Objective information about financial planning, investments, and retirement plans

The Bull Market Turns Seven Now What?

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On March 9, 2009 the market downturn fueled by the financial crisis bottomed out as measured by the S&P 500 Index. On that day the index closed at 677. Yesterday, on the bull market’s seventh birthday, the index closed at 1,989 or an increase of about 194 percent. According to CNBC the Dow Jones Industrial Average has increased 160 percent and the NASDAQ 267 percent over this seven-year time frame.

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With the bull market turning seven, now what? Here are some thoughts and ideas for investors.

How does this bull market stack up?

According to data from the most recent quarterly Guide to the Markets report from JP Morgan Asset Management, the average bull market following a bear market lasts for 53 months and results in a gain of 153%. By both measures this bull market is a long one.

Does this mean that investors should brace for an imminent market correction? Not necessarily but bull markets don’t last forever either.

There have been some speed bumps along the way, including 2011, a sharp decline in the third quarter of 2015 and of course the sharp declines we saw to start off 2016. Again this is not an indicator of anything about the future.

Winners and losers

A commentator on CNBC cited a couple of big winners in this bull market:

  • Netflix (NFLX) +1,667%
  • General Growth Properties (GGP) +9,964%

Additionally, Apple (APPL) closed at a split-adjusted $11.87 per share on March 9, 2009. It closed at $101.12 on March 9, 2016.

The CNBC commentator cited giant retailer Walmart (WMT) as a stock that has missed much of the bounce in this market, as their stock is up only 42% over this time period.

What should investors do now? 

None of us knows what the future will hold. The bull market may be getting long of tooth. There are factors such as potential actions by the Fed, China’s impact on our markets, the threat of terrorism and countless others that could impact the direction of the stock market. It seems there is always something to worry about in that regard.

That all said, my suggestions for investors are pretty much the same “boring” ones that I’ve been giving since I started this blog in 2009.

  • Control the factors that you can control. Your investment costs and your asset allocation are two of the biggest factors within your control.
  • Review and rebalance your portfolio This is a great way to ensure that your allocation and your level of risk stay on track.
  • When in doubt fall back on your financial plan. Review your progress against your plan periodically and, if warranted, adjust your portfolio accordingly.
  • Contribute to your 401(k) plan and make sure that your investment choices are appropriate for your time horizon and risk tolerance. Avoid 401(k) loans if possible and don’t ignore old 401(k) accounts when leaving a company.
  • Don’t overdo it when investing in company stock.
  • If you need professional financial help, get it. Be sure to hire a fee-only financial advisor who will put your interests first.

The Bottom Line 

The now seven-year bull market since the bottom in 2009 has been a very robust period for investors. Many have more than recovered from their losses during the market decline of 2008-09.

Nobody knows what will happen next. In my opinion, investors are wise to control the factors that they can, have a plan in place and follow that plan.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.

20 Best Investing Blogs of 2016 – The College Investor

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I am very flattered to be included in this list of the 20 Best Investing Blogs of 2016  compiled by Robert Farrington on his outstanding blog The College Investor, with it’s tagline “Investing and Personal Finance for Millennials.”

20 Best Investing Blogs of 2016

I know and follow many of these people and read their blogs on a regular basis. There were a few that were new to me and I plan to add their blogs to my regular reading list as well. If you like to read about investing and financial topics this list is a great place to start.

Jim Blankenship, Financial Ducks In A Row

Josh Brown, The Reformed Broker

Ben Carlson, A Wealth of Common Sense

Kathryn Cicoletti, Ms. Cheat Sheet

Jim Dahle, The White Coat Investor

Sam Dogen, Financial Samurai

Eddy Elfenbein, Crossing Wall Street

Michael Kitces, Nerd’s Eye View

Larry Ludwig, Investor Junkie

Michael Piper, Oblivious Investor

Ben Reynolds, Sure Dividend

Barry Ritholtz, The Big Picture

Jeff Rose, Good Financial Cents

Todd Tresidder, Financial Mentor

Joe Udo, Retire By 40

Tadas Viskanta, Abnormal Returns

Roger Wohlner, The Chicago Financial Planner

The Dividend Guy Blog

Don’t Quit Your Day Job

The Mad FIentist

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.

Denver Wins! Time to Go to Cash?

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The Denver Broncos just won Super Bowl 50 and its looking like Peyton Manning will go out a winner. Good news and a feel good story? Not for investors. The Super Bowl Indicator says a win by an AFC team is a bad omen for the stock market for the year. 

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Super Bowl Indicator

The Super Bowl Indicator says that if a team from the old American Football League (AFL) wins the Super Bowl that the stock market will finish down for the year.

This indicator has held true for 40 of the previous 49 Super Bowls played prior to this one, including the past seven years.

