Holding Bonds In IRAs - A Big Mistake?
Monday, August 19, 2013 18:10

Tags: account aggregation | investment management | investment strategies | portfolio management | tax efficient investing | Tax-efficient investing

Advisors who manage their clients' investments at the household level (across accounts) have an opportunity to create tax savings.  Location optimization - holding specific types of investments within specific types of accounts - can minimize tax costs. Unfortunately, in today's market, advisors are getting it wrong. 

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Before I get into why, let's review the basics.

Location optimization organizes accounts into 3 types:

-          Taxable: accounts such as joint accounts, trust accounts and personal accounts that are subject to state and federal tax as income and gains are recognized

-          Tax Deferred: accounts that will be subject to ordinary tax rates at the time that amounts are withdrawn, such as IRAs, 401(k)s and annuities

-          Tax Free: Roth IRAs (assuming held for 5 years and age 59-1/2, otherwise, only the basis is tax-free)

Applying location optimization strategy, investments should be divvied up as follows:

-          Put investments with the highest expected returns in the Roth IRA. Since the Roth will never be taxed (see above), higher returning investments will get the greatest benefit.

-          Put investments that produce regular ordinary income in tax deferred accounts. When distributions begin, they will be taxed at ordinary rates - the same as if held in a taxable account.

-          Put appreciating investments, such as equities, in the taxable accounts. Since appreciation isn't taxed until sold, these assets effectively achieve tax deferral without being held in a tax deferred account. When eventually sold, the appreciation is taxed at capital gain rates.

Currently, most advisors applying location optimization hold U.S. corporate bonds in tax deferred accounts.  This is not ideal in today's market environment. With the new surtax on investment income and municipal bonds often paying more than corporate bonds, advisors should be structuring portfolios differently.  How? Take U.S. bond investments out of IRAs and, instead, hold municipal bonds in taxable accounts. Put other high yielding investments (such as real estate or international bonds) in tax deferred accounts.

When "repositioning" bonds in a client's portfolio, the advisor must consider tax costs.  For example, a tax savvy advisor decides to reposition holdings by placing REITs in the IRA and municipal bonds in the taxable account (rather than holding taxable bonds in the IRA).  Thus, the REITs must be sold in the taxable account. If the REIT holdings have appreciated, the client will recognize capital gains. Clearly, the tax cost on material short-term gains would outweigh the benefit of changing asset location. But, if it's a long-term gain, would the location savings be worth the tax bill? To answer this question, the advisor must consider:

-          How material is the gain?

-          Does the client have capital losses to offset and/or are they in a low tax bracket?

-          How old is the client? (With a young investor, appreciation will likely be taxed at some point anyway.  However, an older client might never pay tax on the appreciation. Thus, recognizing gain for an older client could make the tax cost too steep.)

-          Will the reduction in the investment income surtax be greater than the tax on recognized gain?


Bottom line: To maximize tax benefits for clients, advisors should revisit their bond decisions, considering municipal bond yields vs. taxable yields as well as individual client circumstances.

Looking Ahead To The Fall, September Is Historically The Worst Month For Market Performance
Monday, August 19, 2013 13:34

Tags: investment strategies | markets | stocks | volatility

Most investors and advisors are familiar with the “January effect,” the tendency for the stock market to perform well in January. There’s a less well-known “September effect” that is just the opposite. Will September of 2013 conform to a history of disappointment?

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As shown in the table and graph below, the month of September stands out as being the most likely to disappoint. Here are some observations:
·       September’s -0.8% average return is not only the lowest of all 12 months, it’s the only month with a negative average return.
·       Unlike the other 11 months, September is more likely to produce a negative return (44 months is 51% of the time) than a positive return (43 months is 49%). All of the other months have a history of positive returns 60% of the time.
·       September’s worst return – losing 29.7% in 1931 - is the worst of the worst.
·       September’s best return – 16.7% in 1939 – is far below the average of the best returns, at 21.27%, although it is median.
So why is September such a nasty month? I’d like to hear your opinions, especially regarding your outlook for the upcoming September. I think it’s due to the fact that investors are done with their vacations, so they’re back at their computers trading, and mucking things up.
In his 1999 book, Beast on Wall Street, Dr. Robert Haugen shows that market volatility is mostly driven by investor behavior. He documents the fact that there is only a weak connection between major events and market swings: Little has happened historically on the days of big market swings, and the market response has been ho-hum on big event days.
A related explanation is that investors start their tax loss harvesting in September, to get ahead of the end-of-year crowd. This would represent the flip side of the “January effect,” which is caused by investors buying back the stocks they sold for tax purposes.
If my explanation is correct, this September is likely to disappoint because investors will be back at their trading desks, but history tells us that it is a coin-flip probability – worse than the other 11 months but not all that predictable. For more market insight, see the table and the graph below, and visit PPCA Inc.

