Finance: Mutual Funds and Taxes

Many investors fail to manage their funds based on tax effects. This simply means that you keep the tax-efficient funds in your taxable accounts and the tax-inefficient funds in your tax-advantaged (either deferred or exempt, such as a 401k or Roth IRA) accounts. Obviously it would be best to keep everything in a tax-advantaed account, but this can be impossible once you build up a portfolio of moderate size. Additionally, your employer's 401k may not offer you all the asset classes you need, or they might offer high expense ratio funds that you want to avoid at all costs. I have heard one statistic that poor tax planning can cost you up to 2.5% of your pre-tax return!

From our friend Taylor over at Vanguard Diehards: "Here is a list of securities in approximate order of their tax-efficiency. (Least tax-efficient at the top.)

Hi-Yield bonds
TIPS
Taxable bonds
REIT stocks
Stock trading accounts
Small-Value stocks
Small-Cap stocks
Large Value stocks
International stocks
Large Growth stocks
Most stock index funds
Tax-Managed funds
EE and I-Bonds
Tax-Exempt bonds"

However, there are some who believe that if you can't hold certain asset classes in a tax-advantaged account you shouldn't hold them at all. I disagree with this theory, as I feel like it's letting the tail wag the dog. To my mind, the benefits of diversification outweigh

For example, if my AA plan called for 10% REITs, and I couldn't keep them in the proper account, I would still hold them in my taxable account anyway because they will help reduce overall volatility. However, I might reduce the percentage of that asset class slightly, since the expected return is lower net of tax.

My personal hierarchy of investment criteria:

1. Asset allocation
2. Expense ratio & costs
3. Taxes

Finance: ING Direct Raises Rate to 2.6% APR

Our friends at ING Direct have raised rates on their Orange savings account to 2.6%. While it falls short of some of the higest yielding savings accounts out there (like Emigrant Direct, currently at 3%), the hassle of opening a new account (and the fact that I don't keep much uninvested cash around) is not worth the 40 basis points for me. I am glad that ING is still keeping up with rising interest rates. My concern with Emigrant Direct is that they are using a teaser rate to attract new deposits and then once they have enough cash, they will lower the rate (or allow it to languish while others raise their rates). I don't think you can go wrong with either bank....if I were opening a new account today, I would probably go with Emigrant Direct, even though they have less of a track record than ING. You can find a link to both sites using the Google search box (search for ING Direct or Emigrant Direct!

Career: My First Raise!

I received my first raise today of 7% after 6 months on the job, which is not too shabby. As part of the leadership development program I'm in, my raise is calculated on my job performance and my classroom scores. I am not sure if I can repeat this feat in another 6 months, as 7% is the highest increase you can receive (but I will be doing my best). I'll be happy if I'm anywhere in that range.

While the immediate effects of a raise are obvious, it also has long term implications. Of course, more income means a larger tax bill at the end of the year...but that's a sacrifice I'm willing to make. First, since the company 401k match and pension plan benefits are based on salary, you get an incremental boost from having a higher salary. Second, the earlier in your career you can boost your salary - the better, since your future salary increases will be based off your current compensation. Consider the following two examples: In the first case, someone making $50k/yr gets a 7% raise the first year and then 5% raises for the next 15 years thereafter. In the second, all the raises are 5%. A 2% increase on $50k is only $1000, but over the course of 15 years, that extra 2% adds up to almost a $20k cash difference (see table below). Note that this $20k would be slightly reduced by computing the present value of the incremental income. From this example, you can see that the compounding effect magnifies small differences in annual raises. So go out there and get the best performance evaluation you can!

Year	Salary	Raise		Salary	Raise
1	$ 50,000			$ 50,000
2	$ 53,500	7%		$ 52,500	5%
3	$ 56,175	5%		$ 55,125	5%
4	$ 58,984	5%		$ 57,881	5%
5	$ 61,933	5%		$ 60,775	5%
6	$ 65,030	5%		$ 63,814	5%
7	$ 68,281	5%		$ 67,005	5%
8	$ 71,695	5%		$ 70,355	5%
9	$ 75,280	5%		$ 73,873	5%
10	$ 79,044	5%		$ 77,566	5%
11	$ 82,996	5%		$ 81,445	5%
12	$ 87,146	5%		$ 85,517	5%
13	$ 91,503	5%		$ 89,793	5%
14	$ 96,078	5%		$ 94,282	5%
15	$ 100,882	5%		$ 98,997	5%		Difference
	$1,048,527			$1,028,928			$ 19,599

Finance: Cash back credit cards

Just requested my first rebate check of 2005 from my Citi Dividend card for almost $70. It's free money for things I would've bought anyway...what could be better? I jacked up the rebate in this period by putting all of my relocation expenses on the card, and then getting reimbursed by my employer later. If this trend continues, I will have to keep an eye on my total rebate for the year to make sure I don't hit the $300 limit. If I do, I will switch to one of my other rebate cards.

If you don't already have the Citi Dividend Platnium card, just cut and paste

Citi Dividend Platnium
in the Google box above to find the online application at Citi's site. There is no annual fee.

