Incidentally, that was the same year revolving credit was introduced.  Before that such cards were really charge cards, with the whole balance due at the end of the month.  But starting in 1959, you could have a card that offered to let you carry over your balance, so that you could manage your cash flow better.

Better?!  Talk about flimsy getting flimsier.

I know what you want to tell me.  “Yes, I know, debt is bad.  Just look at Europe.  Or the guy down the street losing his house because he over-extended himself.  In this economy I’m all about curbing spending and paying down debt.”

Apparently, not all of you.  Did you know that November 2011 saw the biggest jump in revolving debt in a decade?   A decade.   A decade mostly overlapping the so-called lost decade of investment non-returns.   It’s ironically horrifying, or horrifyingly ironic, depending on how you want to look at it.

Why is Debt Bad?

In a word, control.  The bible says, “The borrower is slave to the lender.”  If you owe someone, they own a part of you.  They control a part of you.  Therefore you control less of yourself.

Also, debt is what contributed to our most recent financial crisis in the first place.  In the housing boom of the early to mid 2000s, people were buying bigger and bigger houses, taking on bigger and bigger mortgages, in part because debt was cheap with record low interest rates.  Banks made the loans, then sold them to consolidators who batched them and who then bought insurance on them to cover defaults.  When the economy slowed down and people started losing their jobs, the number of defaults rose, along with the number of insurance claims.  When it hit the media in September 2008 that the AIG subsidiary that was a large provider of consolidated mortgage batch insurance realized it had over-extended itself based on a flawed computer model, the whole thing crashed.  We fell off the cliff.  And that cliff was so high, we’re taking years to recover from the fall.

So What Do You Do if You’re in Debt?

The short answer is pay it off.  The long answer is how.

Maybe you’re lucky to have enough cash sitting around to pay it all off at once.  In that case, why were you sitting on it, and then paying interest on your debt?  Unless you do not and will not have a way to replenish your safety cushion, it is best to use your cash to pay off debt.  It’s an automatic raise in your discretionary income.

Most probably, though, you do not have that much excess cash sitting around.  There are two schools of thought when it comes to paying off debt over time – the pay-off-the-smallest-debt-first approach, a la Dave Ramsey; or the pay-off-the-highest-interest-rate-debt first, a la every other financial guru with a talk show or book deal.  Whichever way you choose, there are several steps to go with it.

First you need to control your spending.  Limit discretionary items.  Getting your nails done at the strip mall salon may be cheap, but not as cheap as doing your own.  Playing golf every weekend may be fun, but is way more expensive than a mani-pedi.  In some cases, meat for dinner may be discretionary.  The goal is to spend less than you make, and use the excess to pay down debt.

Then pick a debt and concentrate a significant amount of your available excess income on paying that one off first.  This means paying way more than the minimum.  (Credit card statements now conveniently list how long it will take to pay off your balance depending on how much you pay each month.)  When that debt is paid off, pick the next smallest balance or highest interest rate debt and do the same with that one.  And so on until all debts are paid off.  Pay the minimum on all other debts as you concentrate on the one.

This should be obvious, but don’t incur more debt.  If you are spending less than you make on living expenses, this is automatic.  So watch your budget and control your expenses.  And do keep a reasonable amount of emergency savings to cover those unexpected…well, emergencies.  Dave Ramsey recommends a $1000 “baby emergency fund”.  If you have to use it, stop aggressive debt repayment to build it back up, then restart the debt pay off schedule.

If interest rates are too high such as to make your minimum payments too onerous to allow much wiggle room, do not be shy about calling the debt provider to ask for a reduction in the rate.  They don’t have to honor your request, but it doesn’t hurt to ask.

If you’re really in dire straights, you can ask for a reduced payment schedule.  Just expect a ding on your credit score.  If you’re in even more dire straights, you can ask to see if you can settle for less than you owe.  Typically, companies won’t do this unless you’re several months behind and they fear they won’t receive any of it if they don’t take your offer.  You will need to first save enough for a reasonable lump sum payment, however.  And expect a more significant ding on your credit score.  Please only consider these tactics if there is no other option.  Your conscience will thank you later.

What to Do When its All Paid Off

What do you do when all your debts are paid off (at least your consumer debts)?  Pat yourself on the back and celebrate!  You’ve done what most people won’t even consider doing.  And don’t be afraid to tell all your friends. You may inspire, or guilt, someone into doing the same.

Please don’t negate all your hard work by incurring new debt.  Of course, some debts are unavoidable.  A lot of people can’t buy a house without taking on a mortgage, and this is acceptable debt if it’s within reasonable limits.  A house is an appreciating investment (well, in a normal economy, anyway!).  But a car?  You know cars depreciate.  So pay cash for it.  And you should probably buy used, unless you have a significant amount of savings on hand to not notice the difference in your bank account.

While debt is currently the American way of life, including our government, don’t follow the crowd or your political decision maker.  You’ll be grateful for it.

PASSIVE vs. ACTIVE

We all believe, or want to believe, that we are winners. This mindset can take us far in life, but it is not necessarily how we should approach portfolio management. Of course we want to win in investing, but investors should focus long term, not on the hot stock, sector or asset class of the year. There is a growing realization that actively trading stocks and bonds for short-term gain is a losing bet. We see this in a University of Maryland Study that shows, adjusted for risk, only 0.06% of fund managers beat their index from 1975 to 2007. 1975 is an important year as this is the conception of the Vanguard S&P 500 Index fund.

The buy and hold indexing approach is being fueled by two things: disenchantment with high-cost, under-performing active mutual fund managers; and the migration of brokers from commission firms to fee-only platforms where a fiduciary responsibility forces a better look at active mutual fund management. These issues have increased the use of index funds, specifically exchange traded funds. As plan participants want their 401k accounts to look like their private accounts, ETFs are building momentum to fill this void, especially in small to mid size 401k plans. Plan fiduciaries also realize that adding indexing to active management plan options reduces their liability.

LOW COST INVESTING

If a plan participant can save 1% a year in investment costs on a $20,000 portfolio, over a 20 year period that participant would have 17% more money, not accounting for any performance differences. The benefit of cost savings are more apparent over the last market decade where portfolio rates of return have been nearly flat after the 2000 tech crash, September 11^th and the 2008 financial crisis. The average mutual fund costs 1.15%, where the average iShares ETF costs 0.45%. Core ETFs would be much less.

DIVERSIFICATION

Index funds offer great diversification. IVV or SPY hold all 500 stocks within the S&P 500, where as a similarly styled actively managed mutual fund may hold only 40 – 60 equities, some not even listed on the S&P 500.

ETFs can also provide plan participants access to harder-to-reach asset classes such as emerging market bonds, frontier markets, international bonds or commodities. All of these asset classes can be held at a cost of less than 0.50%.

TRANSPARENCY

Ask any plan participant, or in some cases the plan sponsor, how much their plan costs. This includes the administration and investment fees. Very few will be able to tell you. In 2012 there is new regulation that will help change this, but up until this point transparency has been about as clear as a muddy river. Exchange traded funds provide a daily look into what is held within the portfolio, and management fees are fully disclosed. Add a report showing the participant plan administration fee and you will have a very transparent 401k.

WHO NEEDS ETFs TODAY?

One can argue that large plans have the negotiation power to lower plan participant investment costs. This is true to a certain extent. In some cases a Vanguard Index Tier may be more beneficial to plan participants versus exchange traded funds. The Vanguard Index Tier can drop investments costs below 0.05% if the plan is large enough. Indexing as an option if desired in these plans, whether it is an index mutual fund or exchange traded fund.

The real benefit for ETFs falls in plans with less than $100 million in assets. These 401k plans are currently being serviced by industry leaches such as the Hartford, VALIC, and other annuity-based 401k/403b plans. Participants in these plans can pay nearly 3% annually in fees. Lowering their costs by 2% would be huge.

For some plans that do not offer any form of indexing, often the plan sponsor has allowed the plan provider to offer a brokerage link account. This is where a participant is allowed to move all or a portion of their 401k balance into a brokerage account under the 401k umbrella. Within this account a plan participant can purchase most equities and bonds including index mutual funds and Exchange Traded Funds.

THE BARRIER

An exchange traded fund trades just like a stock, which means that they can be traded intraday with a bid and an ask spread.  A net asset value (NAV) is also calculated; NAV is the value of the underlying securities.  Mutual funds, on the other hand, trade at day end on NAV. There is a good probability that an intraday purchase of an ETF could be made at a value greater than the NAV, which is not a good thing for 401k plans. This issue has been solved by not allowing intraday trading of ETFs inside a 401k. Transactions will take place at the end of the day, just as mutual funds are currently traded. There has been noise that mutual funds have the same NAV issue but at a different level. There is debate that ETFs could, in the end, be traded more efficiently than mutual funds. This is actually good news for proponents of ETFs within 401ks, as just a short time ago this was a case-closed win for mutual funds.

Another barrier for ETFs has been record keeping. Up until recently, accounting systems would only handle mutual funds. Participants can hold fractional shares of a mutual fund. ETFs trade in whole shares. This has changed; through new techniques fractional ETF ownership is possible.

THE PLAYERS

Several companies are offering ETFs within 401k plans. The larger players are ING’s Sharebuilder 401k, Charles Schwab, Invest N Retire, WisdomTree, iShares and TD Ameritrade. All of these companies have invested into architecture that allows for the efficient use of ETFs within a 401k plan.

USERS

Plan sponsors that use ETFs within their plans are innovators, and the organizations understand investing at a level higher than the average sponsor. Case in point: Apple uses all ETFs within its 401k plans. This technology leader is now demonstrating its core value of innovation in its 401k plans as well.  As other CFOs and HR directors learn about indexing and the use of exchange traded funds, the ultimate winners will be plan participants.

IndexUniverse.com recently published a report with all the ETFs that passed through capital gains to their investors. Apparently in 2011 only 93 ETFs made this list. I was very impressed with this report as it is the only one of its kind that I am aware of. You can see the list directly on their site HERE.

The last place that any financial advisor wants to find himself is with a securities attorney. Especially one from the SEC. For this lunch, I found myself sitting with Pat Huddleston, former SEC enforcer, attorney and now author. Joining us was Mike Bishop also an accomplished securities attorney here in Atlanta. Both go after bad financial advisors for a living.

At this lunch, I was sitting with the “good” guys observing the dark side of my industry.  We talked about those terrible variable annuity products. We discussed some of the local ponzi schemes that had taken place over the years. Near the end, Pat and I discussed his book, “The Vigilant Investor.” I have to say that I have met several authors over the years, mostly financial writers, all of whom are very proud of their accomplishments. I found Pat to be humble, intelligent and very determined to help the individual investor protect their investments from fraud. I promised Pat that I would read his book.

Reading the book as a financial advisor has a different feel than a non industry individual reading the book. While my firm would be able to pass Pat’s vigorous “good” advisor criteria, at times I found myself taking notes to help sure up my firms transparency and how we interact with prospects. I understand that clients trust me and that we have safeguards in place to look out for the clients’ best interests. But what if our clients were introduced to any of the smooth talking, real life characters that Pat displays in his book? Certainly their life savings would be gone either by out right theft or a slow death through an annuity. This reality is scary to me.

This book lays out the threats and tells the readers how to look for the signs of trouble. One of my favorite parts of the book is where Pat says he hopes that a broker someday will be able to tell his prospects the unvarnished truth about annuities. He goes on with a script that such an advisor would read. Fees 3% per year, 10 years to get out without a penalty, so the fees will cost you 30%,  if you want a bonus for investing, that’s fine, but the fee will be 4% to cover the cost of the bonus…. Pat acknowledges that this will never happen, but it is still fun to dream.

From my prospective the book is filled with dark stories of greed and deception. Yet it is these stories that investors need to read to understand the reality of what can happen if investors are not vigilant in their search for a financial advisor. The book confirmed why I left AXA Advisors in Atlanta to start my own Fiduciary Fee Only advisory firm over a decade ago. The book also confirmed my dislike of the business model of independent advisors that are also registered as commission brokers. This model defines the term conflict of interest.

You can go with your gut when choosing between steak or chicken. Use knowledge to choose an advisor. This book will help you do that.

http://thevigilantinvestor.com/

What is a Stretch IRA?

A stretch IRA is not officially in the IRS code.  It is a wealth transfer method that allows you to potentially “stretch” and even grow the IRA assets over several generations.  The strategy involves adjusting beneficiary designations to minimize so-called required minimum distributions (RMDs) over a long period of time.

The stretch IRA is not for everyone.  It is most useful for affluent retirees and those who want to leave a financial legacy for their heirs.  It does not work well when distributions need to be higher than the required minimum.  It also is not for the highly undisciplined, as there is no structure that prevents taking more than the required minimum.

The benefit of the stretch IRA is in taking the required minimum distribution and only the required minimum distribution.  Leaving as much money in the IRA as possible allows the bulk of the assets to continue to grow tax-deferred.  Assuming the growth rate is higher than the rate of withdrawal, the IRA balance can actually grow larger over time, perhaps even double, in spite of the withdrawals.

IRA Distributions

It is helpful to review how a traditional IRA normally works.  Contributions and investment income grow tax deferred – meaning no taxes are paid until money is taken out of the account.  Then it is taxed as ordinary income.

If you don’t need the money, you don’t take the money out, thereby avoiding the tax consequence of withdrawals.  Unfortunately, you can’t do this forever.  The IRS eventually gets tired of waiting for its due.  It requires that you start taking annual required minimum distributions (RMDs) beginning the year you turn 70 ½.   Normally, RMDs must be taken by December 31 of each year.  However, the first distribution can be delayed until April 1 following the year the account owner turns 70 ½; this is called the required beginning date.  Two RMDs are due the year of the required beginning date – one for the previous year (by April 1) and one for the current year (by December 31).  As a point of reference, because there is no tax liability due on qualified withdrawals from a Roth, a Roth IRA is not subject to RMDs.

Failure to take the annual required minimum distribution on time is 50% of the amount the RMD should have been.

The formula for determining the amount of your required distribution involves dividing the prior year-end account balance by the life expectancy factor.   The IRS provides charts as to the life expectancy factor (the divisor factor) that should be used, depending on age and status of the one taking the distribution.  There are three different tables currently in use:

• Uniform Lifetime Table – gives a joint life expectancy factor that is equivalent to the joint life expectancy of the account owner and a hypothetical beneficiary who is 10 years younger.  Only the age of the account owner is needed to find the proper life expectancy factor.

• Single Life Table – used for designated beneficiaries who have inherited an IRA, or for an IRA account holder who dies without a designated beneficiary.

• Joint Life and Last Survivor Expectancy Table – used only when the account owner’s sole beneficiary is a spouse more than 10 years younger.  To find the applicable joint life expectancy, you need to choose the column representing the IRS holder’s age, and then the row representing the spousal beneficiary’s age.

The divisor factor goes down at each year of age.  Because you are dividing by a smaller and smaller number each year, the amount of the RMD goes up each year.  Therefore the older you are, the higher the amount of the RMD.  The amount of the required minimum distribution also rises as the account balance rises.

Therefore the key to stretching an IRA farther is to name younger beneficiaries.  The younger the beneficiary, the higher the divisor.  The higher the divisor, the lower the RMD.  The lower the RMD, the better potential for tax-deferred growth.

Distribution Options for the Beneficiary

Choosing beneficiaries is an essential step for implementing a stretch strategy.  Beneficiaries can be your spouse, non-spouse persons, an estate, a trust, or a charitable institution.  There are a number of beneficiary distributions allowed by the IRS.  Different options are allowed, depending on whether the account owner died before or after the required beginning date of his/her RMDs, and who or what the beneficiary is.

Spouse as Sole Beneficiary

If the account owner died before the required beginning date (meaning RMDs have not yet started), and the beneficiary is solely the spouse, the spouse can leave the account in the deceased owner’s name, treat as his/her own, or use the five-year rule.

If the spouse leaves the account in the deceased owner’s name, he/she must take RMDs no later than December 31 of the year the deceased owner would have turned 70 ½; or if the spouse was already 70 ½, by December 31 of the year following the year of death.  The single life expectancy table is used for this calculation, which has a lower divisor per age, which results in comparatively higher RMDs.  Leaving the account in the deceased owner’s name is the default option.

If the spouse is under 70 ½, and decides to treat the account as his/her own, they won’t have to take RMDs until he/she turns 70 ½.  They are also allowed to use the joint life expectancy table, which has a higher divisor per age, and results in lower RMDs.

The third option is to use the five-year rule. Here the surviving spouse is allowed to do whatever he/she wants until December 31 of the fifth year after the account owner dies.  He/she can take money out each year, or wait until the end to take out the whole shebang.  The 50% annual non-withdrawal penalty does not apply in this case.

If the account owner died on or after the required beginning date (meaning RMDs have started), the surviving spouse has two options.  He/she can leave the account in the deceased owner’s name or treat as his/her own.  The five-year rule does not apply.

If the spouse leaves the account in the deceased owner’s name the same requirements apply as above.

If he/she treats the account as his/her own, he/she must take the RMD for that year, calculated as if the owner was still alive.  If the spouse is over 70 ½, the next RMD is due by December 31 of year following the original account owner’s death.  If the spouse is under 70 ½, the spouse is not required to take any more distributions until he/she reaches that age.

Non-Spouse Individuals or Spouse Not Sole Beneficiary

There are cases where the spouse is not the sole beneficiary, or only non-spouse beneficiaries are designated.  Non-spouse beneficiaries can be any individual other than the spouse or a qualified trust.  Regardless of whether the account owner died before, on or after the required beginning date, RMDs must start by December 31 of the year following the account owner’s death, and for each year thereafter.

If the account owner dies before the required beginning date, then distributions can be made based on the life expectancy of the oldest beneficiary (default); by creating separate accounts for each beneficiary, allowing them to take RMDs using their own life expectancy; or using the five-year rule.

In the case of multiple beneficiaries, if the account is not divided into separate accounts for each one, the age of the oldest beneficiary is used to determine the life expectancy factor.  This means that a lower divisor will be used, resulting in a larger RMD.  If separate accounts are created, then each account will use that beneficiary’s own life expectancy factor, lowering the RMD for the younger beneficiaries.

If the account owner dies after the required beginning date, the same options apply, except for the five-year rule.  The RMD for the year of death must be satisfied if not already done for the original account holder. The following year, the RMDs are calculated based on the beneficiary life expectancy.

Non-Individual Beneficiary

A non-individual beneficiary is an estate, charity or non-qualified trust; or there is no designated beneficiary.  In this case, only the five-year rule applies if the account owner died before the required beginning date.  If he/she died after the required beginning date, the RMD is calculated based on the single life expectancy of the owner in the first year and each year thereafter.

A Note about the Five-Year Rule

Don’t do it if at all possible.  Not only do you lose out on the potential for long-term compounded growth, you’ll have a huge tax liability.  The tax liability could be further exasperated if the amount of the withdrawal raises your tax bracket, since the withdrawals are treated as ordinary income.

Also, Don’t Get Caught

Plan custodians have some leeway as to what kind of distributions they allow, among the options the IRS allows.  In short, they don’t have to offer you all of them; for example, some custodians only allow the five-year rule for everyone. If a custodian does not allow you to take distributions the way you want to, you should to switch to another custodian.

A Final Note

The stretch IRA, when used as designed is a useful tool for transferring wealth and providing long-term financial support in a tax efficient manner.  It requires a high degree of trust that your beneficiaries will use it the way you intended.  You will have no recourse from the grave if they don’t.  However, if your real intention is to simply to leave a financial legacy for your heirs for whatever their needs and circumstances are, then implementing a stretch IRA gives them more options as to how they can use the money.

It’s almost 2012. Your business has done better than expected. Here are a few things you may consider to help lower your tax liability before year end, but you had better hurry!

1. Donations. Cash donations are always deductible, but you may also have items lying around your house that could benefit someone else. Donating these items to Goodwill or similar organizations is tax deductible. We recommend keeping an itemized list of the things you are giving away and assign a value to each item.
2. College Savings. Saving for your child’s college is always advised, but a GA 529 plan carries an additional tax benefit. All Georgia taxpayers may now contribute and deduct up to $2,000 each year on behalf of any beneficiary regardless of their annual income. Georgia taxpayers are not required to itemize deductions to make this adjustment to income. Please note that a transfer of funds from another state’s 529 plan is not eligible for the Georgia income tax deduction.
3. Prepay State Tax. For those who will owe Federal and State tax for 2011, you can prepare a draft tax return to estimate your GA tax liability. If you prepay this tax in 2011, it becomes a credit on your federal tax return, thus reducing your federal tax liability.
4. Small Business Retirement Plan. Look at opening a Simple IRA or a SEP IRA to shelter income and save for your retirement. The amount that you put into these type accounts is not taxed in 2011, but will be taxed when you withdraw the money at age 59 ½ or greater. When you are retired, the idea is that you will be in a lower tax bracket and thus you will pay less tax on your money earned in 2011. See our blog on “retirement plans for the self employed” for more information.

But what if his risk tolerance had indeed been very aggressive, as well?  Would his original investment have been then suitable for him?

In a word, no.

No matter how aggressive an investor you are, investing in one company, or even a few companies, is not a wise move.

A Few is Fine, if They’re Quality, Right?

Let’s say you have your portfolio invested roughly equally in five stocks, all strong companies like Coca Cola, Home Depot, Apple, etc.  Return over the long-term has been good.   You think your portfolio is sound.

But what if something happens to shake the very foundations of one of those companies?  What if poison somehow makes its way into millions of bottles of Coke Zero?  Millions of people die from the poison.  Coca Cola is plunged into a legal nightmare.  Pepsi takes advantage of its foe’s troubles by advertising its production process security and quality control measures.  Stock price plummets amid reports of Coca Cola’s eminent ruination.

Where is the value of your Coca Cola investment now?  What if your kid’s college tuition is due and you need to sell Coca Cola stock a month after the first poisonous death?   You could be selling at a loss.  The tax benefit you gain from the capital loss would be pittance compared to the harm it does your portfolio.

Ok, this is surely an unlikely scenario, as Coca Cola’s own quality control and product testing measures are in place to prevent this from happening.  But it’s not impossible.  And you have 20% of your portfolio riding on Coca Cola’s bottling process.  Even the simple market price variation of the stock could be problematic if you need to sell at the wrong time.

Good Diversification Means More than Five

A properly diversified portfolio does not have large concentrations in any one company.  A good portfolio includes hundreds of companies, even thousands if you use funds and not individual stocks.  In such a portfolio, concentration in any one company could be as low as 1%.  If that one company goes under, the impact on your overall portfolio would be miniscule.

So More than Five is All I Need?

Not exactly.  Good diversification also means choosing the right combination.  You don’t want to own the S&P 500, and only the S&P 500.  You don’t want all American companies.  You need a mix of different types of asset classes.

Correlation in the finance industry is a quantitative measure of how closely two investments react compared to each other.  A correlation of 1 indicates that the two investments are perfectly correlated – meaning they will react the same way to changing market conditions.  The closer the correlation is to 1, the more similarly they will react.

A correlation of -1 indicates that two investments will react the opposite of each other.  The closer to -1, the higher degree of opposite directions.  A correlation closer to 0 indicates that the two investments move in ways that are not related to each other.

In relation to your portfolio, you want to make sure you have investments that are not closely correlated.  This involves choosing investments whose correlation approaches 0.  Another technique sometimes used is hedging.  A hedge is an investment used to offset potential losses that may occur by another investment.  This is most often accomplished by using investments involving negative correlation.

Using the S&P 500 example (the S&P 500 includes the 500 largest US companies), a good companion investment would be bonds. Or money markets.  Or foreign stocks.  A hedge against a falling dollar could be investing in foreign bonds in their local currency.

Of course, diversification does not protect you from systemic risk.  As seen in 2008-2009, if the whole market goes down, your portfolio is going to go down with it.  Highly volatile markets tend to erase the benefits of correlation.  You can’t control this kind of risk, like you can investment risk, but that is no reason to forgo diversification.

Enough is Enough

So it’s not enough to choose just a few stocks.  It’s not enough to choose a large amount of the same type of investment.  A desirable portfolio will focus on global long-term healthy asset classes. Within each asset class, a focus on historical volatility, correlation to the S&P 500 and potential future return will net the best results. Such a portfolio is much more efficient, in terms of risk and reward, than just a few stocks of all one type.

Click Here for PDF Version   Click Here For Vanguard Index Tier Information

By now you have received notice that there are some changes happening within the ASA JPMorgan 401k plan. The good news is some of the funds are getting cheaper. The frustrating part is this should and could have happened a long time ago. It should also be known that your ALPA Retirement Committee was not made aware of these changes any earlier than your receipt of the JP Morgan Letter. This is frustrating as the pilot group is the largest contributor to the ASA 401k plan and should have input into their retirement choices.

Despite the secretive and abrupt nature of this change, I will help you dissect these changes and help you figure out what actions you should consider.

Closures

On the “no longer available to us list” are the American Century Ultra and American Funds Growth Fund of America funds. These funds have recently underperformed their peers and or the S&P 500. The replacement for these funds is the JP Morgan Large Cap Growth R6 fund. There are some key measurements that we can look at to dissect if this change is in the participants’ favor.

Alpha – This is the fund manager’s ability to beat the index. In this case the index would be the Russell 1000 or the S&P 500. The higher Alpha, the better. A negative Alpha means the manager has earned too little based on the risk of the investment.

Sharpe Ratio – Most fund managers take on additional risk outside of their assigned index in order to beat the index. Sharpe Ratio does not mean a whole lot by itself. When comparing two funds you want the one with the higher Sharpe Ratio. This means that the additional risk has paid off.

Standard Deviation – This measures the volatility (risk) of the fund from its average rate of return. Ideally an investor wants a high rate of return with little standard deviation, which is hard to find. One certainly does not want a low return with a high standard deviation; this means that risk is not being rewarded with return.

Using the key indicators above we can compare our new JP Morgan Growth Fund R6 to the two outgoing mutual funds.

The data above shows that the mandatory transition from Ultra and Growth Fund of America is not a bad move. Notice how the standard deviation (risk) is virtually the same for all funds yet the end results are very different. This reflects the portfolio managers’ stock picking ability. The American Century Ultra fund has been an underperformer for years. American Funds Growth Fund of America has good ten years risk/reward data; however, it has under performed its peers in the last three years.

As a side note, over the long term 10 + years very few managers actually beat their assigned index. This is why 401k plans that offer Vanguard Index Funds are very desirable. Currently Fed Ex, Hawaiian, SouthWest and United offer 401k plans with a Vanguard Index tier as additional investment options.

Holdings

JP Morgan Large Cap Growth Fund holds 68 total stocks, compared to 310 in Growth Fund of America and 81 in Ultra. The JP Morgan fund has bought and sold (turned over) 84% of its portfolio over the last 12 months compared to 33% in Growth Fund of America and 24% in Ultra. The turnover percent within a fund is important as for every 100% in turnover adds 1.0 – 1.5% in fees paid by the participants.

The top five holdings (as of 9/30/2011) within each fund are as follows:

Fee Changes

Other funds within the ASA 401k plan had fee changes and new tickers assigned.

The new fees average out to be 0.15% in average reductions with the largest change being 0.20% in three mutual funds. In all the funds listed above, the holdings, investment objective and managers remain the same. Only the share class (fee structure) changed. I will note here that the JP Morgan letter shows the JP Morgan Equity Index fee as going from 1.19% to 0.10% in the new index. This has to be a typo as the old fee is published as 0.20%.

Why Did the Changes Take Place?

I have taken many phone calls from plan participants asking why these changes have taken place and what this means to them. The why part is very simple. JP Morgan has been collecting annually an estimated $356,000 in administration fees ($88 per plan participant), which is included in $1,234,000 in fund fees (avg 0.79%).

These fees are not terribly out of line with a plan of our size; currently 155 million in assets.

In my opinion these fees could have been lowered years ago. However, the company certainly has more leverage recently because of the purchase of Express Jet. A joint ASA ExpressJet 401k plan is valued at $400+ million. JP Morgan wants that business and as a result has lowered its fees. With our new fee structure, JP Morgan will still be collecting $238,918 in administration fees ($59 per participant), which is included in $1,072,000 in fund fees (avg 0.69%) just on the ASA 401k, not including Express Jet’s 401k.

This is where competition and larger plan assets benefit the plan participant (you). While this is great news, there is still work to be done. Even though our fund expenses have dropped, we can still do much better.

Three Ways to Invest

There are three ways to invest in the stock market. I love Coca Cola, so lets use cola as an investment example.

I.  Stock

Let’s say we invest $5,000 into Coke stock. Then the evil people at Pepsi infiltrate Coke and poison the syrup.  People are now dying of Coke. What is your Coke stock worth? $0. This is called company risk.  We want to diversify away from company risk such as Enron, Global Crossing and many other bad companies in good industries. This is where mutual funds enter the picture.

II.  Mutual Fund

Investing in a mutual fund is pooling investor’s money together and hiring a fund manager to manage your money. In our cola example, let’s say that there are 50 cola companies in the US. The mutual fund does not know your personal objectives but does operate under a published objective. A mutual fund objective could be to invest in large cap US stocks or foreign bonds. In our example the fund manager is looking for the 20 best cola companies out of an industry of 50. This gives the investor diversification from company specific risk. The funds goal is to beat the index of 50 cola companies.

While very popular, mutual funds have drawbacks. Many of the mutual funds in the ASA 401k plan have over 100% in annual turn over. This means that the fund manager is buying and selling a lot through out the year. For every 100% in turnover we see an added 1.0 – 1.5% in fees. In our cola example, our fund manager would be buying and selling the cola stocks on a regular basis in an attempt to beat the cola index. This type of investing is considered “active” management.

III.  Index Fund

In today’s society we are programmed to think that we are all “winners.” In fact if you think that you are not a winner then you may be depressed and a doctor can proscribe you a pill for that. Applying this thinking to investing can create poor investing behavior. We see this in a study by the University of Maryland “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas” showing that only 0.06% of mutual funds beat their assigned index from 1975 to 2007.  This draws us to our third choice of investing, indexing.

Through Index Mutual Funds or Exchange Traded Funds investors now have the ability to purchase entire asset classes (large, mid or small caps) or sectors (US energy, foreign, real estate, etc.). In our example we could purchase the entire cola index through an index mutual fund or exchange traded fund. Index funds do not have fund managers as the fund is simply purchasing companies chosen by the index provider such as S&P or Russell. This type of investing is considered “passive” investing

A real world example of indexing would be purchasing the entire S&P 500 (500 US companies) through an index versus buying the JP Morgan Large Cap fund that only holds 68 companies. The JP Morgan Large Cap Fund has an expense ratio of 0.80%. The Vanguard S&P 500 Index Fund costs 0.05%.  This cost savings adds up to significantly more money in the plan participants’ pocket at retirement. In this comparison the performance difference over the last 10 years is in the favor of the index fund. History and research show that for time periods greater than ten years, indexing continues to be favored.

Currently the ASA JP Morgan 401k plan has one Index fund – the JP Morgan Equity Index Select. It should be noted that in time periods under ten years, we could usually find good performing actively managed mutual funds. However, most of you are saving for time periods greater than 10 years. For you, keeping costs low, maintaining diversification and investing long term are your keys to success.

The current line-up of ASA Mutual Funds are some of the best performing actively managed funds to choose from. However, during our research we found that a low cost index portfolio using Vanguard index mutual funds is very competitive, especially with the cost savings.

Wiser Wealth recently researched 401k options that could be available to ASA and Express Jet employees. We found that switching 401k plan providers entirely should be considered as JP Morgan provides very poor guidance to ASA plan participants. However after the recent changes with JP Morgan, Sky West/ ASA seems committed to JP Morgan. This leads us to a less known option.

Vanguard Indexing Within the JP Morgan 401k Plan

ASA/Express Jet has the ability to add an “index tier” to the ASA JP Morgan 401k Plan. This simply means that in addition to the current line up of mutual funds plan participants would also be able to choose index funds representing cash, US Bonds, US large caps, US mid caps, US small caps, international developed markets and international emerging markets.

The benefit of an index tier is that it gives 401k participants (you) access to industry leading index funds, low cost investing, plan reduction of active manager risk and historically better performance. The company benefits, as well, in that offering index funds within a plan reduces their litigation risk. A recent court case suggests that having index funds within the plan lower the litigation risk for all plan fiduciaries.

Mike Lucci of Vanguard states,

In closing, Wiser Wealth likes it anytime a plan sponsor (ASA/Express jet) lowers the cost of investing. The recent changes by the company were done with your best interests in mind. We hope that they would consider the benefits of adding indexing to the 401k plan. With a combined $400 million in 401k assets, government encouragement and a fiduciary responsibility to work in the best interest of all plan participants, there is certainly no reasonable rational reason anyone could say no.

See PDF version for more information on adding Vanguard to the JPM Plan.

CLICK HERE FOR MORE JP MORGAN 401k GUIDANCE 

Another most often heard answer is owning foreign currency, which has its own risks. Both this and the gold strategy have something in common – neither pay any type of interest or dividend.

A few years ago we looked at the falling dollar and decided that there had to be another angle to this issue. We found gold to be a difficult purchase. Historically it has not been a good investment, as it has no manufacturing purpose and pays nothing to own it. Owning foreign currency is not as transparent as one would think. Funds that trade or hold currency do not actually hold real currency but track future contracts related to global currency. This creates returns that do not exactly match the movement of the dollar because of additional unwanted variables within the contracts.

Part of the Wiser Wealth solution to a falling dollar lies in our allocation to the ETF iShares S&P/Citigroup International Treasury Bond Fund (IGOV) . IGOV is an international treasury bond fund holding foreign government bonds from around the world in their local currency. With 624 bonds from 20 countries , IGOV has returned 4.35% year to date and yields 3.53% (as of 9/30/11), while the US Dollar index has rebounded to just above flat year to date.  The chart below shows IGOV’s negative correlation with the US Dollar over the last 6 months.

The iShares S&P/Citigroup International Treasury Bond Fund (IGOV) has an expense ratio of 0.35%. The fund has an average duration of 6.35 years. IGOV is a passive index dollar hedge play that has a yield. The ETF tracks the S&P/Citigroup International Treasury Bond Index Ex-US. The index methodology is to track a broad diverse group of international treasury bonds with maturities greater than one year and which are market value weighted. The index is rebalanced monthly, with country weights changing annually using January-end data. There will be no country weighted more than 24.95%, and countries weighing less than 10bps are removed. The top 5 countries are as follows: Japan 23.16%; Italy 8.74%; France 7.99%; Germany 7.81%; and the Netherlands 4.88%. The fund currently has 266 million in assets.

Despite the USD recent comeback, we see any future government stimulus only weakening the currency further. IGOV can be used to help cushion the blow to a falling dollar.

So you quit the corporate rat race to start your own business.  It’s hard work, but you enjoy the freedom and the thrill of being your own boss.  There is nothing that you miss about your old job.

Except maybe your 401(k). 

Traditional and Roth IRAs are nice, but limited as to the amount you’re allowed to contribute each year.  You feel it’s not enough to fully fund your retirement needs.  And you need tax savings now.

Consider the world of small business retirement plans.  There are several plans that are specific or adaptable for small businesses or sole proprietorships.  These include the SIMPLE IRAs, SEP and SARSEP IRAs, and Keogh plans.  Keogh plans (also called HR-10 plans) are qualified plans that include Solo 401(k)s, profit sharing plans, money purchase plans and defined benefit plans.  Each plan has its advantages and disadvantages, and applicability to different business situations.  Each one is highlighted below.

SIMPLE IRA

The SIMPLE IRA (Savings Incentive Match Plan for Employees Individual Retirement Account) is a tax-deferred employer-sponsored retirement plan similar to large 401(k) and 403(b) plans, but with simpler and less costly administration.  The SIMPLE IRA is funded with pre-tax dollars. 

Contributions are currently limited to 100% of net earnings up to an $11,500 maximum ($14,000 for persons over 50).  This is lower than the current limit of $16,500 for traditional 401(k) and 403(b) plans, but more than double that of traditional IRAs. 

Only employers with less than 100 employees may establish SIMPLE IRAs.  After crossing the 100-employee threshold, the SIMPLE may continue for two more years before a different plan must be implemented. 

Employees are not required to make regular contributions, but the plan does require a certain minimum contribution from the employer.  This minimum is either a dollar for dollar match on the first 3% of employee salary, or a flat 2% of salary for each employee with at least $5000 in compensation for the year.

This type of plan would be appropriate for businesses with no employees, or with few employees if you’d like to offer them an incentive to continue to work for you.  The mandatory employer contribution is generally less for a SIMPLE than for a SEP.  If the number of employees is getting close to 100, you may want to consider a traditional corporate retirement plan to save the hassle of having to change it over.

SEP IRA

The SEP IRA (Simplified Employee Pension Individual Retirement Account) is a variation of the IRA.  It has no significant administration costs for self-employed persons with no employees.   

Contributions for the self-employed person is limited to 25% of net earnings from self-employment, or $49,000, whichever is less.  The formula for net earnings from self-employment is all revenues minus expenses minus the deduction for one half of your self-employment tax minus deductions for contributions to the SEP IRA.  (If this sounds convoluted to you, don’t worry; the IRS has a cheat sheet for this calculation.)

