Archive for 2017

How to prepare a portfolio for war with North Korea

Thursday, August 10th, 2017

QVM Clients:

I have received some calls asking whether and how to prepare portfolios for possible war with North Korea. Whether a war is likely is beyond my capacity to respond, but whether portfolios should be prepared for extreme market conditions resulting from any number of catastrophic situations is something on which I will comment.

Let me state right out of the gate, preparing a portfolio for a generalized Black Swan or catastrophic event is prudent. We should all have a protective component of our portfolios, all of the time – more for the older of us and less for the younger of us, based in great part on the time horizon before calling on the portfolio for withdrawals. However, tailoring a portfolio against a specific catastrophic event is generally not prudent, unless you are dead certain it will happen. And in that case, everybody else is probably dead certain too, and the event would already be substantially priced into the market.

So, while I can suggest a portfolio specifically tailored for a war between the USA and North Korea, I do not recommend implementing it. Such a portfolio would not represent your long-term strategy (which should include a protective component), and if that specific event did not materialize you could find yourself way off course.

With that caveat, let’s think about what a portfolio specifically tailored for an anticipated war between the USA and North Korea.

Don’t think me cold-hearted in discussing portfolio war preparation, because the tragic death of 100’s of thousands of people, including thousands of US troops stationed in South Korea would be horrific almost beyond imagination. According to former US Defense Secretary Cohen today, North Korea could lay waste to Seoul South Korea in about 1 minute from the 10,000 artillery pieces trained on that city at all times. But some of you asked about portfolios, not human tragedy. I am not inclined to plunge into portfolio war preparation, unless an individual should prevail upon me to do so, but I am prepared to say what portfolio might fare better in the event of such a war.

So whether it is war with North Korea, or worldwide plague, or hackers shutting down our electrical grid and somehow disabling our Internet for a prolonged period; the assets that provide clear defensive protection are:

• Cash (insured bank accounts or Treasury money market funds)
• Gold (proxy: GLD)
• Treasury bonds (proxy: VGIT).

Holding any of these three assets creates a current drag on portfolio income, and with the possible exception of gold, a drag on total return. Any form of protection (like insurance) has a cost, and that cost is a lower long-term total return than a flat-out equity market exposure. Except for investors with a very long time horizon before entering the withdrawal stage, some level of cash and bonds is appropriate in any event

Now for the specific war preparation portfolio, keep these index weights in mind, which will help interpret the allocation suggestions below:

  • South Korea is almost 15% of the Emerging Markets index followed by iShares; but 0% of the index followed by Vanguard
  • South Korea is almost 5% of the non-US Developed Markets index followed by Vanguard; but 0% of the index followed by iShares
  • China is about 29% of Emerging Markets indexes
  • Taiwan is about 16% of Emerging Markets indexes
  • Hong Kong is about 3% of non-US Developed Markets indexes
  • Japan is about 21% to 23% of non-US Developed Markets indexes
  • Apple is about 4% of the S&P 500 and about 5% of the Dow Jones Industrials

Changes one might consider (excluding shorting and options) to specifically prepare for possible war with North Korea are:

  • Above target cash
  • Target or above target level gold (proxy: GLD)
  • Above target intermediate-Treasuries (proxy: VGIT)
  • Add defense industry exposure (proxy: ITA)
  • Below target Emerging Markets allocation – to reduce China, Taiwan, Hong Kong and South Korea Exposure
  • Within reduced diversified Emerging Markets allocation; Hold VWO not EEM – to eliminate South Korea Exposure
  • Within non-US Developed Markets exposure, hold EFA not VEA – to reduce South Korea Exposure
  • Possibly replace diversified non-US Developed Markets funds with Europe funds (VGK) – to reduce Japan exposure (proxy: EWJ)
  • Reduce broadly diversified US stock holdings (proxy: SPY) beyond lowered target levels, and rebuild to lowered target levels with sector funds, not including technology sector (proxy: XLK)
  • Sell single stock Apple holdings (AAPL).

Note, there may be significant non-recoverable tax costs to such a portfolio reconfiguration in regular taxable accounts. That would need to be evaluated in terms of each investor’s embedded gains, and how much of which assets are held in tax deferred or tax-exempt accounts, as well as other aspects of the investor’s general tax situation.

Why sell Apple or reduce technology sector exposure? Because, South Korea (think Samsung) is a key part of the technology supply chain (including parts for iPhones). It could take a couple of years to build replacement chip foundries to supply the needed chips for Apple, unless they could find non-Asia suppliers.

