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Posts from the ‘Mutual Funds & Exchange, Traded Funds (ETFs)’ Category

8
May

Changing Market: Municipal Bonds After Tax Reform

January is typically a strong month for the municipal bond market, but 2018 began with the worst January performance since 1981, driven by rising interest rates and uncertainty over changes in the Tax Cuts and Jobs Act (TCJA).1 The muni market stabilized through April 2018, but uncertainty remains.2 The tax law changed the playing field for these investments, which could affect supply and demand.

When considering these dynamics, keep in mind that bond prices and yields have an inverse relationship, so increased demand generally drives bond prices higher and yields lower, and vice versa. Any such changes directly affect the secondary market for bonds and might also influence new-issue bonds. If you hold bonds to maturity, you should receive the principal and interest unless the bond issuer defaults.

Tax rates and deduction limits

Municipal bonds are issued by state and local governments to help fund ongoing expenses and finance public projects such as roads, water systems, schools, and stadiums. The primary appeal of these bonds is that the interest is generally exempt from federal income tax, as well as from state and local taxes if you live in the state where the bond was issued. Because of this tax advantage, a muni with a lower yield might offer greater value than a taxable bond with a higher yield, especially for investors in higher tax brackets.

The lower federal income tax rates established by the new tax law would cut into this added value, but the difference is relatively small and unlikely to affect demand. Many taxpayers, especially in high-tax states, may find munis even more appealing to help replace deductions lost to other TCJA provisions, including the $10,000 cap for deductions of state and local taxes.3 Tax-free muni interest can help lower taxable income regardless of whether you itemize deductions.

The large corporate tax reduction from a top rate of 35% to 21% is likely to have a more significant effect on demand for munis. Corporations, which own a little less than 30% of the muni market, may hold on to bonds they currently own but become more selective in purchasing future bonds.4

A tightening market

The supply of new municipal bonds dropped after the fiscal crisis as local governments became more cautious about borrowing. The TCJA further tightened the market by eliminating “advanced refunding” bonds, issued to replace older bonds at lower interest rates, which have accounted for about 15% of new issues.5

This is expected to reduce the supply of bonds for the next three years or so, but the long-term effects are unclear. If interest rates continue to climb, there is less to gain by replacing older bonds, but local governments may issue taxable bonds if they see an opportunity to reduce interest payments. There may also be changes to the structure of future muni issues.6

Risk and rising interest rates

Munis are considered less risky than corporate bonds and less sensitive to changing interest rates than Treasuries, making them an appealing middle ground for many investors. For the period 2007 to 2016, which includes the recession, the five-year default rate for municipal bonds was 0.15%, compared with 6.92% for corporate bonds. Most of those defaults were related to severe fiscal situations such as those in Detroit and Puerto Rico. The five-year default rate for investment-grade bonds (rated AAA to BBB/Baa) was just 0.05%.7

Treasuries, which are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, are considered the most stable fixed-income investment, and rising Treasury yields, as occurred in early 2018, tend to put downward pressure on munis.8 However, Treasuries are more sensitive to interest rate changes, and stock market volatility makes both Treasuries and munis appealing to investors looking for stability.

Bond funds

The most convenient way to add municipal bonds to your portfolio is through mutual funds, which also provide diversification that can be difficult to create with individual bonds. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against investment loss.

Muni funds focused on a single state offer the added value of tax deductibility for residents of those states, but smaller state funds may not offer the level of diversification found in larger states. It’s also important to consider the holdings and credit risks of any bond fund, including those dedicated to a specific state. For example, in October 2017, many state funds still held Puerto Rico bonds, which are generally exempt from state income tax but carry high credit risk.9

If a bond was issued by a municipality outside the state in which you reside, the interest may be subject to state and local income taxes. If you sell a municipal bond at a profit, you could incur capital gains taxes. Some municipal bond interest may be subject to the alternative minimum tax.

The return and principal value of bonds and bond fund shares fluctuate with changes in market conditions. When redeemed, they may be worth more or less than their original cost. Bond funds are subject to the same inflation, interest rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance. Investments offering the potential for higher rates of return involve a higher degree of risk.

Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

1, 8) CNBC, February 28, 2018

2) Bloomberg, 2018 (Bloomberg Barclays U.S. Municipal Index for the period 1/1/2018 to 4/16/2018)

3-4, 6) The Bond Buyer, February 12, 2018

5) The New York Times, February 23, 2018

7) Moody’s Investors Service, 2017

9) CNBC, October 10, 2017

22
Feb

Highlights from various articles of note

Target Date Funds:
An article by John Sullivan in the inaugural issue of “401k Specialist” discussed Target Date Funds (TDF).  The article is based on a panel discussion at the 2015 Morningstar Investment Conference.   Initially these funds were disappointing.  One area of concern related to asset-class diversification. The question was not just about the ratio of stocks to bonds.  The portion in domestic, foreign and alternative investments was also a concern.  Another area requiring improvement was how the mix of assets changed over time and during retirement.

TDFs have improved since their introduction. Three companies account for 70% of the assets in these funds.  At one point they accounted for 80%.  Only one firm had funds (3) in the highest 10 performing funds.  The other top performing TDF’s were from 2 other firms.

The greatest benefits of TDFs from my viewpoint is the improvement in investor behavior.   “Investors are using them well.  They don’t exhibit the typical behaviors of fear and greed with target date funds, and as a result stay the course and remain invested longer.”

Not all TDFs are the same.  You want one that is consistent with your situation and your plan.

Retirement Planning Calculators:
This is the subject of a Wall Street Journal article, “New Study Questions Retirement Planning Calculators’ Accuracy.” This article was update online Feb. 22, 2016.

The article discusses an academic study of 36 retirement planning calculators.  “… ‘in most cases, the available offerings are extremely misleading ‘ and generally not helpful to consumers trying to figure out if they will have enough money to cover their expenses for the rest of their lives.”

The study was based on “… a hypothetical couple in their late 50s earning $50,000 each and aiming to retire at ages 65 and 63.”  The calculators were described as “…free and low-cost…” The cause of the misleading results was the limited amount of information used by the calculators.

“…the researchers identified a list of more than 20 factors they believe should be included…”

Do not use the simplest calculator available.  Pick one that has many questions.  Also review the assumptions they are using.  All calculators are use assumptions.  Some assumptions to all calculators are: life expectancy, health, inflation rates, investment returns.  Other questions would include the amount of your current investments and amounts you are currently savings.

31
Jan

The No. 1 stock over 30 years illustrates the advantage of index funds.

The “super stocks”  over this period “…have all undergone at least one near-death experience.” according to David Salem.   “Balchem shows the patience, grit and good luck it takes for a company to turn into a superstock.”

“The stock didn’t attract a single major institutional holder until 1999, even though it had returned an average of 21.3% annually over the previous decade.

“Investment professionals often ridicule index funds-those autopilot portfolios that mechanically own every stock in a market benchmark – for holding overpriced stocks and riding them all the way down. But one of the unsung virtues of index funds is that, by design they cling to their holding through even the worst downdrafts.”

His summary of the article is that most people are better off with index funds. “In the long term, capturing the full upward sweep of a super-stock requires enduring several near-death experiences along the way.”

The article did not attempt to discuss the differences among index funds. The differences are important in developing a portfolio.  Each index may include different companies or a different mix of companies.  Size, industry, location, performance are examples of differences.  The type and portion of companies can vary.   The expenses of each fund also vary.  Very few individuals can outperform the market.  Select funds that are best for you.

14
Jul

A Harvard professor of economics thinks inveseting is complicated

The article’s title,  “Why Investing Is So Complicated, and How to Make It Simpler”, caught my attention.  The article was in the July 11, 2015 edition of TheUpshot NY Times.   Sendhil Mullainathan (the author of the article) compared investing to “taking a final exam in a class” he never attended.

Sendhil concludes his article with his realization that paralysis is the biggest cost of procrastination.  The paralysis was caused by his fear of making a mistake in choosing an investment.  During the time he did not act his money did not earn anything as his money was not invested.

