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Financial Security by Design
925.299.0472 or Fax 925.299.0473
e-mail: lingane@post.harvard.edu

May 1999

With the passing of April 15th, I suspect that you have thought enough about taxes for a while. So, I’m going to spend this newsletter talking about the design of your investment portfolio.

But First, a Few Words on the Roth IRA. In all that has been written about the Roth IRA, there has not been a lot of discussion on how conversion allows parents to create wealth for their children after they are gone. Yet this is often the most important conversion benefit for families of ordinary means. I’d be happy to send you an illustration of how this works or you can download "Roth Might Mean Rethinking Your Estate Plan" from my web site.

This article also describes the travails that you are likely to experience in trying to get your IRA custodian to accept a customized beneficiary designation, one which includes a disclaimer to assist in the funding of your by-pass trust. One brokerage firm representative refused to accept a customized designation while a number of other firms misinterpreted the terms.

My recommendation is to choose from among the options on your custodian’s standard beneficiary designation form. Change custodians if the standard choices won’t let you achieve your goals. In this regard, Vanguard has the most flexible form that I have encountered. It is available on the web at www.vanguard.com/pdf/wr350.pdf.

Picking Mutual Funds. An anthology of Jonathan Clements’ "Getting Going" columns, which appear in the Wall Street Journal, would make a great text for a financial planning curriculum. (I may be biased since Mr. Clements based his Roth IRA article of about eighteen months ago partially on my input!)

Mr. Clements’ May 11th column identifies sixty four mutual funds for the reader’s further consideration from among the thousands of possibilities. Each has better than average historical performance relative to its peers, stable management, no front end load and a lower than average expense charge.

There is no selection method which can predict next year’s winners with unfailing accuracy. Mr. Clements’ approach is no exception. The funds which he identified last year out performed their peers on average during this past year, meaning that the screening process adds value, but several of last year’s picks were disappointing. As Mr. Clements himself concludes, picking good mutual involves more than running a few computer screens.

If your goal is to select mutual funds with the highest possible returns, you are going to have identify the "more" or risk being disappointed by your choices.

If your goal is to earn a return which, over time, will grow your portfolio enough to finance a comfortable retirement, and if your goal would be met by achieving at least the average market return, then consider index funds.

Or rather, consider a portfolio of index funds diversified among market sectors.

Benefits of Market Diversification. My conclusions are that it is easy to achieve substantial benefits by diversification but that further improvements from choosing the very best sector allocations are smaller and a lot more work.

Consequently, my investment philosophy is to invest broadly and to rebalance periodically and to vary sector allocations only when I think that there has been a fundamental change in market outlooks.

My research led me to devise a portfolio of equity funds illustrating the benefits of market diversification.

The cumulative gain, net of expenses, over the past nine years for the four market sectors comprising the portfolio are shown below.

If you had invested $400 in a fund tracking the S&P 500 US large company index, $200 tracking the Russell 2000 US small company index, $100 tracking real estate investment trusts and $300 tracking the Morgan Stanley Capital International’s EAFE ("Europe, Australia, Far East") foreign stock index, your $1,000 would have grown to $3,410 over nine years. This "weighted average" return represents a cumulative 241% gain.

If your portfolio were rebalanced periodically to maintain a constant allocation to each sector, your cumulative gain would increase to 303%.

Rebalancing your portfolio means buying more shares in a market sector when it is down. Rebalancing, like dollar cost averaging, generates extra profits because you own more shares when the depressed sector rebounds.

Rebalancing a diversified portfolio also makes the portfolio less volatile. If one sector is down when another is up, your portfolio grows with shallower peaks and valleys. To illustrate, the value of the portfolio varied by 3.9% month to month which is lower than the variation of any of the component sectors. (See the table. Volatility is being characterized by the monthly standard deviation.)

Professionals managing large portfolios do not keep sector allocations constant. They seek a slightly higher return by buying those market sectors that they expect will outperform the rest of the market. They don’t have to be right every time to achieve a measurable improvement and even one percent more means big bucks to a pension fund or insurance company.