The New York Giants, one of the earliest teams from the NFL, won the Super Bowl in 2008 but as we all recall the stock market had its worst year since the Great Depression with the S&P 500 being down 37% for the year. I guess a little thing like the mortgage fueled financial crises trumps a “sure fire” stock market predictor like the outcome of the Super Bowl.

The January Effect 

The Stock Trader’s Almanac says that if the month of January is down then 75% of the time the stock market will be down for the year.

The January Effect says that stocks that were sold off in December for tax-loss harvesting purposes will rally in January when investors buy them at reduced prices.

With the S&P 500 and the Dow Jones Industrial Average both down over 5% for the month this clearly didn’t happen.

Time to go to cash? 

Clearly investors should not peg their actions to any type of indicator like the Super Bowl Indicator or any of the others of a similar nature that have cropped up over the years.

The best course for investors has always been to have a financial plan, have an investing strategy and stick to their plan.

The Bottom Line 

The Super Bowl Indicator is fun and part of the Super Bowl hype. At the end of the day there is really no correlation between the performance of the stock market and who wins the Super Bowl. Investors should invest based upon their goals, their time horizon and their risk tolerance. I will say this, however. The market will be way up in 2017 after my Green Bay Packers bring the Lombardi Trophy back to its rightful home, Lambeau Field. OK no predictions, I have no idea what the market will do after the Packers win (which is a sure thing, I hope).

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.

6 Investment Expenses You Need to Understand

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Investment expenses reduce your investment returns. While nobody should expect investment managers, financial advisors or other service providers to offer their services for free, investors should understand all costs and fees involved and work to reduce investment expenses to the greatest extent possible.

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Here are 6 investment expenses you need to understand in order to maximize your returns.

Mutual fund and ETF expense ratios

All mutual fund and ETFs have expense ratios. These fees cover such things as trading costs, compensation for fund managers and support staff and the fund firm’s profit. Expense ratios matter and investors shouldn’t pay more than they need to.

Vanguard’s site, as you might expect, deals with this topic at length. In one example, it shows the impact of differing levels of fees on a hypothetical $100,000 initial account balance over 30 years with a yearly return of 6%. After 30 years the balance in the account would be:

$574,349 with no investment cost

$532,899 with an investment cost of 25 basis points

$438,976 with an investment cost of 90 basis points

These numbers clearly illustrate the impact of fund fees on an investor’s returns and their ability to accumulate assets for financial goals like retirement and funding their children’s college educations.

Mutual fund expense ratios are an example of where paying more doesn’t get you more. Case in point, Vanguard Growth Index Adm (VIGAX) has an expense ratio of 0.09%. The Morningstar category average for the large cap growth asset class is 1.21%. For the three years ending January 31, 2016 the fund ranked in the top 32% of all of the funds in the category; for the trailing five years the fund placed in the 19% and for the trailing ten years the top 17% in terms of investment performance.

Sales loads and 12b-1 fees

Front-end sales loads are an upfront payment to a financial advisor or registered rep. Front-end sales loads reduce the amount of your initial investment that actually goes to work for you. For example, if a rep suggests investing in a mutual fund like the American Funds EuroPacific Growth A (AEPGX) for every $10,000 the investor wants to invest, $575 or 5.75% will be deducted from their initial investment balance to cover the sales load. Over time this will reduce the investor’s return versus another version of the same fund with a similar expense ratio that doesn’t charge a sales load.

Some will argue that this load is a one-time payment to the advisor and their firm for their advice. This strikes me as dubious at best, but investors need to decide for themselves whether the advice received in exchange for paying a sales load warrants this drain on their initial and subsequent investments. This share class has an expense ratio of 0.89% which includes a 12b-1 fee of 0.21% (see more on 12b-1 fees below).

Deferred sales loads associated with B shares are largely a thing of the past. Carrying the American Funds example forward, the EuroPacific Growth B (AEGBX) which has been closed to new investors since 2009, was purchased at NAV with a deferred sales charge of 5%. The fund carried a surrender charge over a period of years whereby if the investor sold the fund during this time they would be assessed a surrender charge (see below for more on surrender charges) on a declining basis. In order to compensate the advisor for not receiving an upfront sales commission the fund’s expense ratio is 1.69% which includes a 0.99% 12b-1 fee which compensates the advisor. After a set period of time B shares are supposed to convert to the lower cost A shares. If you are still in a B share of any fund you should aggressively ask why this is and demand to have the shares converted to A shares if eligible.

Level loads are associated with C shares. The American Funds EuroPacific Growth C (AEPCX) fund has a level load of 1% in the form of a 12b-1 fee and an overall expense ratio of 1.61%. Brokers and registered reps love these as the level load stays in place for eight years until the funds convert to a no load share class of the fund. There is a 1% surrender charge if the fund is redeemed within the first year of ownership.