If the self-employed person does have employees, the employees must receive the same benefits as the owner (the same percentage rate).  For the employees, the SEP IRA is similar to a traditional IRA only with higher contributions limits and with contributions made by the employer, not the employee.  The IRS maximum restrictions on employee eligibility is be at least 21 years of age, has worked for the employer for at least three of the last five years, and received at least $500 in compensation during the year.  Your plan eligibility may be less strict than this(i.e., younger age, etc.), but not more. 

A SAR-SEP is a variation in which the employee may also contribute a portion of their pre-tax pay.  SAR SEPs are allowed only if the employer has fewer than 25 employees during the prior year.

Similar to a SIMPLE IRA, a SEP IRA would be appropriate for businesses with no employees, or with few employees if you’d like to offer them an incentive to continue to work for you.  The mandatory employer contribution would be higher for a SEP than for a SIMPLE.  Another difference in choosing between a SEP or a SIMPLE IRA is in the amount of net earnings from self-employment.  The pivot point is $46,000.  Using the SEP calculation, 25% of $46,000 is $11,500 – the maximum contribution for the SIMPLE.  At less than $46,000, a SEP actually would allow a maximum contribution that is less than what would be allowed in a SIMPLE.  So for a self-employed person with no employees, and with net earnings from self-employment above $46,000, a SEP IRA would be a wise choice; otherwise, use a SIMPLE IRA.

Keogh Plans

Also called HR-10 plans, these are considered qualified plans for tax purposes.  These include Solo 401(k)s, profit sharing plans, money purchase pension plans, and defined benefit plans

Solo 401(k)

Similar to a corporate 401(k), a Solo 401(k) offers tax-deferred savings for business owners.  The business must be very small, limited to the business owners and their spouses.  It also works for partnerships, including partners’ spouses.  You may have part-time employees who work less than 1,000 per year; they will be excluded from the plan.  If you have an employee that works more than that, you can’t do a Solo 401(k)

There was a man who considered himself to be a very conservative investor.  He said he could not handle any losses in his accounts.  He asked his newly acquired financial advisor to take a look at his 401(k) account, to which he had been contributing for over 20 years.  His employer used a major 401(k) provider, who offered hundreds of fund choices with the plan.

His financial advisor took a look.  And was shocked.  And well, was not shocked at the same time.  This man was 100 percent invested in company stock.  This is about the riskiest investment you can have in a 401(k) plan.

This man was a US citizen who had immigrated to this country many years back.  With a native tongue that was not English, he was sometimes confused when discussing the more technical aspects of financial dealings.  So he relied more heavily on the opinion of those people who portrayed themselves as experts.  Before his recent foray into using a financial advisor, he essentially used the advice of his employer, the plan sponsor, by accepting the default investment.  In this case, the default was company stock.

Plan sponsors can’t do this anymore – use company stock as the default investment when their plan participants don’t choose their own investments.  This was one benefit of recent disasters where participants lost their life savings when the value of their company’s stock plummeted to zero.  The trend now is to use a life cycle fund as the default, or a very conservative investment.  But this trend change was too late for this man’s original investment choice.

He was fortunate in that he worked for a stable, growing company, whose stock value had increased significantly over time.  However, besides the lack of diversification, this man had one year to go before retirement.  Very aggressive investments were inappropriate on both counts.   Obviously, his financial advisor quickly had him move to much safer investments.

You’d think he’d be happy now, right?  Turns out he liked the rapid growth of his retirement account.  He rather grudgingly accepted the wisdom that conservative investing was appropriate for his life stage and risk tolerance, not liking the reduced rate of return.  But he still had no framework for risk of loss.  Attracted to and overconfident in strong growth (and outside of the advice of his financial advisor) he invested $5000 of other money in the initial public offering of his son’s company.

The IPO opened at $50 per share.  Within a day or two, the value had risen to $52 per share.  After the initial excitement, however, the value settled down to around $49 per share, where it has been holding steady.  At 100 shares, he is now sitting on a book loss of about $100.

Has he complained?  Oh, yes!  Yes, he has.  You see, he is indeed a very conservative investor, having conniptions over an unrealized book loss of 2 percent.  Even though he doesn’t need his investment back, he now wants to sell immediately, not trusting the value to rise up again.

So why the flip flop?  In a word, greed.

Risk vs. Reward

There is no room for greed in investing.  In the investing world you can’t have your cake and eat it, too.  If you want the reward you have to take on the risk as well.  Put another way, you have the potential to be rewarded for the amount of risk that you take.  Notice I said “potential”.  Reward is not a guarantee.  The reason is risk.

To illustrate, let’s look at a savings account.  The interest on savings accounts nowadays is so low it might as well be non-existent.  Your deposits are also federally insured, so there is little risk of loss.  So a savings account would be a baseline investment, illustrated by a flat level line.

Let’s step up the risk.  An investment-grade bond has the potential for higher return than a savings account, but also the potential for higher loss.  The swing can be measured as going above and below the baseline.  For an investment grade bond, the swing will be fairly narrow.

A high yield bond offers the potential for a higher return than for an investment grade bond, and also a higher potential loss.  So the swing on a high yield bond would be wider.  A stock offers an even wider swing than that, with greater potential for both gain and loss.

In short, you have a diagram that looks like this:

The farther out you go in risk, the greater the potential for gain or loss.

I think you’ll agree you’re like most people.  Looking at reward only, you want the biggest reward you can get.  Who wouldn’t?  The question then becomes, how much are you willing to lose?

Ah.  That is the crux of the matter.  It’s the reason why risk tolerance questionnaires focus on how you would react to a downturn in the market, instead of focusing on your reaction to an upturn.  Because this is where your true colors come out – when you are facing the loss of something precious to you.

Investors who have trouble contemplating potential losses should not be aggressively invested, no matter how much they desire big returns.  Investors who are comfortable taking on risk, and who have the capacity to withstand a large loss should it come about, would be fine investing aggressively.

The problem comes in when investors don’t fully understand or appreciate risk.  Take the man in my tale.  In not paying attention to his 401(k), he missed the impact of the ups and downs of his company stock’s market price over time.   He just saw that he started with nothing, put a little money in each paycheck, and ended up with a large chunk of change.  It wasn’t until he invested in the IPO and watched the price go up and down, and saw the impact on his invested principal, that he fully comprehended this thing called risk.  Now he knows for sure that he’s a conservative investor.  And he has stopped squawking about the conservative returns on his 401(k).

His financial advisor celebrated with a slice of pie.

There are two types of plastic in the world today – credit cards and debit cards.  Most financial gurus would say that debit cards are better than credit cards:  while credit cards increase one’s debt liability, debit cards use money you already have, coming straight out of your checking out. 

The advent of debit cards certainly has made life easier.  It fits in with the instantaneous, I’ve-got-a-million-things-to-do-so-hurry-up philosophy of our society.  Check-outs go faster since people no longer have to spend 60 to 90 extra seconds writing checks after their purchase is totaled.  You’d be amazed how much time that saves over the course of a day in the grocery store.  Most of the time, you don’t have to sign a slip of paper to finish the transaction; you merely enter your PIN – and you can do that before the total is rung up.  You don’t even have to do any of that at the fast food drive-through.

The Hidden Cost

But is a debit card really better than a credit card?  Studies have shown that we spend more when using a credit card.  You’d think that using a debit card would alleviate this problem, since you know that you’re using your own money to make the purchase.  This isn’t true.  Some smart college students I know have figured out they do indeed spend more using a debit card, and now use cash for most purchases.

Think about it.  If you use cash, you are physically limited to spending only up to the amount of cash you have on hand.  Cashiers are reluctant to take less than the amount of the bill, darn them.  If you don’t have enough cash to cover the entire purchase, you have to put something back.  Unlike as portrayed in a certain old movie, the guy behind you probably doesn’t want to cover your shortfall.

In contrast, debit cards usually have an over-the-limit feature, which is tied to a savings account or a credit card.  Which means if you don’t have enough money in your checking account, the purchase amount is still covered because the bank can use money from your savings or credit card to fulfill the purchase amount.  They offer this “benefit” for fee, of course, for each such transaction; hence you’re using more of your own money.

And let’s be honest.  Remember how you subtracted each purchase from your checkbook balance at the point of sale?  (Well, at least you conscientious types did, taking an extra 30 seconds or more.)  With debit cards, you don’t really keep a running balance in front of your face, do you?  This makes it hard to keep track of how much you’re really spending.  Likewise, when was the last time you did a monthly reconciliation of your account?  Yeah, I thought so.

Six of One, Half Dozen of the Other

Debit cards have changed the type of fraud we see.  With checks, the fraud was check kiting.  This was where retail establishments unknowingly took checks written on accounts with insufficient funds.  Some people did this deliberately.  A thief could also steal checks and forge signatures; some even went so far as to print false checks.

If your wallet is stolen, the thief is limited to spending to the amount of cash on hand.  With a debit card (like a credit card or check), the thief can run up untold amounts before you can call the financial institution to report the loss.  I’ll admit to one benefit of debit cards over cash – in theft situations, some financial institutions will limit your loss to a certain amount (generally relatively small), bearing the burden for the rest of it.  You’re out of luck with stolen cash.

Another benefit is the ability to make online purchases; at least with a debit card, you aren’t increasing you debt load as with a credit card.

So Which is Better?

Am I advocating avoiding debit cards altogether?  Not necessarily.  In some cases, debit cards are necessary – such as for online purchases, as mentioned above, or when buying food on an airplane (now that is aggravating, isn’t it?).  For day to day budgeting, however, cash is king.  If money is tight, it is easier to stay within your $300 wardrobe budget if you only take that amount of cash to the department store.

It is best to use cash when possible. Obviously, you’d most often use your debit card at the ATM, of course, to get this cash.  If/when you do use debit cards for other purchases, the key is to use them prudently.  Total up your debit receipts each day – even tie them to budget accounts – to keep track of how much you’re really spending.  This enables you more quickly realize if you’re going over budget in a certain area, and to adjust your spending accordingly.  Be sure to tie your cash purchases to these budget accounts, too, for an accurate picture of your spending habits.

All in all, debit card are a necessary evil.  It behooves you to use them with caution.

Worry can drive investors to behave irrationally, and actually do more harm to their portfolios than good.  When the market is high, investors want to capitalize on the growth and tend to buy stocks.  Conversely, when the market is low, investors tend to run to safety and sell off their stocks.

This is the exact opposite of what an investor should do.

Schoolhouse Rock has it Right

Buy low and sell high is the name of the game.  The Schoolhouse Rock DVD has a song about this truth (although it was not shown as often – if at all – as the one about conjunctions).  The premise is that you want to buy when prices are low and sell when prices are high so that you make a profit.  This makes sense when one is thinking logically.  The problem comes in when emotions swing as high as the stock market swings widely.

Think of it this way.  You have a house.  You bought it at the top of the market in 2007.   Today, the house is worth less than you paid for it.  Are you going to sell your house today because it’s worth less?  Not if you don’t have to.  You’ll wait until the housing market comes back up, and the worth of your house improves.

In another scenario, let’s say you don’t own a house yet, or have some excess cash on hand.  Prices for housing are low.  Now would be a good time to buy, either for yourself or as an investment.  In this case, you would be able to profit in the short-term through rental income on the investment property, and in the long-term if/when you eventually sell the property.

The same goes for your money.  February of 2009 was the perfect time to invest more in the stock market.  Starting the beginning of March, the stock market began rising, and within a three months, had gained back more than 58 percent of its then current value.  That’s a 58+ percent return on the investment.  This phenomenon is so common in the market cycle that it has a name – the dead cat bounce (although a bouncing ball would be a more appropriate analogy).  It refers to the pattern that when the market bottoms out at its lowest point in the current cycle, most of the following growth occurs in the first bounce up.  Then it will drop again, but not as far.  The next growth event will not be as high as the first one.  And so on and so on.

If, due to panic, you sold out of your stock investments as the market was crashing to move to cash or at least safer investments, you’re selling at a loss.  Less skittish folk tend to have a lower stock price trigger point when it comes to selling, thereby making their losses larger.  When the market starts rising again, you may not trust that the run is sustainable, so you wait a while before you buy back into the market.  Not only do you realize the losses at the point of sell, you miss the time period of the biggest gains.  Thus your overall portfolio performance is harmed.

What to Do, What to Do

The only way to benefit from a market drop would be to sell out right before the bubble bursts to protect your profits, and then buy back in at the point where the market bottoms out to take advantage of the low prices and capitalize on the coming growth.  Most people – even professional money managers – cannot time the market this efficiently.

So what do you do instead?  The best thing to do is stay put.  It’s much easier to stay put if you are properly allocated according to your risk tolerance and time horizon.  If market drops make you nervous or if your time horizon is short, you should not be aggressively invested.  Likewise, if significant market losses don’t bother you as much or you have a long time horizon, then a more aggressive portfolio would be fine.  You need to understand, though, that in minimizing your potential for loss, you need to accept that your potential for gain will also be reduced.  You can’t seek high potential for gain with little to no risk of loss.

It can be hard to stomach the idea of staying put when the media sensationalizes the wide market swings.  It helps to limit your exposure to those financial talking heads.  In fact, there is data to support that staying put is the best option.  A Harvard study of investment habits found that investors who consumed no financial news earned better returns than those who were fed a steady stream of it.  Investors in volatile markets earned more than twice as much as similar investors whose trades were influenced by the media.  In financial challenges, maintain your emergency savings and limit debt, sure.  But don’t waiver from a sound investment plan.

Understanding What is Normal

It helps to understand that the market is normally cyclical.  The market goes up, then it goes down, then it goes up again.  It’s like radio waves.  Sometimes the swings are narrow, sometimes they are wide.  Over the very long-term, the overall trend is up.  The definition of long-term is relative, however; due to the 2008 crash, the stock market lost 10 years worth of growth, and 10 years is typically considered long-term.  To an extent, you can control the width of the swing through allocation appropriate to your risk tolerance.

So why does it seem the market swings more widely now that it used to?  You can thank computers for that.  In the olden days, buys and sells were conducted using actual people.  Now a lot of the buying and selling is computerized.  Computers operate much faster than humans, and can be programmed to buy and sell in huge blocks at specific triggers.  Large institutions have created computer programs that set target prices whereby if stock prices reach that point, the computer initiates a wide-spread buys or sells.  The target prices are generally not that far off current prices, but the bulk trading tends to result in driving prices further than the target – sometimes much further.  And it all happens pretty much in the blink of an eye.  There is no way a human can keep up with this pace, so one shouldn’t even try.

It All Comes Down to Risk Tolerance

You should base your investment portfolio on the amount of risk you are willing to take.  There are five major risk profiles:  conservative, moderately conservative, moderate, moderately aggressive, and aggressive.  Risk tolerance questionnaires can be found on the internet or from your financial advisor.  The questionnaires ask questions concerning your time horizon, your realistic expectations for growth, your sell-off trigger points for losses, and your overall comfort level regarding negative market performance.  Your answers to these questions help determine what risk tolerance level would be appropriate for you.  If you have multiple investment accounts, risk tolerance can vary from account to account; meaning your retirement account will likely have a different risk profile than your child’s education fund.  Your risk profile should be reviewed on a regular basis and adjusted as necessary to accommodate changes in your financial picture and life circumstances.

This reported demise of the credit trust reminds me of Mark Twain’s famous observation, after his obituary had been mistakenly published by the New York Journal, that “The reports of my death are greatly exaggerated.” Like Mark Twain’s “death,” it seems to me that reports of the demise of the credit trust are greatly exaggerated.

Understanding portability involves mastering two new estate tax terms: the basic exclusion amount and the deceased spousal unused exclusion amount (DSUEA). The basic exclusion amount is the surviving spouse’s applicable exclusion of $5 million, reduced by lifetime taxable gifts. The DSUEA is the predeceased

Tax Act Terms

As keen-eyed readers will note, the definition of the basic exclusion amount and the DSUEA provides the first hint that the importance of portability may be exaggerated. Both definitions include a reference to an applicable exclusion of $5 million, which is available under the 2010 Tax Act only for people dying during the 24-month period beginning January 1, 2011, and ending December 31, 2012. As of the date of writing this column, portability will exist only if both spouses die within the next 18 months.

A second fly in the ointment is created by Section 303(a)(5) of the 2010 Tax Act, which provides that the surviving spouse may only make use of his or her predeceased spouse’s DSUEA if the predeceased spouse’s estate files a timely estate tax return that shows the amount of the DSUEA and contains an irrevocable election to the effect that the surviving spouse may use such DSUEA [NOTE: big problem. How many of your clients will do this?  Geri] Advocates of using portability in lieu of credit trusts argue that portability reduces the cost of estate planning because plans relying on portability will be simpler documents to draft and the survivor will be faced with less post-death complexity because the number of trusts the survivor must contend with will be reduced. Both assumptions are questionable.

Portability vs. Credit Trust Costs

Portability may actually increase the cost of administration by requiring the filing of an estate tax return that otherwise would not be necessary. For example, assume that a husband dies in 2011 with an estate of $3 million, all of which he leaves to his wife, who has an estate of $5 million. No estate tax return is required because the husband’s estate is less than his applicable exclusion. In order for the wife to make use of the husband’s DSUEA, a timely estate tax return must be filed with the appropriate irrevocable election. The cost of preparing an otherwise unnecessary estate tax return could easily equal or exceed the cost savings of not including a credit trust in the husband’s estate plan. Moreover, complexity is actually increased because the client must not only file an otherwise unnecessary estate tax return but that return must be filed timely and must contain the appropriate election.

Reliance on portability in lieu of the use of credit shelter trusts creates several other problems as well. Although the 2010 Tax Act provides that the $5 million applicable exclusion amount is subject to an inflation adjustment, that adjustment ceases to apply once the taxpayer dies. Unlike a credit trust that shelters post-death appreciation in value, the amount of the DSUEA is fixed as of the date of the pre-deceased spouse’s death and does not protect post-death increases in value of the pre-deceased spouse’s assets. Returning to the example of the husband who dies in 2011 with an estate of $3 million, all of which is left to a widow with a separate estate of her own of $5 million, assume that the husband’s assets appreciate in value to $10 million and the widow dies on December 31, 2012. Had the husband left his estate in a credit shelter trust, the entire appreciated value of the assets would have been excluded from the widow’s taxable estate, as well as having been exempt from the generation-skipping transfer tax. Because the parties relied on portability, the husband’s DSUEA is fixed at $5 million. The surviving spouse’s taxable estate amounts to $15 million (her $5 million plus the husband’s $10 million) and her applicable exclusion amount is $10 million, consisting of her basic exclusion amount of $5 million and her husband’s DSUEA of $5 million. The remaining $5 million of the widow’s taxable estate would be subject to a 35 percent tax rate, producing an entirely unnecessary estate tax of $1.75 million.

Blended Family Estates

Reliance on portability may also defeat, either intentionally or unintentionally, the testamentary plan of the pre-deceased spouse. It is common today for one or both spouses to have children by prior marriages. There is no assurance that a surviving spouse who inherits outright the estate of his or her pre-deceased spouse will leave that property to the pre-deceased spouse’s children. It is equally common for a surviving spouse to remarry. If such a remarriage ends in divorce, it is possible that some or all of the inherited assets may be subject to division by the family law court. If the marriage is successful, it is equally possible that the surviving spouse will leave his or her new spouse some or all of the assets inherited from the pre-deceased spouse.

It is interesting to note that estate planners were having this same discussion of the drawbacks of leaving property outright to a surviving spouse in the 1960s and 1970s prior to Congress amending the estate tax laws to create the QTIP trust, thereby permitting a pre-deceased spouse to qualify for the marital deduction but still control the ultimate disposition of property left a surviving spouse. I am reminded of a George Santayana remark that those who cannot remember the past are condemned to repeat it. On the other hand, assets left in a credit shelter trust in which the surviving spouse has a life estate—like assets left in a QTIP trust—pass to the designated remainder beneficiaries at the surviving spouse’s subsequent death.

Tax Considerations

A credit shelter trust is also potentially more tax efficient than reliance on portability. A properly drafted credit trust can be used to sprinkle taxable income to beneficiaries in lower tax brackets, which cannot occur when property is left outright to the surviving spouse. Principal distributions may be made from a credit trust to children during the lifetime of the surviving spouse without such distributions being treated as taxable gifts. If portability is relied upon and the pre-deceased spouse leaves his or her estate to the survivor, transfers by the surviving spouse to children during his or her lifetime will constitute taxable gifts to the extent they exceed the surviving spouse’s annual exclusion.

Lastly, planners should keep in mind that portability will sunset for people dying on or after January 1, 2013. Planners relying on portability are limited to factual situations in which both spouses die prior to that date. In most situations, it appears estate plans that use credit trusts are far more practical and far less dangerous than reliance on portability.

Jon J. Gallo, J.D., chairs the Family Wealth Practice Group of Greenberg Glusker Fields Claman Machtinger & Kinsella LLP in Los Angeles, California. Together with his wife, Eileen Gallo, Ph.D., he is a founder of the Gallo Institute and the author of two books on children and money. Their websites are www.galloinstitute.org and www.fiparent.com.

Endnote

1. Officially, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L. No. 111-312, 124 Stat. 3296.

Definition

Emerging markets are defined as those nations with social or business activity in the process of rapid growth and industrialization.  They have a relatively short history of open market relations and foreign investment.  Emerging market is characteristic of a country that has previously had a centrally planned and isolated economy, generally due to long-standing one-party political and socioeconomic systems, or a developing nation emerging from poverty or economic sanctions.

Currently, there are more than 40 emerging markets in the world, with China and India considered the largest.  The ASEAN – China Free Trade Area, launched January 1, 2010, is the largest regional emerging market in the world.  The stock markets of any given emerging market tends to be more volatile than a more established market.

Frontier markets are a subset of emerging markets, and includes countries that have lower market capitalization and liquidity than more developed emerging markets.  They are generally expected to increase in liquidity as their markets further develop, and will exhibit similar risk characteristics as larger, more liquid developed emerging markets.

Classification of countries as either emerging or frontier markets can vary.  The two main classification systems are provided by FTSE Group and MSCI Barra.  FTSE further classifies emerging markets as advanced or secondary by gross national income (GNI).  Advanced markets include upper middle income GNI countries with advanced market infrastructures or high income GNI countries with lesser developed market infrastructures.  Secondary markets include upper middle, lower middle and low income GNI countries with reasonable market infrastructures and significant size, and some upper middle income GNI countries with lesser developed market infrastructures.

The following chart identifies where countries are classified, based on system.  Notice that some countries are included on one system but not the other, and some are considered emerging on one system, but considered frontier on the other.

Impact on World Economy

From 2003 to 2009, emerging markets grew from 4.5% to 13% of the weighting in the MSCI All Country World Index.  At the same time, the US percentage dropped from 52.5% to just under 42%, while all developed countries dropped from 95.5% to 87%.

In terms of ranking, in 1987, only Brazil ranked among the top 10 nations by GDP weight, landing at # 8.  By 2008, China entered the mix landing in the # 3 spot.  By 2030, it is projected that BRIC countries (Brazil, China, India, Russia) will account for almost 25% of world GDP.

According to global management consultancy McKinsey & Co. in April 2011, seven emerging economies – China, India, Brazil, Mexico, Russia, Turkey and Indonesia – are expected to contribute about 45% of global GDP growth in the coming decade.

Impacts on Emerging Markets Performance

Emerging markets tend to exhibit higher volatility, and the quality of economic and financial data from emerging countries tends to be less robust than that of developed markets.  Performance can be impacted by politics, socioeconomic developments and environmental factors.  Investments in the Middle East took a hit due to the political unrest that started in Egypt in early 2011 and spread to neighboring countries, while oil investments surged upwards.  Investments in Japan also took a hit due to the March earthquake and tsunami.  In the case of the Japan earthquake, the markets of South Korea experienced an increase, led by automobile makers such as Hyundai and Kia who were poised to fill the void left by Toyota’s forced manufacturing hiatus.

The Future of Emerging Markets and Benefits to Portfolios

Emerging markets are growing rapidly, more so than in developed markets.  In select frontier markets, growth is even faster, and also exceeds the growth in developed markets by a wide margin.  However, historically we’ve seen a low correlation between GDP growth and stock market returns.  Correlation between GDP growth and emerging market stock returns for 16 countries between 1990 and 2002 is negative .37, and moves to zero from 1950 to 2002.  In 21 emerging markets, stock returns and GDP growth had a correlation of negative .298 from 1999 to 2007.   However, growth is not only economic but also expansion in the breadth and depth of capital markets.  Some markets are becoming larger and more liquid, a plus for investors concerned about investment movement restrictions in emerging markets. Positive fundamentals could potentially enhance performance as well.

One risk is that things can change very quickly.  Due to the regional crises in the Middle East and Japan in February and March, we saw significant investment outflows from emerging markets; a scant two months later, the trend reversed.

What we are beginning to see is increased cooperation among the larger emerging markets.  For instance, Brazil and China recently entered into a number of economic and investment accords in areas such as energy, agriculture, defense, and technology.  South Korea and Peru finalized a free trade agreement aimed at boosting trade and economic relations.  Also, the larger emerging markets such as the BRIC countries are becoming more like developed markets, as they are investing into frontier markets in the areas of construction, transportation, telecommunications, banking and finance.

While individual emerging markets can be more risky than other investments, broad diversification lowers risk.  A properly diversified portfolio that includes emerging markets may see less volatility than one invested solely in developed markets.

During our research we found that the best correlation for the emerging markets fund VWO, which best tracks the MSCI EM Index and FRN, representing the BONY EM Frontier Index was US Small Caps. We often hear that Emerging Markets are tied to commodity prices. We found the following:

Comparison of Specific Emerging and Frontier Markets ETFs

Funds chosen for analysis include emerging market and frontier market ETFs with over $100 million in assets under management.  A total of 14 emerging market ETFs and one frontier market ETF were considered.  The oldest such ETF is nine years old; most are in the 3-4 year range, while a few were established within the last year.  Of the 15 funds, there is very little duplication of associated benchmark indices.  A summary chart of all funds can be found in the Appendix.

Hypothetical Model Portfolios

While a truly diversified portfolio will include emerging markets as a portion of the total investment holdings, for the purpose of this report, we created a model portfolio with purely emerging market ETFs.

To start, we narrowed the list of ETFs to consider to five, based on high Sharpe ratio, low expense ratio and diversification (more than 100 holdings):  EEM, VWO, EWX, DGS, and DEM.  We also included FRN because it is the only one of its asset class.  When looking at the three-year Sharpe ratios, all but FRN were in the top five among all funds (FRN being too new to have a Sharpe ratio).  EEM, VWO, EWX, DGS and DEM had significantly higher Sharpe ratios than the rest of the funds.

EEM and VWO are similar and provide a large-cap blend investment style and broad country diversification.  EWX provides exposure to large- and mid-caps, with concentrations in Latin America, and Middle East/Africa.  FRN is similar in exposures to EWX, just in the frontier markets.  DGS provides a mid- and small-cap value style with concentrations in developed and emerging Asia and Middle East/Africa; it has a dividend yield around 3%.  DEM invests in high-quality large-caps and has a dividend yield in the 3-4% range.

As for regional concentrations, EEM, VWO and DGS all have significant concentrations in Asia.  FRN, in contrast, has large concentrations in Latin America.

When we look as specific countries, EEM and VWO have virtually the same concentrations in the same countries of China, South  Korea, Taiwan,and Brazil.  DGS shows similar preferences for Asia, with Taiwan, South Korea, and Thailand, with South Africa thrown into the mix as well.  FRN’s top countries, on the other hand, are the Latin American countries of Chile, Columbia, and Argentina, as well as Egypt.

At what age is it better to save for retirement?  In your early years of working, money is probably tight.  It’s hard to find the extra money to save towards such a far end goal, when the rent needs to be paid, and you have a more immediate need to build emergency savings.  You might think that waiting until later in life to save for retirement, when your income is likely higher and you can more likely afford to do so, would be the best option.

Or maybe not.

Take Frankie and Johnny.  Both are age 20 and have decent jobs.  Frankie and Johnny want to have money for retirement, but take two different savings tracks.  Frankie wants to save now, when she has fewer expenses; she anticipates she may have to stop saving as expenses rise.    Even though he has a good job, Johnny thinks his current expenses are too high to justify saving right now; he wants to wait until he can get his income up before saving.

Both anticipate they will save $200 per month, and estimate they will earn 6% on their investments, compounded monthly.  They both plan on retiring at age 65.  The only difference is the point in time when Frankie stops saving and Johnny starts.

The 5-Year Plan

In this plan, Frankie contributes for five years, then stops.  Johnny starts saving after five years, and saves for the next 40.

Frankie contributes at total of $12,000 over the five-year period.  At age 65, she has a retirement balance of $153,665.  Johnny, in contrast, contributes $96,000 and ends up with $400,290.  Johnny contributes in total eight times what Frankie contributes, and realizes 2.6 times Frankie’s results.  Still, $400,290 is more comforting than $153,665.  To match Johnny’s results, Frankie would have needed to contribute $5,708 per month for the first five years; that’s 28.5 times the original $200 per month.

The 10-Year Plan

In this scenario, the pivot point is 10 years. Frankie contributes a total of $24,000 over that 10 year period, while Johnny goes on to contribute $84,000 over the course of 35 years.  At retirement, Frankie has a balance of $267,588.  Johnny has a balance of $286,367.  Johnny contributes in total 3.5 times what Frankie contributes, for only 7% more in his retirement account.  To match what Johnny ends up with, Frankie would have needed to save only 7% more, or $214.04 per month.

The 15-Year Plan

Let’s take this out to 15 years.  Frankie saves a total of $36,000 and ends up with $352,047 at retirement.  Johnny contributes $72,000 and has $201,908 at retirement.  Johnny contributes twice as much as Frankie (in twice as many years), but ends up with 42.6% less.  To match Frankie’s gross balance of $352,047, Johnny would have needed to save 75% more, or $348.72 per month.

A Split Pivot Point

Let’s throw one more scenario into the mix.  Let’s go back to the five-year plan, where Johnny ends up with so much more money than Frankie.  This time around, let’s have Frankie save for 20 years, starting at age 20.  Johnny still waits five years, but then contributes for the next 40.  In this case, Frankie ends up with $414,663, compared with Johnny’s $400,290.  But Frankie only needs to save half as much as Johnny to end up with nearly the same results.

So what does this all mean?

The key point is that the longer you wait, the more you pay, the longer you pay, and sometimes the less you end up with.  This is the time value of money.

It is better to live leanly in early adulthood, even though you typically have less income, because you also typically have fewer obligations and perhaps are more used to being “thrifty”.  Later, when income has risen, so generally have your expenses, and it’s hard to cut your lifestyle down at that point.  Saving early gives you a worthwhile discipline that will always serve you well.

If you have put things off, don’t stress; it’s not too late to put a plan into action.  Just know that you will need to pay more for the privilege.   What is important is to not put it off any longer.  Don’t let time pass your money by.

Financial Aid Options

Parents and students who do not have the financial resources to pay for college themselves may pursue other options for educational funding.  These include scholarships, grants and loans, plus several other options you may not have thought of.

Scholarships

Scholarships are free money.  They do not need to be repaid.  Most are awarded on merit, be it academic, athletic, or other skill or talent.  Some are based on need or disadvantage.  Others are based on connection to an organization.  They are offered by the federal government, some states, the college or university in question, and public and private organizations (which can be for-profit companies or non-profit institutions).  There are literally hundreds of different scholarships that are available, waiting to be tapped.  You just have to find them.   A book or reference guide on the subject can help you with this endeavor.

Grants

Grants are also free money, offered by the same groups as scholarships.  These are generally based on need or disadvantage.  The most widely known grant program is the Pell Grant.

The Pell Grant is a federally funded program.  Millions of dollars are awarded each year on the basis of need.  Most go to households whose incomes are below $50,000 per year.  Pell grants are only available for undergraduate studies, except for post-baccalaureate teacher certification in some cases.  Only one per student is granted per year.  The amount awarded depends on need and costs, whether or not the student is full-time or part-time, and whether or not the student attends the full academic year or only part of it.  It is also determined by the federal budget and the size of the applicant pool, making this grant a relatively undependable source of college funding.

Another grant is the Federal Supplemental Educational Opportunity Grant (FSEOGS).  This grant is for undergraduates who demonstrate exceptional need.  The amount ranges annually from $100 to $4000.  It can be awarded in addition to the Pell Grant.

Loans

Loans are offered by the federal government, some states, and banks.  The federal government may subsidize certain student loans if financial need is demonstrated.

Stafford loans are available for undergraduate and graduate studies.  These loans can be subsidized or unsubsidized, and have maximum amount limits.  Stafford loans have fixed interest rates, and loan proceeds are paid directly to the school.  The student must attend at least part-time.  Subsidized Stafford student loans used to be available through a variety of institutions, but as of July 1, 2010, they are offered only through the federal government.

Subsidized Stafford loans offer a slightly lower interest rate than unsubsidized loans.  Interest does not accrue while the student is in school and during the deferment period.  Payment can be deferred until up to six months after leaving school.  Subsidized loans are based on need and require a FAFSA.

Unsubsidized Stafford loans are available to any student regardless of need.  Interest accrues from the date disbursed, but payments can be deferred while enrolled.  This increases the size and cost of the loan.

The Federal Perkins loan program is available for undergraduate and graduate studies.  This low interest loan is granted by the college or university and reimbursed by the federal government.  This loan is given based on need.  All or part of the loan may be forgiven for certain public, military, or teaching service.

A PLUS loan is a student loan offered to parents of students enrolled at least part-time at eligible institutions.  Interest is fixed at 7.9% (higher than for Stafford loans) for the life of the loan, and begins to accrue from the date of first disbursement.  Repayment plans can vary.  Repayment begins 60 days after the final disbursement, or can be deferred until six months after the student ceases to be enrolled at least half-time.  PLUS loans can be obtained for amounts that cover up to the entire cost of education, including living expenses, less other financial aid.  A PLUS loan is a commitment of the parent, not the student.  Parent must have a good credit history to be eligible.  A PLUS loan is also available to graduate and professional students directly; in this case, the student is responsible for repayment and must have his/her own good credit history.

Private student loans are available through banks and other commercial financial institutions.  Rates, amounts and eligibility criteria can vary.

Work Study

The federal work study program offers part-time work on campus for compensation that is applied towards college expenses.  The compensation paid out by the school is reimbursed by the federal government.  Total payments cannot exceed the size of the federal grant to the school.

Direct Aid from Colleges

Colleges and universities often have their own budgets for scholarships and other aid, often provided by alumni gifts and endowments.  Criteria for award and amounts vary by school.

Armed Forces

Examples of funding sources available through the armed forces include the GI Bill, ROTC scholarships, and Congressional appointments to a military academy.  These require a specified term of service.

Employers

Employer sponsored scholarships are awarded to dependents of the employee.  For the employee himself/herself, employers may provide up to $5250 per year reimbursement for employee educational expenses not related to the employee’s job function.  This reimbursement is not reportable as income to the employee.

Applying for Financial Aid

For many financial aid programs, families need to complete the FAFSA form (Free Application for Federal Student Aid).  This form should be completed as early in the tax year as possible, and needs to be submitted to the U.S. Department of Education.  After review, the department issues and SAR (Student Aid Report) and copy of the EFC (Expected Family Contribution) to each school listed on the FAFSA.

The EFC is the amount the family and student are expected to personally contribute towards the cost of higher education.  The EFC measures family financial strength, and is used to determine the eligibility for federal student aid.  Based on a 1965 formula, financial aid need equals cost minus EFC.

Personal Funding

There are several options available for parents or other individuals to personally pay for a student’s college education, either in whole or in part (the expected family contribution).  Tax treatment differs for each option, and should be carefully evaluated to determine the best option(s).

Private Investment Accounts

Private investment accounts are typically the least tax efficient option for funding education.  The advantages include no maximum on the amount contributed, absolute control over use, and unlimited flexibility in how assets are managed.  However, with each disbursement, earnings and capital gains taxes are realized.  This disadvantage with private accounts is often larger than the disadvantages of lower flexibility, contribution limits and control of assets of other options.

Custodial Accounts (UTMA/UGMA)

Custodial accounts allow minors to have assets titled in their name but managed by an adult (the custodian) until age 18 or 21, depending on the state.  At the age of majority, the child gains full control of the assets.  The advantages are that the custodian maintains full control until the child reaches the age of majority, and earnings generally get more favorable tax treatment than parents’ private accounts.

At the age of majority, however, the child assumes full control of both the investment decisions and the disbursements.  The child can choose how to spend the money – either on college (as earmarked by the donor) or on anything else the child wishes.  Also once set up, the parent cannot give assets to another child.

Contributions to a custodial account are considered gifts and are therefore subject to gift tax rules involving maximum limits to avoid the gift tax.  If the donor and the custodian are the same person, the donor/custodian is considered to have sufficient control over the assets so as to have the assets included in the custodian’s estate until the student’s age of majority.

Coverdell Education Savings Accounts (ESAs)

Coverdell ESAs operate much like IRAs in terms of tax-deferred treatment; however the maximum contribution per year is currently limited to $2000 per year.  Earnings are exempt from taxes if used for qualified educational distributions; therefore, earnings grow faster than in private accounts.  Qualified distributions include expenses for primary, secondary and higher education.  Individuals direct the investments.  All assets must be distributed by 30 days after the student reaches age 30.  Participation is limited based on income; higher income earners are not able to use this type of account for education savings.

529 Plans

529 plans are another alternative for tax-advantaged savings, and are the most popular.  Set up by states, 529s offer higher contribution limits, and greater donor control over the assets.  There are no adjusted income limits.  However, if allowed by income, savers can do both the 529 and the Coverdell.

