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Investing Blog Roundup: Morningstar Style Box “Refresh”

Morningstar’s 3×3 “style box” for stock mutual funds has always been a useful tool for showing what portion of the fund is allocated to each category of stocks (e.g., large-cap growth, small-cap value, etc.). When the style box was originally created, the allocation of the overall stock market was by definition one-third growth, one-third blend, and one-third value. However, due to the explosive returns of large-cap growth stocks over the last several years, now even a “total stock market” index fund is categorized as a large-cap growth fund.

Allan Roth discusses the topic, as well as an update that Morningstar will be making in the near future:

Other Recommended Reading

Thanks for reading!

Is a “Total Bond” Fund Still a Good Choice?

One of the most common questions I see in my email inbox, on the Bogleheads forum, and on Bogleheads reddit is something along these lines:

“I bought Vanguard Total Bond Market Index Fund (or ETF) as my core bond holding several years ago. Its performance has been enthusiastically lackluster. Is this fund still suitable for use as the bond part of my portfolio?”

Vanguard Total Bond Market ETF (BND) has had a roughly 16% cumulative return over the last 10 years (annualized return of 1.5%). Given 32% cumulative inflation (2.82% annualized) over the same period, that’s not great. And compared to the mind-blowing 222% cumulative (12.43% annualized) return that Vanguard Total Stock Market ETF has provided over the last 10 years, it does indeed feel very lackluster.

But it’s not as if this unimpressive performance is the fund’s fault. Per Morningstar, it has been in the top half of funds in its category over the period in question. In other words, the fund has been managed just fine.

And it’s not as if “total bond” funds have been particularly bad. It’s been an uninspiring period for basically any type of bond fund. For instance:

  • Vanguard Short-Term Treasury Fund (lower risk than a “total bond” fund) has had an annualized return of 1.05% over the last 10 years.
  • Vanguard Intermediate-Term Treasury Fund (lower risk than a total bond fund but higher risk than a short-term Treasury fund) has had an annualized return of 1.26% over the last 10 years.
  • Vanguard Intermediate-Term Investment Grade Fund (higher risk than a total bond fund) has had an annualized return of 2.49% over the last 10 years.

Why have bond funds struggled?

Bond funds have struggled simply because interest rates went up. For any given bond, when market interest rates for similar bonds rise by a given percentage, the price of that bond will fall by approximately the bond’s duration multiplied by the increase in interest rates.

Interest rates for intermediate-term bonds have risen by about 2% (for both Treasury bonds and investment-grade corporate bonds) over the last 10 years. Vanguard Total Bond Market has an average duration of about 6 years. So, for a fund with an average duration of 6 years, a 2% increase in rates means that the decline in price gobbled up roughly 12% -worth of return. And interest rates were fairly low to begin with (about 2.2% for 7-year Treasury bonds as of July 2014), so that rising-rates headwind was quite a hurdle to overcome.

In other words, bonds did what they do, in a period of rising rates. Nothing particularly strange about this. It admittedly doesn’t feel great, compared to the inflation we’ve had and compared to the superstar returns that we would have earned if the money we’d had invested in bonds would have been invested in stocks instead. But it’s not as if “bond funds are broken” or “bonds are obsolete” or anything like that.

Looking Forward

A total bond fund is still a very reasonable core bond holding, in my opinion — as would be a short-term Treasury fund, intermediate-term Treasury fund, short or intermediate-term TIPS fund, collection of individual CDs, or a ladder of individual TIPS.

There many different reasonable choices. If you want to have a specific amount of purchasing power available on a specific date, you need individual TIPS, held to maturity (or I-Bonds). But for anybody who just wants bonds to be “the thing in the portfolio that’s less risky than stocks, while still providing some return,” then any reasonably low-risk, low-cost bond fund would be acceptable.

I don’t believe there’s any magic in asset allocation, and that’s as applicable with bonds as it is with stocks. Riskier bonds tend to be rewarded with higher returns over time. The safer you want your bonds to be, the less return they’ll probably give you over time.

Right now, we have an “inverted yield curve” (meaning shorter-term bonds actually have higher yields than longer-term bonds). That’s uncommon because short-term bonds are lower-risk than long-term bonds. It may look like a free lunch (i.e., higher yields with lower risk), but really it’s the bond market’s way of saying “we expect interest rates to fall.” That is, right now, the market sees longer-term bonds as an opportunity to lock in unusually high interest rates, whereas shorter-term bonds give you higher rates for now but with the risk that you’ll be earning lower yields again soon if interest rates fall.

