Fixed Annuities in Place of Bonds?

Posted On June 15, 2015 By Admin In Portfolio Management /

Today’s low interest rate environment is challenging for investors. Cash is paying virtually nothing, and even the 10-year Treasury has a yield of only 2.3% to 2.4%. If you do invest in longer-dated bonds, you have the risk of falling prices if interest rates begin to rise.

Low interest rates have pushed many investors to seek out higher yielding securities. But, there is no free lunch, as higher bond yields come with lower credit quality, heightened risk of default, and increased volatility.

Treasury bonds are a good tool for portfolio construction, because they have a very low correlation to equities. However, if investors replace those very safe (but low yielding) Treasuries with high yield bonds, they are increasing the probability that both their equity and fixed income positions will be down at the same time.

In 2008, for example, as equities tumbled, the iShares High Yield ETF (HYG) was down more than 17% for the year. Although high yield bonds have a place, investors need to understand that junk bonds may not provide much defense when the stock market takes a dive.

Cautious investors have been hiding out in short-term bonds, which might be yielding 1% or less. And while that will limit losses if rates rise, no one knows how long we will be stuck with today’s low rates. If low rates persist for years, short-term bonds aren’t providing much return to help you achieve your investment goals.

As an alternative to taking the risks of chasing yield, or the opportunity cost of hiding in short-term bonds or cash, some investors might want to consider a Fixed Annuity. These come in a variety of formats, but I am only suggesting annuities with a fixed, multi-year guaranteed rate. These are sometimes compared to CDs, but it is very important that investors understand how annuities differ.

Here’s the attraction: we can offer up to 3.25%, principal and interest guaranteed, on a 5-year Fixed Annuity today. And that’s the net figure to investors, which is fairly compelling for a safe yield. It’s more than 1% higher than the SEC yield on a US Aggregate Bond Index fund, like AGG.

Here are five key points to help you understand how annuities work and determine if an annuity is a good choice for you.

Tax-deferral. Annuities are a tax-sheltered account. While you don’t get an upfront tax deduction, an Annuity will grow tax-deferred until you withdraw your money. When withdrawn, gains are taxed as ordinary income, and do not receive capital gains treatment.
Like an IRA, withdrawals from an Annuity prior to age 59 1/2 are considered a pre-mature distribution and subject to a 10% penalty. This is an important consideration: only invest in an Annuity money that you won’t need until after age 59 1/2. This is obviously easier for someone who is in their 50’s or 60’s compared to younger investors.
Limited liquidity. Annuity companies want investors who can commit to the full-term and not need to access their principal. They may impose very high surrender charges on investors who withdraw money before the term is completed.
At the end of the term, investors have several options. You can take your money and walk away. You can leave the money in the annuity at the current interest rate (often a floor of 1%). You can roll the annuity into a new annuity and keep it tax deferred. If the annuity is an IRA already, you can roll it back into your regular IRA brokerage account. Or lastly, you can annuitize the contract, which means you can exchange your principal for a series of monthly payments, guaranteed for a fixed period, or for life. I don’t think very many investors annuitize – most will walk away or reinvest into another annuity.
Annuities are guaranteed by the issuing insurance company, and that guarantee is only as good as the financial strength of the company. Similar to how CDs are insured the by the FDIC, investors in Annuities are protected by your state Guaranty Association (Texas Guaranty Association). Since coverage for annuities in Texas is only up to $250,000, I would never invest more than this amount with any one company.

What I like about the annuity is that it can provide a guaranteed rate of return and price stability, unlike a bond fund. An annuity also can reduce a number of types of portfolio risks, such as interest rate risk, default risk, and will have no correlation to equity returns.

Is an annuity right for you? You should be able to invest the funds for at least 3-7 years and have ample money elsewhere you can access in case of an emergency. You can invest money from an IRA or a regular account, but either way, should not plan on withdrawing money from an annuity until after age 59 1/2. And we’re only using money that would have otherwise been allocated to bonds, CDs, or cash in your investment portfolio. If this describes you, please give me a call at 214-478-3398 and we can discuss Fixed Annuities and their role in your portfolio in greater detail.

Please note that as an insurance product, an annuity will pay the issuing agent a commission. Clients are not charged an AUM fee on monies invested in Annuities. We aim to disclose all conflicts of interest and provide transparency on how we are paid.

