Archives for October 2011

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Fixing a Broken Portfolio: Is it OK to Sell Low?

Dan writes in to ask,

“I have a portfolio with a large brokerage firm. It’s primarily invested in individual stocks, with a handful of mutual funds thrown in as well. The individual stocks have performed very poorly. The mutual funds have performed better, but (I’m now learning) they have very high expenses and they’ve underperformed the market by a wide margin.

I know that I want to move my money. I’ve been reading on your blog and in several books about using index funds to invest with low costs. But if I sell everything now, after a period of very poor performance, wouldn’t I be selling low? Isn’t that the opposite of prudent investing? Wouldn’t it make sense to wait a few months to see if the stocks come back?”

I get lots of emails like this. People realize that their portfolio is a mess and that it has performed very poorly. Sometimes they even know exactly what they’d like to switch their portfolio to, but they are still reluctant to make the switch because they don’t want to “sell low.” They don’t want to “lock in” their losses.

Look Forward, Not Backward

The problem with this line of thinking is that, tax considerations aside, it’s irrelevant how your portfolio has performed in the past. The only thing that matters is how to make it perform as well as possible in the future.

It can be helpful to look at the situation this way: If your entire portfolio was in cash right now, how would you invest it?

However you answer that question is (in most cases) how you should invest your portfolio.

In other words, either:

  1. You have a good reason to think that your current holdings will outperform a lower-cost, more diversified portfolio in the future, or
  2. You do not.

If you have such a reason, why switch your portfolio at all? And if you don’t have such a reason, why wait to make the switch?

And remember, the mere fact that a stock has declined in the recent past (or that a mutual fund has had sub-par performance) is not a reason to think it’s going to have better-than-average performance in the future.

Possible Exceptions

There’s a potential exception for investors who are currently invested in funds that have contingent deferred sales charges. These charges are commissions on certain share classes of certain mutual funds that are charged if you sell the fund within the first several years. Because they decrease (and eventually disappear) over time, it sometimes makes sense to wait before selling the fund.

Alternatively, if the investments in question are in a taxable account, it can sometimes make sense to stick with your current holdings in order to avoid paying taxes on large capital gains,  even if those holdings are not something you’d buy if you were just getting started today. However, if your current holdings have unrealized capital losses, “selling low” would provide some tax savings — giving you all the more reason to make the switch now.

1035 Exchange: Getting Out of a Bad Annuity

While fixed lifetime annuities can be a helpful part of a portfolio (during retirement), variable annuities are usually quite the opposite. More often than not, they’re loaded with very high fees and are only purchased as a result of a slick sales presentation.

Unfortunately, once you’ve purchased a variable annuity, it can be quite costly to get your money out of it. The insurance company will often require you to pay a surrender charge. And, if the variable annuity was a deferred variable annuity, there will be tax costs as well:

Note #1: These tax costs only apply if the annuity is in a taxable account. If the annuity is in a tax-sheltered account (such as a 401(k) or IRA), you can sell it and move to a different investment within that tax-sheltered account.

Note #2: If the annuity is in a taxable account, but it currently has an unrealized loss (rather than a gain) it might actually be beneficial to liquidate it rather than do the 1035 exchange described below, due to the fact that the tax only applies to gains, not to the entire amount of the annuity.

Tax-Free 1035 Exchange

Fortunately, there’s a way to get around the tax costs. Section 1035 of the Internal Revenue Code allows you to make an exchange from one annuity contract to another, without paying any taxes as a result of the transaction — thereby allowing you to switch to an annuity from a low-cost provider like Vanguard or Fidelity.

Potentially important point: Section 1035 also allows for the tax-free exchange of an annuity to a long-term care insurance contract, which in some cases may be more beneficial.

It’s analogous to rolling a 401(k) into an IRA: The money goes from one place to another, but (when done properly) it’s not a taxable transaction.

Should You Do a 1035 Exchange?

The fact that you can make an exchange without paying taxes doesn’t necessarily mean it’s a good idea.