What actually will happen with interest rates going forward? I have no idea. That’s why I still think both short-term or intermediate-term bond funds are a reasonable choice. Or long-term TIPS if held to maturity.

Investing Blog Roundup: Small Business Tax Books (2024 Editions)

Just a quick announcement for today, since people often ask about timing for new editions of my books. The 2024 editions for my two small business tax books are now available on Amazon:

Other Recommended Reading

Thanks for reading!

Age-Based Asset Allocation (I’m Not a Fan)

A reader writes in, asking:

“I am curious for your take on the age-in-bonds rule of asset allocation. It seems to me that maybe it’s a bit out of date, and today higher stock allocations are called for.”

I have never particularly been a fan of the “age in bonds” rule. But that’s not because I think that it needs to be adjusted to “age minus 20” or anything like that. Rather, I think that age is simply not a very good stand-in for risk tolerance.

For example: consider my wife and me. When we were 25, our incomes were pretty modest. Our assets were very modest. Our Roth IRAs were definitely not intended to function as emergency funds, but it wasn’t at all out of the question that if a large unexpected expense came up, that’s where we’d be going for the cash necessary to pay the bill. It would have been either raid the Roth IRAs or put it on a credit card. Point being, despite being young, we simply had a limited financial ability to take on risk.

Today, we’re both age 40. And there’s no question that our ability to take risk is greater than it was at age 25. We’re still far enough from retiring that a market decline wouldn’t throw off our plans in any meaningful way. We now have considerably higher household income. After 15 more years of saving and investment returns our assets are dramatically greater than they were at that time. And now the portfolio isn’t doing double-duty as an emergency fund in the way that it was at age 25. We are now more financially secure in every way.

15 years older, but with much greater ability to take on risk in the portfolio. And there’s nothing remotely weird about that set of circumstances. That is in fact the normal path for a household’s finances to take, over that particular age range.

Or consider this example: Jimmy and Bob are two unmarried retirees, who have completely identical finances (identical portfolios, identical Social Security income, both spending let’s say 4% from the portfolio per year, etc.). The only difference is that Jimmy is age 65 while Bob is age 95.

Bob has a greater ability to take on risk than Jimmy does. At age 65, Jimmy’s portfolio is still overwhelmingly a retirement portfolio (i.e., intended largely for the purpose of funding his own spending during retirement). For Bob at age 95 with a 4% spending rate, there’s functionally zero chance of running out of money during his lifetime; a large portion of his portfolio is now a bequest portfolio.

Again, the older person has a greater ability to take on risk. And again, there’s nothing particularly weird/unusual about that hypothetical. It’s not rare for it to become clear at some point that the portfolio is, to a significant extent, now being invested on behalf of one’s intended heirs rather than on behalf of one’s own self.

All of this isn’t to say that the ability to take risk always goes up with age, because that’s definitely not true either. Rather, there are specific times in a person’s life where a risky portfolio is simply more dangerous, such as:

  • Very early in the career when the portfolio is also the emergency fund and income/assets are very limited, and
  • In the few years right before and right after retiring.

I think, rather than any age-based rule, it’s prudent to actually look at your own household’s specific circumstances: how harmful would a major stock market decline be, for you, right now? And the answer to that question (regardless of your age) pretty well informs the question of what asset allocation is likely to be appropriate. (And as always I’ll note that for any one household, there’s not one single allocation that’s “correct.” There’s a whole range of allocations that would be reasonable.)

Investing Blog Roundup: Solo 401(k) and the “Age 55 Rule”

A question that comes up from time to time regarding solo 401(k) plans is whether self-employed people with such a plan could ever take advantage of the “age 55 rule.” The tricky point is that you have to “separate from service” in order to take advantage of that rule. And, if you have separated from service (i.e., you’re no longer doing the self-employed work in question), would you still count as an “employer” in order to maintain the plan, or does the plan have to be rolled into an IRA?

Sean Mullaney recently did a deep dive into that topic, and I find his reasoning convincing:

Other Recommended Reading

Thanks for reading!

Why Are ETFs (Sometimes) More Tax-Efficient Than Mutual Funds?

A reader writes in, asking:

“Could you provide an explanation of why ETFs are often said to be more tax efficient than mutual funds or index funds? I’ve read about it before but have never been able to follow.”

I’m happy to discuss this, but in order to understand the idea, we have to cover some background information first. Specifically, we have to discuss:

  • One basic concept about the tax treatment of funds, and
  • How shares of an ETF are created.

What Happens When a Fund Sells Something?