He identified some of the reasons why investing is so difficult.  One reason is the lack of sound employer-provided pension plans.  Today we must take the steps to provide the comfortable retirement that we want.  Savings  becomes a primary activity required to meet our financial goals.  I am including investing as part of savings for this purpose.  Maximizing contributions to 401(k) accounts and IRAs (Traditional and/or Roth) become important. Adopting tax favored retirement plans are an important tool for the self-employed entrepreneur.

Finding quality financial advisers was another issue he identified.  A study he was associated with “…examined advisers who did not charge clients directly.  Their advice was ‘free,’  but under current rules, their advice only had to meet a very low standard – it only had to be ‘suitable’ in a broad sense of the word.”  Mr. Mullaimathan referred to the need for a meaningful fiduciary standard.  The struggle to adopt a fiduciary standard has been going on for a long time.  Congress seems to have been the roadblock.  I leave to your imagination why they resist holding all financial advisers to a fiduciary standard.

The discussion included the variation in funds (mutual funds and exchange traded funds).  His approach was to find a broad-based indexed fund.  He mentioned the Standard & Poor’s 500 and the Russell 2000 indexes.  Many funds do not include the entire index.  There are funds that use statistical sampling to include a desired portion of all the securities in the index.  Other funds filter out some securities.  A fund may use one or more factors to determine the securities to be included. Some, but not all the, factors are: how may years the firm has existed, how long the security has been listed, profitability, dividends,  balance sheet and sales.  There are indexes that only include specific sectors, specific regions, specific firm size, growth characteristics, social responsibility, etc.  Another variation is the weight each security has within the index. Some, but not all, determine the amount of each security by: the firms total market value, by the value of a share, and equal amount of each security.

There are a lot of advantages to using index funds.  Look for what is included, what is excluded and weighting the fund gives to each security included in the index.   The number of funds and types of funds you should have should be determined based on your specific situation.  Pay close attention to cost.  One potential advantage of an indexed approach is reduced cost.  Too many indexes could defeat the diversification of a portfolio. You should also look at how the index fund compares to the index.  If the performance is not close to the index, then you may not get what you are looking for.

 

 

 

5
Jan

A helpful list for investors

It seems that everyone has a list on almost every topic, especially at year-end and the start of a new year.   I sometimes wonder what to do with this information.  Anna Prior’s Jan. 2, 2015 New York Times article, “The 15 Numbers Every Investor Needs to Know” is an exception.  It provides an approach to planning.  Following is a condensed discussion of the article:

  • Know what allocation of stocks, bonds and cash is appropriate for you.  Among the many factors to consider are: your financial goals, the value of your current investments, your health, your age, and your ability to withstand a drop in the value of your investments.
  • Take advantage of your ability to contribute to your employers’ 401(k) retirement plan, if applicable, for your situation.  The 2015 maximum contribution is $18,000 for a pretax traditional 401(k) plan and after-tax Roth 401(k) plan.  Those 50 or older can contribute an additional $6,000.  Understand the requirements and impact of taking distributions from your retirement plans.
  • Be familiar with the general valuations of stocks.  This will help you gage your investment risk.  Compare the average price/earnings (PE) ratio of stocks to the current PE.  The S&P 500 is commonly used as a proxy for the stock market.
  • Some consider bonds as a source of safety for investors.  It is difficult to predict how bonds will perform in the short-term.  The yield on the 10-year Treasury note will give you an indication of what the yield on bonds will be in the next 10 years or so.
  • High investment costs will reduce your returns  The expense ratios of your funds can be found in the fund prospectus, the website of the fund company and other media sources.
  • Be aware of your adjusted gross income (AGI).  This is the amount at the bottom of page one of you individual U.S income tax return.  The AGI will determine if other taxes or limitations will apply to you.  Examples are the 3.8% surtax on investment income, Medicare Part B & D premiums, deduction of some retirement plans, and some itemized deductions.
  • Estate-tax exemption of the states are often lower than the U.S. estate exemption.  This must be considered  in your planing for your family, heirs and charitable entities.
  • The amount of your essential and discretionary costs should be reviewed periodically.  This is important for: retirement planning, insurance planning and maintaining an adequate reserve fund for the unexpected and untimely expenditures.
  • Understand your health-care expenses.  This is need for; insurance planning, retirement planning and maintaining an adequate reserve fund.
  • Be aware of the difference between replacement cost and fair market value.  The difference to rebuilding a home can vary from what the home would sell for.  Replacing the contents of you home may be more than the fair market of the items.
  • The difference between owning and renting a home can have a major impact on your cash flow and quality of life.  The impact maybe more significant  when buying a first home and when retiring.
  • How long you are likely to live has a significant impact on your investment planning and cash flow planning.
  • Your approach to borrowing and repaying loans impacts your cash flow planning, investment planning and retirement planning.
  • Be aware of current and anticipated mortgage rates.  These impact planning relating to refinancing and debt repayment (cash flow planning).