12b-1 fees are a part of the mutual fund’s expense ratio and were originally designated to be marketing costs. They are now used as trialing compensation for financial advisors and reps who earn compensation from selling investment products. They can also be used to provide revenue-sharing in a 401(k) plan. While 12b-1 fees don’t increase expenses as they are part of the fund’s expense ratio, typically funds with a 12b-1 fee will have a higher expense ratio than those that don’t in my experience.

401(k) expenses

For many of us our 401(k) plan is our primary retirement savings vehicle. Beyond the expense ratios of the mutual funds or other investments offered, there are costs for an outside investment advisor (or perhaps a registered rep or broker who sold the plan) plus recordkeeping and administration among other things. If your employer has these costs paid by the plan they are coming out of your account and reducing the return on your investment.

Add to this mutual funds that may be more expensive than needed to compensate a brokerage firm or insurance company and all of a sudden the expenses associated with your 401(k) plan are a real drag on your investment returns.

Financial advice fees

Fees for financial advice will vary depending upon the type of financial advisor you work with.

Fee-only financial advisors will charge fees for their advice only and not tied to any financial products they recommend. Fees might be charged on an hourly basis, on a project basis for a specific task like a financial plan, based on assets under management or a flat retainer fee. The latter two options would generally pertain to an ongoing relationship with the financial advisor.

Fee-based or fee and commission financial advisors will typically charge a fee for and initial financial plan and then sell you financial products from which they earn some sort of commission if you choose to implement their recommendations. Another version of this model might have the advisor charging a fee for investment management services, perhaps via a brokerage wrap account, and receiving commissions for selling any insurance or annuity products. They also would likely receive any trailing 12b-1 fees from the mutual funds used in the wrap account or from the sale of loaded mutual funds.

Commissions arise from the sale of financial and insurance products including mutual funds, annuities, life insurance policies and others. The financial advisor is compensated from the sale of the product and in one way or another you pay for this in the form of higher expenses and/or a lower net return on your investment. Additionally, financial sales types are incentivized to sell you products for which they are compensated, it is highly unlikely they will push a low-cost Vanguard index fund.

Investors need to understand these fees and what they are getting in return. In fact, a great question to ask any prospective financial advisor is to have them disclose all sources of compensation that they will receive from their relationship with you.

Surrender charges

Surrender charges are common with annuities and some mutual funds. There will be a period of time where if the investor tries to sell the contract or the fund they will be hit with a surrender charge. I’ve seen surrender periods on some annuities that range out to ten years or more. If you decide the annuity is not for you or you find a better annuity the penalty to leave is onerous and costly.

Taxes 

Taxes are a fact of life and come into play with your investments. Investments held in taxable accounts will be taxed as either long or short-term when capital gains are realized. You may also be subject to taxes from distributions from mutual funds and ETF for dividends and capital gains as well.

Investments held in a tax-deferred account such as a 401(k) or an IRA will not be taxed while held in the account but will be subject to taxes when distributions are taken.

Tax planning to minimize the impact of taxes on your investment returns can help, but investment decisions should not be made solely for tax reasons.

The Bottom Line

Fees and expenses can take a big bite out of your investment returns and your ability to accumulate a sufficient amount to achieve your financial goals. Investors should understand the expenses listed above and others and take steps to minimize these costs.

Not sure if you are invested properly for your situation? Do you wonder if your investment expenses are too high? Check out my Financial Review/Second Opinion for Individuals service.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out the Hire Me tab to learn more about my freelance financial writing and financial consulting services.  

3 Financial Planning Lessons from the Cincinnati Bengals

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Long-time readers of The Chicago Financial Planner know that I am a die-hard football fan and avid supporter of the Green Bay Packers. Come playoff time, I try catch all of the games as they are often memorable. The game this past Saturday between the Pittsburgh Steelers and the Cincinnati Bengals was memorable for the wrong reasons if you are a Bengals fan.

Rarely, if ever, in my 50 years of watching NFL games have I ever seen a team give away a game (especially a playoff game) in such a bonehead fashion as did the Bengals. Besides some just plain dumb moves, the level of dirty play and bad sportsmanship was disgusting.

What can we learn from the Bengals about financial planning? Here are 3 financial planning lessons from the Cincinnati Bengals.

Protect your downside 

The Bengals had gained the lead in the final quarter after being held scoreless for the first three quarters of the game. On what should have been a routine running play, (in the Steelers end no less) to try to run the clock out, the Bengals’ running back fumbled. In this situation ball security should have been his first priority, not gaining any yardage.

Unless you are very young, most investors are wise to diversify their portfolios in order to dampen the impact of market declines like the financial crisis or even the market volatility that we’ve seen since the start of the new year.

Keep your emotions in check 

Cincinnati linebacker Vontaz Burfict made a key interception that looked like it might seal an improbable comeback win for the Bengals. After the fumble mentioned above, he proceeded to make one of the absolute dumbest and dirtiest hits to the head of a Steelers receiver resulting in a key 15-yard penalty.

