LendingClub Realistic Return Expectations Chart

Thinking about investing in P2P loans? Even though I still believe that decent returns are possible, I think it is important to have realistic expectations. I’ve given out the following warnings since they started:

  • You won’t get the stated interest rates on your loans. Let’s say the loans you invested in are charging 12% interest to the borrowers. First, there are fees to pay. Second, these are unsecured loans to faceless individuals on the internet. You don’t get to repossess a house or even a car. All you can do is hurt their credit score. They could empty their bank account and walk away the next day. Defaults are gonna happen; you should expect it.
  • Your reported return will decline over time. I see many people who have loans being very happy about their 10% reported returns after a year or so. Well, expect it to drop 1 to 3% or possibly more by the time the loans actually finish their full terms. If you keep rolling over your interest into new 3 year loans, that means your average loan age will likely remain around 1.5 years (often even younger due to high prepayment rates).

Recently, LendingClub started showing this on their performance and statistics pages:

This chart illustrates how returns typically decline over the life of an investment. If your account is relatively new, it is likely that your returns will decline over time as some of your Notes become past-due and charge off. This chart is not a prediction of how your portfolio will perform and actual results may vary.

Here’s the chart with a focus on the beginning (3-9 months = 9.8% median return):

lc_returns3

Here’s the chart with a focus on the end (24-30 months = 7.2% median return):

lc_returns4

That’s a performance drop of 2.6% over 21 months if you take the average loan ages (6 months to 27 months). I can see why the chart starts at 3 months, as no loan can be charged off until the payments are at least 90 days late. I’m not quite sure why the chart ends only at 30 months though, not 36 months, as I think the numbers would drop even further. (As an aside, I know than some investors basically try to sell their loans on the secondary market at full expected value after 12 months or so to maximize returns. If you could find buyers at that price, that might not be a bad strategy.)

A historical 7.2% median annualized return is still pretty solid. For a rough approximation, here are the returns of some corporate junk bond funds, probably the closest publicly-traded asset class available. Per Morningstar as of 4/14/2015, the 3-year trailing total return of the Barclays High Yield Bond ETF (JNK) was 6.67%. As of 4/14/2015, the 3-year trailing total return of the Vanguard High-Yield Corporate Bond Fund (VWEHX) was 7.21%. Given that the timeframes don’t match up perfectly, I would only go as far as saying that the return figures are in the same ballpark.

It is worth noting though that the mutual funds offer the same broad diversification for everyone, whereas an individual investor at LendingClub has more scatter in returns (either higher or lower than average). As for me, apparently I’m below the 10th percentile myself with my 4.3% annualized returns. Arrgh!

Prosper vs. LendingClub Investor Experiment: 2.5 Year Update

lcvspr_clipoIn November 2012, I invested $10,000 into person-to-person loans split evenly between Prosper Lending and Lending Club, both out of curiosity and for a chance at higher returns from a new asset class. After diligently reinvesting my earned interest into new loans, I stopped my after one year (see previous updates here) and started just collecting the interest and waiting see how my final numbers would turn out at the end of the 3-year terms.

My last update was 6 months ago, so here’s what things look like after roughly two and a half years. This will be my last update before final liquidation of my portfolio (see recap below).

$5,000 LendingClub Portfolio. As of April 14, 2015, the LendingClub portfolio had 129 current and active loans remaining with a principal value of $1,003 (1 in grace period). 96 loans were paid off early and 29 were charged-off . 1 loan is between 31-120 days late and 2 are in default, which I will assume to be unrecoverable ($37.07 in principal). $417.94 in uninvested cash is left in the account, and I also withdrew $4,000 previously (payments and interest). Total adjusted balance is $5,421.

1504_lc2

$5,000 Prosper Portfolio. My Prosper portfolio now has 110 current and active loans with a principal value of $1,404. 114 loans were paid off early, 42 charged-off. 1 loans are between 1-30 days late ($22). 3 are over 30 days late, which I am going to write off completely (~$18). $410.26 in uninvested cash is left in the account, and I also withdrew $3,500 previously (payments and interest). Total adjusted balance is $5,336.

