4 Steps to determine your target asset allocation

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

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

Assess your risk tolerance

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

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

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

A free risk tolerance test is available here:

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

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

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

 

Set your financial goals

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

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

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

More aggressive goals will require more aggressive investment mix.

More balanced goals will call for more balanced investment portfolio.

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

Define your investment horizon

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

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

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

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

 

 Know your tax bracket

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

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

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

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

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

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

A Guide to Investing in REITs

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

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

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

What is REIT?

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

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

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

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

Legal  Status

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

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

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Distributions

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

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

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

Tax implications

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

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

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

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

Timber REITs

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

 

Economic Cycle 

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

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

Interest Rates

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

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

Loan maturities

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

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

Lease duration

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

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

Risk and return

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

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

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

REIT Performance by Sector
Source: Lazard Asset Management

 

Valuations

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

 

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

Diversification

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

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

 

Investing Strategies

Directly

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

 

ETFs

Top 5 REITs ETFs

Top 5 REITs ETFs
Source: Morningstar.com

 

VNQ

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

IYR

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

ICF

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

 

RWR / SCHH

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

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

 

Performance 

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

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

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

 

 

Mutual Funds

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

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

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

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

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

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

Performance

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

REITs Mutual Funds
Source: Morningstar.com

 

 

 

 

 

 

 

 

 

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

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

Where to allocate REITs investments?

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

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

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

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

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

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

 

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

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

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

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

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

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

www.morningstar.com

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

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

Мaximize the benefits of Roth IRA

Roth IRA is a tax-exempt investment account that allows the owner to make after-tax contributions to save for retirement.  The plan has a tax free status. All investments grow tax-free. The Roth IRA offers a lot of flexibility and few constraints.  There are numerous ways to maximize the benefits of the Roth IRA.

Learn more about our Private Client Services

Save for the future. Opening a Roth IRA account is a great way to start planning for your financial future. The plan is an excellent saving opportunity for many young professionals with limited access to workplace retirement plans. Even those with who have 401k plans with their employer can open a Roth IRA.

Flexibility. There is no age limit for contributions. Minors and retired investors can invest in Roth IRA as well.

No investment restrictions. There is no restriction on the type of investments in the account. Investors can invest in any asset class that suits their risk tolerance and financial goals.

No taxes. There are no taxes on the distributions from this account once the owner reaches the age of 59 ½. Your investments will grow tax-free. You will never pay taxes on your capital gains and dividends either. 

No penalties if you withdraw your original investment. While not always recommended, Roth IRA allows you to withdraw your original dollar contributions (but not the return from them) before reaching retirement, penalty and tax-free. Say, you invested $5,000 several years ago. And now the account has grown to $15,000. You can withdraw your initial contribution of $5,000 without penalties.

Roth IRA helps you diversify your future tax exposure. Since most retirement savings sit in 401k and investment accounts, Roth IRA adds a very flexible tax-advantaged component to your investments. Naturally, nobody can predict what will happen in several years or decades. Nobody knows how the tax laws will change by the time they need to take out money from the account. That is why I highly recommend devitrifying your mix of investment accounts and take full advantage of your Roth IRA.

Roth IRA is ideal for investors who are in a lower tax bracket but expect to jump in a higher one when they retire. Naturally, nobody can predict what will happen in several years or decades. Nobody knows how the tax laws will change by the time they need to take out money from the account. That is why I highly recommend devitrifying your mix of investment accounts and take full advantage of your Roth IRA.

No minimum distributions.  Unlike 401k plans, Roth IRA doesn’t have any minimum distributions requirements. Investors have the freedom to withdraw their savings at their wish or keep them intact indefinitely.

Roth IRA has two main restrictions. First, you can’t contribute more than what you earned for the year. If you made $4,000, you could only invest $4,000.

Second, you can only contribute up to $5,500 plus a catch-up $1,000 per year if you make $117,000 and under for 2016 tax year.

Since Roth IRA enjoys a special tax status, there are several ways to capitalize on these benefits.

1. Maximize your contribution

If you earn $117,000 or less, you can contribute up to $5,500 per year. Individuals 50 years old and above can add a catch-up contribution of $1,000.

If your aggregated gross income is between $117,000 and $131,999 you can still make contributions but with decreasing value. The chart below will help you determine how much you can add if your income falls within this range.