S&P500 Returns for the 1,044 months from January, 1926 – December, 2012












# Plus

# Minus









































































































Source: PPCA Inc


You May Be Surprised To Learn The Best Regions Worldwide For Investors To Seek Safety
Tuesday, August 13, 2013 13:56

Tags: dividends | global investing | income planning | investment strategies | value investing

Many investors are focused on safety right now for understandable reasons: The world economic situation is unclear at best. What regions of the globe currently offer the most safety for investment dollars?

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I started by comparing the investment markets of countries and regions in terms of “Value,” defined as low price/earnings ratios and high dividend yields. The following graph shows the current situation:
As you can see, the United States is currently not offering the best value, since it has the highest P/E ratio and the second lowest dividend yields. But it’s not clear from this graphic which area does offer the best value. On a P/E basis, “Emerging Markets” and “Asia Without Japan” are the better buys, but “Australia and New Zealand” and “United Kingdom” boast the highest yields.
To resolve the confusion, I created a composite measure that adds earnings yield (the reciprocal of P/E) to dividend yield, and came up with the following scores:
And the winners are “Australia and New Zealand” and “Emerging Markets.” If you’d like to stay closer to home, Canada looks good.
Now you know. I hope you find this useful. For more investing ideas, visit PPCA Inc.
22 Questions And Answers From Prof. Craig Israelsen’s Webinar About The Attributes Of Major Asset Classes And Associated Behavioral Finance Issues
Monday, July 29, 2013 10:05

Tags: asset allocation


Prof. Craig Israelsen, a regular speaker at A4A webinars, answers 22 questions below that we did not have time to cover at his last session in which he reviewed attributes of asset classes and assocaitad behavioral issues.
Given that MLPs have outperformed substantially during 2000-2009, what is your opinion regarding the use of both hedged and unhedged emerging market bonds?
Among non-US developed fixed income both hedged and unhedged approaches are used. For example, the new Vanguard emerging markets bond fund (VGOVX) hedges currency risk. One solution is to use one fund that hedges and another that does not.
Did you ever research the preferability of value versus growth in your equity exposure in your 7Twelve portfolio?
I have found that a value tilt in US small cap stock tends to produce better results than small cap growth over the long haul. There is a value “premium” among US mid cap stock and US large cap, but not as distinct as in US small cap.

