On The Hiking Trail

3/16/17

By Michael McKeown, CFA, CPA - Chief Investment Officer

During the previous business cycle, the Federal Reserve raised interest rates 17 times in increments of 0.25%, taking the Fed funds rate from 1.00% to 5.25%.  The committee increased rates at each meeting over 24 months from June 2004 to July of 2006.  While the Federal Reserve controls the Fed funds rate, it influences the bond market.  The following table shows the effect of a rising Fed funds rate on a range of maturities and returns during the last cycle.

This business cycle has been longer, but slower in developing due to the depth of the 2008 financial crisis.  The recovery began officially in June 2009.  The interest rate hiking cycle began in December 2015 when the Federal Reserve raised interest rates 0.25%.  Its second hike came in December 2016 and third one in March 2017.  Each of these was a quarter of a point.

In their meeting on March 15th, the Fed statement included, “The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate.”  The median expectations of total hikes for 2017 is three.  However, four of the 17 Fed governors see four hikes this year, with an outlier seeing six hikes.

One of our top managers believes there will be four total interest rate hikes in 2017 and 2018.  Even if one disagrees with the forecast, going through a scenario analysis is worthwhile to prepare for potential volatility which would surprise markets.

The chart below goes back to 1986 with yields on the left axis.  It shows the interest rates of various maturities of Treasury bills and bonds.

Over the past twenty years, the 2-year Treasury bill sits an average of 0.28% higher than the Fed Funds rate.  The bands are wide though, from -1% to +1.5%.  In past hiking cycles, we see tend to see this difference decline.  The same goes for other maturities.  Arguably, if the Fed Funds tops out at 3%, the curve will converge around those levels.

The Fed’s latest dot projections puts its terminal Fed Funds rate at 3%.  If past is any prelude, interest rates across maturities should converge around this Fed Funds level (which occurred in 1989, 2000, and 2006 as shown in the pink circles above).  Given the current projections, the timing would be approximately 2019.  This would be a point of value for possibly extending maturities for bond investors.  It would also be a sign of trouble for the economy, as a flat or inverted yield curve typically precedes a recession.

The good news is that we are quite a bit away from that sign coming to fruition.  Broad economic conditions are positive; consumers are spending and businesses are confident.  Positive fiscal policy expectations are outweighing any negative effects from higher interest rates.

We think investors should have an above average weight to floating rate assets in bond portfolios today.  This does not mean just bank loans, which are junk-rated (or the more palatable name, ‘high yield’).  It means investment grade quality assets as well.   The key is bonds with yields that will float higher with the interest rates hiking higher, such as asset-backed securities.   In addition, several of our managers have currency trades which express the expectations of higher bond yields.  Avoiding short duration funds holding fixed rate assets in the two to five-year area of the curve seems wise.  This is the area of the yield curve highly affected by rising interest rates.

There is plenty that could evolve differently over the next two years.  Inflation expectations could fall greatly if the tax and stimulus bills are not passed.  Janet Yellen’s term as Chair of the Fed ends in January 2018 and it is unlikely that she returns for another.  As always, there are plenty of unknowns… and then there are also “unknowns, unknowns.”

Going through this exercise frames expectations in case the facts change.  As Sir John Maynard Keynes said, “When the facts change, I change my mind.  What do you do sir?”

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Snowball Lessons

3/1/2017

Michael McKeown, CFA, CPA – Chief Investment Officer

I have a confession to make.  Despite Warren Buffett being the most successful investor of all time, I never was really interested in him.  He felt like the mega-band that everyone already knew about; like proclaiming U2 was your favorite band at the peak of Bono’s popularity.  As the kids say today, it was “basic” (i.e., extremely conventional) to call Warren Buffett your favorite investor.  I still read Security Analysis, the bible of value investing by his teacher Ben Graham, and the works by other value acolytes (Seth Klarman, et al.).  The value style of investing makes intuitive sense to me, as it does for many others.  Thus, I adopted value investing as my credo.