To see whether or not an exchange makes sense, you’ll first want to find out how much you’d be saving per year (in the form of reduced expenses) if you did make the switch. Against that, you’ll want to compare:

  • Any applicable surrender fee, and
  • The value of any insurance benefit you’d be giving up (if, for example, the policy has a death benefit that’s far higher than the annuity’s current market value).

With that information, you can see how many years it would take before the annual savings from switching would surpass the one-time costs you’d have to pay to switch.

How to Do a 1035 Exchange

The most important thing to know about executing a 1035 exchange is this: Do not liquidate your existing annuity with the intent of using the money to buy another. That would not be a tax-free exchange. That would be a taxable transaction.

Instead, the exchange must occur directly between the two insurance companies.

To get the process started, just call the annuity provider you’re planning to switch to and give them your information. They’ll pre-fill the necessary paperwork and send it to you for your signature.

Once you send that back in, the transfer will take place entirely between the two annuity providers.

As far as tax reporting goes, you shouldn’t have to do anything. You’ll receive a Form 1099-R that reports the distribution as a tax-free 1035 exchange, but you don’t have to do anything with that form other than keep it for your records.

Evaluating Vanguard’s New LifeStrategy Funds

To date, I haven’t written much about Vanguard’s LifeStrategy funds. That’s because I’ve never liked them very much.

But that’s about to change. Vanguard recently announced that over the next few months they’ll be lowering the expense ratios on the LifeStrategy funds (to an estimated range of 0.14% to 0.18%) and eliminating the Asset Allocation Fund from the LifeStrategy portfolios.

Background information: Vanguard’s Asset Allocation Fund is basically their market timing fund. It’s allowed to be 100% in stocks, 100% in bonds, or 100% in cash. Because the LifeStrategy funds included this fund, you could never predict exactly how any of the LifeStrategy funds would be allocated. Personally, I saw that as a significant drawback.

However, once the changes go into effect, each of the LifeStrategy funds will hold a static asset allocation made up of three different funds:

  • Vanguard Total Stock Market Index Fund
  • Vanguard Total International Stock Index Fund, and
  • Vanguard Total Bond Market Index Fund.

The allocations will be as follows:

  • LifeStrategy Growth Fund: 80% stocks, 20% bonds,
  • LifeStrategy Moderate Growth Fund : 60% stocks, 40% bonds,
  • LifeStrategy Conservative Growth Fund: 40% stocks, 60% bonds, and
  • LifeStrategy Income Fund : 20% stocks, 80% bonds

Each of the funds will allocate 70% of the stock portion of the portfolio to the Total Stock Market Index Fund and 30% to the Total International Stock Index Fund.

LifeStrategy vs. Target Retirement Funds

Given that the three funds included in the LifeStrategy portfolios are the same three included in Vanguard’s Target Retirement funds, it’s natural to compare and contrast the two fund groups.

One difference is that the most conservative target retirement funds include an allocation to Vanguard’s TIPS fund, while TIPS are not included in any of the LifeStrategy funds. As someone who finds TIPS to be an especially useful tool for retirees, I think this is an advantage for the target retirement funds.

On the other hand, one thing I like about the LifeStrategy funds is that, under their new construction, they’ll be less likely to be misused than target retirement funds.

With target retirement funds, people often (quite understandably) choose which fund to use based entirely on the date in the name. This can be problematic because there’s more to an investor’s risk tolerance than simply his/her age. For example, a conservative investor who expects to retire in 2050 may well be better served by the 2030 fund than the 2050 fund.

In contrast, the names of the LifeStrategy funds are much more intuitive, and I think this will be helpful for many investors.

The biggest difference between the target retirement funds and the LifeStrategy funds is that the LifeStrategy funds have a static allocation rather than one that changes over time. Shifting to a more conservative allocation over time is the conventional approach, but my understanding is that the jury is still out on whether or not that’s actually any better than a static allocation.

LifeStrategy vs. Vanguard Balanced Index Fund

There’s also an easy comparison to draw between the LifeStrategy Moderate Growth Fund and the Vanguard Balanced Index Fund, as they each hold a static 60% stock, 40% bond allocation.