There are two basic types of 529 plans.  The first are 529 savings plans.  In these plans the contributor makes contributions and selects investments from those offered within the plan.  The donor takes on the investment risk as to whether or not there will be enough money to pay for school.  The second type is prepaid tuition plans.  In these plans the contributor makes contributions to cover future higher education expenses.  Amounts are determined by a number of factors, and there are no investment options to choose from.  In this case, the school/state takes on the investment risk.  If the student attends an in-state public school, he or she does not have to worry if there will be enough money to pay for college.

In either plan, sponsorship is limited to eligible state programs and eligible private institutions.  They can be set up by the state/state agency or by the educational institution.  States offer savings plans or prepaid tuition plans.  Schools only offer prepaid tuition plans.

Contributors may be family members or non-family.  Contributors are able to change the beneficiary, but only to another family member of the beneficiary (prepaid plans may adjust the premium in this case).

Students must be enrolled at least half-term.  Eligible institutions include most colleges, universities, community colleges, vocational schools, and even some foreign institutions.

Contributions are made in cash.  This prevents attempts to avoid capital gains taxes by contributing appreciated assets.  In the case of 529 savings plans, rollovers are allowed from other 529 savings plans, UTMA/UGMA and Coverdell accounts, or certain US savings bonds issued after 1989.

Contributors are allowed to invest in a 529 savings plan from most any state regardless of the state in which the student resides (some states do restrict this).  However, it may be of some tax benefit to choose the plan in the home state. The contributor would need to compare the tax benefit of the home state’s plan with the investment opportunities available in another state’s plan.

Contributors are not allowed to individually direct investments outside of the choices available within the plan.  Assets cannot be used as collateral to secure a loan.  Plan contributions are limited to the cost of five years at the most expensive schools in the U.S.

There are several advantages to these plans.  Investment earnings are tax deferred, accelerating growth potential.  Qualified distributions are not taxed.  In some states contributions are tax deductible.  Contributors are able to take advantage of accelerated gift tax treatment, which equates of tax free transfers in one year up to the annual gift tax limit times five.

If withdrawals are not used for qualified educational expenses – tuition, fees, books, supplies, equipment, or room and board – earnings will be subject to ordinary income taxes plus an extra 10 percent penalty.  An exception to the penalty only is made in the event of death or disability of the beneficiary or receipt of a scholarship; ordinary income taxes still apply on the amount withdrawn.  In the case of a scholarship, this penalty exception only applies to the amount of the scholarship.

For prepaid tuition plans, the contract is purchased for a specific price, which defines the specific costs for a specific student.  These plans may guarantee to pay tuition and fees at in-state public schools.  For out-of-state or private schools, these plans typically pay the average of in-state public tuition; the family must make up the difference.  When the student starts school, the plan pays out at the level required at that time.

Prepaid contract expected contributions are based on a number of factors:  current cost of in-state public school tuition and fees; age of prospective student; number of years of education to be purchased; time period over which contract will be paid (i.e., lump sum or 10-year installments, etc.); and actuarial assumptions on how much tuition and fees will be in the future and future return on investments.

Series EE Government Bonds

These bonds are issued at half of the face value.  Interest accrues each year until maturity.  Interest can be partially or fully federal tax-free when used to pay qualified higher education expenses in year of maturity.  Bond prices range from $50 to $10,000.

Use of Series EE bonds have certain requirements. The purchaser must be 24 years old on first day of the month purchased.  Bonds must be registered in one or both parents’ names.  Married parents must file jointly.  Deductibility is phased out for higher adjusted incomes.  Both principal and interest must be used for qualified expenses.

Trust Accounts

Instead of a custodial account, a 2503(c) trust can be established to pay for educational expenses.  The trust is irrevocable once funded.  The student is entitled to the principal at age of majority.  Income can be retained or distributed; if distributed, amounts are taxed at the child’s tax rate, and is therefore subject to the “kiddie” tax. Contributions qualify for the annual gift tax exclusion.

IRAs and other Parental Retirement Plans

Yes, it is possible to sacrifice your own personal retirement needs to send your kids off to school in style.  While you certainly would not use funds truly earmarked for your own retirement, you might consider opening an IRA for yourself that you personally designate as a college fund.  Remember, this is in addition to what you are saving for your retirement.  For employer-sponsored 401(k) and other retirement plans, loans and distributions are allowed for educational expenses.

Both traditional and Roth IRAs can be used for this purpose.  All IRA/Roth rules apply.  However, for a traditional IRA, amounts used for qualified high education expenses are exempt from the 10 percent early withdrawal penalty; ordinary income taxes on the full amount withdrawn still apply.  For a Roth IRA, such expenses are also exempt from the 10 percent early withdrawal penalty.  Ordinary income taxes are paid on earnings only.

Impact of Personal Funding on Financial Aid

Some forms of personal savings can impact the eligibility for financial aid.  Whole books are written on this subject of how the FAFSA form gets evaluated, and we recommend that you take advantage of these resources.   Here are a few major items to keep in mind, though:

Ownership of the assets has a great impact on the level of financial aid that gets awarded.  Generally, it is better to have assets listed in the parent(s) names, as the expected contribution is calculated lower for parental assets than for student assets.  The advantage of putting assets in the student’s name is to take advantage of the student’s lower tax bracket.  However, this generally does not compensate for the amount of potential financial aid lost in doing this.  Also, when the assets are in the student’s name, they have discretion on how the money is spent, and it may not be for education.

Retirement funds, pensions, tax-deferred annuities and life insurance are not considered assets in the need-based formulas.  However, this exclusion only counts for contributions/premiums made before the base year (year of evaluation/first enrollment).  Small businesses owned and controlled by the family are also excluded.

The only debt that counts in the needs analysis is debt secured by property; credit card debt is not included.  So if you owe a lot on credit cards, it would behoove you to pay it down to protect your cash flow once you are paying for college.

Custodial versions of 529 savings plans, prepaid tuition plans and Coverdell education savings accounts are disregarded if the student can be claimed as a dependent.

If you are saving money for a big dollar purchase, make that purchase before submitting the FAFSA.  Otherwise, that savings must be reported on the form, and it is assumed that money will be used to help pay for college.  Related to this, student assets should be spent before spending parental assets.  So when sending Junior off to college and he needs a vehicle, let him buy his own car.

Income Tax Benefits

There are several tax credits or deductions that may be available when using personal funding to pay for college.  The American Opportunity Tax Credit applies to 100 percent of qualified tuition, fees and course materials for self or a dependant, up to a maximum of $2500 per student (up to $2000 plus 25 percent of the next $2000).  The student must attend at least half-time.  This tax credit can only be claimed for the first four years of higher educational expenses.  Other credits or deductions cannot be claimed in the same year.  This credit is phased out for higher adjusted income levels.

The Lifetime Learning Credit applies to qualified expenses at qualified schools for at least part-time studies to improve or upgrade job skills.  This credit is limited to a maximum of $2000 per family (20 percent of the first $10,000).  This cannot be claimed with others in the same year, and is phased out beyond certain income levels.

Interest paid on private or government-sponsored student loans are deductible from gross income to a maximum of $2500.  This deduction is phased out beyond certain income levels.

Calculating College Costs for Personal Funding

There are several steps to calculating college costs.   But first you need to identify several pieces of information.

Information Needed

The first piece is to determine what scale of college you’d like to fund.  Do you want to send Juniorette to an Ivy League school, or will the local community college suffice?  What about a state school versus private college?  In-state versus out-of-state?  The cost per year can vary widely depending on your preferences.

Current costs for the preferred type of college are easy to obtain.  You then need to make some assumptions as to how much those costs are likely to increase each year.  The usual college cost inflation rate used is 6 percent.

The next piece is to identify how long you have until funds are needed, and how many years you’d like to fund.  Age of the beneficiary answers the first question.  The second involves whether or not you want to pay for just an undergraduate education, or if you’re willing to pay for a masters or professional degree.

The fourth piece is to determine how much you can afford to save, and how much you have saved already.  This is a budget function. You may or may not be able to save the full amount you’d like to save.  You also need to incorporate the current value of any assets already saved, and to estimate an annual return on assets.

The fifth piece is to consider what kind and what level of financial aid you expect Juniorette to receive.  Expected financial aid would reduce the amount you would need to personally save.  As stated before, some forms of personal savings can impact financial aid eligibility, and you would need to carefully take this into account in determining where to put your money.

The Actual Calculation

All this information is used in the actual calculation.  The first step of this calculation is to determine the first year of college costs in the year of enrollment, based on the value of the cost at the time of enrollment adjusted by the annual cost inflation rate between now and then.

The second step is to determine the amount of capital needed to fund the number of years of college.  This step uses the amount obtained in step one and an adjusted rate of return that incorporates the estimated investment return and the expected cost growth rate.

If any assets are already accumulated, we then solve for the future value of those assets for the year those assets are needed.  This amount is subtracted from the amount obtained in the second step to determine the net amount needed to save.

The last step determines the savings needed now to pay for these future costs.  The calculation can be solved for a lump sum amount to be invested, or for a monthly savings program.

A good financial advisor would be able to help you with these calculations.

Conclusion

College is an expensive endeavor, and it becomes more and more expensive each year.  However, with careful planning, you’ll be able to send your child to college without sweating, at least about the paying for it part.  You will still need to nag about grades and extra-curricular activities.  Sorry about that, and good luck!

Best Execution is a very difficult metric to measure since it is such a subjective benchmark. In a “thinner” ETF with a wide spread, such as MNA (IndexIQ Merger Arbitrage), you have a 20 cent spread and very low volume. If you buy on the offer, or sell at the bid, this would be construed as “best execution”, but a position bid (where your broker fills you on the whole order, immediately, at one price) should fill you within the NBBO. (See 43,190 MNA sold on May 25th within the spread). If you consider beating the VWAP/TWAP to be “best execution”, what happens when you beat VWAP/TWAP by 5 cents but have 20 cents of market impact in beating the VWAP/TWAP? For many investors these dilemmas are solved by trading exclusively with their custodians or getting position bids. So, what is the best way to trade ETF’s and achieve Best Execution?

While algorithmic styles such as VWAP/TWAP have been considered as acceptable practices by many investors, many advisors and custodians have sought to minimize their trading costs and market impact by seeking position bids on their trades. The argument that has been made is that by sourcing liquidity and finding a counter-party to “put up the trade” at one price, the investor is getting best execution. While this may be true in some regards, such as the MNA trade example above, in many cases this is an extremely ineffective way to trade, and is the polar opposite of best execution.

The examples of when position bids achieve less than “Best Execution” and why. Selling In A Rising Market/ Buying In A Falling Market:

Since most ETFs (there are caveats depending on if the ETF is domestic/international equity based, fixed income, commodity, or otherwise based) trade around the IIV (Indicative Value) of the underlying basket of securities, asking or taking a position bid for a sell order in a rising market not only takes you out of the market at significantly lower prices than you can achieve but also creates a volume spike that skews your benchmarks. Conversely, taking a position bid to buy an ETF in a falling market only achieves an immediate execution at a worse price than you would receive if you waited a few more minutes. While all of the above would seem to be very obvious to an educated investor, there is still a hidden side of the position bids that impacts an investors’ execution. This would be “Rebates” or “Payments for Order Flow”. The ETF Industry relies on Authorized Participants (AP’s) and Market Makers (MM’s) being enabled to trade the underlying basket of securities in the ETF and converting the underlying basket to ETF shares for the client. In many cases, these AP’s and MM’s will pay a rebate to the executing broker as an enticement to get the order. This rebate is added into the client price, so the investor does not see the rebate being paid out, but it is baked into the execution price. For example, if you buy 50,000 shares of XYZ as a position bid and your execution price is 25.69, and your broker received a penny rebate, then your buy order would have been filled at 25.68 (or less as discussed later) and you paid the extra penny rebate through higher execution costs, as well as your broker commission. This does not only affect institutional customers such as Investment Advisors, but retail customers as well.

If you are a retail investor and trade through your custodian, and your custodian receives rebates on your orders, while you do not pay a per share commission, your execution price is still impacted by the rebate that is baked into your fill and paid to your custodian. As a retail investor buying smaller share amounts the cost of paying a rebate is not as great as for institutional investors, but the costs for Institutional Investors is much larger than just the rebate.

Penny Assumption

These examples assume that a client is paying only a penny a share as a rebate back to the client. While that may be the case, the price received may not only be skewed by a penny. For example, when pricing an ETF for position, some firms will have different pricing for rebated versus no rebated orders. In selling MNA an AP indicated a price to sell at 25.25 without a rebate, but 25.22-25.23 with a penny rebate added in. The price to the institutional investor is not always skewed by only a penny because the broker is receiving a penny rebate. But in the following example we will assume a penny rebate and penny commission to outline the potential costs to the Institutional Investor and their clients: Assuming the Large trade on May 17 was a position bid with a rebate Institutional Investor sells 3.4 million shares of EWY as a position bid around 11:12. The bid is about 63.75 and the order is filled at 63.60. If the broker was rebated a penny, and paid a commission on the trade, they received $68,000 in compensation for the trade with the investor paying $34,000 and a minimum of $34,000 in a lower execution price. Assuming the price to the client was only impacted one penny for the rebate, that client lost 1.57 basis points on that trade, not including the fact that there was 15 cents of market impact. The ETF closed at 63.95 that day, and the Institution in essence paid 2 cents per share to execute the trade. I’m sure the Institution considers their fill to have met Best execution, but in the above scenario it would have been AT LEAST 1.57 Basis points away from best execution, andmost likely over 3 basis points away from where it should have been executed. This is a high dollar value stock, where the basis points missed is going to be lower, can you imagine the number of basis points you give away to rebates on lower priced stocks? Or the cumulative result of losing 3-5 basis points on every trade you do for a year. You would lose 3-7% off your annual performance just because you paid your broker or custodial desk, rebates on top of commissions. That is 3-7% of your assets that you do not get paid on, and a reduction in your performance number when you are trying to grow your business and attract more assets. With all of these examples, how can an investor truly achieve best execution? For one, make sure your custodian goes to counter parties for pricing and does not receive a rebate for the flow. If trading outside of your custodian, make sure your broker informs you of the rebate they received on the trade (if any), and do not trade exclusively on position bids. Your broker is there to work for you. Make your broker seek best execution through the marketplace, over time and with position bids if necessary as a combined strategy to get you—the client—the best price, not to pay the broker twice as much in compensation. Recapturing basis points through better executions is the broker’s job, not to double your fees paid to the broker. You built your business and you are the one who should reap the greatest rewards from it. It will benefit you, the advisor, in the long run through better performance numbers, being easier to attract new assets and having a larger AUM.

Scott Freeze is the President of Street One Financial. Scott has been involved in ETFs from both a trading/execution and a product strategy standpoint since the beginning of the decade. He brings his relationships with RIAs and institutional portfolio managers to Street One where he helps construct better portfolios, and recapture basis points that would otherwise be lost in the marketplace, through better trade execution. Scott holds the Series 3, 4, 7, 24, 53, 55, and 63 licenses.

You have done well for yourself.  You’ve watched your pennies, saved aggressively, invested wisely, and now, in your golden years, you have a retirement nest egg that is more than you need.  You have a philanthropic bent – an alma mater you’re fond of, a charity that is near and dear to your heart.  How can you donate to these worthy causes without sacrificing to the IRS more than you think it deserves?

An IRA charitable rollover is one way to do it.  In 2006, Congress enacted the Pension Protection Act.  One item in the act permits individuals to donate – or roll over – up to $100,000 from an IRA to an eligible charitable institution without recognizing those assets as income.  This means, in a nutshell, the amount rolled over isn’t taxed.

Before this act, one would need to withdraw the funds, pay the ordinary income taxes on the amount, and then donate the net proceeds to the charity.  With the enactment of this act, 100 percent goes to the organization.

While this act had an original time limit through the end of 2007, it has been extended a number of times.  The latest extension allows such charitable rollovers through the end of 2011.

There are rules, of course.  Individuals must be 70 ½ or older; this is the same age as when required minimum distributions must begin, and charitable rollovers count towards meeting this requirement.  Only eligible charitable institutions are acceptable.  The rollover must be completed before December 31, 2011, per the new extension.  Rollovers can be made only from IRAs, so if you have money sitting in a 401(k) or a 403(b) still, it would need to be rolled over into an IRA before making the charitable rollover.  And as stated before, rollovers cannot exceed $100,000; amounts more than this will be taxed as ordinary income.

There are also exceptions to the tax advantage of this kind of rollover.  Donor-advised funds are one example.  In a donor-advised fund, the donor makes recommendations as to how the money can be used.  The donor also cannot receive any gift of substantial monetary value in return for the donation.

The tax exclusion is also limited to public charities, for the most part.  To enable a charitable rollover to a private fund to qualify as a tax exclusion, the fund must elect to meet conduit rules in the year of distribution.  This means that the fund must pay out 100 percent of the funds received in its tax year by the 15^th day of the third after the close of that tax year.  This is in addition to meeting its 5 percent distribution requirements.  Private funds elect whether or not to be a conduit foundation each year, so one year a charitable rollover may be eligible, and the next year not, depending on how the fund’s board of directors vote.

For a donation not eligible for the IRA charitable rollover exclusion, the amount of the donation from an IRA is considered a traditional distribution and will be taxed to the donor as ordinary income.   However, the donor can then take the charitable deduction on his/her itemized tax return, which would offset at least part of the tax increase (people who’s donation is eligible for the IRA charitable rollover exclusion are not eligible to turn around and use the amount as charitable deduction on their tax return).  There are limits to this deduction, of course.  The itemized deductions are limited to 50 percent of adjusted gross income for gifts to public charities, or 30 percent to private charities; allowed amounts of itemized deductions are also reduced by 3 percent of the amount that income exceeds a certain threshold.

IRA charitable rollovers are not for everyone. Those who could benefit from IRA charitable rollovers include:  people who don’t need or want to avoid receiving required minimum distributions; people who don’t itemize and would otherwise not receive any tax benefit for donating to charity; those who donate charitable gifts that exceed the 50/30 percent limits on adjusted gross income; people for whom Social Security income is taxable; residents of some states; and those who want to reduce their taxable estate.

If you think a IRA charitable rollover is something you’d like to consider, please consult your tax professional.

The research staff here at Wiser Wealth recently analyzed all the broad based ETFs that track emerging market indices. The staple in Emerging Markets is currently Vanguards VWO and iShares’ EEM. The comparison articles on these funds are endless. One fund that filtered to the top of the Emerging Market ETF list that might be less known is Wisdom Tree’s DEM. We compared it in this article to Vanguards VWO. The following report helps compare the DEM and VWO Emerging Market strategies as well as the results of the last few years.

Many firms develop ETFs to track only one world region, or sometimes only one country.  However, the ETFs that expose themselves to a number of regions are more diversified in their holdings and are typically less risky investments.

There are two ETFs of particular interest due to their contrasting natures:  Vanguard’s MSCI Emerging Markets ETF – ticker VWO) and Wisdom Tree’s Emerging Markets Equity Income Fund – ticker DEM).  VWO has been widely used in part due to the size of the fund, holding $48.67 billion in assets. It also has a trading volume of 13,117,869 and a 30-day average bid-ask spread of $0.01. All of these things combined would give VWO a good tradability grade. In contrast, DEM is a much smaller fund with only $1.59 billion assets under management, 300,901 in trading volume, and a $0.50 bid-ask spread. Both ETFs are trading at a premium. Recently, VWO is trading at a 0.676% premium while DEM is higher at a 1.557% premium.

Past Performance

The apparent bias for VWO over DEM cannot be explained by a superior performance.  According to Morningstar reports released 5/31/2011, DEM performed better than VWO.  Since VWO’s inception in May 2005, it has spent every year in the bottom two performance quartiles for its category. Although DEM can only fall back on three full years of historical data since its inception in July 2007, it has shown a more impressive finish. It made a top-quartile placement in 2008, suffering a dip to the second-lowest quartile in 2009, and recovering to the second-highest quartile in 2010. The graph below depicts the actual performance of the two funds against each other.

Country and Stock Diversification

As already mentioned, the greater diversity, hypothetically, means less risk. DEM, the arguably smaller of the two, has 628 total stocks in its holdings, while VWO holds 854 total stocks. The following tables show a percentage breakdown by country and by sector of each ETFs stocks.

VWO is heavily weighted in Asian countries, both emerging and developed, and has a little less than one-quarter of its holdings in Latin America.  DEM has given one-quarter of its holdings to Latin American, another quarter to Asia developed, and around one-fifth each to Europe and Asia emerging.  If a current portfolio already favors one of these regions, it may be of benefit to add the fund that will result in a more diversified regional balance.  Some reports speculate that Latin America emerging markets, particularly Brazil, may have increasing influence on the world’s GDP in the next 5-10 years.

Market Capitalization

Another area to consider when trying to balance and diversify a portfolio is market capitalization, or size of holdings. Both VWO and DEM have the majority of their holdings in large cap companies.  However, VWO has allocated 84.45% of its stocks in giant and large cap companies, while DEM only has 69.89% in giant and large caps.  VWO has little mid and small cap exposure, making it susceptible to downturns in large cap company market prices.  DEM has allotted 21.25% of its stocks to be held in mid cap companies, and 8.85% in small caps.  Smaller cap firms have the potential for rapid growth, but with added risk.  Mid cap companies offer greater stability than small caps due to size, and higher growth potential that large caps.  We also find that large cap emerging market companies are more closely aligned with global economies where mid and small cap companies selling locally are somewhat shielded from global issues. DEM offers better protection than VWO in providing more balanced exposure among all market asset classes.

Analytics

Risk and reward can be measured by standard deviation and Sharpe ratio.  The higher the standard deviation, the higher the risk.  Based on a three-year period ending May 31, 2011, the standard deviation for VWO is 32.59, while DEM stands at 26.52.

The Sharpe ratio helps determine if there is enough reward to make the risk worthwhile.  The higher the Sharpe ratio, the more worthwhile the risk.  As of May 31, 2011, VWO had a three-year Sharpe ratio of 0.18, while DEM had 0.42.  Based on these numbers, DEM offers a higher reward potential for the risk taken.

Indexes and Style

VWO and DEM track different indexes, in different ways.  VWO tracks the MSCI Emerging Markets Index, which examines economic development, size, liquidity and market accessibility, and then weights its holdings based on their market capitalization.  DEM has created a unique mix of companies by following the WisdomTree Emerging Markets Equity Index, which is actually assembled based on the highest 30% of dividend-yielding stocks from another index, the WisdomTree Emerging Markets Dividend Index.  DEM offers some protection from the regular volatility associated with the emerging markets through dividends.  As of August 1, 2011, DEM reports a distribution yield of 6.18% (calculated based on the last divided multiplied times four), which is much higher compared to VWO with a 1.680 distribution yield (calculated based on the last four dividend payments).

Summary and Conclusions

In summary, VWO has a longer history and larger assets under management compared to DEM (roughly a 50/.1.5 ratio).  It has a higher trading volume and lower bid-ask spread.  VWO has a relatively higher number of holdings.  However, VWO performance has trailed that of DEM.

VWO is heavily concentrated in Asia, both emerging and developed, while DEM is more evenly spread among four emerging market regions.  VWO also has a significantly high concentration in giant and large cap companies, with miniscule amounts in mid and small caps.  DEM includes twice as much concentration in mid and small caps, as compared to VWO.

VWO has higher standard deviation than DEM, with lower Sharpe ratio, indicating DEM offers a potentially higher reward for the risk undertaken.  DEM also includes a much higher dividend.

For investors looking for liquidity or to add more Asian investments to their portfolio, VWO would be a good choice.  For investors looking for greater diversity in region, market cap and style concentrations, DEM would be the better choice.  From a pure analytical perspective, DEM offers potentially better return on the investment.

Elizabeth Jones, Intern Research Analyst and Sonja Gonzalez, Financial Advisor contributed to this article.

What is the individual investor to do in these volatile times? I would urge you to do nothing IF your portfolio is properly allocated. Why? Investors tend to do poorly when they react to what the market does instead of preparing for what has historically happened over the many years of market history.

Reactionary behavior creates poor performance, thus bad investments. Data from Morningstar indicates that investors tend to buy investments high and then sell investments low. We see this through inflows and outflows in the stock market. The largest inflows come at historical market peaks while the largest outflows come at historical market bottoms. To make matters worse, those outflows from stocks flow into bonds, which are at their historical highs. This seems like a simple, commonsense problem, but each time extraordinary events happen in the stock market, people will ultimately say, “This time it’s different.”

John Templeton, a mutual fund pioneer and asset manager said, “The most dangerous words in investing are ‘This time is different.’”

Going forward into the unknown, investors will make money by creating a wise investment strategy and sticking to it. Good investment strategies may still have time periods where performance lags in times of crisis. For example, during the rise of the tech bubble at the end of the 90s, a good investment strategy lagged the performance of the tech stocks people were using to get rich. However, the good investment strategy didn’t crash like many of the tech stocks. What is a wise investment strategy? When investing, you want to maintain a diversified portfolio, keep cost low and always invest for the long term. Do this by choosing an asset allocation of stocks, bonds and commodities that matches your age and or objectives. Be wary of stockbrokers; they are there to make a sale, not provide advice for individual needs. People in this line of work usually talk fast and may make you feel good, but in the end, you are the one stuck with paying a Cadillac price for a Chevy Nova. Choose index funds over mutual funds. Finally, when the market becomes volatile, stick to your allocation.

There are many free resources to help an investor choose a proper allocation by age or risk tolerance. Morningstar, S&P and Down Jones all have their own allocations that are available on the web.  If you are 15 years away from retirement and a moderate risk taker your portfolio can look something like the following.

A Person approaching retirement or looking for more income growth opportunities can adjust the allocations above and include investments focused on dividends. Wiser Wealth Management uses a model similar to the one below.

Current 12 Month Portfolio Yield 3.9% One Key difference between the most successful investors and everyone else is the ability to do the opposite of your instincts. Look at your portfolio and pick an allocation for today, meaning do not look at the past portfolio performance but simply focus on where you need to be in relation to risk going forward. You cannot change the past, but you can change how your portfolio reacts to major down swings in the future.  When the next correction happens, ignore that temptation to move to cash and stick with you portfolio that has been built to weather the storm.

Investors should never chase yield, meaning simply buying the highest yielding product with no concern about who is paying the interest. No company pays a high yield on its bond simply because they just want to be nice. Yield is based on the risk of getting your money back. A US Treasury Bond pays a lower yield because chances of getting paid back are nearly 100%. If you lent money to General Motors several years prior to bankruptcy, you got a very high yield, but then lost your entire principal after the government takeover. Lending money to Coke would fall in between the US government and GM. Coke is not as secure as Uncle Sam, but the risk of Coke going out of business in the near term is not realistic either.

A way to increase portfolio yield and not increase overall risk is to reallocate a portion of your equity holdings into dividend-paying domestic and international index funds and preferred stock.

Every conservative or income growth portfolio has some exposure to equities. A sample income growth model is listed in the table below. The portfolio is made up of 30% equities, 60% bonds, 3% commodities and 10% cash. The current 12-month yield is 2.7%, with a 5-year 5.78% annualized rate of return through December 31, 2010. The 5-year standard deviation is 9.6. The portfolio is made up entirely of index funds. Over the same time period, the S&P 500 had a standard deviation of 18 and a return of 2.29%.

Below, I explore the options in using exchange-traded funds to supplement the equity allocation in the above portfolio.

DOMESTIC DIVIDEND ETFs

Simply adding exchange-traded funds (ETFs), like Vanguard’s Dividend Appreciation Index (VIG), to a portfolio can increase a portfolio’s yield. VIG holds over 140 large cap companies that have increased their dividends consecutively over the last 10 years. The fund yields 2%; this is 10% higher than the S&P 500. According to Morningstar, VIG is allocated with 50% giant, 35% large, 12% mid and 2% small cap domestic exposure. VIG’s expense ratio is 23 bps. This fund has $4.6 billion in assets under management. As of 12/31/10, VIG had a 3-year rate of return of .2% with a standard deviation of 18.69.

State Street’s SPDR S&P Dividend ETF (SDY) tracks the S&P Dividend Aristocrats Index, which holds 60 S&P 1500 companies that have increased their dividends every year for the last 25 years. The companies must have a market cap of at least $3 billion and an average trading volume of $5 million for at least six months. The fund currently yields 3.35%. Morningstar breaks down this Large Cap Value ETF with 17% giant, 34% large, 39% mid and 9% small cap companies. The expense ratio is 35 bps. This fund has $5.2 billion in assets under management. As of 12/31/10, SDY had a 5-year rate of return of 3.31% and a 5-year standard deviation of 18.63.

The iShares Dow Jones Dividend ETF (DVY) currently yields 3.42%. This ETF tracks the Dow Jones Global Select Dividend Index. The methodology behind this index is to track the top 100 yielding stocks in the Dow Jones US index, excluding REITs.  Morningstar divides this ETF as 11% giant, 37% large, 35% mid and 15% small cap stocks. The ETF has $6 billion in assets under management with an expense ratio of 40 bps. As of 12/31/10, DVY had a 5-year rate of return of -.2% with a standard deviation of 19.02.

Many advisors would consider VIG, SDY and DVY to be the same. However, just a quick study of their underlying index methodology tells a different story. VIG could be used as a core asset allocation strategy to replace value/growth neutral holdings. It should also be noted that this ETF holds only 6% financials.

SDY can be used in portfolios where growth and value holdings are strategically allocated. Traditional large and mid cap holdings could be reduced and SDY used to supplement portfolio yield with equity dividends.

DVY is more tilted towards value compared to SDY and carries more small cap equities. 70% of holdings are in the US manufacturing sector. This ETF could be used as an alternative to SDY, but it is still not an apple-to-apple comparison.

PREFERRED STOCK

Preferred stock is a hybrid between a bond and a stock. I always tell my clients a stock gives them voting rights, but if the company goes out of business they could lose their principal. If you hold the company’s bonds, you do not have a voting right, but you get regular income from the bond and possibly a desk or a forklift (collateral) if the company folds. A preferred stock gets a higher dividend than the common stockholders and preferred shareholders get paid first. The higher dividend is closer to the bond yields and you can get equity-like returns. This, of course, does not mean that preferreds should be chosen over common stock. Preferreds are generally related to financial and utility companies. It should also be noted that, as seen in the chart below, preferred stock did not hold up well during the financial. However, with 7% yields and a financial industry bailed out and healthier, perhaps the future risks of preferreds will be less than the past three years.

iShares S&P US Preferred ETF (PFF) tracks the S&P US Preferred Stock Index. The ETF currently yields 7.32% with an expense ratio of 48 bps. The index is comprised of U.S. traded preferred stocks that meet criteria relating to minimum size, liquidity, exchange listing and time to maturity. The index is calculated with a modified capitalization weighted scheme, with modifications being made to index shares to prevent single issuer concentration and improve index liquidity. The index is rebalanced on a quarterly basis. Virtually all of PFF’s (83%) holdings are in the US financial sector. PFF currently has 220 holdings and $6 billion in assets under management. As of 12/31/10, PFF had a three-year rate of return of 6.81% and a standard deviation of 33.28.

State Street offers SPDR Wells Fargo Preferred Stock ETF (PSK). PSK tracks the Wells Fargo Hybrid and Preferred Securities Aggregate Index. The index methodology seeks to track non-convertible preferred stock and securities that are functionally equivalent to preferred stock, including but not limited to, depositary preferred securities, perpetual subordinated debt and certain securities issued by banks and other financial institutions that are eligible for capital treatment. PSK holds 160 preferred stocks, with $106 million in assets under management. 83% of the ETF’s holdings are in the finance sector; 5% are in utilities. The fund’s expense ratio is 45 bps. This ETF was created on 9/16/2009, thus we have no 3 or 5-year data.

ETF provider PowerShares offers two ETFs covering preferreds. PGX, the PowerShares Preferred ETF, tracks the BofA Merrill Lynch Core Fixed Rate Preferred Securities Index. The index tracks investment-grade preferred securities. The index is rebalanced on a monthly basis. The ETF has 70 holdings, $1.3 billion in assets, a yield of 6.74% and an expense ratio of 50 bps. This ETF began trading on 1/31/08, thus we do not have three-year data.

PGF  – PowerShares Financial Preferred ETF tracks the Wells Fargo Hybrid and Preferred Securities Financial Index. The index captures US listed securities issued by financial institutions. The ETF has 45 holdings, a yield of 7.08%, $1.7 billion in assets and an expense ratio of 65 bps. As of 12/31/10, this ETF had a three-year rate of return of 1.6% with a standard deviation of 39.78.

Each of these preferred stock ETFs is uniquely different, with iShares’ PFF holding the most assets and carrying the title of most diversified. Adding a small percentage of preferred stocks to a portfolio can boost overall yield. Investors should also note the high standard deviation of these indexes/ETFs.

INTERNATIONAL DIVIDEND ETFs

MSCI EAFA has been a staple in investing outside the United States for many years, covering Europe, Australia, the Far East and Asia. Taking another look at dividend weighted or focused ETFs investing in companies outside the US with will help boost portfolio yields.

State Street’s SPDR S&P International Dividend ETF (DWX) tracks the S&P International Dividends Opportunity Index. The index is designed to measure the performance of the 100 highest dividend yielding common stocks and ADRs listed in primary exchanges of countries included in the S&P/Citigroup Broad Market Index. The ETF yields 4.23%, with $343 million in assets under management and an expense ratio of 45 bps. Morningstar indicates that the fund is allocated with 10% giant, 30% large, 58% mid and 0% small cap international exposure. The fund currently holds 101 foreign companies. DWX began trading on 2/12/08 and does not yet have a three-year track record.

iShares Dow Jones International Select Dividend Index ETF (IDV) tracks the Dow Jones International Select Dividend Index. The index tracks the top 100 dividend payers based with country and company weightings, rebalanced annually. The ETF has a 12 month yield of 3.94%, $358 million in assets and is tilted towards international large cap value. Morningstar breaks down the ETF’s 99 holdings cap size as 34% giant, 32% large, 31% mid and 1% small cap. The expense ratio is 50 bps. As of 12/31/10, the ETF has a three-year rate of return of -5.17% with a standard deviation on 31.93.

WisdomTree offers an ETF that tracks the WisdomTree DEFA Index, ticker DWM. The index is fundamentally weighted and measures the performance of dividend paying companies in the industrialized world (excluding Canada and the United States) that pay regular cash dividends and meet other liquidity and capitalization requirements. The ETF is tilted towards international large cap value with a Morningstar reported cap size of 54% giant, 28% large, 14% mid and 2% small. There are currently 636 companies in the ETF, providing the portfolio a yield of 3.24%. The expense ratio is 48 bps and it has $418 million in assets. As of 12/31/10, the ETF has a three-year rate of return of -8.3% and a standard deviation of 26.5.

Reviewing these three options, WisdomTree’s DWM offers the largest diversification and a lower standard deviation. However, the ETF also has the lowest return: -8.3%.

When comparing ETFs or building portfolios using ETFs, the investor often does not have enough history to back test theories and strategies. A way around this is to actually look at the raw index performance. An investor cannot invest directly into an index but it certainly gives him or her guidance as to the expected performance of the ETF. The ETF will not track the index exactly as fees, portfolio optimization and illiquid or poorly priced securities will cause tracking error. Tracking error is something that should always be observed before investing in an ETF.

For the purposes of this portfolio, we will simply focus on yield and risk. Referring back to our original portfolio, we will add 4% of SPDR S&P Dividend ETF (SDY), 8% of the SPDR S&P International Dividend Opportunity ETF(DWX) and 4% of the iShares Preferred Stock ETF (PFF). Our goal is to keep risk virtually unchanged while also increasing yield. In our portfolio, we are willing to have a value tilt in domestic and international large cap and take on a small percentage of preferred stock. The results can be seen on the chart below.

With our changes, yield increases from 2.77% to 3.2%, a 15% increase; 5-year return was up from 5.78 to 6.08%. Overall portfolio risk did increase slightly, but our Sharpe Ratio, a measure used to see if additional risk is being compensated for, increased from .39 to .41.

While investors and advisors may not have chosen the same ETFs used here, the point is to show that a reallocation of equities can increase portfolio yield while keeping overall risk in check.

However, I do want to share with you the blog of an Egyptian-born pastor here in Atlanta. Dr. Michael Youssef is the pastor of the Church of the Apostles (www.apostles.org). He is also the lead voice of Leading The Way, a worldwide outreach ministry also based here in Atlanta. Many of the news anchors that you are listening to, as well as key US government officials, do not understand the root cause of the Egyptian protests.

Here is an excerpt of Dr. Youssef’s recent blog on Eqypt:

“Westerners are looking at what is happening on the Egyptian streets and wondering if it is good for an oppressed people to protest against a semi-dictatorial regime. Most of these young protesters cannot find jobs, and inflation has ravaged the middle class, to say nothing of the gulf between the very rich and the very poor.

On the surface, this is an understandable situation. But before you judge the motives of the protesters, you must know who is really behind those young people on the streets.” Click HERE to read his full blog.

In another blog, Dr. Youssef writes about America’s Role in this crisis:

“The problem with freedom and democracy in the Muslim world is that it is a figment of the imagination that only exists in the minds of Condoleezza Rice and Hillary Clinton.” Click HERE for his full blog.