1504_prosper1

Experiment Recap and Conclusions

  • P2P lending has successfully gone mainstream. The fact that institutional investors are buying a significant portion of Prosper and LendingClub loan inventory would seem to prove that the concept is viable. This WSJ article says 66% of Prosper loans in 2014 had been sold to institutional investors. What started out as the Wild West of unsecured loans is now accepted by Wall Street. LendingClub had a successful IPO in December 2014 (which they generously let their lenders participate in).
  • LendingClub reports my adjusted* annualized returns as 4.30% annualized. Prosper reports my annualized returns as 4.10% annualized. These returns are certainly above that of a savings account or bank CD, but not as good as many other asset classes over the same period. Considering the weighted average interest rate on those loans was 12% for LendingClub and 14% on Prosper, I saw a lot of defaults. (*Adjusted means you assume all loans 30+ days late will be total losses.)
  • My reported returns consistently deteriorated as my loans aged. 10 months ago Prosper said my returns were 5.76%. 14 months ago Prosper said my returns were 7.55%. LendingClub reported my unadjusted annualized return 6 months ago as as 5.27%. 10 months ago, it was 5.94%. The lesson here is that your returns will continue to vary and likely deteriorate as your loans age, so don’t assume your returns will always stay the same as they are in the beginning. Also, your returns will look higher if you keep reinvesting into new loans.
  • I am not a good loan picker. But will you be better? My returns are below average when compared to the advertised historical numbers. Certainly, I have seen reported numbers from other people who have done much better. Who knows, you may be the next P2P Bond King! :) But I took my shot, diversified into over 400 loans, and here are my honest results. Not everyone who gets bad returns is willing to share about them.
  • For small-time individual investors, dealing with unfamiliar forms at tax time can be tedious and time-consuming. Dealing with the tax forms each year isn’t impossible, but it isn’t fun either. If I were to invest all over again, I would definitely do it within an IRA to avoid tax headaches. To save more time, I would also buy at least 100 loans x $25, which also happens to be the $2,500 minimum for free auto-investment at LendingClub (no minimum at Prosper).
  • I plan on liquidating the rest of my portfolio by the end of 2015. In June 2014, I still had $5,493 of principal in active loans in both LendingClub and Prosper. (The rest was idle cash, mostly withdrawn.) Now, roughly 10 months later, I only have $2,407 in principal and my total balance grew by a measly $67. $67 dollars! After filing my 2014 tax returns, I decided it was not worth the headache of dealing with the 1099s involved with these little loans. Thus, I plan on selling my remaining notes on the secondary market, probably soon but definitely by year-end. I might try again in the future inside an IRA, but for now I choose simplicity.
  • LendingClub vs. Prosper relative performance. I tried my best to invest at both websites with the same criteria and overall risk preference. As noted, my LendingClub reported returns (4.3%) are a bit higher than my Prosper reported returns (4.1%). This is also supported by my own balance updates, although I wouldn’t put too much importance on the absolute numbers as I stopped reinvesting into new loans after the first year. Here’s an updated chart:

    1504_lcprosper

Wealthfront Offers Tax Loss Harvesting With No Minimums

wealthtlh_logoAutomated portfolio managers like Wealthfront will set you up with a diversified mix of index funds and manage it for you for a small fee. I’m an investing geek, so I always lean towards keeping the small fee and manage things myself. But an important variable to this equation is tax-loss harvesting. Tax-loss harvesting tries to improve your returns by minimizing your tax bill, but it is also tedious work that is ideally suited to handing over to a computer.

