Archives for December 2012

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Should I Sell My Out-of-State Muni Bonds?

A reader writes in, asking:

“After retiring, my husband and I moved to a less expensive part of the country. But our portfolio still includes municipal bonds from the state we used to live in. I understand that we will now have to pay state income taxes on the interest from these out of state bonds. We’re in the 25% tax bracket. Would you suggest holding the bonds or selling them?”

There’s nothing necessarily bad about owning municipal bonds from another state. In fact, for many investors, it makes perfect sense to own a portfolio of muni bonds from around the country for diversification’s sake.

So the question here is primarily about whether or not the tax savings from switching to in-state bonds would outweigh the costs of making the switch. A few of the factors that would impact the decision would include:

  • Does the state in which you currently live exempt in-state municipal bonds from state income taxes?
  • What is your marginal tax rate for state income taxes (that is, what state income tax bracket are you in)?
  • Are the municipal bonds you currently own held individually, or is it a state-specific muni bond fund that you own?
  • How does your cost basis in the bonds (or bond fund) compare to their current market value?

How Much Savings Could You Achieve By Switching?

If you current state of residence does not exempt in-state bonds from state income taxes, there’s no tax savings to be had from selling the bonds and buying new ones. (That said, depending on the cost of switching, it might make sense to do so simply to get some additional diversification among borrowers.)

Assuming that in-state bonds are exempt from state income taxes, the amount of savings per year is going to be the difference between the after-tax yield on your current bonds and the after-tax yield on in state-bonds of a similar duration and credit quality. Naturally, the higher your state income tax rate, the greater the annual savings from switching.

If the currently-owned bonds are individual bonds, switching to in-state bonds would only result in tax savings for the years between now and the time the currently-held bonds would mature. In contrast, if it’s a bond fund that you own, it will never mature (because the fund will continue to buy more bonds over time), and the savings would be for an indefinite period.

What is the Cost of Switching?

The costs of switching from out-of-state bonds to in-state bonds would consist of:

  • Capital gains taxes (if any), and
  • Brokerage-related costs.

The lower your cost basis in the bonds relative to the bonds’ current market value, and the higher your tax rate on capital gains, the more expensive it would be to sell your existing bond holdings, making it less likely to make sense to switch.

With regard to brokerage costs, in addition to considering any commissions you would have to pay to sell your current bonds or bond fund, you would want to consider the cost of buying new bonds. For example, if there is no low-cost bond fund that owns bonds from your current state of residence, you would have to put together a portfolio on your own, which is more work and sometimes more costly due to having to pay high markups on the bonds.

Predicting Bond Fund Returns: Yield or Past Performance?

A reader writes in, asking:

“My question is about bond fund returns. Which number is the best to use for determining what a customer actually gets in his account: yield or average annual returns? On the Vanguard web site the short term bond index fund has a yield of 0.42% and a 10-year average annual return of 3.77%. Which number should I be looking at?”

If you want to know how a bond fund did over a given period, look at annual return figures. If you want an estimate as to how a fund will do going forward, use the fund’s yield.

Components of Bond Returns

A bond fund’s return can come from two places:

  1. Interest on the bonds it holds, and
  2. Price appreciation for the bonds it holds if interest rates fall (note that this works in the other direction when rates rise instead of fall).

Right now, most bond funds have very good recent past performance figures. That’s because interest rates have been falling for the last few years, pushing bond prices up. But with rates as low as they are right now, they can’t fall very much further.*

In other words, when a bond fund’s yield is very low, that tells us that, for the near-term future, both of the return components are likely to be very low as well — the fund is likely to be earning a low rate of interest, and the fund can’t earn much via price appreciation, because there’s so little yield to give up.

For example, looking at the Vanguard Short-Term Bond Index Fund mentioned above, we see that its SEC yield is currently 0.42%, and it has an average duration of 2.7 years. This tells us that, for the near-term future at least, there’s nowhere for 3.77%-type returns to come from.

  • Unless nominal interest rates fall below zero, the most price appreciation the fund could experience is 1.13% (that is, a 0.42% decline in rates, multiplied by 2.7-year average duration), and
  • The only way for the fund to earn interest in excess of its 0.42% yield would be for rates to rise — which would hamper the near-term returns for the fund because it would push the price of the fund down.

Higher Yield Means Higher Risk

It’s important to understand, however, that while bond funds with higher yields do have higher expected returns, they also have the higher risk (either interest rate risk, credit risk, or both). It’s a very direct relationship. In other words, when choosing a bond fund for your portfolio, it is not usually a good idea to just pick the one with the highest yield.

*Please understand that this is not a prediction that rates will be rising any time soon. They might, or they might not. I have no idea.

Are Income Replacement Funds Better than Annuities?

A reader writes in, asking:

“My question is in regards to income replacement funds. What do you think of them?  Are they better than an annuity?  I like that fact that you can get to your money if you want to do so.”

I like the idea of such funds. But I haven’t seen one yet that I’ve been particularly fond of.

As a bit of background, the idea behind income replacement funds (at least, Fidelity’s “Income Replacement” funds and Vanguard’s “Managed Payout” funds) is that they’re funds-of-funds that have unique (and potentially convenient) distribution schedules.