Changing allocations is not practical for individual investors since predicting which market sectors might outperform takes lots of expensive data and time consuming analysis. Hiring an institution to make allocations on your behalf is also problematic because fees reduces the potential gain.

A constant allocation to several market sectors will not provide the best return. But it will provide an improved return which, over time, will probably grow your portfolio enough to achieve your financial goals. Isn’t that sufficient?

Choosing the Portfolio Components. While there is consensus that index funds are a good way to own large US companies, there is considerable evidence that money managers can outperform foreign stock indices.

For example, Albert J. Fredman, professor of finance at California State University, Fullerton, reports that more than 80% of the actively managed foreign stock mutual funds beat the EAFE index over the past ten years. (Professor Fredman argues that index funds can make sense even for foreign stocks. "The Index Fund Advantage: Low-Cost Passive Investing," AAII Journal, May 1999. Non AAII members can access this article by signing up for a free trial at www.aaii.com, key words "Join E*Membership.")

It has been reported (Pui-Wing Tam, "Putting Index Funds in Their Place," Wall Street Journal, March 12, 1999) that Schwab recommends holding 70% of your foreign portfolio in actively managed funds and only 30% in index funds.

Might it be possible to improve the portfolio return by substituting an actively managed foreign stock fund for the foreign index fund? I selected the T. Rowe Price and Scudder international stock funds to test this hypothesis. Both have earned Morningstar "Four Star" ratings, which places them in the top third of foreign funds in terms of risk weighted performance, and their historical returns exceed the return from a 50:50 mix of Vanguard’s European and Pacific portfolios. (The blend of these Vanguard funds, which began operation in mid 1990, approximates the MSCI-EAFE index.)

Substitution increases the weighted annualized portfolio return by about a quarter of a percent a year, reflecting the better return of the Price/Scudder funds. On the other hand, the Vanguard blend is more independent of the other portfolio components than is the Price/Scudder blend, which means that the Vanguard funds prove more beneficial when the portfolio is rebalanced. The net effect is that substituting the Price and Scudder offerings for the index funds lowers the cumulative gain from 303 to 285% over nine years and decreases the annualized portfolio return from 16.7 to 16.1%.

Both portfolios tend to be equally "efficient", to use modern portfolio terminology, since substitution slightly lowers return and volatility.

I conclude that choosing the best portfolio means identifying the fund in each market sector with the best future track record and the lowest future correlation to the performance of the other sectors. There are doubtless ways that this can be approached but they clearly will not be simple ways.

Fortunately, the practical benefits from identifying the very best sector funds appear to be modest. In which case, the important question is not how to design a better portfolio but rather

"How has your portfolio performed in comparison to the existing benchmark?"

If the annualized return of your equity portfolio has exceeded sixteen or seventeen percent a year over the past decade net of expenses, and if volatility has been below four percent a month, congratulations. If has not, and if there is no ready explanation for the under performance, consider building your equity portfolio by purchasing the funds which comprise this benchmark.

Bonds. Most portfolios should have a fixed income component in addition to equities. I often suggest owning a ladder of individual five or ten year Treasury obligations inside a non IRA account. Treasury obligations are safe, liquid and state income tax-free. They can be purchased through Treasury Direct at par.

Buying bonds at par means less work at tax time since you don’t have to consider amortizing market premiums and discounts.

You need to rely upon your broker’s judgment in order to purchase corporate or municipal bonds since choice is limited. You can’t buy many corporate or municipal bonds with intermediate maturities at par.

You could buy bonds through a mutual bond fund. The management fee will take a big bite out of your income in a low interest rate environment but you are going to have to pay something to buy individual bonds. A bond fund also provides diversification, professional management and bookkeeping services.

I am leery of bond funds because their price performance is less predictable than individual bonds which are always worth a known value on a known date. Bond funds realize attractive total returns when interest rates are declining and bond prices appreciating but bond returns can be terrible when rates rise.

Bond funds are a reasonable choice if your goal is income and you don’t plan to spend principal. Owning individual bonds is probably the better choice when you are withdrawing principal and when saving for a near term goal like a down payment or college expenses.

