A Bond Primer

We have been adding individual bonds and CDs across many accounts since December, as we looked to reduce our equity exposure and take advantage of higher yields now available in short-term, investment grade fixed income. When you are an owner of individual bonds, you are likely to encounter some terminology that may be new, even if you’ve been investing in bond funds for many years. Here are some important things to know:

Bonds are generally priced in $1,000 increments. One bond will mature at $1,000. However, instead of quoting bond prices in actual dollars, we basically use percentages. A bond priced at 100 (note, no dollar sign or percentage symbol is used) would cost $1,000. 100 is called its Par value. If you are buying newly issued bonds, they are generally issued at Par (100). This is called the Primary Market – where issuers directly sell their bonds to the public. We also buy bonds in the Secondary Market, which is where bond desks trade existing bonds between each other. 

In the Secondary Market, bond prices are set by market participants. A bond priced at 98.50 would cost $985, and would be said to be at a discount to Par. A bond priced at 102 would cost $1,020, called a premium. As interest rates rise, the value of existing (lower yielding bonds) will fall. There is an inverse relationship between price and interest rates – when one rises, the other falls.

Bonds have a set Maturity date. That is when the issuer will return the $1,000 they borrowed from the bondholder and cancel the debt. Some bonds are also Callable, which means that the issuer has the right to buy the bond back before its maturity date. This benefits the company, but not the bondholder, because when interest rates are low, companies can refinance their debt to a lower rate.

Most bonds pay interest semi-annually (twice a year). We call this the Coupon. A bond with a 4% coupon would pay $20 in interest, twice a year. If the bond is priced exactly at Par, then the coupon is the same as the effective yield. However, if the bond is priced differently, we are more interested in its Yield to Maturity, commonly listed as YTM. This is very helpful for comparing bonds with different coupons. 

Most bonds pay a fixed coupon, although some pay a step coupon, which rises over time, and others are floating, tied to an interest rate index, or inflation. When we purchase a bond between interest payments, the buyer will receive all of the next payment, so the buyer will also pay the seller Accrued Interest, which is the interest they have earned calculated to the day of sale.

For bonds which are callable, we also have the Yield to Call (YTC), which measures what your yield would be if the bond is called early. Generally, if we are buying a bond at a discount, Yield to Call is attractive. If we buy at 96 and they redeem at 100, that’s a good thing. But if we buy a bond at a premium, we need to carefully examine if or when it might be callable. Yield to Worst (YTW) will show the worst possible return, whether that is to maturity or to a specific call date. 

Some bonds do not pay a coupon and are called Zero Coupon Bonds. Instead, they are issued at a discount and grow to 100 at maturity. Treasury Bills are the most common type of zero coupon bonds. US Government Bonds include Treasury Bills (under one year), Treasury Notes (1 to 10 years), and Treasury Bonds (10 to 30 years). There also are Treasury Inflation Protected Securities (TIPS), which are tied to the Consumer Price Index, and Agency Bonds, which are issued by government sponsored entities, such as Fannie Mae or Freddie Mac.

In addition to Government Bonds, we also buy Corporate Bonds – those issued by public and private companies, Municipal Bonds issued by state and local governments, including school districts, and Certificates of Deposit (CDs) from Banks. 

Most Municipal Bonds are tax exempt, at the Federal and possibly at the state level. If you live in New York, any Municipal Bond would be tax-free at the Federal Level, but only NY bonds would be tax-free for NY state income tax. In states with no income tax, such as Texas, a tax-exempt bond from any state will be tax-free for Federal Income Tax purposes. 

To make their bonds more attractive, some municipal bonds are Insured, which means that if they were to default, a private insurance company would make investors whole. Those municipal insurers got in trouble in the previous financial crisis, and some are still weak today. My preferred insurer is Assured Guaranty (AGMC).

Please note that some Municipal Bonds are taxable; we sometimes buy these for retirement accounts. In addition to the types of bonds we’ve discussed, there are thousands of bonds issued outside of the US, in other currencies, but we do not purchase those bonds directly. 

There are several agencies that provide credit ratings to assess the financial strength of the issuer. Standard and Poor’s highest rating is AAA, followed by AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-. These are considered all Investment Grade. Below this level, from BB+ to C are below Investment Grade, often called High Yield or Junk Bonds. D means a bond has Defaulted. Moody’s ratings scale is slightly different: Aaa is the highest, followed by Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, and Baa3 for Investment Grade. Junk Bonds include Ba(1,2,3), B(1,2,3), Caa(1,2,3), Ca, and C.

There are about 5,000 stocks issued in the US, but there are probably over a million individual bonds issued, each one identified by a unique CUSIP number. Every week, there are bonds which mature and new ones which are issued. 

Our approach for individual bonds is to buy only investment grade bonds, and ladder them from one to five years with diversified issuers. We also sometimes invest in other types of bonds, such as floating rate bonds, mortgage backed securities, emerging markets debt, or high yield. For those categories, we will use a fund or ETF because it’s more important to diversify very broadly with lower credit quality.  

