2013 was a great year for US stocks, and that also means that many mutual funds distributed (taxable) capital gains to their shareholders. ETFs are hot right now and there are many articles like this one which tout the tax-efficiency aspect of ETFs as to why they are superior to mutual funds.

Yes, it is true that ETFs have an inherent structural advantage over mutual funds in avoiding the production of capital gains. (I won’t explain it here, but here is one explanation.) However, the primary reason that mutual funds tend to distribute more capital gains is that most ETFs are passive and thus trade sparingly, while actively-managed funds by definition buy and sell much more frequently (what else are you paying them to do?).

But if you hold a good index fund, it will have very low turnover and thus you’ll rarely have to deal with capital gains either way. For example, both the Vanguard S&P 500 Index Fund (VFINX) and the Fidelity Spartan 500 Index Fund (FUSEX) had zero capital gains distributions in 2013 despite being up over 30% for the year.

On top of all that, at Vanguard their mutual funds and ETFs of the same name are structured as different share classes of the same basket of securities. That means the mutual funds and ETFs have exactly the same level of tax-efficiency. From the Vanguard website:

Are there tax advantages to owning Vanguard ETFs?
Because Vanguard ETFs are shares of conventional Vanguard index funds, they can take full advantage of tax-management strategies available to conventional funds and to ETFs. Conventional index funds can manage tax liabilities by selling high-cost securities to realize losses to offset realized gains. Vanguard ETFs can also limit a fund’s potential capital gains exposure by using in-kind redemptions to eliminate stocks with high built-in capital gains from the portfolio. This advantage gives our Vanguard ETFs management team more flexibility in implementing tax-management strategies.

For example in 2013, both the Vanguard Total Bond Market Index mutual fund (VBMFX) and ETF version Vanguard Total Bond Market ETF (BND) distributed a small long-term capital gain 0.076% of NAV.

Bottom line: If you hold passively-managed index funds, it really won’t matter much tax-wise if you pick ETF or mutual fund. If you hold Vanguard funds, it won’t matter at all. There are other factors like expense ratio differences or intra-day pricing availability that may sway you to either mutual fund or ETFs.

If you hold actively-managed funds, you will be less tax-efficient and that will be an additional drag on performance unless you hold them in tax-advantaged accounts.

While dividend size is not the primary driver of my investment decisions, I still love seeing dividend distributions arrive in my brokerage account and consider them a critical part of my portfolio’s total return.

Eddy Elfenbein of Crossing Wall Street created the chart below, plotting both the S&P 500 index value (blue) and its dividends (red). The vertical axes are scaled 50:1, so that when they cross the dividend yield is 2%. We see that while dividends don’t always go up in the short term, they have been bouncing back and growing along with stock prices today (unlike during the dot-com boom).

If you take a step back and look at the bigger picture, Multpl.com has a chart showing the dividend growth for the S&P 500 on a real (inflation-adjusted) basis since 1870. While the dividend yield remains at historical lows, the total amount of dividends still appear to grow faster than inflation over longer (10+ year) periods. Note the vertical axis is on a log-scale.

The blog Short Side of Long has a nice post discussing the relative performance of several different asset classes over the last few years. The charts especially caught my eye, and I went over to Stockcharts.com to make my own with the asset classes that I prefer to follow.

Here are 2013 year-to-date price charts for selected major asset classes (using representative ETFs): total US stock market (ticker VTI), total international stock market (ticker VXUS), total US bond market (ticker BND), inflation-protected US bonds (ticker TIP), and gold (ticker GLD). Dividends are not included. As mentioned earlier, 2013 was year where assets didn’t move in sync (lower correlations).

(click to enlarge)

The chart below shows the same ETFs over all of 2012. Looking back, it felt like every asset class ended positively and everything was recovering in 2012.

[Read more…]

Due to a lack of tax-deferred space, my current tax bracket, and the current interest rate spread over US Treasury bonds, I started investing part of my portfolio in Vanguard’s tax-exempt municipal bond funds. As a result, I try to read every single muni bond article that Vanguard puts out. In this month’s blog post Municipal debt, Detroit, and diversification, one of the topics covered was the importance of minimizing fund fees.

Research shows that lower-cost mutual funds have tended to perform better than higher-cost funds over time. So instead of worrying about things we can’t control (e.g., how a judge in a municipal bankruptcy is going to decide a case), we should focus on controlling the one variable that we can, which is cost.

The article included the chart below, which plots the net fund expense ratios of municipal bond funds against their 5-year annualized returns.

Source: Vanguard Blog, Morningstar

[Read more…]

More charts! The Atlantic has a big collection of 41 economic charts for 2013. Some are neat, some I don’t understand, and some I don’t think anyone really understands. 😉 Here are two investing-related graphs that caught my eye. The first one shows that correlations between multiple asset classes have dropped significantly recently. Submitted by Joe Weisenthal of Business Insider, who states that “one of the characteristics of a crisis is extreme correlation between multiple asset classes: everything trades up or down together.”

The second one shows the cumulative investment inflows into stock and bonds funds over the last year. Submitted by Joshua Brown of The Reformed Broker, who suggests that this shows “America is regaining confidence in the institution of investing again”.

When I see low correlations, it feels like a good time to rebalance your asset allocation. At the same time, it certainly looks like stocks have some momentum right now. Perhaps it’s best just to take a long nap until 2014.

