Financial Professionals

This is my quarterly missive intended primarily for my fellow financial professionals wherein I share items I have run across or thought about this quarter which I think might be beneficial to you.

I am in the process of booking speaking engagements for 2017. If you are looking for a speaker at your professional conference or event and think I might be a good fit, please feel free to contact me for more information.

First, back in October as hurricane Matthew was in the news I was thinking about catastrophe bonds. Specifically, what should be the expected return? Counterintuitively, I think the same as regular corporate bonds of the same maturity – to the extent you can diversify with enough of them (more on that toward the end).

The returns on bonds can be decomposed into three parts:

The real risk-free rate.
Expected inflation.
Risk premium.

Before I decompose the last one further, I want to explain how I think of bonds. In my (admittedly idiosyncratic) view, all bonds are bundles of zero coupon bonds. Obviously explanation is in order. Every expected payment from a bond can be thought of as an individual zero. A normal, interest-paying bond is a bundle of these zeros. For a zero we have the following risks:

Liquidity risk – if the market for the bond is thin or non-existent it will yield more.
Currency risk – this is from the point of view of an investor in each country. There will only be a currency premium if the marginal investor in a bond is from a foreign country. In other words, suppose all investors everywhere require 5% to own certain bonds, but if the bond is not denominated in the investor’s native currency, they demand a 1% risk premium. So if your bond buyers are in the country of origin they require 5% and in other countries require 6%. Country P will sell bonds at 5% unless they run out of native purchasers. Country R will also sell its bonds at 5% unless it runs out of native purchasers. But suppose country R (for “Rich”) has a very wealthy population and low debt and country P (for “Poor”) has a relatively impoverished population and higher (though not high enough in my example that we get into a difference in credit ratings) debt. Country P’s citizens will not be able to afford to buy all of country P’s debt. Country R’s citizens won’t have enough country R debt to buy for their portfolios. Hence bonds in country R end up yielding 5% and country P’s 6%.
Term – longer term bonds typically pay more than shorter term bonds because people tend to want a premium for bearing uncertainty.
Credit/Political – this is the risk that you won’t get paid because there isn’t the funds (or will) to do so. This also incorporates the mere prospect of getting paid changing – aka downgrade risk.
Reinvestment risk – if you purchase a bond with the “right” maturity (remember in my little world all bonds are zeros) this doesn’t apply, but suppose there is lots of demand for 30-year bonds (say lots of people needed a lump sum in 30 years) but little for 15 year bonds. The 30 will trade lower than the 15. People will buy the 15 but demand a premium because of the risk that when it matures and they buy another 15 (to get to the 30 total) rates may have changed.
Idiosyncratic – this would be the cat bonds. Since all the other risks of cat bonds are the same as regular bonds, we are left with how to price the catastrophe risks. Since they are fully diversifiable (a hurricane in FL has no relationship to a tsunami in Japan) in theory there should in theory be no risk premium! The only holders of cat bonds should be institutions large enough to have a fully diversified portfolio. To the extent this is true, there won’t be a risk premium. If the marginal purchaser is not fully diversified however (i.e. there aren’t enough of those institutions), there will be a risk premium. The problem is that apparently the vast majority of these bonds are issued in relation to risks in North America. Thus you can’t actually fully diversify them (within this category, you can of course diversify into other asset classes entirely).

Obviously much of the above is oversimplified, there is a supply-demand curve for every factor and every bond.

Second, I recently joined the AICPA (even though I am not a CPA) in part because of the financial planning resources. This page has good stuff.

Third, as you may have seen, the Social Security wage base jumps from $118,500 to $127,200 for 2017. So for a high-income, self-employed, person their taxes increased by just over $1,000 [($127,200 - $118,500) * 0.124 = $1,078.80].

Fourth, as part of their estate planning we recommend clients have a letter that tells survivors things they need to know. I just ran across a version that is extremely (perhaps too) comprehensive.