There are many moving factors in planning.  An understanding of the parts and the alternatives are essential to a successful plan.

 

 

23
Jul

Is your portfo as divesified as you think it is?

The following is taken fron an article in the July 2014 issue of Morningstar ETFInvestor.  Samuel Lee was the author of the article.

“Most investors understand that they should diversify a lot.  However, some hurt themselves by behaving inconsistently.  They diversify a lot while implicitly behaving as if they know a lot.  A big subset of this group is investors who own lots of different expensive funds.  Owning one expensive fund is a high-confidence bet on the manager.  Well-done studies estimate that the percentage of truly skilled mutual fund managers is in the low single digits.

It would be strange if your process for assessing mangers turns up lots and lots of skilled ones, because there aren’t many in the first place.  (If you see skilled mangers everywhere, chances are your process is broken or not discriminating enough.)  It  would be even stranger if you bet on many of them.  Doing so dooms you to getting index-like results while paying hefty fees.  It makes little sense to pay 1% or more of assets on an aggregate portfolio with hundreds of positions and marketlike behavior.

An exception is if you assemble a portfolio of extremely concentrated fund mangers.  Owning 10 funds with 10 stocks each put together will look like a moderately concentrated fund manager.  This is a model some successful endowments, hedge funds, and mutual funds use.

Most investors should own diversified, low-cost funds.  Those who believe they know something should concentrate to the extent that they’re confident in their own abilities.  A big dang is that humans are overconfident; many will concentrate when they should be diversified.”

Pay special attention to the above if you think it does not apply to you!

11
Mar

A financial plan is essential for you to know how to invest your money.

To over simplify, financial planning is how you manage your finances and establish a path to reaching your goals.  Investment management is one part of managing your finances.  It is the part that determines how your savings will be invested.

Financial planning starts with your goals.  The amount and timing are critical.  Prioritizing your financial goals is necessary.   You can assign a priority of 1 to 10 or categorize your goals by what is needed, what is wanted and what is wished for.  This will be essential as you monitor your progress.  Life and unanticipated events are not controllable and may require adjustments.  Adjustments may result in changes to your goals, the timing of your goals, or your spending.

A reserve fund is needed to absorb unexpected events.   Reserves should be held so that they are quickly assessable, that is, liquid.   Six months of reserve are generally recommended.   As you approach each goal, the reserve fund should be increased.  This will avoid the impact of fluctuating investment values when the funds are needed.   The amount of liquid assets should be increased as you near retirement.  This minimizes the need to sell investments when the market is depressed.  Two years of liquid funds are generally recommended for retirees.  A portion of the funds for living expenses in retirement might be held in short-term bond funds or bonds.

Investments are purchased with the amount of your savings that exceed your reserves.  The amount that is used for investments must be sufficient to reach your goals.  Education expenses and health care are two categories of expenses that have exceeded what people anticipated.  Many people underestimate the amount they will need in retirement.  Because life expectancy has increased and people have retired early, many people will not be able meet their retirement goals.

The planning process needs to consider the above events and your ability to withstand losses.

The above has touched on cash planning, investment planning, education planning, risk assessment and retirement planning.  All the planning areas need to fit together.  How you manage your investments is dependent on the other areas of your financial plan.
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9
Jul

Due Diligence is required in selecting target-date funds.