This past month, I finally got around to reading the go-to biography on Warren Buffett, The Snowball

Another confession – I didn’t read it, I listened to the book on Audible.  Listening to books may not be as noble as reading them, but I think it brings us back to our storytelling days around the fire, or radio, or at the pub with friends.  And hey, it is 37 hours long!

After hearing Warren Buffett’s life story, from his childhood to starting the Buffett Partnerships, to buying Berkshire Hathaway, I finally get it.  There is a reason why The Beatles are so many people’s favorite band of all-time and the same goes for Warren Buffett.  I will not go through a book review here, other than to highly recommend it.

The book inspired me to go back and read some of the Buffett Partnership letters, from the ‘hedge fund’ that he launched in 1957.  His tone and notes on value investing still bear resemblance to the annual Berkshire Hathaway letters, the latest of which just came out this past weekend.

The 1961 letter discussed some of the same issues in financial markets we see today, such as passive versus active investing.  It was a year in which his partnerships were up 45% gross against the Dow Jones Industrials gain of 22%.  The cumulative gain of his fund for the previous five years was 251% against 74% for the Dow Jones.  He reviewed 38 other mutual funds and investment trusts for performance over the previous five years.  Of those, 32 underperformed the Dow and only 6 beat it.  That is a hit rate of only 16%. 

For the past five years ending December 31st, 2016, there were 703 mutual funds in the large cap core space, according to Lipper.  Of those, only 15% outperformed the S&P 500 Index.   Sound familiar?

Over the last nine years, investors pulled over one trillion dollars from actively managed funds and put over $1 trillion into indexed vehicles. 

For our part, we have chosen to index a large portion of domestic equities.  Cost and tax efficiency are two of the chief reasons.  What about active management?  To paraphrase Head of Global Financial Strategies at Credit Suisse, Michael Mauboussin, we want to sit down at the poker table where we have an advantage against the other players.  We want to look for ‘easy games,’ where active views can add value.  This is, where certain asset types have lower information efficiency and higher dispersion among investment manager returns.  These areas include international and emerging market equities, real estate, and across fixed income markets.

In our analysis, there are certain characteristics of successful investment managers that do not differ across regions and asset classes.  Successful portfolio managers have a keen eye for understanding the value of underlying businesses and securities.  There is an emphasis on purchasing assets with a margin of safety to the intrinsic value, which is the key feature of the process.  Finally, the best managers steadfastly execute their process on securities within their circle of competence.

Buying cheap, out of favor asset classes and companies will not go out of style.

“Price is what you pay.  Value is what you get.” – Warren Buffett

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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U.S. Economic Update

2/21/17

By Michael McKeown, CFA, CPA - Chief Investment Officer

Broadly speaking, the U.S. economy continues expanding nicely. 

When looking at leading economic data from the 50 states, 45 are in expansionary mode.  Below is a sample of five states in different regions of the country.  We typically see a synchronous decline prior to any trouble.  The worst state today is North Dakota, shown in green, due to less fracking activity and the heavy reliance on oil.

Consumers make up 70% of the economy.  Sales are as steady as they have been for the last seven years.  Below we show retail sales adjusted for both population and inflation.  It continues to expand at an annual rate of 3%.  Prior to a recession (grey bars), sales flatten out or decline as consumers cut back on discretionary items.

Ten years ago, the first sub-prime borrowers began defaulting on mortgages.  Today, mortgage delinquency rates continue declining to the lowest levels of the decade.  Home price indices are flirting with new highs, despite the home ownership rate being near a 60-year low.  In surveys of prospective home buyers, expectations of new purchases and actual sales were above the levels from last year.