If the management fee they charge is say 0.25%, as long as the benefit from tax-loss harvesting is at least 0.25%, then you’re already ahead of the game. The problem is that predicting the actual benefit of TLH is difficult. Wealthfront claims that based on past data, their tax-loss harvesting implementation could add 1% annually to your after-tax returns:

wealthtlh_full

Up until recently, you also needed $100k in your portfolio. But Wealthfront has recently announced that as of April 2015, their daily tax-loss harvesting service will be available to all taxable accounts with no minimum balance requirement:

We’re proud to announce that our daily tax-loss harvesting service will be made available to all Wealthfront taxable accounts, starting in April. At Wealthfront, we believe everyone deserves sophisticated financial advice, and this brings us one step closer to that goal.

I would not have predicted this a few years ago: automated tax-loss harvesting for any account size and at such a low cost. A customer with $10,000 would be getting TLH and portfolio management for free. The minimum needed to open a Wealthfront account remains $5,000.

I would say that I am confident the benefit of TLH over the long-run will be greater than zero. However, I would not count on 1%. But even if we split the difference and assume it is 0.5%, then using such a service still has to be considered as it is greater that their management fee of 0.25%. I hate giving up control though, so while I have put a little seed money in various places, I am still 95%+ DIY and keeping a close eye on future developments.

Current sign-up promotions. Wealthfront usually allows your first $10,000 managed for free. With this special invite link, you can get your first $15,000 managed for free, forever (an additional $5k).

(Note: Competitor Betterment also has a similar tax-loss harvesting service. The post structure is similar, but I wanted to make sure any readers that may see only one post get the full context.)

Betterment Offers Tax Loss Harvesting With No Minimums

bettertlh_logoAutomated portfolio managers like Betterment will set you up with a diversified mix of index funds and manage it for you for a small fee. I’m an investing geek, so I always lean towards keeping the small fee and manage things myself. But an important variable to this equation is tax-loss harvesting (TLH). Tax-loss harvesting tries to improve your returns by minimizing your tax bill, but it is also tedious work that is ideally suited to handing over to a computer.

If the management fee they charge is theoretically 0.25%, as long as the benefit from tax-loss harvesting is at least 0.25%, then you’re already ahead of the game. The problem is that predicting the actual benefit of TLH is difficult. Betterment claims that based on past data, their Tax Loss Harvesting+ service could add an estimated +0.77% in after-tax returns, annually:

bettertlh_full

Up until recently, you also needed $50k in your portfolio. But Betterment just sent me an e-mail today (April 2015) that their tax-loss harvesting service will be available to all taxable accounts with no minimum balance requirement:

Using our smarter technology, we’ve now made Tax Loss Harvesting+ available to you and all of our customers—regardless of balance—at no additional cost.

We are the only automated investing service to provide this tax-reduction strategy, once only available to the wealthiest, for all investors. By democratizing tax loss harvesting, we are continuing our mission of making smarter investing accessible to everyone.

I would not have predicted this a few years ago: automated tax-loss harvesting for any account size and at such a low cost. A customer with $10,000 would be getting TLH and portfolio management for $25 a year. Betterment has no minimum investment requirement.

I would say that I am confident the benefit of TLH over the long-run will be greater than zero. However, I would not count on 0.77%. But even if we split the difference and assume it is 0.4%, then using such a service still has to be considered as it is greater that their management fee of 0.15% to 0.35%. I hate giving up control though, so while I have put a little seed money in various places, I am still 95%+ DIY and keeping a close eye on future developments.

Current sign-up promotions. Betterment is currently offering up to 6 months of free portfolio management fees, depending on your initial deposit amount.

(Note: Competitor Wealthfront has a similar tax-loss harvesting service. I know my posts about both are very similar, but I wanted to make sure any readers that may see only one post get the full context.)

Global Asset Allocation Book Review: Comparing 12+ Expert Model Portfolios

gaafaberI am a regular reader of Meb Faber’s online writings, and volunteered to received a free review copy of his new book Global Asset Allocation: A Survey of the World’s Top Asset Allocation Strategies. It is a rather short book and would probably be around 100 pages if printed, but it condensed a lot of information into that small package.

