Index Funds vs. Hedge Funds: Buffett $1,000,000 Bet Update 2016

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We are now 8 years in on the 10-year bet between Warren Buffett and a successful hedge fund manager. In 2007, Warren Buffett challenged any hedge fund to a long-term bet against the S&P 500. He found a taker.

Fortune magazine announced “Buffett’s Big Bet”, where $1,000,000 would go to the charity chosen by the winner. The bet would run from 2008 to 2018. Buffett would take the S&P 500, represented by the Vanguard S&P 500 index fund (Admiral shares). Protégé Partners would stand behind hedge funds, represented by the average return of five hand-picked hedge funds.

Carol Loomis has just posted the 2016 update in Fortune. The hedge funds made up a little bit of ground in 2015, but overall still lag significantly:

  • Last year (2015) the S&P 500 index fund went up 1.36%, but the hedge funds went up 1.7%.
  • Since inception (2008 through 2015), the S&P 500 index fund is up 66%. The hedge funds went up 22%. The performance gap is over 40%.

Here are the historical annual breakdowns:

protege2016

An important aspect of this bet is that we are comparing performance after fees. Hedge funds may employ some bright minds but also charge hefty fees of roughly 2% of assets annually + 20% of any gains. That is like running into a heavy and persistent headwind. Meanwhile, the Admiral shares of the Vanguard 500 Index Fund charge only a flat 0.05% annually.

Another important lesson that it is easy to point on good performance in retrospect. It is MUCH harder to pick out winning managers ahead of time (and harder on those managers when everyone is looking and there is too much money to deploy). At the start of the bet, the past performance of the hedge funds were excellent – from inception in July 2002 through the end of 2007, the Protégé fund gained 95% (after all fees), soundly beating the Vanguard S&P 500 index fund’s 64%.

Finally, my last point is that it is hard to know when to drop a winning strategy gone sour. The handpicked hedge funds have some serious catching up to do. But there are two years left in the bet, so technically it is still anyone’s game. If you were invested in these hedge funds, would you stick it out or cut your losses?

Read the full terms of the bet and each side’s opening arguments at LongBets.org. See my original 2008 blog post and halfway 5-year update here.

Vanguard Target Date Retirement Funds: Embrace Your Inner Ronco Rotisserie Oven!

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I’m a fan of the Vanguard Target Retirement 20XX Funds. These Target Date Funds (TDFs) may not be perfect, but they are a low-cost, broadly-diversified, “set-it-and-forget-it” fund that I feel are consistently under-appreciated and easily maligned due to their inherent “one-size-fits-most” nature.

In a recent Vanguard blog post titled “TDF investors are not rotisserie ovens”, senior product manager John Croke felt the “set it and forget it” description “fuels the misperception that many investors in TDF strategies are disengaged, disinterested, and generally unaware of what they’re invested in.”

The subsequent points he makes are certainly valid, but I happen to think the rotisserie oven analogy should be worn as a badge of honor! As Jason Zweig writes in the WSJ article “Radical Investing Advice: Do Nothing, Nada, Zilch, Zippo”:

Target-date investors, says Jeff Holt, an analyst at Morningstar, “are less prone to take matters into their own hands and move their assets around when markets are gyrating.”

[…] research by Financial Engines found that participants with little or no money in target-date funds underperform them by an average of 2.1 percentage points annually.

You won’t see Vanguard Target Retirement funds being touted very much in the financial media. Their returns are rarely at the top since they are index-based, so magazines and newsletters won’t write about them. Most advisors are supposedly charging you for their “expert” advice, so they will of course recommend something more complicated. Even index fund enthusiasts like myself often don’t invest in them because we like to fine-tune and tinker (sometimes to our detriment). They never seem to be the “best” move, just something you settle for when you can’t think of anything better. I think this cartoon describes the situation well (found via @michaelbatnick):

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It is an unpleasant truth that most people would be better off just focusing their energy on savings rate and leaving the investing to a Vanguard Target Retirement Fund. Another example of the power of inaction: A person who bought the 30 largest US companies back in 1935 and did absolutely nothing after that would have outperformed the S&P 500 over the last 40 years.