AGILimitCatch-UpTotal
 117,000 and under 5,500 1,000 6,500
 118,000 5,133 1,000 6,133
 119,000 4,767 1,000 5,767
 120,000 4,400 1,000 5,400
 121,000 4,033 1,000 5,033
 122,000 3,667 1,000 4,667
 123,000 3,300 1,000 4,300
 124,000 2,933 1,000 3,933
 125,000 2,567 1,000 3,567
 126,000 2,200 1,000 3,200
 127,000 1,833 1,000 2,833
 128,000 1,467 1,000 2,467
 129,000 1,100 1,000 2,100
 130,000 733 1,000 1,733
 131,000 367 1,000 1,367
 132,000 – –

2. Start early

To maximize the full potential of Roth IRA, you need to start saving early. With an average historical growth rate of 7%, your investment of $5,500 today can bring you $41,867 in 30 years completely tax-free. The cumulative effect of your return and the tax status of the account will help your investments grow faster.

Roth IRA is an excellent starting point for young professionals who just start their career. If you make under $117k, you are in your full right to invest the full amount of $5,500.

Minors who earn income can also invest in Roth IRA. While youngsters have fewer opportunities to make money, there are some that will count – babysitting, garden cleaning, child acting, modeling, selling lemonade, distributing papers, etc.

If you can only afford to save $5,500 this year, put them in Roth IRA.

3. Rollover from Traditional IRA and 401k plans

Under certain circumstances, it makes sense to rollover assets from your Traditional IRA and old 401k  accounts to Roth IRA. If you expect to earn less income or pay lower taxes in a particular year, it could be beneficial to consider Roth IRA rollover. Your rollover amount will be taxable at your current ordinary income tax level.

Another strategy is to consider annual rollovers in amounts that will keep you within your tax bracket.

4. Do a Backdoor rollover

Due to recent legal changes investors who do not satisfy the requirements for direct Roth IRA contributions, can still make investments to it. The process starts with taxable contributions, up to the annual limit, into a Traditional IRA. Eventually, the contributions are rolled from the Traditional IRA to the Roth IRA.

5. Best way to manage your Roth IRA

If the Roth IRA holds the bulk of your retirement savings, you have to maintain a diversified portfolio that is in line with your risk tolerance and financial goals.

However, due to the set contribution limits, Roth IRA accounts tend to be smaller relative to other investment accounts. In this case, you can take a more holistic approach and overweight certain assets in the Roth IRA, by maintaining your overall assets allocation within your risk tolerance level and financial targets.

How to invest 

Growth investments

The favorable tax status of the Roth IRA gives the advantage to high growth investments. Large-cap and small-cap growth and emerging market stocks are one of the most fittings investments for Roth IRA accounts. These investments have a common characteristic. They have higher than average expected future returns.

When you overweight these investments in your Roth IRA, you will avoid paying significant capital gain taxes if your investments were in the regular taxable account or high-income taxes if your investments were in a tax-deferred account like 401k.

High-yielding securities

Investments paying large distributions like high yield bonds, emerging market bonds, and REITs are also a good match for the Roth IRA. These investments generate above-average distributions taxable at the ordinary income rate. Placing them in your Roth IRA will shelter their income from taxes and let them grow tax-free.

Commodities

Commodities investments including Gold have complex taxation rules. Gold ETFs like GLD and IAU are taxed as collectibles with 28% for long-term capital gains. Commodity ETFs are taxed at the 60/40 rule, 60% long-term, 40% short term (20% max/39.6% max) regardless of holding period. Commodity ETNs are taxed at 20% max for the long-term capital gain and 39.6% for short-term gains. Having commodity investments in your Roth IRA account will let you protect their return from these complex taxation rules.

Active mutual funds

Active mutual funds have higher turnover than ETFs and index funds. Therefore they often release capital gains to their shareholders. The short-term capital gains are taxable as ordinary income plus 3.8% Medicare surcharge. While long-term gains are taxed at the lower long-term capital gain rate of 0%, 15% or 20% plus 3.8% Medicare surcharge.

When these funds sit in your Roth IRA account, they will not trigger any taxes when the management releases the gains.

What to avoid

Tax-Exempt Municipal Bonds

The interest on tax-exempt municipal bonds is free from Federal and in some cases state taxes. These instruments are most suitable for taxable accounts where investors can take advantage of the favorable tax treatment. The benefit is not available if the municipal bonds sit in a Roth IRA account.

Investors interested in Municipal bond exposure in their Roth IRA may consider taxable municipal bonds. Their distributions are taxable at the ordinary income level. Hence you will avoid paying taxes on those investments.

MLPs

Managed Limited Partnerships (MLPs) distribute at least 90% of their income to their partners. MLPs are attractive for their dividends. Also, on average 80% of the income payout is in the form of a tax-deferred return of capital. These type of distributions reduce the cost basis of the owenership and create a huge tax benefit for buy-and-hold investors. They will pay capital gain taxes on their shares only at the time of sale. However, this tax benefit will disappear if the MLP holdings sit in a Roth IRA account. They will lose their tax advantage status.