In the post Foreign Stocks For The Long Run, author Rick Ferri recently revisited the topic of how much international stock exposure you should add to your portfolio’s asset allocation. I also have an older post about this – Choosing An Asset Allocation: Deciding On The Domestic/International Ratio – as part of my Rough Guide to Investing series.

One of the reasons to invest in international stocks is for the diversification benefit. While both have historical average returns of 8-10% annually before inflation, they don’t always move in sync (not perfectly correlated). As a result, Markowitz showed us you can attain a higher risk-adjusted return by holding some of both as opposed to just one or the other. So how much of each should you hold?

In my 2007 post, I posted this chart taken from the then-current edition of the bestseller A Random Walk Down Wall Street by Burton Malkiel. It maps the risk/return for portfolios that range from 100% US stocks to 100% EAFA (Non-US Developed countries) for the period January 1970 to June 2006:

From 1970-2006, foreign stocks outperformed US stocks, while the point of optimal risk-adjusted returns was a split of 76% US and 24% Foreign (70% is a typo).

However, the updated data collected by Ferri shows a different yet similar story (see chart below). From 1970-2013, we see that now US stocks outperformed foreign stocks instead, with the point of optimal risk-adjusted returns at 70% US and 30% Foreign.

[Read more…]

Howard Marks is famous among many investors for his Client Memos as the chairman and cofounder of Oaktree Capital Management. He even weaved many of the older ones into a book, which I read and reviewed. I now try to read every one that comes out. Here’s the most recent client memo dated November 26th, 2013 [pdf]. Below are a few selected excerpts. First, a quick lesson on risk aversion:

Risk aversion is the essential element in sane markets. People are supposed to prefer safety over uncertainty, all other things being equal. When investors are sufficiently risk averse, they’ll (a) approach risky investments with caution and skepticism, (b) perform thorough due diligence, incorporating conservative assumptions, and (c) demand healthy incremental return as compensation for accepting incremental risk. This sort of behavior makes the market a relatively safe place.

In short, it’s my belief that when investors take on added risks – whether because of increased optimism or because they’re coerced to do so (as now) – they often forget to apply the caution they should. That’s bad for them. But if we’re not cognizant of the implications, it can also be bad for the rest of us.

What about now? Marks does see an increase in risk tolerance recently. But how bad is it?

[Read more…]

How time flies. Almost exactly 5 years ago on November 21st, 2008, I was sitting alone in yet another hotel on a business trip in a city that I can’t even remember. CNN was on TV as I wrote the following in a blog post with the title S&P 500 at 750:

While the present looks bleak, the potential for future returns is looking brighter and brighter for long-term investors. The opposite was true a few years ago. If you’re young and still putting money away, this is a good thing! (Although adequate emergency funds should be your first goal.)

Here are selected comments on that post that I admit gave me some doubt:

However, EPS estimates, and therefore valuations, are ridiculously high.

Putting money into a market that represents the old model right now seems like pure folly.

This bear market will last 3-12 years!

I think it’s funny that many of you are down 50% and think that you will break even in a few years, or justify by saying “I’m for the long term”. […] Also, most of the dividends being advertised are based on fantasy (again), just like the EPS, because companies will be cutting them a lot to survive. So no, the S&P isn’t cheap to buy and buy-and-hold is really dead.

[Read more…]

Speaking of holding municipal bonds, I’ve been catching up on the troubles in Detroit and Puerto Rico. Last month, there was a flurry of articles warning about mutual funds with high exposure to Puerto Rico bonds, as they were yielding over 9% and trading at 60 cents on the dollar. Most junk corporate bonds don’t yield that much! Yet, they still clung to investment-grade status from the major ratings agencies because if they went any lower, the bonds would crash as many mutual funds would be then forced by their mandates to sell the bonds. Don’t you love ratings agencies?

From NY Times:

For example, the $34 billion Vanguard Intermediate Term Tax Exempt fund [VWITX], the biggest muni bond fund, lost more than 5 percent from May through August. And the largest exchange-traded tax-exempt fund, the $3 billion iShares National A.M.T.-Free Muni Bond fund [MUB], lost 8.3 percent in the same period. […]

In late August, it was Puerto Rico’s turn to roil the market. A Barron’s article detailed the territory’s high debt load and an economy that wasn’t producing enough revenue to easily cover that debt. The S.& P. Puerto Rico municipal bond index fell 10 percent over the next two weeks before the bleeding stopped. Still, the index was down 16.4 percent in the first nine months of the year.

As of 11/19/2013, Morningstar reports the trailing YTD total return of MUB was -2.97% and VWITX was -1.43%. From Reuters:

[Read more…]

I would characterize my personal portfolio as 85% passive, 15% active, and 100% low-cost. Why is part of my portfolio managed by people trying to generate “alpha”? Aren’t I supposed to say that index funds are always better? Author and money manager Rick Ferri has a good post about When Active Funds Makes Sense, even he is a well-known index fund advocate.

Here are a few circumstances when I consider an actively managed fund over an index-tracking product:

1. The absence of a diversified low-cost index fund or ETF that tracks the asset class.
2. An active fund is lower in cost than an equally diversified index fund.
3. An active fund has greater diversification than an index product, even if the fee is slightly more.
4. The unique risk I am trying to capture is better suited to active management than in an index-tracking product.

He then discusses in detail a few categories that satisfy these conditions: municipal bonds, high-yield corporate bonds, and value stock strategies. I was particularly interested in the muni bonds part:

[Read more…]