Adding Convertible Bonds

Adding Convertible Bonds

This week, we are adding Convertible Bonds to our Premiere Wealth Management portfolios. This will shift 2-6 percent of portfolios from equities to our Alternative Investments sleeve. What are convertible bonds and why now?

Convertible bonds and are unique in that they have an option to convert from a bond into shares of stock of a company. Why would you want to do that? Let’s say a $1,000 bond has an option to convert it into 20 shares of stock. That would give a convert price of $50 a share. If the stock price stays at $40 a share, you would just let the bond mature and get back your $1,000 in principal. But if the stock price rises to $60 a share, you could convert your $1,000 bond into 20 shares. Then you could sell the shares for $60 a share, or $1,200. And while you wait, the bond pays interest.

Benefits of Convertible Bonds

Why do companies offer convertible bonds? There are a couple of benefits to the company:

  • Convertible bonds typically pay lower interest rates since there is also potential upside for investors. This saves the company on interest costs versus issuing regular bonds.
  • If the bonds do convert to stock, the company issues new shares and does not have to use cash to pay back the loan. Imagine borrowing $100 million and then paying it off by issuing stock!
  • Compared to issuing new shares right away, a convertible bond delays diluting existing shareholders for several years. The interest expense is deductible for the company, whereas paying a stock dividend would not.

Here are the benefits for investors of convertible bonds:

Other Considerations

What are the risks of convertible bonds?

  • Companies who issue convertible bonds can be lower credit quality, and more than half do not carry a credit rating. Some of these bonds will default.
  • The volatility of convertibles can be closer to stocks than it is to high quality bonds like Treasury Bonds. Once the stock price is above the convert price, the price of the bond will be about as volatile as the stock.

How to invest in Convertible Bonds?

Because Convertible Bonds are closely related to equities, I consider them more of a substitute for stocks rather than fixed income. For this reason, we reduced equities to purchase a Convertible Bond Fund. I would recommend buying a fund rather than individual bonds. The fund can research the credit quality of unrated issuers and will diversify into a large number of bonds.

The fund we are adding has a 27-year track record and a five-star rating from Morningstar. Here is the most recent quarterly fact sheet on the fund. We will invest in the Institutional Share class, which has a lower expense ratio. Typically, investors would need $1 million to buy the institutional shares, but I can buy shares for my clients as a Registered Investment Advisor.

Why now?

We have had a very strong rebound in stocks markets since the lows of March. While there are a lot of reasons for optimism, the economic recovery from the Coronavirus seems to be priced into stocks. Bond yields are near zero, and offer little return potential compared to stocks. In this environment, I would like to add alternative investments that might offer returns better than bonds, but with less downside risk than stocks.

Currently, we have 10% allocated to Alternatives, using Preferred Stocks and a Hedge Fund replication strategy. Adding Convertible Bonds, our target weighting in Alternatives will be to 12-16 percent. No one can predict what markets will do in the near future. What we can do is to diversify our sources of return and risk. We can evaluate which investments have offered effective risk-adjusted returns historically and how they might work today. If you have questions about investing during the Coronavirus, please send me a message.

Past performance is no guarantee of future results. Investing in convertible bonds carries risk of loss.

Stock Crash Pattern

Stock Crash Pattern

There is a stock crash pattern which is playing out in 2020. We’ve seen this before. We saw it in 2008-2009 with the mortgage crisis, in 2000 with the Tech bubble, and in 1987. The cause of every crash is different, but I’d like you to consider that the way each crash occurs and recovers is similar. Let’s learn from history. What worked for investors in 2000 and 2008 to recover?

I don’t believe in the value of forecasts, and no one can predict how long the Coronavirus will last. This week, things are getting worse, not better. Truthfully, a market bottom could be weeks or months away. No one can predict this, yet it’s human nature to seek certainty and guarantees.