Dr. Youssef on CNN Television

Youssef on CNN

TRND is an ETN, so the investor is not actually purchasing the S&P 500 or treasuries. An ETN is essentially a promissory note. The investor is taking on the credit risk of the Royal Bank of Scotland, which received a large bailout from Scotland during the financial crisis. TRND is paying a return based on the S&P 500 200 moving day strategy. Should RBS default, the ETN holder will be left with nothing, as there are no assets tied to ETNs.

TRND is the first exchange traded product to have a two tier cost structure. If the S&P 500 is above its 200 day moving average, then the cost is 1% to investors. If the S&P 500 is below its 200 day moving average, thus tracking the short US treasury index, the fee is .50%. Many ETF commentators have balked at this price, but is it really that expensive compared to the alternatives? Can TRND replace other products?

Many variable annuity sales come from investors wanting S&P like returns with no risk. They can’t find this on their own, so they walk into the bank to purchase a CD. The teller then refers them to the bank “financial advisor,” better known as a commission salesperson. This salesperson tells the investor that there is something called a variable annuity available, but that there is a cost involved. Unfortunately, what most investors don’t find out until it’s too late is that the majority of variable annuities are like bags of potato chips, full of air with little substance.

With these annuities, the investor is purchasing an insurance product that allows him or her to invest their cash value into mutual fund-like accounts. The investor can take on the investment risk being guaranteed that their account will grow by 3% or some other predefined amount. This is great in concept, but there’s a catch, of course. The investor has to pay for a death benefit, a fee for the guaranteed account and a fee for each separate managed account within the annuity. These fees are not cheap and add up quickly, deteriorating the real rate of return.

The variable annuity concept is to reduce the overall risk of investing, but is flawed for several reasons. The stock market has never had a twenty year losing record, so over the long term what is the investor insuring against? This makes using a variable annuity as a means for saving for retirement absurd. The fees on insurance based variable annuities are high and oftentimes hidden. Pending legislation may fix this problem, but for millions of investors the damage has been done. Annuities are also a big payday for the commission salesperson. This is why insurance-based annuities charge a high fee to cash them in for seven years or sometimes up to fourteen years. The point here is that the investor is looking for gain with principal protection, specifically protection from financial crises.

This is where TRND can be viewed as a real deal:  in its potential as a replacement for the variable annuity. The variable annuity can cost up to 4% a year in fees, which makes TRND’s 1% fee seems bargain basement. The ETN will also provide protection, triggered when the S&P 500 goes below its 200 day moving average.

Variable annuities are also pushed by salespeople for their tax deferral feature, meaning that the money that is invested in the product grows tax deferred. TRND, because of its tax efficiency, provides the same benefit. Until you sell TRND, there are no negative tax consequences. This is possible because TRND’s price is adjusting to compensate the investor for the performance of the S&P 500 200 day moving average strategy and not actually trading this concept. This provides another advantage, as the investor does not have the trading cost of this strategy or the slippage in the reaction time to get the trades placed when the S&P 500 drops below the 200 day moving average.

When an annuity is passed through death to its beneficiaries, the entire gain will be taxed. The ETN, under the current estate tax laws, will receive a step up in basis, making it more tax efficient than the annuity.

Currently, the annuity will offer a complete portfolio under its umbrella. TRND is just an S&P 500 allocation, but an advisor with creative thinking could complement TRND with other ETFs and ETNs to build the same concept.

TRND seems to be a great replacement for index annuities as well. The term ‘index annuity’ is a play off the positive connotation of index funds. The devil is in the detail here, and I assure you the math does not add up. Most index annuities are based on the price changes in the S&P 500, not the total return including dividends like TRND. TRND can be liquidated instantly with no penalty whereas many index annuities have a hefty ‘get out’ fee up to fourteen years. The guarantee of an index annuity is the protection, and that would be accomplished with TRND as it will move to treasuries for safety. In the long run, TRND would have greater returns and even at the 1% fee, it is still considerably cheaper.

Will TRND replace variable and index annuity sales? Financial advisors who sell annuities are compensated by commission. They only have to prove that the investor is suitable for the annuity, not that the annuity is the best product for the client. TRND does not pay a commission to anyone, thus it will probably only show up in advisory firms that fall under fiduciary responsibility and are compensated hourly, by assets under management or a flat fee. Will these advisors embrace TRND? Time will tell, but at first glance, these advisors will think the 1% fee is outrageous because expensive products generally do not show up at fiduciary firms.

Casey T. Smith

President

Wiser Wealth Management, Inc

This article also appears at http://www.etfmarketpro.com/an-etn-to-replace-a-variable-annuity.html

This article also appears at http://seekingalpha.com/article/244648-rbs-trend-pilot-etn-to-replace-the-variable-annuity?source=dashboard_etfs

Here is a brief summary of the estate planning components of the new law:

*     Originally there was no estate tax in 2010.  Now there is a RETROACTIVE ESTATE TAX on amounts over $5.0 million per individual which will be taxed at a 35% rate.  However, estates of individuals passing away in 2010 will get to CHOOSE between the RETROACTIVE TAX or the “NO TAX” AND IT’S CARRYOVER BASIS.

*       The estate tax will be imposed on individual estates in excess of $5 million in 2011 and 2012 at a rate of 35%.

*       THE GIFT TAX EXEMPTION WILL BE $5 MILLION.  That’s right – MUCH higher than it has been or anyone anticipated it would be.  This will allow for some incredible, once-in-a-lifetime opportunities to create a legacy that will last for generations to come.

*       PORTABILITY IS ADDED.  This is a new concept to many people (and many attorneys and planners too!).  For married couples, any unused portion of the estate tax exemption from the first spouse to die can be used as an added exemption when the second spouse passes.  Watch out though, as there are certain procedures that must be followed when the first spouse passes for this to work.  More to come on that later.  This doesn’t invalidate the need for proper estate planning – just the opposite.

*       THE GENERATION SKIPPING TRANSFER TAX EXEMPTION amount is increased to $5 million as well.  One significant planning Christmas gift that Congress gave us is NO GST TAX THIS YEAR!  If you have a client who wanted to set up trusts for grandchildren or skip persons – you only have until December 31st to do so!!  The Act provides that for any GST made after December 31, 2009 but before January 1, 2011, the GST tax rate is ZERO.  What Congress has done by reviving the GST tax for 2010 and setting the rate at 0% is to acknowledge that GST’s may be made in 2010 and such GST’s are subject to taxation, albeit at a tax rate of 0%.

The critical thing is that the new tax law ONLY LASTS FOR TWO YEARS!  It seems that hasn’t had much play in the media yet, but two years will go very fast, and what planning do we need to do after that?  Still up in the air. Congress came close to letting the law revert back to 2001 law this time, so what will they do next time?  We still are in a state of flux for planning purposes.

Details on how you can support his project are HERE.

The bank and its securities division are in business to make money. This is okay if the compensation among all the bank’s product offerings were the same, allowing for unbiased advice. This is not the case, however, as annuities provide the biggest payday to the bank and its sales force (6-7% average commission for the salesperson).

Annuities are costly because they are insurance-based products that have to make up the cost of what they are guaranteeing you. For example, many annuities guarantee that you will never lose principle, while at the same time allowing you to make money through separate accounts similar to mutual funds. The reality is, and a better explanation of this offer is, that your beneficiaries are guaranteed your principle upon your death, not you. This guarantee had little benefit during the financial crisis if you were at the doorstep of retirement.

According to Morningstar, the average expense of a variable annuity is 2.2%. If you invest $10,000 into an annuity and the market returns 8%, in 20 years you should have $30,882 including fees. If you instead invested in an index portfolio costing you 0.20%, you would have $44,498; that’s $13,616 more!

For younger investors, the annuity is pushed as a tax deferral investment program. A variable annuity will give you that at a cost. For those investors who are maxing out their 401k and IRAs and looking for tax sheltered retirement savings, I have determined that the best vehicle is a taxable, tax efficient portfolio. With the growing popularity of Exchange Traded Funds (ETFs), an investor can build a very tax friendly portfolio at an investment cost less than 0.30%.

Why do consumers fall for the annuity bait and switch? It comes down to the persuasion of the salesperson and the bank playing to the consumer’s fears of investing. Many bank-going consumers would probably never invest in the market at all, deeming it too risky. The annuity appears to have the safeguards that the consumer wants. Just remember that there is no such thing as a free lunch. If it sounds too good to be true, it is. There are many alternatives to managing investment risk that will cost you one tenth of the average annuity. A fiduciary fee only advisor can help you explore these options.

While the article has some interesting points, the ETF industry has quickly proven the thesis absolutely false. How?

Kyle Waller, research analyst at Wiser Wealth Management, Inc, states that “only properly settled shares, in good delivery, can be delivered to the Issuer for redemption.” This basically means that if you purchase an ETF and the trade has settled, then you own the underlying shares. A person simply shorting an ETF does not own settled shares. Therefore, they are taking on the additional risk.

Matt Hougan of IndexUniverse.com stated in his blog, “the [researchers] concern is addressed in the prospectus and Statement of Additional Information (SAI) of every ETF I’ve ever looked at. Here’s what it says in XRT’s [Retail ETF questioned in the article] SAI:”

“An Authorized Participant submitting a redemption request is deemed to represent to the Trust that it (or its client) (i) owns outright or has full legal authority and legal beneficial right to tender for redemption the requisite number of Shares to be redeemed and can receive the entire proceeds of the redemption, and (ii) the Shares to be redeemed have not been loaned or pledged to another party nor are they the subject of a repurchase agreement, securities lending agreement or such other arrangement which would preclude the delivery of such Shares to the Trust. The Trust reserves the right to verify these representations at its discretion, but will typically require verification with respect to a redemption request from a Fund in connection with higher levels of redemption activity and/or short interest in the Fund. If the Authorized Participant, upon receipt of a verification request, does not provide sufficient verification of its representations as determined by the Trust, the redemption request will not be considered to have been received in proper form and may be rejected by the Trust.”

Hougan goes on to say, “This means, when redeeming shares of XRT, you have to say that the shares aren’t lent out. If there’s high short interest in the fund, you’ll have to prove it, or the redemption doesn’t go through.”

Looking at the ETFs that we use here at Wiser, I agree with the assessments of Matt and Kyle. I do not see the Bogan & Connor report as having much merit for concern, especially with the ETFs that we use in our models.

What does concern me is how quickly this report showed up on CNBC without the completion of any fact checks. The report itself lacked the data to prove its points and also contained a few assumptions that are not correct. The report incorrectly assumes that investors poorly understand ETFs because they represent 70% of the canceled trades on May 6^th, now known as the “flash crash.”  A recent article in Barrons points the finger at Waddell and Reed, a mutual fund company, for starting the flash crash. This triggered other program trading, which resulted in a very volatile day in the market.

Not only did CNBC not do some fact checking prior to talking about the Bogan & Connor report, they also did not really portray ETFs correctly. Kyle Waller picked up on this and commented that, “CNBC called ETFs derivative products, which implies a lot of risk to the average investor.  However, the plain vanilla stock ETF truly represents an un-leveraged position in a basket of stocks, deriving its value from the underlying creation unit.  These kind of ETFs are derivatives the same way common stocks are derivatives of the company’s value.”

It seems to me that more people need to attend the next ETF conference. So many advisors, individuals, institutions, media outlets and, evidently, Ph.Ds do not understand this innovative product.

You can read the Bogan & Connor Report, CNBC’s coverage and Matt Hougan’s blog here:

http://ftalphaville.ft.com/blog/2010/09/18/346406/can-an-etf-collapse/

http://www.cnbc.com/id/39309280

http://www.indexuniverse.com/sections/blog/8122-can-an-etf-collapse-no.html

The providers participating in the free commission trades are as follows:

Barclays Bank PLC

iShares

Vanguard

Deutsche Bank AG

PowerShares

Van Eck

iPath

SSGA

Wisdom Tree

On this list of 100 ETFs, there are eleven that Wiser uses in its ETF portfolio models. There is great news for our younger clients who contribute monthly to their accounts.  The iShares asset allocation ETFs are included in this list.  This means that you can invest monthly into AOA, AOM, AOR, AOK or AOC and 100% of your funds get invested without having to pay a $9.99 commission to TD Ameritrade.

Most accounts at Wiser Wealth hold twelve ETFs.  Assuming a rebalance is needed on an annual basis, this new program at TD Ameritrade will save our clients $60 a year.  Clients contributing to their accounts on a monthly basis will save $120 a year, and new clients will save at least $200 the first year.

Wiser maintains five ETF models managed for overall investment risk.  The listing of commission free ETFs will be added to our screening process during our next model review.

However, all advisors are not the same. So, how do you pick one? Below are five factors to take into consideration when making your choice.

CHOOSE AN ADVISOR WITH FIDUCIARY RESPONSIBILITY

Make sure the advisor accepts “Fiduciary Responsibility” in writing. Fiduciary duty separates a financial advisor from a broker, who is held to a lesser ‘suitability’ standard. Fiduciary requires an advisor to put each client’s interest first and disclose any possible conflicts of interest. While a non-fiduciary advisor may have your best interest at heart, his or her tool box of investment choices is littered with products that may not be the best available.

FEE ONLY OR HOURLY COMPENSATION

Would you want to go to a doctor who gets paid by the drug companies? Essentially, that is what can happen if you work with a broker. Brokers are paid through the products they sell. A fee-only advisor has no incentive other than to search for the best investments. The amount that you pay the advisor will vary. Most fee only firms will charge a percentage of assets that they manage. This percentage varies from 0.25% to 1.5%, depending on the services offered. Some firms will work for an hourly rate.

TAKE CUSTODY OF YOUR ASSETS

Never write a check with funds intended for investments directly to an advisor or his or her firm. You should be depositing your investments into a third party custodian such as TD Ameritrade, Fidelity or Charles Schwab. You are essentially hiring the independent advisor to manage the account. This system creates checks and balances, reducing your chance of fraud.

CHOOSE A COMPREHENSIVE ADVISOR

If possible, choose an advisor who offers tax preparation and estate planning services in addition to financial planning and management. Advisors with a complete understanding of the tax implications to their investing strategy and your individual tax situation will save you money in the long term. In addition to tax planning and preparation, working with a firm that understands and offers estate-planning strategies will help you with the big picture. For example, if your assets are over the death tax exclusion when you die, your estate could be taxed at 55%. The bottom line is that if you hear “consult your tax advisor” or “consult your attorney,” you may consider looking for a firm that offers all three.

DO AN ADVISOR BACKGROUND CHECK

In Georgia, just about anyone can hang out a sign that says “financial advisor.” Make sure to look into the advisor’s background. Does the advisor have a finance, economics or accounting degree? Does he/she have any financial designations? (The CFP® designation is important if the advisor comes from a non-financial background, however it does not guarantee anything other than that they studied the core principles of financial planning.)

You can research independent advisors through the following link:

www.sec.gov/answers/iapd.htm

[Independent fee-only advisors cannot be found at a transaction-driven organization such as a brokerage firm or a bank, which depends on volume and not necessarily relationships when it comes to investing. Independent Advisors often own their own firms and are considered “Investment Advisor Representatives” (IAR) of their firms, which are registered as “Registered Investment Advisors” (RIA) with the State of Georgia or the SEC.]

Hopefully, these guidelines will help you choose a financial advisor whom you can trust and best meets your investing needs.

CASEY TYLER SMITH

Casey Smith is President of Marietta-based Wiser Wealth Management, Inc, a fiduciary fee-only investment advisory firm offering investment management, tax planning-preparation, and estate planning. www.wiserinvestor.com

For long term investors, the Vanguard product would bring value. For investors looking to write options on the index, State Street’s Spyder has the most volume. iShares S&P 500 also offers option trading. However, we have found that the volume/liquidity is not sufficient at some prices in this volatile market. The Vanguard fund does not offer option trading.

iShares IVV reinvests its dividends into the S&P 500 until they are due to be paid out quarterly. State Street’s SPY holds the dividends in cash until payout. This creates a dividend drag in SPY. Although a very slight performance difference, the volatility in IVV is slightly higher. Vanguard’s prospectus was not clear, but appeared to indicate that dividends would be held in cash prior to investor payout.

State Street’s Spyder was the first ETF created in 1993 for institutions to park assets in the market until they found individual companies to invest in. Between 2000 and 2004, many new ETFs came to market, creating a new passive investing strategy that was cheaper and covering more asset classes than ever seen before. Active traders also like ETFs for the ease of access, liquidity and reduced company risk that indexing offers.

Vanguard is a powerhouse in the indexing world and has always been able to bring quality index vehicles to the market.  With the addition of ETFs to access S&P indices, we see additional value at great pricing. Price is not the only factor in choosing an ETF, but certainly is in the top five of considerations.

I do not believe that the Mosque in New York should be placed near the World Trade Towers. There are many Mosques in New York, over 100 I believe. So religious freedom is certainly intact and the argument that such freedom is being penalized is not a valid one. It really comes down to symbolism. The World Trade Towers symbolized something very tangible, American Capitalism created from a free people. The Towers reminded us that Americans have the freedom to invest. The freedom the innovate. The freedom to take risks and earn great rewards. The freedom to learn. The freedom to live…. a free people.

On 9/11 a group of extremist Muslims assaulted that freedom. The 9/11 attack was anti free-thinking. Anti Women’s rights. Anti free speech. Anti freedom of religion. Anti the freedoms that have made America and its people the most blessed people in the world.  The Mosque’s name symbolizes victory over freedom and capitalism, victory over a free people that some Muslims call “infidels.”

We are at war. It does not feel or look like the wars of the past, but nevertheless we are at war with people just like those who flew planes into the World Trade Towers. Why do they get to place a victory mosque over the graves of so many Americans whose bodies were never recovered? Why are they allowed to celebrate on American soil the deaths of innocent Americans? Because of religious freedom? If a sect of a religion has declared war on America, their freedoms should be removed and action taken to protect the American people. The Muslims who condemn the actions of 9/11 should be granted freedom of religion, but ones who refrain from comment should be considered an enemy of the State. From key Muslim leaders at ground zero, we have heard a frustrating and disappointing, “no comment.”

Enough of my view. Here is a good Southerner who also gets the magnitude of this Mosque:

Newt Gingrich

 July 21, 2010 6pm

There should be no mosque near Ground Zero in New York so long as there are no churches or synagogues in Saudi Arabia. The time for double standards that allow Islamists to behave aggressively toward us while they demand our weakness and submission is over.

The proposed “Cordoba House” overlooking the World Trade Center site – where a group of jihadists killed over 3000  Americans and destroyed one of our most famous landmarks – is a test of the timidity, passivity and historic ignorance of American elites. For example, most don’t understand that “Cordoba House” is a deliberately insulting term. It refers to Cordoba, Spain – the capital of Muslim conquerors who symbolized their victory over the Christian Spaniards by transforming a church there into the world’s third-largest mosque complex.

 Today, some of the Mosque’s backers insist this term  is being used to “symbolize interfaith cooperation” when, in fact, every Islamist in the world recognizes Cordoba as a symbol of Islamic conquest.  It is a sign of their contempt for Americans and their confidence in our historic ignorance that they would deliberately insult us this way. Those Islamists and their apologists who argue for “religious toleration” are arrogantly dishonest. They ignore the fact that more than 100 mosques already exist in New York City. Meanwhile, there are no churches or synagogues in all of Saudi Arabia. In fact, no Christian or Jew can even enter Mecca. And they lecture us about tolerance. 

If the people behind the Cordoba House were serious about religious toleration, they would be imploring the Saudis, as fellow Muslims, to immediately open up Mecca to all and immediately announce their intention to allow non-Muslim houses of worship in the Kingdom. They should be asked by the news media if they would be willing to lead such a campaign. 

We have not been able to rebuild the World Trade Center in nine years. Now we are being told a 13 story, $100 million mega mosque will be built within a year overlooking the site of the most devastating surprise attack in American history. 

Finally, “where is the money coming from?” The people behind the Cordoba House refuse to reveal all their funding sources. America is experiencing an Islamist cultural-political offensive designed to undermine and destroy our civilization. Sadly, too many of our elites are the willing apologists for those who would destroy them if they could.

No  mosque. No self deception. No surrender.

The time to take a stand is now – at this site on this issue.

Emerging market bonds are a unique asset class with extraordinary characteristics, which many ETF investors have chosen to make a part of their portfolios.  Emerging market bonds have high absolute returns with low correlation to other markets, and are also high yielding vehicles.

Of the products on the market, The WisdomTree fund is the only local currency and actively managed fund.  The passive US Dollar ETFs have been on the market for some time and Van Eck Global launched its Market Vectors Emerging Markets Local Currency Bond ETF (NYSEArca: EMLC) recently as the first local currency emerging market bond ETF, which is also a passive product.

Because of these two newer entrants into the emerging market bond space, investors have a lot of choices when including emerging market debt into portfolios.

The WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD) is unlike other emerging market bonds in the ETF marketplace to date. Given in its name, the WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD) invests in emerging market bonds dominated in their local currency.  This is in contrast to the other bond ETFs in the category on the market.  For example, the iShares JPMorgan USD Emerging Markets Bond Fund (NYSEArca: EMB) is the largest in the category with assets of $1,962,167,846.  EMB is a passively managed index fund.  The index that this fund tracks invests in bonds issued by emerging market governments in US Dollars.  The reason for US Dollar dominated bonds is to add a layer of currency security.  Emerging market currencies tend to be extremely volatile with wide swings down and up.  With US Dollar bonds, the issuing governments bear the risks from the currency volatility.  Long-term currency valuations are, however, reflected in the value of the bonds despite the issuing currency, since currency can express many relative things to an economy-such as a country’s relative strength to the US or Europe.

The WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD) affords investors an opportunity to gain access to emerging market bonds issued in local currency and an active edge on the asset class.

“ELD will offer full exposure to local currencies, a feature we consider important for many investors because of the potential lower correlations and currency appreciation against the U.S. Dollar,” said Bruce Lavine, President and CEO of WisdomTree, in a press release.

Currency does have a significant impact on total returns of international investments.  Over the last year, currency has contributed to a 3.80% difference between local currency and US Dollar returns in Emerging Market stocks; the MCSI Emerging Market Index Local Currency returned 13.98% and the MSCI Emerging Market Index USD returned 17.78 over the same time period.  During other time periods, however, this effect has hurt the US investor and can cause a significant difference in returns.

Long-Term Focus in Emerging Markets

In an ETF category with four investment vehicles all offering a small twist on the asset class, it will be a great study on which style of investment works best for emerging market bonds over different market conditions. The WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD) is active and will seek to take advantage of inefficiency in the emerging bond markets.  This will be very interesting.  In inefficient markets, bonds can offer many places where a manager can take advantage of including duration, currency, default risks and valuation.

A major concern brought up by many ETF commentators is how passive bond indexes will award issuers who have more debt issues with higher allocations.  In effect, this means that the funds reward debt, allocating more heavily towards more indebted countries and companies.  Active managers should be able to bypass this problem very easily and will therefore lower some of the inherent risks in the bond portfolio.

So What Happens

Bad investments happen when investors buy investments high and then sell investments low.  This seems like a simple, common sense and easy to follow rule, but each time extraordinary events happen in the stock market and the rule is broken, people will ultimately say, “This time it’s different.”  John Templeton, a mutual fund pioneer and asset manager, had this to say, “The most dangerous words in investing are ‘This time is different.’”

As the chart shows, when stocks are historically at their cheapest, investors sell stocks and buy bonds.  When stocks are at high prices historically, investors buy stocks and sell bonds.

Going Forward

Going forward into the unknown, investors will make money by having a wise investment strategy and sticking to it.  Good investment strategies may still have time periods where performance lags in times of crisis.  For example, during the rise of the tech bubble at the end of the 90s, a good investment strategy lagged the performance of tech stocks people were using to get rich.  However, the good investment strategy didn’t crash like many of the tech stocks.

Before getting into downfalls of the market, it’s worth pointing out that corporate earnings in the first quarter have shown that consumers and businesses are once again willing to buy and invest. A very broad example of this can be seen in the hardware sector. Apple’s stock price is up more than 7% due to strong iPad and iPhone sales. This has also benefited Sandisk, a supplier of flash memory for mobile devices.  The company returned 21% in the quarter.

There is still an elevated unemployment rate, and job growth may be slow or delayed for months or even years in the future. The uncertainty among the American population regarding their job security and employment prospects makes it difficult to stabilize the housing market and boost consumer spending. Recent housing data has shown that even though mortgage rates are at record lows, the demand remains significantly down. Of course, it’s just common sense that people unsure of future cash flows will hold off on purchases that require a large monthly obligation, so investors are left skeptical of the housing market’s ability to recover fully after the expiration of the housing tax credit.

In the Manufacturing Sector, energy companies have been harmed by falling oil prices, the drilling moratorium, and fear over increased regulation in the wake of the Gulf oil spill. The anxiety over increased regulation seems to be a common denominator across the market, as there has been a weak performance of the financial sector as well. This is due to Washington and Wall Street turning their attention to financial reform. With this news of government intervention, bank and financial stocks were sold off as investors feared the impact of reform.

Large-cap companies have also been subject to substantial headline risk in 2010 as well. When the public focuses on large companies like banks, oil companies, and healthcare, Congress does so as well. These negative headlines not only affect investor sentiment, but can also affect the company’s underlying business. A general idea of the impact of the financial reform bill being passed should become clear in the upcoming month, as the financial sector gains a little more clarity on what it faces in terms of new regulations and compliance.

Excessive government debt is another uncertainty that has been at the forefront throughout 2010. The flight from the troubled European debt of Portugal, Italy, Ireland, Greece and Spain has led to a historic rally in the U.S. treasuries. The U.S. dollar, like in the past, has been seen as a safe haven to invest in despite growing borrowing needs and fundamentals that might suggest a rise in interest rates. The Federal Reserve, though, has committed to keep interest rates low for the foreseeable future. Although the U.S. still holds AAA status and should be in no immediate danger of a downgrade, the mounting debt issue with the US government will come under pressure unless measures are taken to reduce the record budget deficit, according to Moody’s Investor Service.

Granted, uncertainly will always be a factor in the market. Accurately predicting the future in the midst of reform, regulation, unstable governments, and future debt obligations is an extremely difficult proposition. In these times of negative feelings and general uncertainty, though, we can be certain that the different sectors will react negatively as they have this past quarter. In subsequent quarters, many of these unknowns will begin to come to light and the uncertainty driving the market currently will be clearer to investors.

By Paige Slusser

Top 5 estate planning mistakes

I recently read a report that suggested that only about 20 percent of the population has a formal estate plan. After reviewing the points below, please take a minute to consider whether it’s time for you to create or update your estate plan.

Here are a few of the top 5 avoidable estate planning mistakes:

1. Dying without a will or trust – If you die without a will or trust, the state in which you reside and the IRS will simply make one for you.  Of course, they have no interest in avoiding or reducing estate taxes, minimizing estate administration costs or protecting your family and legacy. The distribution of your assets will just be turned over to the Probate Court. The probate process is needlessly time consuming, frustrating and expensive. It is also open to the public, meaning creditors, predators or anyone else will have complete access to all information about your estate. For the vast majority of people, the benefits far outweigh any initial costs.

2. Having an “I love you” will – An “I love you” will is one in which all the decedent’s assets have been left to the spouse. On paper, it might seem to be a caring, thoughtful gesture, but the reality is quite different, because such a will simply passes the complex issues and problems associated with transferring and protecting wealth onto the spouse or other loved ones.  It creates more problems than it solves, particularly for future generations.

3. Giving property outright to your children – Here is another solution that might sound good at first, but ignores several important realities. For instance, what if the child in question is too immature to handle the responsibility of a large sum of money on his or her own? What if the child suffers a severe financial setback that puts the inheritance at risk to creditors?  What if the child marries a fortune-hunter, is addicted to drugs or alcohol, gets divorced or remarried? You may need to protect your children and heirs from their own poor decisions.  These assets are also gifted assets which carry potentially large IRS penalties if not handled properly.

4. Owning property jointly – There are two types of joint ownership, Joint Tenancy with Right of Survivorship (JTWROS) and Tenants in Common (TIC).  Problems with JTWROS include postponement of probate only until last tenancy, the loss of the double step-up in tax basis creating more to pay in capital gains taxes, and outright distribution.  With TIC, you also lose the double step-up in tax basis where it’s available, and your property is subject to the estate plan of each tenant as well as probate for each tenant.

5. Not having a trust – A trust is the single most effective estate planning tool available. There are many different types of trusts.  Among the better known and more commonly used are revocable trusts, irrevocable trusts and testamentary trusts. A trust protects your privacy, and will help you leave what you want, to whom you want, in the way you want at the lowest possible cost overall.

Gravitating towards shorter duration bond holdings in the TIPS marketplace will mean choosing a higher correlation with inflation, lower volatility and only small yield differences.  PIMCO is currently the only ETF issuer with a full family of TIPS exchange-traded products.

Duration is a measure of the average life of a bond.  The duration of a bond is the percentage change that a 1% change in interest rates will move the bond’s price in the opposite direction.  For example, a bond with a 5-year duration will decrease 5% when interest rates increase 1%, all things being equal.

Currently, PIMCO 1-5 Yr US TIPS Index Fund (NYSEArca: STPZ) is the only TIPS ETF giving investors access to the short end of the yield curve in the TIPS marketplace.  The ETF in this space with the 2^nd lowest duration is the iShares Barclays TIPS Bond (NYSEArca: TIP).  The iShares Barclays TIPS Bond (NYSEArca: TIP) has an effective duration of 4.15, while PIMCO 1-5 Yr US TIPS Index Fund (NYSEArca: STPZ) has an effective duration of 2.55.

TIPS ETF funds are great to compare since the US government equally backs up the income and principle from the bonds held by these funds.  Of the two lowest duration funds, SPTZ and TIP, the yield difference is important when looked at in relation to duration and risk.

Here’s a breakdown of the ETFs on the market today that compares average coupons and duration.  The chart below is similar to a risk/reward scatter-plot, replacing risk with duration and return with the average coupon payment.   Data is from Morningstar, Inc.

There is a very clear pattern formed in that duration is rewarded with risk, but not in an efficient way.  This is not a yield curve, since maturity and yield are not being measured, but rather a measure of maturity and a measure of yield (average coupon).

Inflation Correlation

TIPS, or Treasury Inflation Protected Securities, have a built in feature that adjusts the principle of the bond based on changes in inflation. When investing in TIP Securities, the lower term the bond is, the higher correlation to inflation the bond will have.  This is because shorter-term bonds are effected less by interest rate movements and investors’ interest or inflation sediments.  Therefore, a change in inflation is more clearly reflected the shorter-term TIPS bond.

According to PIMCO’s research, The BofA Merrill Lynch 1-5 Year US Inflation-Linked Treasury Index (the index PIMCO’s STPZ tracks) has a .27% correlation to inflation, while the Barclays Capital U.S. Treasury Inflation Protected Securities (TIPS) Index (the index for iShares’ TIP) has a .07 correlation to inflation. In the current low inflation and interest rate environment, now is a good time to buy inflation insurance and dial down on duration exposure.

TIPS have another unique usage for investors that relates to inflation.  Investors often purchase commodities as a way to protect against inflation and use TIPS as collateral for their commodity futures positions.  For instance, PIMCO uses TIPS as collateral in its Commodity Real Return mutual fund.  Since the yield from TIPS is a real return, meaning inflation is included, investors do not need to worry about losing in a high inflation environment.

Scenarios With TIPS

The main case for TIPS would be during an inflation spike.  The Federal Reserve appears to be committed to low inflation and low rates for the time being, aiding the US Government with a low borrowing rate.  The question is whether or not this is an artificial environment.  Will inflation begin to happen despite the Fed’s best effort because of the country’s growing debt-to-GDP level, currently at 54%?

There are some particular market scenarios where TIP Securities do great and some others where TIPS can be a scary investment and lose a substantial amount of value.

In a scenario mentioned by Anne Lester, a senior portfolio manager at JPMorgan Funds in a May 2009 WSJ article, interest rates rose from 10% to 15% while inflation (CPI) fell from 14% to 10% from July 1980 to July 1981.  She refers to this time (TIP Securities did not exist at the time) as the “perfect storm’’ that could cause TIPS to lose 20% in value.

It is important to note that with TIPS indexes, bonds are being rolled in and out as they fit into or become excluded from the indexes target ranges, and many indexes do not just hold bonds until maturity.  Also, it should be noted that the par value of bonds is changed based on the change in inflation.  Like the situation above, in a high inflation environment where inflation moves down, par values of these Treasury Bonds would decrease.

PIMCO’s TIPS Family ETFs

Although PIMCO is firm about active bond strategies being more efficient than indexing, they seem to be dedicated to running an effective indexing strategy with the ETF vehicle offering a full family of indexed TIPS ETFs, ranging from long, broad, and short term.

The PIMCO 1-5 Year US TIPS Index Fund (NYSEArca: STPZ) is the most popular of the three with over $500 Million in assets.  The underlying index, the BofA Merrill Lynch 1-5 Year US Inflation-Linked Treasury Index, is capitalization weighted and is rebalanced monthly.  The PIMCO 1-5 Year US TIPS Index Fund (NYSEArca: STPZ) pays dividends monthly and has a low 20 basis point expense ratio.  Holding only 11 bonds, this ETF is set up to efficiently have low turnover.  The effective duration of this fund is 2.55 years.

Conclusion

With a specialized bond like TIP Securities, keeping maturities low is where the benefit of the inflation hedge is at its best.  The other factors that affect bond price can be minimized in lower maturities.  The primary reason an investor allocates into TIPS is to hedge against inflation.  Low duration TIPS will benefit from increasing inflation (CPI) and the expectation of inflation increasing.  Both of these factors will be directly affect these bonds’ prices and lower maturities will allow the highest correlation to these factors that the investor is looking to access.

This public debt isn’t anything new for our economy; it’s a part of our history. The only time when the U.S. was actually debt free was during Andrew Jackson’s presidency, when he ordered it to all be repaid. Today, our national debt remains at around 53% of our GDP. Compared to Japan’s public debt to GDP of 192%, the US doesn’t look quite as bad. Still, debt is borrowed and has to be paid back eventually. The Federal Reserve could crank up their printing press and increase inflation to pay it all back, or default on government bonds. Neither of these situations are likely, but since the Federal Reserve has done the ‘print more money’ trick before, it’s not improbable to think that something drastic couldn’t be considered.

Below is a comparison of the immense Federal Government deficit to American household debt. If public debt is increasing, it should follow that private debt is on the same path. When plotted on a simple graph, it is true and highly positively correlated at 97%:

Of course, just because two figures are highly correlated, there is not necessarily a cause and effect relationship. When public debt increases, it doesn’t cause private debt to increase. There are numerous other factors that play a role. That being said, seeing the exponential explosion of debt and the relationship between the two figures on a graph can help put things in perspective and lends a little credence to the theory that overall, Americans are becoming desensitized to debt.

With the economic recession and high unemployment levels, it isn’t surprising that household debt has increased. Cardweb.com, a credit industry reporting website, states that American households with at least one credit card owe more than $8,000 in debt. However, this number has been found to be skewed by a portion of the population with a vast amount of debt. After analyzing the credit card debt of those surveyed, Bill Whitt at the VIP Forum, a Washington D.C. research firm, found that only 29% of households owe $1,000 or more on their cards. Although almost 75% of Americans owe less than $1,000 on their credit card bills, the effect on the economy can be huge. The collapse of the mortgage market is an easy illustration of how the default of a small portion of loans can have a tremendous effect on the economy.

How can you safely leverage yourself against the perils of debt? Unlike the Federal Deficit, there are ways to tangibly protect you and your family from debt and potential bankruptcy in your own home. One of the first and probably hardest lessons to learn is to not let your eyes be bigger than your wallet. Simply speaking, don’t buy things you can’t afford – especially if its monthly payments will max out your budget. Small amounts of debt over time will end up accumulating and eating away at your savings. Another couple of steps to take are in the world of credit cards. The best way to maintain good credit is by paying your balances in full and on time. If you are unable to keep track of your different balances, then you many want to consolidate into one or two cards.

There is no simple “cookie-cutter” answer on personal debt that would suffice for every personal situation. The best advice is common sense. Be fully aware of the combination of your personal credit balances (bills, loans, and mortgages), disposable income and spending habits. From there, set a budget and adjust to your own wants and needs. You may find that you’re spending more than you’re making and need to cut back in a certain area, or that you should go ahead and pay off a high interest bill while maintaining the minimum payment on others. You may even find that you are able to save for retirement or other endeavors.

If the general population becomes more aware and averse to debt while they are still able to recoup, maybe the government will learn a lesson from its people – to cut out unnecessary spending and manage current resources wisely.

By Paige Slusser

The bill ventures into some areas that legislation has previously left alone. In many ways, the financial system needs some changes. However, for the most part, the Independence Day bill is more confusing than freedom-promoting.

Business Models

You may have guessed it, but banks will be receiving many new regulations. Economists believe that the increased costs to employ these new regulations will increase the cost of credit to the individual and small business, will drive out smaller banks from the market and exclude many of those who are less creditworthy from receiving credit. Those costs could be acceptable if the bill is effective, but it is largely unclear as to whether it will be. The Senate is somewhat split over the bill as a solution to these issues.

The financial industry landscape is a diverse one, ranging from financial advisors serving individual clients, hedge funds serving unique wealthy investors, and interest groups, venture capitalists and broker-dealers creating the transactions on the stock exchanges. Also to consider are the myriad of other functions and business models like investment banks, market makers and mutual fund-type companies functioning in a wide range of capacities to help the financial sector run.