His teammate (and I’m sure fellow Mensa member) Adam Pacman Jones then garnered another 15-yard penalty for shoving a Pittsburgh assistant coach during an on-field altercation that set-up a chip-shot game winning field goal for the Steelers.

Burfict is known as a loose cannon and has been fined in the past and Jones is not a choir boy either. Both personal fouls can be attributed to a combination of bad judgment and a failure to keep their emotions in check in a key situation.

Investors need to stay calm during periods of upheaval in the economy and the financial markets. So far 2016 has started off with roughly a 5% loss in some the major market averages.

Back in 2008 and early 2009 the financial press was filled with stories of investors who panicked and sold out of their stock holdings, including mutual funds and ETFs, at or near the bottom of the market. Many of these investors stayed out missing all or most of the six plus year rally we’ve seen since the lows of March 9, 2009. Sadly, for those who were near retirement they booked substantial losses and never gave their portfolios a chance to recover.

Investors need to stay calm. One way to help in this area is to have a plan. Have an asset allocation that that reflects your situation including your time horizon for the money and your risk tolerance. Review your portfolio at regular intervals and rebalance as needed. A plan does not eliminate market volatility or the stress that it can bring, but it can help to prevent you from acting on your emotions, usually to your detriment. 

Build a team that you can depend on 

While both Burfict and Jones are talented players, both have a history of issues. Jones has been in trouble with the NFL for off-field activities and has been suspended by the league in the past. Burfict was suspended for this hit and has been fined for prior transgressions. He was undrafted, many say as a result of a reputation for being hard to deal with.

As a viewer of the game I would say these two players let their teammates and fans down at the most critical point in the most important game of the season. The Bengals have not won a playoff game since 1991 and their comeback to take the lead and put themselves into a position to win was heroic, only to be destroyed by the lack of self-control of these two.

In the course of accumulating money for goals such as retirement and college for your kids, many of you will seek advice along the way. In doing so it is important to build a team of advisors and partners that you can trust.

If a financial advisor is needed be sure to choose a fee-only advisor. This isn’t to say that one who derives some or all of their compensation from the sale of financial products isn’t competent, but someone who doesn’t have the conflict of interest inherent in the sale of financial products starts out as more objective.

Find an investment custodian who has reasonable fees and offers the types of investments and accounts that meet your needs. Free ETF platforms are nice, but who cares if the ETFs on the platform are not the ones that are right for you.

Other advisors might include a CPA or an attorney to handle estate planning matters.

In all cases don’t be afraid to ask questions. In the case of a financial advisor it is important to understand if they have worked with clients in similar situations as you and to understand what you will receive for the fees paid.

The Bottom Line 

As I’ve written here in the past, football and the world of financial planning and investing have some similarities. Learn from the Cincinnati Bengals and be sure to protect your financial downside, keep your emotions in check and build a team that you can trust. These steps will put you on track towards achieving your financial goals.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email.

8 Portfolio Rebalancing Tips

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My last post discussed 4 Benefits of Portfolio Rebalancing. This post continues on the rebalancing theme and looks at some ways to implement a rebalancing strategy. Here are 8 portfolio rebalancing tips that you can use.

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Set a target asset allocation 

Your asset allocation should be an outgrowth of a target asset allocation from your financial plan and/or a written investment policy. This is the target asset allocation that should be used when rebalancing your portfolio. 

Establish a time frame to rebalance 

Ideally you are reviewing your portfolio and your investments on a regular basis. As part of this process you should incorporate a review of your asset allocation at a set interval. This might be semi-annually for example. I generally suggest no more frequently than quarterly. An exception would be after a precipitous move up or down in the markets.

Take a total portfolio view 

When rebalancing your portfolio take a total portfolio view. This includes taxable accounts as well as retirement accounts like an IRA or your 401(k). This approach allows you to be strategic and tax-efficient when rebalancing and ensures that you are not taking too little or too much risk on an overall basis.

Incorporate new money 

If you have new money to invest take a look at your asset allocation first and use these funds to shore up portions of your asset allocation that may be below their target allocation. A twist on this is to direct new 401(k) contributions to one or two funds in order to get your overall asset allocation back in balance. In this case your will need to take any use of your plan’s auto rebalance feature into account as well. 

Use auto pilot 

For those with an employer sponsored retirement plan such as a 401(k), 403(b) or similar defined contribution plan many plans offer an auto-rebalancing feature. This allows you to select a time interval at which your account will be rebalanced back to the allocation that you select.

This serves two purposes. First it saves you from having to remember to do it. Second it takes the emotion and potential hesitation out of the decision to pare back on your winners and redistribute these funds to other holdings in your account.