Think of the war a step farther out. China decides not to fight the USA on behalf of North Korea, but does decide the war is the perfect time to invade Taiwan to reclaim it. The USA might well be unprepared to defend Taiwan while fighting North Korea, and might accept the invasion of Taiwan in exchange for China not involving itself in the North Korea conflict. Such an invasion could further damage the technology supply chain. Then, of course, Vladimir might decide to take the rest of the Ukraine or some other land grab, which would be very hard on the Europe stock markets.

What happens after the early war stages is unknowable, but as past wars have shown, the world rebuilds, and capital continues to work. So be prepared to restore equity allocation once hostilities are clearly over and stock markets begin to recover.

There would, of course, be no option to do those things to the portfolio once a shooting war opened up, as the pricing adjustments would be near instantaneous. For myself, I am not making such drastic single scenario preparations, but rather holding some level of generally protective assets along with a diversified global equity exposure. That is what I suggest to you.

This is a quite unpleasant topic to contemplate, but to make sure we’re always thinking, this is what we can fathom at the moment, as preparation for first order effects. Where second and third order effects go, is beyond pure speculation.

 

[securities mentioned in this letter: GLD, VGIT, ITA, VWO, EEM, VEA, EFA, VGK, SPY, EWJ, XLK, AAPL]

QVM Market Notes: Bull and Bear Markets and U.S. Large-Cap Stocks Valuations

Friday, June 16th, 2017

QVM Clients (May 6, 2017):

The current Bull market is the second longest with the second largest cumulative gain since 1900. In another 16 months, if it continues as according to the “Street” consensus, it will be the longest running Bull since 1900.

(click images to enlarge)

20170506_1

Augmented valuations based on expectations of Trump getting his key economic agenda implemented soon (including tax reform, overseas capital repatriation, and massive infrastructure investments) is substantially diminished at this time due to all the conflict and dysfunction at the Federal level. Accordingly, most or all of any “Trump Bump” in U.S. stock valuations may be unwarranted.

There are also many risks facing stocks. I have my list. You have your list. They are both good. Both lists are significant, ranging from Central Bank actions, to globally shifting national political profiles, to spreading terrorism, to highly indebted governments, to disappointing strength of GDP growth, etc.

Valuation is an issue, but not likely to be a cause of the next Bear market. Markets can remain overvalued or undervalued for extended periods. A market peak is created not by overvaluation, but by an event or circumstance that causes investors to lose confidence or become fearful.

Of valuation and inevitable Federal Reserve actions, famed investor Bill Gross, formerly CIO at PIMCO, said last week “Instead of buying low and selling high, investors are buying high and crossing their fingers”.

Independent of the Trump goals, there is growth in the U.S. and the world, which is keeping stocks moving forward, but in the U.S. stocks may be a bit ahead of themselves.

In the face of most U.S. stock valuation multiples being well above median levels, one key measure is much better than median and helps keep money flowing into stocks — that is the spread between the yield on Treasuries and the earnings yield (earnings divided by price) of stocks. One other key measure is in the attractive zone:

  • Earnings yield spread to 10-Yr Treasuries yield is well above the 50-year median, and the internet era median, and only a bit below the 145 year median — ATTRACTIVE
  • Dividend yield is approximately at the median level during the internet era — ATTRACTIVE
  • BUT, other price multiple measures are in the expensive range.

Earnings Yield Spread

Due to depressed interest rates, stocks continue to generate an earnings yield greater than Treasuries — and in a world where investors chose between alternatives, they are choosing stocks while the yield spread is positive in favor of stocks.

Very few living and currently active investors have more than 50 year of investment experience, which means for almost every investor, the current earnings yield spread makes stocks more attractive than bonds from a return perspective (although not from a maximum drawdown risk perspective).

Before the 1960’s (and before the academic field called “Modern Portfolio Theory”) investors required a lot more yield advantage from stocks than bonds. Will those days every return? Probably not, but it is not impossible.

20170506_2

S&P 500 Large-Cap Valuation Multiples in the Internet Era

  • Price to Earnings
  • Price to Cash Flow
  • Price to Sales
  • Price to Book Value
  • Dividend Yield

All multiples are above median, except for dividend yield which is at the median level. Only price to sales is very high in historical terms. Conclusions, S&P 500 is expensive by these measures (except for dividend yield), but is not excessively expensive.

20170506_3

 

Here are 10-year charts of the trailing and forward P/E ratio of the S&P 500 from FactSet.  Both are well above their 5-year and 10-year averages.

20170506_5

20170506_6

 

Growth at a Reasonable Price

Five-year forecasts are aggressive, because they see historically high earnings growth rates, and earnings continuing to outpace sales signficantly – that can’t go on perpetually. The S&P 500 is priced in the upper part of the mid-range of history with the 1 year forward P/E ratio about 1.5 times the 5 year earnings growth forecast (the “PEG Ratio”).