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How does this model work during a distribution phase or retirement?
I have designed several “age-based” 7Twelve models for the distribution phase. In general, the allocation to cash increases and the allocations to the other 11 asset classes decrease. But, importantly, the model stays diversified across all 12 asset classes over the entire life-cycle of the investor.
Not sure if any one mentioned municipal bonds. Where do they fit here?
 I don’t have a specific slot for municipal bonds in the 7Twelve model. For investors in certain states, they could certainly be added as an “satellite” asset class around the 7Twelve “core”.
How is this similar to or what are the differences from the Fama & French research and their value and small-cap tilt?
The 7Twelve model is similar in that it fully weights small cap in the model. In other words, of the 12 funds used in the model, large cap US equity has an allocation of 8.33%, the mid cap US equity allocation is 8.33%, and the small cap US allocation is 8.33%.  If I used a single total market US equity mutual fund that employs market cap weighting (which is typical), the allocation to large cap US equity would be 70%, mid cap 20%, and small cap 10%. In short, the 7Twelve model “respects” large cap, mid cap, and small cap US stock equally.
Craig's salsa analogy (for creating a diversified portfolio) works really well with clients. Does he have any other analogies like that for dealing with incorrect benchmarking or the importance of avoiding large losses?
Thank you. Some of the other analogies that seem to make sense to my students are the following:
Benchmarking is all about fair comparisons. Comparing the taste of a slice of pepperoni to the taste of the entire pizza is not a fair comparison—just like comparing the performance of an entire diversified portfolio to the performance of one of its ingredients is silly.
The large loss issue is best demonstrated by showing the sheer math of it. A 50% loss requires a 100% gain to break even. Whereas a 75% loss requires a 300% gain to break even. Motto: don’t go there.
With regard to your Fidelity, Vanguard, T. Rowe Price, active and passive portfolios, are the recommended funds seven in number or twelve in number? Also, you mentioned in an earlier webcast that for clients who are more conservative your portfolios are tweaked for reduce equity percentage. Do you provide alternative portfolios suitable for those more conservative clients?
All of the 7Twelve models I’ve built use 12 actual mutual funds and/or ETFs. Yes, the research reports that I have prepared outline in detail the “age-based” (that is, risk reduced) 7Twelve models that would suitable for more conservative clients.
Please elaborate on whether an advisor can use either the seven asset classes or the 12 asset classes. Your research in the slides showed seven asset classes over 43 years. Do you believe the 12 asset classes would result in similar findings?
An advisor can build a 7-asset portfolio and/or a 12-asset portfolio. All of the research reports that I have prepared utilize a 12-asset model. Generally speaking they perform similarly, but the 12-asset model is more broadly diversified.
What’s the cost of your book and also the cost of your research for advisors?
The 7Twelve book purchased from me is $23 and is written for a lay audience. The research reports that I sell range from $75 to $350.   The $350 report is designed for financial advisors and outlines a variety of 7Twelve models that I have built (the Active model, the Passive model, a Vanguard model, a Fidelity model, a T. Rowe Price model, a DFA model, and a tax-efficient model).
Regarding slide 41, how to vary the 7Twelve portfolio for investors over 65?
For investors over age 65 cash would be over-weighted and the other 11 asset classes would have a reduced weighting. In the most extreme case cash could have a 63% allocation. But, only the advisor will know the correct cash allocation after considering a host of variables that will influence the overall portfolio allocation (age of client, amount of retirement assets accumulated, health of client, number of dependents, amount of debt, other sources of retirement income, etc.).
Do you use any of the CRSP indices? If not, why not?
I currently do not use CRSP index data simply because I don’t have access to it. Vanguard has switched some of their equity benchmarks over to CRSP indexes. While interesting and probably relevant, in a multi-asset portfolio such as 7Twelve there is not enough differential between CRSP indexes and MSCI or S&P indexes to dramatically alter any of my fund selections.
Does your advisor research report include the JNL reports?
No, the JNL reports that cover the Elite Access platform and the Perspective II VA platform are sold as separate reports for $150 each.
Why do you not break out non-US small cap?
Good observation. I break out developed non-US equity and emerging non-US equity. One approach would be to sub-divide the non-US developed allocation of 8.33% across both large cap and mid/small cap. Large cap might have a 5% allocation and mid/small a 3.33% allocation—or something along that line.
Would you consider a glide path to change allocations from growth to conservative strategy?
Yes, that is essentially what is happening in the allocations in my various “age-based” 7Twelve models. The changes are not the smooth changes inherent in a glide-path, but accomplish the same objective—albeit in more dramatic shifts at certain ages.
For those needing Income (not total return), how does the 7Twelve compare?
The current yield of the Passive 7Twelve model is just under 2%. It could be enhance somewhat by selectively using high dividend equity funds where possible.
Have you researched optimization of allocations among asset classes versus equally-weighted allocations?
Yes, I’ve tinkered a lot – but in the end I never know how to optimize going forward. Because I don’t know which asset class will outperform in any given year I find that equal-weighting is the most rationale approach.
Please explain in more detail about choosing appropriate benchmarks.
An appropriate benchmark for the 7Twelve would need to have a 42% equity, 25% diversifier, 33% fixed income allocation to reasonably mimic the 7Twelve approach. If a benchmark is much different than that it becomes less relevant as a useful benchmark. 
The other benchmark approach is to use cash as the benchmark for everything.  When people exit the “market” they often go to cash—so cash is a benchmark in that sense.
How frequently do you rebalance 7Twelve portfolios?
I measure the performance of the 7Twelve models assuming monthly, quarterly, and annual rebalancing. Quarterly and annual rebalancing tend to produce the best results.
By allocating equal weights to your 7Twelve asset classes, do you not make judgments about expected returns.  Can you tweak the allocations?
Certainly. The allocations are “tweak-able” according to the goals and constraints imposed by the advisor and client. What I have found is that to effect a material change in the performance of the 7Twelve model the allocations need to be tweaked quite a bit. Small changes, such as moving one asset class from 8.33% to 8.00%, have almost no impact in a broadly diversified portfolio such as 7Twelve.
What was the backwardation/contango environment in the 1970's?
I don’t recall, I’d have to dig around to find that. But, the link below is an article on the general topic of backwardation and contango.
What was the performance of the 7Twelve in Q2 2012, when bonds, especially TIPS, cratered?
The Active 7Twelve was down 1.82% in Q2 2013 (I assume you meant 2013, not 2012). The Passive model was down 2.63% in Q2 2013. A diversified model shines over time. The 15-year average annualized return of the Active 7Twelve was 8.74% (as of 6/30/2013) and 7.70% for the Passive 7Twelve. 
Any comments on your thought process that led to your recent change in cash allocation to his multi-asset portfolios for those over the age of 50?
The performance of bonds has been spectacular for the past 30+ years (since 1982) when interest rates in the economy started their decline (aggregate US bonds have averaged nearly a 9% annual return since 1982 whereas from 1948-1981 aggregate US bonds averaged about a 4% annualized return). 
Going forward, as rates begin to move upward, the performance of bonds will likely return to the levels experienced pre-1981. In a diversified portfolio the impact of lower bond returns isn't that big of a deal (which is why I didn't adjust any allocations in the "core" equally-weighted 7Twelve model).
However, I felt that in the age-based models the heavy TIPS allocation was not worth the risk at this point. Older investors simply cannot sustain large losses. Preservation of capital is more important. Hence, my shift to more cash and less TIPS. 
Of course, each advisor and client must examine their own specific situation to determine the right “age-based” allocation. My suggested allocations are generic because I don’t the specific situation of any specific clients.