Furthermore, distributions that exceed $1,000 for each unitholder are considered unrelated business taxable income, or UBTI, and are subject to taxes even while in Roth IRA account.

Investors interested in MLPs for their Roth IRA should consider buying exchange-traded funds and mutual funds. They provide diversified exposure to MLPs and are not subject to the UBTI rule.

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

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

http://www.rothira.com/how-convert-to-a-roth-ira

Introduction to portfolio diversification

Introduction

Portfolio diversification is one of the main pillars of retirement planning. The old proverb “Never put all your eggs in one basket” applies in full strength to investing.

Even the Bible talks about diversification. Ecclesiastes 11:2 says “Divide your portion to seven, or even to eight, for you do not know what misfortune may occur on the earth.”

Wealth and asset managers use diversification as a tool to reduce overall portfolio risk. Diversification of investments with little correlation to one another allows the portfolio to grow at various stages of the economic cycle as the performance of the assets moves in different directions.

What is diversification?

According to the Securities and Exchange Commission (SEC): “The Magic of Diversification. The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.” – https://www.sec.gov/investor/pubs/assetallocation.htm

By combining low correlated and uncorrelated assets in a portfolio and being disciplined over an extended period, you aim to achieve the highest return per certain level of risk.

Diversification reduces your exposure to a single company or an asset class. As assets move up and down each year, a diversified portfolio will allow you to build a cushion for losses and avoid being dependent on one security in case it loses its value or has a rocky year.

The financial history remembers many examples of fallen stocks, such as Enron and Lehman Brothers. The employees of these companies who invested heavily in their employer’s stock without diversifying lost a significant amount of their retirement savings.

Correlated Investments

Correlated investments move in similar fashion driven by related factors. Owning two or more securities from the same industry or with similar risk profile does not contribute to your portfolio diversification. Hence, these securities will concentrate your exposure to the same market factors. 

These three pairs are an example for correlated stocks – Coca-Cola and Pepsi, Target and Costco, Verizon and AT&T. While there are some differences in their business model and historical performance, the pairs are exposed to the same economic factors, industry drivers, and consumer sentiments.

Uncorrelated Investments

The combination of uncorrelated investments decreases the overall portfolio risk

The classic example of uncorrelated investments is stocks, bonds, and gold. Historically these large asset categories have moved independently from each other.  Their returns were influenced by different events and economic drivers.

Even within the equity space alone, investors can significantly improve their portfolio diversification by looking at companies in various industries and exposure to regional and international markets.

The pair – Amazon and PG&E is a model for uncorrelated companies. Amazon is a global online marketplace that sells discretionary consumer items. Amazon business is dependent on the economic cycle and consumer spending sentiments. PG&E is a California-based utility company that provides electricity and gas to its customers. PG&E customers (being one of them) have a limited choice for service providers. Amazon competes with many large and small-size, local and foreign companies. PG&E has virtually no competition apart from renewable sources. Amazon has expansive market potential. PG&E growth is constrained to its local market. Therefore the difference between their core business models reflects on their historical price performance and risk profile. Their shares’ price depends on different factors and hence fluctuates independently.

Sharpe Ratio

Before we continue, I want to introduce a key performance metric in asset management called Sharpe Ratio. The ratio got its name from its creator the Nobel laureate William F. Sharpe.

The Sharpe ratio measures the excess return per unit of risk of an investment asset or a portfolio.  It is also known as the risk-adjusted return.

This is the formula:

Sharpe Ratio

 

 

 

Where:

Rp is the Return of your security or portfolio.

Rf is the risk-free return of a US Treasury bond

σp is the standard deviation of your portfolio. Standard deviation measures the volatility of your portfolio returns.

 

The Sharpe ratio allows performance comparison between separate portfolios and asset classes with different return and risk. As a rule of thumb, the Sharp metric penalizes portfolios with higher volatility.

Take a very simplified example; portfolio ‘A’ has 5% return and standard deviation of 10%. Portfolio ‘B’ has 6% return and standard deviation of 15%. The risk-free rate is 1%

‘A’ portfolio: Sharpe Ratio is equal to (5% – 1%)/10% = 0.4

‘B’ portfolio: Sharpe Ratio is equal to (6% – 1%)/15% = 0.33

Portfolio ‘A’ has the higher Sharpe ratio and therefore the higher risk-adjusted return. Despite its lower return, it benefited from its lower volatility.

Even though ‘B’ had a higher return, it was penalized for having a higher risk.

 

Test 1

We will continue the explanation of the benefits of diversification with an example with real securities.