Once we accept that we cannot predict the future, what should we do? I believe the answer is to study what has worked best in the past. That is what we plan to do here at Good Life Wealth Management for our client portfolios. Here’s our playbook.

Stock Crash Pattern Steps

  1. Don’t sell. I had clients who sold in November of 2008 and March of 2009. Luckily, we got them back into the market within a few months. Unfortunately, they still missed out on a substantial part of the initial recovery. The initial recovery will likely be very rapid. We aren’t going to try to time the market.
  2. Rebalance. In our initial financial planning process, we examine each client’s risk tolerance and risk capacity. This leads to a target asset allocation, such as 50/50 or 70/30. Because stocks have fallen so far, a 60/40 portfolio might be closer to 50/50 today. Rebalancing will sell bonds and buy stocks to return to the target allocation. This process is a built-in way to buy low and sell high. (Selling today would be selling low. It’s too late for that.)
  3. Diversify. The investors who have concentrated positions in one stock, one sector, or country jeopardize their ability to recover. Some stocks might not make it out of this recession. Some sectors will remain depressed. Don’t try to pick the winners and losers here. We know that when the recovery does occur, an index fund will give us the diversification and broad exposure we want.
  4. Tax loss harvest. If you have a taxable account, sell losses and immediately replace those positions with a different fund. For example, we might sell a Vanguard US Large Cap fund and replace it with a SPDR US Large Cap fund. Or vice versa. The result is the same allocation, but we have captured a tax loss to offset future gains. Losses carry forward indefinitely and you can use $3,000 a year of losses against ordinary income. Tax loss harvesting adds value.
  5. Stay disciplined, keep moving forward. When it feels like the plan isn’t working, it’s natural to question if you should abandon ship. Unfortunately, we know from past crashes that selling just locks in your loss. Instead, keep contributing to your 401(k) and IRAs, and invest that money as usual.

This Time Is Different

The most dangerous sentence in investing is This time is different. It isn’t true in Bull Markets and it isn’t true in Bear Markets. In the midst of a crash, people abandon hope and feel completely defeated. Maybe you will feel that way, maybe you already feel that way. Maybe you are thinking that this is the Zombie Apocalypse and all stocks are going to zero.

What history shows is that all past crashes have recovered and led to new highs. If you’re going to invest, this is what you have to believe. Even though things are terrible right now, if you think that this time there will be no recovery, I think you will be making a mistake.

The stock market will continue to go down for as long as there are more sellers than buyers. Panic selling is the driver, not fundamentals. No one knows how long that will take. Eventually, we will reach a point of capitulation, when all the sellers will have thrown in the towel. That will be the bottom, visible only in hindsight.

My recommendation is to study past crashes, not for the causes, but to see the charts of the recoveries. I believe that 2020 will have a similar stock crash pattern to 2008, 2000, and previous crashes. We don’t know how long this takes or how deep it goes, but we do know what behavior worked in past crashes.

We have a plan, and I have faith in the plan. Things may be ugly for a while, probably a lot longer than we’d like. All we can control is our response. Let’s make sure that response is based on logic and history, and have faith in the pattern and process.

Investing involves risk of loss. Diversification and dollar cost averaging cannot guarantee a profit.

2020 Stock Market Crash

2020 Stock Market Crash

This month will likely be called the 2020 Stock Market Crash in the years ahead. Investopedia defines a crash as a double digit drop over a few days as the result of a crisis or catastrophic event. A crash typically occurs after a period of speculation which drives stock prices to above average valuations. Panic is a hallmark of a crash, versus a Bear Market. Certainly, we have met the definition of a crash.

Risk is perceived as danger when it occurs, but only in hindsight do we see another definition of risk: opportunity. If you look at the purchases you made in your 401(k) back in 2008 and 2009, you may be astonished by the gains you made at those low prices!

Your emotional response to a crash may be to ask if you should sell. But then you might miss out on today’s opportunities. Even if you are fully invested today, consider these five actions instead of selling.