Win by Avoiding These Mistakes

Posted On June 8, 2015 By Admin In Behavioral Finance /

This week, I heard an orchestra conductor say, “It’s not simple to make it sound easy.” While he was talking about music, I was thinking how this applies to investing, too. The more we know about investing and the more experience we have, the more we recognize the benefits of following a very straightforward approach. You don’t have to be a genius to be a successful investor, you just have to avoid making a couple of big mistakes. The game of investing is not won by brilliant moves, but rather by patience and avoiding the common pitfalls that lure investors in year after year.

It’s easy to recognize mistakes in hindsight. The challenge is to anticipate these outcomes in advance, so you can prevent these these errors whenever you are tempted to make changes to your portfolio. Is your decision based on a logical examination of the facts, or an emotional response or ingrained bias? You can be successful over time by following a smart plan, even if it is not complicated. Let the market run its course and know that your plan will work best when you don’t get in the way! Here are three of most costly mistakes I’ve seen investors make in the past 15 years and the solution for you to avoid these each of these missteps. These are real, actual people, but I’ve changed the names here to protect their identity. Learn from their losses!

1) Lack of diversification. 10 years ago, I met Peter who was a client of another financial advisor at my firm. Peter was an engineer at Nortel, and like many employees at tech companies in the 90’s, he received substantial stock options. For years, the stock would double and split every 18 m0nths or so, which meant that anyone who sold their stock options regretted not holding for longer. Peter had more than 12,000 options when Nortel hit $90 a share in the spring of 2000, giving his options a value of over $1 million. At every meeting, they discussed exercising his options, selling his shares and diversifying, but Peter wanted to wait longer. The stock fell to $85, and Peter finally agreed to sell, but said that he had his heart set on a higher price and would sell as soon as it got back over $90 a share.

Unfortunately, the stock never regained the $90 level, and instead lost 90% of its value over the next nine months. His options were now worthless and his hopes of retiring in his 50’s lost forever. Nortel went bankrupt in 2009 and his division was sold to competitor. Peter had the majority of his net worth in company stock and the loss truly decimated his investment portfolio and derailed his retirement plans.

It is often said that diversification is the only free lunch in investing. By being diversified, you can avoid the risk of having one stock wipe out your plans. And I should mention that this also applies to bonds. I met another investor who had $100,000 of Lehman Brothers bonds for their portfolio. As I recall, I believe the investor recovered only about 25 cents on the dollar after the Lehman bankruptcy in 2008.

Solution: Don’t let company stock – or any single stock – comprise more than 10% of your portfolio. Even better, avoid single stocks altogether and use ETFs or mutual funds. For bonds, I’d suggest keeping any single issuer to only 1-2% of your portfolio. The potential benefits of having a concentrated stock position are outweighed by the magnitude of losses if things go wrong.

2) Trying to Outsmart the Market. Luke considered himself a sophisticated investor and enjoyed reading and learning about investing. He had an MBA and felt that with his knowledge and a subscription to the Wall Street Journal, he should be focused on beating the market. He looked at his portfolio almost every day and would be very concerned if any of his funds were lagging the overall market. As a result, he wanted to trade frequently, to put his money into whatever sector, fund, or category was currently performing best.

Funds typically include the disclaimer that “past performance is no guarantee of future results”, and yet, so many investors are focused on picking funds based on their most recent past performance. In Luke’s case, his insistence on “hot funds” meant that he was often invested in sector funds. His performance over time was actually worse than the benchmarks, because in spite of all his research and knowledge, he was focused on looking backwards rather than forwards.

Solution: stay diversified and don’t chase hot funds. Typically, 65% to 80% of all active managers under perform their benchmark over five years, which means that your safest bet is to never bet on a manager’s skill but to bet on the house. Using index funds works, and adopting an index approach means you can focus on what really matters for accumulation: how much you save. Luke’s portfolio was relatively small, under $100,000. Ironically, investors with smaller accounts are often the ones who believe that they need to outsmart the market to be successful. When I worked with a client with over $100 million, he had no qualms about index funds whatsoever.