Fifth, here are some “Amazing Facts About the Economy” – and that's not just clickbait hyperbole.

Sixth, we have “the genius of John Bogle in 9 quotes” from this article:

Diversification: “Don’t look for the needle in the haystack. Just buy the haystack.”

Expenses: “The grim irony of investing is that we investors as a group not only don't get what we pay for, we get precisely what we don’t pay for.”

Market timing: “The idea that a bell rings to signal when investors should get into or out of the market is simply not credible. After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently.”

Trading volume: “In recent years, annual trading in stocks – necessarily creating, by reason of the transaction costs involved, negative value for traders – averaged some $33 trillion. But capital formation – that is, directing fresh investment capital to its highest and best uses, such as new businesses, new technology, medical breakthroughs, and modern plant and equipment for existing business – averaged some $250 billion. Put another way, speculation represented about 99.2% of the activities of our equity market system, with capital formation accounting for 0.8%.”

Index funds: “The index fund is a sensible, serviceable method for obtaining the market’s rate of return with absolutely no effort and minimal expense. Index funds eliminate the risks of individual stocks, market sectors and manager selection, leaving only stock market risk.”

Investing simplified: “Investing is not nearly as difficult as it looks. Successful investing involves doing a few things right and avoiding serious mistakes.”

Time and patience: “Time is your friend; impulse is your enemy.”

Stock-market risk: “If you have trouble imagining a 20% loss in the stock market, you shouldn't be in stocks.”

Trusting brokers: “It’s amazing how difficult it is for a man to understand something if he's paid a small fortune not to understand it.”

Seventh, I got a query from a reporter, “What are you telling clients about tax loss harvesting this year? Has any of your advice changed from last year? What are the biggest mistakes people make when trying to harvest tax losses?” I replied that there were three mistakes I see people (including advisors) make:

Losses should be harvested whenever they are economically meaningful – not just at year end.
Multi-period analysis rather than single period analysis should be used – in other words, harvesting the loss today leads to higher taxes on eventual disposition in the future. The analysis of whether to harvest should incorporate the present value of those higher future taxes.
Tax gain harvesting, particularly for those in the zero percent LTCG bracket, is also important.

Eighth, one of the ways a high-quality advisor adds value is by paying attention to asset location. Low-quality advisors tend to ignore it. There are three reasons they may do so:

They don’t care. The advisor may have the cynical view that clients only focus on pre-tax returns so don’t worry about it. If the primary objective is sales rather than actually doing the best possible job, this makes sense.
It’s too hard. It adds operational complexity. Particularly for advisors with a high number of small accounts, it is easier to just “mirror” all the accounts exactly the same way.
They don’t know. They either don’t know about the strategy at all, or don’t know how to implement it.

Taxes should not determine asset allocation (though it may influence it slightly at the margin), but once the proper allocation is determined, location is important. Optimal asset location is simply locating the least tax-efficient assets inside of tax-advantaged (i.e. retirement) accounts and the most tax-efficient in taxable (i.e. non-retirement) accounts. A combination of three factors are multiplied together determine tax efficiency:

Investment return. An investment with a rate of return of 0% (e.g. cash) is perfectly tax-efficient. The higher the return the lower the efficiency.
Tax rate. An investment with a tax rate of 0% (e.g. munis) is perfectly tax-efficient. The higher the rate (e.g. ordinary income vs. long-term capital gains) the lower the efficiency.
Turnover. If an investment is never sold, under current tax law there is a full “step-up” in basis at death and thus is perfectly tax-efficient. Keep in mind that yield (dividends and interest) are a form of turnover. The higher the turnover the lower the efficiency (basically, there can be “good” turnover where losses are being harvested). In the case of a mutual fund, use the higher of the expected fund turnover or the inverse of the investor’s expected holding period in years but not more than 100%.