I generally suggest using a six-month time frame and no more frequently than quarterly and no less than annually. Remember you can opt out or change the interval at any time you wish and you can rebalance your account between the set intervals if needed.

Make charitable contributions with appreciated assets 

If you are charitably inclined consider gifting shares of appreciated holdings in taxable accounts such as individual stocks, mutual funds and ETFs to charity as part of the rebalancing process. This allows you to forgo paying taxes on the capital gains and provides a charitable tax deduction on the market value of the securities donated.

Most major custodians can help facilitate this and many charities are set-up to accept donations on this type. Make sure that you have held the security for at least a year and a day in order to get the maximum benefit. This is often associated with year-end planning but this is something that you can do at any point during the year.

Incorporate tax-loss harvesting

This is another tactic that is often associated with year-end planning but one that can be implemented throughout the year. Tax-loss harvesting involves selling holdings with an unrealized loss in order to realize that loss for tax purposes.

You might periodically look at holdings with an unrealized loss and sell some of them off as part of the rebalancing process. Note I only suggest taking a tax loss if makes sense from an investment standpoint, it is not a good idea to “let the tax tail wag the investment dog.”

Be sure that you are aware of and abide by the wash sale rules that pertain to realizing and deducting tax losses.

Don’t think you are smarter than the market 

It’s tough to sell winners and then invest that money back into portions of your portfolio that haven’t done as well. However, portfolio rebalancing is part of a disciplined investment process.  It can be tempting to let your winners run, but too much of this can skew your allocation too far in the direction of stocks and increase your downside risk.

If you think you can outsmart the market, trust me you can’t. How devastating can the impact of being wrong be? Just ask those who bought into the mantra “…it’s different this time…” before the Dot Com bubble burst or just before the stock market debacle of the last recession.

The Bottom Line 

Portfolio rebalancing is a key strategy to control the risk of your investment portfolio. It is important that you review your portfolio for potential rebalancing at set intervals and that you have the discipline to follow through and execute if needed.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email.

5 Reasons 401(k) Lawsuits Matter to You

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Several 401(k) lawsuits against major employers have been in the news this year. These suits are about high fees, conflicts of interest and plan sponsors failing to live up to their fiduciary obligations.

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Ameriprise Financial settled a suit that alleged that the firm offered a number of its own proprietary mutual funds in the company’s 401(k) plan and collected revenue sharing payments on these funds from an Ameriprise subsidiary.

The U.S. Supreme Court ruled in Tibble vs. Edison International that the large utility company had a duty to monitor the investments offered in the plan no matter how long along they were initially added to the plan. One of the issues here surrounds the fact that lower cost share classes of these funds became available but the plan stayed with the higher cost retail share class.

Most recently Boeing settled a lawsuit that was first filed in 2006 for $57 million. The suit alleged that the company had breached its fiduciary duty to its employees by using high cost and risky investment options in the plan and by allowing the plan’s record keeper to charge employees and retirees excessive fees.

While all of this may be interesting, you may be asking what does any of this have to do with me? Here are 5 reasons 401(k) lawsuits matter to you.

Plan Sponsors have a fiduciary obligation 

These and a growing number of 401(k) related lawsuits have reaffirmed that retirement plan sponsors have a fiduciary obligation to act in the best interests of the plan participants. This includes:

  • The selection and monitoring of the mutual funds (or other investment vehicles) offered in the plan.
  • The selection and monitoring of the service providers selected for the plan.
  • All costs and fees associated with the plan.

Moreover plan sponsors should have a process in place to manage all aspects of the plan.

Mutual Fund share classes 

Several of the lawsuits centered on plan sponsors offering expensive retail share classes of funds when lower cost share classes were available. These higher cost share classes might throw off more revenue sharing and other fees to the plan but they are more expensive for the plan participants. It behooves plan sponsors more now than ever to offer the lowest cost share classes of a given fund available to them.

Numerous studies have shown the connection between lower investment costs and investment return. Well-run 401(k) plans strive to keep investment costs down and one way to do this is to ensure that the plan offers the lowest mutual fund share classes available.

Duty to monitor 

As shown in the Tibble versus Edison ruling the Supreme Court said plan sponsors have a duty to continue to monitor the investments offered in the plan long after they may have been initially offered. This dovetails into an ongoing duty of plan sponsors to monitor the investments offered to you to ensure the costs are reasonable and that they meet a set of criteria.

Typically a 401(k) that is well-monitored and managed via a consistent investment process will tend to offer a better investment line-up to their participants.

Manage plan expenses 

Boeing recently settled the second largest 401(k) suit in history at $57 million. In part the allegations included that Boeing allowed its outside record keeper to charge employees and retirees excessive fees.

This and other suits underscore the responsibility of plan sponsors to manage 401(k) plan costs and the activities of plan providers such as an outside record keeper. To the extent that administrative expenses are paid out of plan assets plan sponsors who strive to keep these expenses low are doing the right thing for their employees.

