Search Results for: Buying Stocks

The general consensus behind target-date retirement funds is often “They’re okay… but here’s something better!”. Any all-in-one product will be imperfect. But I still like them on the whole and have written previously about how Vanguard’s target-date retirement funds are underrated. If you’re invested in them, this Bloomberg article and Morningstar data should make you feel even better about it.

Most mutual fund investors actually do worse than market returns due to poor behavior, termed the “behavior gap“:

But target-date funds have one big advantage over other kinds of mutual funds, the data show. The average mutual fund has a flaw, which is that the average investor hardly ever does as well as his or her funds. Investors tend to jump in and out of funds at the wrong time. They buy high, choosing funds only after they’ve done well. And they sell low, dumping underperforming funds just as they’re about to take off.

However, owners of target-date fund actually did better:

On average, target-date fund investors are doing 1.1 percent better per year than their funds. Investors in almost every other fund category lagged their funds over the past decade, including a -0.98 percent underperformance for U.S. equity funds and -1.3 percent for municipal bond funds.

The outperformance may be a temporary anomaly, but I do think there are unique features of these all-in-one funds (and their investors) that will persist:

1. Self-selection. If you buy a target-date fund, you desire simplicity. You have a degree of humility. You don’t overestimate your skills as an investor, otherwise you’d buy something else.
2. Optical illusions. If you own an all-in-one fund that holds both stocks and bonds together, you don’t have the problem of seeing one investment drop while the other rises. It’s all mixed together in one pot, so the impact is usually dulled. This is the benefit of buying a “balanced” fund.
3. Automatic rebalancing. Anything that makes you look at your investments is an opportunity to make an emotionally-driven choice. Since these funds even rebalance their holdings for you automatically, you’re not even required to rebalance, which can be hard to do. Right now, a portfolio would probably have to sell stocks and buy some bonds while the media keeps talking about rising rates.
4. Tweaking is difficult. If you have one stock fund and one bond fund, it’s very easy to buy little more of one or a little less of the other. With an all-in-one fund, it’s harder to tweak your mix.

So you don’t have to do anything, and if you want to do something besides just buy more, it’s a pain. All this means less trading, which over the long run is a good thing.

So don’t be ashamed of buying a diversified, low-cost Target Date fund like Vanguard 20XX or Fidelity Freedom *Index* 20XX funds. The article ends with a good reminder that costs still matter. Don’t overpay for one of these funds either, and maybe even raise a little stink if you are being asked to.

Here’s a reader question that arrived this week:

I know you write a lot about investing, but can you write a little more about ComputerShare as a way to save money vs buying stock with online brokerages. I just read in WSJ how its cheaper if you are a buy and hold kind and its just as good as someone holding your paper stock certificates.

I am assuming that the WSJ article in question is the one about Ronald Read, the maintenance worker and janitor who saved up $8 million using DRIP plans.

A thrifty lifestyle, solid investing acumen, plenty of patience and the benefits of compounding were at the center of the story of Ronald Read—the quiet and simple-living Vermonter who enjoyed playing the stock market and left behind a nearly $8 million estate when he died last year at the age of 92.

Dividend Re-Investment Plans (DRIPs) traditionally refer to companies that let individuals to buy their shares directly from them and then allow them to automatically reinvest any dividends into more shares. Reinvesting those dividends increased the number of shares owned, and when combined with per-share price appreciation often leads to significant gains over time.

DRIPs were one of the first low-cost, buy-and-hold investment strategies. Stock commissions used to run over $30 per trade, whereas many DRIP plans let you buy shares for free or just a few bucks. This allowed mom-and-pop investors to put away as little as $25 a month without the entire nut being eaten by fees.

I started learning a tiny bit about investing in the late 1990s, which was near the rise of the online broker and the beginning of end of for DRIP plans. I still remember buying a book about DRIPs from Moe’s Books (used book store that is still going!) and being very fascinated by the idea. These days, paper certificates are pretty much gone and transfer agents like ComputerShare manage DRIP plans for most companies electronically. ComputerShare manages plans for Procter & Gamble, ExxonMobil, Coca-Cola, Johnson & Johnson, Wal-Mart, AT&T, Verizon, and several more.