It seems that some of these business models will have to endure higher taxes and higher audit and regulation fees where there was previously only some oversight.

The Individual

One area where this bill truly gets it right is looking at the standard of care given to the individual investor. After all, isn’t that what it should be all about? The entire bill came into existence so that America and Americans would avoid another major financial collapse and to plug the holes up in the system.

Currently, depending on whom the individual investor goes to for portfolio management, they could have an advisor who is compensated from the products them sell, and is regulated by how the advisor sells them. For example, a broker must only sell a product (like a mutual fund or annuity) to someone who is suitable for the product. There are many philosophies on what this means, but basically it comes down to the question of if a reasonable person would invest with this product.  If the answer is yes, then the investor is considered suitable.

In contrast to the above situation, an individual investor may go to an advisor regulated not by what they sell, but by the advice they give. As such, these advisors are unable to receive any kickbacks from the service they provide. They must give the client their best advice, and act in the best interest of that person. This role is similar to a defense attorney and it is called fiduciary. Registered Investment Advisors have a fiduciary standard of care to clients. Brokers have a suitability standard of care to clients.

Currently, brokers are not required by law to give their best advice. Registered Investment Advisors are.

Why is this an issue?

In 1855, William Travers, a New York businessman, was in Rhode Island and saw a long line of yachts and was informed stockbrokers owned them all.  This led him to ask his famous question, “Where are all their clients’ yachts?”

We have created an industry and a culture inside the stockbroker industry of double-mindedness when serving clients in how the advisor is compensated.

New words like fee-only have come up to express the way Registered Investment Advisors are paid, by a plain, transparent fee, only. They cannot accept payment from mutual funds for selling the product and receive no benefit from not giving the best advice possible.

Last year, in the early talks of the Financial Reform Bill, the problem was raised that people just cannot tell the difference between fiduciary advisors or Registered Investment Advisors and Brokers. Both had a similar “Advisor” type title and from research,  it was determined that these people are all perceived the same by investors.

In The Bill

The bill appears to give the SEC the ability to begin to regulate brokerages in a much stricter way and would allow them to be brought under the fiduciary standard.  Small advisories under $100 million in assets would be regulated by each state. This would greatly increase the level of protection individual clients would receive, as the SEC, who currently regulates those size firms, does not properly look at firms that small in size.

Reform seems to be coming this 4^th of July and though not giving investors more freedom, some protection seems to be on its way, slowly.  Investors do have options available to get fee-only advice, where kickbacks and product sales do not exist, but they will have to know what they are looking for:  an independent, fee-only, Registered Investment Advisor.

PowerShares International Corporate Bond Portfolio (NYSEArca: PICB) is designed to track the S&P International Corporate Bond Index. The index includes investment grade bonds, rated by S&P or Moody’s issued in the following currencies, Australia dollar (AUD), British pound (GBP), Canadian dollar (CAD), Euro (EUR), Japanese yen (JPY), Swiss franc (CHF), Danish Krone (DKK), New Zealand dollar (NZD), Norwegian Krone (NOK) and Swedish Krona (SEK).

Like many other bond indexes, the S&P International Corporate Bond Portfolio uses a modified market valuation methodology. This is similar to a market capitalization methodology, except the allocation of bonds in each currency is limited to no more than 50%. Currently, bonds issued in the Euro have the maximum 50% weighting.

The fund rebalances monthly and contains a feature designed to boost yield. During each monthly rebalance, any currency with more than 10% allocation will exclude the lowest 25% of bonds with the lowest yield. This is an interesting feature and could be viewed as something similar to fundamentally weighting an equity index with a twist. The twist is that the rebalance makes sure the bonds with the lowest yield, which could also mean the bonds with the most recent run up in price, are excluded. Yield reflects risk, so by using this method, the PowerShares International Corporate Bond Portfolio (NYSEAcra: PICB) will keep only average yielding bonds within a currency. Dropping the lowest yielding bonds could possibly mean dropping the strongest bonds in the currency; this could be an unwanted risk, but will make the yield higher than it would be otherwise. In the same way that fundamentally weighting stock indexes use a factor other than price to determine weight, this methodology will be dropping high priced bonds.

Capping Debt

Turnover will also be high, due to this fund’s monthly rebalancing schedule. Typically in investment indexes, a passive investor likes to see very low turnover with not a lot of activity. In this case, however, investors might welcome keeping a tight rein on allocations in this fund, as bond markets can quickly shift. Some ETF investors have argued that bond ETFs do not work because of their overly passive approach to allocating to higher levels of debt.

For example, most bond indexes use a market capitalization style methodology, a system that works great for equity indexes since as a company issues more stock, stock prices will reflect the new ownership dilution. Whereas with bonds, companies and countries can issue debt and artificially get market capitalization as long as the market believes it can repay and will not default.  This is why Japan typically dominates international government issued fixed-income indexes. Japan has a national debt to GDP ratio of 192%. The risk is obvious there, but extremely passive fixed-income indexes will reward that debt level with allocation and not cap it.

The State Street Global Advisor’s two-week-old ETF, The Barclays Capital International Corporate Bond ETF (NYSEArca: IBND), tracks the more passive The Barclays Capital Global Aggregate ex-USD >$1B, which includes bonds over $1 billion in market value. Doing this keeps the fund and index extremely liquid. The ETF is more Euro heavy than its competitor and holds its highest Euro allocation in the relatively strong Eurozone nation of Germany at 18%, immediately followed by US companies issuing in non-US Dollar fixed income at 17%.

The Barclays Capital International Corporate Bond ETF (NYSEArca: IBND) has an expense ratio of 0.55%, while the PowerShares International Corporate Bond Portfolio (NYSEArca: PICB) has a slightly lower cost at 0.50%. With these two funds being issued in such close timeframes, it will be a test to see which ETF emerges as investors’ preferred choice. Both funds have similar targets, prices and coverage zones. The question is whether investors will choose an ETF more concerned with liquidity like IBND, or an ETF capped to improve yield and limited exposure like PICB.

Risk Factors

The international corporate bond market is something that has been missing in the ETF space. There has been exposure to different international fixed income in the arena of emerging market bonds and developed market government debt, but the corporate space has long been empty. International corporate bonds are affected by both the risk factors of the currencies they are issued in and the credit risks of the individual issuer.

The unfolding of credit problems in Europe will be a large determinant of how these funds will perform. Currency will be a major contributing factor if the Euro continues to fall, hurting returns. The funds do contain high quality issues and will be an extremely low cost way to gain exposure to this important part of the global fixed income market. Since these funds are fixed income with total return coming both from price and income, currency will affect income, as it is translated into US Dollar. This could be a huge benefit for income seekers, since currency works in the US investors’ favor.

Bond ETFs are tricky, and definitely not as simple as equity indexes. The differences need to be understood, as well as the historic instances and implications of credit freezes. Bond ETFs can be liquid when the underlying bonds are not, even with large international bond issues such as those in these ETFs. These instances might look like significant tracking error, when the bond market was actually just not trading and no updated prices were being given. An ETF, being liquid, will reflect current prices, even when markets are closed where the underlying bonds trade, like these international issues. Overall, bond ETFs have been seen as efficient even when efficiency measures like tracking error and premiums and discounts look differently.

This is, of course, just an economic theory. What does it mean for you and your investment strategies? While this certainly isn’t true 100 percent of the time, in today’s world of instant information, it is fairly difficult for the average investor to find an undervalued stock, or a specific stock to successfully short. For example, if a newspaper or a magazine suggests that readers buy a certain company now, it is likely that the readers are too late to capitalize on the investment. Maybe the publication’s sources tell them that the stock is undervalued, or that the price will double because of X, Y and Z. By the time the information, already ancient just a few short hours later, is in the investors’ hands, the stock should already have this information incorporated in the current price. The information could have even changed entirely.

Granted, there are anomalies. Consider Enron for example. Bethany Mclean, columnist for Fortune Magazine, looked at Enron’s financial reports and discovered that they were overpriced at their peak. Mclean questioned Enron’s inflated stock price and wrote an article in Fortune entitled, “Is Enron Overpriced?”. If she, or anyone for that matter, had continued to look into the unclear revenues the books showed, they probably would have sold their stock before the scandal hit full swing.

However, a normal investor will probably not take the time to dig through each company’s annual reports, analyze ratios or read the disclosure notes to find these price discrepancies.

Picking out individual stocks can be time consuming, risky and difficult to do without complete information. Of course, the individual investor still usually wants to invest in the stock market. There are ways to do this that are both safe and profitable.

At Wiser Wealth Management, we invest in Exchange Traded Funds (ETFs). ETFs track indexes, such as the S&P 500, and trade on the stock exchange. An ETF is similar to a mutual fund in that it is a combination of stocks, but that’s where the similarities end. Our ETFs do not come with a slew of broker commissions for unnecessary trades or mysterious 12B-1 fees. ETFs insulate the investor from company-specific risk and provide a simpler, more practical way to invest.

Article contributed by Paige Slusser

Among issuers, there are no major changes year-over-year. In April 2009, the National Stock Exchange reported that the number of ETFs and ETNs on the market was 844, 89% of those being ETFs. In April 2010, the ETF/ETN marketplace has grown to 998 securities, 90% being ETFs.

To gain some perspective on how that breaks down and to what extent the market actually utilizes those 998 ETFs and ETNs, the chart below displays the number of ETFs and ETNs above $100 million in assets. This serves no purpose other than to show to what extent ETFs are adopted by the marketplace. As you can see, only a relatively small number of ETFs get the majority of investment. This could be for a number of reasons, including index popularity, for example. It seems that the ETF marketplace is increasingly becoming more educated, and the most efficient ETFs are rewarded with usage. That being said, I do believe that there are many inefficient and useless ETFs out there, and in the past, investors have used the more expensive and less efficient of two ETFs that track the same index. Despite those situations, the chart below lends credence to the idea that investors haven’t taken hold of a majority of ETFs.

Where the Money is Going

Compared to this time last year, when investors were pulling billions from large cap ETFs, there are now normal inflows into that category. Cash flows to note are in the fixed income and global ETF categories. Despite potential worries in both categories, assets have been flowing into the ETFs

To put fixed income ETFs in perspective, there are no fixed income ETFs currently listed in the top ten ETFs, which continues to be largely made up of stock funds and the Goliath gold fund, GLD.

As shown above, over the same time period year-to-date, fixed income has not led to cash flows. Although not hugely significant, we can see this by looking at investors’ usage of both fixed income and global ETFs. Global ETFs are also a statement of currency fluctuations and it is something to note that YTD, currency ETFs have negative cash flows, while global ETFs report inflows.

I am sure that the recent fallout in the market has many of you wondering what Greece has to do with US investors and how we can see a such a large decline in the stock market, even with job creation in the US. We will address that below.

I want to remind you that just as in 2008 when the US markets caused the world’s financial instability, that because we stayed the course and maintained our index allocations, the portfolios recovered with the market. Last summer, we rebuilt our index models to include more short-term bonds and purchased protection for those of you who needed it with a large exposure to the S&P 500. This move to overall more conservative portfolios and equity protection will help us weather this European crisis even better than the US financial breakdown. As of Thursday, May 6^th, all models remain in positive territory for 2010. We will continue to monitor and learn more about the European Crisis to keep you informed.

European Problems and Our Portfolios,

By:  Kyle Waller – Research Analyst

“Because major developed markets are now so highly linked, there is no way for problems in Europe to remain isolated there; we will see a ripple effect here in the US.”

The Greek government has recently agreed to receive a Eurozone government bailout from stronger countries in the EU. This bailout is very similar to the way many large US financial institutions were bailed out at the US taxpayers’ expense. In that case, the US government purchased assets from non-government companies. In the European case, governments are giving money to another government to prevent the risk of default of on bonds and other obligations.

The Greek economy is made of mainly government jobs, either direct government employment or subsidized employment. Overall, they have a weak free market system, which may be why people rioted in the streets Thursday due to 2% tax increases and dissatisfaction that the EU central bank did not choose to do more than its $145 billion rescue plan to stabilize the Greek economy.

Greece may be the first of many other bailouts that takes place to secure sovereign debt of other European countries.

The Effect

Such actions have caused the euro to decrease against other currencies, most significantly against currency alternatives to the euro as a major trade and reserve currency, i.e. the US Dollar, Pound and Yen. Significant losses have also occurred in both European bond and stock prices due to future profits becoming less secure. However, with fast, panicked selling, it is likely that the market has oversold many stock and bond holdings. Therefore, the opportunity to profit from this news has passed and it is unclear whether the market will continue to sell or regain some stability.

Overall, any company linked with global trading will be negatively effected and has already been. According to S&P analysts, the companies in the S&P 500 make up nearly 50% of sales from outside the US in recent years. With the S&P 500 making up nearly 80% of the US market, it follows that this would make US products more expensive to Europeans and therefore drop demand.

As uncertainty in Europe continues, uncertainty in the US will as well.  A Greek stabilization plan was passed on Thursday and should begin to stabilize that economy and its problems. There is still fear that other Euro countries may require the same actions, but the EU is showing its dedication to market stabilization.

Because major developed markets are now so highly linked, there is no way for problems in Europe to remain isolated there; we will see a ripple effect here in the US.

Going Forward

There are many factors affecting what is happening in the global marketplace and the US is a major player in all of it. Global investors are flocking to US Treasuries, increasing price through demand, which will help keep rates low. Low rates, in turn, increase demand for borrowing. In the same vein, though, demand for the US Dollar has grown, which has a negative effect on US exports and will slow a full recovery in the US, just like failing stock prices.

Going forward is about positioning portfolios to be participants in the global marketplace while being keenly aware of potential risks. We know that markets can act irrationally during unstable times and the answer for portfolios is to hold the course, maintain diversification and prepare for future risks.

Weekend Update

Just as I went to publish this note, the European Union, in a 12 hour weekend meeting, put their final stamp of approval on the Greece bailout. Many economists have dubbed the 1 trillion dollar package the “nuclear option,” but the EU sees the bailout as necessary to keep the euro from free falling in value. The risk going forward is repeating these steps with other countries. If Portugal, Ireland and Spain need the same type of bailout, Europe could easily spend another 500 billion euros. Today as this note is published, the US market is up 400 points in a positive reaction that maybe this is over. I believe that there is probably more to come and hope that it only lasts a week like in the Greece scenario.

Sincerely,

Casey T. Smith

President

Wiser Wealth Management, Inc

So why is an increasing employment rate good in this case?

The amount of jobs added went up in April even well above what is expected, adding 290,000 jobs to the market.  This is up from 200,000 added in March.

The fact that the employment rate is down is showing that there are more people actively looking for jobs.

The workforce, defined as those looking for employment and have employment, rose to over 800,000 according to the government, and despite increasing job numbers, percentages are down.

This means that optimism about job growth among the unemployed is rising, which is a positive.

While this is a very simplistic synopsis of the situation, and there are certainly more details to be heard from the defendants, there was a very interesting exchange yesterday between Lloyd Blankfein, the President of Goldman Sachs, and a Congressman. The Congressman asked Mr. Blankfein if he thought that his firm should be acting in the best interest of its clients. Mr. Blankfein paused for a great deal of time and then simply answered with a vague, “We do what we can” answer.

Mr. Blankfein could not answer “Yes” to that question because financial institutions like Goldman Sachs, Bank of America, Edward Jones and AG Edwards cannot legally accept fiduciary responsibility for their actions. Fiduciary simply means to always act in your client’s best interest and to disclose all conflicts of interest. Was there a conflict of interest in this Goldman Sachs product? You bet.

Part of the problem here is that the government allows companies like Goldman and other brokers to act under suitability rules. This means that a client has to be suitable for the investment, but does not mean that the product is the best for the client. To give you an idea of what this means, think of a mortgage. You might be qualified to get a million dollar mortgage, but that does not mean it is your best interest to have one.

I believe that anyone acting under the title “financial advisor” should be held to a fiduciary responsibility, just like your doctor, attorney and even your real estate agent. Brokers, commonly called financial advisors, do not give advice! They are not in the business of giving advice-they are in the business of representing products and completing transactions.

The problem with financial advice comes down to this fact:  advice should be paid for separately from products and products should not pay the advice giver. And guess what, the overall cost of paying for independent advice will most certainly cost less than the expensive products being sold to you.

Brokerage houses have a lot of power in lobbying to Washington and have thus far kept themselves out of being fiduciaries to clients.

Currently, the only fiduciary advisors are independent firms that are not associated directly with any broker dealer, but rather a custodian like TD Ameritrade or similar. TD Ameritrade holds the client’s assets that are being managed, but the advice comes from an independent advisor hired by the client. Fee Only Independent advisors are regulated by the SEC or directly by individual states. Fee only advisors have the entire financial product world available to them, thus they can and should always act in a client’s best interest. If they do not, there are serious consequences. In comparison, the broker can get off scot free, just like Goldman Sachs probably will.

The first ETF came about in the US in 1993 under the ticker SPY, also known as the “spyder.” The spyder enabled institutional investors to purchase the entire S&P 500. This allowed the investor access to market returns, while limiting specific company risk. This indexing concept through ETFs increased in popularity in 2000. Just seven short years later, investors could access virtually any worldwide asset class at a quarter of the expense of mutual funds.

It is these Exchange Traded Funds that have taken hold in America that are just now starting to take root here in Europe. I see a few roadblocks that may prevent ETFs from taking off here, though. A few of these obstacles were present in the US market during the rise of the ETFs, but Europe has some additional issues as well.

At Wiser Wealth Management, we are an independent wealth management firm with allegiance to no one to other than our clients. When we built our tool box of investment models and strategies, we only looked at products that maintained our investing philosophy of investing for the long term, keeping cost low and always maintaining a diversified portfolio. We never chase returns, but rather manage overall portfolio risks adjusted for each client’s investment objective. We will not work for a commission, only a flat fee. This fee only approach to asset management binds our objective to the clients’ best interest. The final seal to the sitting on the same side as the client is our regulatory responsibility as a fiduciary; this is something our brokerage and banker counter parts refuse to accept. They are regulated in a way that allows them to sell products that may be suitable for the investor, but not necessarily in their best interest.

It is this independent fiduciary fee only platform that is lacking in Europe, thus most advisors there are pushing high cost and high advisor commission insurance-based products. Most of Europe’s ETFs are traded by institutions. In the United States, the Institutional/Retail breakdown is 50/50. One of my reasons for coming to this conference is to be an ambassador for fee only advisors in the US and encourage our colleagues across the pond to take up a platform that is more beneficial to their clients.  My concept involves ETFs because ETFs do not pay a commission and are great tools in building portfolios. This does not mean that a commission broker will not use ETFs, it just means that they have an incentive to not use them.

I was speaking with an Italian trader one evening. We discussed how fee only advice could start in Italy. He said that it was very difficult to start your own business in Italy and if it failed and the owner had to declare bankruptcy, he or she could go to prison. Maybe socialism has some drawbacks? So maybe in Italy advisors will not be jumping ship from the large banks and venturing out on their own, but there is always a possibility that they could make a policy change like that of the UK. In the UK, the government has passed a new directive to make their financial institutions look at all investing opportunities, not just their own financial products. This is an open door to more ETF usage in UK portfolios.

Another difference between the US and Europe is how ETFs are traded. This difference causes some liquidity issues in ETF trading. One reason for this is that ETFs can be traded on the local country exchange, OTC (Over the Counter) or directly from the issuer at NAV (Net Asset Value). Currently, the only reported trades are those done on the exchange. This multi-trading platform at times creates large bid/ask spreads. Trading volume would help close the bid/ask spreads. There was a lot of talk at the conference about reporting the ETF trade to a third party to help share information on pricing.

For the most part, ETFs in the US are simply purchasing an entire index, like one share of SPY buys you the entire S&P 500. Should the provider of the ETF ever fail, the ETF assets are not in question. The fund would simply be liquidated and you would receive your investment back at the current market value of the underlying securities. In Europe, some ETFs are not this straightforward, as there are two types. Physical ETFs are what we are using here in the States. Europe also has Synthetic ETFs, which are more complicated, and not necessarily straightforward for retail investors. If not used properly and with caution, these synthetic ETFs could get bad press and hurt the overall impression of Exchange Traded Funds. This is much like the inverse funds here in the United States.

Another challenge for ETF providers in Europe is that while each country shares a common currency, tax laws can be much different. Because of this, we see ETFs being purchased within each country’s own exchange. US ETFs are not purchased off our exchange, as a European investor may have to pay US tax.

I will also note that the conference of several hundred delegates only had about 12 actual advisors. The others were institutional managers, traders and lawyers. This tells me that ETFs have really not made it to the individual European investor. Next year, should I be invited back to the conference, I would expect and hope to see more retail advisors.

Dawn R. Levine – Attorney at Law – Marietta, GA

www.GaEstatePlan.com

As of December 2009, the national unemployment rate was above 10%. In Cobb County, we are not far behind at 9.3%. Each month, the unemployment rate increases and many agree that the real national rate is around 15%. (Chart HERE) The US Government has tried unsuccessfully to stimulate the economy. It has spent more time debating the unaffordable health care bill that makes us more dependent on Government Bureaucracy than on ways to stimulate the economy. They still plan to raise taxes in 2011, making small businesses reluctant to hire. What will return America back to solvency and prosperity? The same thing as during the Great Depression, WWII, 9/11 and many other times of hurt in America- the will of the American People. In times of crisis, the American people band together to help one another get back on their feet and once again work for the American Dream.

Wiser Wealth Management wants to help those currently unemployed by offering a free, CPA prepared 2009 Federal and State tax return. There are no strings attached. We want to use our tools to help those in our community in this time of need. We hope that other businesses follow our example and offer services to help those in our community get back on their feet. All you need to do  is to call our office at 678.905.4450 ext 1 or 3 to set up an appointment.

Casey T Smith

President

Currency is a huge contributor to the total return of any international investment; so, naturally, falling foreign currency against the investor’s currency hurts its performance in the same way falling US Dollar benefits its return. For this reason, many investors have included foreign investments in their portfolio, recognizing its importance to the global economy.

Shown above is the iPath Euro/USD Exchange Rate ETN. This is an ETN that tracks the spot rates of the Euro/US Dollar exchanges, showing a short history of the two currencies. The Euro makes up 44% of the currency hedged by the WisdomTree International Hedged Equity (HEDJ). ETNs have no tracking error because of their structure.

As shown in the graph, the Euro has recently plunged against the Dollar similar to the way it did in the 4th quarter of 2008 when the Dollar was globally relied on as a safety currency during the September credit crisis. In the years before, the Euro steadily rose against the Dollar. This recent Euro downturn has been caused by Greece’s and other struggling Euro countries’ economies under the euro currency, unlike in 2008.

The new ETF, issued by WisdomTree, is the first of its kind to hedge international currency risk in the ETF space.  The fund, WisdomTree International Hedged Equity (HEDJ), is intended to invest in the WisdomTree DEFA index, which is tracked by the WisdomTree DEFA ETF (DWM); only HEDJ hedges the currency exposure of DWM. This means that investing in HEDJ is designed to be similar to investing in local markets with local currency. If an investor were to switch between the two funds, the expense ratio would not be prohibitive- a ten basis point difference. The newer WisdomTree International Hedged Equity ETF (HEDJ) is charging 0.58%, while the WisdomTree DEFA ETF (DWM) charges investors 0.48% annually. These expense ratios aren’t cheap by ETF standards, but both ETFs offer unique qualities not found elsewhere on the market, which may justify the cost.

How WisdomTree Delivers the Hedge

WisdomTree, as an ETF issuer, is a true innovator in the area of fundamental indexing and providing currency exposure inside of an ETF package, thus allowing the investor to avoid the ETN structure. To date, WisdomTree has a full line of currency income ETFs, including the WisdomTree Dreyfus Emerging Currency Fund (CEW), which tracks a basket of emerging market currencies.

The company has been able to provide this kind of exposure through its expertise in managing currency forward contracts. The WisdomTree International hedged Equity ETF (HEDJ) will hedge currencies by using the same kind of rolling forward contracts. The fund will replicate owning the index as if the investor were investing in the local markets.

Erasing Currency in Your International Investment

This ETF is interesting because the short-term movement of currencies is extremely volatile, making up a good deal of the volatility in the MCSI EAFE Index (an index benchmark for Europe, Australasia, and Far East)-a market cap weighted index in a similar space as the WisdomTree DEFA Index.

In the last 3 years, currency has added about 21% more variability than a local investment would have incurred over the same time period. Currencies also tend to trend against one another in a long-run generalized way. Until 2008, the Euro and many other developed currencies have gained against the US Dollar.  With the problems in the Euro’s economies, the Euro has been floundering against the US Dollar. Investors with this viewpoint can use WisdomTree International Hedged Equity ETF (HEDJ) to stay invested in the international developed markets while dropping their currency exposure.

This strategy is sensible when investors like the long run growth potential of developed nations covered in the ETF, but would prefer not to see direct losses if the US Dollar strengthens.

Furthermore, the WisdomTree DEFA Fund, DWM, and WisdomTree International Hedged Equity (HEDJ) can be ‘twin’ ETFs, allowing investors to switch fluidly between them, exchanging currency risk (benefiting when the dollar falls) for a currency hedged fund (safeguarding against falling foreign currency).

Currency is often associated with national economic growth and regularly reflects the relative growth of national growth. This trend is what makes emerging market currencies attractive when the economies of those nations eventually develop.

A Fundamental Index

WisdomTree employs a fundamental indexing strategy in its equity ETFs. For the two ETFs discussed, this means a value-tilt to the funds. According to WisdomTree, this allows for better long run performance. Whether this is true or not, these two funds allow for access to unique investment qualities- the ability to hedge or not hedge the same equity stocks.

This report shows that only one third of fund managers had a positive alpha over the last three years. The report also goes on to show that expenses and taxes greatly degrade fund performance. Another interesting note is that active fund managers tend to outperform in poor performing areas of the market, but in “hot” areas they tend not to keep up with the index.

Overall, there is really nothing new, just a reminder that low cost passive investing should have a place in everyone’s portfolio. This report supports the Wiser investment philosophy of maintaining a diversified portfolio, keeping cost low and always investing for the long term.

VIEW THE MORNINGSTAR BOX SCORE REPORT HERE

Those investors looking to invest in ETFs, but still only desire to support companies within their values can now turn to a company called Faith Shares. Faith Shares has recently launched five new ETFs that invest with Christian values in mind. The company’s product line includes a Catholic Values Fund, Baptist Values Fund, Christian Values Fund, Lutheran Values Fund and the Methodist Values Fund.

All funds are built by selecting the 400 largest US companies. These companies are screened by the fund’s religious values and then ranked by their Environmental, Social and Governance (ESG) score by industry. The companies are then sorted by industry in a way that mirrors the FTSE US Index. The top 100 stocks will make up the fund, allocated at 1% each. The passively managed portfolios will be rebalanced and could have company changes each June.

This equal weighted approach to investing allows the funds to be non-cap size biased. In comparison, the S&P 500 (SPY) ranks companies by size, thus the investor has a larger portion of the mega size companies. The equal weighted approach (RSP) has outperformed the traditional S&P 500 weightings 1.54% to 0.41% over the last five years.  However, because the equal weighted approach allocates with smaller companies, there is additional risk. The five-year Standard Deviation of the S&P 500 is 16.0 whereas the equal weighted approach is 19.96 (as of 2/12/2010 comparing SPY to RSP as Faith Shares does not have an actual 5 year record).

The funds have virtually the same holdings with a few minor differences. For example, the Baptist fund is restricted to hold alcohol companies while the Catholic fund will. Investing with your values in mind certainly does not come without a price, though. The ETFs currently have an exceptionally high cost of 0.87% in annual management fees. In comparison, the S&P 500 index (SPY) is less than 0.10%. Faith Shares does donate 10% of its funds revenue to a charity and hopes to lower the fee as assets grow.

Faith Shares is also planning a launch of an international product in the near future. Currently, Faith Shares has the only Christian faith based ETF product line on the market. The company’s website nor third party sites show the size of the ETFs, so due to the newness of the funds we assume that the assets in each fund are less than $100 million. This throws up a caution flag. We can see that the daily trading volume of the funds is relatively low, so if you want to trade this ETF, make sure that you use limit orders based on the intraday value of the fund.

With proper trading techniques and a realization that these funds should complement a bigger asset allocation strategy, these funds should fit well with faith-based investors. My biggest issue is the fee. Hopefully with success, Faith Shares will do the right thing and lower the fee below 0.50%. Below 0.20% seems even more reasonable.

To clarify, there is nothing wrong with selling products; many salesman have become successful by being honest when others are not and by giving honest opinions even when it means they don’t get the business.

However, would you see a cancer doctor who was only compensated by selling drugs by certain drug manufacturers?  Would you hire a lawyer that was selling something?

So, why would we seek investment advice from those whose main source of revenue comes from selling mutual funds, annuities and stock trades? This happens all the time, under the guise of “Financial Advisor.”

Not all Brokers take advantage of clients; they usually just do not have the freedom not to.

Trading Tips

A while back on the Front page of the Wall Street Journal was an article uncovering some disturbing practices by Goldman Sachs. Goldman Sachs has been sending out written research reports by their analysts to thousands of their clients, all the while holding weekly analyst conference calls with select clients called the “trading huddle.” During these conference calls, analysts give their true opinions about company stocks, the overall market and which stocks are likely to rise in value over the short run. Often these conference calls go against the written reports.

There is also an example given that after one day after the Janus Capital Group, Inc was given a neutral rating, research analysts called 50 of the firm’s selected clients to tell them the stock was likely to move higher. Unfortunately, news leaks out like this all the time, where unethical practices take advantage of clients to the gain of the company.

Other major brokerage houses do the same thing; however, they disclose that they may give advice to premium-paying clients that differs from the written reports.

T.V. Selling

When you watch interviews with CEOs and leading market strategists, they explain with great enthusiasm what they are doing for their clients-today. To be clear, chief strategists and research analysts are hired by large security firms to sell advice to clients in order to generate income through the trading of stocks and bonds.

Something that drove this home for me was watching a guest host-a chief strategist for some well-known securities firm one day, say in a very long winded speech that he agreed with others at the table that traders should raise their cash allocations, but should do so by taking a short position in their stocks equal to their long position in order to quickly reenter the market when they became more bullish.  If you’re confused about this, know that I am too.

Close to Home

We use TD Ameritrade to hold all our client’s assets and also use them to execute transactions for us. TD Ameritrade is responsible for a large percentage of daily trading on the US stock exchanges. They have two main “sides” to the business: retail and institutional. Retail is a place for individuals to keep traditional and Roth IRAs or to have a regular trading account. Institutional is for professional money managers to keep assets there; this is called a custodial relationship. The institutional side has many features and functions retail investors do not have access to.

The main difference between the two sides is that the retail side of individuals is flooded with reports and features for the technical, frequently trading, active investor. On the institutional side, there is no such push or functionality for this kind of charting. Why? Because most professionals who do not receive compensation for trades do not invest clients’ assets in this way.

Most independent money management firms invest with a long term outlook.  This is true of most pension consulting groups, endowments, bank trusts, mutual funds and financial journalists.

The reason for this difference is because TD Ameritrade receives a very reasonable $9.99 per trade.

What It Comes Down To

The problem with financial advice comes down to this fact: advice should be paid for separately from products and products should not pay the advice giver. And guess what, the overall cost of paying for independent advice will most certainly cost less than the expensive products being sold to you.

An industry word we throw around a lot called fiduciary is the difference here.  Doctors, lawyers and even real estate agents have this same standard. Fiduciary means to act on someone else’s behalf; simply put, to act in a person’s best interest. Brokerage houses have a lot of power in lobbying to Washington and have thus far kept themselves out of being fiduciaries to clients.

What most independent, fee-only, Registered Investment Advisors see as the largest problem, is that the general public and many politicians see brokers and Registered Investment Advisors the same. Brokers, for years now, have put “Financial Advisor” on the business cards and in their titles. Titles like financial advisor and financial planner blur the lines between the two. All major brokerage houses run commercials that further blur the lines. Many people, now, are not even aware that there is anything else.

Many clients that come to us from Brokerage houses are confused when we plainly disclose the predetermined fees we bill them each quarter. This is because when you work with “financial advisors” or brokers, fees are hidden and reported as decrease in return. In this way, “financial advisors” can charge you fees no one would agree to if they knew. This is how not even the most honest, most genuine financial advisor could possibly serve the best interest of their clients.

If you’re new to ETFs, the simple way to explain them is to compare them to mutual funds.  A mutual fund manager is buying and selling stock throughout the year to try and beat an index, say the S&P 500, which is made up of the 500 largest companies in America.  History shows us that fund managers have a hard time doing this over the long term.  If you buy an ETF of the S&P 500, you are buying and holding all 500 companies in the index at usually at least 1% less than the mutual fund managers cost.

So now that there are over 900 ETFs to choose from, covering everything from domestic large cap to frontier markets, it leaves one to wonder why these ETFs are not showing up in 401ks.  There are several hurdles that 401k providers have to overcome to have ETFs actually inside the 401k plan choices for a participant.  One of these is the trading of the ETF.  ETFs trade on exchanges just like stocks, so for each transaction there is a cost.  This trading cost can quickly erode returns and each transaction could cost as much as $15.  For a participant depositing $100 per paycheck into a 401k, this does not make sense.  Another issue is the automatic reinvestment of dividends.  ETFs do not trade in partial shares like mutual funds.  Additionally, for companies like Vanguard, there is really not any reason to offer ETFs in their 401k plans, as their offerings include their index mutual funds at virtually the same cost to the investors.

The good news is that for all the other smaller 401k plans that Vanguard will not work with, these problems have been solved.  Companies like Wisdom Tree, Ishares, and a few other smaller players can now bring ETFs to a 401K plan, as well as traditional actively managed mutual funds.  Now the issue seems to be education.  In many cases, a company’s HR department is the gateway for 401k change.  Unfortunately, most HR people seem to be treating ETFs as some form of investing voodoo!  This is partially understandable with all the negative press surrounding inverse and leveraged ETFs.  If you take a closer look at leveraged and inverse ETFs, you will see that they only make up a small percentage of ETFs, are usually traded by professionals, and can be easily excluded from 401k plans.

The debate as to why ETFs should be in 401k plans could be argued on fund performance.  The active vs. passive debate has been covered a lot over the years.  The winner is usually a mix of both strategies, although in the interest of full disclosure, my firm uses a buy and hold global indexing approach to investing.  This keeps to our investing philosophy of maintaining a diversified portfolio, keeping cost low, and always investing for the long term.  Allowing index funds or ETFs into a 401k plan would certainly increase diversification and lower cost dramatically.

The cost of investing is something that is very hard for individual investors to follow.  The brokers gloss over the cost of investing.  Most that I have met don’t even understand that a mutual fund’s transaction fees aren’t included in the management or 12b-1 fee disclosures.  The average mutual fund costs 1.42%.  The average iShares ETF costs .41%.  The average index mutual fund costs .69%.  Since most 401ks have actively managed index mutual funds, in this cost comparison, there is a 1.01% difference in cost between ETFs and mutual funds.  If an investor had $20,000 in his or her retirement account and switched to an ETF portfolio, growing at 7% per year for 20 years, paying .50% in fees, the fund would grow to $70,500.  If the 401k participant used mutual funds at a fee of 1.5%, the money would only grow to $58,400.  This is a 17% difference!  Add in the fact that a University of Maryland study showed that only .06% of fund managers beat their assigned index from 1975 to 2007, performance is not even an issue; proper asset allocation and low fees are the key to success.

I don’t believe that rapid change is coming to 401k plans across America, but it could if employees understood what their real cost of investing is, and understood the power of global asset allocation indexing.  Certainly if Congress understood how insurance companies and America’s large financial companies are stealing from Main Street 401k plans, we might get change that we could invest in.

Until the day when indexing has its rightful place in 401k plans, there is a work around; a brokerage link.  Many 401k plans secretly have the ability to move a portion of a plan participant’s balance into a brokerage account.  Through this brokerage account, a participant can invest in individual stocks or… you guessed it… ETFs.  Buying individual stocks in your 401k is borderline reckless in my opinion; however a mix of large cap, mid cap, small cap, developed international, small cap international, emerging market, US bonds, US treasuries, international treasuries, and commodity indexes would be incredible.  I say brokerage links are secretly available because plan sponsors usually do not advertise this option. Why?  Most companies do not want their employees taking their retirement choices into their own hands.  I have met a few individuals that I would want to exclude as well, but in a free country, you’re fee to be stupid (or smart, as the case may be).  Another reason to do this is the low cost of ETFs.  A plan provider such as Merrill Lynch, Fidelity, or JP Morgan receives revenue from the mutual funds that are in the plan.  If a participant moves money to a brokerage link and purchases an ETF, the participant will pay a transaction fee to the plan provider; however if the participant uses a buy and hold strategy, the plan provider will not receive any more revenue.

I recently worked with the Atlantic Southeast Airlines Airline Pilots Association (ASA ALPA) on how to get more index mutual funds within the group’s 401k plan.  Despite the company’s fiduciary responsibility to look out for the best interest of the plan participants, the company continues to allow their plan provider, JP Morgan, to fill the 401k with proprietary funds like a Morgan Stanley mid cap that has not been in the top 50% of its peers in the last 5 years.  The company fails to understand the concept of indexing, asset allocation, and probably standard deviation and the Sharpe ratio as well.  These are things that someone who selects a 401k plan should know.  ASA  ALPA is in a unique situation in that the company wants a new pilot bidding system.  In return the pilots get a list of things, including a brokerage link.  Finally, the employees of ASA can buy and hold the ETF, thus saving them thousands in management fees.  Well and good, you would think, but JP Morgan has just put into place a new brokerage link policy that does not allow ETFs to be held in 401k plans.  Why?  Of course no rightly minded JP Morgan call center employee would go on the record, but let’s look at the facts.