In addition to the three factors above, there are two more things to keep in mind:

Volatility. An investment with high volatility is more valuable in taxable account because of the possibility of being able to tax-loss harvest in an early year. Of course, more volatile investments also tend to have higher expected returns which I noted above are better held in tax-advantaged accounts. In general, I would say the expected return dominates the volatility, but it is something to keep in mind.
Foreign source income. Foreign investments (e.g. foreign stock funds) are better held in taxable accounts so as to be able to take a credit or a deduction (the credit is usually better) for foreign taxes paid. The effect is partially offset by the fact that the yields on foreign stocks tend to be higher than those on domestic stocks which I noted above would indicate holding the higher-yielding investments in the deferred account. In general, I would say it is just slightly better to have the foreign stocks located in the taxable account.

There are two types of tax-advantaged accounts, tax-deferred (e.g. traditional IRAs, 401(k) plans, etc.), and tax-free (e.g. Coverdell and 529 accounts if used for education, Roth IRAs, etc.). Between those two, because (under the current tax code) the Roth does not have RMDs (Required Minimum Distributions), it is better to have higher returning assets located in the tax-free accounts. Most people think that the reason is because it is tax-free, but this is not so. There is no difference between a Roth and an IRA except the investor owns 100% of the Roth while (assuming a 25% tax rate) she owns only 75% of the IRA (the government is a 25% partner) but both are completely tax-free once you make that initial adjustment.

Again, the most tax-efficient assets are optimally held in the taxable account and the least tax-efficient in the tax-advantaged accounts. But suppose relatively large amounts of inefficient holdings are end up in the taxable account anyway (either because the size of the tax-advantaged accounts is small or the holdings are large, or a combination). For example, suppose the least tax-efficient holding in the taxable account is a total bond market bond fund (all ordinary income). Particularly if interest rates are higher (say 6% rather than the current 2.5%), there are five things to consider doing to improve the tax efficiency:

Buy a municipal bond fund instead. This is particularly appropriate for high-tax-bracket investors.
Make non-deductible IRA contributions. While I would not make non-deductible contributions if the marginal holding is eligible for capital gain treatment and might receive a step-up on death, in a case where it is already ordinary income this probably makes sense. The downside is the loss of liquidity if the investor is younger than 59½.
Use a variable annuity wrapper. This is exactly like the previous recommendation of the non-deductible IRA from a tax perspective, but has additional cost. Despite the additional cost, if it is cheap enough (and I have in mind a plain-vanilla annuity with no riders at 25-30 basis points) and the time horizon long enough, this can make sense (not today, but in a higher interest rate environment). I have discussed this option here.
Buy permanent life insurance. I am not a fan of permanent life insurance in general, but as I have noted before there are rare cases where it is recommended. Ordinary-income holdings like bonds in the taxable account is one of the factors.
Pay down your mortgage instead. There are many other aspects to this decision also which I have covered here.

Ninth, apparently “Advisor Exposure to U.S. Equities at Record High” (a little down this page – I can't link directly to it):

U.S. equities accounted for 80 percent of equity allocations in advisor portfolios at the end of the third quarter, a record high level in the history of Natixis Portfolio Clarity U.S. Trends Report, a quarterly report that tracks the asset allocations and performances of 306 moderate model portfolios submitted by U.S. financial advisors. That hindered performance, Natixis said, as global and emerging market stocks rallied during the quarter. The average moderate risk model portfolio analyzed by Natixis returned 3.24 percent during the third quarter, compared to 3.85 percent for the S&P 500. Average expenses declined from 83 basis points in 2013 to 69 basis points in the third quarter. Also interesting, for the first time Natixis looked at how portfolio performance relates to expenses and found that the more expensive portfolios outperformed the lower-cost ones 60 percent of the time over the past three years.

This is a bearish indicator.

Tenth, good paper here “Lessons from Capital Market History.” One quibble, in one portion the fat tails (aka positive kurtosis) in monthly returns is discussed, but you should know that rolling 12-month returns don’t exhibit that. (Monthly returns 1926 to 2015 have kurtosis of 7.43815; calendar year returns over the same period have kurtosis of just 0.04015. Zero means the distribution is normal.)