Five Opportunities

  1. Keep buying. Dollar cost average in your 401(k), IRA or other accounts. The shares you buy at a low price could be your largest future gains. If you have not made your IRA contribution for 2019 or 2020, this might be a good time.
  2. Roth Conversion. Thinking about converting part of your IRA to a Roth? If so, you would now pay 11% less in taxes versus last month. After that, your gains will be tax-free in the Roth.
  3. Rebalance. Hopefully you started with a defined allocation, like 60/40 or 70/30. If that has subsequently gotten off-target, now may be an opportune moment to make rebalancing trades.
  4. Replace low yielding bonds. Look at the SEC Yield of your bond funds. The SEC Yield measures the yield to maturity of a fund’s bonds and subtracts the expense ratio. It is the best measure of expected returns for a bond fund. Bonds can work as portfolio ballast: a way to offset the risk of stocks. If that is your objective, stay safe. Unfortunately, the actual contribution of bonds to your portfolio return is terrible, maybe 2%, or even less than 1% if you own short-term treasuries. Instead, what I find attractive after this crash is Preferred Stocks, non-callable CDs (versus Treasuries of the same duration), and Fixed Annuities. If your SEC Yields are unacceptable consider changes, but proceed with great caution. Above all, avoid trading down from a safe bond to a risky bond just for a higher yield.
  5. Do nothing. Markets go up and down. You have the choice of just ignoring it. Selling on today’s panic is the worst type of market timing, giving into fear. So, take a deep breath and realize that after the crash it is often best to hold.

Work on Your Financial Plan

There’s more to your financial success than just whether the stock market is up or down. Ask yourself the following questions:

  • Am I on track for retirement?
  • Do I have an Estate Plan?
  • Am I prepared for my children’s college education expenses?
  • Have I protected my family with a term life insurance policy? Additionally, are there risks to my career, business, health, or family which I need to address?
  • Do I have a disability and long-term care plan?
  • How am I addressing my charitable goals?
  • Are there additional ways to save on taxes?
  • Should I refinance my mortgage?
  • Am I eligible for a Health Savings Account or Flexible Spending Account?
  • Have I calculated the optimal age to begin Social Security for myself and my spouse?

Don’t let investing in the stock market consume all your attention, because it is only one piece of your financial plan!

Think Long Term

Risk is danger and risk is opportunity. Instead of worrying about this month, imagine that it is 2021 or 2022 and the market has recovered. What would you have wished you had done in the 2020 Stock Market Crash?

Ignoring the panic of the day isn’t easy. Thankfully, a good investor doesn’t have to make predictions about the market going up or down. We can’t control that. The key is managing how you respond when the market is at its worst. Finally, if you know you need work on your financial plan or would benefit from professional advice on managing your portfolio, I am here to help.

Past performance is no guarantee of future results. Stock market investing involves risk of loss of principal. Dollar cost averaging does not guarantee a gain.

Preferred Stocks Belong in Your Portfolio

Why do we own Preferred Stocks? US Stocks are expensive today. Bond yields are very low. Neither are terribly attractive. With any allocation, the expected return of the portfolio going forward is lower than historical returns. Risks, however, remain in the market. That’s not a dire prediction, just a statement of fact. We hope 2020 is another great year, like 2019.

The challenge for a portfolio manager like myself, is to diversify and find the sweet spot of risk and return. Because of today’s high prices of stocks and bonds, we include a 10% allocation to alternative investments. We’re looking for things which might offer a higher yield than bonds, but with less risk than stocks. And ideally, with a low correlation to stocks or bonds.

What is a Preferred Stock?

A Preferred Stock is a hybrid security. It has characteristics of both a common stock and a bond. It trades like a stock and pays a quarterly dividend. Like a bond, it has a fixed rate of return and a par value. With a Par value of $25, a company issues a Preferred stock at $25 and can redeem it at $25. 