Like many others, we are hoping for clarity from Congress and the administration soon on tax changes, both from the actual policy and timetable.  Ideally, the legislation would be complete in 2017 and apply to this year, but 2018 is quite possible.  A new corporate and income tax plan would increase growth with greater spending power for companies and consumers.  A fiscal spending package targeting infrastructure would also be a plus to keeping the positive economic momentum going.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Stock Cycles and Value

1/31/2017

By Michael McKeown, CFA, CPA - Chief Investment Officer

“Reversion to the mean is the iron rule of financial markets.” – John Bogle, founder of Vanguard

On a cyclical basis, regional outperformance tends to beget outperformance.  We call this the ability of markets to ‘trend,’ while our contemporaries describe it as ‘momentum.’  Yet it does not go on forever.  The chart below displays how emerging markets and the S&P 500 have traded the lead over the past 29 years.

During past cycles, lasting six to eight years, there was dramatic outperformance by the winner.  It started with emerging markets from 1988 to 1993, with the S&P 500 taking the lead during the technology bubble.  Then emerging markets crushed with the commodity boom and decline of the dollar in the 2000s.  The S&P 500 won the latest round coming out of the global financial crisis.

The pivots of the relative performance difference came at valuation extremes.  Below we show the enterprise value to sales ratio.  Enterprise value adds up both the market value of equity and debt for the market.  Sales are a great metric because there are no accounting adjustments made to ‘massage’ the numbers, like earnings.  One of our favorite contrarian managers uses this measure to try to find unloved companies that are at ten or twenty year valuation lows.  This is where expectations are at the bottom of the barrel and most sellers capitulate.  Because the financial sector has such different regulations from country to regions, we use indices that exclude the entire sector.

The chart below shows the latest Enterprise Value to Sales ratios.  The United States is closer to its peak in the late 1990s than to the troughs in the mid 1990s or 2009.  On the other hand, emerging markets look closer to the lows of 2002 and 2009.  The bottom chart shows that the difference is more than one standard deviation than the historical average.

In 2016, the tide turned, with an essential tie on a total return basis.  The turn in commodity prices, including oil, helped the stock markets of commodity exporting nations.  The speed of dollar appreciation against these countries’ currencies also slowed.  In turn, sales and earnings began to trough.

Even with the concern of protectionist policies by the new administration, the emerging markets showed resilience during January.  One year does not make a trend, but there are signs that reversion to the mean is flexing its muscle.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Why Do We Love Round Numbers?

12/22/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

As the stock market pushes to new highs, the Dow Jones Industrial Average Index is nearing a level it never breached before – 20,000.  Financial news anchors are downright giddy (so we hear, watching too much CNBC can rot your eyes). 

There is something satisfying about round numbers.  Per a News Works article, SAT takers are more likely to retake the test if they fall just short of a round number.  Major League baseball players are four times as likely to end the season with a .300 batting average than .299.

It is how we talk about age, being in our 30s, 40s or 50s.  It is how we think about numbers all the time. So why this obsession with round numbers and the base of 10 number system? 

According to Eugenia Cheng, a scientist at the School of the Art Institute of Chicago, “It’s very intimately linked to the fact we have 10 fingers.”  Experts agree that the evolutionary accident of humans having ten fingers for counting drives our obsession with a base-10 number system.  Why do we have ten fingers (and ten toes)?  One theory is the Limb Law, which states that based on the length of the limbs (arm), animals develop an optimal number of further limbs (in this case, fingers).  Based on the size and length of human arms, five fingers on each hand turns out to be optimal.

We fixate on round numbers due to our own selves.  And this is partly why we care about Dow 20,000.

The Dow Jones Industrial Average is a price-based index.  The price of all the stocks are added together to come up with the Dow’s price.  The actual size of the company does not matter, the dollar value of the stock price is what is important.  This makes it an imperfect measure of stock market performance.

As an investor, most important is the percentage move of an index, not the dollar-based price move.