First off, you are shown how any individual asset class contains its own risks, from cash to stocks. The only “free lunch” out there is diversification, meaning that you should hold a portfolio of different, non-correlated asset classes. For the purposes of this book, the major asset classes are broken down into:

  • US Large Cap Stocks
  • US Small Cap Stocks
  • Foreign Developed Markets Stocks
  • Foreign Emerging Markets Stocks
  • US Corporate Bonds
  • US T-Bills
  • US 10-Year Treasury Bonds
  • US 30-Year Treasury Bonds
  • 10-Year Foreign Gov’t Bonds
  • TIPS (US Inflation-linked Treasuries)
  • Commodities (GSCI)
  • Gold (GFD)
  • REITs (NAREIT)

So, what mix of these “ingredients” is best? Faber discusses and compares model asset allocations from various experts and sources. I will only include the name and brief description below, but the book expands on the portfolios a little more. Don’t expect a comprehensive review of each model and its underpinnings, however.

  • Classic 60/40 – the benchmark portfolio, 60% stocks (S&P 500) and 40% bonds (10-year US Treasuries).
  • Global 60/40 – stocks split 50/50 US/foreign, bonds also split 50/50 US/foreign.
  • Ray Dalio All Seasons – proposed by well-known hedge fund manager in Master The Money Game book.
  • Harry Browne Permanent Portfolio – 25% stocks/25% cash/25% Long-term Treasuries/25% Gold.
  • Global Market Portfolio – Based on the estimated market-weighted composition of asset classes worldwide.
  • Rob Arnott Portfolio – Well-known proponent of fundamental indexing and “smart beta”.
  • Marc Faber Portfolio – Author of the “Gloom, Boom, and Doom” newsletter.
  • David Swensen Portfolio – Yale Endowment manager, from his book Unconventional Success.
  • Mohamad El-Erian Portfolio – Former Harvard Endowment manager, from his book When Markets Collide.
  • Warren Buffett Portfolio – As directed to Buffett’s trust for his wife’s benefit upon his passing.
  • Andrew Tobias Portfolio – 1/3rd each of: US Large, Foreign Developed, US 10-Year Treasuries.
  • Talmud Portfolio – “Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep by him in reserve.”
  • 7Twelve Portfolio – From the book 7Twelve by Craig Israelsen.
  • William Bernstein Portfolio – From his book The Intelligent Asset Allocator.
  • Larry Swedroe Portfolio – Specifically, his “Eliminate Fat Tails” portfolio.

Faber collected and calculated the average annualized returns, volatility, Sharpe ratio, and Max Drawdown percentage (peak-to-trough drop in value) of all these model asset allocations from 1973-2013. So what were his conclusions? Here some excerpts from the book:

If you exclude the Permanent Portfolio, all of the allocations are within one percentage point.

What if someone was able to predict the best-performing strategy in 1973 and then decided to implement it via the average mutual fund? We also looked at the effect if someone decided to use a financial advisor who then invested client assets in the average mutual fund. Predicting the best asset allocation, but implementing it via the average mutual fund would push returns down to roughly even with the Permanent Portfolio. If you added advisory fees on top of that, it had the effect of transforming the BEST performing asset allocation into lower than the WORST.

Think about that for a second. Fees are far more important than your asset allocation decision! Now what do you spend most of your time thinking about? Probably the asset allocation decision and not fees! This is the main point we are trying to drive home in this book – if you are going to allocate to a buy and hold portfolio you want to be paying as little as possible in total fees and costs.

So after collecting the best strategies from the smartest gurus out there, all with very different allocations, the difference in past performance between the 12+ portfolios was less than 1% a year (besides the permanent portfolio, which had performance roughly another 1% lower but also the smallest max drawdown). Now, there were some differences in Sharpe ratio, volatility, and max drawdown which was addressed a little but wasn’t explored in much detail. There was no “winner” that was crowned, but for the curious the Arnott portfolio had the highest Sharpe ratio by a little bit and the Permanent portfolio had the smallest max drawdown by a little bit.