Now, I should throw in a few quick points from the Vanguard blog post about what investors shouldn’t forget about:

  • TDFs will continue to hold a certain amount of stock risk after you reach your target retirement age.
  • Along the same lines, TDFs do not provide guaranteed income in retirement.

To summarize, don’t be insulted when being compared to a Ronco rotisserie oven. Be proud to “Set it and forget it”. Vanguard Target Retirement Funds even perform the chore of rebalancing between stocks and bonds for you automatically. Perhaps Vanguard could even use some tips from Ron Popeil about marketing their low, low pricing 😉

Vanguard ETF and Mutual Fund Expense Ratios (Last Updated March 2016)

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March 2016 Update. Added announcement links for January 2016 and February 2016. There were some significant price drops in the Target Retirement and International funds:

  • Vanguard Target Retirement 20XX Funds lowered expense ratios to 0.14% to 0.16% depending on year, down from 0.16% to 0.18%.
  • Short-Term Inflation-Protected Securities ETF (VTIP) and Admiral shares (VTAPX) now at 0.08%, down from 0.10%. Investor shares 0.17%.
  • FTSE All-World ex-US ETF (VEU) and Admiral shares (VFWAX) now at 0.13%, down from 0.14%. Investor shares 0.26%.
  • FTSE All–World ex–US Small–Cap (VSS) now at 0.17%, down from 0.19%.
  • Global ex–U.S. REIT (VNQI) and Admiral shares (VGRLX) now at 0.18%, down from 0.24%. Investor shares 0.36%.
  • Total International Bond ETF (BNDX) now at 0.15%, down from 0.19%. Admiral shares 0.14%. Investor shares 0.17%.
  • Total International Stock ETF (VXUS) now at 0.13%, down from 0.14%. Admiral shares 0.12%. Investor shares 0.19%.
  • Total World Stock ETF (VT) now at 0.14%, down from 0.17%. Investor 0.25%.

Background. When you invest in a mutual fund or ETF, the fund company charges you a fee for managing that basket of stocks or bonds. This is called the annual net expense ratio, usually expressed as a percentage. If you hold a steady $10,000 in a hypothetical fund with a 1% expense ratio, that would result in an annual charge of $100. These expenses are actually deducted daily day from the funds’ net asset value (NAV), and while the numbers can seem small they will compound quietly and relentlessly over time. Here is an illustration from the Vanguard website:

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Vanguard has a long history of lowering their expense ratios as their assets under management grow, whereas the industry average hasn’t changed very much.

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You don’t need to track every little change as an investor, but I subscribe to updates of their expense ratio change announcements anyway. Vanguard runs their funds “at cost”, so sometimes as their costs go up, the expense ratios can also rise a bit. I’ll try to keep this list updated, along with some brief highlights.

2015 Announcement Links

  • February 2016. Lower expense ratios for 42 mutual fund and ETF shares.
  • January 2016. Lower expense ratios for 35 mutual fund and ETF shares.
  • December 2015. Lower expense ratios for 53 mutual fund shares, including 21 ETFs.
  • May 2015. REIT Index fund expense ratios went up. VNQ went up to 0.12%.
  • April 2015. Total Bond Market ETF (BND) and Total Bond Market Index Admiral Shares (VBTLX) dropped to 0.07%.
  • March 2015. Only one change: Lower expense ratio for Vanguard Convertible Securities Fund.
  • February 2015. Lower expense ratios for 6 international ETFs.
  • January 2015. Expense ratio changes for several actively managed funds.