Let’s show why this matters.  Goldman Sachs’ stock price is $243.  It is the highest price stock of the 30 companies in the Dow Jones Industrial Average.  Thus, it is the largest percentage weight of the index at 8.33%.  Yet, it is not the largest company by market value (at $99 billion) in the U.S. That honor goes to Apple whose value is $626 billion.   Goldman Sachs is the 45th largest company by market value.  The S&P 500 is an index based on market value.  Within the S&P 500, Goldman Sachs has a weight of 0.46%, or less than half a percent.  It is 18 times larger in the Dow Jones Industrial Average and its daily changes affect it that much more.  This is significant because the S&P 500 is the most popular index and most tracked by mutual funds and exchange-traded funds (ETFs). 

There are other ways to consider the significance of reaching milestones or all-time highs in the stock market.  One could inflation adjust the index by dividing by the consumer price index to get a ‘real’ value of the stock market.  Alternatively, most quoted price indices exclude dividends, which is not really a true representation of the experience of a ‘buy and hold’ investor.  Looking at a ‘total return’ would be more accurate.

Setting new highs means equity portfolio values are also setting new high-water marks.  The nostalgia of passing the round numbers also holds some significance.  People remember the ill-timed book Dow 40,000, published in 1999 during the midst of the tech bubble.  Finally, 17 years later and flirting with Dow 20,000, we are half way there!

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

Sources: http://www.newsworks.org/index.php/local/the-pulse/80394-10-50-100-why-do-we-find-comfort-in-round-numbers

http://www.science20.com/mark_changizi/why_do_we_have_ten_fingers

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The Starting Line for Reagan vs. Trump

12/9/16

By Michael McKeown, CFA, CPA - Chief Investment Officer

“Timing in life is everything.” – Leonard Maltin

There is a post-term narrative on each President’s economic policies.   Blame or praise comes from the performance of businesses, the economy, and financial assets.   There is probably too much time wasted cheerleading the accomplishments, and too much time spent by the other side tearing it down.  The “team” you are on determines the prism through which you view the success of a Presidency.  This is true from Reagan to Clinton.  Far more important to the big picture are financial and economic factors along with the life stage of technology at the start of each Presidency.

Many people compare the incoming policies of President Elect Donald Trump to Ronald Reagan.  The new Reaganomics is Trumponomics.  Prior to the election, one of Trump’s primary economic advisers, Larry Kudlow, gave a talk that I attended in New York.  He advised essentially the same prescriptions as he had for Reagan - supply side economics.  Lower taxes and regulations will bring about a greater supply of goods and services for consumers at lower prices.  The goal of which is greater growth for all.   Based on the campaign, Trump also supports a $1 trillion infrastructure plan.  This is decidedly not supply side economics or what core Republicans stood for the last several years. 

The success or failure for Trump’s post narrative Presidency will have much to do with the starting point of financial and economic data.  Let’s compare a variety of these data points to 1980, when Reagan took office, to 2016 for Trump.

Jobs are what many believe this past election was all about.  When Ronald Reagan took office in 1980, the unemployment rate was 6.3% and already rising.   In contrast, the unemployment rate today is at 4.6% or at the lowest 10th percentile.  In other words, it has been higher 90% of the time over the last 42 years.  In addition, the economic expansion is in its eighth year, with few signs of a recession in the next twelve months.  In contrast, Reagan’s first term began with a mild economic recession, for which he did not get the blame.  This is a more difficult starting point for Trump.  It can be said that it is best to have a recession early in your first term if you want a successful presidency! 

Let’s turn toward financial assets and look at stocks, bonds, and the dollar.

For financial assets, 2016 is a much harder spot to begin a presidency.  The sideways bear market of the 1970s gave stocks a cumulative return of 6% for the eight years ending in 1980.   From 1980 to 1988, stocks returned 245%.  With high valuations and low interest rates, future returns will be tough to compare to the rocking Reagan years.  Obama was fortunate to come into office in the middle of the Great Recession and after stocks lost 24% cumulatively the prior eight years.  Stocks went on to return 217% in the following eight years. 

The strength in the dollar is a concern in the near term because it can lower exports.  There is room for an orderly devaluation of the dollar to provide stimulus to the economy.

