fact, consider their effective state tax rate instead of their actual tax rate. The formula is:

Effective state tax rate = State Income Tax rate x (1 – Federal Income Tax Rate)

Example, if an investor resides in a state with 9% state tax and has 35% federal tax rate, what is the effective tax rate:

Effective state tax rate = 9% x (1 – .35) = 5.85%

If that same investor is comparing two in- and out-of-state bonds, all else equal she is more likely to pick the bond with the highest yield on net tax bases.

AMT status

One important consideration when purchasing muni bonds is their Alternative Minimum Tax (AMT) status. Most municipal bond will be AMT-free. However, the interest from private activity bonds, which are issued to fund stadiums, hospitals, and housing projects, is included as part of the AMT calculation. If an investor is subject to AMT, the bond interest income could be taxable at a rate of 28%.

Social Security Benefits

If investors receive Medicare and Social Security benefits, their municipal bond tax-free interest could be subject to taxes. The IRS considers the muni bond interest as part of the “modified adjusted gross income” for determining how much of their Social Security benefits, if any, are taxable. For instance, if a couple earns half of their Social Security benefits plus other income, including tax-exempt muni bond interest, above $44,000 ($34,000 for single filers), up to 85% of their Social Security benefits are taxable.

 

Diversification

Muni bonds are good choice to boost diversification to the investment portfolio.  Historically they have a very low correlation with the other asset classes. Therefore,  municipal bonds returns have observed a smaller impact by developments in the broader stock and bond markets.

For example, municipal bonds’ correlation to the stock market is at 0.03%. Their correlation to the 10-year Treasury is at 0.37%.

 

Interest Rate Risk

Municipal bonds are sensitive to interest rate fluctuations. There is an inverse relationship between bond prices and interest rates. As the rate go up, muni bond prices will go down. And reversely, as the interest rates decline, the bond prices will rise. When you invest in muni bonds, you have to consider your overall interest rate sensitivity and risk tolerance.

Credit Risk

Similar to the corporate world, the municipal bonds and the bond issuers receive a credit rating by the major credit agencies like Moody’s, S&P 500 and Fitch. The credit rating shows the ability of the municipality to pay off the issued debt. The bonds receive a rating between AAA and C with AAA being the highest possible and C the lowest. BBB is the lowest investment grade rating, while all issuance under BBB are known as high-yield or “junk” bonds. The major credit agencies have different methodologies to determine the credit rating of each issuance. However, historically the ratings tend to be similar.

Unlike corporations, which can go bankrupt and disappear, municipals cannot go away. They have to continue serving their constituents. Therefore, many defaults end up with debt restructuring followed by continued debt service. Between 1970 and 2014 there were 95 municipal defaults. The vast majority of them belong to housing and health care projects.

In general, many investors consider municipal debt to be less risky. The historical default rates among municipal issuances is a lot smaller than those for comparable corporate bonds.

 

Limited secondary market

The secondary market for municipal bonds sets a lot of limitations for the individual investor. While institutional investors dominate the primary market, the secondary market for municipal bonds offers limited investment inventory and real-time pricing. Municipal bonds are less liquid than Treasury and corporate bonds. Municipal bond investing tends to be part of a buy and hold strategy as most investors look for their tax-exempt coupon.

Fragmentation

The municipal bond market is very fragmented due to issuances by different states and local authorities. MUB, the largest Municipal ETF holds 2,852 muni bonds with the highest individual bond weight at.45%. Top 5% holdings of the ETF make 1.84% of the total assets under management. For comparison, TLT, 20-year old Treasury ETF, has 32 holdings with the largest individual weight at 8.88%. Top 5% make up 38.14% of the assets under management.

 

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. Hs 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_designer491′>designer491 / 123RF Stock Photo</a>

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