Bonds for Safety in 2019

2018 saw rising interest rates, which hurt the prices of bonds. Most bond funds were flat to slightly down for the year. Rising interest rates also means higher yields, and we now see sufficient yields to justify buying short-term bonds. We have been reducing our equity exposure over the last few weeks, and have been using those proceeds to buy individual investment grade short-term bonds and Exchange Traded Funds (ETFs). 

I wanted to share a couple of themes which will guide our investment process for fixed income in the year ahead. In general, this is not a great time to be taking a lot of risk with your bond allocation. We want to use bonds to offset the risk of stocks to dampen overall portfolio volatility. Thankfully, bonds can now also make a positive contribution to your return albeit in a very modest 2-4% range, and with low or very low risk.

1. Credit doesn’t pay. A credit spread measures the difference in yield between a high quality bond, such as a US Treasury bond, versus say a bond issued by a company which has lower credit. That spread remains very tight today, meaning that you are not getting much additional yield for accepting the credit risk of a lower quality issuer.

This has led us to be selective about which corporate bonds we buy, only buying issues which have enough spread to justify their purchase. In today’s market, this primarily leads us to financial companies, especially the large banks, and to municipal bonds, including the rarely-discussed taxable municipal bonds which are a good choice for IRAs or other non-taxable accounts.

Both Treasury and US Government Agency bonds still have lower yields than CDs. This month, we bought some one-year CDs at 2.70% to 2.75% while the one-year Treasury was around 2.50%. That spread widens as we look to two and three year maturities.

I should explain that we offer “Brokerage CDs”, which are a little different than your typical bank CDs. Brokerage CDs are FDIC-insured against loss and we can shop for the best rates available, from both top banks like Wells Fargo or JP Morgan Chase and from smaller local banks who want to compete for the best yield. 

While you can typically redeem a bank CD early, albeit with an interest penalty of a few months, with a Brokerage CD, you would have to sell the CD in the bond market. If interest rates continue to rise, you would likely have to sell at less than full value. While these CDs offer the excellent rates, they are best used when you can hold to maturity.

We use CD rates as the basis of our spread comparison, rather than the traditional Treasury bonds. If we can’t find an improvement of at least 0.35% to 0.50% for an A-rated bond, then it’s not worth taking even the small risk over the CD. We will still use Treasury Bills for maturities of 6 months or less.

2. 5-year Ladder. In larger accounts, our goal is to create a ladder of bonds and CDs that mature over the following five years (2019, 2020, 2021, 2022, and 2023). This gives us a nice diversification of maturities while still maintaining a low overall duration. When the 2019 bonds mature, we purchase 2024 bonds to maintain a 5-year structure. In a rising rate environment, we are likely to be able buy new bonds at a higher rate. 

Besides being a sensible way to build a bond portfolio, a ladder also can be used to meet future needs for withdrawals or Required Minimum Distributions. Then instead of needing to sell equities or bond funds which could be down, we have a bond that is maturing to meet those cash needs. As a result, an investor might not need to touch their equities for the next five years. If or when their equities do grow, we can rebalance by selling stocks and buying new bonds at the top of the ladder.

While bond prices may go down if interest rates continue to rise in 2019, when you have an individual bond or CD, you know that it will mature at its full face value. So even if prices fluctuate, you will realize your stated Yield to Maturity when you do hold to maturity, which should be very possible with a 5-year ladder.

(Two notes: 1. While we can say that CDs and Treasury Bonds are guaranteed, other types of bonds do have some risk of default and cannot be described as guaranteed. 2. Investors who try to predict interest rates have as little success as investors who try to predict stock markets. We do not want to make bets on the direction of interest rates.)

3. Fixed Annuities. Annuities get a bad rap, but a Fixed Annuity is a third type of guaranteed fixed income investment. They deserve a closer look by investors as a bond substitute and work well with a 5-year laddered approach.

The current rate for a 5-year fixed annuity is 3.80% from one carrier I use. That compares to a 5-year CD at 3.35% to 3.60%. That’s not much of an improvement, however, the Fixed Annuity is an insurance product outside of our managed portfolio, so there are no investment management fees. Your net return is 3.80%. The insurance company will pay me a small commission directly, which does not impact your principal or your rate of return.

I think laddering fixed annuities can make sense for some, as a bond replacement, and more investors should learn about this before dismissing it as soon as they hear the word annuity. A 3.80% percent return on an annuity would be the equivalent of a 4.80% bond if you include a 1% annual management fee.

We wrote about doing a 5-year ladder of Fixed Annuities back in February 2016 in this blog, and I think it still makes sense for some investors. We would count this as part of your fixed income target for your overall portfolio allocation (60/40, etc.).

The stock market gets a lot of attention, but we don’t neglect fixed income in our portfolios. I do think there are benefits to managing your bond portfolio, and we spend as much time sweating the details of our fixed income selections as we do our stock market exposures.

The Persistence Scorecard

As investors begin reviewing their year-end 2018 statements for their 401(k) and other accounts, I know many will want to change funds after a disappointing year. What do investors do? If they have 15 funds available in their plan, they will often sell out of their lagging fund and put money into whichever funds are performing best.