In 2008, when billions were flowing out of mutual funds, ETFs saw record inflows, gaining assets from the mutual fund business.  There are over 900 ETFs on the market offering diversification in virtually any global asset class, many at less than 0.25% a year in fees.  Who loses here?  Well, besides the fund companies, plan providers such as JP Morgan will lose.  In this case I believe that the company (ASA) has the ability to say “Give it to us or we’re moving to one of the other providers (all of them) that do,” and the case will be closed.  The pilots have the ability to motivate the company to do this by simply stating, “No ETFs, no new bidding system.”  After all, we could be looking at a 17% difference in fund performance at retirement.  That is a pay raise they, and the rest of America, cannot afford to give up.

We have now come full circle here, and I believe that it all comes back to education.  An educated investor, armed with the understanding that no one is responsible for their financial freedom other than themselves, will be a successful investor.

Now go out, diversify, keep your cost low, and always invest for the long term.

Casey is the principal of Wiser Wealth Management, Inc., and has spoken around the world about ETFs and passive index investing, including the recent Inside ETF Conference in Boca Raton, FL.  He is also a pilot for Atlantic Southeast Airlines and works with ASA ALPA’s retirement committee but in no way represents the committee, ASA pilots, JP Morgan or the ASA, the company.  This article was written for www.ETFmarketpro.com.

What is your strategy and why do you use ETFs?

Matt, there are three ways to invest.  You can buy a stock, buy a mutual fund, or invest directly into indexes (ETFs).  The easiest way for me to explain this is if you purchased Coke stock and the evil people at Pepsi poisoned the Coke syrup, causing people around the world to die from Coke, your investment would be worth 0!  This is called company risk.  While everyone one tells you about their Google-type investment success story, many fail to mention the Enron type losses.  The next way to invest would be through a mutual fund.  While there are certainly some outstanding fund managers out there, the industry as a whole has had a hard time keeping up with the indexes over long periods of time.  If you hired a fund manager to pick your next cola investments, you are beting on his or her ability to avoid the Coke scenario I just mentioned.  A less expensive, more transparent, more liquid, and better diversified choice is investing directly into the index using an Exchange Traded Fund.  This is like buying all the cola companies out there, which greatly reduces your company and manager risk.  Our advisory fee plus the .25% cost of the ETF portfolio is over 1% cheaper than where you are today.  In real world terms, Wiser Wealth will purchases ETFs like the SPY that actually purchases all the companies in the S&P 500.  The same applies to TIPs, corporate bonds, small cap international, emerging market bonds, and stocks.

Wiser builds portfolios using mostly ETFs like the ones I just described to access various types of indexes around the world.  Our core investing philosophy is to maintain a diversified portfolio, keep cost low, and always invest for the long term.  We consider ourselves passive indexers with a buy and hold strategy.  However, each year we review our models to see if there is a need for rebalancing.  While our overall strategy is to buy and hold long term healthy assets classes, we essentially rebuild our 4 main models each summer.  While most of the indexes and allocations remains intact, this forces us to look to see if there is access to new ETFs/indexes/asset classes that will help us achieve a portfolio’s objective.  We build our portfolios in two ways.  Our aggressive model strives to achieve the maximum amount of gain for the least amount of risk.  All other models, such as conservative through moderate, strive to achieve the maximum amount of gain for a given amount of risk.  Here are some examples……………. Let’s compare the cost and performance of these models to where you are now.

What are the risks of ETFs that you’re not telling me about? What could go wrong?

The ETFs that we trade in are large, proven investments that have been around for a long time.  There are ETFs that use leverage or investing formulas that are not very clear.  These ETFs have additional risks.  We do use a commodity ETN that gives you the returns of a commodity index; however, you do not actually own any commodities.  What you own is a promise to pay the index’s returns.  Should the provider go out of business, you could lose your investment in that ETN.  We monitor the financial health of the issuer in this case.  For example, when Lehman began having issues, we looked closely at the health of Barclays.

Why not use index mutual funds?

Wiser uses a complete indexing approach.  We do not seek out actively managed mutual funds, as they generally are more expensive than indexing.  We do not believe that timing the market has proven successful.  There are index mutual funds that work for individual investors, but at our custodian, trading an ETF costs half as much as trading an index mutual fund.  Index mutual funds do have some tax disadvantages compared to ETFs and, for the individual investor, index mutual funds are more expensive.

I’ve heard commodity ETFs don’t actually deliver the spot returns you expect.  Why is that?

The way commodities get represented in commodity indexes and inside ETFs are typically through rolling futures contracts.  Returns from these contracts come from the change in the expected future price of the commodity; this price is very different from the actual price of the commodity that can be bought today, which is the spot price.

Many investors were surprised this year when the oil fund they thought was tracking oil prices was actually tracking the expected future price of oil.

Why should I pay an advisor to manage a passive investment strategy?  Can’t I do it myself?

For many investors, asset allocation is built on feeling rather than using standard deviation, the Sharpe ratio, and other types of risk measuring tools.  Will you rebalance your portfolio on your own?  Will you be able to understand economic events and how to adjust the portfolio accordingly?  Do you ever have tax questions or estate planning questions?  Our AUM fee covers not just portfolio management, but also tax and estate planning.  These are the questions that I would ask a do-it-yourself investor.  You have to take the emotion out of investing.  Many individuals have a hard time doing this, which is why at my firm, we manage by committee.

If you really want to invest on your own through a company like Vanguard, you do have the option to hire us by the hour.  However, it is usually cheaper to become a full service cleint.

How do you ensure you get good trade executions?

Most trades at Wiser Wealth are done through batch trades.  Batch trades allows us to pull all the investors’ trades together.  We then set limit prices on the ETF buys and sells.  Our limit prices are based on the NAV of the ETF at that moment of trading.  A simple way to get the real time NAV is through Yahoo finance.  Just add ^iv to most ETF symbols.  A Bloomberg terminal is the other way to get NAV.

What about currency?

We do not invest in currency as an asset class, but some of our indexes, like IGOV and EFA, have benefited from a falling dollar.  Last summer, we added TIPS to the portfolio while they were cheap, as no one was talking about inflation.  Currency ETFs are trading on currency futures, not actually buying the foreign currency.  This has additional risk in an abnormal market.  Long term investing in currency is not somehting that we see as healthy at this time.

I read about all the blowups in the leveraged ETFs.  How do I know who to trust?  Would you use leverage ETFs in your account?  What’s wrong with them anyway?

There is nothing wrong with leveraged ETFs IF you understand them.  We do not use leveraged ETFs.

I just don’t want my portfolio to go down 50%.  What can you do to help me?

For all our models other than the aggressive model, a loss of that magnitude is virtually impossible.  However, if losses are not an option, we can employ an option strategy on the S&P 500 to add income and create short term insurance on a portion of the portfolio.

Should I buy an ETN?

Yes, but carefully and probably only for commodity exposure.

I’ve read that you can only buy ETFs with $100 million in assets.  Is that true?

That is a good point, but there are 250 ETFs with less than $20 million in assets.  You can buy them, but if not traded carefully, you may end up purchasing at a premium.  Only one of our ETFs, IGOV, approaches that asset level, with $134M in assets.  We noticed when we added IGOV during our last rebalance that it took much longer to purchase at our limit price near the NAV vs. the quick trade at market.  The performance has been just fine, it just took a few extra hours to move the trade through.  Should it have taken longer, we would have simply called the TD Ameritrade trading desk to call the exchange to get the trade processed.

As a bonus here is a great link concerning the recent run up and fall of GOLD prices!!

            Salespersons, often disguised as “financial advisors,” sell mutual funds for a commission.  What many people don’t know is that the mutual fund industry organizes how these salespeople can receive their commission.  There are primarily three types of classes of mutual funds; A, B, and C.  All of these give the client access to the same manager and portfolio.

            ‘A’ shares are the most common type.  When a client chooses these, he or she will pay upwards of 5.75% of their initial investment in commission.  On top of that, the client will also pay an annual 12b-1 fee and management fee, usually greater than 1%, just for holding the mutual fund.  This means that the salesperson will receive the bulk of their commission at the beginning of the sale, followed by a smaller amount each quarter.  The ‘C’ share of a mutual fund does not have an upfront sales commission, but carries a higher annual management fee.  The ‘C’ share offers the salesperson the highest quarterly payout.

            The ‘B’ share of a mutual fund is often referred to as the back-end load fund.  This term is used because there is no fee charged for the client’s initial investment, but if the client wants out over the next 5 to 7 years, a penalty fee is assessed.  The salesperson in this case may still receive the bulk of the commission upfront from the fund company, so the back-end fee is placed in order to make sure that the company can recoup their commission payment.  The ‘B’ fund also carries an annual management and 12b-1 fee, usually more than the ‘A’ share, and equal to a ‘C.’  If the client holds the ‘B’ share for the 5 – 7 year period, it will convert to an ‘A’ share. 

            In 2000, Morningstar reported that ‘B’ share mutual funds made up 7% of mutual funds offered.     9 years later, this number has dropped to only 1%.  The Wall Street Journal (WSJ) recently reported that Goldman Sachs, Allianz, and American Century have all exited the ‘B’ share market, citing low client demand.

            According to Larry Light of the WSJ, ‘B’ shares were created to compete with the no-load mutual funds offered by Vanguard and T. Rowe Price in the late 80’s.  No-load funds do not have any upfront fees and comparatively low annual fees.  Mr. Light’s WSJ article also states that the brokerage firms are tight lipped about why they are getting out of the ‘B’ share market.

            At the beginning of the article, I mentioned the term financial advisor using quotations.  This was to help explain the difference between the two current standards for financial advisors.  The brokerage houses (Edward Jones, AG Edwards, Morgan Stanley, etc.) are not held liable if they sell the client a product that isn’t in his or her best interest.  The client only has to be ‘suitable’ for the investment.  (For more information about what this means, follow this link for an article on the Cruel World of Financial Advice ).  On the other hand, an Independent Advisor is required to put the client’s interest first.  This is called fiduciary responsibility.  The Obama Administration believes that every advisor should be held to a fiduciary standard.  On this point, I agree with the President (for once).  Brokerage houses are fighting this fiduciary standard because when they look at the bulk of their “tool box,” they see that this requirement would wipe out their under performing overpriced products.

            So is the “lack of demand” for the ‘B’ product because brokers are cleaning up their act and ditching one terrible product to show that they really don’t need to be fiduciaries to have the client’s best interest at heart?  And so they can shill other overpriced products instead?  Or, are investors wising up and letting “advisors” know that these are bad investments?

            In my opinion, ‘B’ shares were never really good investments.  In fact, the regulators capped the maximum that could be placed in a ‘B’ fund at $50,000.  They probably wanted to do away with them completely, but, as things often go, the big brokerage lobbyists worked a compromise to keep these unfair investments alive.

           For many, the benefits of creating a long term diversified index portfolio are well known.  In fact the emergence of ETFs, with their easy access to small cap international, emerging markets, commodities, foreign currency, and many other hard to reach asset classes, has helped passive indexers achieve more diversification and many index professionals achieve higher returns.  I have seen a resurgence this past year in the active versus passive debate, due to the S&P 500 having a negative 10 year track record. On our news media outlets, the defenders of passive investing always seem to refer to the dilemma of buying and holding individual securities vs. actively trading securities.  However,  there is also a debate on whether to buy and hold index funds or buy and hold mutual funds.  Active fund managers want you to believe that they can always time the market’s ups and downs and that, for the most part, they will pick winning stocks.  This is absurd, of course, but many individual investors, confused by all the debate and different investing schools of thought, fall for the sizzle of short term performance without thinking of long term results.

            There is an old joke that financial news journalists write about the hot stock or mutual fund by day and privately invest in long term healthy index funds by night.  Could this be true of active fund managers as well?  This is where the term “closet indexer” comes from.  A closet indexer is a fund manager that mimics the index, or benchmark, that he or she is assigned to outperform.  For example, if a fund manager has the same holdings as the S&P 500, thus the same performance, the manager would be a closet indexer.  The problem here is that the investor is probably paying 50bps (0.50%) or more for the performance, and thus would have been better off buying the S&P 500 index, SPY, or the Vanguard S&P500 index mutual fund equivalent with fees less than 1/10 of a percent.

            Job security and fund size are two major reasons why a fund manager would mimic its assigned index.  Fund managers have their performance measured quarterly, so they do not want to stray too far from their assigned index.  While they may take additional risk at times to attempt to make up for their fees or try to outperform the market, the overall portfolio is invested in the same sector percentages as the index.  The idea is that fund investors would not pull their money out for poor performance if the fund manager performed near the index or his or her peers.

            The size of the mutual fund may also push the manager towards being a closet indexer, since only so much can be invested in companies that the manager sees as outperforming the market.  The remainder of the fund’s assets are then invested in securities that match the index so that overall performance versus the index will not go awry.

            Closet indexers are fairly easy to spot.  The most common way to find one is to take the R Squared of the fund.  R Squared is a statistical measure that represents the percentage of a fund or security’s movements that can be explained by movements in a benchmark index.  For example if a fund has an R Squared of 97, then 97% of its movements matched that of its assigned index.

            A search within Morningstar’s database of 24,900 open ended mutual funds for a 10 year R Squared greater than 96 and fees greater than 0.50% found 742 funds.  In most cases, an ETF should not cost you more than 35bps (0.35%), but I gave the fund managers the benefit of the doubt by searching for management fees greater than 50bps (0.50%).  This means that 3% of all open ended mutual funds perform no better than their assigned index over a ten year period and cost double what they should.

            When I dropped the R Squared to 95 or greater, 1,723 funds were returned, making 7% of open ended mutual funds subject to our closet indexer title.  I then looked for an R Squared of 97 or greater over the last 12 months with a management fee greater than 0.50%, and the return increased greatly. 5,377 funds were returned, making 22% no better than the index itself.

            As you look at your mutual fund, you have to take into account the cost of active management.  Maybe your manager beats the market by a few percentage points, but what kind of fees do you have to pay for this performance?  Is the net performance near the index returns? Is your fund manager a closet indexer?

            This New Year, you should resolve to consider putting your portfolio on a diet and look at the benefits of low cost Exchange Traded Funds (ETFs).

The death tax has always been a hot topic as many believe that this money has already been taxed and should be left alone. Others see the dead as easy targets to generate tax revenues for their favorite government projects.

You should always do financial planning on current laws versus what might be.  In this case, it appears that the tax is not going away.

Casey T Smith, Master of Estate Preservation (MEP)

Today was my first day on the job as stay at home dad. Well, we did not really stay home. Since the kids were in school, I got a half day in at the office and by the time I got the kids home at 1:30, our two year old was trying to climb into her crib as she was telling me “nite nite” and our four year old was equally sleepy. So, my work continued while they slept. Later, Banks, our English Springer Spaniel, informed me that the mailman had arrived and that I must act immediately. This also meant that my wife may soon be home and my first day as king of the house might end with no screaming, crying or broken bones, and the house left in better condition than when she departed at 6am this morning. Only 14 days left!

As I sorted through the mail, I noticed a postcard advertising “401K Maximizer.”  This caught my eye since most 401k plans are loaded with unnecessary fees, underperforming fund managers, and are usually the most under advised assets in the industry (from a participant perspective). To further my curiosity even more, it was geared only toward airline employees, the most underpaid and overworked population outside of stay at home moms and dads, teachers and a few others.

This 401K Maximizer appears to only be available to those employed by Southwest, Northwest and American Airlines. The service chooses the best (we would say the least worst) mutual fund available in the 401K plan for that particular airline each month according to a conservative, moderate and aggressive risk strategy. The service also will measure the risk of the market and move out of the market based on certain indications. This requires a subscriber to make monthly allocation changes to their 401k.

The website boasts significant returns vs. the S&P 500 since 2001, using an investment method described as “actively upgrading” and said of passive investing, “Buy and hold asset allocation is a recipe for under performance.” For example, the subscription service shows $1,000 invested in 1998 using their service now worth $5,000 vs. the S&P 500 worth just over $1,300. We must note here that back testing must have been used since a quick search on the website shows this as a relatively new product.

Citing the University of Maryland’s Study on the long term performance of mutual funds managers, where only .06% actually beat their assigned index, and recent reports from Morningstar showing that even short term performance leaves little to be desired, we certainly would like to see another strategy used in 401ks other than active mutual fund management and the buying and holding of underperforming mutual funds. However, I am very skeptical that any market timing monthly trading model can hold up over a long term investment time horizon. If this is indeed it, then it would fall into the .06% of managers that can beat the market over the long term. Actually, they are not really managers, but managers of mutual funds, which would make them active traders of actively trading fund managers!

Buying and holding 12 Exchange Traded Funds in asset classes such as commodities, emerging markets, foreign treasuries, emerging market bonds and other traditional long term healthy asset classes, an investor can easily beat the S&P 500 with much less risk. This buy and hold passive approach with a investing cost less than 25bps (0.25%) has a much higher probability of long term success and is much cheaper than active investing.

To avoid repeating myself, I will refer you to my recent entry on indexing HERE.

To those of you eager to make monthly changes to your 401K plan, I urge you to do four things first.

1. If you have access to a brokerage link within your 401k, invest using ETFs vs. the mutual funds within your plan.
2. If no brokerage link is available, then email your HR Benefits department and request that a brokerage link be added in order to access lower cost, better performing ETFs. You can also request that Index Funds be added to your plan, or if you are really shooting for the moon, ask for a Vanguard 401k plan.
3. Resist the urge to day trade your retirement. Open a brokerage account with money you can lose and experiment with that rather than your life’s savings.
4. If I still can’t convince you, then read the disclosure page on the 401 Maximizer website:

“The publisher does not analyze the suitability of any particular fund or investment approach for individual investors nor make specific recommendations tailored for individual investors. These portfolios have significant risk and are for the sophisticated investor willing and able to assume a high degree of risk. It is up to the investor to decide their risk level and investment method. Model performance results may have inherent limitations, some of which are as follows. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently significant differences between hypothetical performance results subsequently achieved by following a particular strategy. There are numerous other factors related to the markets in general or the implementation of any specific trading strategy which cannot be fully accounted for in the preparation of model performance results and all of which can adversely affect actual trading results. This material has been prepared or is distributed solely for informational purposes. Past performance is no guarantee of future results. Further, 401k Maximizer, Inc. does not accept any responsibility for gains for losses an individual may experience. All trading is done at your own risk”.

I certainly welcome a new approach to 401k management, but I believe that it is through employer sponsored education on investing and a passive approach using index funds. I will acknowledge that the 401k Maximizer approach may achieve superior short term results, but the higher probability of success lies in the less flashy, more boring buy and hold approach. We also have the data to prove it!

Keep your investing cost low, maintain a diversified portfolio, and always invest for the long term.

By breaking down the global sector ETF products on the market, the investor can get a grasp of the best way to capture sector returns throughout the globe, in domestic, developed and emerging markets.

Businesses throughout the globe seem to correlate most with other companies within sector groups even before country, region, size and style.  Therefore, when using a strategy involving sectors, reaching outside the US, even into emerging markets, makes sense as a way to add better risk and reward possibilities while controlling sector exposure, which tends to be correlated even across regions and borders.

Global returns can be explained by sector returns. Correlations among countries can even be explained in a great deal by sectors and the differences in asset allocations between their respective market indexes.

The Global Benchmark

The 10 global sector iShares ETFs represent the sector makeup of the S&P Global 1200, which represents 70% of the world’s market cap. The sectors are broken down from this index based on the 10 GICS (Global Industry Classification Standard) sectors, which are jointly managed by S&P and MSCI Barra. Below is a chart of the iShares global sector ETFs. Each ETF represents a GICS sector from the S&P Global 1200 Index. Also included are each ETF’s total net assets.

The GICS sectors are designed to place companies throughout the globe into sector categories.  Currently, the S&P Global 1200 Index, which is made up of the 10 GICS sectors, is broken down below as of 9/30/2009.

Data: Morningstar Office 9/30/2009

Why Global

Since sectors have a higher correlation globally compared to different sectors domestically, investing on a global sector basis could provide significant risk reward profiles, as making sector decisions for the US is benefited by global correlations and the higher growth possibilities abroad and the lower correlations to the overall US market. Instead of concentration on sectors domestically and adding international exposure, moving to a global sector strategy is a way to capture both domestic and international exposure. Since sectors seem to correlate throughout the globe, from US companies to companies within emerging markets, using global sector ETFs is a way to efficiently execute an investment strategy involving sectors.

Data: Morningstar Office 10/1/2004-9/30/2009 (US sectors are the S&P 500 GICS Sectors and Global Sectors are the GICS Sectors from the S&P Global 1200 Index.)

The above scatter plot displays the similar risk and total return characteristics of the US sectors, shown as circles, and the global sectors, shown as squares of similar colors. Note that the global sectors do include a significant allocation of US holdings and the chart merely shows the movements of a sector as international developed and emerging markets are added. In general, the movement from US to global has a positive risk reward effect.

Comparing global sectors to the S&P 500 GICS Sectors shows the benefit that could be added to US sectors by adding international holdings. The differences vary throughout the different sectors; however, typically, the global sectors (squares) are above and often to the left, showing higher total return and less risk throughout the last five years. This is what using global sectors would have added even if the investment decision was based on the more familiar US sector analysis. Based on the above chart, over the past five years, adding international sector holdings to US sectors had a positive effect.

Reaching Out Internationally

The Global Sector ETFs, being market cap weighted, have heavy US allocations. This provides a way for the investor to make global sector allocation decisions while leaving domestic and international, developed and emerging market and market cap decisions to the index or marketplace since correlations among sectors run high across borders.

This means that the risk of adding international sectors to sector strategy decisions has a low marginal affect on risk relative to the overall sector decision. This is because correlations have been proven to be high within sectors, explaining returns. Therefore, the largest risk factor is in the sector and the risks associated with it.  Emerging and developed international markets will bring unique risks; however, the risks of the sector are among the most dominant.

The graph below breaks down the exposures of US, international developed and emerging market  holdings within the iShares ETF series. It is interesting to note that the breakdown of developed versus emerging markets shows the areas where emerging markets have the greatest effect on the global economy. For example, the iShares S&P Global Materials Sector Index Fund (NYSE Arca: MXI) has an 8.5% exposure to emerging markets, which shows the growth of the world’s demand of developing countries’ mining products, metals and other materials.

Data: Morningstar Office 10/6/2009

Sectors Have A Place

Keep in mind that this is not necessarily a call to abandon broad diversification, but a need to focus on the importance of sectors as they relate to global return. Also, when investing with sectors, using and adding international exposure has returned benefits to almost every sector. In this way, an investor can analyze and invest among US sectors, while gaining correlated international exposure, which has higher long term risk and reward potential.

International bond ETFs are an asset we can no longer ignore, but as some industry experts have brought up in the past, bond ETF construction has many inherent flaws.

The construction flaws in ETFs often stem from the methodology of the indexes which the ETFs track. Bond indexes use a method similar to market cap weighting, sometimes called market value weighted, in which bonds are weighted by debt outstanding, rewarding companies and countries that have more debt with a higher percentage of the index’s allocation.

Below is a chart of the growth in the iShares Barclays Aggregate Bond Fund (AGG) compared to the two international Treasury bond funds,  iShares, S&P/Citi International Treasury Bond (IGOV) and SPDR Barclays Capital International Treasury Bond (BWX), 1/23/2009 through 11/15/2009 (Source: Morningstar Office).

As the chart shows, there’s been significant growth in the international bond funds, with a AA rating for both the international funds. This outperformance is mostly due to the favorable change in the dollar relative to other currencies.

The low correlation and ability to capture returns from a falling dollar inside of a fixed income product can be extremely beneficial when investors want exposure to international markets, but are wary of the potential risks from overexposure to international stock markets.

Structural Risks In Bond ETFs

As discussed above, bond ETFs weight by the amount of debt outstanding, and this applies on a country level for these international Treasury bond ETFs. When looking at international debt market indexes, we notice a significant slanting towards Japan, because the large amount of debt the country holds.

As shown in the graph, Japan makes up large percentages in both ETFs and The SPDR Barclays Capital International Treasury Bond (BWX). Italy also has a large holding. Because of the diversification rules for the funds, any country weight is capped at 24.95% and the bond ETFs are rebalanced monthly to maintain the country exposure, set annually in March.

These two bond funds represent the developed international treasury market as determined by debt amounts. Countries with higher debt levels are given higher allocations. This is a risk, since countries with larger liabilities have more risk and a higher chance of defaulting on those bonds, despite the low probability of that actually occurring.

Investors are compensated for the extra risk they carry. Currently, The SPDR Barclays Capital International Treasury Bond (BWX) has an average coupon of 4.32%, as of 10/31/2009. The iShares S&P/Citi International Treasury Bond (IGOV) has an average coupon of 3.85%, as of 11/11/2009. For a comparison, a US intermediate Treasury benchmark ETF, iShares Barclays 3-7 Year Treasury Bond (IEI), has an average coupon of 3.58% as of 11/11/2009.  Keep in mind that the international Bond ETFs have seen large returns this year, which has pushed down yields. The iShares S&P/Citi International Treasury Bond (IGOV) has risen 13.02 in the last six months, ending 10/31/2009, and The SPDR Barclays Capital International Treasury Bond (BWX) has returned 12.68% during that same time period. Meanwhile, US Treasury ETF, iShares Barclays 3-7 Year Treasury Bond (IEI), has returned 0.70% in those last six months (Source: Morningstar Office).

When analyzing bond ETFs, it is important to consider the diversification and allocations of the underlying indexes and where the fund’s risks may be. The international developed treasury asset class has many aspects that would be a powerful addition to a portfolio, giving access to profiting from a falling dollar with less volatility than would be present in international stock portfolios, all while providing income and low correlation to US bond sectors.

My first stop is with my friends at Index Universe. www.IndexUniverse.com is a great resource on ETFs and their quarterly newsletter “Journal of Indexes” is a free publication to financial advisors. This quarterly publication is treated like gold in our office. Each quarter, some of the best talents in the world of finance write articles about indexing. The cover of the current edition reads “death of the dollar?”

In the first article, “Currency the Overlooked Asset,” authors Dave Nadig, Matt Hougan and Lara Crigger describe what moves currency. This will help you understand the basics of what makes the dollar move.

You have to understand that the dollar does not have a value alone on the market like Coke or GE stock, but we must compare the dollar to other currencies to get a relative value. The world’s major currencies are the US dollar (USD), the euro (EUR), the British sterling pound (GBP), the Japanese yen (JPY), the Swiss frank (CHF), the Australian dollar (AUD) and the Canadian dollar (CAD). We can now take a look at what moves these currencies. I quote the article directly.

“Interest rates: Every currency lives in the context of the interest rates being paid by a country’s central bank for purchases of government bonds. Comparatively high interest rates tend to attract investor to a currency. Lower interest rates, on the other hand, tend to depress a currency’s value.

Inflation/Deflation: Countries with low inflation will see their currency appreciate, as their purchasing power rises relative to other countries. High inflation, on the other hand, usually depreciates currency values.

Economic Indicators: Employment data, retail sales data, GDP growth and other economic health indicators can influence the value of a country’s currency, but these signals are often highly contextual. For example, strong employment data after a market crisis might support a currency, as it suggests economic recovery. But in a healthy economy, it could signal inflation which would depreciate a currency.

International Trade: Countries that import more than they export (e.g. Japan) must sell their own currency in order to purchase the currency of their export partners and thus will see their own currency value depreciate as a result. Thus, shifts in macroeconomic international trade metrics such as current account, capital account and financial account data can all influence exchange rates.

Geopolitical or Global Economic Events/Default Risk: Wars, coups, civil unrest, elections, fiscal policy decisions and local or worldwide financial crises can all change a country’s underlying economic health, and even increase its default risk, thus affecting its currency.

Commodity Prices: If natural resources drive the bulk of a country’s economy, then the country’s currency is also move with value of the commodity.”

So now that we see the basics of what makes a currency move, my second stop is Bill Gross of Pimco. Mr. Gross is probably the best bond fund manager in the world and has the track record to prove it. He recently appeared on CNBC to discuss king Dollar. My summary of the discussion is as follows: (Full article here)

Bill Gross believes that the dollar will continue to decline. He believes that the dollar is “over owned” in that the government has increased borrowing and this will make the dollar “more and more owned and less and less desirable” but this is necessary for balancing the world economy, as it may result in higher production in the US and lower production in China.

He also adds that the US Government talks that it wants a strong dollar but its actions are the opposite and maybe for a good reason. ”Let’s face it, a lower dollar is basically a protectionist barrier,” he said. “The Federal Reserve is likely to keep rates at the same level for a while, because the economy would need to grow by nominal rates of 4 percent or 5 percent to prevent debt from destroying growth,” he said. “They [the Fed] have to stay low because the embedded cost of debt in the economy is 67 percent,” said Gross.

Gross also talks about a “new normal,” where companies will be de-leveraging and where home buyers are just going to have to put 20% down as opposed to 0%.

The US workforce is currently at a high level of unemployment, the Feds are keeping interest rates low and the government is borrowing money at record rates. This is a very simple explanation as to the decline in the US dollar. There are certainly more complicated issues, but the point here is that we need an economic recovery to regain the value of our currency.

Additional Note: As I write this, the US Government is debating entering into the health care business for which it currently does not have the funds. Certainly, curbing government lending would help the dollar. After all, as Bill Gross mentioned, China and other foreign countries will only lend so much. At some point, we have to stop borrowing. Maybe a health care bill should wait until we have money to spend, or we better hope China will be offering no payment and 0% interest for 100 years!

The report shows that overall only 37% of actively managed mutual funds beat the assigned Morningstar Style Index over the past three years. Over the past five years, investors had a 50/50 chance. The report also noted that over long periods of time active mutual fund outperformance vs. the index is very rare.

For the funds that did beat the assigned index, they did it with less investing risk than their peers, meaning that the under performing funds that were fully invested did worse that the ones that held more cash. Historically, this scenario is reversed, however the last three years have altered normal risk reward expectations.

Over the last 5 years, 25% of mutual funds have gone out of business. These funds generally were under performing or had other issues, but were taken into account in this report to prevent a survivorship bias in the results.

The report certainly shows that there can be winners in the active mutual fund market; however, we at Wiser do not think that it is efficient or feasible to chase the “hot” manager and would rather invest directly into indexes. This allows us to eliminate manager risk, maintain more diversification than fund managers, keep cost low and invest for the long term. We know that the odds of success are 99% in the long term and this report shows that we could beat the active managers in the short term with the odds of 63%.

You can view the Morningstar report HERE.

If you watch just 30 minutes of CNBC commercials or peek at web banner ads, there is a big push for companies selling their investment strategies. One company claims their strategy called the “top of the market” in 2007 and the massive sell off last fall. Another has a foolproof system to back test your technical strategy. Amazingly, some of these folks believe they are reasonable. I think most people and financial advisors can see through this sales pitch, but how many people do you know think they personally have an above average investment strategy?

I think it is in our human nature, or at least in the nature of financial professionals, to believe that we can be winners. Thus, we believe that we can beat the market over the long term.

As an advisor, it is always interesting to see the portfolios when they are first transferred. Most of our assets seem to come in from brokerage houses, thus we see clients in A Funds,  all in the same fund family. The fees are typically high and most are lacking in a lot of ways compared to their benchmark and mutual fund peers.

Throughout 2008 and 2009, we have been reading that buy and hold is dead. I agree that if you bought and held just the S&P 500, this could be the case. However, applying even just your college basics of investing 101, we know not to do that. By simply using the long term standard deviation and correlation of several asset classes and the S&P 500 as the benchmark, one can add treasuries, high yield bonds, emerging market bonds, international treasuries, the US Bond market, commodities, small cap, mid cap, large cap, developed international, international small cap and emerging markets to a portfolio. The right allocation can hold up in bull and bear markets with overall less risk and usually a greater return than the S&P 500 and even an asset allocation benchmark. It is, of course, not a perfect system, but it seems by mixing asset classes, a portfolio can become very above average.

I know this from experience; since I took my firm to all indexing in 2004, this has been the case. If you back test the same portfolios 10 years, we see the same results. Prior to 2004 and my ownership of the company, Wiser Wealth was a stock picking firm. The stock picking did okay during those years, however, after capital gain taxes and transaction fees, clients fell behind the mark. After switching to ETFs and a passive strategy, the capital gain tax bills shrank and our clients liked the reduction in trade confirmations!

After reading thoroughly through the Journal of Indexes, two publications of Active vs. Passive and the University of Maryland Study that shows that less than 1% of active managers have beat their benchmarks net of fees from 1975 to 2007, I don’t see how advisors can chose active management over passive. At least they should admit passive is better for everyone but themselves, right?

10 Year Risk Reward Chart – Source – Morningstar Office Edition

Is buy-and-hold dead? No way. Passively investing broad-based index funds throughout the globe works, and that strategy has no tricks to it or special systems.  The above scatter plot shows the risk/reward for various asset classes over the last 10 years as of 9/31/2009.  As seen above, different asset classes had very different risk and return characteristics over the last 10 years. Bonds and Treasury Inflation Protected Securities had an annualized average return of 6.8% and 7.1%, even with inflation at historically low rates, to which the bonds are linked. Emerging Markets with an annualized 10 year return of 12% took on more risk, but it paid off with its above average return.

As more advisors become independent and get away from the old commission system and take on fiduciary responsibility, buy and hold indexing will thrive. Diversifying a portfolio throughout global asset classes makes a difference. And even in times of crisis, it tends to lessen the affects of even a global recession, where investors fled stocks to invest in government bonds, pulling money from global investments to the US, increasing the value of the US Dollar (temporarily) and US Treasury Bonds.

The cost of indexing is minimal compared to an actively trading mutual fund manager. As more conflicts of interest are revealed with the mutual fund world and commission brokers, the brighter the indexing option will shine. After all, with all the turmoil of 2008, ETFs actually increased in usage and size.

Currently, if you die in 2009, the Federal Government will not tax your estate unless your net worth is over 3.5 million. After this individual exemption, a maximum tax rate of 45% applies. If you die in 2010, there is no death tax regardless of the value of your estate; there are rumblings that the House of Representatives may extend the 2009 schedule for one year, but the Senate wants a much larger exemption and significantly lower rates.

Currently, beginning in 2011, the death tax will come back with an exemption of 1 million per individual and a top tax rate of 55%. It is highly unlikely that Congress will do nothing since these 2010 and 2011 numbers seemed so far away when the estate tax laws were modified.

There are three key estate tax bills floating out there: Senate Bill 722, House Bill 2032 and House Bill H.R. 436.

Senate Bill 722 would make permanent the 2009 3.5 million exclusion and the top 45% tax rate. The bill will also reunify the estate and gift tax credit, allow for the transfer of a deceased spouse’s unused exemption to the surviving spouse and index the exemptions for inflation.

House Bill 2032 will make permanent the exemption level at 2 million, index that level for inflation and establish a progressive tax rate of 45 percent for estates valued between 2-5 million, 50 percent  for estates valued at 5-10 million and 55 percent  for estates over 10 million. The bill will also reunify the estate and gift tax, create exemption portability, restore the state estate tax credit and provide indexing for inflation.

House Bill 436 would freeze the exclusion and tax rate at the 2009 levels, reunify the estate and gift tax so that the cap on tax free lifetime gifts would go from the present 1 million to 3.5 million, limit the valuation discount for family limited partnerships and provide strict valuation rules for transfer of non business assets.

The Congressional Budget Office has a report out that offers four additional options.

Alternative 1 would set the exemption for the combined tax at 5 million starting in 2010, index that for inflation, set the tax rate equal to the top tax rate on capital gains, allow stepped-up basis for assets transferred from a decedent and deny a deduction or credit for state death taxes.

Alternative 2 would be the same changes as 1, but apply a two tiered rate where the first 25 million transferred would be taxed at the highest capital gains rate. Anything above 25 million would be taxed at 30% and indexed for inflation.

Alternative 3 would retain the 3.5 million exemption, index that for inflation, set the top tax rate at 45%, retain the step up in basis and allow a deduction for state death taxes.

Alternative 4 repeals the estate tax in 2010, retains the 1M gift tax exemption and institutes a carryover basis regime.

With respect to the four CBO options,  Ron Aucutt of McGuire Woods, LLP points out that “CBO reports like this, which are issued from time to time, are usually routine contributions to the data available to Congress. They analyze the estimated spending and revenue impacts of proposals known to be under consideration or seriously proposed. They typically do not develop new options on their own or make recommendations among options. Usually, the reports get relatively little public attention. But this time, presumably because of the high political profile of the cost of health care reform and the recent political spotlight on the CBO (including the unusual invitation of the CBO Director to the White House), this report inevitably has a higher profile. As with past reports, it purports only to analyze known options for altering federal spending and revenues.”

Investable indexes are designed to be realistic representations of actual market spaces (the S&P 500 index represents the securities in the S&P500); however, in some asset classes, indexes are too idealistic to be managed as ETFs in a cost effective and efficient manner. Many Exchange-Traded Fund companies employ index sampling techniques called index optimization to help track the index more effectively. This is where the index will not attempt to purchase every stock in the index, but purchase a sampling of securities. There are drawbacks and benefits to optimization techniques, which vary among asset classes and ETF issuers.