Here is the forecast from the most recent Standard and Poor’s spreadsheet for the S&P 500 (Standard and Poor’s opinion only).

 

20170506_4

 

Yardeni Research publishes a S&P 500 PEG ratio time series from 1995 forward.

It shows that the high (most expensive based on forecasts) was between 1.65x to 1.70x reached in 2015 and 2016. The low (least expensive based on forecasts) was in 2008 during the last crash. The median is in the vicinity of 1.30x to 1.35x. The current ratio is about 1.4, — just a bit more expensive than the median market in the internet era.

Mean reversion of valuation multiples is a powerful force, and mean reversion of all of the above measures (except for dividend yield), when pressured by outside forces, would cause U.S. stock prices to either decline, or slow down for economics to catch up. The problem is predicting when mean reversion will kick in.

We will keep an eye out for change.

Directly Related S&P 500 Funds: SPY, IVV, VOO, VFINX

21 Lowest and 21 Highest Cost US Large-Cap ETFs In The Current Expenses Price War

Monday, May 1st, 2017

There is a price war going on among fund sponsors with some ETFs now having expense ratios from 3 basis points to 5 basis points.

Keeping costs low is key to long-term returns generally, and specifically to index funds.

Here is a list of the 21 lowest expense ratio and 21 highest expense ratio US large-cap ETFs that have at least $100 million of assets under management.

(click image to enlarge)

2017-05-01_LowestCostAndHighestCostUS-LC_ETFs
The largest ETF (the S&P 500 tracker, SPY) is among the least expensive at 9 basis points, but more expensive than two other S&P 500 ETFs (IVV at 7 basis points, and VOO at 4 basis points).

For a $1 million position, 1 basis point amounts to $100 per year; or $200 extra return per year with IVV and $500 per year extra return with VOO.

If all you want to do is buy and hold the S&P 500, VOO probably is the most sensible approach.  On the other hand, if you want to be able to sell covered options on your S&P 500 position for income, you need to stick with SPY.

Schwab has a US large-cap and a US broad market (also large-cap) ETF at 3 basis points.

Before you know it, some very large ETFs may have zero expense ratios — it could happen.

How so?  Two things possibly:

  • Some sponsors may chose to offer “lead funds” such as a US large-cap fund at zero expense (operating at a loss) to gather assets on the assumption that if they can capture a core assets, they have a good shot at capturing other assets that are operated profitably — certainly that has been the case with money market funds for the past 8 years.
  • The combination of mega-size and revenue from securities lending should make is possible to operate at least marginally profitably on some funds to either gather assets, or compete to retain assets against others who lower fees to gather assets.  When funds lend securities, they earn a fee, which is shared partially with the manager in most cases (not shared at Vanguard).

iShares, for example keeps from 15% to 28.5% of the securities lending revenue on it funds.  If sponsors could live off of the lending revenue share alone, and also make certain competitive asset gathering or retention decisions, expense ratios on some funds could go to zero.

Here is some of what iShares published about securities lending by ETFs:

2017-05-01_ishare sec lending dist

2017-05-01_sharesLendingRev

iShareSecLending

Whether sponsors do or do not keep a share of securities lending fees, as expense ratios approach zero (and 3 basis point to 5 basis point expense ratios are approaching zero in effect), the impact of securities lending begins to have a significant effect on the tracking error of an index fund — such that on occasion the fund could outperform its benchmark even with the drag of a management fee.

Other important factors that impact tracking error include the amount of cash held for liquidity; the effectiveness of sampling if index replication is not used; and the timeliness and accuracy of rebalancing and reconstitution.

Anyway, we are approaching the time where Warren Buffet’s concern about Wall Street drag on returns, and the damage to investors, may be approaching an end for large index funds.  It is typically said that you cannot buy an index, only a fund tracking an index.  Well, they two are approaching the point of being one and the same.

Overall, the highest costs US large-cap funds, with expense ratios from 48 to 64 basis points did not do worse than the lowest costs funds.

In fact if you simply average the returns (not asset weighted), the highest cost group did a little bit better than the lowest cost group.  That was not due to better management, but to somewhat specialized large-cap strategies that did better, such as technology oriented NASDAQ exposures.

That shows that it is possible for higher fees to be justified in some cases by deviating from the broadest indexes, but that is a case-by-case situation.

If you are buying broad indexes, pay really close attention to expenses as one of the primary drivers.  For specialized funds, category relative expenses can be important, but absolute expenses may not be as important as for broad index funds.