Instead of trying to predict future performance, it would appear much more reliable to focus on fees and taxes. I would also add that all of these portfolio backtests looked pretty good, but they were all theoretical returns based on strict application of the model asset allocation. If you are going to use a buy-and-hold portfolio and get these sort of returns, you have to keep buying and keep holding through both the good times and bad.

Although I don’t believe it is explicitly mentioned in this book, Faber’s company has a new ETF that just happens to help you do these things. The Cambria Global Asset Allocation ETF (GAA) is an “all-in-one” ETF that includes 29 underlying funds with an approximate allocation of 40% stocks, 40% bonds, and 20% real assets. The total expense ratio is 0.29% which includes the expenses of the underlying funds with no separate management fee. The ETF holdings have a big chunk of various Vanguard index funds, but it also holds about 9% in Cambria ETFs managed by Faber.

Since it is an all-in-one fund, theoretically you can’t fiddle around with the asset allocation. That’s pretty much how automated advisors like Wealthfront and Betterment work as well. If you have more money to invest, you just hand it over and it will be invested for you, including regular rebalancing. The same idea has also been around for a while through the under-rated Vanguard Target Retirement Funds, which are also all-in-one but stick with simplicity rather than trying to capture possible higher returns though value, momentum, and real asset strategies. The Vanguard Target funds are cheaper though, at around 0.18% expense ratio.

Well, my portfolio already very low in costs. So my own takeaway is that I should… do nothing! :)

Alpha Architect also has a review of this book.

ComputerShare and Company-Specific DRIP Plans: Still A Good Option in 2015?

drip200Here’s a reader question that arrived this week:

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

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

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

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

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

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

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

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

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

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

NAPFA: Warnings When Finding a Financial Advisor

warning_signMany people feel more comfortable with someone else helping them with their finances. A common piece of advice these days is to find a fee-only advisor that doesn’t work on commission. Many times this leads to a recommendation of the National Association of Personal Financial Advisors (NAPFA), whose members must promise to be fee-only and act in a fiduciary manner (putting your interests first). They are regularly mentioned in Kiplinger’s magazine, and I’ve even referred a few readers to their website myself. You’d think that putting your money with the president of NAPFA would be a sound idea, right?

I was surprised to read the following warning from Phil DeMuth in his book The Affluent Investor:

The National Association of Personal Financial Advisors (NAPFA) will happily refer you to a fee-only advisor. Despite their lofty mission, no fewer than two of its recent presidents have been investigated for kickback schemes (one for defrauding clients by secretly putting $47.5 million of client money in a start-up he founded). Several years ago, I referred someone who was looking for an advisor to this group. When I followed up to ask how it went, he said, “The guy they sent me to tried to sell me a variable annuity.” This is exactly what fee-only advisors are not supposed to do: push high-margin commissioned products. This organization is a useful idea and I wish I could endorse it, but the execution leaves something to be desired.

Naturally, I had to learn more about these former NAPFA presidents. Here is a good summary excerpted from Wikipedia (emphasis mine):

Two former presidents of the NAPFA, Mark Spangler (serving in 1998) and James Putman (serving in 1996 and 1997) were charged by the SEC with fraudulent behavior: Putman in 2009, for accepting $1.24 million in kickbacks related to unregistered investment pools, and Spangler in 2011, for secretly investing $47.7 million of client money in two technology companies that he or his firm owned. [...]

On April 24, 2012, a Wisconsin federal court awarded summary judgment to the Commission on its claims against James Putman (“Putman”), a defendant in an action filed by the Commission in May 2009 and orders Putman to pay disgorgement and prejudgment interest in the amount of $1,530,129 and a civil money penalty of $130,000, for a total amount of $1,660,129. [...]