Past Highlights

  • February 2016. Total International Stock, Total International Bond, FTSE All-World ex-US, and Global ex-US REIT funds all lowered their expense ratios.
  • January 2016. Target Retirement 2010-2060 Funds saw their expense ratio drop by 2-3 basis points to 0.14%-0.16%.
  • February 2014. Total US Stock ETF (VTI) was unchanged at 0.05%. Total International Stock ETF (VXUS) dropped to 0.14%. FTSE Emerging Markets ETF (VWO) dropped to 0.15%.
  • January 2013. Target Retirement 2010-2055 Funds saw their expense ratio drop by a basis point to 0.16%-0.18%.
  • May 2012. Vanguard REIT Index Fund, and Vanguard’s Short / Intermediate / Long-Term Investment-Grade Funds, Vanguard’s Short / Intermediate / Long-Term Treasury Funds, and a few other bond funds had expense ratio drops.
  • April 2012. Vanguard Inflation-Protected Securities Fund, Total Bond Market Index Fund, 500 Index Fund, Balanced Index Fund, Extended Market Index Fund, Small-Cap Value Index Fund, Total Stock Market Index Fund, and Value Index Fund had share classes with expense ratio drops.
  • February 2012. Vanguard Emerging Markets Stock Index, FTSE All-World ex-US Index, Total International Stock Index, and Total World Stock Index funds amongst others had share classes with expense ratio drops.

(Note that Vanguard chooses to delete their old announcements after about a year, so everything 2014 and before is now gone.)

In recent years as index funds have shot up in popularity, most of the major providers have introduced similar low-cost products (notably iShares, Fidelity, and Schwab). I think the competition is great and even Vanguard needs to be kept on its toes. However, with my own money, I think Vanguard has both the past history and better ongoing structure to keep costs low over the long haul. I have used both Fidelity Spartan funds and iShares ETFs as alternatives.

Making Your Nest Egg Last: Safe Withdrawal Rates vs. Sustainable Withdrawal Rates

eggosReading Warren Buffett’s Annual Letter always reminds me that stocks are not just some numbers that bop up and down, but are shares of real businesses with land, factories, knowledge, and hard-working people. This helps reassure me that the value of those companies taken together will never go to zero, and will eventually rebound and grow over the long term. At the same time, once you stop working and start selling shares, the prospect of going to zero is real. If you combine a prolonged bear market and forced withdrawals at depressed prices, you risk permanently impairing your portfolio.

According to a Merrill Lynch survey of wealthy families with $5+ million (not just people on the street!), 39% of them thought you could spend 6% or more from your portfolio indefinitely. The reality is closer to 3%.

When you see the term safe withdrawal rate, it almost always refers to how much money you can safely withdraw from an investment portfolio each year without running out of money. Usually, this number is set during the first year, and is adjusted annually for inflation. The key phrase is “without running out of money”. You could start out with a $800,000 dollars, but as long as you end with at least $1 and never drop below zero, you’re considered “safe”. In the real world, having your portfolio nosedive while you’re still relatively young may cause you to panic prematurely.

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Since I last mentioned PortfolioCharts.com, the creator Tyler has released a new tool called the Withdrawal Rates Calculator. It is quite cool, at least for an asset allocation geek like myself. You can enter your own custom asset allocation, and it will show both the historical safe withdrawal rate and the sustainable withdrawal rate. As defined there, a sustainable withdrawal rate is one where you must end the period with your initial principal amount, for example you must both start and end with $800,000 dollars.

Here are the results for the Classic 60/40 portfolio:

60% Total US Stock Market
40% Total US Bond Market

pc_6040

Here are the results for the Swensen Portfolio, on which my portfolio is loosely based:

30% Total US Stock Market
15% International Developed
5% Emerging Markets
15% 5 Year US Treasuries
15% US TIPS
20% US REIT

pc_swensen

For the Classic 60/40 portfolio, the rough numbers for a 40-year period are 4% for Safe WR and 3.4% for Sustainable WR. For the Swensen portfolio, the rough numbers for a 40-year period are 4.6% for Safe WR and 4.2% for Sustainable WR. If you were to focus on the sustainable numbers, that’s a surprising result of 24% higher withdrawals with the Swensen portfolio (and other asset allocations do even better!)

Can you depend on these historical differences to persist into the future? I would be careful about looking at things too finely, as correlations are always shifting. However, I do prefer using the sustainable withdrawal rate number for my own early retirement planning, and I am thankful to have this tool to tinker with.

(You may also be interested to know that a 100% US stock portfolio, despite its higher historical average returns, has a slightly lower 30-year sustainable withdrawal rate that either of the options above.)