Eleventh, you may have already violated your new year's resolutions, but Thomas Jefferson penned what he called a “decalogue of canons for observation in practical life.”

Never put off till tomorrow what you can do to-day.
Never trouble another for what you can do yourself.
Never spend your money before you have it.
Never buy what you do not want, because it is cheap; it will be dear to you.
Pride costs us more than hunger, thirst and cold.
We never repent of having eaten too little.
Nothing is troublesome that we do willingly.
How much pain have cost us the evils which have never happened!
Take things always by their smooth handle.
When angry, count ten, before you speak; if very angry, an hundred.

Timeless advice.

Twelfth, I saw this article again in a list of “best” Aeon articles of 2016, I had read it before, but don’t think I made the connection that the “autodidact physicists” in the article are almost exactly like most investors (both clients and advisors) – limited actual knowledge of what they are doing combined with supreme confidence that they have figured out something the professionals have missed (and yet another example of the Dunning-Kruger effect I have mentioned before).

Thirteenth, I saw this definition on a discussion online, “Success is progressive realization of worthy goals.” I like it

Fourteenth, I have recommended The Fortune Sellers before, but just saw that the first chapter is actually available on-line if you want to check it out here.

Fifteenth, on a lighter note, I thought this was funny (I don't know where it originated, it appears many places on the internet):

The Wall Street Journal is read by the people who run the country.
The Washington Post is read by people who think they run the country.
The New York Times is read by people who think they should run the country, and who are very good at crossword puzzles.
USA Today is read by people who think they ought to run the country but don't really understand The New York Times.
The Los Angeles Times is read by people who wouldn’t mind running the country, if they could find the time and if they didn’t have to leave Southern California to do it.
The Boston Globe is read by people whose parents used to run the country.
The New York Daily News is read by people who aren’t too sure who’s running the country and don’t really care as long as they can get a seat on the train.
The New York Post is read by people who don’t care who is running the country as long as they do something really scandalous, preferably while intoxicated.
The Chicago Tribune is read by people that are in prison that used to run the state, & would like to do so again, as would their constituents that are currently free on bail.
The Miami Herald is read by people who are running another country, but need the baseball scores.
The San Francisco Chronicle is read by people who aren’t sure if there is a country or that anyone is running it; but if so, they oppose all that they stand for. There are occasional exceptions if the leaders are gay, handicapped, minority, feminist, atheists, and those who also happen to be illegal aliens from any other country or galaxy, provided of course, that they are not Republicans.
The National Enquirer is read by people trapped in line at the grocery store.
The Seattle Times is read by people who have recently caught a fish and need something to wrap it in.

Finally, my recurring reminders:

J.P. Morgan’s updated Guide to the Markets for this quarter is out and filled with great data as usual.

Jonathan Clements, Morgan Housel, and Larry Swedroe, all continue to publish great stuff. Just a reminder to go to those links and read whatever catches your fancy since last quarter.

That’s it for this quarter. I hope some of the above was beneficial.

Addendum:

If you are receiving this email directly from me, you are on my list of Financial Professionals who have requested I share things that may be of interest. If you no longer wish to be on this list or have an associate who would like to be on the list, simply let me know.

We have clients nationwide; if you ever have an opportunity to send a potential client our way that would be greatly appreciated. We also have been hired by some of our fellow advisors as consultants to help where we can with their businesses. If you are interested in learning more about that arrangement, please let us know.

We also offer a monthly email newsletter, Financial Foundations, which is intended more for private clients and other non-financial-professionals who are interested. If you would like to be on that list as well, you may edit your preferences here.

Finally, if you have a colleague who would like to subscribe to this list, they may do so from that link as well.

Regards,

David E. Hultstrom
770-517-8160

Disclaimer: The information set forth herein has been obtained or derived from sources believed by author to be reliable. However, the author does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does the author recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such.