For the most part, there are better low-cost, buy-and-hold options out there now. Let’s take a look at the Coca-Cola DRIP plan. It costs $10 to set up, $2 per automatic purchase plus a $0.03 per share processing fee. Reinvestment of dividends cost 5% of amount reinvested up to a maximum of $2.00. You need $500 to start and there is a $50 ongoing minimum investment.

Every company has different rules, and sometimes there is a purchase price discount. However, you are still buying individual stocks so what happens when you end up holding a Enron, MCI Worldcom, or even a Kodak or Sears? You could juggle 30 different stock plans like Ronald Read did – one of his stocks bombed too but his diversification protected his portfolio – but that gets to be a lot of work and paying $2 times 30 starts adding up.

Now consider that you can buy an ETF like the Vanguard Total Stock Market ETF (VTI) with zero commission and zero setup fees from Vanguard or TD Ameritrade and holds 3,800 stocks for you all at once for an expense ratio of $5 a year per $10,000 invested. If you like the dollar-based simplicity of DRIPs (all of your $50 a month gets invested in partial shares), you can buy the mutual fund version (VTSMX) at Vanguard which supports fractional shares and free automatic dividend reinvestment.

Even if you still wanted to buy individual stocks, many discount brokers including TradeKing and TD Ameritrade offer low commissions and free dividend reinvestment. Hold one stock or 100, all on a single statement. The Robinhood app lets you buy stocks with zero commission if you have a smartphone. You can buy up to 30 stocks at once for $9.95 at Motif Investing.

The Vanguard High-Yield Corporate Bond Fund (VWEHX, VWEAX) is a low-cost, actively-managed bond fund that invests in medium- and lower-quality corporate bonds and is advised by Wellington Management Company. I don’t own any in my retirement portfolio, but while reading the book The Affluent Investor by Phil DeMuth, I was intrigued by this interesting tidbit:

If you have settled on buying them anyway, at least wait until the spread between treasury bonds and junk bonds of the same maturity is wide (say, 4 percentage points). The fund to own is Vanguard’s (ticker: VWEHX), which has a gimmick: it buys the highest rated junk bonds. Many institutional investors can only hold investment-grade bonds as a matter of policy, and they are forced to liquidate bonds that get downgraded even when it makes no sense to do so. Vanguard lies in wait to take advantage of their mistake. This is a hedge fund strategy in a bond fund wrapper.

(I should add that this is after the author warns you about the high-yield bond asset class in general, and how if you adjust the higher yields to account for higher defaults, the net advantage can be small or even zero. He also adds that high-yield “junk” bonds are also quite volatile and should be treated like equities.)

But going back to the quote, DeMuth is saying that this fund tries to take advantage of a specific market inefficiency. I’ve never seen this strategy mentioned in either any Vanguard materials or financial media coverage. I went back and took a closer look at their prospectuses and other investor documents.

I was aware that VWEHX tends to invest in the higher-quality portion of the junk spectrum. From the Product Summary on their website:

Created in 1978, this fund seeks to purchase what the advisor considers higher-rated junk bonds. This approach aims to capture consistent income and minimize defaults and principal loss.

From the Fund Prospectus (dated 5/28/14):

The Fund invests primarily in a diversified group of high-yielding, higher-risk corporate bonds—commonly known as “junk bonds”—with medium- and lower-range credit- quality ratings. The Fund invests at least 80% of its assets in corporate bonds that are rated below Baa by Moody’s […] The Fund may not invest more than 20% of its assets in any of the following, taken as a whole: bonds with credit ratings lower than B or the equivalent, convertible securities, preferred stocks, and fixed and floating rate loans of medium- to lower-range credit quality.

Digging further into the Prospectus, we find the following under the “Security Selection” heading:

Wellington Management Company, LLP (Wellington Management), advisor to the Fund, seeks to minimize the substantial investment risk posed by junk bonds, primarily through its use of solid credit research and broad diversification among issuers. […]

The Fund will only invest in bonds and loans that, at the time of initial investment, are rated Caa or higher by Moody‘s; have an equivalent rating by any other independent bond-rating agency; or, if unrated, are determined to be of comparable quality by the advisor. […]

Wellington Management selects bonds on a company-by-company basis, emphasizing fundamental research and a long-term investment horizon. The analysis focuses on the nature of a company’s business, its strategy, and the quality of its management. Based on this analysis, the advisor looks for companies whose prospects are stable or improving and whose bonds offer an attractive yield. Companies with improving prospects are normally more attractive because they offer better assurance of debt repayment and greater potential for capital appreciation. […]

To minimize credit risk, the Fund normally diversifies its holdings among debt of at least 100 separate issuers, representing many industries. As of January 31, 2014, the Fund held debt of 172 corporate issuers. This diversification should lessen the negative impact to the Fund of a particular issuer’s failure to pay either principal or interest.