Spangler, a Seattle investment adviser, was found guilty 11/7/13 of 31 counts of fraud and money laundering after deceiving clients by secretly investing more than $46 million of their money into two risky startups in which he had an ownership interest. [...] Spangler was sentenced 3/14/14 to 16 years in prison [...]

It is important remember the relatively loose relationship between NAPFA and its members. There are many reputable, honest fee-only financial advisors out there that are members of NAPFA. BUT, you can’t solely rely on NAPFA membership to mean that the person you pluck out of their directory will be reputable and fee-only. It’s not very difficult to become a member, so unscrupulous people can join to get that layer of credibility and then abuse it.

Educate and protect yourself. NAPFA is a trade organization, so it mostly about marketing and getting good publicity. There’s nothing wrong with that, but as a potential client there is much more due diligence to be done before settling on an advisor. Make sure your money is kept at a well-known third-party custodian such as Schwab, Fidelity, or TD Ameritrade. Know what products are often sold by commission. Use the helpful resources at this SEC.gov broker check page.

Portfolio Rebalancing Frequency: Even Less Than Annually?

scaleHere’s another data point on the debate on how often to rebalance your portfolio to your target asset allocation. Econompic Data writes about rebalancing a portfolio back to 60% S&P 500 / 40% Barclays Aggregate Bond index from 1976-2014 and finds that rebalancing every 3 years actually produced slightly better average annual returns that rebalancing monthly (via Abnormal Returns):

econompic_rebal

Momentum is cited as a potential reason why this works. Looks good at a glance, but look at that y-axis. We are comparing 10.3% and 10.2%. Is that really significant?

I would point out that in a previous Vanguard research article, a similar backtest was done on a 60/40 Broad US Stock/Broad US Bond portfolio rebalanced across various thresholds from 1926-2009. Their conclusion (emphasis mine):

We found that no one approach produced significantly superior results over another. However, all strategies resulted in more favorable risk-adjusted portfolio returns when compared with returns for portfolios that were never rebalanced.

vgrebal

From a 2008 paper from Dimensional Fund Advisors:

Aside from avoiding excessive trading, there are no optimal rebalancing rules that will yield the highest returns on all portfolios and in every period.

From advisor and author William Bernstein:

The returns differences among various rebalancing strategies are quite small in the long run.

Instead of there being a benefit to rebalancing less often, it may just be safer that the frequency doesn’t matter. On the other hand, given the potential cost of rebalancing from taxes, commissions, and bid/ask spreads perhaps lowering the frequency doesn’t hurt.

I think the most important thing to note is that in every test case above, the rebalancing was done on a strict schedule and without emotion. The problem you are really trying to avoid is being afraid buy whatever has been getting crushed and selling what has been doing awesome. There’s that behavioral/emotional component again.

As for me, I try to check my portfolio once a quarter, but rebalance no more than once a year. An annual frequency is as easy to remember as your birthday, it’s not too often and not too seldom, lots of smart people are proponents, and it gives me the opportunity to do tax-loss harvesting. I use tolerance bands such that if my major asset classes are off by more than 5%, then I will rebalance. Otherwise, I “rebalance lite” year-round using any new money to buy underweight asset classes.

The Only Two States of Your Portfolio: Happy All-Time High or Sad Drawdown

emoinvestQuick question – What was the highest value ever for your investment portfolio? Now, what was the value exactly a year before that? You probably know the answer to the first question, but not the second, even though both have little to do with your final portfolio value.

I am currently reading the e-book Global Asset Allocation by Meb Faber and he had a good observation that I don’t recall ever expressed in this specific manner (emphasis mine):

It is a sad fact that as an investor, you are either at an all-time high with your portfolio or in a drawdown – there is no middle ground – and the largest absolute drawdown will always be in your future as the number can only grow larger.