Plan Sponsors are getting it 

While this is not a blanket statement as there are still plenty of lousy 401(k) plans out there, there is evidence that plan sponsors are getting the message that they have a responsibility to the plan’s participants.

As an example mutual fund expenses in 401(k) plans have been declining for the past 15 years. Fewer companies are mandating the use of company stock in their 401(k) plans and a 2014 Supreme Court ruling will certainly help keep this trend going.

The Bottom Line 

Retirement plan sponsors have a fiduciary obligation to act in the best interests of the plan’s participants. A number of 401(k) lawsuits in recent years have served to reinforce this duty and this is a good thing for those participating in 401(k) plans. As a plan participant become knowledgeable about the investments offered in your plan and how much the plan is costing you. If you have concerns raise them in a constructive fashion to your employer.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out the Hire Me tab to learn more about my freelance financial writing and financial consulting services. 

Smart Beta ETFs the Next Big Thing?

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For those of us involved in financial services it is hard to check your Twitter stream or visit an industry website without seeing the term smart beta. ETF providers have really taken to this trend and have introduced many new ETFs based on some aspect of smart beta.

Nobody follows a trend quite like the folks who market mutual funds or ETFs and smart beta is the hip thing that all of the “cool kids” are doing. At a recent ETF industry conference sponsored by Morningstar (MORN) this was virtually all anyone was talking about in the sessions I attended.

What is smart beta and is it really smart?  Are smart beta ETFs the next big thing in ETF investing?

Smart Beta Defined 

According to Investopedia (for whom I am a frequent contributor):

“Investment managers that follow a smart beta investment strategy seek to passively follow indices, while also taking into account alternative weighting schemes such as volatility. That’s because smart beta strategies are implemented like a typical index strategies in that the index rules are set and transparent. Smart Beta strategies will differ from standard indices, such as the S&P 500 or the Barclays Aggregate, in that the indices focus on areas of the market that offer an opportunity for exploitation.” 

We will attempt to expand on that definition a bit below. 

Factor investing 

Most smart beta ETFs take an aspect or a factor from a traditional index. Traditional index ETFs passively track a market value weighted index like the S&P 500.  Some popular factors include low volatility, momentum; equal-weighted indexes, dividends and quality are common factors. An equal-weighted index would give equal weighting to a huge stock like Apple (APPL) and to the smallest stock in terms of market capitalization in the S&P 500 Index.

An example of a smart beta ETF based on a factor is the Powershares S&P 500 Low Volatility ETF (SPLV).

This ETF invests in the 100 stocks in the index that have exhibited the lowest volatility over the past 12 months. A sound idea in theory and perhaps ultimately in practice.

Like many smart beta ETFs the inception date of SPLV was May 5, 2011 over two years after the low point of the markets during the financial crises. The index the ETF follows was essentially created in the lab via back-testing, much like the Peter Boyle character in the movie Young Frankenstein. This means that most of the “history” of this ETF is via back-testing and not real performance data. As a presenter at the Morningstar conference said, he’s never seen a back-test that did not yield a positive result.

Looking at SPLV’s results, the ETF trails the S&P 500 index in terms of trailing three year returns 12.95% to 14.77% on an average annual basis for the period ending 10/19/2015. However for the year-to-date period through the same date SPLV has gained 1.27% versus 0.41% for the index.

Looking at another measure, standard deviation of return which measures the variability of the ETF’s returns (up and down) over the three year period ending 9/30/2015, the standard deviation for SPLV is +/- 9.63% versus +/- 9.74% for the index. My guess is that a selling point of this ETF would be lower volatility but over the past three years the smart beta ETF is only fractionally less volatile than the index and an investor would have considerably less money if they had held SPLV over a more traditional ETF like the SPDR S&P 500 ETF (SPY).

Is an investment in SPLV a bad idea? I don’t know because I have no idea how this ETF will hold up in a pronounced bear market. Yes it has performed better than the full index so far in 2015 including the volatility in August and September. How will it do if we hit a rough patch like 2000-2002 or 2008-2009? Good question.

A growth area 

According to data from Morningstar as of 6/30/2015:

  • There were 444 smart beta products listed in the U.S.
  • These products accounted for $540 billion in assets under management which was 21% of all U.S ETF assets.
  • Of the new cash flows into ETFs over the past 12 months, 31% went into smart beta products.
  • The assets in these products grew 27% over the same period.
  • A quarter of new ETF launches over the past five years were smart beta products.

Who uses smart beta ETFs? 

From what I have heard and read smart beta ETFs are being used largely by financial advisors and institutional investors versus individuals. You might say so what? These folks are likely investing your money either via your relationship with a financial advisor who may use them in a portfolio or use a TAMP (turnkey asset management program) program offered by a third-party to manage your money.