Here’s a quick summary of the Moody’s Credit Rating hierarchy, per Wikipedia:

Investment Grade

• Aaa – Highest quality and lowest credit risk.
• Aa – High quality and very low credit risk.
• A – Upper-medium grade and low credit risk.
• Baa – Medium grade, with some speculative elements and moderate credit risk.

Below-Investment Grade (“Junk”)

• Ba – Speculative elements and a significant credit risk.
• B – Speculative and a high credit risk.
• Caa -Poor quality and very high credit risk.
• Ca – Highly speculative and with likelihood of being near or in default, but some possibility of recovering principal and interest.
• C – Lowest quality, usually in default and low likelihood of recovering principal or interest.

From the Annual Report (dated 1/31/15):

This is the first time we are reporting the performance of the High-Yield Corporate Fund against its new benchmark composite index, which consists of 95% Barclays U.S. High-Yield Ba/B 2% Issuer Capped Index and 5% Barclays U.S. 1–5 Year Treasury Bond Index. As we mentioned when we made the change in November, we believe that the composite index is a better yardstick for the portfolio. It more closely reflects the portfolio’s longtime strategy of investing in higher-rated securities in the below-investment-grade category while maintaining some exposure to very liquid assets.

From Wellington Management Advisor Letter (part of Annual Report, dated 1/31/15)

The decline in commodity prices sparked a significant widening of high-yield bond spreads, and although the problems now affecting high-yield energy credits are justifiable, they are relatively isolated
to that industry. We are looking to take advantage of recent dislocations created by the sell-off in non-energy companies, where wider spreads are attractive and the credits are well-supported by strong fundamentals.

The fund remains consistent in its investment objective and strategy and maintains a significant exposure to relatively higher-rated companies in the high-yield market. We believe that these issuers have more consistent businesses and more predictable cash flows than those at the lower end of the spectrum. We prefer higher-rated credits in order to minimize defaults and provide stable income. We continue to diversify the fund’s holdings by issuer and industry and to de-emphasize non-cash-paying securities, preferred stock, and equity- linked securities (such as convertibles) because of their potential for volatility.

Costs and Fees

The expense ratio of the High-Yield Corporate Fund Investor Shares at 0.23% and Admiral Shares at 0.13% are very low in comparison to the peer group average of 1.11% for High-Yield Funds (calculated by Lipper). The fact that Vanguard itself runs at-cost and the fund advisor Wellington agrees to only takes a fee of 0.03% are quite impressive:

Wellington Management Company LLP provides investment advisory services to the fund for a fee calculated at an annual percentage rate of average net assets. For the year ended January 31, 2015, the investment advisory fee represented an effective annual rate of 0.03% of the fund’s average net assets.

In comparison, sometimes the creator of an index (like the S&P 500) will want a few basis points just for allowing a fund to follow their computer-generated list of companies. Wellington is pruning through thousands of often-illiquid bonds.

Portfolio Credit Quality

Here is the breakdown of the Vanguard High-Yield Corporate Bond Fund portfolio by credit rating as of 1/31/15. Remember that Baa and above is investment grade, so the vast majority (87%) of their holdings are indeed the top two rungs of the non-investment-grade spectrum. I assume that the 5% allocation to US government bonds is in case of an increase in fund redemptions.

Recap
I am neither recommending nor discouraging investment in this fund. There are many types of risk involved: credit risk, interest rate risk, liquidity risk, poor security selection risk. I was just intrigued by a quote in a book and wanted to dig into it further.

I have read through the prospectus and annual reports and pointed out all of what I saw were pertinent mentions of their investment and bond selection criteria. I didn’t find anything particular in Vanguard’s materials about picking bonds that have recently fallen from investment-grade to just below investment-grade, but such a strategy would certainly align with their historical portfolio and stated goals of holding the “best of the junk”.