We will use two ETFs – SPY which tracks the US Large Cap S&P 500 Index and IEF, which follows the performance of the 10-year US Government bond. Let’s create three portfolios – one invested 100% in SPY,  second invested 100% in IEF and third with 50%/50% split between both funds. Each portfolio starts with hypothetical $1 million. We track the performance for ten years (January 1, 2006, to December 31. 2015).

 

One key assumption is that at the end of each year we will rebalance the 50/50 portfolio back to the original target. We will sell off the excess amount over 50% for the overweight ETF, and we will buy enough shares from the underweight ETF so we can bring it back to 50%.

Results

TickerInitial BalanceFinal BalanceAverage ReturnStandard DeviationBest YearWorst YearMax. DrawdownSharpe RatioUS Market Correlation
IEF$1,000,000$1,698,8665.44%6.46%17.91%-6.59%-7.60%0.68-0.30
50/50$1,000,000$2,002,0797.19%7.11%13.11%-9.45%-20.14%0.860.87
SPY$1,000,000$2,010,1497.23%15.23%32.31%-36.81%-50.80%0.471.00

Diversification2_1

 

 

 

 

 

 

 

 

 

 

The 100% SPY portfolio has the highest return of 7.23% and best overall final balance ($2.01m). The SPY portfolio has the largest gain in a single year, 32.3% but also the biggest yearly loss of -36.8%. It also has the highest measure of risk. Its standard deviation is 15.2%.  Its risk-adjusted return (Sharpe ratio) has the lowest value of 0.47.

IEF has the lowest return of the three portfolios, 5.44% but also has the “best” worst year, -6.6% and the lowest risk, 6.5%. Sharpe ratio is 0.68, higher than that of SPY.

The  50/50 portfolio has an average return of 7.19%, only 0.03% less than SPY alone. It has a standard deviation of 7.1%, only 0.65% higher than that of the 100% EIF. its market correlation is 0.87. Most importantly, the 50/50 portfolio has the highest risk-adjusted return, equal to 0.86.

The 50/50 portfolio illustrates the benefits of diversification. It provides almost the same return as the 100% large-cap portfolio with much lower risk and better returns consistency.

Test 2

In the second example, we will introduce two more portfolios.

Portfolio #4 holds 100% GLD. GLD is the largest and most liquid  ETF in the gold market.

In portfolio #5, we will split SPY and IEF into 45% each and will add 10% in Gold ETF. Same rules apply. Once a year we rebalance the portfolio to the original target allocation 45/45/10.

Results

TickerInitial BalanceFinal BalanceAverage ReturnStandard DevitionBest YearWorst YearMax. DrawdownSharpe RatioUS Market Correlation
IEF$1,000,000$1,698,8665.44%6.46%17.91%-6.59%-7.60%0.68-0.30
50/50$1,000,000$2,002,0797.19%7.11%13.11%-9.45%-20.14%0.860.87
SPY$1,000,000$2,010,1497.23%15.23%32.31%-36.81%-50.80%0.471.00
GLD$1,000,000$1,967,0417.00%19.20%30.45%-28.33%-42.91%0.390.07
45/45/10$1,000,000$2,028,2387.33%7.05%13.92%-8.01%-16.75%0.880.81

 

Diversification4

 

 

 

 

 

 

 

 

 

 

 

The GLD portfolio has the highest volatility. Its standard deviation is 19.20%. It has the lowest risk-adjusted return of 0.39 and a second lowest return of 7%.

Let’s look at our fifth portfolio – 45% SPY, 45% IEF and 10% GLD. The new portfolio has the highest return of 7.33%, the highest final balance of $2.28m, second lowest standard deviation of 7.05% and the highest risk-adjusted return of 0.88. It also has a lower correlation to the US market, 0.81.

Recap

Portfolio #5 is the clear winner of this contest. Why? We build a portfolio of uncorrelated assets, in this case, gold, 10-year Treasury, and large-cap stocks. Subsequently, we not only received an above average annual return, but we also achieved it by decreasing the risk and minimizing the volatility of our portfolio.

These hypothetical examples illustrate the benefits of diversification. Among them are portfolio risk mitigation, reduced volatility, higher risk-adjusted return, and more efficient capital preservation.

 

Asset correlation

So how do you determine the relationship between assets? Any financial software can provide you with this data.

If you are good at math and statistics, you can do parallel performance series for your securities and find the correlation between them.

There are a couple of free online tools, which you can use as well.