Reasons to use Smart Beta 

Morningstar cites several reasons investors and advisors might consider smart beta ETFs:

  • To manage portfolio risk
  • To enhance portfolio returns
  • For tactical asset allocation, meaning an allocation that is based in part on the advisor’s assessment of market conditions
  • Reducing fees versus actively managed mutual funds
  • To use an active strategy grounded by an index core

Many, including me, view strategic beta as a form of active management. A presenter at the Morningstar conference suggested that any smart beta ETF with an expense ratio of 50 basis points or higher should not be considered as this is the lower end of the fee range for the better actively managed mutual funds offering an institutional share class.

What does this mean for individual investors? 

Again I suspect that most of the money invested here will be institutional or via financial advisors. As an individual investor working with a financial advisor who suggests using smart beta ETFs in your portfolio, you should ask them to explain their rational. Why are these ETFs a better choice than an asset allocation strategy using more traditional index products?

If you will using smart beta ETFs on your own, be sure that you fully understand the underlying index which was likely created post-financial crises via back testing. Understand that smart beta strategies may look good on paper but in reality they can take a number of years to prove themselves.  Lastly understand that strategies that look good in testing may not work as well when millions of dollars are actually invested there real-time.

For financial advisors 

Most financial advisors that I know are very deliberate in testing new products and investing ideas before using them with clients. With the rise of third-party advisors such as TAMPs and ETF strategists, financial advisors still need to understand the underlying products and strategies being used to invest their client’s hard-earned money.

The Bottom Line 

Smart beta is the next evolution of ETF investing or so say the firms trying to gather assets into these products. I’m not saying that smart beta isn’t an enhancement or that I am against new investing inovations. I am leery of any investment vehicle designed to solve a problem or fill a role in portfolios that have not gone through a full stock market cycle. With any investment vehicle that you are considering, be sure to fully understand the benefits, the risks and the costs. How smart is smart beta? We really won’t know until the market goes through a full cycle that includes a significant correction.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.  

How Much Apple Stock Do You Really Own?

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Apple (AAPL) stock has been a great investment over the years. Based upon its stock price and the number of shares outstanding it is the largest U.S stock based upon market capitalization.  This means it is the largest holding in popular index mutual funds and ETFs like Vanguard 500 (VFINX) and the SPDR S&P 500 ETF (SPY).

Chuck Jaffe recently wrote an excellent piece for Market Watch discussing the impact that a recent drop in Apple stock had on a number of mutual funds that hold large amounts of Apple.  He cited a list of funds that had at least 10% of their assets in Apple.  On a recent day when Apple stock fell over 4% these funds had single day losses ranging from 0.22% to 2.66%.

The point is not to criticize mutual fund managers for holding large amounts of Apple, but rather as a reminder to investors to understand what they actually own when reviewing their mutual funds and ETFs.

Stock overlap 

In the late 1990s a client had me do a review of their portfolio as part of some work I was doing for the executives of the company. He held 19 different mutual funds and was certain that he was well-diversified.

The reality was that all 19 funds had similar investment styles and all 19 held some of the popular tech stocks of the day including Cisco (CSCO), Intel (INTC) and Microsoft (MSFT). As this was right before the DOT COM bubble burst in early 2000 his portfolio would have taken quite a hit during the market decline of 2000-2002.

Understand what you own 

If you invest in individual stocks you do this by choice. You know what you own. If you have a concentrated position in one or more stocks this is transparent to you.

Those who invest in mutual funds and other professionally managed investment vehicles need to look at the underlying holdings of their funds.  Excessive stock overlap among holdings can occur if your portfolio is concentrated in one or two asset classes. This is another reason why your portfolio should be diversified among several asset classes based upon your time horizon and risk tolerance.

As an extreme example someone who works for a major corporation might own shares of their own company stock in some of the mutual funds and ETFs they own both inside their 401(k) plan and outside. In addition they might directly own shares of company stock within their 401(k) and they might have stock options and own additional shares elsewhere. This can place the investor in a risky position should their company hit a downturn that causes the stock price to drop.  Even worse if they are let go by the company not only has their portfolio suffered but they are without a paycheck from their employer as well.

Concentrated stock positions 

Funds holding concentrated stock positions are not necessarily a bad thing. A case in point is Sequoia (SEQUX) which has beaten its benchmark the S&P 500 by an average of 373 basis points (3.73 percentage points) annually since its inception in 1970.  Sequoia currently has about 26% of its portfolio in its largest holding and another 8% in the two classes of Berkshire Hathaway stock.  Historically the fund has held 25-30 names and at one time held about 30% of the portfolio in Berkshire Hathaway (BRK.A).  Year-to-date through August 14, 2015 the fund is up 16.5% compared to the benchmark’s gain of 2.88%.