3) Timing the Market. Angelina retired in 2007, a year before the stock market slumped. In early 2009, the market was down nearly every day, sometimes losing 5% in a session. We had conversations previously with Angelina about market volatility and had implemented a diversified, balanced portfolio. On March 6, 2009, Angelina called and insisted that we exit all her equity positions. It was that very day that the S&P 500 Index put in its intra-day low of 666. In hindsight, she sold on the actual worst day possible. Luckily, we were able to convince her to buy the equities back by June, but by then, she had missed a 30% rally.

Market timing mistakes aren’t limited to selling at a low; you can also miss out when the market is doing well. Last year, while the market was up double digits, some investors had significant capital in cash, fearing a drop or hoping to profit from any temporary pullback. Those with large cash positions under performed those who were invested in a target allocation. Having looked at hundreds of investors’ performance, I have yet to see anyone who has improved their return through market timing, except from random luck. Trying to get in and out of the market gives you more opportunities to make mistakes.

Solution: Choose an appropriate asset allocation and stick with it. Invest monthly into a diversified portfolio, and don’t stop investing when the market is down. If you think you will wait until you get an “all-clear” signal, you’re going to miss out on gains like Angelina. Rebalancing annually creates a discipline to sell your winners and buy the losers, which is difficult to do otherwise!

Investing should be easy. People have the best intentions when they load up on company stock, invest in a hot fund, or try to time the market. The reality, however, is that the more complicated strategy you adopt, the more likely you will hurt rather than enhance your returns. Our goal is to help investors gain the knowledge, confidence, and discipline to recognize that your most likely path to success is to stick with a simple approach that is proven to work.

Want to read more? Check out Winning The Loser’s Game by Charles Ellis.

Should You Hedge Your Foreign Currency Exposure?

Posted On May 25, 2015 By Admin In Portfolio Management /

When you invest in foreign stocks or bonds, you’re really making two transactions. First, you have to exchange your dollars for the foreign currency and only then can you make the purchase of the investment. Over time, your return will consist of two parts: the change in the price of the investment and the change in the value of the currency. In 2014, foreign stocks – as measured by the MSCI EAFE Index – were up 6.4% in their local currency, but because of a strong dollar, the index was actually down by 4.5% in US dollar terms.

This nearly 11% disparity of returns has made for one of the fastest growing investment segments in 2015: currency-hedged Exchange Traded Funds. These new funds invest in a traditional international index, but then hedge the foreign currency, so US investors can receive a similar return to investors in the local currency. Obviously, a currency hedging strategy has worked well over the past year, but is it a good idea going forward?

As you might imagine, there is no free lunch with currency hedging. There are two important caveats for investors to understand. First, when you hedge, you are making a directional bet that the dollar will strengthen. If the dollar weakens instead, a hedged international fund will under perform a non-hedged fund, or even lose money. Hedging adds an additional element to the investment decision making process, which can increase the possibility of under performance. After all, the most appealing time to hedge will be after the currencies have already made a big move, but in many cases, that will also be too late!

Having foreign denominated investments can provide investors with diversification away from the US dollar. If the dollar were to decline, foreign denominated positions would rise. Having that currency diversification could help investors over time by potentially smoothing returns and providing a defensive element. If you hedge your foreign positions, a declining dollar would negatively impact both your domestic and foreign holdings, which means you may have actually increased your portfolio’s correlations and risk.

The second caveat is cost. Currency hedged funds have a higher expense ratio than regular ETFs, and those management costs do not even include the actual cost of purchasing the hedges. If currencies are relatively stable over a longer period, hedged products will likely lag non-hedged funds due to their higher expenses.

Given these two caveats, I have been reluctant to recommend currency hedged ETFs for long-term investors. Today, however, there are some reasons to believe that the US dollar’s strength may continue. If we look at central bank policy, the US Federal Reserve has been discussing when and under what conditions they will begin to raise interest rates. Compare this to Europe or Japan, where the central banks are looking to create new stimulus and quantitative easing programs. The expectation is that the money supply will increase in Europe and Japan, while the US money supply will be more stable. That’s bullish for the dollar for the near term.

We shouldn’t expect 2014’s nearly 11% difference between hedged and un-hedged indices to continue, but currency trends or cycles can last for several years. I will be talking with our investors to discuss hedging a portion of their international exposure, provided they can make those trades in an IRA. We prefer to make the trades in an IRA to avoid any capital gains on a sale today. Also, we consider the currency-hedged funds to be tactical rather than strategic, meaning that at some point in the future, we will probably want to trade back into the traditional, un-hedged index.