It seems rational enough to believe that a fund manager who is doing well might have above average skills, work harder, or have a better team than other fund managers. That’s why many investors switch funds – in the assumption that an excellent track record is evidence that strong performance will continue. 

You should care about your funds and their managers. But the reality is that switching funds for better performance is not a slam dunk. In December, Standard and Poor’s released their semi-annual Persistence Scorecard. I hope you will read this report. It may change how you invest, how you select funds, and the reasons why you would switch from one fund to another.

In the Scorecard, S&P analyzes returns of over 2,000 US mutual funds, to determine whether high performing funds continue to have strong performance. They evaluate funds by quartile, with data through September 30, 2018. The top 25% of funds would be called first quartile and the worst 25% of funds would be the fourth quartile.

When you buy a fund in the top quartile, what is the likelihood that it will stay a top performer? Let’s go back to September 2016 and track the 550 domestic equity funds that were in the top 25% for the preceding one-year period. Only 21.09% of the top quartile funds stayed in the top quartile in the next year, ending September 2017. And only 7.09% of the 2016 top quartile funds managed to stay in the top quartile for both 2017 and 2018. Of the funds in the top 25% in 2016, only one in thirteen would stay in the top quarter for the next two years.

When you buy this year’s top funds, it is very unlikely that those funds will continue to be the best performers in the subsequent years. Even though we have all heard that “past performance is no guarantee of future results”, everyone still wants to buy the 5-Star fund, even though all that rating tells us is the fund’s most recent performance!

Perhaps you knew better than to put much weight on one year performance. Still, wouldn’t a good manager be able to create a nice long-term track record? The Scorecard also looks at three and five-year returns.

Let’s consider the five-year data:

We will go back to September 2013 and track the 497 funds which were in the top quartile for five-year performance. How did they do over they following five years, through September 2018?

Only 27.16% would stay in the top quartile for another five years. 21.73% would fall to the second quartile, 20.32% would fall to the third quartile, and 21.13% would end up in the bottom quartile. Additionally, 9.46% of the top funds in 2013 would not even exist five years later. Fund companies merge or liquidate their worst performing funds to make their track records disappear. That’s right, when you go on Morningstar and look up funds, what you see is the result of Survivorship Bias. The record has been cleansed of the worst offenders and you only see the survivors. Thankfully, S&P keeps all data and includes deleted funds in its study.

To me this is another reason to use index funds rather than active managers. There is little evidence that when you pick a top performing manager that he or she will persist as a top performer. In fact, there is about only a one-in-four chance a top fund will remain in the top quartile. That’s pretty much a roll of the dice. Switching from one active manager who is underperforming to another active manager who was recently outperforming is very unlikely to be a successful strategy.

Instead of focusing on manager selection and risk chasing performance, we take a more structured approach:

1. Start with the overall asset allocation. Your weighting of stocks and bonds (60/40, 70/30, 50/50, etc.) is the largest determinant of your portfolio risk and return in the long run.

2. Determine how much you want in each category, such as US Large Cap, US Small Cap, US Value, International, Emerging Markets, etc. We base this on correlation, risk and return profiles, and diversification benefits. Then, we adjust the weightings towards categories which we feel are presently undervalued relative to the others.

3. Choose funds which closely reflect those categories. If you are buying a mid-cap fund, it should act like a mid-cap fund. 

4. Expenses matter. According to research from Morningstar: “the expense ratio is the most proven predictor of future fund returns.” We prefer funds with low expenses so you can keep more of the performance you are buying.

5. While we could use actively managed funds, we like the track record of index ETFs, along with their low cost, tax efficiency, and transparency. They are great building blocks for a portfolio.

Being diversified means owning a broad basket of holdings. This can be frustrating sometimes, wondering why you own A instead of B, when A is down this year and B is up. But putting all your money into whichever category or fund is doing best at any one point in time is not an effective strategy. That’s not just my opinion – look at the data from Standard and Poor’s Persistence Scorecard and I think you will reach the same conclusion. Bet on the market, not the manager.

Storm Clouds Gathering

Being an investor requires the humility to acknowledge that no one has a crystal ball and we cannot control the future. I find it best to ignore predictions and forecasts and to tune out day to day news, especially from “experts”. It’s just noise that distracts us from our process. There are always Bulls and Bears, so we run the risk of Confirmation Bias, embracing evidence that conforms to our beliefs and disregarding arguments that differ.

The current Bull Market is nine years old and there have been ample reasons for several years to think that we are in the late innings of this expansion. But anyone who has tried to time the market over the past decade has almost certainly hurt their returns rather than enhanced them.
Over the past two weeks, we’ve observed two significant economic signals which like the proverbial “canary in the coal mine” have been strong predictors of past Bear Markets. Because of their rarity and historical significance, I think investors should consider these signals with more weight than opinions, forecasts, or projections.

1. The crossover of the Equity Circuit Breaker. We’ve described this technical analysis previously, but here is a quick review: We look at the S&P 500 Index and calculate Moving Averages based on the previous closing prices of the past 60 and 120 days. That is each day, we look back at the previous 60 and 120 days. When the market is in an uptrend, the 60 day moving average stays above the 120 day average and both lines are sloping upwards. 