A tip for anyone who already has this card - you should request a rebate check as soon as you hit the $50 limit, because they will usually give you a "bouns" +1% rebate for 90 days following it. This means that you earn 2% on all regular purchases and 6% on all gas/supermarket/pharmacy purchases instead of the normal 1%/5%.

The other card I use most frequently is the Profit From Chase card. This gives me 3% cash back on all restaurant meals and 1% back on everything else. One nice thing about this card is that it credits your rebate against your monthly statement so you don't have to request a rebate check. There is no annual fee. You can find an online application by pasting:

Profit From Chase
in the Google box above to find the online application at Chase's site.

Finance: Take the mileage and run (part 2)

Over the next few months, I will have to travel from NC to GA several times for business. Although I have the option of taking a flight and booking a rental car, I've decided to drive my own car. Why? To collect the $0.405/mi reimbursement, of course!

Here's my rationalization of per-mile costs:

• Gas: 0.06
• Depreciation: 0.08
• Maintenance: 0.03

Total: 0.17, which leaves 0.235/mi as after-tax income. So on my 900 mile round-trip, I'll pocket a few hundred dollars which (to me) is worth the hassle of driving. Even a quick flight plus airport waiting time would take about 4 hours, so I don't mind driving 7 hours and pocketing the cash. It's worth noting that the depreciation and maintenance are deferred (until the next oil change or set of tires), so the only cost I incur upfront is for gas.

This strategy isn't for everyone...I wouldn't do this if you have a newer car that depreciates a lot per mile, or an older car that is on its last legs.

I also have a trip to NY later this year...but at 10 hours one-way, it may be too much of a drive even for me.

Finance: Three perspectives on social security

BusinessWeek has an interesting summary of some different approaches to social security reform in its Three New Ideas article. Personally, I think that Bush has made a big to-do about the social security "crisis" when the actual budget shortfall is many decades ahead, and it pales in comparison to the current overal budget deficit (or just the annual spending on Iraq for that matter). Yes, a few trillion dollars is a lot of money, but we're talking about 30 years in the future. As the first president with an MBA, you'd think Bush would understand Net Present Value. Apparently not.

As a financial pragmatist, I'm really annoyed that Bush has associated the idea of private accounts with fixing the shortfall. To my mind, they are two separate and completely unrelated topics. Social security needs to be revised if it's going to continue to exist (in any form) - but there's absolutely no reason that we need to increase taxes by ~$2T in order to preserve some sort of government-guaranteed pension benefit. Are we expected to believe that increasing taxes (to cover the $2T) is going to encourage more personal savings? Yeah, right.

I support a very simple solution to fix social security: index the annual increase in SS benefits to price inflation, not wage inflation (as is done currently). This is similar to the third solution outlined by BusinessWeek. This proposal doesn't involve the risk of the market, it doesn't require any fancy schemes or new accounts, and it doesn't mandate any new taxes. Simply phase the change in over many years so today's workers have time to adjust their expectations about what SS will provide. Current and near-term retirees won't be affected.

Disclaimer: I don't want to turn this blog into a hotbed of political rhetoric...but if my own political philosophy had to be summarized on a bumper sticker, it would probably be "A Republican Against Bush." His neo-conservative agenda is bad for the economy and bad for America's place in the global marketplace.

Finance: Hedge Funds for the Rest of Us

A hedge fund is an investment vehicle for the wealthy among us who have +$1m net worth and at least $100k to invest in a given fund. The advantage is that these funds are no subject to the same restrictions as mutual funds and can find a variety of ways to make money in the market. But for those of us who don't qualify, there are some other options - here are two.

The Gateway Fund (GATEX)

This fund is a modified index fund. It holds the same securities as the S&P 500 but uses an option collar to modify the total return. First, it sells calls above the current market price and collects the cash. Then, it purchases puts below the current market price. This means that the fund has given up some upside potential but limited its downside losses. If the market continues moving sideways for a long period of time, this fund should outperform the index. Similarly, if the market tanks, this fund should be somewhat protected. You could do something similar with ETFs on your own if you were so inclined, but the time and transactions costs would eat into your returns on a small portfolio.

I switched out of Vanguard Total Market Index (VTMSX) and into this fund. One of my pet peeves with Vanguard's index funds is that they charge an extra $10/year fee if your balance is below $10,000. This is not a large sum of money in the grand scheme of things, but I don't like being nickel and dimed (especially ironic coming from Vanguard, where they tout their low-cost mantra). However, I do still have a portion of Vanguard's S&P 500 index fund in my 401k.

The Merger Fund (MERFX)

This is another choice that resembles a hedge fund. It uses arbitrage on the securities of companies that may be merged/acquired/reorganized in order to exploit inefficiencies in the marketplace. Unfortunately, it is closed to new investors at the moment. Yahoo Finance has an article on the Few Choices Among Merger Funds. Of course, the merger funds that are open suffer from high fees, loads, and currently they're sitting on a lot of cash because there's not much M&A activity.