Securities Mentioned In This Article:

SCHX, SCHB, VOO, VTI, ITOT, VV, IVV, MGC, VIG, SPY, GSLC, VUG, SCHG, MGK, IUSG, VTV, SCHD, SCHV, MGV, VYM, IUSV, FTCS, PKW, FEX, PTLC, KLD, DSI, MOAT, FTC, QQXT, QQEW, FPX, PWB, FVD, DEF, FTA, PWV, PFM, RDVY, RDIV, RWL, OUSA

 

 

 

 

 

What Is Asset Allocation For Everybody Else?

Wednesday, April 19th, 2017

(click images to enlarge)

combinedMF-ETF-MMF

AssetAllocation1500ETFs

Breadth Character of the US Stock Market

Monday, March 27th, 2017
  • Major stocks indexes still in intermediate-term up trends
  • Breadth indicators suggest problems underneath with prospect of near-term corrective move
  • Maintain current reserves in anticipation of better entry point for broad index positions

WHAT ARE BREADTH INDICATORS?:

Stock market breath indicators  measure the degree to which the price of a market-cap weighted index, such as the S&P 500 index, and the broad equal weighted market are changing in harmony — looking for “confirmation” or “divergence”. With confirmation, expect more of the same. With divergence be prepared for the path of the index to bend toward the direction of the path of the breadth indicator.

It works in a way similar  to the physical world as described in Newton’s First Law of Motion, which says that an object in motion continues in motion with the same speed and direction unless acted upon by outside force. The object is the stock index price. The force is the breath indicator.

There are multiple forces acting upon the object (the stock index), and it is the sum of those forces  that determine the speed and direction of the  index. Breadth indicators are among the more  powerful forces, because they reflect the effect of other forces (such as earnings and growth prospects and microeconomic news) on each of the index constituents separately.

Breadth indicators tend to be more effective at signaling impending market tops than market bottoms.

As more and more of the broad market issues move in the opposite the direction of the market-cap weighted stock index, the greater is the probability of reversal in the direction of the stock index.  The breath indicator represents the equal weighted broad market, which normally peaks before the market-cap weighted indexes peak..

Additionally, when breath indicators reach extreme values in the same direction as a market-cap index,  the market-cap  index is thought to be overbought or oversold, and subject to moderation back toward the moving average.

Let’s look at a few breadth indicators that we follow weekly to see what they might be suggesting at this time about the Standard & Poor’s 500.

CURRENT S&P 500 INTERMEDIATE-TERM TREND CONDITION:

First, let us stipulate that the S&P 500 is in an uptrend. Actually most major indexes around the world are currently in up trends (see a recent post documenting trends around the world).

Figure 1 shows our 4-factor  monthly intermediate-term trend indicator in the top panel in black (100 = up trend, 0 = down trend, 50 = weak or transitioning trend).  (see video explaining methodology, uses, and performance in a tactical portfolio since 1901).

FIGURE 1:

(click images to enlarge)

2017-03-27_SPY trend

 

BREADTH INDICATORS CONDITION:

Percentage of S&P 1500 In Correction, Bear or Severe Bear

We  look for divergences between the direction of the combined constituents of the S&P 1500 broad market index with the direction of the S&P 500 index.

In Figure 2, we plot the percentages of constituents  in a 10%  Correction or worse;  in a 20% Bear or worse;  and in a 30% Severe Bear or worse versus the price of the S&P 500.

This measure’s how much bad stuff is happening in the broad market.  The weekly data is a bit noisy, so we also plot the 13 week ( 3 month) average shown as a dashed line over the weekly data.

Leading up to the 2015 correction, these indicators (particularly the 10% Correction or worse indicator) gave an early warning of developing risk of a market reversal.

After the 2015 correction, those indicators continued to deteriorate, event though the &P 500 recovered; once again giving a signal that not all was well, which led to the 2016 correction.

After the 2016 correction,  those indicators improved rapidly  until the period before the 2016 election where concerns were rising. After the election, the indicators once again improved very rapidly, but now those issues in Correction, Bear  or Severe Bear  are rising again, suggesting caution about the possibility of another market reversal.

(click images to enlarge)

FIGURE 2:

2017-03-26_CBSB

Percentage of S&P 1500 Stocks Within 2% of 12-Month High:

In Figure 3, we plot the percentage of S&P 1500  constituents within 2% of their 12 month high, versus the price of the S&P 500.   This measures how much good stuff is happening in the broad market.

That breadth indicator  began to decline months before the 2015 correction and continued to decline even as the market recovered from that correction, portending the early 2016 correction.

