My Firm’s Approach to Investing

My firm’s investment policy focuses on using asset allocation and diversification as the primary means of achieving a client’s desired investment goals.  I recognize the preponderance of academic evidence that the capital markets are highly efficient.  Given this, I construct portfolios primarily using securities that are cost-efficient, diversified, and tax efficient.  My strategy seeks to maximize after-tax risk-adjusted total return for the client.

Allocation, Allocation, Allocation
Several academic studies indicate that investment policy and asset allocation explain that from 90% to 100% of a portfolio’s return.  Therefore, our policy focuses on the allocation of several asset classes as the determinant of investment results rather than individual security selection.  Money market funds, fixed income, domestic equities, real estate, and international equities are all integral components of a suitably balanced portfolio.

Stay Indexed & Passive, Avoid Active
Index-based securities and funds are well suited for asset allocation since they are more style specific in terms market capitalization and sector exposure than most actively managed mutual funds which are prone to “style drift”.  For example, a large cap value fund may buy growth stocks in order to improve performance.  Regardless of the correctness fund manager’s judgment call, the risk and return profile of the fund can change substantially from the time the investor initially invested in the fund.  Using indexed-based securities allows the investor to select the appropriate value/growth mix knowing that the underlying securities bought will be more stylistically consistent over the life of the investment.

Follow Academic Research
Based upon considerable academic evidence that value stocks and smaller capitalization stocks outperform over the long term, I seek to add value by judiciously increasing the value bias and smaller company bias in the weighting of the equity portfolio.  The most relevant academic research has been done by Eugene Fama and Kenneth French of the University of Chicago.  Fama received a Nobel prize in 2013 for his research.

I also seek to add value by including international equity investments, real estate investment trust and various alternative assets which offer broader capital market exposure and which have low correlations to the U.S. equity markets.

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Municipal Bonds or Municipal Bond Funds? Don’t Ask WWSOD? (What Would Suze Orman Do?)

Municipal Bonds or Municipal Bond Funds?

 We read an article about Suze Orman in Costco’s magazine a while back.  The Costco mag rag has a few articles and lots of Costco products. In a sidebar to the article, Orman advises investors to buy individual bonds rather than bond funds. Orman’s primary argument is that individual bonds can be held to maturity and that interest income of individual bonds is more stable. We disagree with Orman for the most part. We think she is making a quick punchy magazine bullet point that does a disservice to most readers who take her comments at face value.

A Bit of a Drag

In her article, Orman did not differentiate between taxable and tax-free bonds.  We will focus specifically on municipal bonds where we think Orman’s broad brushed advice is particularly doing readers a disservice.  The primary municipal bond mutual fund that we use in client portfolios is the Vanguard California Intermediate Municipal Bond Fund (VCADX). The internal management fee charged by Vanguard is 0.09 percent annually. One would naturally think that if one were to buy individual municipal bonds, after paying the transaction costs of the original bond purchase, one could at least save 0.09 percent a year avoiding the annual expense ratio drag embedded in the bond mutual fund. This does not turn out to be the case.

A Bit of a Spread

The municipal bond market is more fragmented and less efficient than the stock market. Individual bond investors routinely pay from 1 percent to 4 percent more than what a mutual fund manager would pay for the same bond. The mutual fund companies have a scale and a frequency of buying municipal bonds that allow brokers to lower bond prices and still make money. The difference between what one investor can sell a bond for and the price she would pay for that same bond is called the “spread.” The wider spread that smaller municipal bond investors pay is effectively a fee embedded in the price of the bond and not really fully disclosed. Studies indicating simultaneous prices paid by retail investors versus institutional investors confirm these wide spreads.

(Unlike the bond market, the equities markets are pretty much priced the same for smaller investors and large institutional investors. This is due to a combination of free market competition and regulation. As bond trading platforms improve, we do expect smaller investors to eventually have access to more competitive pricing. We expect this process to take several years.)

Assume you pay 2 percent more than what Vanguard paid for the same bond. Roughly speaking, you would have to hold onto that bond about 22 years (2%/0.09% = 22.3 years) before the 2 percent higher price you paid for the bond starts being more attractive than the additional 0.09 percent in annual fees you pay to Vanguard.

Particularly if you are in the asset building mode, individual municipal bond investing is even more expensive, because the individual investor continues to pay a premium every time she buys more bonds to reinvest municipal bond interest income. Municipal bond funds, however, allow savers automatic monthly reinvestment into the bond fund without a transaction fee. Also, depending on the size of coupon interest, the individual investor may not even be able to find a municipal bond issue small enough to buy in order to stay fully invested.