The Bottom Line 

Mutual fund and ETF investors may hold more of large market capitalization stocks like Apple and Microsoft than they realize due to their prominence not only in large cap index funds but also in many actively managed funds. It is a good idea for investors to periodically review what their funds and ETFs actually own and in what proportions to ensure that they are not too concentrated in a few stocks, increasing their risk beyond what they might have expected.

Not sure if you are invested properly for your situation? Check out my Financial Review/Second Opinion for Individuals service.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out the Hire Me tab to learn more about my freelance financial writing and financial consulting services.  

What is a Hedge Fund?

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The term hedge fund is used often in the financial press.  I suspect, however, that many investors do not really know what a hedge fund is.

What is a Hedge Fund?

 

 

 

 

Investopedia defines a hedge fund as follows:

“An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).” 

Here are a few basics about hedge funds to help you understand them.  Note this is certainly not meant to be an in-depth tutorial but rather is meant to provide an introduction to hedge funds.

Who can invest in hedge funds? 

In order to invest in a hedge fund you must be an accredited investor.  The current definition of an accredited investor is someone with a net worth of $1 million (excluding the equity in their home) and at least $200,000 in income ($300,000 with a spouse) over the past two years.  Many hedge fund investors are institutional investors such as foundations, endowments and pension plans.  About 65 percent of the capital invested in hedge funds comes from institutional investors.

What is the minimum investment? 

The minimum required to invest is often $1 million or more though some smaller hedge funds and funds of funds may have lower minimums.  New companies like Sliced Investing are seeking to change these high minimums by allowing investors to invest as little as $20,000.

Do I have access to my money? 

Unlike mutual funds, ETFs, closed-end funds and individual stocks hedge funds typically do not offer daily access to your money.

Some hedge funds allow investors to subscribe (invest) or redeem their money monthly, for others this might be quarterly or based upon some other time period.  Most hedge funds will require advanced notice for redemptions which might be as long as 180 days.  This allows the fund managers time to raise sufficient cash and allows for an orderly sale of fund investments especially if the redemption is a significant amount.

Some hedge funds also require a lock-up which means that there are no redemptions allowed during this initial period.  A typical lock-up period is one year, though some are as long as two years.  In some cases the lock-up period is “soft” meaning that redemption can be made but there will often be a penalty ranging from 2 percent to as high as 10 percent. 

Some hedge funds may also have the ability to enforce “gates” on redemptions which means they can decide to process only a portion of the redemptions requested.  This provision came into focus during the 2008-2009 market downturn as hedge fund redemptions requests swelled as many investors sought to raise cash.

What types of fees are charged? 

The fees charged by hedge funds vary widely.

Many hedge funds charge a management fee of 2 percent or more.

There might also be incentive fees of 10 to 20 percent of the fund’s profits or more.  This rewards the fund manager for superior performance.  The flip side of this is that the manager generally only collects an incentive fee if the fund’s performance exceeds its former highs, known as a high water mark.

If a fund loses 5 percent in a given year, no incentive fees will be paid to the manager the following year until the 5 percent loss is made up.

The term two and 20 is a common one in the hedge fund world meaning that the fund would charge a 2 percent management fee and a 20 percent incentive fee.  This may seem pricey but if the performance is stellar then investors won’t mind paying it. 

What types of investment strategies are available? 

There is a vast range of investment strategies across the hedge fund landscape.  These might include long-short, global macro, market neutral, convertible arbitrage, distressed securities and many others.  Additionally there are a number of fund of funds offered which means that the fund offers a collection of strategies and fund managers under one umbrella.   

What should I consider before investing in a hedge fund?

From reading the above you might ask yourself why would I invest in hedge funds?  Let’s remember that hedge funds are considered alternative investments.  Ideally they will have a relatively low correlation to the traditional long-only equity and fixed income investments in your portfolio.  At their best well-managed hedge funds can add balance and reduce the overall risk of your portfolio, in some cases the strategies are designed to provide absolute returns across all investing environments.

Before investing in a hedge fund or any alternative investment make sure you have considered and fully understand the following:

  • The fund’s investment strategy.
  • How this investment strategy fits with your overall portfolio and investing strategy.
  • What the fund “brings to the table” that you can’t get with more traditional long-only stock and bond investments.
  • Who is managing the fund and their history and investment track record.
  • The required minimum investment.
  • Any redemption restrictions and/or lock-up periods.  Make sure that you won’t need to tap this money during this time period. 

The Bottom Line 

Like any investment option you might consider it is important to understand the pros and cons of hedge funds in general and any specific fund or strategy that you might be considering for your portfolio.

Disclosure: This blog post was written for Sliced Investing pursuant to a paid content arrangement I have with the company’s representatives as part of an effort to raise awareness about alternative investment options. All views expressed are entirely my own, and were not influenced or directed by Sliced Investing.

Photo courtesy of Wikipedia