We tend to carry the highest value of our portfolio around in our heads because of the powerful cognitive bias of anchoring. Let’s say that 10 years ago you started with $20,000 and today with your contributions and investment growth your total is $100,000. If next year your portfolio experiences a drawdown to $80,000, you’ll probably identify your portfolio as being 20% down from $100,000, as opposed to a 400% increase from $20,000. $100,000 is “what you had” and you will forever be anchored to that number, even if for it only lasted just for a day.

That is, until you reach another all-time high (yes! $105,000) and that will be your new anchor. (This applies to individual holdings as well – I’ve found this especially pervasive when using brokerage smartphone apps that allow me to frequently check in with just a tap.)

If your portfolio is anything like mine, it has been repeatedly been hitting all-time highs for a year or two. The problem is, sooner or later, there is a 100% chance I’ll be stuck in a prolonged drawdown phase. I will think about my high-water value every time I check my statements (which is why perhaps it is better not to check your investment value much more than once a year). I will question my existing asset allocation and how to invest my new money.

Now add in loss aversion – the other finding from behavioral economics that people feel the pain of losses much more severely than the pleasure of gains (studies suggest we hate losses roughly twice as much as gains).

That means drawdowns are always lurking around the corner, and we hate them twice as much as any investment gain. It’s no wonder that investors are often their own worst enemies by not sticking to their investment plans.

The Affluent Investor by Phil DeMuth – Book for $100,000+ Club

affinvestor

This week I’ve been trying to catch up on my book reviews (you should see my “to read” shelf!), and after a good beginner book I thought I’d write about a good intermediate-to-advanced book. You’ve probably noticed there are a lot of starter books out there for novice investors but not as many with more advanced advice ($$$… the potential audience is a fraction of the size). Addressing this deficiency is the goal of The Affluent Investor by Phil DeMuth.

In terms of the title, the industry classifies you as “mass affluent” if you have investable assets between $100,000 and $999,999. From $1 million to $10 million you are “high net worth”. This definition excludes some possibly important stuff – your income, the value of your personal residence, pensions, etc. But in real world terms, I would say this book is for anyone who isn’t living from paycheck-to-paycheck. If you have a $10,000 portfolio and have a surplus each month, sooner or later you will reach $100,000. If instead you have a credit card balance and it just keeps inching up, then you need something closer to a Dave Ramsey book.

The overall tone of the book is that of a close friend who is smart and into finances. DeMuth is already a financial advisor to rich folks so the last part is expected. What I mean is that he will be blunt and isn’t afraid to make stereotypical assumptions in order to rattle off all his tips. At only 200 pages, most things are only touched upon in a concise manner. Here’s a rough outline of the topics covered:

  • Big picture rules. Get and stay married. Make sure you can afford your children. Avoid debt. Save early and invest it. Diversify. Plan ahead.
  • Financial advice based on life stage. He puts you in the basic “affluent” mold of 20-35s have a kid buy a house, 35-55 working hard at professional career making most of your money, 55-65 protect assets and prepare for retirement, and 65+ retire and spend down money.
  • Financial advice based on job. Has special advice for doctors, lawyers, small business owners, and corporate executives.
  • General investing advice and “Can you do better?” investing advice. General investing advice is keep costs low and buy index funds that closely approximate the global market portfolio. “Can you do better?” advice touches on things like value stocks, small-cap stocks, dividend stocks, momentum, low-beta, etc.
  • Asset protection. Being affluent means you have money, and other people will want it. Insurance, buying real estate with LLCs, homestead exemptions, and similar topics are are very complex but his take is condensed into less than a page each.
  • Tax minimization. IRAs, 401ks, Solo Pensions, 529 plans, Health Savings Accounts, etc.

Here are things you might expect from a “book for rich folks” but won’t find inside:

  • You won’t get in-depth, hand-holding walkthroughs of anything. Consider the book as a push in the right direction for researching ideas.
  • You won’t find his secret list of the best hedge fund managers.
  • You won’t find tips on how to get rich with real estate.
  • You won’t find advice on how to pick individual stocks like Warren Buffett.
  • You won’t find him selling his own personal advisory services.