Real World IRA Asset Allocations vs. “Age in Bonds”

As a follow-up to my last post on 100% stocks forever, the referenced NYT article had some neat data that I hadn’t seen anywhere else. This chart shows how the overall asset allocation of IRAs held by Vanguard change according to the age of the investor. The glide path of Vanguard Target Retirement mutual funds is also included for comparison.

nyt_100stocks_glide

Eyeballing things, it appears that past age 65, Traditional IRAs settle at roughly 58% stocks, while Roth IRAs settle at roughly 67% stocks. This “real world glide path” declines much more gradually than ones from the major all-in-one fund providers, and also stays flat from retirement age onward. For comparison, here are additional glide paths for Fidelity, T. Rowe Price, Blackrock, and American Century, taken from a Morningstar paper. (For this chart, retirement age would be roughly 2015.)

target1_full

I don’t know any studies that have found the real reason behind the “real world” numbers. I would suggest as a possible explanation that the average percentage must be asset-weighted, and “rich” people have more assets in aggregate. The “rich” don’t need to make big withdrawals (unless required by law), and so they don’t need to spend every penny before they die. They will leave a chunk of money to heirs and thus have a long time horizon. In turn, this longer time horizon would support the holding of more stocks. Roth IRAs are especially useful as an inheritance vehicle as they don’t have required minimum distributions (RMDs), which could also explain why they are even more strongly weighted in stocks.

Meanwhile, if you need to spend down your assets during retirement, then the asset allocation suggested by Vanguard Target Retirement funds (and all the other major target-date funds) would make more sense. But it’s certainly a good point that these one-size-for-all solutions will not apply to everyone.

If you like low costs, diversification, and simplicity but want more control, I would suggest the option of switching to a Vanguard LifeStrategy all-in-one fund that stays fixed at 40%, 60% or 80% stocks. I use the 60/40 LifeStrategy Moderate Growth Fund (VSMGX) as a benchmark for my own long-term portfolio asset allocation.

Best Asset Allocation Plan: 100% Stocks, Forever?

The NY Times had a provocative two-part series on portfolio asset allocation by David A. Levine, former chief economist at Sanford C. Bernstein & Company:

I enjoyed reading his opinions, but didn’t agree with all of his points. The heart of my argument is that when the writer says “most people”, he seems to be talking about his Wall Street peers with multi-million dollar retirement portfolios, where most of it will eventually be passed onto heirs or charity. Instead, “most people” are actually trying to make something like a $200,000 nest egg last as long as it possibly can.

Time horizon vs. asset size. The first article brings up the topic of “time horizon”:

This consensus view, though, rests on a fallacy: the belief that as people grow older, their investment horizon shortens and, therefore, their ability to withstand volatility diminishes considerably.

I would argue, instead, that there is an insufficient appreciation of just how apt the metaphor of the “investment horizon” is. Just as a sailor sees but never reaches the horizon, the same is true for nearly all investors.

[…] But what if there’s a bear market? “No big deal,” I say. As long as you don’t panic and sell most of your holdings at the worst times, your annual withdrawals are limited. As a result, you should not really worry about fluctuations in the stock market.

A rule of thumb is that stocks can drop 50% in any given year. Again, let say all you have is $200,000 and you’re withdrawing 4% of that ($670 a month) to supplement your Social Security and/or pension income. If your balance drops to $100,000 due to a economic crisis, and you still need that $670 a month to pay the bills, yes you are going to panic.

If you have a $10 million portfolio, and a market crash means that you simply reign in some of your discretionary purchases, then your stress level is going to be lower. As my own portfolio has grown, I now only hold 70% stocks but also worry less about the stock portion as I know can ride out a bad sequence of returns.

As Josh Brown reports on The Reformed Broker:

Having worked directly and indirectly with investors from all walks of life and every region of the country over the last 18 years, I can promise you that almost no one can endure – emotionally speaking – the volatility and drawdowns that an all-equity portfolio brings to the table.