The primary difference between the two is that the LifeStrategy fund has an international allocation, while the Vanguard Balanced Index Fund does not. Personally, I see this additional diversification as a distinct advantage of the LifeStrategy fund.

The Balanced Index Fund has an advantage in that it offers Admiral shares, which allow for lower costs. But we’re talking about a difference of a few hundredths of a percent — not exactly a huge amount.

LifeStrategy vs. DIY Allocation

As compared to a do-it-yourself portfolio of individual Vanguard index funds, the costs of the LifeStrategy funds are likely to be slightly higher as a result of not offering Admiral shares. But again, the difference is quite slim.

A more important point is that, if you’re investing in a taxable account, the LifeStrategy funds are going to be less tax-efficient than a do-it-yourself approach for a few reasons:

  1. There’s less ability to tax-loss harvest than there would be with a DIY portfolio of the three underlying funds,
  2. They use taxable bonds, while tax-exempt muni bonds would be a better choice for high-tax-bracket investors, and
  3. They get in the way of an asset location strategy.

The Verdict?

If you’re looking for a specific allocation that’s not provided by any of the LifeStrategy funds, then you’ll obviously have to craft that allocation on your own. And if you’re investing in a taxable account, you could save some money on taxes with a DIY, fund-by-fund portfolio rather than an all-in-one fund.

But for investors looking for a low-cost, low-maintenance way to implement a diversified portfolio in a tax-sheltered account (401(k), IRA, etc.), Vanguard’s improved LifeStrategy Funds look like they’ll be an appealing choice.

Why Use Index Funds? (It’s About Costs.)

I recently came across a conversation on the Bogleheads Forum in which somebody referred to me as an “indexing extremist.”

At first it just made me laugh. I have a hard time seeing myself as an anything extremist given the quantity of parenthetical explanations and qualifiers (“generally,” “usually,” “tends to,” etc.) that I tend to use.

But the more I thought about it, the more I realized that it’s possible (likely?) that I’ve overstated (or misstated) the case for index funds.

Let’s back up a step in the hope of clearing things up.

The Magic of Indexing?

There’s nothing truly magical about indexing. Or, if there is, it’s just that it’s a very inexpensive way to run a mutual fund without having to sacrifice diversification.

There are some other, less important benefits — like not having to worry that your fund manager will do something dumb with your money. But low costs are the big thing here.

There’s no particular reason to think that having a portfolio in which each investment is weighted according to its market weight is in itself, going to improve your returns. In fact, for most investors, it doesn’t make sense to market-weight your entire portfolio. For example, consider your bond allocation:

  • For investors in high tax brackets investing in taxable accounts, it makes sense to overweight tax-exempt bonds.
  • Conversely, for investors exclusively using tax-sheltered accounts (IRA, 401(k), etc.), it makes sense to underweight tax-exempt bonds — all the way to zero, most likely.
  • For investors who are very exposed to inflation risk, it likely makes sense to dramatically overweight TIPS relative to their market weighting.

In other words, we each have different needs. And as a result, it makes sense for each of us to hold a portfolio that’s different from the market portfolio in one way or another.

Costs Matter.

But index funds (and ETFs) do tend to be the least expensive way to invest. And as it turns out, that’s no small benefit.

As Russel Kinnell of Morningstar wrote last year when summarizing a study he’d done,

“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.”

Or consider an earlier study, also from Morningstar:

“In all categories, funds in the cheapest quintile were more than twice as likely to succeed–that is, beat the average for their categories-than those in the most expensive quintile. Success declines rapidly as you move up in price. Of domestic-stock funds, 47% in the cheapest quintile succeeded over a 10-year period, 33% of the next cheapest quintile succeeded, 30% of the middle quintile succeeded, 27% of the second priciest quintile succeeded, and just 19% of the most expensive quintile beat the category average.

That same general conclusion has been shown by study after study: Lower-cost funds tend to outperform higher-cost funds.

And because index funds and ETFs tend to be the lowest-cost option available, they’re usually a darned good bet.

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