Beta

One easy way to get a sense of the correlation of your securities to the general stock market is Beta. Most financial websites like Google Finance and Yahoo Finance will give you this metric. Beta shows you the stock volatility compared to S&P 500. That said, the beta of S&P 500 is always 1. So for instance, if the beta of your stock is 2, you should expect twice as much volatility of your stock as compared to S&P 500. If the beta is 0.5, you would expect half of the volatility. If the beta is -0.5, then your stock and S&P will be negatively correlated. When one goes up, the other one will go down.

A quick search in Good Finance brought me these results for the securities we discussed earlier.

Beta for IEF is -0.20, SPY is 1, GLD is 0.07, Coca Cola, 0.51, Pepsi, 0.44, Target, 0.63, Costco, 0.55, Verizon, 0.22, AT&T, 0.29, Amazon, 1.1 and PG&E, 0.17,

Few other companies and ETFs of interest are: TLT, 20-year T-bond Index, -0.59, VNQ, REIT Index, 0.81, VYM, Vanguard High Dividend ETF, 0.81, USMV, iShares Low Volatility ETF, 0.68,  Google, 1.03, Facebook, 0.76, Wal-Mart, 0.19, Starbucks, 0.80, McDonalds, 0.51. Walt Disney, 1.32, Bank of America, 1.74.

The beta of the stocks can vary depending on market conditions, economic and business cycles. I recommend using in combination with other metrics like standard deviation, R-square, and Sharpe Ratio. This approach will help you gauge the expected volatility of your stock.

How many assets should you ideally keep in your portfolio?

Some theories call for 7-10 broad asset classes. This method is ideal for smaller-size portfolios. It will help control trading and rebalancing costs.

Other theories call for 20-25 asset classes. This approach is best suitable for large-size portfolios with more complex structure.

A regular portfolio should include these three groups with their subclasses.

Equity includes Large Cap, Mid Cap, Small Cap, Micro Cap, International Developed and Emerging Markets. In addition to that, you can add growth, value, dividend, low volatility, and momentum strategies.

Fixed Income includes US Treasuries, Municipal Bonds,  Investment Grade Corporate Bonds, High Yield, Preferred Stock, International, and Emerging Market Bonds

Alternative Investments include Real Estate, Precious Metals, Commodities, Infrastructure, Private Equity, Hedge Funds.

 

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

 

 

 

How to build your 401k plan

How to build your 401k plan

401k plans are a powerful savings tool for retirement

With total assets reaching $4.8 trillion dollars 401k plans are the most popular retirement vehicle and are increasingly used by employers to recruit and retain key talent.  401k accounts allow employees to build their retirement savings by investing a portion of their salary. Contributions to the plan are tax-deductible, thus reducing your taxable income,  and the money allocated grows tax-free. Taxes are due upon withdrawal of funds during retirement years. In this article, I will discuss how to build your 401k plan.

Does your employer offer a 401k plan?

If you recently joined a new company, find out whether they offer a 401k plan. Some employers offer automatic enrollment, and others require individual registration.

Many companies offer a matching contribution up to a set dollar amount or percentage.

Contributions are usually deducted from each paycheck, but employees can also opt to contribute a lump sum.  The 2016 limit is $18,000 plus a $6,000 “catch-up” contribution for people age 50 and above.

How to decide on your investment choices

Employers must provide ongoing education and training materials about retirement savings plans.

401k plans can offer anywhere between 5 and 20 different mutual funds which invest in various asset classes and strategies.  Your choice will be limited to the funds in your plan. Hence you can not invest in stocks or other financial instruments.

The fundamental goal is to build a diversified and disciplined portfolio with your investment choices. Markets will go up and down, but your diversified portfolio will moderate your risk in times of market turmoil.

Index Funds

Index Funds are passively managed mutual funds. They track a particular index by mirroring its performance. The index funds hold the same proportion of underlying stocks as the index they follow. Many indexes are tracking large-cap, mid-cap, small-cap, international and bond indices. One of the most popular categories is the S&P 500 Index funds.

Due to their passive nature index funds are usually offered at a lower cost compared to actively managed funds. They provide broad diversification with low portfolio turnover. Index funds do not actively trade in and out of their positions and only replace stocks when their benchmark changes. Index funds are easy to buy, sell and rebalance.

Actively Managed Mutual Funds

Actively managed mutual funds are the complete opposite of index funds. A management team usually runs each fund. The mutual funds have a designated benchmark, such as the S & P 500, Russell 2000,  and MSI World. Often the management team aims to beat the benchmark either by a greater absolute or risk-adjusted return. Overall active funds trade more often than index funds. Their portfolio turnover (frequency of trading) is bigger because managers take an active approach and invest in companies or bonds with the goal of beating their benchmark.

There is a broad range of funds with different strategies and asset classes. Some funds trade more actively than others. Even funds that follow the same benchmark can gravitate towards a particular sector, country or niche. For instance, a total bond fund might be more concentrated into government bonds, while another fund may invest heavily in corporate bonds.