One area where Donald Trump’s policy aligns with what we have been focused on, is that the U.S. cannot run out of money.  The risk of spending “too much” is inflation, not default.  Yet, inflation has been what central bankers have been trying to get higher for last five years.  Despite the high overall level of debt, government spending as a percent of GDP was the lowest since 1960 over the last twelve months at 17.6%.  On the other hand, Reagan inherited a small current account surplus while there was a modest deficit over the last year at -2.6%. 

Finally, growth has been slower at only 2.2% annualized over the last four years.  This is the next administration’s focus.  Some might blame the poor demographics, lower increase in workforce (as the 1980s had the tailwind of women joining the work force in droves), and technology displacing many jobs across industries.  Nonetheless, economic stimulus through spending and tax cuts that can be pushed through fast and effectively is Trump’s way of getting GDP back to 4%.  If that happens, Trumpnomics will probably be deemed a success.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Big Bad Bond Market

11/18/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter.  But now I would like to come back as the bond market.  You can intimidate everybody.” – James Carville, political advisor

The biggest post-election news is the bond market.  Yields are up over one half of a percent to 2.25% on the 10-Year Treasury, which means bond prices fell.

The main reason behind the move in prices was higher inflation expectations. One of the main risks bond investors take into account is future inflation.  With President-Elect Trump’s big plans for infrastructure spending and tax cuts, it could mean greater money flowing in the system.  In addition, protectionist trade policy, if implemented, would also be inflationary for goods and services due to less competitiveness among companies.  In turn, this would lead to a larger federal budget deficit.  Traders and investors are pricing in the likelihood of these policies being passed by the Republican led Senate and House.  These policies go against many Congressional Republicans who spent the last several years threatening to shut down the government due to high budget deficits.

The breakeven inflation rate measures the difference between yield of nominal Treasury bonds and Treasury inflation-protected securities (TIPS).  It measures the inflation premium investors demand.  Inflation expectations were very low in the early part of 2016.  This measure increased sharply over the last few months and post-election.  This can be attributed to increasing wage pressures, oil prices bottoming, and talks of infrastructure spending by both candidates.

In the top half of the graph below, the price of the Barclays Long-Term Treasury Index is in teal blue.  Today, the bonds are trading at 108, which is in the lowest 6th percentile since 1990.  In other words, prices have been higher 94% of the time.  The green horizontal line is the average of the past 20 years. 

In the bottom half of the chart, the red area shows Treasury yields.  There has been a defined downtrend over decades.  Every few years it comes up to hit the diagonal downward blue dotted trend line when bond prices sell-off. 

While many worry if now is the time to sell bonds, others are asking if this is an opportune time to buy?

The Cleveland Fed publishes inflation expectations for the next ten years.  Per the website:

“The Federal Reserve Bank of Cleveland’s inflation expectations model uses Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations to calculate the expected inflation rate (CPI) over the next 30 years. The Cleveland Fed model is run every month on the date of the CPI release.  The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.75 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.”

In the big picture, what matters is whether there is secular change for inflation expectations.  If so, bond investors will demand a higher inflation premium for the risk of owning bonds.  The 35-year downtrend in interest rates may come under pressure, depending on how functional the government can be in its push for deregulation, fiscal spending, and tax cuts.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Post-Election Outlook

11/9/2016

By Michael McKeown, CFA, CPA - Chief Investment Officer

Political values are important to individuals, but mixing politics with portfolio decisions is not profitable on a consistent and repeatable basis.

Analysis based on fundamentals and the valuation of asset classes is what matters for investments.   We plan to stay in our lane and take a non-partisan view to what this election means for the economy and investments.

It is difficult to discern the planned policy implementation of Republican President-elect Trump based on his campaign.  Nonetheless, the control of the House of Representatives and the Senate by Republicans means that aggressive change may be coming and we will see healthcare, interest rates, trade policy, tax policy, and fiscal policy set off on a new course from the previous paths.  The unknown for these changes is the implementation timeline, the magnitude, and unintended consequences.