There are also currency hedged ETFs for Emerging Market stocks, but we recommend investors steer clear of those funds. The cost of hedging is tied to short-term interest rates in the foreign currency, so it’s very cheap to hedge Euros or Yen today, but fairly expensive to hedge emerging market currencies where interest rates may run 6-8% or more. And that explains why currency hedged Emerging Market funds are not showing the same out performance we see with currency hedged funds in developed markets, even though the dollar has strengthened in both cases.

Have questions on how to implement this in your portfolio? Please don’t hesitate to call me at 214-478-3398 or send me an email to [email protected] for help!

Our Investment Process

Posted On April 1, 2015 By Admin In Portfolio Management / 1 Comment

Growth Versus Value: An Inflection Point?

Posted On March 30, 2015 By Admin In Portfolio Management /

Over time, Value stocks outperform Growth stocks. There are a number of reasons why this has held true over the history of the market. Value stocks may include sectors which are currently out of favor and inexpensive. Investors, on the other hand, are sometimes willing to pay too much for a sensational growth story rather than a boring, blue chip company. Often, those great sounding stocks flame out rather than shooting higher as hoped. The result is that the long-term benefit of value strategies has persisted.

Although the “Value Anomaly” is a historical fact, it hasn’t worked in all periods, and we’re at such a point in time now. Growth has actually outperformed value over the past decade. Even though growth beat value in only 5 of the past 10 calendar years, the cumulative difference is notable. Over the past 10 years, the Russell 1000 Growth fund (IWF) has returned an annualized 9.18% versus 7.10% for the Russell 1000 Value (IWD). And so far this year, Growth (IWF) is up 5%, whereas Value (IWD) has gained only 0.63%.

The last time growth showed a marked divergence from value was the 90’s. And at that time, we saw the valuations of growth companies rise to unsustainable levels. This largely occurred in the tech sector, where for example, we saw Cicso trade for more than 200 times earnings, and become the most valuable company in the world in 2000. Eventually, growth corrected with the bursting of the tech bubble, and we saw value stocks return to favor. These are the cycles of the market, as inevitable as the seasons, although not as consistent, predictable, or rational!

I don’t think we’re in bubble territory for the market today, but some popular growth names have certainly started to become expensive and value is looking like a relative bargain. Looking at the top 10 stocks in the both indices, the growth stocks have an average PE of 27, versus 17 for the 10 largest value companies. Some of that difference is Facebook, #4 on the Growth list, with a PE of 75. However, the difference in valuation is across the board. Two of the largest value companies, Exxon Mobil and JPMorgan Chase have a PE of only 11.

So, what are the take-aways from the Growth/Value divergence?

Growth has outperformed value in recent years. This will not continue forever.
Our portfolios are diversified, owning both growth and value segments. We have a slight tilt towards value, which we will continue. When value returns to favor, this will benefit not only pure value funds, but will also likely help dividend strategies, low volatility ETFs, and fundamentally-weighted funds.
As the overall market becomes more expensive, I would expect to see that we will move from a unified market, where all stocks move up or down together, to a more segmented market, where stocks move more based on their valuation and fundamentals. Global macro-economics have been the primary driver of stock prices in recent years, but this should abate somewhat as the recovery continues.

We won’t know if we’ve reached an inflection point, where value will overtake growth, until well after the fact. Growth can’t outperform indefinitely, and as investors become more cautious, value stocks will start to look more and more attractive. That’s what we’re seeing in the market today and why we started to increase our value holdings in 2015.

Source of fund data: Morningstar, through 3/27/2015

Are Equities Overvalued?

Posted On January 5, 2015 By Admin In Behavioral Finance, Portfolio Management /

In last week’s blog, we reviewed the fixed income market and discussed how we are positioned for the year ahead. Today, we will turn our attention to the equity portion of our portfolios. Perhaps the top question on most investors’ minds is whether the 5-year bull market can continue in 2015. At this point, are equities overvalued or do they still have room to run?