The 13 week average turned down before the larger part of the corrective move preceding the 2016 election and rose after the election, but now it is  rising again, suggesting the possibility for a corrective move in the near term.

FIGURE 3:2017-03-26_2pct

S&P 1500 Net Buying Pressure:

Figure 4 presents another breath indicator, which recall “Net Buying Pressure”.

It measures the flow of money into rising and falling prices of the constituents of the S&P 1500 for comparison with the  direction of movement of the S&P 500  index.

The chart below plots  the Net Buying Pressure for 3 months, 6 months, and 12 months.

We multiply the price change in Dollars of each of the 1500  constituents each day, and multiply that change by the volume of shares traded each day. We sum  the negative products, and sum the positive products.     We then divide the sum of the positive products by the sum of the positive and negative products combined. If the ratio is more 50%,  that means there is more positive product than negative product, which we called Net Buying Pressure.   If the ratio is less than 50%,  that means there is less positive product than negative product, which we call Net Selling Pressure.

You can see in the chart that Net Buying Pressure began to decline in advance of correction in 2015 and continued to decline even as the index recovered before going into a second correction 2016. Since then net buying pressure has risen until just recently, when it has begun to decline again. That suggests to us trend in the S& 500  is not well supported by the broad market, and may be ready for a corrective move.

FIGURE 4:

2017-03-26_NetPressure

 

Bottom line for us is the view that the broad market foundation of US stocks is materially weakening, making the major market-cap indexes (dominated by the largest stocks) increasingly, visibly vulnerable to a material corrective price move; which suggests a better time later to commit new capital than now.

 

 

Rational Risk Retirement: Gerontological and Estate Perspective on Target Date Funds

Saturday, March 25th, 2017
  • some investors want full auto-pilot on their investments during retirement.
  • many investors will have cognitive impairment sometime during retirement.
  • many investors will develop outright dementia sometime during retirement.
  • all investors planning to leave assets for the benefit of others will die.
  • portfolio construction for these conditions differs from pre-retirement years.

[This is Part 3a of a 3 part series on Rational Risk Retirement – Traditional Withdrawal Strategy, Alternative Withdrawal Strategies and Retirement Portfolio Construction.  Part 1: Withdrawal Strategies is available here. Part 2 is pending.  The is the first two pieces for Part 3 on Retirement Portfolio Construction.]

It is widely acknowledged that longevity risk (risk of outliving your investments) in retirement must be addressed in portfolio construction.

Probabilistic projections such as Monte Carlo simulations are an important part of that process; as well as designing so that withdrawals can be taken from somewhat stable value assets during equity bear markets, to reduce the risk of ruin associated with selling assets into a decline.

In contrast, is not widely acknowledged  that cognitive risk with aging in retirement should also be addressed.

There are numerous dimensions to dealing with cognitive risk, ranging from how assets are titled and held, lines of succession of decision-making if the investor no longer has the capacity to manage assets, and how to structure the portfolio (and the advisor relationship) so that as cognitive decline slowly creeps up from minimal to meaningful, investments are not endangered by lack of attention, poor decisions or conflicts of interest.

For some investors, particularly during or preparing for near-term retirement, target date funds from a major institution may be a suitable choice for part of the cognitive risk mitigation element of retirement.  They may not be a suitable choice for  everybody, but clearly are for  some.  Let’s look a little bit at cognitive decline and then a deep dive into what is actually inside target date funds.

(click images to enlarge)

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This is not an argument against using an advisor.  I am one myself, but not everybody wants to, has affordable access to, or should use an advisor.  Similarly (and this can be an argument for either an advisor or a target date fund), not everybody can, wants to or should manage their own money.

Behavioral Finance

There is a lot of study and discussion of behavioral finance, with an emphasis on the problem with doing the wrong thing with investments due to emotions overriding logic, and  filtering information for confirmation of biases.

That is all well and good to understand, but less well discussed are the behavioral issues of reduced cognitive capacity and less effective problem solving related to aging.  That is a real issue to think about before retirement, and to put the proper vehicles, instructions, trustees and portfolio together at least by the time of retirement, if not before.  Remember, you could have an event at any age that reduces your cognitive capacity (such as a traumatic brain injury from an automobile accident).

About Cognitive Impairment and Investing

In 2011, the American Association of Individual Investors interviewed Harvard economic profession David Laibson about cognitive impairment and dementia impact on investing decisions. He said;

“As we gain experience, we become better investors. But our ability to solve novel problems [is] peaking around 50–55, and then we’re gently declining thereafter. The decline tends to become steeper as we age, and by the time we’re in our 80s, for many of us, the ability to make good decisions is significantly compromised, particularly decisions that involve complicated new problems. ….