If this is indeed a significant market inefficiency, I wonder why it still exists. Perhaps you can only do it with a very low expense ratio? I don’t believe there is any other actively-managed bond fund consisting of high-yield bonds that has such a low expense ratio; 0.13-0.23% is nearly as low as many index funds.

The low costs alone create a relative performance advantage for this fund. I chose not to emphasize past performance as that can be fleeting, but this fund’s past performance numbers also beats their Lipper peer group average over the last 1, 5, and 10 years.

Now, I do own shares of the Vanguard High-Yield Tax-Exempt Fund, which has a different advisor; Vanguard Fixed Income Group. I wonder if they do a similar thing there?

I like seeing my dividend income roll in each quarter, as do many other investors. But are mutual funds artificially “juicing” their reported dividend yields to attract investors? This is explored in a recent academic paper Juicing the Dividend Yield: Mutual Funds and the Demand for Dividends, which I found via Alpha Architect. Here is the abstract:

Some mutual funds purchase stocks before dividend payments to artificially increase their dividends, which we call “juicing.” Funds paid more than twice the dividends implied by their holdings in 7.4% of fund-years examined. Juicing is associated with larger inflows, and is more common among funds with unsophisticated investors. This behavior is consistent with an underlying investor demand for dividends, but is hard to explain by taxes or need for income, as funds can generate equivalent tax-free distributions by returning capital. Juicing is costly to investors through higher turnover and increased taxes of 0.57% to 1.52% of fund assets per year.

The problem with making extra trades to make your dividend yield look higher is that it is not tax-efficient. The increased turnover itself creates extra capital gains and trading costs. Also, when a funds buy a stock just before the ex-dividend date, then that dividend no longer qualifies for the lower dividend tax rate. I just ran across this problem last month when doing my taxes and looking at my qualified dividend income percentages. (I’m not saying that WisdomTree is not engaging in any “juicing” behaviors, it is very hard to actually calculate and there are other factors involved.)

Interestingly, the paper authors propose addressing that exact problem. Make it easier on investors and require funds to report their qualified dividend income percentages (emphasis mine):

One minimally intrusive regulatory change that could improve investor decision-making is to require funds to break out dividend income into qualified dividends (entitled to a reduced income tax rate, when the stock was held for 60 days or more) and non-qualified dividends (which pay the full income tax rate, for stocks held for less than 60 days) when reporting their distributions in filings such as annual reports. Such disclosure would not harm an investor that was already informed about juicing, but would ensure that investors had easy access to the information necessary to make an informed decision if they chose to do so.

Bottom line: Juicing exists and it hurts investors with higher turnover and higher tax bills, but it’s hard to know when by just looking at the usual mutual fund stats. Until then, be careful if you’re buying an actively-managed fund primarily due to their high dividend yield.

An important tenet of portfolio construction is rebalancing your portfolio to maintain your desired risk profile and also provide the best risk-adjusted returns. The next question is usually – Okay, so how often do I rebalance? Well, this Vanguard article targeted at financial advisors answers that question (found via Abnormal Returns).

Longer answer:

Our 2010 study looked at the performance of portfolios that used rebalancing strategies based on various time intervals, allocation thresholds, and combinations of both. The time-based portfolios were rebalanced monthly, quarterly, or annually, while the threshold categories were rebalanced when allocations deviated by a predetermined minimum (in this case 1%, 5%, or 10%) from their target allocations. The “time-and-threshold” strategy combined periodic monitoring with predetermined minimum rebalancing thresholds. […] We found that no one approach produced significantly superior results over another. However, all strategies resulted in more favorable risk-adjusted portfolio returns when compared with returns for portfolios that were never rebalanced.

Short answer: It doesn’t matter, as long as you do it regularly and without emotion. Rebalancing every month was no better than rebalancing just once a year.

Personally, I try to rebalance whenever I make my monthly share purchases by buying underweight asset classes, but I will only sell and create a taxable event once a year if things are really out of whack. The more common problem is that you are afraid to rebalance because that usually means buying whatever has been getting crushed and selling what has been rising. If you haven’t done it recently, that probably involves selling some stocks and buying some bonds. Like the shoe company says, just do it!

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

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

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

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

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

This bear market will last 3-12 years!

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

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