I don’t think it’s useful to try to make predictions about what the market will do in the near future, but I’m certainly interested in understanding what risks we face and what areas may offer the best value for our Good Life Wealth model portfolios. We use a “Core + Satellite” approach which holds low-cost index funds as long-term “Core” positions, and tactically selects “Satellite” funds which we believe may enhance the portfolio over the medium-term (12-months to a couple of years).

The US stock market was a top performer globally in 2014. The S&P 500 Index was up over 13% for the year, and US REITs (Real Estate Investment Trusts) returned 30%. Those are remarkable numbers, especially on the heels of a 32% return for the S&P in 2013. With six years in a row of positive returns, valuations have increased noticeably for US stocks. The S&P now has a forward P/E (Price/Earnings ratio) of 18, slightly above the long term average of 15-16.

While US stocks are no longer cheap, that doesn’t automatically mean that the party is over. With a strong dollar, foreign investors are continuing to buy US equities (and enjoyed a greater than 13% gain in 2014, in their local currency). The US economic recovery is ahead of Europe, where growth remains elusive and structural challenges are firmly in place. Compared to many of the Emerging Market countries, the US economy is very stable. Emerging economies face a number of economic and political issues, and struggle with declining energy prices, often their largest export.

US Stocks remain the most sought-after. While today’s P/E is above average, “average” is not a ceiling. Bull Markets can certainly exceed the average P/E for an extended period. And given today’s unprecedented low bond yields, it’s tough to make a comparison to past stock markets; equities are the only place we can hope to find growth. Current valuations are not in bubble territory, but it seems prudent to set lower expectations for 2015 than what we achieved in the previous five years. And of course, stocks do not only go up; there are any number of possible events which could cause stocks to drop in 2015.

Given the current strength of the US market, you might wonder why we own foreign stocks at all. They certainly were a drag on performance in 2014. In Behavioral Finance, there is a cognitive error called “recency bias”, which means that our brains tend to automatically overweight our most recent experiences. For example, if we did a coin-toss and came up with “heads” four times in a row, we’d be more likely to bet that the fifth toss would also be heads, even though statistically, the odds remain 50/50 for heads or tails.

Checking valuations is a important step to avoid making these types of mistakes. Looking at the current markets, Foreign Developed Stocks do indeed have better value than US stocks, with a P/E of 15.5 versus 18. And Emerging Market stocks, which were expensive a few short years ago, now trade at an attractive P/E of 13. We cannot simply look at which stocks are performing best to create an optimal portfolio allocation. Diversification remains best not just because we don’t know what will happen next year, but because we want to buy tomorrow’s top performers when they are on sale today.

Our greatest tool then is rebalancing, which trims the positions which have soared (and become expensive), to purchase the laggards (which have often become cheap). So we’re making very few changes to the models for 2015, because we want to own what is cheap and want to avoid buying more of what is expensive, even if it does continue to work. We will slightly reduce International Small Cap, and add the proceeds to US Large Cap Value. US Small Cap has become quite expensive, but small cap value now trades at a bit of a discount (or is less over-valued, perhaps), so that is another shift we will make this year.

Each year, I do an in-depth review of our portfolio models and I always find the process interesting and worthwhile. This year, looking at relative valuations in equities reminds me that our best path is to remain diversified, even if owning out-of-favor categories appears to be contrarian in the short-term.

Three Studies for Smart Investors

Posted On June 1, 2014 By Admin In Portfolio Management /

Over the last several years, my investment approach has become more systematic and disciplined. In place of stock picking or manager selection, I believe clients are better served by a focus on strategic asset allocation. Today, we offer investors a series of 5 portfolio models, using ETFs (Exchange Traded Funds) and mutual funds. This approach offers a number of benefits, including diversification, low cost, transparency, and tax efficiency.

This evolution in approach occurred gradually as a result of continued research, personal experience, and pursuing the goal of a consistent client experience. In my previous position, I managed $375 million in client portfolios, performing investment research, designing asset allocation models, rebalancing and implementing trades. I am grateful for having this experience and want to share the reasons why I believe investors are best served by the approach we’re using today.

My investment approach is underpinned by three academic studies. These studies look at long-term investment performance, are updated annually, and offer great insight into what is actually working or not working for investors. As an analyst, I am very interested in what data tells us, and how this may differ from what we think will work or what should work in theory. But even if you aren’t a numbers geek like me, these studies instruct us about investor behavior and where you should focus your efforts and energy. I’m going to give a very brief summary of each study and include a link if you’d like to read more.