Long-term performance vs. asset allocation. The second article makes the point that the historical long-term performance of stocks has been higher than all types of bonds, over many different holding periods:

nyt_100stocks_bonds

In my opinion, the logical conclusion from such tables as above is limited to saying that if you are going to invest in stocks, you need to hold them for 20+ years. So if your portfolio is 60% stocks, keep that portion in stocks for 20+ years. The table doesn’t take into account withdrawals or timing risks where you are forced to take out money to meet spending needs during a period of negative returns.

In addition, Warren Buffett is used as an example because he stipulated 90% S&P 500 stocks and 10% Treasury Bills for his wife’s trust upon his passing. Buffett is worried about the long-term returns, not the risk of his wife running out of money. Do you think her withdrawal rate will be anywhere near 4%? It’s going to be a tiny fraction of 1%. I’d bet big bucks that Buffett would not have set the same asset allocation if she only had $500,000 to live on.

In the end, I guess what I am saying is that your asset allocation also depends on your asset size. Your time horizon matters, but also how close you are to missing a rent payment matters too. Products like target-date retirement funds don’t adjust based on if your balance is $10 million or $10,000. Nor should they really, as they don’t know your future spending needs either. Investors themselves (or their advisors) need to take both of these factors into account.

Of course, it would be great not to have to worry about keeping a balance greater than zero. With a big asset base and modest spending levels, you could indeed have an indefinite time horizon and keep 60% in stocks forever, much like a traditional pension plan. I’d require some enormous amount like $10+ million to be 100% stocks forever, though.

Real Estate Crowdfunding 10-Month Update – Patch of Land

pol_house200Here’s an update on one of my real estate crowdfunding experiments. In mid-April 2015, I invested $5,000 into a loan for a single family fix-and-flip in West Sacramento, California. The loan was supposed to be for 6-months (one of the main reasons I chose it). (More details in my initial update.) Well, the short version is that the fix part happened, but it has now been 10 months and the house is still on the market. The borrower took the option of a month-to-month extension. The loan is still current. Here’s a screenshot and some more thoughts:

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Interest received in a timely manner. So far, I’ve been receiving my $45.83 every month ($550 annualized) on my $5,000 initial investment (11% APR). I enabled the option of having my interest automatically swept to my bank account each month. So far, this investment has required zero maintenance.

Read your contract. Just because there is a “6-month expected term” doesn’t mean you’ll get your money back in 6 months. You should read the terms carefully to see what options are available to the borrower if they can’t make that date. Is an extension automatically granted? Is there an increased interest rate? How long does the extension last?

Liquidity, liquidity, liquidity. One of the defining features of this type of investment is that it is highly illiquid. If I buy a mutual fund, I can sell the entire thing and get fair market value as cash in my bank account in a few business days. With an investment like this, the borrower could pay it back early, take their sweet time, or even default entirely and they’d have to liquidate the home before I get my principal back. You must be prepared for all scenarios.

Be happy with your loan-to-value ratio. I personally believe the house is listed for too high a price, but that part is not under my control. What was under my control was choosing to invest only in a loan where I was comfortable with the collateral. For example, they may be asking ~$320,000 but the loan amount was only for $179,000. As I am (one of the folks) in first position lien on the property, the house would need to sell for under $179,000 in net proceeds for me to lose principal.

In other words, have an adequate cushion so that you don’t lose sleep about it at night. It also helps that I’ve already earned 8.6% of my initial investment back over the last 10 months, cash in hand. Finally, I will repeat that this is a speculative investment using “experimental money” that makes up a very small portion of total assets. (Even Burton Malkiel and Jack Bogle have such “funny money” accounts.)

Tax documents. I received a 1099-INT for the interest earned through this loan. The 2015 form was made available in a timely manner on January 27, 2016. As such, it should be rather easy to add this in at tax time.

Stash App Review: Simplified Investing on Your Smartphone

stash1Got five bucks, a smartphone, and a bank account? You’re just a few taps from investing and owning a piece of hundreds of businesses.

Stash is a new smartphone app with a real brokerage account underneath that lets you invest in a curated selection of roughly 30 different ETFs. You can start with as little as $5 and add more in any increment via fractional share ownership. The app interface is nice and shiny, but I finally took some time to look under the hood a bit.

What do you need to sign up?