A general problem with all books of this type is that the advice is pretty short and to the point, but it doesn’t provide very much supporting evidence. You’ll either have to do your own due diligence, or blindly decide to trust the author. I’ve read books where the author might sound convincing but their advice is horrible. In my opinion, I think for the most part the advice in this book is good. But I’m just another person on the internet, so again do your own research.

In conclusion, I think this book covers a lot of questions that are commonly asked by the intermediate individual investor. It’s not too long and not too short. Some of the advice won’t fit your own situation, but at this level if you just find one solid actionable idea that makes the entire $18 book worth it. I’m personally going to look into the solo defined-beneift plan idea again, although I may still be too young to take full advantage.

Vanguard High-Yield Corporate Bond Fund Review (VWEHX)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Investment Grade

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

Below-Investment Grade (“Junk”)

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

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

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

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

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

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

Costs and Fees

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

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

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

Portfolio Credit Quality

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

vghighyield

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

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

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

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

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

The Elements of Investing – Book Review (Updated Edition)

elements180

There are two major types of investing books for beginner investors: “Instructional to-do list” books basically tell you what you should do. “Inspirational big-picture” focus more on the philosophical reasons why you should do those things. Both can be equally important and useful.

The Elements of Investing: Easy Lessons for Every Investor by Burton G. Malkiel and Charles D. Ellis falls more into the former “list” category. Malkiel is a noted academic and wrote the classic bestseller A Random Walk Down Wall Street. Ellis is a former director of Vanguard Group and wrote the classic bestseller Winning the Loser’s Game.

Basically, two pillars of the investment world got together and tried to whittle down their 80 years of experience into 200 pages and roughly 2-3 hours of reading time. The pages aren’t even big, as the hardcover version is only 7 inches tall. You could read the entire thing in an afternoon or in snippets before going to bed within a week.

In opinion, they did a pretty good job. Topics are covered in a brief, straighforward manner. If you’ve read your share of personal finance material, none of it will be new to you, but they remain critically important. The key takeaways are clearly laid out and repeated over and over to drill them into your head. Things like:

  • Save regularly and never take on credit card debt (most important).
  • Utilize any available tax-advantaged plans like IRAs, 401ks, 403bs.
  • Keep a safe, liquid emergency fund.
  • Diversification, rebalancing, dollar-cost averaging, and low-cost indexing are the keys to investing success.

There are also a lot of little nuggets of wisdom in the book. My two favorite quotes:

The real purpose of saving is to empower you to keep your priorities—not to make you sacrifice. Your goal in saving is not to “squeeze orange juice from a turnip” or to make you feel deprived. Not at all! Your goal is to enable you to feel better and better about your life and the way you are living it by making your own best-for-you choices. Savings can give you an opportunity to take advantage of attractive future opportunities that are important to you.

As in so many human endeavors, the secrets to success are patience, persistence, and minimizing mistakes.

The updated 2013 edition of the book (original edition was 2009) includes some interesting (controversial?) suggestions for dealing with the current low-interest environment for bonds. Since the current yield for US Treasury bonds is so low, and thus the future expected return just as low, they offer up tax-exempt municipal bonds, emerging markets bonds, and even blue-chip dividend stocks.

It was sort of weird to be told “stay the course!” and then in the next chapter be told “here’s how to change course!”. I actually appreciate that they express their honest opinions, even if it appears to contradict passive-investing dogma. Jack Bogle himself does it from time to time. (I personally choose to hold muni bonds instead of US Treasuries as well.)

Bottom line: This investing primer would make a very good gift for a recent college graduate or young worker if they are ready to start getting serious about investing. If they aren’t, the book may be a bit dry. I will be adding it to my recommended books list, once I get around to updating it…