Whenever a fund (whether an ETF or traditional mutual fund) sells one of its holdings from the portfolio, if that holding is sold at a gain, shareholders of the fund have to pay tax on their share of that gain (if they hold the fund in a taxable brokerage account, that is).

How ETF Shares Are Created

When an investor buys shares of a traditional mutual fund, the transaction is a transaction between the investor and the mutual fund itself. The investor gives cash to the fund, and the fund creates new shares of the fund, which are given to the investor.

In contrast, when you or I buy shares of an ETF, we’re buying already-existing shares from some other shareholder who already owned those shares. So how do ETF shares get created in the first place?

The answer has to do with entities known as “authorized participants.” Authorized participants are generally super big financial entities (e.g., banks).

When a company that runs an ETF wants to create shares, it essentially does a swap with an authorized participant. It creates new shares of the ETF, and it gives those shares of the ETF to the authorized participant, in exchange for cash or a “basket” of securities (e.g., the 500 stocks in the S&P 500, if it’s an ETF that tracks the S&P 500). These swaps are usually done in very large dollar amounts (e.g., 50,000 shares of the ETF in exchange for the appropriate amount of other securities).

The ETF Tax Advantages

When an investor in a traditional mutual fund wants to sell his/her shares for cash, the transaction is again a transaction with the mutual fund itself. The fund needs to have cash on hand, so that it can pay that cash out to the shareholder redeeming the shares. And sometimes (depending on how many shares are being redeemed on any given day) raising that cash requires selling stuff. And as we discussed earlier, when a fund sells anything at a gain, shareholders in that fund have to pay tax on their share of that gain. In other words, when one shareholder sells his shares of the mutual fund, if the fund has to sell stuff at a gain in order to pay off that shareholder, that creates a tax cost that will be ultimately be paid by the remaining investors in the fund.

In contrast, if you or I want to sell shares of an ETF, that’s a transaction that happens on the secondary market. We aren’t transacting with the fund itself at all. We’re just selling our shares to somebody else who wants to buy them. And that means that the ETF doesn’t have to do anything — doesn’t have to sell anything, and no tax costs are incurred by remaining shareholders in the fund.

In addition, when an authorized participant wants to redeem shares of the ETF, the ETF basically does the share creation process (i.e., the swap described above), just in the opposite direction. This is known as a share redemption. In an ETF redemption, the ETF gives shares of investments to an authorized participant, and the authorized participant gives ETF shares back to the fund. And because this is an “in-kind” transaction, it’s not considered a taxable event. So the ETF is able to hand off those underlying investment shares without technically having sold them — no tax cost.

This is made even more tax-efficient by the fact that, when the ETF swaps out shares of any given company, it will naturally choose to give away the shares that have the lowest cost basis (i.e., keep the ones that have the highest cost basis, in case they have to be sold — thereby allowing any gains that have to be realized to be smaller gains).

So, in short, ETFs are often more tax-efficient than traditional mutual funds because they have a way of satisfying redemptions without having to actually sell anything and because they have a way of strategically unloading their shares of investments with the lowest cost basis (without generating a capital gain in the process).

Two Important Caveats

While the ETF structure does give it some tax advantages over a traditional mutual fund, there are two important caveats to keep in mind.

First caveat: the underlying portfolio and investment strategy of the fund still matters. It matters a lot. For instance:

  1. A fund (whether it’s an ETF or mutual fund) that follows a “total stock market” strategy is going to be much more tax-efficient than an actively managed stock fund that does a lot of buying and selling. Because, as discussed above, selling stuff at a gain results in tax costs to shareholders. So, higher portfolio turnover generally means worse tax-efficiency, and lower portfolio turnover generally means better tax-efficiency — regardless of whether the fund is an ETF or traditional mutual fund.
  2. A fund that pays a lot of fully-taxable ordinary income (e.g., a high-yield corporate bond fund) is simply not going to be very tax-efficient — and that’s true regardless of whether the fund is an ETF or traditional mutual fund.

Second caveat: this whole discussion largely does not apply to Vanguard ETFs as compared to Vanguard index funds. That’s because for many Vanguard funds, the ETF and index fund are literally the same fund. They’re just different share classes. So the share redemption process that ETFs can use (i.e., swapping out shares of holdings with low cost basis, to authorized participants) benefits the Vanguard index funds as well (as long as the index fund in question also has an ETF share class). In addition, the Vanguard patent on this “ETFs as a separate share class of an existing fund” idea recently expired (in May 2023). So it would not be at all surprising if other fund companies eventually implemented the same concept. (And many companies are already actively in the process of doing so.)

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