  • Download the app. Stash is currently iOS only, but Android is “coming soon”.
  • Your personal information (name, address, SSN) because this is still a real SIPC-insured brokerage account underneath.
  • Fill out a short risk questionnaire, and you will be identified as either a Conservative, Moderate or Aggressive investor.
  • Pick your investment, which you can change later. See below for details.
  • Fund with any bank account. Verification can be done via two small test deposits. For selected banks, you can expedite the linking process by using your bank login credentials instead.

Portfolio details. You can choose from about 30 different “investments”, which are really just re-labelled exchange-traded funds (ETFs) that anyone can buy with any brokerage account. The idea is to make things more approachable and not to scare you away with things like ticker symbols, limit orders, and so on. Here are some example pairings of their investment names and the underlying ETF.

  • Aggressive Mix – iShares Core Growth Allocation ETF (ticker AOR)
  • Moderate Mix – iShares Core Moderate Allocation (AOM)
  • Blue Chips – Vanguard Mega Cap ETF (MGC)
  • Park my Cash – PIMCO Enhanced Short Maturity Active ETF (MINT)
  • Roll with Buffett – Berkshire Hathaway Inc. Class B Shares (BRK.B)
  • Slow & Steady – PowerShares S&P 500 Low Volatility ETF (SPLV)
  • Home Sweet Home – SPDR S&P Homebuilders ETF (XHB)
  • Clean & Green – iShares Global Clean Energy ETFm (ICLN)
  • Global Citizen – Vanguard Total World Stock ETF (VT)
stash4   stash3

Based on a risk questionnaire, you will be identified as either a Conservative, Moderate or Aggressive investor. Some of the options, like the Aggressive Mix / iShares Core Growth Allocation ETF are essentially a old-fashioned balanced fund with 60% stocks and 40% bonds. (Moderate Mix is only 40% stocks and 60% bonds.) Others, like just buying shares of Berkshire Hathaway (BRK), are more focused and potentially volatile. You will only be shown options that are below or at your designated risk level.

Fractional shares are used. That means you can invest odd numbers like $7 or $217 and still have it fully invested in something that costs $100 a share. Based on their FAQ, dividends are not automatically reinvested. Dividends are deposited as cash and will stay there until you decided to invest it.

You cannot invest in individual stocks (unless they happen to be listed an investment).

Fees. Free for the first 3 months. After that, $1 per month for balances below $5,000. Once you reach $5,000, it switches over to 0.25% of your balance per year. (Example. $10,000 x 0.25% = $25 per year.) Fees are taken from your bank account, not from your Stash investment portfolio. Stash does not charge monthly subscription fees if your account balance is $0.

Each underlying ETF has their own embedded expense ratio. No commission fee for stock trades. No fee for deposits or withdrawals via electronic bank transfer.

I installed the app and started the account opening process, but didn’t actually open account. I usually would, but with all these new robo-brokers I’ve been getting a flood of 1099-B forms with lots of tiny little tax lots. It gets tiresome at tax filing time.

This and that. After reading through their FAQs and disclosures, here are other notable items:

  • You can only link one bank account at a time to Stash. If you wish to make a change, you must e-mail them at support@stashinvest.com.
  • Online statements are free. Paper statements are $5 each.
  • You may only deposit up to $10,000 per day via online bank transfer. You cannot deposit physical checks.
  • you may only withdraw up to $10,000 per day via online bank transfer. You cannot request a withdrawals via physical check.
  • Stash uses Apex Clearing as their custodian firm. Many other similar brokerage sites use Apex.

Final thoughts. I may be too old to be a Millennial, but I can still appreciate the power of a good smartphone app. I will even counter the people that point out that $1 a month on even a $600 balance is a 2% management fee. Yes, 2% would be a lot of money a $500,000 portfolio. But $1 is also how much people pay for a song or silly game. The more important question is – will this app start a habit of saving and investing? I don’t know, but this BuzzFeed article describes how Stash used focus groups to suggest their “make-things-not-so-scary” approach will get newbie investors over the hump.