In a Bear Market, a prolonged downturn, the 60 day moving average is below the 120 day average and both are sloping down. The signal occurs when these two lines crossover; this reflects a potential change in regime from an up market to a down market. Because we are looking at longer averages – 60 and 120 days – this analysis usually tunes out brief market panics of a month or two. A crossover occurred this year at the end of November.  

This crossover was a good predictor in past Bear Markets; it would have gotten you out of stocks very early in the 2008 crash and back into stocks in the Fall of 2009. However, it can give false positives. Back in 2016, we also had a crossover occur for several months. That year, if you had traded on the crossovers, you would have gotten out at a loss and then had to buy back into stocks several percentage points higher.

2. Yield Curve Inversion. Typically, longer-dated bonds pay higher interest rates than shorter bonds. This week, however, we briefly saw the five-year Treasury Bond trade at a lower yield than the two-year Treasury, an inversion of the normal upwards slope of the yield curve. 

Why should you care? A Yield Curve Inversion has been a good predictor of previous recessions. This shows that investors are bidding up five-year bonds, preferring to tie up their money for longer, seeing a lack of short-term opportunities elsewhere. It also reflects a belief that interest rates may fall.

Past Yield Curve Inversions have occurred in 1978, 1988, 1998, 2000, 2005-2006. In each case, except for 1998, a recession took place within a year or two. So it does not have a 100% track record of accuracy either, but it is a rare enough of an event that I think it is worth our very careful consideration. The seven previous recessions all were preceded by a yield curve inversion.

Read More: from Bloomberg, “The US Yield Curve Just Inverted. That’s Huge.”

Over the past several years, when people asked me what it would take for me to become concerned about a Bear Market, I would have told them these two things: a crossover of the moving averages and a yield curve inversion. Both have been good (but not perfect) predictors of past Bear Markets and Recessions. And both have occurred since Thanksgiving this year.

The market may continue to go up in 2019, so I cannot assume anything with certainty. Still, I am concerned enough about these two signals that we are going to be slightly reducing our equity exposure and risk levels for our 2019 models. This is a temporary, tactical move and we will look to move back to our target equity weighting either when we feel that prices are significantly distressed, or after the moving averages have crossed back upwards. We are not going 100% to cash; at this point, we are considering reducing equities by 20%, pending further analysis this week.

We will be making necessary trades on a household by household basis before January 1, making sure we minimize any possible tax liabilities. We will look to harvest losses in taxable accounts and to try to avoid creating gains except in IRAs. 

While there’s no guarantee these trades will be profitable, I take these two signals seriously enough that I feel compelled to act and will be doing the same trades in my own portfolio. If we do have a prolonged Bear Market, we may wish to have sold even more. However, I want to balance that risk with the fact that these signals could be wrong this time. Perhaps the market continues up for another year or two before there is a recession and we miss out on significant further gains.  

Investors were not at all successful at timing the market back in 2007-2009, even though with the gift of hindsight, we might think it will be “easy” to see and act next time around. My goal remains to create effective, diversified portfolios that are logical, low cost, and tax-efficient. Making tactical adjustments to reduce risk and hopefully enhance returns is what clients expect from me, but we do not make these changes lightly. If you have questions about your portfolio, or want to talk in more detail about these signals, or the economy, I am always happy to have a conversation about what we can do for you.

Investing for Good

Four years ago, I wrote about Socially Responsible Investing (SRI) in this blog. SRI is investing in companies based on an assessment of their Environmental, Social, and Governance policies, or ESG. In 2014, SRI funds had just passed $100 Billion in assets and have since grown twenty-fold to over $2 Trillion globally.

At that time, I had reservations that SRI funds carried a number of pitfalls, including weak diversification, high expense ratios, and poor performance. I discussed one of the original SRI exchange traded funds, KLD, which in 2014 had an expense ratio of 0.50%.

Things have changed for the better. Today we have new SRI funds which are better diversified and have reduced tracking error versus a core Index-based ETF like we normally suggest. Expense ratios have fallen dramatically, with some SRI funds as low as 0.15% to 0.20%, which is much more competitive with traditional ETFs.

With these newer funds, I think we can now say that investing using SRI principles should have similar performance to our traditional portfolios. I don’t know that the performance will be any better, but I no longer am concerned that SRI will automatically condemn you to under-performing a non-SRI approach today.

For the first time, we have the tools to create a globally diversified portfolio of SRI funds which are low cost, transparent, and rules-based. What is lacking, however, is a long track record: of the 38 or so SRI ETFs available to US investors today, about half are less than two years old. This requires extra research and due diligence to understand what you are actually buying and how the fund might perform in different market environments.

For a lot of investors, we want to invest in companies which do good, and not the ones who pollute the environment, support dictators, sell tobacco, or treat their employees, customers, or shareholders with callous disregard. That’s the appeal of SRI; it aligns our money with our values.

When you invest in an index fund, you own all the stocks in a benchmark, including some which maybe you’d rather not own. With the proliferation of index investing, the largest shareholders of many companies are often Vanguard and Blackrock, the two largest index fund providers.