  • Fidelity’s Income Replacement funds seek to distribute the entire balance by the date in question (e.g., by 2030 for the Income Replacement 2030 Fund). In other words, if an investor was spending every dime that the fund distributed, she would deplete her holding by the date in the name.
  • Vanguard’s Managed Payout funds do not seek to deplete the fund balance. Rather, they seek to maintain the fund balance (or, in the case of the more growth-oriented funds, have the balance grow) while providing a steady (or, in the case of the more growth-oriented funds, a growing) level of income for an indefinite period.

In other words, relative to using a regular all-in-one fund (e.g., Vanguard’s Target Retirement Income fund) and taking monthly (or quarterly, or annual) distributions yourself, what income replacement funds provide is additional convenience, but not any additional safety.

In exchange for that convenience, rather than the 0.17% expense ratio of the Vanguard Target Retirement Income Fund, they carry expense ratios ranging from 0.34% at the low end (for Vanguard’s Managed Payout Growth Focus Fund) to 0.75% at the high end (for Fidelity’s Income Replacement 2032 Fund). In other words, your investment costs are at least doubling by using such a fund.

And if any of your money is in a taxable account (as opposed to IRAs or other tax-sheltered retirement accounts), these funds still have all the tax-inefficiencies that come with funds of funds as compared to a DIY portfolio using a few individual index funds.

As Compared to Annuities

Unlike income replacement funds, lifetime annuities do provide additional safety as well as convenience. The level of income that they’re promising is guaranteed by an insurance company as opposed to being reliant upon the performance of underlying (sometimes risky) investments.

That’s not to say that everybody should be using lifetime annuities. They certainly have their drawbacks — chief among them being the facts that they’re perfectly illiquid and that the money disappears when you die.

On the other hand, it’s worth remembering that lifetime annuities are able to provide a higher level of income than you can safely take from a typical stock/bond portfolio precisely because the money disappears when the annuitant dies. Instead of going to the annuitant’s heirs, it goes to fund the payments for still-living annuitants.

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Should I Use Fidelity’s Freedom Funds in My 401k?

A reader writes in, asking:

“I know you like Vanguard’s target funds, but my 401-k is run by Fidelity. Are their ‘freedom funds’ a good choice? I like the idea of something that I don’t have to manage.”

The short answer is, “it depends.”

  • If we’re talking about Fidelity’s Freedom Index funds, then yes, I like them a lot. They’re an easy way to build a low-cost diversified portfolio.
  • If, however, we’re just talking about Fidelity’s Freedom funds (i.e., no “index” in the name), that’s a different story. They’re a hodgepodge of actively managed funds with significantly higher costs. (Fidelity Freedom 2050, for example, has an expense ratio of 0.77% as compared to Fidelity Freedom Index 2050’s expense ratio of 0.19%.)

Unfortunately, the Fidelity Freedom Index funds are less common in employer-sponsored plans than their non-index counterparts, and they’re not available to retail investors at all (e.g., in an IRA or regular brokerage account).

What Does a 0.06% Allocation Get You?

In addition to having higher costs, Fidelity’s Freedom funds give me the distinct impression that they were created with Fidelity’s goals in mind rather than investors’ goals.

Let’s again use Fidelity’s Freedom 2050 fund as an example. Take a look at the fund’s current holdings:

  • 12.27% Fidelity Series All-Sector Equity Fund
  • 10.59% Fidelity Series Large Cap Value Fund
  • 8.32% Fidelity Growth Company Fund
  • 7.43% Fidelity Series 100 Index Fund
  • 5.65% Fidelity Disciplined Equity Fund
  • 3.92% Fidelity Blue Chip Growth Fund
  • 2.06% Fidelity Series Small Cap Opportunities Fund
  • 1.21% Fidelity Small Cap Value Fund
  • 1.17% Fidelity Small Cap Growth Fund
  • 0.72% Fidelity Series Real Estate Equity Fund
  • 9.50% Fidelity Series Commodity Strategy Fund
  • 8.44% Fidelity Series International Value Fund
  • 8.22% Fidelity Series International Growth Fund
  • 5.22% Fidelity Series Emerging Markets Fund
  • 1.70% Fidelity Series International Small Cap Fund
  • 3.13% Fidelity Series Investment Grade Bond Fund
  • 9.26% Fidelity Series High Income Fund
  • 0.10% Fidelity Series Floating Rate High Income Fund
  • 0.97% Fidelity Series Emerging Markets Debt Fund
  • 0.06% Fidelity Series Real Estate Income Fund

If you were given a clean slate and asked to create a portfolio using Fidelity mutual funds, what would have be going through your mind in order for you to build that?

There are four holdings with allocations of less than 1%. The idea that a fund could merit inclusion in the portfolio, yet not merit even a 1% allocation (or, in the case of the Real Estate Income Fund, not even a 0.1% allocation) seems absurd to me. What can an investor possibly hope to achieve with a 0.06% allocation to something?