The likelihood of dementia .. doubles every five years … starting out as tiny levels in the early 60’s .. by the time we get to our 80’s, the likelihood of having dementia is about 20%. … and about 30% of the population in their 80’s has cognitive impairment but not dementia … in total, half the population in the 80’s is not in a position to make important financial decisions.

[a] mistake that I think people make is that they falsely believe that somehow they’re going to magically notice significant cognitive decline setting in, and then at exactly the right moment do [all the things they need to do], before the cognitive decline is too significant. They’ll somehow time it perfectly. At age 82, they’ll wake up one morning and say, “You know what? I’m losing a lot of cognitive function”; they’ll walk out that day [and do what they need to do]. That’s a grave mistake. We don’t have that ability to suddenly recognize it and do the right thing just before we lose the capacity to make these decisions well.”

He provided this data on the prevalence of cognitive impairment and dementia in North America.

2017-03-25_dementia

State Street Global Investors published a paper in 2016 titled “The Impact of Aging on Financial Decisions”.

They also talk about the difficulties advisors have raising and exploring the investment implications of aging; and the reluctance and fear clients have discussing the topic or planning for what needs to be done.

They discussed many aspects of aging and investments, including a mini-max graph of increasing wisdom and understanding with experience versus declining problem solving ability, with the suggestion that people are generally at peak decision-making capacity in their mid-50;s (as shown in the image below).

2017-03-25_slide

 

I am sure than many of you have witnessed the cognitive decline problem in real life with your parents or other people in your family or among friends, as I have as well.  You may also have observed or been involved in modifying the investments and investment management control of portfolios for parents no longer able to monitor and control the situation, as I have as well.  It is good to do all you can to minimize those problems ahead of time.

Nicole Anderson, associate professor of psychiatry at the University of Toronto identified these intellectual problems experienced with cognitive impairment:

  • reduced memory
  • reduced ability to multi-task
  • reduced ability to switch back and forth between two tasks
  • reduced ability to inhibit irrelevant information to stay focused on what it is important

Anderson also points out that the best ways to reduce cognitive impairment risk are brain exercise along with body exercise and healthy diet:

  • obtain higher levels of education
  • continuing education and intellectual activities
  • job with complex mental requirements
  • social networking
  • avoiding depression.

Heredity is luck of the draw, but there is some hope to pushing that cross-over point farther into the future. It is about brain exercise in youth and throughout life.  Just as your body is a use it or lose it proposition; so to is your brain, and its capacity to make decisions and solve problems.

What are some of the arguments supporting target date funds?

(1) Some investors want to totally retire – no job, no involvement in their investments, and no concerns about who is managing their money or how

(2) In retirement, for many (and you could be one), there will come a time when cognitive skills will fade; at which point it may not be reasonable to manage one’s own money.  At that time use of an advisor may not be a good choice, because the investor would no longer have sufficient intellectual capacity to adequately monitor the activity of the advisor, and would not necessarily know when or if to make a change — and in a change may not have sufficient intellectual capacity to make a good substitution choice.

(3) If dementia sets in (and that could include you), an investor is incompetent to manage or oversee management of assets.  In preparation for that possibility, assets in trust with specific arrangements for asset management for potentially many years could be useful

(4) After death, presuming there are significant residual assets in a trust, or to be put into trust, for a surviving spouse or other family members; there is no opportunity for the deceased investor to assure that the money is being managed responsibly, cost effectively and prudently, if left to the judgement and decisions of trustees to manage it themselves; or to retain an advisor or broker or annuity agent to do the job, particularly non-professional trustees.

(5) After death, if a professional trustee is used, that is another significant layer of expense, that portfolios can ill-afford, — as cost control is one of the keys to long-term total return.

(6) Cognitive decline and death aside, target date funds for some may be a reasonable way to hold a core position (a boring, quiet bucket) in a portfolio at any age without the complexity of owning multiple broad core funds — using the other assets to tactically tilt overall exposures, or to pursue specific opportunities (an interesting, active bucket).

For those and similar reasons, some people may be good candidates for a large or full allocation of their portfolio to a low-cost, index-based target date fund from a well established investment organization that is likely to be around longer than the investor is likely to be alive; or longer than the portfolio is expected to exist post-death.

Even if target date funds are not the best investments, they are far from the worst.  They are diversified, world asset, all season funds, suitable for  a long-term horizon.

On-Balance Best Choice

Why emphasize large, well established organization?