Although index funds vote on behalf of shareholders, they have largely voted in favor of management proposals. Indexers cannot sell their shares if a company is doing bad things. If it’s in the index, the fund has to own it. This weakens the role of shareholders as owners and beneficiaries of corporate decisions and the accountability of executives to shareholders.

I see a beneficial role for SRI investors within capitalism because they tell company executives and boards that they have to do better on ESG criteria or we will not invest in their company. To that extent, I believe we are already seeing improved corporate behavior thanks to SRI investors including ETFs, activist funds, and large pension plans such as CalPERS.

Are you interested in Socially Responsible Investing? Would you like to see what your portfolio might look like if we used SRI funds instead of traditional Index ETFs? We do not want to sacrifice performance, which is why we have been cautious about adopting SRI funds. But with better diversification and lower expense ratios, today’s SRI funds are significantly improved. Let’s talk about how we might implement SRI for you.

How to Get Paid for Limit Orders

When we place an order for a stock or Exchange Traded Fund (ETF), there are a couple of ways we can make a purchase. The easiest is a Market Order, which simply instructs our custodian (TD Ameritrade Institutional) to purchase the specified number of shares at the current market price.

Sometimes, however, we may want to purchase shares at a lower price or wait until the market falls to a specific level. This can be achieved through a Limit Order – which says that we will buy our position only at or below a price we indicate. Of course, the challenge with a Limit Order is that there is no guarantee that the price will in fact fall to our target!

Many investors who use Limit Orders, especially in a Bull Market like we’ve had in recent years, see prices move up and their orders never fill. Then they are faced with the ugly choice of having to buy at a higher price than if they had just used a Market Order at the beginning. And instead of participating in the growth of the market, they sit on the sidelines in cash. So there can be a real opportunity cost to Limit Orders. In reality, Limit Orders are a type of market timing, where an investor thinks they can predict short term moves and profit from those fluctuations.

There is a third, more complicated option, which most investors don’t know how to do. Like a Limit Order, we can select a target price that we would like buy a stock or ETF within a certain time frame. And like a Limit Order, if the price falls to or below this level, we will buy the shares at our target price. Unlike a Limit Order, we can get paid for our willingness to buy these shares, regardless of whether or not the order fills, by using options.

It is done by selling a Put. A Put is an option which requires you to buy a security for a specific price (called the “strike price”) before or at the expiration of the option (typically one month to one year). When you sell a Put, you receive a premium upfront in exchange for agreeing to buy shares at the strike price. One options contract equals 100 shares.

Let’s walk through an example. You are looking to buy the iShares Emerging Markets Index, ticker EEM. As of the Friday August 17 close, you could have bought EEM at the market at $42.21. 100 shares would have cost $4,221. But maybe you thought it could go lower, so instead, you enter a Limit Order for $40. Now, if EEM falls to $40, you will buy your 100 shares for $4,000.

Alternatively, you could sell a November $40 Put on EEM for $83. That means you would get paid $83 in exchange for the right for someone else to make you buy 100 shares of EEM for $40 a share between now and November 16, 90 days from now. If EEM falls to $40 or below, you will buy 100 shares for $4,000 just like in the limit order, plus you made the $83. Even if EEM stays above $40, you keep the $83 no matter what.

I know that $83 isn’t much, it represents about 2% of the price of EEM. That’s over 90 days, so if we consider the value of selling this option on an annualized basis, it is a bit over 8% a year. That’s a lot better than using a limit order and not making anything.

Let’s consider the difference between a market order, a limit order, and selling a Put using two different scenarios, at 100 shares. Today’s price is $42.21 and I’m disregarding commissions and taxes in these examples.

1. The price rises to $45. If you bought at the market ($4,221), you would have a profit of $279. If you placed a limit order at $40, your order never filled and you have nothing. If you sold the put, you would not have any shares, but you would have the $83.

2. The price of EEM falls over time to $38 a share. If you bought 100 shares at the market ($4,221), your shares are now worth $3,800 and you are down $421. If you set a limit order at $40, you would have bought 100 shares for $4,000 and you are now down by $200. If you sold a put, you’d also buy 100 shares at $4,000, but since you collected the $83, you now have a lesser loss of $117.

So whether the price goes up or down, selling a Put is generally going to be better than a limit order. The only example where this might not occur is if a stock has a big gap down overnight – for example, it is at $41 one day and the next morning opens at $38. In this case, your limit order will fill at the open at $38. This does happen sometimes, but it is fairly unusual. Most limit orders, if they fill, end up being executed right at your limit price.

Who is taking the other side of the option? The buyer of a Put is likely a “hedger”: they are buying the Put as protection to preserve their money in case the stock goes down. Or they are a speculator who is betting that the stock will fall. Both are bad bets, statistically. When the expected return of the market is only 8%, paying an 8% annualized premium to hedge your position is in effect giving away all of your potential upside.

Instead, I’d rather be the person selling them this insurance and be the seller of the Put. I’ve spent may years selling Puts (and Calls, too) and am not recommending this is something you try to do on your own. Not every stock or ETF has an active options market and you should be very careful with thinly traded options.