Treasury obligations don’t pay as much, after-tax, as do corporate bonds but they have been, historically, a better deal than municipal bonds for couples with taxable incomes below about $100,000. The historical advantage of Treasury obligations over municipal bonds has been out of whack recently for reasons which I discussed back in January.

At last week’s auction, five year Treasury notes sold at 5.4%, the highest yield in nearly a year. Treasuries may have struggled back to where they are again competitive with municipal bonds for someone in the 28 or 31% marginal federal tax bracket. (Check out the MUNI/TREAS YIELD RATIO published in the Bond Market Data Base section of the Wall Street Journal.)

Determining how much of your portfolio should be in bonds is a very individual decision. You should keep your emergency fund and your savings for near term goals in short term bonds or in certificates of deposit. Consider investing the rest of your money in stocks, if you are growing your portfolio, since equities have historically outperformed bonds over long periods of time.

You should own more bonds if your goal is wealth preservation. Some people are comfortable owning only enough bonds to tide them over if the market goes haywire. If you want to be able to wait out a five year market decline, you need to own enough bonds to pay for five years of living expenses.

Others will want more bonds to lessen the volatility of their portfolio or because they fear a protracted market decline. However, an all bond portfolio is not as conservative a strategy as it might appear for those of ordinary means because of the risk of inflation. My historical research indicates that having more than about half of your portfolio in bonds provides less, not more, financial security.

Overweighting stocks makes your portfolio more volatile but helps it to grow more rapidly. Overweighting bonds reduces volatility but increases the risk of running out of money before you run out of breath. Balance is the key.

Limited Partnerships. Fifteen years ago, someone convinced you to purchase a real estate limited partnership. Overbuilding and the 1986 tax law changes caused the value of your partnership shares to fall sharply.

You held on and waited and you are now getting solicitations to purchase your shares. The prices offered are only a fraction of what you paid and you can’t help wondering, "Do the professionals know something? Will I lose if I sell?"

Even though the offering price seems low, selling might still let you get all of your money back. To understand why, you have to understand how to figure how much money you currently have invested in the partnership.

This may seem like a foolish question. After all, you paid $1,000 a share and so selling for anything less means that you are going to lose money. Right?

This reasoning is generally correct for an investment in stocks and bonds. When you sell a stock or bond, you get all of your money back if you sell for more than you paid and you have a loss when you sell for less.

Partnerships are different because partnership distributions do not reflect taxable income like they do with stocks and bonds. You might even have to report income on your tax return in a year when there are no distributions!

Partnership distributions are a return of your initial investment. Every time you cash a distribution check you are getting some of your own money back. Distributions reduce the amount of money invested in the partnership.

Sometimes the partnership reports a gain on the Form K-1 that you receive each year. They don’t send you the cash because the gain has been re-invested in the original venture. Partnership gains that you report on your income tax return increase your investment in the partnership.

Sometimes the partnership reports a loss. You don’t have to send in a check because the partnership covers the loss by spending the capital you have already invested. Thus a loss reduces your investment in the partnership.

Your current investment in the partnership is calculated, therefore, by adding up the gains and subtracting the losses and distributions beginning from the time of your first investment. The result should equal the entry on the Form K-1 which is labeled "shareholder’s capital account at the end of the year."

You need to compare the offer price to the value of your capital account in order to know whether an offer to purchase your shares is high enough to get all of your money back. If the offer price is the same as or a little larger than your capital account, you have already gotten most of your investment back in dribs and drabs over the years and selling will let you recover the rest.

If selling lets you recover the rest of your investment, then not selling is the same as making a new investment in the partnership. The speculator wants your shares because he hopes to double his money in a couple of years. If you don’t sell, then you are betting that the speculator is right and that the value of your capital account will also double in a couple of years.

Knowing what you now know about investing in limited partnerships, could anything induce you to invest in another one? Yet this is exactly what you are doing when you reject an offer which exceeds the value of your capital account.

You will recognize that I have been talking in generalities and you will appreciate that financial decisions require careful consideration of your specific circumstances. I’m sure that you also understand that we can learn much from the past but that historical performance does not guarantee the future.

I hope that you have learned something from this newsletter. Please think of me when you have a tax problem or need assistance in designing your financial security. Have a great summer!

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