If I had to bet, I would bet that the goal for including those funds was not to improve the Freedom funds in any meaningful way, but rather to give Fidelity an easy way to get some money into their new funds. (If you look, you’ll find that each of the funds with an allocation of less than 1% was started in 2011.)

 Why You Might Want to Use Them Anyway

In short, I think Fidelity’s (non-index) Freedom funds are a mess. Still, depending on what’s available in your 401(k), it’s possible that there’s nothing better.

Before using the Fidelity Freedom funds, I’d suggest checking for less-expensive funds that can be used as any of the major pieces in a portfolio (i.e., U.S. stocks, international stocks, and bonds). In a plan run by Fidelity, you’ll especially want to check for their “Spartan” index funds, which are super low-cost and easy to use to build a diversified portfolio.

If you do decide to use a target-date fund — from any company — it’s important to make your choice based on the fund’s underlying allocation rather than just the date in the name. You might find that the fund that best matches your risk tolerance is one intended for people significantly older or younger than you.

I Am Not an Investment Advisor. (But Plenty of People Are.)

In the last few weeks I’ve received emails from several readers asking about engaging me in an investment advisory (or other financial planning) capacity.

While I’m flattered that some of you trust me enough to include me on your list of advisor candidates, I am not a registered investment adviser (or representative thereof), and I am not in the business of providing investment advice (or tax advice) in exchange for compensation.

In other words, writing books, writing these articles, and corresponding with readers is the extent of my business. (Though as I’ve mentioned before, please do not hesitate to ask me questions via email. Readers’ questions serve as the inspiration for almost every article here.)

Fortunately, there are plenty of good people out there doing good advisory work at a reasonable cost.

Where to Look for an Investment Advisor

Naturally, as a DIY investor, I’ve never personally used the services of an advisor. However, one result of writing this blog is that I get the opportunity to interact with many excellent people who do advisory work.

I’ve had positive interactions with many advisors including (but not limited to) Allan RothRick Ferri, and numerous people from NAPFA and the Garrett Planning Network.

So, perhaps those would be good places to start a search.

Finding the Right Type of Advisor

Regardless of where you look to find potential advisors, I think a useful step when considering a given advisor is to confirm that his/her investment philosophy matches your own philosophy prior to contacting him/her. (If you can’t find this information on the advisor’s website, you should be able to find it easily by looking at their Form ADV II.)

For example, if you’re looking for an advisor who uses a buy/hold/rebalance strategy with low-cost index funds or ETFs, you’re going to be wasting your time contacting (and giving your contact information to) an advisor who uses actively managed funds.

In addition, when looking for an advisor, it usually makes sense to narrow the field based upon what service(s) you’re looking for. For example:

  • Some advisors provide as-needed advice on an hourly basis (or on a fixed fee-for-service basis),
  • Some advisors provide portfolio management services (i.e., the actual running of the portfolio — buying, selling, rebalancing, etc.) on an annual-fee basis, and
  • Many advisors provide both services for a combined fee.

Naturally, if you only need one service or the other, it is generally not desirable to pay for both.

Why Don’t People Use Mid-Cap Funds?

A reader writes in, asking:

“I notice that in your ‘8 lazy ETF portfolios‘ article, there are exactly zero funds focused on mid caps, but several ETFs focusing on small caps are included in the various portfolios. I guess my question is… why is this? I’m seeking to weight my Vanguard Roth more heavily toward smaller domestic stocks, and I don’t quite understand the lack of interest in mid cap.”

When it comes to diversification within the stock portion of one’s portfolio, there are two schools of thought within the broader “passive investing” group of investors.

Diversification via Number of Stocks

One line of thinking is that, once you have an allocation to as many stocks as possible, you cannot get any more diversified. In other words, with regard to US stocks, a “total market” fund is as diversified as you can be, because it already includes the entire US stock market (or as close to it as possible). And ditto with a “total international” fund.

This is the line of thinking that Allan Roth, for example, is using with his “Second Grader Portfolio.” It’s also the line of thinking that Vanguard uses with their Target Retirement funds (which hold three underlying funds: Vanguard Total Stock Market, Vanguard Total International Stock, and Vanguard Total Bond).

Diversification via Risk Factors

Twenty years ago, researchers Eugene Fama and Kenneth French found that certain types of stocks (specifically, small-cap stocks and value stocks) perform noticeably differently than other stocks (specifically, they have higher returns, presumably due to higher risk).

The second school of thought within the broader “passive investing” school argues that additional diversification can be achieved by exposing one’s portfolio to a significant amount of small-cap risk and value risk in addition to normal stock market risk. And, naturally, the easiest way to do this is to add a fund all the way at the small-cap/value end of the spectrum rather than going only half-way down the spectrum with mid-cap funds.

Where Do Mid-Cap Funds Fit?

In other words, there’s nothing at all wrong with mid-cap funds (or, more broadly, with mid-cap stocks). They just don’t fit very neatly into either of the two major schools of thought. One school of thought thinks a total market fund is all you need. And the other school of thought, seeking to achieve small-cap exposure in the easiest way possible, goes directly to small-cap funds as a way to supplement a “total market” holding.

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