An advanced age investor who has cognitive impairment would not be in a position to make a change decision if the target date fund was liquidated or the investment organization changed so radically that the target date fund moved in a different direction, or the expenses ramped up.

We think Vanguard is a particularly good choice.

Their target date funds are massive, and invest in a collection of massive low-cost index funds, none of which is likely to be liquidated.  They are a mutual company, which means they are not a takeover target as a stockholder owned assets manager may be.  Because they use index funds, their target date funds are not subject to risk of a manager going “sour” or leaving and being replaced by someone of lesser talent.  They have great depth of skills at index management.  Remember, you might be holding the target date fund for a very long time.

Advisors Not Excluded

All that said, a well selected advisor, can do something a target date fund cannot do, and that a robo-advisor can’t do well — tailor a portfolio to the specific goals, preferences, risk limits, asset complexity, tax exposures and other  circumstances of each unique individual investor (which can be complex with wealthier investors) — as well as to help keep the investor on an even emotional keel, to avoid emotional versus rational investment decisions during periods of excess risk enthusiasm or pessimism.

Target Date Funds to Dominate Defined Contribution Plans

Even if you don’t like the idea of target date funds, they are a large and growing part of the employee benefits landscape.  They currently account for 12.5% of assets in employer defined contribution plans, such as 401-k and 403-b plans.  They are projected to be 48% of plan assets by 2020, according to Kiplingers.

It is a lot less stressful on employees to choose a retirement date than an asset allocation plan among plan choices.  And, it is less stressful (and lower liability) for employers to offer target date funds along with the traditional menu of stock and bond funds.  Target date funds are here to stay, so people should be aware of them.

Three Primary Asset Types Determine 80% to 90% of Return

Investors can get fancy and complex in their portfolio construction, but in the end 3 primary asset categories have been shown to determine the vast bulk of portfolio returns (80% to 90% in some studies).  That leaves only 10% to 20% of return coming from asset category subsets of the primary classes and from security selection.

LOR simple small

There are only 3 things you can do with investment money (outside of speculating with derivatives such as options and futures), and those are Owning something, Loaning money to others, and holding cash or equivalents in Reserve.

Accordingly, we refer to those categories as OWN, LOAN and RESERVE.

For the most part, OWN is stocks, but it also includes tangible assets such as real estate, physical commodities such as gold, and private equity funds and venture capital investments.  For the most part, LOAN is bonds, but it also includes private debt funds, private individual mortgages and other non-traded debt.  RESERVE includes sweep cash in brokerage accounts, demand accounts and ultra-short CDs at banks, fixed price money market funds, and variable price ultra-short bond funds, and cash under the mattress or buried in the back yard.

OWN, LOAN and RESERVE is a functional description of asset categories, instead of a mere label such as equities and bonds.  We believe using functional terms helps investors better understand what is in their portfolios.

We have examined target date funds timeline glide paths in terms of those functional categories.  To keep it very simple, and because target date funds conceptually do not raise tactical reserves, we have combined LOAN and RESERVE in the glide path chart as simply LOAN.

The Glide Path

A key attribute of target date funds is the “glide path”.  Each fund sponsor has a planned schedule of allocation change for each fund as the current date approaches the fund’s stated retirement target date.

The glide paths of the leading fund sponsors differ, but they behave similarly, as shown in this glide path chart for 6 target date fund families that carry current Gold or Silver ratings by Morningstar for expected forward relative performance within their class.

Those families are: Vanguard, Fidelity, T. Rowe Price, BlackRock, JP Morgan, and American Funds.  All are no-load funds at the retail level, except American Funds, which are load funds.  We specifically recommend against investing in any load fund.  There are just too many good no-load funds to give up assets to a load fund.  At the 401-k or 403-b level American Funds are not load funds.

In this chart the black lines are for the Vanguard funds (solid line for OWN) and dashed line for (LOAN).  The red lines are for the highest allocation for OWN and LOAN by any of the six fund families along the path. The blue lines are for the lowest allocation for OWN or LOAN by any of the funds.

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Side Bar: Capitalizing Pension Income

It may not be unreasonable to “capitalize” highly secure pension income as if it were from bond holdings, and to use that capitalized value in measuring the OWN / LOAN allocation of your “portfolio”.

For example, if an investor receives $30,000 from Social Security, at a 3% capitalization rate, that is the equivalent of having $1,000,000 in AAA bonds (at 4% capitalization rate the bond equivalent is more like $750,000).  And since there is a COLA on Social Security, it’s better than a bond which has fixed interest payments.  The same sort of capitalization could be done with a pension benefit from employment.