Stability, Income, and Diversification

We think a common investor opinion that the income from individual bonds is more stable than the income from bond funds is incorrect. Let’s say an investor builds a laddered bond strategy and attempts to keep a fairly stable average weighted maturity (or duration, which is a metric used by institutional investors and is a little more complex) by buying longer, such as by buying bonds of rolling maturities. If the investor keeps buying a replacement bond of the longest desired maturity every time a bond matures, she faces the risk that the reinvested coupon interest may be less than the coupon paid by the last maturing bond.

Another common investor sentiment goes something like, “Well, if I hold on to the bond until maturity, I will always get my principal back.” Bond prices fluctuate daily, just like bond mutual funds. Every investment should be evaluated on a total return basis, which incorporates both the change in price from one period to the next and the cash flow earned from the investment. Factoring changes in interest rates, the time value of money, and inflation, a known nominal fixed dollar payment ten to twenty years out really is not much of an assurance of the value of your bond today. More importantly, that fixed dollar amount that will be paid off that far out in the future is not much of an assurance of what your real economic return will be from that investment.

Digging through the actual mechanics and going over the details confirms what we really think: Any comfort that comes from knowing exactly when your individual bonds will mature relative to the constant maturity of a bond fund is really a false sense of security.

Finally two more points on why municipal bond funds may be better for you than individual municipal bonds. The first one is fairly simple. Unless the client has a large dollar amount to be dedicated to municipal bonds, the amount of diversification achievable through a bond fund such as VCADX is difficult to replicate.

The second point is a little more conceptually difficult. Broadly speaking, a portfolio of individual bonds becomes a little shorter in maturity every day. That may lead to your bond allocation moving from its original specified risk tolerance. This can be adjusted when new money is invested in bonds and when a bond matures. Developing strategies using municipal bond funds that target specific maturity ranges (i.e., short-term, intermediate, and long-term) is likely a better way to customize a municipal fixed income allocation tailored specifically for an individual’s interest rate sensitivity and risk tolerance.

Taxes Do Matter

Key points I want you to take away from this post are:

• In a low return and increasing tax rate world, the tax drag is increasingly important

• Tax efficiency starts with initial portfolio design

• An effective tax strategy carries on for the life of the portfolio.

Where We Are At
Many respected experts think long-term returns for several asset classes will be lower going forward than historical norms. Given that so much is unknown regarding the future performance of a particular investment strategy, not taking advantage of what is known, i.e. the tax impact, is leaving valuable information on the table. If future investment returns are lower than historical norms, working on maintaining a tax efficient process will help contribute to a larger portion of the real net return. Compounding this circumstance are the likely increases in tax rates at some point in time in the future which will be necessary to address Federal and State budget and debt needs.

Upon Inception
Tax efficiency starts upon portfolio inception. While it is difficult to predict future tax rates, steps can be taken at the point of starting a portfolio strategy which can help insulate against current and future taxes. For example most equity mutual funds are inherently tax inefficient and should be avoided for the most part in taxable accounts. (We do make an exception for a few tax managed equity funds we use in taxable accounts.) We prefer to use more tax efficient exchange traded funds (ETFs) in taxable accounts. If you have a Roth IRA, we should take advantage of the tax free aspect of that account to stock up on your highest expected return assets or perhaps some inherently tax inefficient assets which can be sheltered by the completely tax free nature of a Roth. We generally prefer to hold a larger portion of income producing bonds and high dividend paying REITs in tax deferred accounts like a traditional IRA or 401k plan. Once an asset allocation is determined, working on “asset location” or which investments go into which type of account, is the next logical step.

Carry On
Keeping a portfolio focused on providing suitable after-tax returns takes ongoing discipline. We work on rebalancing portfolios as tax efficiently as possible, often rebalancing the entire portfolio by trading assets within the tax sheltered accounts to avoid creating taxable capital gains. We are inclined to realize losses in taxable accounts in order use these captured losses at a later time to eliminate the tax burden of realized gains. We use specific tax lot identification in all taxable accounts which allows us to clearly identify the tax impact of any investment security sale in client taxable accounts and to seek the most tax efficient combination of tax lots when we do sell.

While I did start by saying taxes do matter and that they are an integral part of the investment decision making process, I do think there are examples when the tax tail should not wag the investment dog. One clear example is when an investor has a concentrated holding with large embedded unrealized taxable capital gains. While the investment industry has offered some (usually commission laden) strategies, most often selling a reasonable portion of the asset to reduce risk is the logical and prudent choice. Also, if a portfolio’s riskier assets have increased appreciably; taxable capital gains may have to be realized to keep a portfolio within acceptable risk tolerance levels.

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