But this is a strategy we use with some of our clients in place of Limit Orders and I wanted to share with all of you an very brief overview of how it works. Please note that options are only available on securities which trade on the exchange and not on mutual funds. What I do not recommend is selling Puts as a speculative bet. Only sell Puts for shares you want to buy and own as a long-term investment. Additionally, to sell Puts, you must either have either cash in the account or a margin account. If you’re interested in learning more about selling Puts in place of limit orders, please reply to this email.

Note: accounts must be approved for options before trading can begin. Please see The Characteristics and Risks of Standardized Options for more information.

Increase Returns Without Increasing Your Risk

In theory, Return and Risk are linked – you cannot get a higher rate of return on an asset allocation without taking more risk. However, portfolios can be inefficient and there are a number of ways we can improve your return without adding risk or changing your asset allocation. Here are five ways to increase your returns:

1. Lower Expense Ratios. Many mutual funds offer different “share classes” with different expense ratios. The holdings are the same, but if one share class has 0.25% more in expenses, those shareholders will under perform by 0.25% a year. Here at Good Life Wealth Management, we have access to Institutional shares which have the lowest expense ratio. Generally, these funds are available only to institutions or individuals who invest over $1 million. We can buy these shares for our investors, without a minimum, which frequently offer savings of 0.25% or more versus “retail” share classes.

2. Increase your Cash Returns. If you have a significant amount of cash in your holdings, make sure you are getting a competitive return. Many banks are still paying 0% or close to zero, when we could be making 1.5% to 2% elsewhere.

3. Buy Treasury Bills. If you have a bond mutual fund and it charges 0.60%, that expense reduces your yield. If the bonds they own yield 2.8%, subtracting the expense ratio leaves you with an estimated return of 2.2%. Today, we can get that level of yield by buying Treasury Bills, such as the 26-week or 1-year Bill, which have a short duration and no credit risk. If you are in a high expense bond fund, especially a AAA-rated fund, it may be preferable to own Treasury bonds directly and cut out the mutual fund expenses. We participate in Treasury auctions to buy bonds for our clients.

4. Buy an Index Fund. If you have a large-cap mutual fund, how has it done compared to the S&P 500 Index over the past 5 and 10 years? According to the S&P Index Versus Active report, for the 10-years ended December 2017, 89.51% of all large-cap funds did worse than the S&P 500 Index. Keep your same allocation, replace actively managed funds with index funds, and there’s a good chance you will come out ahead over the long term.

5. Reduce Taxes. Two funds may have identical returns, but one may have much higher capital gains distributions, producing higher taxes for its shareholders. If you’re investing in a taxable account, take some time to look at the “tax-adjusted return” listed in Morningstar, under the “tax” tab, and not just the gross returns. Even better: stick with Exchange Traded Funds (ETFs) which typically have much lower or even zero capital gains distributions. This is where an 8% return of one fund can be better than an 8% return of another fund! We prefer to hold ETFs until we can achieve long-term capital gains, and especially want to avoid funds that distribute short-term gains. We also look to harvest losses annually, when they occur, to offset gains elsewhere.

How can we help you with your investment portfolio? We’d welcome the chance to discuss our approach and see if we would be a good fit with your goals.

Manager Risk: Avoidable and Unnecessary

You can choose between two funds, A or B. If Fund A has an 85% chance of beating Fund B over five years, would those be good enough odds for you to want to pick Fund B?

More and more investors are realizing that using active equity managers is a bad bet. This is Manager Risk, which is the risk that your portfolio fails to achieve your target returns because of the active managers you selected. When there is a significant probability that a manager lags an index fund and only a small chance that a manager beats that index, taking that risk is going to be a losing proposition for the majority of investors.

Here are three ways Manager Risk can bite you:

1. Performance chasing doesn’t work. Top funds often have a good story about their “disciplined process”, or “fundamental research” approach, but there are so many reasons why today’s leader is often tomorrow’s laggard:

  • Massive in-flows of cash into popular funds make it more difficult for managers to be nimble and to find enough good investment ideas to execute.
  • It’s possible that the fund’s specific approach (style, size, sector, country, etc.) was in-favor recently and then goes out of favor.
  • With thousands of funds, some are going to be randomly lucky and have a period of strong performance that is not repeatable or attributable to skill.

2. The data is clear: over a long-period, the vast majority of funds do not keep up with their index. According to the Standard and Poors Index Versus Active (SPIVA) report: 84.23% of large cap funds failed to keep pace with the S&P 500 Index over the five-years through December 29, 2017.

If 17 out of 20 large cap funds do worse than the S&P 500, why do people bother trying to pick a winning fund, instead of just investing in an Index Fund? I think some of it is that over shorter periods, it can be pretty easy to fund funds that are out-performing and people mistakenly think that recent leaders are going to continue their winning streak.

Consider, amazingly, that nearly 85% of Small Cap Growth funds did better than their benchmark in 2017 according to SPIVA. What a great environment for active managers, right? They must have a lot of skill! But let’s look back further: over the past 15 years, 98.73% of those Small Cap Growth funds lagged their index. That is the worst performance of any investment category in the SPIVA report.