1) Standard & Poors Index Versus Active (SPIVA)

Published semi-annually, SPIVA looks at all actively managed mutual funds and calculates how many active managers outperform their benchmarks. The long-term results are consistently disappointing. As of December 31, 2013, 72.72% of all large cap funds lagged the S&P 500 Index over the previous five years.

Sometimes, I hear that Small Cap or Emerging Market funds are better suited for active management because they invest in smaller, less efficient markets. This sounds plausible, but the numbers do not confirm this. The data from SPIVA shows that 66.77% of small cap funds lagged their benchmark and 80.00% (!) of Emerging Market funds under performed over the past five years.

The lesson from SPIVA is that using an index fund or ETF to track a benchmark is a sensible long-term approach. Indexing may not be exciting or produce the best performance in any given year, but it has produced good results over time and reduces the risk that we select the wrong fund or manager. Our approach is to use Index funds as a core component to our portfolio models.

The other conclusion I draw from SPIVA is that if large mutual fund companies, with hundreds of analysts, cannot consistently beat the benchmark, it would be foolish to think that a lone financial advisor picking individual stocks could do better.

2) S&P Persistence Scorecard

After looking at SPIVA, it may occur to investors that 20-35% of funds actually did beat their benchmarks over 5 years. Why not just pick those funds? Why settle for average when you can be in a top-performing fund?

The S&P Persistence Scorecard looks at mutual funds over the past 10 years. At the 5-year mark, the scorecard ranks funds in quartiles by performance and looks at how the funds’ returns were in the subsequent five years. This tells us if a top performing fund is likely to remain a leader.

Looking at all US Equity funds, we start with the funds which were in the top quartile in September 2008. Below is breakdown of how those top quartile funds ranked in the subsequent five years, through September 30, 2013:

1st Quartile: 22.43%

2nd Quartile 27.92%

3rd Quartile: 20.53%

4th Quartile: 16.71%

Merged/Liquidated: 12.41%

Of the funds in the 1st Quartile in 2008, only 22% remained in the top category in the following 5 years. 29%, however, fell to the bottom quartile or were merged or liquidated in the following 5 years. So, if your method is to go to Morningstar and find the best performing fund, please be warned,past performance is no guarantee of future results. In fact, the Persistence Scorecard tells us that not only is past performance not a guarantee, it isn’t even a good indicator of future results. The results above aren’t much different than a random chance of 1 in 4 (25%). Albeit disappointing and counter-intuitive, the reality is that past performance offers virtually no predictive information.

3) Dalbar Quantitative Analysis of Investor Behavior (QAIB)

Now in its 20th year, QAIB compares mutual fund returns to investor returns. The reason why they differ is because of the timing of investors’ contributions and withdrawals from mutual funds. For example, people may think that it is safer to invest when the market is doing well and they buy at a high. Or, investors chase last year’s hot sector and sell out of a fund that is at a low and just about to turn around. Investor decisions are consistently so poor that we can actually measure the gap between the average investor’s return and the benchmark. You might want to sit down for this one – over the 20 year period through 2013, the S&P 500 Index returned 9.22% annually, but the average investor return from equity mutual funds was only 5.02%. The behavior gap cost investors 4.20% a year over two decades.

We can draw three very important conclusions from QAIB:

– We should avoid trying to time the market (buy/sell);

– Chasing performance is more likely to hurt returns than improve returns;

– Without a disciplined approach, including a target asset allocation and monitoring/rebalancing process, what may feel like a good investment decision at the time may ultimately prove to be a poor choice in hindsight.

These three studies are so important that I carry excerpts from the reports with me to discuss with investors. They’re fundamental to my investment approach, and hopefully, their significance can easily be grasped and appreciated by all our clients.

While we’ve focused exclusively on investment philosophy in this post, I would be remiss to not add that the benefits of working with a CFP(R) practitioner are not limited to portfolio management. A comprehensive financial plan includes many elements, such as savings/debt analysis, risk management, tax strategies, and estate planning. The investment management component tends to get the greatest attention, but the other elements of a personal financial plan are equally important in creating a foundation for your financial security.