July 30, 2018: Tax Efficient Portfolios

Jul 31, 2018 | Asset-Allocation, Bonds, Economy, Feature, Gold, Headline, Income, Investments, IRA, Markets, Mutual-Funds, Newsletter, Retirement

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

For regular SAA and TAA portfolios, the next re-balance will be on Monday, August 20, 2018. You can also find the re-balance calendar for 2017 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Tax Efficient Portfolios

We continue to answer an often asked question (which was also asked by the same user whose another part of question was discussed in our previous newsletter July 9, 2018: Conservative Allocation Mutual Funds Based Portfolios): how to construct a tax efficient portfolio. 

Tax efficient stock investments

An investor’s overall investments mainly consist of two parts: stock (equity) and bond investments. For stock investments, there are strategic (buy and hold) and tactical (active) portfolios. To avoid tax incurred in an investment lifetime, one should minimize capital gain tax, especially short term capital gain tax (investments sold in less than a year). A natural way is to buy and hold securities for a long time. 

Holding a security for a long time works also for the nature of compounding (see for example, April 9, 2018: Exponential Or Compounding Nature In Investing). In general, as what we have discussed numerously times, for capitals that are deemed not to be needed for a long time (by MyPlanIQ’s standard, at least more than 15 years, preferably more than 20 years), one should really considering to invest such capitals in a long term buy and hold SAA portfolio, as long as when you start to invest, stock valuation is at a reasonable level. 

To invest in stocks, MyPlanIQ maintains that one should invest in low cost index funds, either in index mutual funds or index ETFs. Note that the funds should be 

  1. low cost: as we discussed before, many brokerages don’t have low cost index mutual funds available (example, Merrill Edge’s US stock index funds often charged more than 0.4% compared with Vanguard’s 0.1% or so expense). In this case, the best way is to invest index ETFs (such as Vanguard ETFs) whose expense ratios are often lower than index mutual funds’. 
  2. Furthermore, index ETFs have a slight advantage over index mutual funds because of their structures: when you invest in a mutual fund, you might end up being penalized with some of the capital gain that was already embedded in the fund. Though in a long period of time, such difference tends to diminish. 
  3. However, index mutual funds are especially good for those who are trade averse: because mutual funds’ pricing is determined by market closing prices of each underlying securities, it’s much easier to trade these than ETFs in a rebalance.  Since the price of an ETF can fluctuate during a day, it’s possible that you might not be able to get a fair price. 

However, for capitals that are needed within 15 years or a shorter period or for those who are really concerned with portfolio value fluctuation (think about whether you can stomach through a 40% or 50% cut in your investments’ value), you might find some tactical portfolios appealing. In MyPlanIQ, you can either use Tactical Asset Allocation (TAA) or a long term timing based portfolios such as 200 days moving average. Since MyPlanIQ’s TAA uses asset class momentum score to pick top assets to invest, it’s actually not very tax efficient. Here, our preference is on using a long term timing portfolio. The following are the portfolios that we favor. They are listed on Advanced Strategies page: 

Portfolio Performance Comparison (as of 7/27/2018):
Ticker/Portfolio Name 15 Yr Max Drawdown YTD
Return**		 1Yr AR 3Yr AR 5Yr AR 10Yr AR Since 2001 AR
P SMA 200d VFINX Total Return Bond As Cash Monthly 17.5% 6.5% 15.9% 11.6% 12.0% 14.1% 12.4%
P Warren Buffett Total Stock Market Valuation to GNP Ratio SO SU Weekly Strategy Total Return Bond Funds As Cash 18.6% -1.3% 1.7% 4.5% 7.6% 13.5% 11.4%
P Shiller Cyclically Adjusted PE 10 SO SU Stock Market Timing Strategy Weekly Total Return Bond Funds As Cash 18.6% -1.3% 1.7% 4.5% 5.2% 11.9% 11.2%
VFINX (Vanguard 500 Index Investor) 55.3% 6.5% 15.9% 13.0% 12.9% 10.6% 6.6%

The SMA 200d portfolio uses 200 days (roughly 10 month) moving average to decide whether to buy VFINX (Vanguard S&P 500 index fund) or just invest in a total return bond fund portfolio. It only does rebalance at the end of a month. Since 2001, this portfolio buys and sells VFINX 15 times, thus only averaging less than one time per year (in 17.5 years): 

It’s interesting to see that this portfolio can capture a secular trend that lasts for several years without doing any trades. For example, the last trade it did was on 3/31/2016 (more than 2 years ago). The one before this is from 12/30/2011 to 8/31/2015, almost 4 years. The other long one is from 9/30/2004 to 12/31/2007, another 3 plus years.