(How well do you understand bonds? Read: A Bond Primer.)

Historically, Preferred Stocks were “perpetual”, meaning that they had no ending date. More commonly today, Preferred Stocks are callable. Companies can buy back their Preferreds at $25 after a specific date in the future, most often five years after issue. Other Preferreds have a specific redemption date, when the company will buy back all of the shares.

Dividends of a Perpetual Preferred are typically qualified dividends. They qualify for the 15% tax rate on dividends. Other Preferreds, with redemption dates, may treat dividends as ordinary income, like bonds. As a result, we prefer to buy Preferreds in an IRA. 

The Investment Rationale

We are interested in Preferreds which are callable or have a redemption date of less than 10 years. The reason is that, unlike perpetual Preferreds, these ones are trading for close to $25 a share. The ones we own have coupons of 4.75% to 7.25% or higher. We are generally paying a little above $25 today, but plan to hold until the shares are redeemed or called. (We can also sell them any day if desired, as they are liquid.)  

You buy Preferreds for the dividend. They do not offer any growth. But that also means we have more stability. They tend to trade right around $25. And for those with a redemption date, we know the company will buy them for $25. So, any price volatility is likely a temporary fluctuation.

I am featured in this article “Are Preferred Stocks Preferable?” at US News & World Report from the summer of 2016. Since then, the relative attractiveness of Preferreds versus common stocks has improved significantly. Today, I think they have a place in our portfolios.

How to Invest in Preferred Stocks

Because Preferred Stocks carry the credit risk of the company, we prefer to purchase a basket rather than just one. Typically, we have a 5-6% allocation to Preferreds per household, and will buy at least five different issuers. That gives us some diversification of risks. Like any stock or bond, if the company goes bankrupt, you lose money. That’s why we diversify with a basket of small positions.

There are also funds and ETFs for Preferreds which offer a bigger basket. But, I prefer to pick the duration and companies I want. Also, we can save clients the expense ratio of a fund, often 0.50% to 1% a year. That would take a big bite out of your yield.

Preferreds are a niche investment and not a part of our core holdings. Given today’s market, we think they offer a nice complement to our traditional stock and bond holdings. Most advisors have never purchased a Preferred Stock, but I have been analyzing and trading the sector for over 15 years. We generally buy on the open market, but this month we have also participated in IPOs of Preferreds from Wells Fargo, AT&T, and Capital One. People want these yields. They’re no magic bullet, but Preferred Stocks are an interesting tool and we think a good fit for what our clients want.

If you’re looking for more than just a generic robo portfolio or a target date fund, let’s talk. Our Premiere Wealth Management Portfolios are for investors with at least $250,000 to invest.

Investment carries risk of loss of principal. Preferred Stocks are not guaranteed. 

Long Bonds Beating Stocks in 2019

Through August 31, the S&P 500 Index is up 18.34%, including dividends. Would it surprise you to learn that bonds did even better? The Morningstar US Long Government Bond Index was up 18.40% in the same period. Even with this remarkable stock market performance, you would have done slightly better by buying a 30-year Treasury Bond in January!

How do bonds yielding under 3% give an 18% gain in eight months? Bond prices move inversely to yields, so as yields fall, prices rise. The longer the duration of the bond, the greater impact a change of interest rates has on its price. This year’s unexpected decrease in rates has sent the prices of long bonds soaring. While bonds have made a nice contribution to portfolios this year because of their price increases, today’s yields are not very attractive. And longer dated bonds – those which enjoyed the biggest price increases in 2019 – could eventually suffer equivalent losses if interest rates were to swing the other direction. We find bonds going up 18% to be scary and not something to try to chase. 

Today’s low interest rates are a conundrum for investors. The yields on Treasury bonds, from the shortest T-Bills to 10-year bonds are all below 2%. CDs, Municipal bonds, and investment grade corporate bonds have all seen their yields plummet this year. In some countries, there are bonds with zero or even negative yields.