Perhaps nearly as important – Stash already has some serious competition. The Robinhood app also has a nice user interface on top of a traditional brokerage account (no fractional shares) that lets you trade any stock with no commissions (i.e. no training wheels or investment guidance). The “invest in your interests” idea and fractional share ownership is also available at Motif Investing. The Acorns app adds a behavioral trick where it rounds up your daily purchases and sweeps the “spare change” over automatically.

Dilbert’s Financial Advice on an Index Card

Scott Adams continues to convert wise observations about the workplace into clever and funny comics. Occasionally, he tackles investing and personal finance, like in this recent Dilbert comic:

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This older comic is more subtle but reflective of why market timing is so alluring:

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Recently, Ron Lieber of the New York Times profiled a new book about financial advice that fits on an index card. Included was a link to Dilbert’s One-Page Guide to Personal Finance. Looking back on it, I would have to say that Adams’ list stands up to the test of time. I might put #7 about emergency funds a little bit higher on the list, but that’s just nitpicking. For the vast majority of people, sticking to such simple advice would be more than adequate. Certainly much better than Wally’s “above-average” plan!

The Big Short: Movie Notes and Real World Follow-Up

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I managed to catch the movie The Big Short (trailer) before it left the theaters. Having read the book with great interest back in 2011, I wondered how it would remade for the big screen. Isn’t it hard to believe that the events described started roughly an entire decade ago? There are plenty of reviews at all the big media sites, but here are my notes:

  • The original book The Big Short by Michael Lewis was classified as non-fiction.* The movie, however, is only “based on a true story”. As such, many of the individual names were changed. Steve Eisman (real person) became Mark Baum (movie character). Ben Hockett became Ben Rickert. Charles Ledley & James Mai became Charlie Geller & Jamie Shipley. Cornwall Capital became Brownfield Capital. For some reason, the names of Dr. Michael Burry and his firm Scion Capital went unchanged.
  • The director, Adam McKay, is probably best known for his comedies with Will Ferrell in Anchorman and Talladega Nights. Oh, and the classic short The Landlord (censored version). I suppose The Big Short could be called a dark comedy.
  • In retrospect, it might seem like betting against the housing market was an easy and obvious bet. While the movie might dramatize things, it did take courage and conviction. They had to put up millions of dollars to place the bet, and then more millions to keep the derivative bets running. Most other investors thought they were stupid, and tried to get them to reverse the bets. The banks also tried to make them sell their positions before they could realize profits. They were risking their own money, their family and friends’ money, and their entire careers.
  • The movie does a good job showing you how the bubble persisted for so long because everyone was incentivized to keep it going. Wall Street workers made money by packaging and selling the bonds. The pension funds and large institutions got to buy “safe” high-interest bonds. The money managers got to collect their fees. The mortgage brokers and real estate agents collected commissions. Homeowners saw their equity grow. Everyone was happy.
  • In contrast, the people who did the contrarian bet were all on the margins, outsiders, even a little weird. Hedge funds run by a guy who avoided human contact and wore cargo shorts and a free t-shirt everyday. (Christian Bale actually asked the real Michael Burry to take off his cloths and give them to him.) Another one based out of their parent’s garage.
  • The revolving door between the regulators and the industry that they regulate remains open. People go from big paychecks on Wall Street, to smaller paychecks at the SEC and other government roles, and then go back to big paychecks on Wall Street. People usually don’t like to burn bridges with future employers. See this Michael Lewis interview.
  • * As the book was non-fiction, CDO manager Wing Chau actually sued Michael Lewis for libel. Chau’s defamation lawsuit was dismissed and his appeal was denied. The SEC actually investigated him and his firm, found them both liable for fraud, banned him personally from the industry, and fined them $3 million in total. He probably didn’t like how he was portrayed in the movie, either.
  • Where are they investing now? In a January 2012 post, I wrote about the current investments of Michael Burry and Steve Eisman. Burry’s water investments seem like a long-term play, but Eisman’s bet against for-profit education is already starting to unfold. In May 2015, Corinthian College and twenty four of its subsidiaries (i.e. Heald College, WyoTech) filed for bankruptcy after challenges by both US and Canadian governments.