Finance: The Yield Curve

The yield curve is the graphical representation of interest rates paid by bonds of varying durations. Generally it slopes upward because as the length of a bond increases, investors demand a higher return to compensate them for the increased risk. Although logical, this is not always the case. SmartMoney's The Living Yield Curve article discusses some situations where the yield curve was not upward sloping, and the implications for investors.

If you're like me, you want to grapple with the numbers yourself to see how the curve really looks. You can use the Java applet on their site, or you can get the Treasury Department's current and historical rates on their Daily Treasury Yield Curve site. It's easy to paste these numbers into Excel and generate a quick graph. A comparison of Jan-04 versus Feb-05 shows that the curve has indeed flattened over the last year into a nearly perfect diagonal line. At the same time, the difference between the 20-yr and the 1-mo rates has shrunk from 433 basis points (100 basis points = 1%) to 242 basis points. Does this mean we're heading back into a recessionary period (we should short the Dow)? Are long-term rates ready to shoot upward (we should short the long bond)? I'm going to have to ask someone else...my crystal ball isn't working.

Finance: The efficient market

JLP asked a good question in response to my last post:

I agree with you that the markets are pretty much efficient. However, how do you explain the outstanding performance of someone like Warren Buffett, Peter Lynch, Bill Miller,...? If the markets were "truly" efficient, none of those guys would be as successful as they have been.

I don't want to turn the site into an EMH debate (which is unlikely to be resolved anytime soon) but you could look at this question from a few different angles.

First, you could think about it statistically. If 1000 people flip a coin 1000 times, it is very unlikely that any particular person will have 1000 heads or 1000 tails. However, the results are normally distributed, so there most of the people will have close to a 50/50 ratio of heads/tails, but there should be a few people at the "tails" of the distribution curve that have many more heads than tails (or vice versa). Are those people any "better" than average at flipping a coin? Doubtful. Nor are they any more likely to continue their streak in the future. Putting this example in finance terms: There are a large number investors out there. Most will earn average returns (before fees and expenses), while a smaller number will earn substantially less and others substantially more. But if the market obeys the laws of statistics, those exceptional fund managers may be nothing more than a statistical blip.

Second, we have the uber-investors like Warren Buffet, who has become an institution unto himself. He is not like the individual investor who sits on the sidelines and watches mergers & acquitsitions (M&A) activity happen - he is actively involved in the deals and knows the key players personally. It is not hard to imagine that he has access to exceptional information through his relationships. This doesn't explain how he got his start, but it may help us understand how he has been able to leverage his experience (and exploit human capital resources) once he had enough money to be a player.

Third, let's say that there are a few special individuals out there who really can beat the market over the long-term (which may be possible, I just think it's improbable). It is very easy to identify them ex post because of the attention they receive in the media. But how would you identify them ahead of time? Could you have picked Buffet out of the crowd 30 years ago when his track record of success was much shorter?

Finance: The periodic table of investments

I believe that the equity markets are fairly efficient. This means that assets are fairly priced at any given time so it's hard to find true "bargains." Fair pricing comes from the fact that so many investors are researching and trading any given security at a point in time, so if the security was grossly over- or under-valued, the investor would buy (or sell short) the asset, pushing the price back to the "true" value. This seems like a very logical approach to the markets. This is a quick summary of the Efficient Market Hypothesis (EMH), which leads to CAPM, beta, and a variety of other finance concepts.

Ivory tower pontifications aside, what does the EMH have to do with the individual investor? Index funds! If you can't beat all the other investors, you should join them by purchasing a variety of low-cost mutual funds that are diversified across the major asset classes. Let all the Wall Street types spend 80 hours a week in Excel figuring out where to put their millions - then you come along and trade off of their hard work. What could be better than that?

Of course, there are plenty of people who think they can outsmart the market. And who knows, maybe it is possible - but I think it's exceedingly difficult to do over a long period of time. As evidence of how difficult it is to pick the winning sectors in advance, check out the Periodic Table of Investments (PDF). It shows the return from a variety of asset classes grouped by year from 1995-2004. Can you spot the pattern? I sure can't. So put a sensible asset allocation to work instead.

If you're interested in learning more about the EMH and random short-term volatility in equity prices, check out A Random Walk Down Wall Street by Malkiel.

However, the EMH is not the grand unified equation of finance. After all, if the market is so efficient, why did we have the tech bubble of 2001? Good question. Enter the field of behavorial finance, which has started to challenge the EMH.

Finance: The lazy portfolio

A fund manager that advocates a diversified, low-expense ratio, index fund approach to investing? Be still my beating heart! Ted Aronson seems to fit the bill with his Lazy Portfolio:

CBS MarketWatch: The Lazy Portfolio 2004

His portfolio is not too different from what you might construct after reading "The Four Pillars of Investing," "The Coffeehouse Investor," or anything by Bogle (though he wouldn't support the 30% allocation to international). While this portfolio scores high on simplicity, I suspect it could be improved with the addition of a few more asset classes: REITs, metals, commodities, I-bonds, and international bonds. But then, everyone may not have the stomach to slice-and-dice.