Aurum maintained a long running assumption that the coordinated executive and legislative branches of the government would be bullish for the domestic economy.  Trump proposed tax cuts and fiscal spending (both areas we implored for cooperation in over the last five years).  Specifically, he discussed infrastructure spending of $500 billion to $1 trillion in addition to individual federal tax cuts.  Of course, this does not align with the more vocal wings of the Republican party as it would increase the federal budget deficit.  If passed, though, the likelihood of higher growth and inflation would be probable.  This would be a net positive for wage earners and the economy overall.  The rise in inflation expectations would push up yields on government bonds (as of this writing, the 10-year Treasury is up 0.26% from the overnight lows to 1.96%).

At risk are global trade and companies tied to exports.  Protectionist policy could offset the positive domestic economy to a certain degree.  Despite the initial reaction by the currency markets, this should be good for foreign currencies against the U.S. dollar.

Geopolitical risk is another key area of concern.  Given the campaign rhetoric, it is unknown what policies will or will not be implemented; but a heightened sense of uncertainty could cause greater global stock market volatility.

Just like pilots do not take off without a contingency plan for a storm, our investment committee laid out plans for multiple scenarios.  This includes analyzing and maintaining the prices at which we would be willing to commit more money to stocks and bonds.  This is a constant process that occurs regardless of political events or elections.

We believe the largest new opportunity is in the global bond and currency markets.  Today, our analysis shows that we are getting paid the most in the last ten years to own a thoughtfully constructed global bond portfolio. 

In an emotional time (both exhilarating or outright negative), this is a period to look at lessons from behavioral finance.  Emotions drive decision making in most areas of our daily lives, and we simply rationalize those moves to ourselves.  Awareness of the psychological shortcomings (from hindsight bias, to recency bias, to loss aversion) can help prevent mistakes that can plague long-term investment results.  Being the strong hand of investing does not mean buying or selling on a whim.  It means thoughtfully incorporating changes in fundamentals and executing on the investment plan.  As we gain clarity on what the pending shifts in policy are, we will keep you apprised of the effects on the economy, client financial plans and portfolios, and the changes we implement to capitalize on the situation.

If you have questions or comments, we welcome the opportunity to discuss the election implications further.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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Do You Know What’s In Your Index?

11/4/2016

By Michael McKeown, CFA, CPA – Chief Investment Officer

Passive investing is all the rage these days.  Low fees, tax efficiency – who wouldn’t want to be in on this party?  We sure are.  In our view, it makes sense for certain parts of our portfolios.  Per Morgan Stanley, since 2007, US passive strategies have seen $914 billion in inflows while active funds had $857 billion in outflows.

In certain asset classes, there are nuances with indices that may not be what the end user intends.  But because indexing is automatically considered great these days, few are going beyond the surface to dig deeper.

The Barclays Aggregate Bond Index will soon include the name “Bloomberg” at the beginning of its name, as Bloomberg purchased the licensing rights.  Before Barclays, it was named after Lehman Brothers.  It is the key benchmark for most bond allocations.  Though interesting, the name of the index is not the most relevant fact to investors. 

Despite this broad measure of the fixed income market being around since 1973, the Barclays Aggregate Bond Index does not cover even half of the U.S. bond market!

The graph below from Guggenheim Investments displays the sectors and value included in the index.  The left side of the bar chart displays just shy of $17 trillion in value.  The right part of the bar chart, at $21 Trillion in value, displays the non-indexed securities and sectors.   Many of these sectors such as corporate, bank loans, ABS, and Non-agency MBS have much higher yields and credit risk profiles than the index.

The index is dominated by government debt from both Treasuries and agency mortgages.  It was previously more diversified.  An increase in government issued debt grew the Treasury piece of the Barclays Index from 23% in 2007 to 43% in 2016.

Major stock market indices are based on size (also known as market capitalization).  The bigger the company or country, the bigger the weight in the index.  The Morgan Stanley Capital International (MSCI) Emerging Markets Index contains 23 countries, yet the top three make up over half of the index.  China (27%), Korea (15%), and Taiwan (12%) are the big three, though some index providers classify Korea as a developed nation.  Just another argument to know what’s in your index!