Active funds charge higher fees than comparable index funds. These fees cover salaries, management, administrative, research, marketing, and trading costs. Funds investing in niche markets like small-cap and emerging market will have higher costs. Fees are also dependent on the size of the fund and its turnover strategy.

It’s critical to do at least a basic research before you decide which fund to purchase. Morningstar.com is a great website for mutual fund information and stats.

Target Retirement funds

These are mutual funds that invest your retirement assets according to a target allocation based on your expected year of retirement. The further away you are from retirement, the more your target fund asset allocation will lean toward equity investments. As you get closer to retirement, the portion of equity will go down and will be replaced by fixed income investments. The reason behind target retirement funds is to maintain a disciplined investment approach over time without being impacted by market trends.

One significant drawback of the retirement funds is that they assume your risk tolerance is based on your age. If you are a risk taker or risk averse, these funds may not represent your actual financial goals and willingness to take the risk.

In addition to that, investors also need to consider how target retirement funds fit within their overall investment portfolio in both taxable and tax-advantaged accounts.

Most large fund managers offer target retirement funds. However, there are some large differences between fund families. Some of the discrepancies come from the choice of active versus passive investment strategies and fees.

Without endorsing any of the two providers below I will illustrate some of the fundamental differences between Vanguard and T. Rowe Price Target Retirement funds.

Vanguard Target Retirement funds

Vanguard Target Retirement funds offer low-cost retirement fund at an expense ratio of 0.15%. All funds allocate holdings into five passively managed broadly diversified Vanguard index fund.

Vanguard Target Retirement2015202520352045
Total Stock Market Index28.4439.8648.7554.07
Total Intl Stock Index19.0126.5632.4535.9
Total Bond Market II Index30.3223.6613.237.05
Total Intl Bond Index13.379.925.572.98
Short-Term Infl-Protected Sec Index8.86
% Assets100.00100.00100.00100.00
By asset class
Equity47.4566.4281.289.97
Fixed Income52.5533.5818.810.03

T. Rowe Target Retirement funds

On the other spectrum are T. Rowe retirement funds. Their funds have a higher expense ratio. They charge between 0.65% and 0.75%. All target funds invest in active T. Rowe mutual funds in 18 different categories. T. Rowe target funds are a bit more aggressive. They have a higher allocation to equity and offer a wider range of investment strategies.

T. Rowe Target Retirement Fund2015202520352045
New Income24.3817.3410.646.74
Equity Index 50022.1514.859.317.41
Ltd Dur Infl Focus Bd11.013.530.540.53
International Gr & Inc5.046.687.858.35
Overseas Stock5.016.647.828.3
International Stock4.425.786.87.26
Emerging Markets Bond3.552.471.431.01
Growth Stock3.4311.7417.8420.26
International Bond3.422.441.510.98
High Yield3.262.321.420.91
Value3.111.3117.3619.75
Emerging Markets Stock2.883.874.494.71
Real Assets2.12.783.283.5
Mid-Cap Value1.852.462.953.12
Mid-Cap Growth1.782.352.732.9
Small-Cap Value0.931.231.481.55
Small-Cap Stock0.881.151.411.53
New Horizons0.720.941.11.12
% Assets100100100100
By Asset Class
Equity54.2971.7884.4289.76
Fixed Income45.6228.115.5410.17

Which approach is better? There is no distinctive winner. It depends on your risk tolerance.

Vanguard funds have lower expense ratio and a lower 10-year return. However, they have a lower risk.

T. Rowe funds have higher absolute and risk-adjusted return but also carry more risk.

10-year Performance Analysis, 2045 Target Retirement Fund

 Standard10-yearSharpe
FundNameDeviationReturn Ratio
VTIVXVanguard Target 204514.655.480.36
TRRKXT. Rowe Target 204515.825.890.38

 *** Data provided by Morningstar

Most 401k plans will offer only one family of target funds, so you don’t have to decide between Vanguard, T. Rowe or another manager. You will have to decide whether to invest in any of them at all or put your money in the index or active funds. For further information, check out our dedicated article on target date funds

ETFs

ETFs are a great alternative to index and active mutual funds. They are liquid and actively trade on the exchange throughout the day.

As of now, very few plans offer ETFs. One of the main concerns for adding them to retirement plans is the timeliness of trade execution. Right now this problem is shifted to the fund managers who only issue end of day price once all trades are complete.

I expect that ETFs will become a more common choice as they grow in popularity and liquidity. Many small and mid-size companies that look for low-cost solutions can use them for them as an alternative to their for their workplace retirement plans.