Basically, the shorter term trades in this portfolio are only for some minor gains or even loss while big gains are those from a longer period. Thus these big gains are usually long term capital gains that have much lower tax than a short term one. 

In our opinion, tax consideration should not override your risk consideration, especially if you are very much in need of this capital earlier. 

Finally, for the long term buy and hold capital, you might question our qualifier in the above: ‘as long as when you start to invest, stock valuation is at a reasonable level.” For example, at the moment, stock valuation are at historically high. So for new money, unless you are doing dollar cost average (i.e. invest in several chunks) and it’s only a small chunk of the overall capital invested in this buy and hold portfolio (for example, regular monthly savings earmarked for long term retirement need), we wouldn’t recommend to invest in a buy and hold portfolio right now.  You can either invest in a fixed income portfolio or if you really want, invest in a tactical portfolio (even here, we would like to suggest using dollar cost average method) to wait it out until the stock valuation reaches a reasonable level, then you can buy and hold for a long time. This is similar to our Invest and Speculate portfolio that invests in a tactical portfolio when stock valuation is high and invest in a buy and hold portfolio when stock valuation is at a reasonable or undervalued level. 

Tax efficient fixed income investments

Naturally, for the bond (fixed income) investments, a tax efficient way is to invest in a tax exempt municipal bond fund portfolio. We just discussed these portfolios in the previous newsletter July 23, 2018: Municipal Bond Funds And Portfolios. 

Note the gains of these portfolios consist of two parts: capital gains resulted from buy and sell municipal bond funds and interests paid from these funds. The capital gains do incur tax (often can be short term gain tax) while the interests paid are mostly tax exempt. However, because of the much higher extra returns and much lower drawdown in these portfolios, we believe such active or tactical portfolios are better than buy and hold municipal bond fund portfolios, even after taking tax into consideration. 

We often touted that for cash like investments (for capital needed within 2 years), one should considers directly buying Treasury bills (TBills). See, for example, March 19, 2018: Treasury Bills vs. Brokered CDs. A less well known tax benefit for buying Treasury bills instead of investing in a bank savings account is that the interest paid from a T Bill is only subject to federal tax. It’s tax exempt at state or local level. This, coupled with no extra fee/markup charged by a bank or a money market fund (some of money market funds like TDAmeritrade are paying extremely low interest at the moment), can further increase returns. 

Market Overview

A little more than half (53%) of S&P 500 companies had reported Q2 earnings by last Friday. Based on Factset, the blended earnings growth is 21.3%, which is better than the 20% expected on 6/30. However, the expected earnings growth for the next quarter is actually lower than the expected: 21.2% vs. 21.5% expected on 6/30/2018. Though one shouldn’t read too much into this minor difference, recent market behavior does warrant some attention: the prices of high flying FAANG stocks have declined substantially: Facebook is now in a bear market while Netflix is also very close to lose more than 20% from its high. Furthermore, trade tariff concern is now frequently mentioned in the recent earnings reports. Whether these will manifest into a real correction or decline is anyone’s guess. However, we are reminded that market weakness is often started from the very euphoric period. Furthermore, at the current historically high stock price level, the future correction can be a very steep one that can lose as much as 50% of its value. 

As always, we call for staying the course.  

For more detailed asset trend scores, please refer to 360° Market Overview. 

Now that the Trump administration has been in the office for more than a year, the economy and financial markets are in general still in a good shape. Whether the economy will continue to benefit from the supposedly trickle down of the tax cut, the deregulation, and the promised infrastructure spending remains to be seen.  On the other hand, stocks continued to ascend, regardless of the progress. Looking ahead, however, we remain convinced that markets will experience more volatilities at some point when reality finally sets in. 

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic about U.S. economy in the long term and believe much better investment opportunities will arise in the future. 

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot. 

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