You might want to put that capitalization into your asset allocation assessment, and potentially take on less actual LOAN assets and more OWN assets to achieve your overall intended risk level, in light of your secure Social Security and pension income.

55%/45% OWN/LOAN to 40%/60% OWN/LOAN

Vanguard ends up with a 45% OWN and 55% LOAN portfolio in retirement.  Within the group of six families the highest  OWN allocation in retirement is 55% and the lowest is 38%.  The highest LOAN allocation is 62%, and the lowest is 45%.

So for someone following the same general approach using multiple funds, those sponsors are suggesting for retirement somewhere generally in the 55% OWN/ 45% LOAN to the 40% OWN to 60% LOAN range.  Vanguard in the middle area at 45% OWN/55% LOAN.

Note that target date fund are basically funds-of-funds.  They just hold them for the investor in the target date fund wrapper and do the rebalancing and allocation shifting automatically over time.

When it comes to the allocation to sub-classes within OWN and LOAN, the funds separate more in how they structure the portfolios.  In addition to the difference between active management and index funds within OWN and LOAN; the allocation to US and international assets differs; as does the allocation to large-cap and small-cap equities; as does the allocation to duration and credit quality among bonds.  They also hold different levels of cash, perhaps more as a function of tactical decisions among those using active management instead of indexes within their funds.

Deep Dive Into 2020 Target Date Funds

For those nearing retirement, a year 2020 target date fund may be of interest.  Let’s look deeply at the six 2020 funds to see what is inside.  The title in the charts should be sufficient to let you know what they are about.

In each case, data for Vanguard’s 60/40 balanced fund (domestic only, using S&P 500 and US Aggregate bonds) fund is provided for comparison — that being a traditional all-in-one fund.

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In terms of return and risk ratings by Morningstar, the Vanguard target date fund is superior.

Keep in mind as you view the allocation between US and international assets, that this level of portfolio allocation is programmatic, even if the security selection is active in some of the funds.

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Notice the allocation between developed and emerging markets diverges significantly.

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The allocation between economically cyclical, defensive and in between (sensitive) stocks differs markedly.

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So too does the equity sector allocation vary significantly.

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The rolling returns and volatility are more similar than the detailed portfolio composition.  That is because the primary OWN/LOAN ratios more similar than the detailed portfolio composition.

This is anecdotal support to the research conclusions that asset allocation between OWN, LOAN and RESERVE (mostly stocks, bonds and cash) determines perhaps 80%-90% of portfolio returns.  And, that only about 10% to 20%, or so, of returns come from more granular asset allocation and individual security selection.

You can see that T.Rowe Price had the superior returns, but at the cost of the highest volatility.  The next table will solidify the appearance on this table that Vanguard had the best balance between return and volatility.

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Vanguard and American Funds came out ahead in terms of risk/reward, both by Sharpe Ratio (which considers both up and down volatility), and the Sortino Ratio (which considers only downside volatility).

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On a calendar year basis, Vanguard had the lowest drawdown in the 2008 crash.

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For assets in tax deferred accounts everything comes out as ordinary income, but in regular taxable accounts, taxation of distributions and proceeds is really important.

Taxation of proceeds depend on the investors holding time, but taxation of distributions is a function of what goes on inside the funds — long-term and short-term cap gains; qualified and non-qualified dividends; and interest earned — as reported on 1099’s to the IRS.  Vanguard and T.  Rowe Price look best in terms of after-tax distributions.

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These equity valuation data do not include earnings quality or earnings growth rates which would help interpret the valuations, but it looks like Vanguard has lower equity valuation multiples than the other funds — slightly more of a value proposition.

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Bond metrics are a little harder to compare visually, but here is a simple thing that may be grossly useful in comparing the overall valuation of the bond portfolios:  multiply the yield by the duration and divide that by a numeric value of the credit quality (AAA = 1, AA =2, A = 3 …..).  If you do that, Vanguard seems to give more yield for the combination of duration and credit quality than the other funds.

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Vanguard and BlackRock have only investment grade credit quality, while the other four families use some below investment grade credits.

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Fidelity and BlackRock are holding a lot more cash than the other funds.

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Target date funds may or may not be appropriate for you or someone in your family, but they should not be dismissed out of hand, as some have done.

The word NEVER is never supposed to be used in investment, but this I can say with confidence,”As diversified portfolios (like any diversified portfolio), target date funds will never be the very top performing funds, and will never be the very worst performing funds (that is an attribute of diversification), but they are designed to be solid performers over the long-term.”

Target date funds might be used as a component of the broad-based core of an investment portfolio (the quiet, boring part); or for some people in retirement as the entirety of a portfolio.

Please call —  happy to discuss.