Company stock

Many companies offer their stock as a matching contribution or profit sharing incentive in their employee 401k plan. Doing so aligns employees’ objectives with the company’s success.  While this may have positive intentions, current or former employees run the risk of having a large concentrated position in their portfolios.  Even if your company has a record of high returns, holding significant amounts of company stock creates substantial financial risk during periods of crisis because one is both employee and shareholder.  Enron and Lehman Brothers are great examples of this danger.  Being overinvested in your company shares can lead to simultaneous unemployment and depletion of retirement savings if the business fails.

Allocation mix

You will most likely have a choice between a family of target retirement funds and a group of large-cap, mid-cap, small-cap, international developed, emerging markets stocks, a REIT, US government, corporate, high yield and international bond funds.

Your final selection should reflect your risk tolerance and financial goals. You should consider your age, family size, years to retirement, risk sensitivity, total wealth, saving and spending habits, significant future spending and so on.

You can use the table below as a high-level guidance.

401k asset allocation mix

Data source: Ibbotson Associates, 2016, (1926-2015). Past performance is no guarantee of future results. Returns include the reinvestment of dividends and other earnings. This chart is for illustrative purposes only. It is not possible to invest directly in an index. For information on the indexes used to construct this table, see footnote 1. The purpose of the target asset mixes is to show how target asset mixes may be created with different risk and return characteristics to help meet an investor’s goals. You should choose your investments based on your particular objectives and situation. Be sure to review your decisions periodically to make sure they are still consistent with your goals.
Source: https://www.fidelity.com/viewpoints/retirement/ira-portfolio?ccsource=email_monthly

Final recommendations

Here are some finals ideas how to make the best out of your 401k savings:

  • At a minimum, you should set aside enough money in your 401k plan to take advantage of your employer’s matching contribution. It’s free money after all. However, the vesting usually comes with certain conditions. So definitely pay attention to these rules. They can be tricky.
  • 2016 maximum contribution to 401k is $18,000 plus $6,000 for individuals over 50. If you can afford to set aside this amount, you will maximize the full potential of retirement savings.
  • If your 401k plan is your only retirement saving, you need to have a broad diversification of your assets. Invest in a target retirement fund or mix of individual mutual funds to avoid concentration of your investments in one asset class or security.
  • If your 401k plan is one of many retirement saving options – taxable account, real estate, saving accounts, annuity, Roth IRA, SEP-IRA, Rollover IRA or a prior employer’s 401k plan, you will need to have a holistic view of your assets in order to achieve a comprehensive and tax optimized asset allocation.
  • Beware of hidden trading costs in your plan choices. Most no-load mutual funds will charge anywhere between 0.15% and 1.5% to manage your money. This fee will cover their management, administrative, research and trading costs. Some funds also charge upfront and backload fees. As you invest in those funds your purchase cost will be higher compared to no-load funds.
  • If you hold large concentrated positions of your current or former employer’s stock, you need to mitigate your risk by diversifying the remainder of your portfolio.

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

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

About the author:

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

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

A beginner’s guide to ETFs

Guide to ETFs

A beginner’s guide to ETFs. The ETF industry was born as a result of the market crash in October 1987. The initial goal behind ETFs was to provide liquidity and mitigate volatility for market participants. Over the last 20 years, ETFs became a favorite investment vehicle for individual investors and asset managers. Today, globally there are 6,870 ETF products on 60 exchanges and over $3 trillion of assets under management.

ETF stands for an exchange-traded fund. ETF is a passively managed marketable security that tracks an index, a commodity, or pool of bonds. ETFs trade on the stock exchange and their price fluctuates throughout the day.

The media and investors often compare ETFs with mutual funds.  In contrast with ETFs, the mutual fund managers actively look for securities in an attempt to beat their designated benchmark.

ETFs typically have higher daily liquidity and lower fees than most mutual funds.  This makes them an attractive alternative for individual investors.

By design, ETFs do not produce positive alpha. Alpha is the difference between the fund and the benchmark performance.  ETFs strictly follow their index, and as a result, their alpha is always zero.

ETFs popularity spiked in the past five years due to the rise of robo-advisers and lowering management fees. At the same time, many emblematic active managers underperformed their benchmarks and saw significant fund outflows.

To illustrate this, in 2015 Morningstar reported a $206.7 billion outflow from active funds and a $412.8 billion inflow in passive strategies.

 

Underlying Index

There are significant variations in the index composition between indices tracking the same asset class.  The ETFs structure and performance reflect these differences.

In the small-cap space, for example, IJR tracks the S&P 600 Small-Cap index, and IWM follows Russell 2000 Small Cap index. As the name suggests, the S&P index has 600 constituents, while Russell index has 2,000 members. While there are many similarities and overlaps between the two, there are also significant variations in their returns, risk and sector exposure.