What can investors do? I am going to give you three considerations before you make any changes and then three ideas for investors who want to aim for higher returns.

1. Don’t bet on interest rates. Don’t try to guess which direction interest rates are going to go next. We prefer short (0-2 year) and intermediate (3-7 year) bonds to minimize the impact that interest rates will have on the price of bonds. With a flat or inverted yield curve today, you are not getting paid any additional yield to take on this interest rate risk. Instead, we take a laddered approach. If you own long bonds which have shot up this year, consider taking some of your profits off the table.

2. Bonds are for safety. The reason why we have a 60/40 portfolio is because a portfolio of 100% stocks would be too risky and volatile for many investors. Bonds provide a way to offset the risk of stocks and provide a smoother trajectory for the portfolio. If this is why you own bonds, then a decrease in yield from 3% to 2% isn’t important. The bonds are there to protect that portion of your money from the next time stocks go down 20 or 30 percent.

3. Real Yields. Many of my clients remember CDs yielding 10 percent or more. But if inflation is running 8%, your purchasing power is actually only growing at 2%. Similarly, if inflation is zero and you are getting a 2% yield, you have the same 2% real rate of return. While yields today are low on any measure, when we consider the impact of inflation, historical yields are a lot less volatile than they may appear. 

Still want to aim for higher returns? We can help. Here are three ideas, depending on how aggressive you want to go.

1. Fixed Annuities. We have 5-year fixed annuities with yields over 3.5%. These are guaranteed for principal and interest. We suggest building a 5-year ladder. These will give you a higher return than Treasuries or CDs, although with a trade-off of limited or no liquidity. If you don’t need 100% of your bonds to be liquid, these can make a lot of sense. Some investors think annuity is a dirty word, and it’s not a magic bullet. But more investors should be using this tool; it is a very effective way to invest in fixed income today. 
Read more: 5-year Annuity Ladder

2. High Yield is getting attractive. Back in 2017, we sold our position in high yield bonds as rising prices created very narrow spreads over investment grade bonds.  Those spreads have widened this year and yields are over 5%. That’s not high by historical standards, but is attractive for today. Don’t trade all your high quality bonds for junk, but adding a small percentage of a diversified high-yield fund to a portfolio can increase yields with a relatively small increase in portfolio volatility.

3. Dividend stocks on sale. While the overall stock market is only down a couple of percent from its all time high in July, I am seeing some US and international blue chip stocks which are down 20 percent or more from their 2018 highs. Some of these companies are selling for a genuinely low price, when we consider profitability, book value, and future earnings potential. And many yield 3-5%, which is double the 1.5% you get on the US 10-year Treasury bond, as of Friday. 

While we don’t have a crystal ball on what the stock market will do next, if I had to choose between owning a 10-year bond to maturity or a basket of companies with a long record of paying dividends, I’d pick the stocks. For investors who want a higher yield and can accept the additional volatility, they may want to shift some money from bonds into quality, dividend stocks. For example, a 60/40 portfolio could be moved to a 70/30 target, using 10% of the bonds to buy value stocks today. 

When central banks cut rates, they want to make bonds unattractive so that investors will buy riskier assets and support those prices. When rates are really low, and being cut, don’t fight the Fed.

Long bonds have had a great performance in 2019 and I know the market is looking for an additional rate cut. But don’t buy long bonds looking for capital appreciation. Trying to bet on the direction of interest rates is an attempt at market timing and investors ability to profit from timing bonds is no better than stocks. If you are concerned how today’s low yields are going to negatively impact your portfolio going forward, then let’s talk through your options and see which might make the most sense for your goals.  

Source of data: Morningstar.com on September 2, 2019.

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.  

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.