U.S. Stocks Continued To Outperform The Rest Of The World In The Second Quarter. What’s Next?
Monday, July 08, 2013 10:47

Tags: active management | Economic Outlook | momentum investing | stocks | style classification

The second quarter brought more good news for investors in U.S. stocks, which continued to dominate the global investment scene. No other asset class even comes close to the lofty 14% return on U.S. stocks so far this year. Will this dominance continue? Read on for my views on that question and for a review of second-quarter results.


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U.S. stocks earned 2.5% in the second quarter, bringing the year-to-date return up to 14%. By contrast, the EAFE index lost 1% in the quarter, bringing the year-to-date return down to 4%. Since U.S. stocks earned 16% last year, the 18-month return through June was 32%.
Small cap growth stocks led the way in the first half, earning more than 19%. By contrast, large cap core companies earned only 7.5%. Other than these extremes, style returns clustered around 14%. (See Surz Style Pure® classifications.) On the sector front, consumer discretionary and health care fared best, earning 20%. By contrast, materials lost 7.5%.
When you cross styles with sectors you can exploit momentum effects. In Searching for Alpha in Heat Maps I showed how heat maps can be used to forecast winners and losers, based on momentum.
The following table shows the forecast I made in April (check me out) and the actual results. As you can see, momentum “worked” in the second quarter, with my picks to outperform doubling the market with a 4.8% return while my forecast underperformers lost big time, decreasing by 8.4% on average.

U.S. Market  in 2nd Quarter of 2013 Earned 2.4%

High Momentum Earned 4.8%

Low Momentum Lost 8.4%

Mid-cap Core Consumer Staples


Small-cap Core Telephones & Utilities


Small-cap Growth Financials


Small-cap Growth Materials


Small-cap Core Consumer Staples


Small-cap Growth Energy


Using the same method, I have forecast winning and losing sectors for the third quarter. For my picks, go to the full version of my Quarter 2 Commentary.
Foreign markets earned 2%, lagging both the U.S. stock market’s 14% return and EAFE’s 4.5% return. All countries outside Europe and Japan suffered losses.
I also forecast winning and losing segments in foreign markets for this quarter, and my foreign forecasts did not turn out as well as my U.S. forecasts. The “Low” momentum underperformed as predicted, but so did the “High” momentum. My full Quarter 2 Commentary includes my sector forecasts for the third quarter in world markets.
Remember, momentum doesn’t always work. My full commentary includes an analysis of the June slide, along with my predictions on quantitative easing, gold and bonds.
My goal is to give you some places to look for opportunities. Good luck!
So What's Next?

Quantitative easing will end, along with its distorting effects. Markets will adjust to an un-manipulated reality: higher interest rates, inflation and the pain of controlling our crazy spending, especially government spending. It won't be easy, but it is inevitable. U.S. markets will not be the best place to be during the transition.


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