In the Emerging market space, indices provided by MSCI include South Korea in their list of emerging market countries. At the same time, indices run by FTSE exclude South Korea and have it in their developed country list.

Investors seeking to manage their exposure to a particular asset class through ETFs need to consider the index differences and suitability against their overall portfolio.

 Fees

The fees are the cost associated with managing the fund – transaction cost, exchange fees, administrative, legal and accounting expenses. They are subtracted from the fund performance. The costs are reported in the fund prospectus as an expense ratio. They can be as low as 0.08% and as high as 2% and more. The percentage represents the total amount of management fees over the value of assets under management.

Consider two ETFs that follow the same index.  All else equal the ETF with the lower fee will always outperform the ETF with the higher one.

Liquidity

The ETF liquidity is critical in volatile markets and flash-sales when investors want to exit their position.

Asset under management, daily volume, and bid/ask spread drive the ETF liquidity. Larger funds offer better liquidity and lower spread.

The liquidity and the spread will impact the cost to buy or sell the fund. The spread will determine the premium you will pay to buy the ETFs on the stocks exchange. The discount is what you will need to give up to sell the ETFs. The lower the spread, the smaller difference between purchase and sale price will be. Funds with less spread will have lower exit costs.

ETF varieties

Exchange Traded Notes are an offshoot of the ETFs products. ETNs are structured debt instruments that promise to pay the return on the tracking assets. This structure is very popular for Oil, Commodity and Volatility trading. They offer flexibility and easy access for investors to trade in and out of the products.

I believe that long-term investors should avoid Exchange Traded Notes (ETNs), volatility (VIX) ETFs, inverse and leveraged (2x and 3x Index) ETFs and ETNs products. While increasing in popularity and liquidity, they are not appropriate for long-term investing and retirement planning. These types of funds are more suitable for daily and short-term trading. They incur a higher cost and have higher risk profile.

Smart Beta ETFs are also increasing in popularity. While the name was given for marketing purposes, this particular breed of ETFs uses a single or multi-factor approach to select securities from a pre-defined pool – S&P 500, Russell 2000, MSCI world index or others.

The Single Factor ETFs like Low Volatility or High Dividend are strictly focusing on one particular characteristic. They offer a low-cost alternative to investing in a portfolio of income generating or less volatile stocks.

The multi-factor ETFs are a hybrid of active management and ETFs. ETF providers have established an in-house index that will follow the rules of their multi-factor model. The model will select securities from an index following specific parameters with the intention of outperforming the index. The ETF will buy only the securities provided by the model. The multi-factor ETFs are competing directly with the actively managed mutual funds, which are using similar techniques to select securities. Their advantage is the lower cost and easy entry point.

Will smart beta ETFs succeed? Only time will tell. For now, we don’t have enough historical data to confirm their ability to outperform their index consistently.

Currency Hedged International ETFs is another newcomer in the ETF space. Their goal is to track a foreign equity index by neutralizing the currency exposure. They can be attractive to investors with interest in international markets who are concerned about their FX risk.  Some of the more popular ETFs in this category include HEDJ, which tracks Europe developed markets, and DXJ, which follows Japan exporting companies.

Where to place ETFs?

ETFs are a great alternative to all investment accounts.

Due to their passive management, low turnover and tax-advantaged structure ETFs are a great option for taxable and brokerage accounts.

For now, ETFs have not made their way to corporate 401k plans, where mutual funds are still dominating. I am expecting this to change as more small and mid-size companies are looking for low-cost solutions for their workplace retirement plans.

Tax-sensitive investors, however, need to consider all circumstances before adding ETF holdings to their portfolio. The ETF tax treatment follows the tax treatment of their underlying assets. Qualified dividends paid by your ETF will trigger a favorable rate of 0%, 15% or 20%. The interest from bond ETFs and dividends from REITs are taxed at the ordinary tax income rate of up to 39.6%.

Higher-yielding ETFs like those tracking REITs, High Yield, and Emerging Markets Bonds are suitable for the tax-advantaged accounts like 401k, IRA and Roth IRA where their income will be sheltered from taxes.

Equity Growth, Municipal, and MLP ETFs have favorable tax treatment, which makes them a great fit for taxable investment accounts.

 

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 the 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.
Resources:
Great Bloomberg article about the history of ETFs:
http://www.bloomberg.com/features/2016-etf-files/
2015 Morningstar Direct U.S. Asset Flows:
http://corporate.morningstar.com/US/documents/AssetFlows/AssetFlowsJan2016.pdf