The Wall Street Journal July 8, 2012 published another article discussing target-date funds,  “One Target, but Many Ways to Hit It”.  The sub-title of Michael A. Pollock’s article is “Target-date retirement funds sound simple.  But competing strategies make it tough to choose one.”  The article starts with: “With target-date funds, the targets themselves never change.  But the strategies for hitting those targets are all over the place.” 
“But even as dollars pour into such funds, the asset-management industry continues to debate how best to design the funds for their central mission. 
This article provides a discussion of the factors that differ among the various investment firms.  Understanding these issues may help you select the target date funds that fits your personal profile.  It will help if you know what your financial goals are, when the goals occur, your current investment assets, your health, whether you can tolerate the fluctuation in the values,  your tolerance for losses, and many other factors.
You should understand the mix of assets (stock, bonds, alternatives) and how they change to the target date.  As important is how they change after the target date.  How does the fund inform the investors when they change these factors and the timeliness of the disclosures should be considered.  Naturally, the expenses of the fund should be a factor.
With these factors you can pick the fund that comes closest to your situation.
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14
Apr

Do you consider Exchange-Traded Notes (ETN) the same as Exchange-Traded Funds?

Samuel Lee, an analyst at Morningstar, the research firm is quoted in Jason Zweig’s column in today’sThe Wall Street Journal.  “When it comes to expenses, I consider all ETNs to be suspect unless you’ve combed through every page of the prospectus.”  “Don’t even try that unless you have a couple of hours, a magnifying glass, a financial calculator and a few pints of strong coffee.”
One of the basics in inveting is that you should only invest it what you understand.  ETF are increasingly being used in portfolios.  There is concern that too many people think ETNs are the same as ETFs.
Costs are one factor that is different.  The costs are generally higher and more difficult to discover than ETFs and mutual funds.  Some are significantly higher.  The “…reported expenses, as high as they sound, might understate the costs.”
Tax efficiencies is one of the advantage of ETFs.  The taxation of ETNs is not as clear.  The income of many ETNs maybe ordinary income, taxed at ordinay income rates rather than lower rates that apply to capital gains.  
ETNs can trade at higher premiums than ETF.  Large ETFs tend to generally trade very close to the underlying index.  ETNs are “generally…structured as borrowings…regulated like bonds…”   
If you are considering ETNs and think you understand ETNs, make sure you understand how they would help your portfolio.  That includes a reasonable expectation that risk is being compensated with higher returns.
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24
Dec

Do you know what factors to consider in picking stocks, mutual funds or Exchange Traded Funds?

You will not be surprised that my answer to the above question is “it depends”.  “Here’s What’s Really Driving Your Returns”, an article in today’s Wall Street Journal Weekend Investor, touts the advantages of “factor investing”.  This concept has been around for a long time.  My preference is to call it “fundamental” investing.  It is selecting the data points to consider and how to weight hem.  
There are an infinite number of data points that can be considered.  If you are familiar with Morningstar, you have probably noticed that they are constantly adding data points for investors to consider.  They include alpha, assets, beta, book value, concentration,  dividends, earnings, debt, growth, liquidity, price, profits, risk,  sales, size, style,  turnover, weighting, Oh My!  Some of these data points are compared to other data points.  Be sure to understand the data points that you watch and how they should be compared to other data points.  
If you are selecting individual stocks you need to determine what criteria you are using.  If you are using mutual funds you need to determine how the manager is weighting these dat points.  If you are using an index fund or an Exchange Traded Fund you need to know how the various factors are weighted.  Do your research, be consistent, and consider costs.
When constructing you investment portfolio, understand the factors that are important to your unique situation.  To do this you must know (at a minimum) what your financial goals are, the time when the goals are to be realized, and your risk level.  How sensitivity to the ups and downs of the market and likelihood of loss are you?  Design a benchmark to measure the performance of your portfolio.  Monitor you progress.  If you think you need to monitor your progress daily, your portfolio is probably too risky.
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