If your odds of outperforming the index over 15 years is only 1 in 100, you’d be crazy to bet on an active manager. It’s a risk that isn’t worth taking.

3. In some categories, there are 10-20% of managers who do outperform the benchmark over five or more years, which means that there might be dozens of funds which have done a nice job for their shareholders. Why not just pick one of those funds?

Standard and Poors also produces The Persistence Scorecard, which evaluates how funds perform in subsequent periods. Let’s look at two five year periods, in other words, the past 10 years. Imagine that five years ago, you looked at the top quartile (the top 25%) of all US Equity funds. How did those top funds do over the next five years (through December 2017)?

25.34% remained in the top quartile
21.56% fell to the 2nd quartile
18.87% fell to the 3rd quartile
23.45% sank to the bottom quartile (the worst 25% of all funds)
10.24% were liquidated or merged, which is the way fund companies make their lousy funds’ track records disappear.

So, if you picked a top quartile fund, you had about only a one-in-four chance (25.34%) that your fund stayed in the top quartile (which is no guarantee that you outperformed the index, by the way). But, you had a one-in-three chance (33.69%) that your fund fell to the bottom quartile or was liquidated and didn’t even exist five years later. Again, those are not odds that are in your favor.

This is why fund companies are required to state, Past performance is no guarantee of future results. We can look backwards at fund history, but that information has no predictive value for how the fund will perform going forward.

It’s an unnecessary risk for investors to use actively managed funds. And that’s why I have moved away from trying to pick 5-star actively managed funds, and have embraced using Index funds.

From time to time, you may hear, “this is a stock picker’s market”, because of volatility, or concentrated returns, or whatever. Don’t believe it. Even when active managers are able to have a good month, quarter, or year, the vast majority remain unable to string together enough good years in a row to beat their benchmark.

There’s enough risk in investing as it is. Let’s reject Manager Risk and instead recognize that an Index Fund is the most likely way to beat 80, 90% or more active funds over the long-term.

When To Get Out Of Equities

Look at each time the S&P 500 Index fell by 8% since 1928, and you will find two very different types of outcomes. 85% of the time, an 8% drop resulted in only a shallow correction, an average of 13%, which the market recovered from, on average, in just 106 days. That’s tolerable.

However, in 15% of the 8% drops, the stock market was headed into a severe Bear Market, suffering an average decline of 43%, which took 1090 days to recover.* That’s three years – from the bottom – just to get back to even. Anyone who invested through the Tech Bubble in 2000-2001 and the Crash of 2008-2009 needs no reminder that Bear markets have always been a part of investing.

Given a choice, wouldn’t you rather be on the sidelines when things are falling apart? Investors of all ages feel this way, but for those who are closer to retirement, we don’t have the luxury of saying, “Well, I can just Dollar Cost Average since I don’t need to touch this money for 30 years”.

Most sources say you cannot time the market. That’s because people usually base their decisions on sentiment and worthless forecasts. We are blind to our own confirmation bias, where we look for opinions that support our prejudices, rather than looking objectively at all evidence.

Without a crystal ball, how can you tell when a small drop is just a brief correction versus the first weeks of a longer Bear Market?

To remove human emotion and look solely at the price movement of the market is the objective of Technical Analysis. Let’s consider a chart of the historical prices of the S&P 500 Index. One of the ways to examine the larger trend of market is through a Moving Average (MA). This is simply a measure of the average price over a number of days, such as 20, 60, 120, or 200 days. A Moving Average with small number of days responds quickly to changes in market prices, whereas a MA based on a large number of days is smoother and slower to react.

When the market is boldly moving up (like in 2017), a chart will have these characteristics:

  • The 60-day moving average is above the 120-day moving average, and both have an upwards slope, gaining each day.
  • The current price of the market is above the moving averages, pulling the averages higher.

When we are in a prolonged decline (like in 2008), a chart will typically have the reverse characteristics:

  • The 60-day moving average is below the 120-day moving average, and both have a downwards slope, sinking each day.
  • The current price of the market is below the moving averages, pulling the averages lower.

A brief drop, like we experienced in February, is a temporary blip in the market price and has little impact on the longer 60 or 120 day moving averages. Technical Analysis suggests that a Bear Market may be starting when there is a crossover – when the 60-day MA goes from being above the 120-day MA to being below it.

Crossovers are considered a major shift in the direction of the market, and often do not occur for years at a time. Crossovers occurred relatively early in the previous two Bear Markets and if you had used that signal to sell, you would have significantly reduced your losses. The reverse crossover, when the 60-day breaks above the 120-day MA, is considered a Bullish indicator that the downwards trend has broken. That’s the Buy signal to get back into the market.

A few caveats are in order: these signals will not pinpoint the top or bottom of the market. With a 60-day lag, the market could have already have suffered significant losses before we get a “Sell” signal. Similarly, at the bottom, the market could have rebounded by a substantial percentage before we get the “Buy” signal to get back in. In a shorter Bear Market, these indicators might have you get out at a loss and then buy back in at a higher level, adding insult to injury.