Skin In The Game

Leading up to the last financial crisis, bankers made hundreds of millions by packaging together mortgages and selling them. They were paid upfront and had no repercussions when those mortgages went into foreclosure and both the homeowners and investors lost money.  The asymmetry that bankers had an enormous upside to sell something but shared none of the downside risk led to catastrophic losses.

This is the subject of Skin In The Game, a new book by Nassim Nicholas Taleb, perhaps the foremost writer on risk and the practical application of the mathematics of probability. I’ve just finished the book and while it was not an easy read, its ideas are relevant to investors.

Skin in the game – having shared risks and rewards – is essential for investors to achieve better outcomes with their advisors and investment managers. Taleb points out interesting and not always obvious situations where these asymmetries present potential pitfalls in investing, politics, economics, and everyday life.

Investors would be well-served to think about whether their advisors have skin in the game and aligned interests, or if they are like the bankers who win regardless of whether their clients profit or not.

Before starting my own firm, I worked at two companies for 10 years. I had one colleague, who in spite of making a lot of money over many years, actually had less than $50,000 in investments. His top priority was paying down his mortgage. He talked about investments all day long yet had almost no interest in putting his own money in what he recommended to clients.

Another colleague invested significant sums every month and became one of the three largest clients of the firm. And every purchase was into the exact same funds as our clients. Which of those Financial Advisors would you prefer to manage your money? One who didn’t want to invest or one who couldn’t get enough of the funds we bought for clients?

Strangely, to me at least, clients rarely ask questions about Skin In The Game. I became a Financial Advisor because I was fascinated with investing and found myself spending all my evenings and weekends reading everything I could find and investing every dime I could scrape together. I opened my firm with one purpose: to treat every client as I would want to be treated.

That’s why I’d encourage investors to think and ask about Skin In The Game. Here are some ways to do that:

1. Doing not Saying. If you really want to know what people believe, find out what they do, rather than what they say. Understanding the difference is a BS-detector. Do you invest in this fund? How much of your net worth is in this strategy? Have you bought this investment for your mother’s account? Those answers, if you can get an honest one, are more telling than any pitch. In other words, don’t buy a Ford from someone who drives a Toyota.

2. Appearances. Taleb is trying to choose between two surgeons: one has an Ivy League undergraduate diploma, and wears immaculate bespoke suits. The other wore rumpled clothes, was a bit slovenly, and came from a middle class background. Taleb suggests choosing the latter surgeon, because he had to work much harder to achieve his career and is therefore likely more skilled. The first was more successful in looking like a surgeon rather than being the best possible surgeon.

(Thank you to all the clients who have hired a former music teacher to manage millions of their dollars. I used to get up at 5 am for years to study for the CFP and then CFA exams before going to work. It hasn’t been an easy road.)

3. Simple is better than complex. Complex solutions are sometimes created as a hook to sell something. Often, a simple, well-tried approach is more effective. Convoluted structures conceal many flaws, hidden fees, and conflicts of interest. If something seems unnecessarily complex, that’s a red flag.

4. “Scientism”. Facts and book knowledge can be bent to your point of view. Consider for example: “homeowners have 30-times the wealth of renters”. I heard this statement this week, along with the conclusion that buying a house therefore causes wealth. Correlation is not causation! You could also reach the opposite conclusion: you have to be very wealthy to afford a house in America.

Both are flawed because the thought process of going from the fact to the conclusion is biased. If I got an apartment, would I become poor? No, of course not. Taleb calls this “Scientism”, dangerous ideas which sound scientific, but don’t actually follow the objective hypothesis-testing process demanded by real science.

You cannot become wealthy without taking risks. The best way of ensuring a good outcome is through the fairness of symmetry and shared risks. That means both sides have an upside and a downside.

I don’t have a crystal ball about what the market will do, but I do invest in the same ETFs and Funds as my clients (I use our Growth Portfolio Model). By having Skin In The Game, I think it does provide an important motivation to spend extra time on due diligence, think carefully about risks, and follow our positions closely.

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.