The main reasons that an index would need to be sampled by an ETF are liquidity, trading costs and large numbers of holdings. There are many issues surrounding this topic and investors should be aware and include these risks in their analysis.

Creation Units

A fundamental feature of ETFs is that they trade over exchanges with intraday market prices. These market prices are ideally supposed to be in line with the intraday movements of the underlying holdings of the fund, but some variance is normal. A basket of underlying securities or assets that the ETF represents is called a creation unit. The intraday price of a creation unit is tracked by an ETF’s intraday indicative value (IIV), which is the fund’s net asset value (NAV). The ETF’s NAV is managed and has one objective-to track the index benchmark.

A creation unit is one basket of securities, which together make up the ETF’s NAV and underlying investments. Each day, the creation unit is set by the ETF’s management so that market makers can create liquidity for the ETF by trading in ETF creation units for ETF shares or delivering in ETF shares for creation units.

Since it is market makers that create this liquidity and fair pricing for ETFs, it is important to have a liquid and tradeable creation unit so that this process can be smoothly done. This is why splitting ETF shares makes a lot of sense and is extremely practical. This is unlike stock splits, which add no actual value. Since creation units are traded in units of 50,000, splitting an ETF from $100 to $50 (with no change in value) allows a creation unit to be handled with only $2.5 million instead of $5 million. This is a useful ability when cash is harder to obtain or tie up.

In the same way, when a creation unit is made up of a small number of very liquid assets, the creation units are easier to obtain and trade and therefore make the ETF more efficient. For example, the stocks within the S&P 500 are so easy to obtain and trade that on any day, that S&P 500 ETFs are some of the world’s most efficient ETFs.

Below is a chart showing the difference between the number of holdings in two ETFs that track the same index compared to the index which they both track. The differences between the two ETFs and the index are vast and each has different benefits and risks.

Vanguard, in general, does not optimize or sample indexes, but includes all or most of the underlying holdings of the index. They do this to minimize the risk of tracking error and desire to represent the index without any management decision. The ETF included below actually has more holdings than the index; this is because of the international nature of the emerging market investments and the need to have underlying liquidity during US trading hours while international markets are closed. Vanguard merely “doubles up” on holdings when the exact same international stock is available as an ADR investment.

IShares, in general, practices sampling of the indexes which they track. As seen in the chart below, the iShares emerging market ETF has half the holdings of the index. The reason for this, as addressed above, is that the creation units of the ETF have 386 stocks instead of the 751 stocks in the index. This smaller basket makes creating and redeeming creation units much easier, especially since liquidity may be an issue with some of the stocks from emerging market countries. The risk of this kind of sampling is that tracking error may happen. A report on the tracking error of these two funds is here.

Data: Morningstar Office 9/30/2009

Liquidity

Emerging market ETFs are a good example of the differences between sampling and full replication ETF products. The tracking errors and cost have been extremely different in the past. The example of emerging markets is not the only place with these differences between funds. However, it is a good example to show how to break down and explore these differences in any asset class.

Liquidity in many asset classes is an issue, especially when dealing with ETFs. It is widely thought that ETF liquidity only matters when concerning bid/ask spreads, but the most important liquidity factor is in the underlying holdings of a creation unit of an ETF.

Like the example of emerging markets above, liquidity is something that ETF managers optimize since it is so important. For example, when a stock within an index represents .001% of the overall index, it has a low marginal effect on the overall returns of the index. In this case, sampling the index to exclude stocks with this little amount of overall effect allows the creation unit to be free from obtaining this stock (which may be costly) with little effect on tracking error. When an index contains a majority of very small holdings, the issuing becomes harder.  The creation unit is more costly to put together and trade for market makers, and when the small holdings are extremely illiquid, as they will often be since most indexes are market cap weighted, the pricing on these stocks, which are the majority of the fund, can be inefficient.

Explore the Differences

Investors must choose between index sampling ETFs and full replication products. Each asset class has a unique set of issues and risks surrounding sampling and should be dealt with on an individual asset class basis. An investor should be looking for the least amount of structural risk within an ETF product that will allow for the best representation of the assigned category.

Commodity ETFs are different than traditional, plain vanilla ETFs and investors need to be made aware of the risks.

Exchange-Traded Funds come in many different “flavors” and therefore, are useful in many different ways for a large variety of investors. Commodity ETFs and Exchange-Traded Notes have different legal and regulatory structures that make them unique ETF and ETN products.

Commodities are in themselves different investments that require a different structure to be used as ETFs. Some commodities, like gold, can be directly held with only limited costs since it can be stored in vaults. Other commodities, like wheat, cannot be stored because of its limited useful life, or are inefficient or extremely difficult to store like oil or natural gas.

For hard to physically hold commodities, investment through futures contracts is more appropriate. Futures contracts are simply a contract to buy something in the future at a future price. Futures contracts come in many different duration lengths where the market determines the future price.

Trusts and Taxes

Commodities inside of ETFs are generally structured as Grantor Trusts and the tax consequences may surprise some investors. The typical tax structure for traditional ETFs tends to be highly tax efficient, and investors typically only need to incur tax consequences from buying, selling and funds distributions. For these trusts, investors will receive tax documents as partners in the trusts. Simply, commodity ETFs have not-so-simple tax structures that investors need to understand before investing, going much further than the simple discussion above.

The trusts’ structures are different from other ETFs. For example, iShares gives this warning on their website for the iShares COMEX Gold Trusts, IAU.

The iShares® COMEX Gold Trust (“Gold Trust”) is not an investment company registered under the Investment Company Act of 1940 or a commodity pool for purposes of the Commodity Exchange Act. Shares of the Gold Trust are not subject to the same regulatory requirements as mutual funds. This information must be accompanied by a current prospectus.

Exchange-Traded Notes

ETNs are a way for commodities to be packaged into an exchange-traded product structure, while being free from some of the complexities trusts have. ETNs are debt notes issued by investment banks to give the investor the total return of an index. The investor does not actually own anything but a promissory note for the total return of the index. ETNs, despite having counterparty risks, have no tracking error other than their expenses.

Commodities are Strategies

The way commodities get represented in commodity indexes and inside ETNs and ETFs are typically through rolling futures contracts. Returns from these contracts come from the change in the expected future price of the commodity; this price is very different from the actual price of the commodity that can be bought today, which is the spot price.

Many investors were surprised this year when the oil fund they thought was tracking oil prices was actually tracking the expected future price of oil. Below is a growth chart of the S&P GSCI Crude Oil Spot Index shown by the blue line and the United States oil fund (USO) shown in green.

Structural Risks of Futures

With the style of rolling futures contracts, they are specific risks in certain market conditions.  These passive investment vehicles will renew the futures contracts held by the fund in a systematic way. For example, an ETF may use three month futures contracts, so every three months the fund management renews and rolls the fund’s assets into new, three month contracts. The potential for issues is when the market has conditions that systematically erode value.

Contango and Backwardation

Investing in funds that are continually rolling into new futures contracts before expiration can face positive or negative roll yield. Roll yield is the gain or loss caused by rolling into higher priced or lower priced contracts.

A term call Backwardation is where there is a positive roll yield from buying cheaper contracts, meaning that prices are lower as the investor buys contracts to take delivery farther out in the future. Rolling future contracts in this market condition can be profitable as the fund is able to purchase more contracts at lower prices. The risk is if the market moves into a condition where prices are higher for contracts taking delivery further out. This market condition is called Contango and negatively affects funds with a rolling futures contract strategy. This will cause the contracts to depreciate in value.

In this way, investors can gain or lose value in these types of market conditions from positive or negative roll yield.  The roll yield can affect the ETFs investing this way and is a risk of these kinds of products.

The graph above, displaying how the United States oil fund (USO) has been veering away from the spot, is not being helped by the Contango market where it must purchase more expensive future contracts even as the market continues to be volatile. These negative roll yields hurt investors and make tracking movements in the spot price difficult. In the oil market, this is especially frustrating for investors who thought they would see returns as the spot price of oil, and in turn, gas prices, increase.

Careful analysis is required when investing and understanding the structural risks in the marketplace in each particular asset class.

“Neither the Trust nor the Investing Pool is an investment company registered under the Investment Company Act. Shares of the trust are not subject to the same regulatory requirements as mutual funds,” said iShares in a new warning on its Web site about GSG. (Quote Source: IndexUniverse.com)

“The different set of regulatory approvals needed by commodity pools includes government approval to issue more shares at certain predetermined periods,” said Murray Coleman, Editor of IU.com, in a report on the subject.

Why?

Since I’ve been studying ETFs, there have been rumors of potential problems with commodity ETFs that the regulatory agencies have been overlooking. Recently, the problem came up with the United Natural Gas Fund (NYSEArca: UNG) after quickly gaining assets this spring. The fund stopped issuing shares in mid-August due to regulatory investigation into the commodity marketplace and the role of these kinds of ETFs. Basically, UNG was controlling the vast majority of all trading in the natural gas market. UNG’s management is looking for ways to reopen the ETF and minimize the use of futures-this may be through the use of SWAP agreements. This fund since closing has traded at a significant premium-16% last week.

The Main Issue

The main issue being looked at is position limits for these funds. For example, the SPDR, GLD, holds more gold than many of the world’s central banks, including Canada. Possible outcomes are unknown as the CFTC (Chicago Futures Trading Commission) looks further into the matter. According to analysts, the CFTC will not overlook the use of SWAP agreements by ETFs. If size limits are enforced, funds may be forced to sell shares.

Closing Announcements

• The U.S. Natural Gas Fund (NYSEArca: UNG): Halted
• iShares S&P GSCI Commodity Index Trust (NYSEArca: GSG): to close when shares reach 55.9 million (currently 52 mil)
• The iPath Dow Jones-AIG Natural Gas (NYSEArca: GAZ): Halted
• The PowerShares DB Crude Oil Double Long ETN (NYSEArca: DXO): Halted

From a very broad sense, the best diversifier is between stock and bonds. From 1998 to 2001, the correlation between the two was -.49. This shows us that bonds were moving opposite of stock during that time frame.

I gave you that description to help explain a new report by Morningstar showing correlations of several asset classes prior to October 2007 and during the crash. We see in the chart below that diversification prior to the crash is much different than what happened during the crash. A great example is in international stocks. Prior to October 2007, the correlation to the S&P 500 was 0.57. During the crash, it moved up to 0.91, meaning that it was almost in lock step with the S&P 500. However, from 1980 to 2009, we see a correlation of 0.14. The two bright spots were Gold and Government Bonds. Both of these asset classes moved into negative correlation with the S&P 500 from October 2007 to March 2009, meaning that as stocks fell, these asset classes went up.

What we can learn from this is the magnitude of the 2007 – 2009 crash and how just about every asset class moved up in correlation to the S&P 500. By analyzing the correlation of these asset classes over the long term, it appears that we are diversified; however, during the bear market’s perfect storm of failing banks, consumer spending and government intervention, the textbook approach to diversification may have surprised many investors.

I will add that he refers to purchasing a tax efficient mutual fund. When he writes about this, block that term out and replace it with an Exchange Traded Fund. ETFs are more tax efficient than any tax efficient mutual fund. Except for that error, I will back him up on the thesis of his report.

Enjoy!

Click HERE to see the article.

UPDATE:

For our advanced readers, my friend Russ Thornton brought a new article to my attention. This article walks you through the math of the guarantees of an annuity. I would be willing to bet the salesman selling this product doesn’t even understand this concept! Click HERE for the article.

“To conclude: It’s time to acknowledge that a 7 percent guarantee is really closer to a 2 percent investment return, a 6 percent guarantee to a paltry 1 percent return.”

The Massachusetts Secretary of State, William Galvin, is looking into the marketing of leveraged ETFs and has reportedly written letters to the three biggest players in this market, ProShares, Direxion and Rydex.

In addition, FINRA, a regulatory agency for brokers and advisors, has issued a warning that leveraged ETFs are usually unsuitable for investors who plan to hold them for longer than one day.

At this time, all leveraged ETFs have the objective  to provide a daily short or leveraged position in an index. The key word is daily and often the returns can vary greatly from that expectation.

The firms issuing these ETFs are very clear to that point and advise that the funds are only intended to give daily exposure.

The concern is losses for the Massachusetts Secretary of State, as he wants to determine whether the issuing ETF providers are at fault, leading the unknowing brokers to these kind of products.

What I think is mostly overlooked is that FINRA is setting up a situation for brokers to be at fault.

The Distinction

There is a major distinction between brokers and advisors, which I believe may be part of the problem here. Brokers should, but aren’t required to, act in client’s best interest, as long as investments are suitable. An investment is deemed suitable if it makes sense to be in a client’s portfolio-not whether it is the highest quality product or whether it is prudent.

Advisors, on the other hand, are required to act in the client’s best interest. Investments must be suitable, appropriate and represent the client’s best interest.

Advisors Not Off the Hook

I have looked, with a lot of detail, at leveraged ETFs. The issuing companies and prospectuses are clear that the ETFs will not meet their objective longer than a day.

With FINRA and other Government agencies catching on to this and looking for someone the blame for major losses investors take in these funds, advisors and brokers who have misused these funds will be soon coming under a lot of heat.

Know Your Investments

Here at Wiser Wealth, we have always understood the risks of leveraged ETFs and have been very surprised to see that many of our peers do not. In 2008, if you shorted the S&P 500, you would have actually lost money. How is this possible? The S&P 500’s up days were (in percentages) higher than the down days. Since leveraged ETFs compound daily and the up days had bigger losses than the down day gains, the perfect losing recipe was in place.

There have been a few infamous ETFs to bite the dust because of poor design and complex strategies that did not work. Adopting a policy of ”if you cannot explain how the investment works to a client, then it doesn’t make the list” might be a good idea for professionals who take everything at face value.

Clearly the regulatory authorities understand the leverage risk. Do you?

Currencies are different than any other type of investment. The recent sharp fall in the dollar means good things for US investors who are investing abroad. Looking at where foreign investment returns really come from can give a perspective on the purpose of holding foreign assets.

Currencies, unlike stocks, bonds and commodities, can only derive value on a relative basis against other currencies.  For example, the US Dollar can increase in value against the Euro while decreasing in value against the Chinese Yen.  So, currency valuation is always on a relative basis, as it’s a matter of perspective.

Recently, it has been popularized that investors should invest portions of their portfolios overseas in developed markets like Europe and developing markets like Brazil, Russia, India and China-coined the BRIC countries.

Every investor who invests money in international markets should know what really drives returns. The naïve thought would be that those assets alone cause price fluctuations. However, taking an in-depth look at international returns, we can see that US investors can receive much more benefit and punishment from currency fluctuations than meets the eye. 

The chart below shows the price appreciation in the MSCI EAFE Index. MSCI EAFE is the index representing equity in developed nations within Europe, Australia, Asia and the Far East (EAFE). The Red line depicts the index measured in US Dollars while the blue line measures the EAFE Index in its local currency with no currency effect. The time period is 1969 through July 2009. The difference is noteworthy.

The MSCI EAFE Index is tracked by an iShares ETF, the iShares MSCI EAFE Index Fund (NYSE Arca: EFA).

Source: MSCI Barra

The currency effect in the EAFE Index is the difference between the two lines. Since 1969, currency has benefited the US investor. Looking at the difference on an annual basis over that time period shows that currency adds volatility.  Below is the excess return the US investor had caused by currency. The calculation is simply the difference between the returns of the US Dollar Index and Local Currency Index.

Source: MSCI Barra and author’s own calculation

Since 1969, currency has increased returns to the US investor.  However, volatility was also increased by 16%, meaning that monthly returns varied up or down from a long term average 16%, more than they would have without currency effects.

Recently, I’ve seen it reported that Harvard’s endowment portfolio performed well during 2008 because of alternative investments.  As it turns out, the reporter meant their fiscal year 2008, which ends in June. It was a perfect time to end the year, right before all asset classes lost significant value…great reporting.

So, as a follow-up to that original article, let’s look at fiscal year 2009.

The Wall Street Journal reported today that one of Harvard Endowment’s top bond managers made $6,300,000 last year, managing the fixed income portion of the now $37 billion fund. It has been announced that this manager is leaving the endowment. Why?

The endowment is forecasting one of its worst years, down almost 30% at the end of June and is positioning itself to become more liquid.

This move to become more liquid is the result of being very illiquid in the past.  So much so that during the credit crisis, the school had to make cuts, lay-off employees, and borrow money due to the endowment being tied up in illiquid investments like hedge funds and private equity.

The school and endowment like other schools’ endowments have more problems than I have quickly mentioned.  It seems that the endowment, created to provide for the schools needs (the school gets 34% of its revenue from the endowment), is now in a way holding the school hostage.

Before the credit crisis, the endowment’s illiquid investments helped the portfolio to average 14% annually. This over allocation (greed) ended up hurting the school.

This shows that there is a deeper problem in the financial services industry and should bring up the question; who’s serving whom?

Index Universe asked the following questions to Mr. Bogle following his on-line presentation:

Wiandt: Every year we hear from active managers that “this is the year of active management.” Do you believe that there are environments that are more favorable to active management than passive management and index investing? And if so, what do those times look like?

Bogle: There is no way that active managers can possibly have an advantage no matter what the circumstances are. Just think about this: Almost 75% almost of all stocks are owned by institutional investors now, and they are basically, by and large, professional investors. They are pension fund investors. They are pension money managers, they are pension trustees I should say, pension money managers, mutual fund managers, which also manage pension funds and endowment funds. And that’s 75% of all stocks, and only 75% of all stocks. It is just not possible that they can be taking the individual investor on the other side— the remaining part of the market—to the cleaners with every trade. There is no evidence of that.

So what we find is that institutional investors and individual investors basically each capture the market return and they each capture the market—and together they each capture the total market return. That is inevitable. And that’s before cost. So when you take out costs, which are high, you end up explaining almost all the reasons that active managers cannot and do not beat the funds, beat the market itself. It is just statistically, mathematically, tautologically impossible.

Wiandt: An asset allocation question: One of the main reasons we use asset allocation and diversification in our portfolio is to balance the risk. So if one thing is going up, another thing is coming down. If one thing is coming down, you’ve got something else coming up. The problem is—and if you look to October you can see this—when things go bad, it seems like everything goes down. And so what can you say to that? Is there anything that people should do in that environment or do you just ride it out?

Bogle:To me, first, in general, the question is correct insofar as it applies to equities. And it’s been long said—many, many years ago, and it’s proved so true in every crisis since then—international diversification lets us down just when we need it the most. And truer words than that were never spoken. On the other hand, the fact is that bonds produce a very good countercyclical return.

I don’t know exactly what they did in September. But I mentioned at the beginning of my remarks that the bond index fund went up 5% last year. That really was counter in direction, if not in amount, to the 35%, 37% decline in the U.S. stock market. Now I look at bonds as being the ultimate diversifier. I don’t look at diversification in equities [in terms of] being in different equity styles as being particularly helpful in the long run.

Look, we all know there are times when growth is doing better than value and vice versa, that large-cap is doing better than small-cap and vice versa. But they seem to come back. They seem to revert to the mean over long, long periods of time. And it’s very hard. Individual stocks, individual styles, have a very similar correlation with a stock market as a whole, a very similar correlation with one another and with the stock market as a whole—even down to the individual stock level and the style level and the manager level. So I think if you are looking for safety, the best instrument for safety is a high-grade bond portfolio, including Treasuries and high-grade corporates.

Wiandt: It looks like we have got an active investor here with a question. I think you may enjoy this one. He says, “Jack, you continue to encourage individual investors to buy and hold. However, I challenge you to name one goal-oriented endeavor besides investing where an intelligent individual would select a passive approach over an active one. Can you name even one?” he says.

Bogle: I’m sorry. You are just going to have to explain the question. Name even one investor?

Wiandt: Some activity that you would want to do in life where you would choose to be passive instead of active as a way of succeeding.

Bogle: Oh, that is such a great question! And, you know, there is an answer to it. And this is why we get so messed up in the financial business. Would you go to an average doctor? No. Why would anyone go to an active doctor, to a passive doctor or not the best doctor around? The problem is, in the financial markets, they are different from any other endeavor in American life. And that is, there is a market out there and it has a certain value. And all of us together own that market. So literally the only way to capture the market return is to own the market without cost. That cannot be done. But you can do it with a cost of as little as 0.1%, and you will, by definition, beat all these other investors who do it at a cost of maybe 2%–2.5%. There is really not any mystery about this. It is all what I’ve been willing to call or have been able to call the “relentless rules of humble arithmetic.” Get the croupiers’ take out and you capture the market return; you as a group of investors. Lave the croupiers’ take in—pay the croupier … pay Wall Street … pay the money managers … pay the brokers … pay the investment bankers … pay the investment advisers … and you get what’s left.

You know, you are sitting—you individual investor who has asked the question—you, pal, are sitting at the bottom of the food chain of investing. You know, everybody gets paid before you do. Where else is that true in American business? I don’t know if it is true anywhere else at all. So, yes, unequivocally, it is different and it has to be different. And our failure to acknowledge that difference is what gets us into so much behavioral problem.

This is where the philosophy of “keep investing cost low” comes from. Every penny you pay in fees, those you see and those you don’t, is one less penny you have to compound into the future.

Thank you Index Universe for this great interview.

Casey T Smith – Wiser Wealth Management, Inc

After reading this article, I did a search for the FDIC’s failed bank list to see which GA banks were on the brink of failure. I quickly became aware that the FDIC does not publish its failure watch list. This makes some sense as this could cause a “run on the bank” that would cause the institution in question to surely collapse. They do publish the banks that have been taken over by the government.

This list for GA is quite lengthy, but after going through the list I could not help but notice one glaring similarity, but first, let me explain how I came to this discovery.

At Wiser Wealth, we manage CDs for many of our more senior clients. For a small fee, we can access CDs across the country and place them all in one brokerage account. This keeps our clients from driving across town and by using various banks, we can keep the entire account FDIC insured. Inevitably, a client would call me up and say that he was driving and saw a sign that said “Bob’s Bank”  had a 5%, 1 year CD.  I would explain that we could not do business with just any bank but only those that established a relationship with TD Ameritrade, our custodian. I also saw the CD advertisements in our local Marietta Daily Journal.

And so, as I looked over the failed bank list, I saw Alpha Bank, Integrity Bank and American Southern Bank. I realized that these banks were just a few I remembered offering these very generous 5% CDs.

A bank is on the FDIC watch list for several reasons, but one is certainly not having the funds to keep operations running. If a bank needs to raise deposits, CDs are one way to do this. And certainly if the funds are needed quickly, a 5% CD in this environment is certainly going to get the attention of the conservative investing public. I am not saying that every bank that offers a exceptionally high CD rate is on the brink of extention, but it should be noted that this pattern at least applies to our failed banks in Georgia.

Currently the FDIC insurance limit per person is $250,000 (until 2014). One should never exceed this at a bank, especially in this environment. A brokerage account filled with various bank CDs is  much more secure than all your savings at one bank, no matter what the institution size.

Certainly these banks did not get on the failed list because of 5% CDs. In Georgia, most of these banks failed because of unpaid loans from real estate. Regardless, the old saying that “there is no free lunch” applies here!

Casey T Smith – Wiser Wealth Management, Inc

When investing in mutual funds, the investor is handing his money over to a mutual fund manager, giving him or her full discretion in trading the asset as he or she sees fit.   This is a simplified scenario, as behind the scenes there are usually a lot of internal and external controls put on the managers, but from the small investor’s standpoint, he has no say in how the fund is run.

Exchange Traded Funds (ETFs) bring much more transparency to the table.  Instead of having no control and limited knowledge about what your investment assets are up to, ETFs allow you to know throughout the day what they hold and the value of those holdings.  ETFs are also rule based, meaning that you will know exactly how an ETF will function, as its only objective is to track an index.

This gives the investor, who needs diversification, a way to have zero manager risk.  This means that the investor now has control of a diversified basket of stocks in an inexpensive wrapper.  With now hundreds of ETFs available, basically, any investment view can be expressed using ETFs.

With this power, comes more responsibility for the investor.  ETFs are extremely efficient and effective tools and those who understand their basic principles can utilize them in almost every situation.  On the flip side of that, a misunderstanding of the unique features and risks of ETFs can lead to problems.

This is why, as with any investment decision, it is best to at least get some advice or research report concerning the investment strategy and investment vehicle.

Supply and Demand

Sometimes when people ask me about ETFs and I can tell they don’t want a long answer, I say “ETFs are like mutual funds that trade like stocks and track an index at a low cost.”  This statement is true and not true at the same time.  It’s like a mutual fund in that it is a way to be diversified and like a stock in the way you can trade it throughout the day.

It’s this “throughout the day” that is important to distinguish here.  Stock prices are set by the demand for that particular stock.  An increase in buying demand will cause the price to increase just like selling demand will drive prices down.

ETFs Are Followers Not Leaders

ETFs, unlike stocks are price followers, as their price is not determined by supply and demand.  To be clear, just like a stock, the price will change with demand but this is artificial since ETFs are simply tracking its holdings’ market prices.  With traditional ETF structures, the ETF’s objective is to track an index.  The ETF company will put together a basket of stocks, bonds, or futures and options (when tracking asset classes like commodities).  The price of this basket is called the ETF’s NAV or net asset value.  The ability of this NAV to track the index is measured by its tracking error.

The ETF will then trade on the market at a price which should, in theory, reflect the NAV.  When the market price is above the NAV price, the ETF is trading at a premium.  When the price is below NAV, the ETF is trading at a discount.

This is why, when buying and selling positions of ETFs, it is best to use a limit order.  A limit order will buy or sell an ETF at a determined price or better.  A limit order guarantees a price but not execution.  In this way, you are trying to buy the ETF that reflects its characteristic as a price follower not a price determined by demand.

Using a limit order to buy and sell ETFs is a smart way to reflect an understanding that ETFs sometimes trade at a premium or a discount to NAV and that when you buy a large amount of ETFs that have low trading volume, you may not get the price you wanted or thought.  A smarter way to buy would be to set a limit order at NAV, since ETFs are followers of that NAV price. The NAV price for an ETF can be obtained from your broker’s trading desk. At a recent Power Shares event, it was mentioned that a good rule of thumb is to place a limit order between the bid and ask price for an ETF. This spread can be pennies and in some cases dollars.

If an investor placed a market order to buy an ETF, a scenario could be the following:

NAV for XYZ ETF is 90. The Bid is 89.9 and the Ask is 90.1. There are Sell Limit orders from the market as follows:

Limit 92          1000 shares

Limit 91.5       1000 shares

Ask    90.1       1000 shares

Your market order for 1000 shares is placed the same time as another investor’s 1000 share market order. Your order’s que is milliseconds behind the other which allows the first purchase to get the NAV price at 90, then your order got routed to the next available price at 91.50. You just paid a $1.5 premium per share!!! If you had used a Limit order at NAV, your order would have waited in que for the next seller at NAV.

Why ETF Trading Volume Does Not Matter

For an ETF purchaser or seller, ETF trading volume does not matter. ETF trading volume is the number of shares of the ETF that have traded over a time period. This is usually reported daily.

If a new ETF came out tracking the S&P 500, it may have low trading volume, especially if it charged more than the ETF’s tracking that index already on the market.  Even if the volume of the ETF was very low, that does not mean that the ETF is illiquid or will fail to execute its objective. If properly handled, the investor would place a limit order at the ETF’s NAV. Should there not be enough demand to execute the order, the market maker will go onto the market and purchase the stock within the index then convert the shares into shares of the ETF, which will allow for the order to be executed. The reverse would happen in a sell situation. In reality, if you place a NAV limit order and it is not executed quickly and you are in a low volume situation, call your trading desk. The trading desk will contact the market maker.

Large orders will not “move the market” but will actually get poor pricing if limit orders are not placed.

Final Thought

The issue of liquidity and ETFs brings me to my last point, which is exceptions.  What we have covered above are some principles of ETF investing that investors should be aware of in general.  The point of view I took was from an investor, not a trader (who may be very concerned with bid/ask spreads). With limit orders and knowing the NAV, we aren’t too worried about that spread.  There are always exceptions to these ETF principles.

For instance, ETFs that track indexes trading overseas have a unique attribute.  Where most ETFs are price followers, these ETFs can have an element of price discovery.  This happens when new information comes into the market when overseas markets are closed and investors have only the ETF through which to express the information.  There are other instances of this in the bond markets where market-to-market pricing is used and ETFs can add liquidity to a bond market that is not liquid.

All and all, ETFs make the market more efficient.  They are a powerful tool for any investor at any size.  It is because they are powerful tools that they need to be understood. I recommended that advice be sought before investing on your own.

This article was written for www.etfmarketpro.com.

Casey Smith – Wiser Wealth Management, Inc

Borrowing from Mr. Zweig’s example, this securities lending is much like subletting your house except the fund will keep upwards of 50% of the funds earned from this lending practice. In some cases 100% of the money is kept by the fund manager, who is usually the lending agent for the transaction. Once these shares are lent out, the shareholders of the fund are at risk, not the fund advisor. An example of this risk of lending is the mutual fund Calamos Growth CNWGX. This fund took 475 million that it receives from lending securities and invested it in a money market that then purchased Lehman Brothers. The fund lost 8.6 million in the transaction, of which 100% is passed on to the fund’s shareholders.

I agree with Mr. Zweig in that securities lending should take place and that nearly 100% of the proceeds should go to the investors, not the fund managers.  I will note that here at Wiser Wealth, our iShares and Vanguard index funds do pass on the proceeds at the near 100% mark. This process is fairly transparent in indexing, but in the Mutual Fund world, it is less obvious as the current process of lending is not regulated by the government.

In my opinion, this is another case where the transparency of indexing is better for the individual investor.

Casey Smith – Wiser Wealth Management, Inc

Each quarter, Standard and Poors comes out with a report detailing how mutual funds performed compared to passive investments or indexes.  Remember, ETFs are investment products that track indexes and are comparable with them.  This report, the Standard and Poor’s Passive Verses Active Scorecard or SPIVA Scorecard, takes a unique view of how mutual funds performed verses indexes.  The scorecard weights its category averages of mutual funds by average investor experience, or simply, how much money investors as a whole have in the funds, with more money invested giving the fund a higher weighting in the category average.  This is unique in that it details how the average person is invested in America.  From this we can show if the average investor would be better served elsewhere.

Below is a 5 year comparison of the active manager’s annual return verses a comparable index.  The active management’s numbers are averaged by S&P using the asset weighted approach to analyze where the average investor’s assets where located.

In all three broad US categories, passive benchmarks outperform active benchmarks.  In a further breakdown of style (Growth and Value), international, and real estate category averages verses benchmarks we can see that in 2008 and the 5 years prior to the end of 2008, passive benchmarks outperformed the highly paid, professional money managers, who, for the most part, spent their careers specializing in investing.  The table below shows the fund category, comparable benchmark, and the percentage of funds that did not beat their benchmarks over the time periods.  The fund averages are equally weighted and all information has been gathered from the latest SPIVA Scorecard.

Mutual funds have difficulties outperforming benchmarks.  This happens for several reasons and goes against general conceptions of the industry.  These facts uncover a common myth in the investment industry, that mutual funds, with professional oversight, can sidestep obvious market downturns.  This is apparently not true for the majority of mutual funds

By their nature, mutual funds hold some amount of cash for withdrawals, which in market downturns, would slightly soften the funds’ performance on the downside; however on the whole, the majority of mutual funds in most categories did not demonstrate any softening effect during the most recent downturn.

The sad part about this picture is that investors do not receive the quality investment advice they need.

A Winning Strategy: Making the Switch

As explained, the majority of mutual funds will not allow an investor to win even with a great diversification and asset allocation strategy.  Exchange Traded Funds, ETFs, can update your old investment toolbox and allow for a winning strategy to be effective.

For example, the S&P 500 which outperformed 71.9% of large cap mutual funds from 2004-2008, can be cheaply and effectively utilized through either of two ETFs.  Below is a chart of the iShares S&P 500 Index (IVV) and the first and largest ETF, the SPDR S&P 500 ETF (SPY) graphed against the S&P 500 Index.

Notice that the two ETFs track the index very closely.  This is just one example showing the importance of  having an effective investing tool.  A mutual fund that underperforms and is very costly to own will drag performance down over time and as the economy recovers, there is no guarantee that the mutual fund will recover with it.

With ETFs, where an investor held a large cap value index, switching over to a similar ETF like iShares S&P 500 Value Index Fund (IVE) can be a way to keep the same investor strategy or asset allocation but update the tool.  This is a common misconception of what really drives returns.  It is typically not a manager that drives a fund’s return but the strategy of the fund like large cap value or large cap core, that drives the return and the investment tool or which fund you choose allows you to capture that return characteristic.

ETFs are a cheap and highly efficient way to build a highly diversified portfolio based on your long term investment strategy.  For nearly every asset class and mutual fund category there is a comparable ETF that would allow the investor to access an asset class’ complete return characteristics.

Casey Smith – Wiser Wealth Management, Inc

A blog posted on CNNMoney.com’s Money and Main Street, Click Here, discusses a vague disclosure report from the White House concerning President Obama’s household assets and investments.

Page two of the original report, which the blogger links to, lists the President’s assets, where and what they are held in and an estimated value.

What is most interesting is that the President has somewhere between $1-5 million in US Treasury Bonds and the second largest holding of somewhere between $115-250 thousand in the Vanguard FTSE Social Index.

The Obama Portfolio

When President Obama was first elected, there were many people who advertised “Obama Portfolios.”  As it turns out, the original Obama Portfolio favors US Treasury issued debt and socially responsible companies in a simple index fund package.

The interesting part is that the President of the United States, who would have the best investment advisors at his disposal, chose a low cost, diversified portfolio of US stocks.

In light of recent market turmoil, many ETF industry commentators are saying the ETF market place is too crowded and grew faster than it was able to attract assets.

Bruce Bond, president and CEO of Invesco PowerShares, said this about the closings in the press release, “After carefully evaluating numerous factors including shareholder considerations, length of time on the market, asset levels, and the potential for future growth, we proposed closing certain portfolios that have not gained sufficient acceptance with investors.”

PowerShares closes some of the category of funds it is best known for, the FTSE RAFI Index tracking ETFs and 4 ETFs tracking Dynamic Intellidex Indexes.

12 of the closing ETFs are ETFs following the RAFI Indexes created by Robert Arnott, RAFI standing for Research Affiliates Fundamental Index, which weight index components by five fundamental factors.  Fundamental indexing proponents propose that market capitalization weighted indexes tend to overload themselves with overvalued stocks, the opposite of what an investor would want to do. These weigh an index based on fundamental factors and not by market cap which is a function of price. The 12 ETFs are all sector funds and the PowerShares FTSE RAFI Asia Pacific ex-Japan Small-Mid Portfolio.

The other seven ETFs closing represent either small slices of the market or niche concepts like the PowerShares High Growth Rate Dividend Achievers Portfolio, PHJ, which seeks to track an index that includes 100 companies with the highest dividend growths rates who have increased their annual dividends for the last ten consecutive years.

The closing Process

ETFs have closed in the past and since ETF assets are held outside of the company’s balance sheet, in trust, ETF assets are returned to an ETF investor upon the issuing company closing for bankruptcy or the ETF closing.

As PowerShares has announced, it will begin the process of closing the funds in the first part of May.  During this time, the funds will no longer be required to meet their investor objective of tracking the index but will be seeking to get best price and execution of the underlying securities.  This will cause tracking error to increase.

As of May 19, 2009, the 19 closing ETFs will no longer allow new investors in the funds.  Investors who hold the ETFs at the close of trading on May 18, 2009 will receive the NAV of the ETFs as of May 22, 2009 as a cash deposit in their brokerage accounts.

Up to the closing of the funds to new investors, on May 19, creation and redemption of the funds can still take place to ensure that the ETFs represent the basket of underlying securities, which will keep this period of ETF closing orderly.  Investors will be able to trade the ETFs up to the closing of new investments and should seek receive prices close to NAV, which may include the using limit orders.

IndexIQ, on March 25, 2009, launched its first hedge fund ETF. This is following in the wake of 2008 where many hedge funds were affected by mass withdrawals and highly leveraged bets went bad, causing many to shut down.IndexIQ, through its new ETF, provides a way for investors to access a low cost, no commitment and highly liquid hedge fund replication vehicle. The introduction of this hedge fund ETF allows access to the category at any net worth size, opening doors for clients’ portfolios, where before they were limited.

Unlike what it may seem, the IQ Hedge Multi-Strategy Tracker ETF, QAI, does not invest directly in hedge funds, nor does it follow an index of hedge funds. Instead, IndexIQ replicates the return, risk and low correlation characteristics of hedge funds using ETFs as the underlying investment. In this way, using ETFs within an ETF allows investments to stay as liquid and transparent as possible as IndexIQ implements its proprietary methodology in creating hedge fund replication.

The Benefit of Hedge Fund Replication

IndexIQ, using research and technology based on studying hedge fund returns, can provide hedge fund returns to investors through copying hedge fund methods. They do this while removing the risks of being highly leveraged and the problems associated with investing in highly illiquid markets. This methodology, matched with the transparency of ETFs, allows investors to reach for very liquid and cheap alternative strategies. IndexIQ has coined themselves as “the alternative to the alternatives.”  The IndexIQ ETF will charge a .75% expense ratio. This is inexpensive compared to similar hedge fund strategies charging 2% of all assets, 20% of all profits and sometimes more.