Looking at back-tested funds which use this approach, however, they would have had lower losses in the past two Bear Markets. While it’s nice to avoid the losses, what is even more compelling is how well the strategy performs over 10 or more years. After studying this for nearly two years, we are now going to offer this strategy to our clients, calling it the Equity Circuit Breaker.

This does not change what we purchase in our portfolios. Investors will have the choice of adding the Equity Circuit Breaker or not. If you want to participate, we will track these moving averages and when a crossover occurs, we will sell your equity positions and move the proceeds into cash or short-term Treasuries. When the Bullish crossover occurs, we will buy back into your equity funds, returning to your target asset allocation.

The goal is to reduce losses then next time we have a Bear Market. While there is no guarantee this program will work exactly as it has in the past, you might prefer to have a defensive strategy in place versus the alternative of staying invested for the whole ride down and back up.

I am making this optional for two reasons. First, some investors have a long enough time frame to accept market volatility and prefer a simpler approach. Second, taxes. Selling your equity positions in a taxable account could generate capital gains.

But let’s take a closer look at the tax question. Let’s say you have a 50% gain in your equity positions. You started at $200,000 and it has grown to $300,000. If we were to sell those positions and create $100,000 in long-term capital gains, you’d be looking at 15% tax, or $15,000. (Long-Term Capital Gains could be as high as 23.8% for those in the top tax bracket.) That is a substantial amount of tax, but could still be worth it. If we avoid a 20% drop, you would have prevented $60,000 of losses.

Paying some taxes along the way also will increase your cost basis and basically just pre-pay taxes you would otherwise pay later. For example, Investor A buys a fund for $10,000, sells it at $15,000 after year two and generates a $5,000 capital gain. Then she buys back into the fund with the $15,000 and sells it at $18,000 at year five, for a $3,000 gain. Investor B buys a fund for $10,000, holds it for the same five years, and then sells for $18,000. Both investors will pay the same tax on $8,000 in capital gains. Investor A just split that tax into two segments whereas Investor B paid the tax all at the end.

Of course, if your accounts are IRAs, we could trade without any tax consequences. If you’d like to add the Equity Circuit Breaker to your Good Life Wealth Management Portfolio, there is no additional cost, just reply to this email. We also offer the option of limiting the Equity Circuit Breaker to your IRAs and not to your taxable accounts. I’ll be talking with clients individually throughout the Spring about the new program.

As of today, we have not had a crossover, so there is not yet a trigger for us to sell. I will be looking at this on a regular basis. Investors should make the decision about participating well in advance of the trigger occurring. Once the losses have already started, it is harder to make a decision. I think the best use of this approach is passive – to consider it carefully in advance, turn it on (or not), and then leave it alone. We will do the work for you.

If today’s market is making you nervous, the Equity Circuit Breaker may help you sleep better at night. You have been telling us “we want to participate in the upside, but want to step aside when things get ugly.” If that’s what you’ve been thinking, feeling, or wishing, we can provide you with a plan that’s based on a disciplined process.

*Market Pulse, Goldman Sachs Asset Management, February 2018

Markets Soared in 2017

2017 was an outstanding year for investors. Markets went up throughout the year with little volatility and no significant pull-backs. This certainly has been a pleasant surprise, given the political uncertainty, noise, and dysfunction in Washington. Here’s a quick overview of the performance of major indices this past year.

The S&P 500 Index was up 21.83%, in total return. US stocks were already fairly valued at the start of the year, but investor enthusiasm for technology companies has pushed markets even higher. That means we start 2018 at even higher valuations than those which concerned us a year ago.

I’d also note that growth stocks outperformed value strategies, by nearly 2X in 2017. I think this will reverse at some point as value stocks have a widening discount to growth companies. US Large Cap outperformed Small Cap by a wide margin, reflecting the more expensive valuations of small companies.

Look at international markets, the MSCI EAFE index, representing developed economies outside the US, was up 25.03%. The MSCI Emerging Markets Index soared 34.35% on the year. Both of these were boosted by a sagging dollar in 2017. We don’t make active bets on currency direction, so we don’t have an opinion on whether or not this continues to enhance returns in 2018. However, economic growth and stock fundamentals are both favorable for international stocks in the year ahead.

Turning to bonds, the Barclay’s Aggregate Bond Index was up 3.54%, a decent return for a year in which the Federal Reserve raised rates three times. We believe that bond investors should have modest expectations for 2018. Rising rates suggest favoring shorter duration bonds for defense.

We’ve updated our portfolio models for 2018 and can celebrate the returns we received in 2017. We remain broadly diversified and get most of our equity exposure from low-cost, tax-efficient index ETFs. Our overweight to Emerging Markets has been beneficial this past year, although our allocation to US Value has been a drag on performance. The rationale for both positions remains unchanged so we will continue to hold both.

We spend considerable time on investment management, but generally, think it is more beneficial to you to write here about financial planning topics. As always, if you have any questions about investment strategies, please feel free to reply or call anytime.

Source of data: Morningstar as of 12/30/2017.