Weights as of 9/30/16

While this may be the intended allocation for some, getting greater exposure to a country such as India requires the use of active managers or country specific Exchange Traded Funds (ETFs).

Indexing can make sense over using an active manager when the opportunity set is low.  For example, there are many mutual funds that invest exclusively in Treasury Inflation Protected Securities (TIPS) and use the Barclays U.S. TIPS Index as the benchmark.  There are only 38 different bonds that make up this index.  With such few security choices, making a portfolio look much different than the index can prove difficult for active managers.  This can also be true in niche areas of the market that have high correlation among securities, such as REITs.

While the proliferation of indices of all shapes and sizes is great for investors and constructing portfolios, it does have shortfalls.  Knowing what’s on the inside of an index fund or ETF that tracks an index is just as important as choosing the most efficient implementation.

 

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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IRA + HSA - The Alphabet Soup of Retirement Savings

10/19/2016

Michael Baker, CFP® - Manager of Financial Planning

Health Savings Accounts (HSAs) have been around since 2003 as a tax-preferred savings vehicle for participants in high-deductible health insurance plans. Despite their name, HSAs can serve as an excellent tool for retirement savings as well.

First, the basics. If your health insurance plan includes a deductible of at least $1,250 ($2,500 for a family), it is considered a High-Deductible Health Plan. Participants in a High-Deductible Health Plan are eligible to open an HSA and contribute up to $3,350 per year for an individual, or $6,750 per family per year. Like an Individual Retirement Account (IRA), there’s a “catch-up provision” that allows you to save an extra $1,000 per year if you’re age 55 or older.

Let’s be clear: HSAs are not retirement plans; but they are structured much like IRAs under IRS rules. Like an IRA, contributions to HSAs are pre-tax and grow tax-deferred. In addition, withdrawals are tax-free when used to cover qualified health care expenses, thus providing a triple tax-free benefit.

While the accounts were created to help people save for health care expenses, the reality is that they aren’t required to be used for this purpose. Unlike with Flexible Spending Accounts (FSAs), there is no “use it or lose it” provision. Funds in an HSA can roll over year after year. So even if you don’t take any withdrawals, you can continue to contribute to the HSA and enjoy the tax-deferred accumulation.

Once you reach the age of 65, any non-medical withdrawals from an HSA are taxed at your ordinary income rate, just like a traditional IRA. Younger investors face an extra 20% penalty. For a married couple maxing out their 401(k) and/or IRA contributions every year, the ability to save another $6,750 per year pre-tax is an appealing option.

Unfortunately, HSA holders often don’t take advantage of the investment component offered by some providers. According to the Employee Benefit Research Institute (EBRI), only 6.4% of HSA owners used the investment option in 2014. “A lot of people who have these accounts don’t know they can invest with them,” says Paul Fronstin, EBRI’s director of health research.

Retirement savings aside, a recent study by Fidelity suggests that health care costs for a 65-year-old couple living into their 80s will come to an estimated $260,000 during their lifetime. Given the choice between paying for these expenses with taxable/after-tax dollars from an IRA or savings account, or leveraging the triple tax-free benefit of an HSA, the benefits of including an HSA in the financial planning discussion becomes obvious.

As always, fees are a concern. It’s important to make sure you understand the underlying fees charged by your HSA provider. Some providers charge a monthly fee; others charge check-writing fees and/or transaction fees. It’s critical that you understand the nuances of your plan.

In the end, because you are able to contribute to an HSA even after you’ve maxed out your 401(k) and IRA, it does raise the cap on tax-deferred savings. Given the potential for massive health care expenditures in retirement, an HSA can serve as a way to increase retirement assets with the bonus of tax-free withdrawals for qualified medical expenses.

Contact Aurum Wealth Management Group to learn more about this and other strategies to meet your financial objectives.

This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.

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