Graphed is the multi-strategy hedge fund category average as defined by Morningstar, Inc. There is great value in an investment product replicating this kind of risk/return profile relative to the S&P 500 benchmark, which is not the most appropriate standard for hedge fund managers to be compared against, but is important to show the return and risk reduction against a common index available to most advisors and investors.

How it works

The IQ Hedge Multi-Strategy Tracker ETF, QAI, according to their recent press release, replicates various hedge fund strategies including long/short equity, global macro, market neutral, event driven, fixed income arbitrage and emerging market strategies. All of these hedge fund replicating strategies, packaged as an ETF, trade intraday.

The idea of hedge fund replication is that many active managers in the hedge fund space are really giving the investor what has been coined as “Alternative Beta.” Alternative Beta, according to IndexIQ, has been mislabeled as alpha, when in fact, managers are just accessing beta that is outside the realm of typical asset classes. In this case, alpha is defined as excess return over a benchmark. Beta is the broad category.

Looking at hedge fund performance, and using heavy quantitative analysis, replication of a hedge fund investment strategy can be picked out from the data. IndexIQ promotes that it can use tradeable securities like ETFs and derivatives to replicate the strategies. This replication is really the beta of the hedge fund strategy and managers outperforming this strategy are creating true alpha. These hedge fund strategies are said to deliver the low correlation, risk reduction and return characteristics hedge fund investors are looking for, which is this “alternative beta.”

When it is really the alternative beta that investors want, they can stop paying for high priced alpha when the alternative beta is really the main component driving the low correlated returns.

This is really what IndexIQ is creating with their new ETF, and a whole line of ETFs to come, a way for any investor to add alternative beta to their portfolios. IndexIQ uses quantitative models and academic research supported by their all-star line up of finance academic leaders and ETF research specialists like Paul Mazzilli, a leader in ETF research, analytics and development, to create the first ever US listed hedge fund ETF.

The index that the IndexIQ ETF tracks has only been published since September of 2008, but back tested data shows the five year hypothetical risk reward profile against HFRX Global Hedge Fund Index and the S&P 500 as of December 31, 2008, according to QAI’s Factsheet.

When investors and clients see the value in having alternative beta in their portfolios, the IndexIQ ETF gives this exposure at a very low price. This ETF will force others to rethink what they are actually getting from managers, alpha or beta. Also, QAI, being an ETF fund of funds, shows that ETFs are a diverse investment vehicle which can cater to many unique investment strategies.

In Barron’s March 9, 2009 issue, Andrew Bary reported in the issue’s cover story that over a six month time span, gold had risen $140 to its current price at the time of $942 an ounce.

The point of the article was to show stocks relative value. The relationship between gold and stocks indicated that stocks may be undervalued, as seen in the following quote.

“The S&P 500 index is worth about 75% of an ounce of gold, verses a peak of more than five times the value of gold in 2000 when the S&P peaked at more than 1,500 and gold languished around $300 an ounce. Over the past 40 years, the S&P has averaged 1.6 times the value of an ounce of gold.”

Gold and other precious metals are an interesting investment and have gained a lot of press recently through radio and TV advertising. During this current credit crisis, gold has been seen as a “safe” investment that never loses its value like stocks and bonds because it is gold, the asset that was once used to peg many currencies, including that of the US during the time of the gold standard.

Even as a perceived safe investment, the increase in its price shows that investors view that gold is perceived as a quality and safe investment relative to other asset classes. The question is whether gold deserves a long term place in an investor’s portfolio and in what proportion. In the same way, the question is not whether gold is rare or was useful to pegging currencies, but how an investor should view gold as an investment in the short and long term.

There are some that view physically holding gold as insurance for “end of the world” type situations. Other than those investors, gold inventories held by small, individual investors are very impractical. The cost or risks of this kind of investing through physically holding gold must be fully realized. The cost of insurance, security, storage, transporting and inspecting true quality may make this kind of investment completely impractical. A better, more efficient way to purchase gold is through ETFs and ETNs, which track the price movement of gold by following a gold index. These ETFs track indexes, a range of investment options from physical gold to rolling gold futures. Precious metal ETFs like GLD actually hold physical gold in trust in secure bank vaults. There are unique tax implications when investing in these ETFs that should be understood before investing.

The Difference Among Asset Pricing

Theoretically, the price and value of publicly traded companies is the present value of all future cash flows. This may not seem always true and often prices can vary greatly from “fair value” or the present value of all future cash flows. In the long run, investors have been rewarded for purchasing stock in companies below this “fair market price” and selling it above the “fair market price.”

Even if all stock prices reflected the fair market values, investors would still realize gains and receive dividends from the stocks they hold. Why? Because, if stock prices should be the present value of all future cash flows, the more recent cash flows will have the greatest affect on stock prices.

Gold has no expected return. Unlike a stock, gold and other precious metals do not have any future cash flows and therefore their values and prices are only based on supply and demand. Supply and demand forces are more complicated when describing commodities. We could say the value of gas is the price we pay at the pump or the future price that market participants have contracted with each other to deliver gas or oil in the future. This is interesting because the supply and demand of a commodity like oranges is not only the supply or demand of today’s price, but the price in the future. This is why orange producers are so concerned with predicting weather, as weather in Florida will greatly affect the future supply in the marketplace. This helps guide their decisions on the future price of oranges.

When recently asked about investing in gold and where it will be in five years, Warren Buffett said that, “I have no idea where [gold] will be, but the one thing I can tell you is it won’t do anything between now and then except look at you.” He went on to say, “It’s a lot better to have a goose that keeps laying eggs than a goose that just sits there and eats insurance and storage and a few things like that.”

Warren Buffet’s advice is not the bottom line, but an interesting perspective from someone who has had great success investing based on strict principles.

Gold’s Supply and Demand

Many people believe that rare commodities will only get scarcer and that prices of those items must increase in value. This is most popular regarding oil, but relates to all commodities. Before discussing why this may not be true, this same line of thinking happened in many places in the world over the price of land and home values.

The thinking that led to the bursting of the housing bubble in the US and Japan in the 90s, which they have yet to recover from, is that there is only so much land. Reason tells us that as the earth becomes more populated, property values will increase due to a fixed supply and increasing demand.

This is not true. In the short term, the supply curve can be shifted (to the left) signifying less quantity available to consumers and a new equilibrium price will be set above the previous price. But the long term is a different story, (economists define the long term as the period where all costs are variable, meaning that big fixed costs like owning a house is fixed in the short term, but in the long term you can move). In the long term, this new price based on a decreased demand is not sustainable for reasons that will let consumers and suppliers shift the demand and supply curve back to lower or previous equilibrium prices.

Gold’s Difference

The appeal of gold is as a place of safety as investors flee towards quality. There are reasons behind why investors see gold as safe and reasons for the play. As financial systems continue to fail, the system of paper money may fail and the usefulness of gold as a monetary unit will return. In addition, as the government measures continue to not restore investor confidence, the fear that inflation will follow and that gold, as a commodity, will be a hedge against the inflation. Also, there is a popular notion that even in the face of inflation, gold will benefit as an inflation hedge. So in either case, gold works

In a recent analyst report by Keith Lerner, Chief Market Strategist for SunTrust Robinson Humphrey, published in Indexuniverse.com, reported that gold is a difficult asset to place a fair value on

“Since gold neither pays a dividend nor generates cash flow, we have never felt a great comfort in assigning a fair value for the precious commodity. Often, in our opinion, its direction is driven primarily by investor psychology and it trades on momentum…”

According to the same report, the analyst views gold as “technical/chart perspective.” He sees the near term risks for the commodity to be outflows in gold as the economy returns back to normal and the need for safety decreases.

Gold in Perspective

What we are seeing above is that gold, as an investment, is more volatile than the S&P 500 and annually over a 36 year period gold has annually returned less.

This is not to say gold is a horrible investment in all cases, but to say that the stock market historically has performed better with less risk than gold.

Commodities in general and especially gold have a low correlation to the stock market. Since it has a low correlation and higher volatility, adding commodities and gold in appropriate amounts can provide long term benefits. The hard part is figuring out the appropriate amount to allocate to gold or commodities as a wider asset class.

The Gold Run Up

As we have already discussed previously, gold has recently seen a large price increase. Investors have been flowing funds into gold due to many factors including gold’s historic uses as currency.

Graphed below is the S&P 500 and the price of gold as seen through the London Fix Gold PM Index from 12/29/1972 through 2/28/2009. This long term price performance difference is important to notice. The better long term investment is the stock market as seen through the S&P 500. This long term perspective matched with a strong theoretical understanding behind asset pricing and value differences goes a long way.

gold-chart5

All this being said, is there a place for gold and other precious metals in portfolios of all risk levels? In short, yes. The trick is in what percent and through what investment vehicle.

Here at Wiser Wealth Management, we have between 3%-5% commodities in our portfolios. We currently use the ETN, ticker symbol DJP, an ETN that tracks that Dow Jones AIG Commodity Index. The breakdown of commodities is diversified and the index follows rolling futures contracts.

Precious metals make up 13% of the entire commodity portfolio and gold is 9.41% of the entire commodity portfolio. Please note that the percentages of commodities and gold we currently have in our portfolios is a function of the suitability of our client base and may not be appropriate or suitable for you. Also, please be aware that an ETN is different from an ETF and assumes full credit risk of the issuing investment bank.

An investor can track commodities and gold using ETFs and ETNs. The most popular of these products are the SPDR Gold Trust, GLD, United States Oil, USO, iShares COMEX Gold Trust, IAU, iPath DJ-AIG Commodity, and iShares GSCI Commodity, GSG. All have different exposure to commodities and gain exposure to the commodities they cover in different ways. Careful research is needed to determine proper exposure and suitability and to understand the difference between exchange-traded products and the methods they use to track the underlying indexes.

The information contained in this report is for informational purposes only and is not investment advice. A note about the data: All gold prices are quoted as the London Fix Gold PM Price Return USD index. Data obtained from Morningstar Advisor Workstation Office Editor.

Forbes has picked up on this and has made a slideshow of the worst  and best index-tracking ETFs.  The article, “ETFs Behaving Badly” , links to the slideshow.

Most notably, there were many emerging market ETFs in the list from all the major ETF providers; SSgA, iShares, and PowerShares.  Preferred Stock and individual real estate sectors seem to be broadly included in the worst list.  Also, the TDAX Independence Lifecycle Funds were included in the list with large tracking errors. However, these ETFs cover some different indexes designed by Zacks.

The IQ Hedge Multi-Strategy Tracker ETF seeks to track, before fees and expenses, the performance of the IQ Hedge Multi-Strategy Index. The Index attempts to replicate the risk-adjusted return characteristics of the collective hedge funds using various hedge fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage and emerging markets.

Why this is important?

This hedge fund ETF is a game changer because unlike other ETFs that merely track completely passive indexes or use a very simple systematic approach to choosing index constitutes, this ETF, through its index, is a hedge fund, using the strategies of hedge funds that have been around for some time. Technically, the ETF replicates hedge fund strategies. The hedge fund index does not track hedge fund performance, (this would be difficult because of liquidity issues) but it replicates performance through replicating strategies.

Now, through this ETF, all investors can gain the benefit of hedge fund strategies.

Hedge Fund ETF Strategies

Using the hedge fund strategies already mentioned like Long/Short and event driven, QAI uses ETFs as its investment vehicle to implement these strategies. QAI is a Hedge Fund of ETFs.

Costs

QAI having an expense ratio of .75% seems high compared to other passively managed ETFs. However, .75% is a low cost for any mutual fund that actively manages any asset class. Compared to other hedge funds, .75% seems like nothing. The traditional hedge fund fee structure 2 and 20 means that the hedge fund charges 2% of all assets and 20% of all profits. That in itself makes beating benchmarks a high hurdle.

held discussions with a number of potentially interested parties as part of its practice of regularly reviewing the group’s portfolio of business.

The potential sale of its ETF subsidiary is in light of Barclays announcement to participate in the British government’s asset protection program. Potential buyers of iShares could be from any number of financial companies wanting to get at 46% of all of the ETF assets.

For iShares ETF Investors

For investors holding iShares ETFs, there is zero threat of assets being lost from any corporate action. ETF assets are held in trust, separate from the issuing company’s balance sheet.  In the case of the company closing the funds, the assets of the ETF will be liquidated and delivered back to the investor.

Here for the full report

For 15 years, QAIB has shown that investor returns lag what performance reports and prospectuses would lead one to believe is acheivable.  While those returns are, in fact, theoretically acheivable, the reality is that investors are not rational, and make buy and sell decisions at the worst possible moments.

2008, like all the over years shows investors losing more than the market.  Last year (2008) equity fund investors lost 41.6% and the S&P 500 lost 37.7%.

DALBAR included in their report that investors guessed market directions right 42% of the time by buying low and selling high.  That means that 58% of the time investors bought high and sold low.  For example most investors sold after the September melt down, realizing their losses.

So everyone involved had a bad year last year but the key thing to point out is that the people who paid for it (mutual fund investors) did worse than those that could have just bought the S&P 500 index.  Some mutual did do better than others but what DALBAR points out is that the average investor did worst by investing in mutual funds compared to the old S&P 500 which cannot avoid or side step anything like mutual fund managers can.

What this data says to us is that investors are far better off

1. Investing using index funds, building highly diversified portfolios.  We happen to use ETFs
2. Investing with a good adviser can help reduce the gap between market returns and average mutual fund investors returns.

• The above statements correspond with our Wiser Advice, Keep costs Low, Diversify, and Always Invest for the Long Term

To correct some of these investor behaviors that lead to this underperformance, DALBAR suggests

• Dollar cost averaging
• “Purpose Driven Asset Management” for advisors, which is splitting up clients assets into different investments that are for different purposes.  This strategy is designed to help calm clients panic and fears.
• For advisors to provide a better understanding to clients the investment’s leverage exposure.

For more information about the study, click here.

To learn more about us as wealth managers, visit the ‘About’ tab at the top of this page, or visit www.wiserinvestor.com.  You can also use the ‘Contact Us’ at the top of the page to have your questions answers and learn more about how we can lower the gap addressed above.

For a more in-dept news report, click here.

We hear a lot today about ETFs. ETFs are certainly great products that reduce company risk and allow for superior diversification. I want to discuss the ETF’s Cousin, Exchange Traded Notes. Both ETFs and ETNs track an assigned index, trade like a stock and are very liquid. The similarities stop there.

ETFs are structured such that the shareholder owns a basket of securities. Should the ETF provider go bankrupt or shutdown the ETF, the shareholder will usually recieve cash for the market value of the basket of securities. If you own more than 50,000 shares, then you could request to take distribution of the securities.

ETNs are debt instruments. Debt instruments do not own anything but a promise to track an index. The largest ETN based on assets is Barclay’s iPath Dow Jones Commodity Index (DJP). From iPath’s website, we see DJP’s largest holdings are 30% energy, 21% grains, 19% industrial metals, 12% precious metals, 2% livestock and 16% other. At first glance, it would appear that you own commodities with this allocation. However, this allocation is used only as a measure for performance. An investor does not own any commodities, only a promise from Barclays to pay an investor the theoretical allocation of the commodity index. If an ETN provider should go bankrupt, the investor will not receive his or her investment back. Why? Because an ETN is considered an unsecured debt instrument.

An example of this is the recent Lehman Brothers failed ETNs. The three ETNs were Opta Lehman Commodity, Agriculture and Private Equity. In September 2008, these ETNs halted trading when Lehman Brothers failed. Currently, the final results are being sorted out, but it appears that Lehman ETN holders will receive 2 cents on the dollar from their original investment. Shortly after Lehman’s collapse, Bear Stearn’s ETN holders were hours from the same fate, when JP Morgan stepped in an purchased the company.

Currently the top three ETNs based on assets are:

1. Barclays iPath Dow Jones AIG Commodity Index (DJP)

2. Powershares DB Crude Oil Double Long (DXO)

3. Barclays iPath S&P GSCI Crude Oil (OIL)

When purchasing an ETN, it is a good idea to ask yourself if you would lend money to the ETN provider. After all, ETNs are only a promise to pay, which is unsecured. One simple way to observe the risk of investing in an ETN is to look at the provider’s credit rating. On December 19th, 2008, CNBC showed Morgan Stanley, Goldman Sachs and HSBC with an A S&P rating. Barclay’s has a AA rating.

The credit rating is only a birds eye view (if that). For example, Barclay’s may have a AA rating, but recently the bank was speculated to become state owned because of its poor condition. We have seen the results of an ETN bankruptcy, but not a government takeover. My guess would be that the ETN would continue operating, but this market has been full of surprises.

So, now that you are scared of ETNs, why would you invest in an ETN? Access to certain markets or indexes can be difficult to manage from direct investing. An example of this would be an advisor who decided to invest directly into commodities. If he made a misstep, his client could end up taking delivery of the actual barrels of oil or herds of cattle. This would certainly not be adding value to the relationship, especially of the client lived in the city!

The structure of an ETN gives it great flexibility. This flexibility gives ETNs the ability to track the performance of commodities, countries with limited access, gold, volatility indexes, buy write strategies and currency. The cost of actually implementing these strategies through an ETF structure could be very expensive and have a wide tracking error. The ETN format allows perfect index tracking as long as the provider keeps their promise.

Always know what you are investing in..

Casey Smith – president/owner Wiser Wealth Management, Inc

Please visit www.indexuniverse.com our go directly to the article here http://www.indexuniverse.com/sections/features/5305-what-to-do-with-currency-etfs.html

We’d love to hear any feedback from our viewers.  You can use the “Contact Us” tab on this site to give us advice on how we can better inform you about ETFs and investing in this economic climate.

iPath is set to issue two new ETNs covering iPath S&P 500 VIX Short-Term Futures and the iPath S&P 500 VIX Mid-Term Futures ETNs .  Read Murray Coleman’s article on the topic here.

Among the conference speakers were many presidents from ETF and index companies and many of the leading thinkers within the industry.  In this post I wanted to highlight some of the things talked about at the conference.

The conference was very interesting because during 2008, ETFs accounted for up to 40% of trading volume.  This means that large institutions have completely accepted and are using ETFs.

Leveraged and inverse ETFs were among the main topics to everyone.  During 2008 short and leveraged funds became very popular.  However, the math behind short and leveraged ETFs is not simple when held longer than one day.  Companies who issue these products are extremely forthcoming about this and do not intend their product for the average person and repeatedly state that their objective is to give 2x long or short the DAILY value of the underlying index.  Over the long run, the funds can get very far away from 2x long or short.  Explaining the math may come in a latter post.

Option strategies using ETFs were covered heavily.  Using options with ETFs is a little different since a stock may very well go to zero when a company goes bankrupt but it is extremely unlikely that a broad index represented by an ETF would go to zero and so would complicated options strategies can be used to hedge risk.  The strategy discussed at the conference was the vertical spread with a fully collateralized at the money put.  This strategy has been named, insulated beta and is used to hedge against moderate downside and capping extreme upside.  I would like to do more research on this strategy and write a post about it in the future.

Also, addressed at the conference were the hedge fund like portfolios one can build with ETFs, especially using currency and commodity ETNs.

In 2008, many hedge funds, once available only to the wealthy, closed their doors, loosing all their investors’ money, or stopped allowing withdrawals from accounts. One of the biggest financial investing scams was uncovered, loosing overall billions and for several prominent families and charities, millions. I have never understood why someone would invest in a vehicle that would not disclose its holdings or require money to be locked away for a lengthy period.

I have never been in combat or seen first hand the death and destruction afterwards but I can see how witnessing such events could leave a person with a great emotional burden. This is the best way I can describe how I feel about 2008. I have spent many sleepless nights wondering how I could make the financial punishment stop, only to awaken to a significant market rebound that a few days later retreated to make another new low.  I have wondered if long term buy and hold investing is dead and if we have to invest in the stock market like one would play in Vegas. I have spent countless hours agonizing over how to deal with investments strategies that worked for years and now have been brought down by the market’s terrible losses. I carry a heavy burden knowing that each client has entrusted to me to look out for their financial well being and I take this responsibility very seriously.

After a careful review of our passive indexing approach to investing, I still see the benefits of long term index investing. While our portfolio returns varied all across the spectrum of portfolio risk, overall long term (5 years +), we still show better returns vs. risk than picking individual securities or hiring a fund manager.  The question is when the market will start a recovery.

Market history shows us that after the October 1987 market crash it rebounded 14% after one year and 96% in 5 years. The stock market crash in 2001, due to the September 11th attacks lost 20% after the first year and gained 40% after 5 years. This shows us that time will heal market wounds but it will require much patience.

I am not making any predictions for 2009 other than to observe that there have been billions of dollars pumped into financial systems around the globe and this will eventually come to fruition. The incoming administration is considering additional stimulus that now seems appropriate to implement. Large institutional investors appear to be investing back into the market. We can see this by the volume of buys even as more bad economic data is published.

This Quarter I am participating in some seminars around the world. This is new to me and I am very excited to have received the invitations. Next week Kyle and I will be in Boca Raton presenting at the Inside ETF Conference. Our session is on the practical applications of Exchange Traded Funds. In late January I will be doing two workshops for the 1700 ASA pilots. This workshop will focus on the group’s JP Morgan 401K plan. In February we will be in Singapore to present at the ETF Asia Conference. Kyle and I will be doing a one day workshop on the basics if ETF’s and how to build ETF portfolio.

Exchange Traded Funds are relatively new to those markets and we expect a large turn out. On day two of the conference I will be speaking to 200+ of my Asian peers about the difference between an Exchange Traded Note and an Exchange Traded Fund. I hope that as Wiser Wealth grows, these experiences will help set me apart from other firms.

Starting out in 2009 we have several families that are themselves or have loved ones hospitalized due to illness. I pray that each of you have a speedy recovery and that good health returns for 2009.

I will close this quarterly newsletter with a quote from Ben Stein, whom I met at a TD Ameritrade Conference in 2007. This is from his article “More Lessons From the Financial Crisis.”

“I will take some comfort in knowing that even Warren Buffett’s stock fell by about 45 percent in the 2007-2008 debacle; if the father of value investing could feel he had made mistakes, and if the gurus of value investing got clobbered, then I will not torture myself too much about the horrible year and a quarter just passed.

“After all, my wife has not lost value. My dogs have not lost value. My son has gained greatly in value by getting engaged to a fabulous young woman. My friends have not lost value (but, sadly, there are fewer and fewer of them). The sunshine outside my house in Rancho Mirage, Calif., has not lost value, and every year I have left has greater value because of scarcity.”

Happy New Year!

Casey T Smith – President – Wiser Wealth Management, Inc

By looking at MSCI EAFE USD Index and the EAFE Local Currency Index currency risk can be shown through the differences. During the first half of 2008, the EAFE USD index gave returns over EAFE Local Currency. This was due to the falling dollar relative to many of the currencies included within EAFE. As the credit crisis peaked in September, the dollar began to reverse and strengthened against foreign currencies, creating a lag for US investors holding EAFE.

The currency risk also increases standard deviation. As seen below, the volatility of currency exchange rates to the dollar caused a currency difference. During 2008, The USD invested in EAFE lost 5.36% more due to unfavorable currency exchange rates. There is also a risk premium that the currency exchange rate causes. During 2008 this risk premium was 3.79%.

ETNs are promissory notes issued to represent and give the return of ownership of a currency exchange, commodity, and any asset that poses a barrier for others to invest directly into for a fee they receive through an expense ratio. The key difference is that ETNs do not have hold the underlying assets but instead are like a bond, promising return but representing no ownership The appeal of these investments is the ability to gain easy access to unique assets or investment strategies.

ETFs have a different structure that mandates an issuer hold the underlying assets. Commodity ETFs track an index of continuously renewing futures contracts for the underlying commodities.

Unlike many other stock indexes which have a lot of similar characteristics and holdings, commodity indexes are very different. Each broad commodity index has a unique way of weighting among different commodities and has different methods for the commodities the index selects for inclusion. Commodities are a broad category and the benefits commodities provide vary by the individual commodity as each commodity has vastly different risks and diversification benefits. When adding commodities to a portfolio two things should be considered, the kind of commodities and weather an exchange trade note or fund is most suitable.

Choosing ETF or ETN

Commodity ETFs are structured differently from stock and bond ETFs. When investing in every other kind of ETF outside of commodities, the ETF structure is relatively tax efficient. Commodity ETFs do not have this tax efficient structure and investors are considered shareholders in a trust whose sole purpose is to invest in the underlying index. Because of this, owners of a commodity ETF will receive a K-1 tax form for their share of gains and losses of the fund from the trading of the underlying futures contracts. Unlike other ETFs no selling is required for there to be tax consequences at the end of each year.

ETNs remain tax efficient but lack a certain level of security since the products are unsecured debt. The assurance of repayment lies in the issuing investment bank’s ability to meet its obligations. Lehman Brothers unfortunately defaulted on its ETNs in the wake of their bankruptcy. The risk of investing in ETNs is two fold. The first risk is the credit risk of the issuer especially with the uncertainty of banks and financial institutions continuing to remain viable. Of course the second risk is the risk from investing in the asset represented by the ETN.

What holds many back from having a very successful indexing strategy using ETFs is getting distracted by the interesting and exotic ETF offerings, giving the investor exposure to foreign and domestic niche markets and asset classes.  I think many of these newer ETFs provide value to a portfolio but too often become over-weighted because of the promise of historical performance and historical correlations to the overall market

Something that I think is flying under the radar is the introduction of iShares S&P Target Risk ETFs.  This is an area that has no previous ETF exposure.  The target risk ETFs, listed below, each track an S&P Target Risk Series Index.

Made for Success?

These risk based funds like the very similar iShares target date funds, are created by surveying other actively managed risk based mutual funds and using the aggregate of their asset allocation decisions, then using ETFs to match those asset allocation decisions.  If indexing is indeed the better strategy in each of the asset class categories, all these risk based funds need to do is continue to have the lowest total cost.  Simply, they will beat the average of their mutual fund peers.

The Passive, Passive Strategy

The target risk based ETFs can solve the problem and tendency for investors to chase after trends and fads in the investing universe, especially in so called passive indexed portfolios.  The expense ratios include the cost of the underlying ETFs and represent the category average mutual fund’s asset allocation decisions while avoiding stock selection and market timing risks.

This leaves investors with only one decision, their risk level.  There are many resources for figuring this out and the ETFs themselves, being very transparent with their allocations and holdings can send investors very clear signals on the suitability of each fund.

A New Dawn for ETFs?

These new ETFs no doubt will allow for an easier transition into 401k plans and dollar cost averaging strategies used by investors saving for retirement.  Now the trading cost of buying many ETFs can be reduced to one.  These ETFs give the advantage of professional allocation strategies and the intelligence of indexing while reducing trading cost and the risk of over allocating trends in the ETF industry.

Diversification

Diversification when investing is spreading your investments out to eliminate business risk.  Business risk is the risk one company, industry, or sector has.  This does not include the risk of the economy but the risk of a particular business model and the risk from management making poor decisions.  Proper diversification takes this risk away.  The other risk that can not be taken away is market risk.  Market risk is the risk of the overall economy on the stock market.  ‘Cashing out’ of the stock market is a common method of trying to eliminate this risk but the difficulties of forecasting downturns often makes this method hard to act on.  September 2008 showed how hard it is to avoid market risk.  When the giant, Lehman Brothers filed bankruptcy many money market funds’ value dropped below $1.  This means that what people thought of as cash lost value.  A dollar invested in cash became at that time $.98.  If you are following this, you know that a money market fund breaking a dollar is business risk gone badly.  This is a small example, and those holding any insurance or banking stock will know, business risk has been abundant in 2008.

In the past, it was thought that proper diversification could be found in 15 stocks, than it was 30 stocks.  Now, finance books report 50 stocks are needed to supply diversification.  So what does that mean, 50 stocks are needed to gain diversification?  It means that the there is no more additional benefit in adding one more stock.  However, William Bernstein has written about the research done by Burton Malkiel, author of “A Random Walk Down Wall Street.”  In Burton Malkiel’s research he shows that proper diversification requires a lot more than 15 stocks.  Berstein goes further to add that 200 stocks are not enough and that the only way is to hold all the stocks in the stock market.  This may be new to you but in affect, this is called indexing.  He does not provide a recipe for the weightings of all the stocks in the stock market but he is clear that there is no point where adding another stock is not beneficial.  It is clear by looking at all the research that there is the most addition benefit in adding stocks to a portfolio with less than 50 securities, however what this research says is that risk reduction can still be had by having highly diversified portfolio representing all the stocks available.  In affect, this is free and easy risk reduction.

Diversifying Through ETFs

To obtain and build a highly diversified portfolio is very costly for most investors, since they must incur trading costs.  Exchange Traded Funds (ETFs) can solve this problem.  ETFs are like mutual funds, except they make no management decisions, are designed to track an index like the S&P 500 or Russell 1000.  Investors can trade ETFs intraday like stocks.  ETFs can be considered investable indexes.  Investors wanting to use indexing or add an indexing component to their portfolios can utilize the benefits of constructing portfolios or different asset classes.  Building efficient portfolios can be done easily with knowledge of modern portfolio theory and its techniques.

Structure is Everything

When ETFs were first being created they were called Unit Investment Trusts (UITs).  UITs are structured in a way that the investors in the fund actually can redeem the underlying holdings or have it done automatically on the UIT’s termination date.  For an ETF investor, redeeming the underlying securities is reserved only for market makers and is prohibited to individual investors.  The units can only be created and redeemed in units of 50,000. ETFs filed as UITs are held in trust and units of the trust are sold and traded.

State Street’s “Spider”

The SPDR fund, SPY, is the oldest and most traded ETF in the US. SPY is set up as an UIT and State Street is the trustee of the fund.  SPY has no termination date and is continuously held until the ETF shares are sold. What is notable about the fund is that SPY sells at 1/10 of the index price.

The manager of SPY must fully replicate the S&P 500 at all times. The manager cannot lend shares as a way to generate revenue. Dividends must be held in cash until paid to shareholders. All Fund Expenses (0.08%) are paid from the dividends earned by the underlying holdings.

Because SPY’s net asset value (NAV) always closely mimics the S&P 500 index it is very reliable and suitable for options trading.  Without this strict structure, price deviations from the index may disrupt an option strategy. Any strategy depending on the ETF tracking very closely S&P 500 should rely on SPY.  Because of that reason SPY is a favorite, relative to IVV for intraday trading.  Traders and strategy investors demand no surprises other than what is reflected by the underlying stocks or trading on the ETF.  In the same way, long term investors are not as concerned with small price differences.

Dividends that are earned from the underlying equities in SPY are held in cash until paid out on a quarterly basis. Since dividends cannot be reinvested, a ‘dividend drag’ is created where during climbing markets dividends are not reinvested to add to the return of SPY.  During descending market periods holding the dividends in cash is more profitable.

iShares IVV

Barclay’s iShares, a leading ETF provider, offers IVV as a way to track the S&P 500. The open-end structure of IVV gives the portfolio manager more freedom.  For instance, IVV can loan shares and receive interest.  IVV is not required to hold all 500 of the underlying stocks in the index, although it usually does. The fund can also use an optimization approach to best represent the index.  All these freedoms allow IVV to reduce the cost of operation to investors. The most important difference between IVV from SPY is that as dividends are earned by the underlying equities, IVV reinvest them into the index until they are to be paid out quarterly. This will increase the return in an upward moving market or the opposite in a downward market.

Option trading on IVV is available; however trading volume is not as competitive as SPY. In highly volatile markets, we have not seen the option prices move with price fluctuations of IVV. For a protection strategy this may be ok, but for more speculative trading this could cause a problem.

Conclusion

The difference between SPY and IVV is fairly straight forward; do you want your dividends reinvested into the index, or held in cash. Since 2000 Barclays and State Street have competed for assets and continually lower expense ratios.  This competition has made the two ETFs some of the lowest cost funds available. We will note that SPY has the lower annual expense ratio at .08% and IVV closely trails at .09%.  However SSgA writes in small print on the SPY section of their website: “agreed to waive a portion of its fee until February 1, 2009, but may thereafter discontinue this voluntary waiver policy.”  This indicates that the small price tag on SPY may just be a bait and switch tactic. We suspect that as the market recovers and money flows back into the market that both fees will continue to decrease. When you are ready to invest in a large cap index ETF, you are now equipped to make the right choice for you.

Casey T Smith

Research by Kyle Waller

IShares has just issued a dozen new unique ETFs which track the S&P Target Date Index Series and the Target Risk Index Series.  Below is a breakdown of the two categories with the tickers and expense ratios.

Methodology

The S&P Target Date Index Series and Target Risk Index Series are composed entirely of iShares ETFs, similar to a fund of funds.  Each underlying ETF is chosen as a broad representation of an asset class. According to Standard and Poor’s Target Date Index Series methodology guide,

“The index series reflects the market consensus for asset allocations for different target date horizons.  In particular, each index is representative of the investment opportunity available to investors for the corresponding target date horizon, with asset class exposure driven by a survey of available target date funds for that horizon.”

This means that it is the two index series’ intention to provide a benchmark based on asset allocation opportunities available in the marketplace.  This is different from most indexes that systematically hold the entire or a representation of an investable universe, defined by an asset class, style, sector, industry, etc.  These indexes instead, represent aggregate asset allocations by each index’s mutual fund peer group.

To determine the asset-class weights for each target date and target risk index, S&P surveys mutual funds categorized as Target Date funds or Target Risk funds by the Lipper and Morningstar databases.  After surveying a category peer group, a trend line is fitted to the data points, only utilizing asset classes with more than 1%.  Measures are taken to solve an outlier effect without removing the number of funds used in the survey.  The indexes are rebalanced annually using the same surveying method.

The goal of these indexes is to represent allocation decisions among asset classes and not sector, style, or individual security selections. To represent an asset class allocation, iShares ETFs are used.  It is very clear that S&P intended and designed the indexes to become ETFs.  It is interesting that S&P choose ETFs as the underlying assets instead of the indexes that those ETFs track.  This makes the creation and redemption of the ETF simpler since hundreds of individual securities are represented by the underlying ETFs.

The expense ratios of the target date and target risk index funds listed above include the expense ratios charged by the underlying ETFs of each Fund.  The expense ratio fees of the underlying ETFs, which are all iShares products, are discounted when held by the fund.  Listed below are the ETFs S&P can employ for asset allocations that are determined for their Target Date Index and Target Risk Index Series.  Each index may or may not contain all these funds depending on their asset class inclusion in each index.

Target Date Indexing

Unlike other ETFs, target-date ETFs have an ending signified by their given target date.  The S&P Target Date Retirement Income Index Fund (TGR) is designed to be the endpoint for all target date funds. According to S&P, three years after an index’s target date, the target date index will than match the Retirement Income Index.  Once an ETF reaches its designated target date it will be rolled into the S&P Target Date Retirement Income Fund.  The ETFs tracking the indexes should follow this same method.

Opening Doors for ETFs

By creating ETFs made entirely of ETFs, highly diversified global portfolios diversified among asset classes and all sectors give investors a one stop shop for risk managed portfolios or risk appropriate portfolios.  For individual investors, the trading cost of trading several ETFs can be eliminated to one ETF, since the ETF is a representation of nine other highly diversified funds.  Also, these funds can act as an investable benchmark against their advisor’s performance or be used by individual investors who want exposure to asset classes like emerging markets and international but are not sure what their exposure should be given their risk tolerance.

These ETFs are designed by sponging off of mutual funds the aggregate of their asset allocation decisions while removing their market timing and stock picking decisions.  Interestingly, these ETFs depend on mutual funds for their allocation results and therefore are perfect substitutes, suited to outperform the average comparable mutual fund taking into account fees and expenses.

The question is not whether these ETFs will compete with mutual funds and advisors but where they will compete.  Target funds are very popular in retirement 401k plans, thought of as an autopilot approach.  With software being developed to trade ETFs on an omnibus trading platform, ETFs can now be offered in a complete way to plan participates.  The need for this kind of ETF has been clear and many companies and advisors have been offering target date and risk profiled model portfolios made from ETFs.  WisdomTree, a major frontrunner in offering ETFs in 401k plans with an omnibus trading platform, has been providing model portfolios for 401k plans constructed entirely of ETFs.  The similar iShares ETF products bring more transparency by providing a direct way to invest in the model.  The drawback to the ETF structure relative to an advisor’s model portfolio is that the iShares ETFs will change weightings as market prices change and weightings can be shifted away from the original allocation when you invest since the fund is rebalanced annually.  With WisdomTree’s models one can invest in the model allocations when they decide to invest.  The problem will be solved to an investor once the fund is rebalanced annually.

Without a doubt these 12 funds open doors to new ETF investors, provide direct competition to mutual fund assets in 401k plans, and prove that having an all ETF portfolio is accessible, cheap, and potentially optimal.  I am happy to say that these new advances in ETFs fit with traditional indexing strategies providing a framework for indexing to work with all platforms, for all investors, and at very cost effective prices.

To Be Fair

IShares is actually not the first to have target date funds, TDX Independence was.  Last year TDX Independence issued 4 target date funds and 1 retirement fund, TDX Independence In-Target ETF (TDX).  On average the TDX Independence funds are twice the price of the similar iShares products and are based on Zacks Investment Research Lifecycle Index series.  The index structure tries to select equity and fixed income securities that they believe will outperform the benchmarks.  This is very different from the S&P series which is more systematic and utilizes indexing principles.