If you can’t watch some great acting performances by Christian Bale, Ryan Gosling, and Steve Carell, you could always get a refresher course via cartoon stick figures instead. :)

SavingForCollege.com Top 529 Plan Rankings 2015

sfc5capSavingforcollege.com is a popular privately-run site for researching and comparing 529 college savings plans. They released their updated ratings this month, which represents their “opinion of the overall usefulness of a state’s 529 plan based on many considerations.” The judgement criteria include:

  • Performance. They selected similar “apples-to-apples” portfolios with 7 different asset allocations from each plan and rated them based on historical performance. Rankings are updated each quarter.
  • Costs. Total average asset-based expense ratios among plans are compared, in addition to separately considering program manager fees, administrator fees, and annual account maintenance fees.
  • Features. This includes other factors that affect participants, including the ability of the plan change their investment options quickly if called for; creditor protection under the sponsoring state’s laws; availability of FDIC-insured options; minimum and maximum contribution restrictions.
  • Reliability. The appears to measure the likelihood of a good plan staying a good plan. Do they have experienced program managers? Does the plan have a good amount of assets? What is the quality of the documentation and reporting? How restrictive are the withdrawal and rollover processes?

Here is the full list of 5-Cap Ratings for each state, on a scale of 0 to 5 Caps. Note that there are separate ratings for in-state and out-of-state residents. The following plans received a 5-Cap Rating for in-state residents (alphabetical order):

  • California: The ScholarShare College Savings Plan
  • Colorado: Direct Portfolio College Savings Plan
  • Colorado: Scholars Choice College Savings Program – Advisor Plan
  • Illinois: Bright Start College Savings Program – Direct Plan
  • Iowa: College Savings Iowa
  • Maine: NextGen College Investing Plan – Direct Plan
  • Maine: NextGen College Investing Plan – Advisor Plan
  • Michigan: Michigan Education Savings Program
  • Nebraska: Nebraska Education Savings Trust – Advisor Plan
  • Nebraska: Nebraska Education Savings Trust – Direct Plan
  • New York: New York’s College Savings Program – Direct Plan
  • Ohio: Ohio CollegeAdvantage 529 Savings Plan
  • Rhode Island: CollegeBoundfund – Direct Plan
  • South Carolina: Future Scholar 529 College Savings Plan – Advisor Plan
  • South Carolina: Future Scholar 529 College Savings Plan – Direct Plan
  • Utah: Utah Educational Savings Plan (USEP)
  • West Virginia: SMART529 WV Direct College Savings Plan
  • Wisconsin: Edvest

Out of the 100+ different plans they rated, here are the 4 programs that attained the top 5-Cap Rating for out-of-state residents (alphabetical order):

  • California: The ScholarShare College Savings Plan
  • Maine NextGen College Investing Plan – Direct Plan
  • New York’s College Savings Program – Direct Plan
  • Ohio CollegeAdvantage 529 Savings Plan

Consistently top-rated plans. The last time I noted these rankings was 2012, and the following plans were 5-Cap rated back then and also now: California, New York, and Ohio.

I should point out that the SavingForCollege Top-rated 5-Cap plans are different than the Morningstar Top-rated Gold plans. In fact, there is no overlap at all! Two of my favorite Gold-rated plans, the Vanguard 529 Savings Plan (Nevada) and Utah Educational Savings Plan received 4.5 out of 5 Caps, although I am not exactly sure why.

However, in general the top 15 or so plans are pretty much the same for both. With that in mind, I see nothing wrong with most Morningstar Silver Plans and/or the 4.5 Cap SavingForCollege plans, if their investment options meet your needs. Here were my personal finalist 529 plans and asset allocations.

Finally, here is another resource about comparing the state-specific tax benefits that may be available to you.

Exceeding $500,000 SIPC Insurance Limit at Vanguard (or any Brokerage)

sipcThis post is for the fortunate folks who may possibly exceed the often-quoted $500,000 limits for SIPC insurance ($250,000 for cash). The way this insurance works wasn’t necessarily obvious to me, and although it is often compared to the FDIC insurance of banks, there are many important differences.

The Securities Investor Protection Corporation (SIPC) is a federally-mandated and member-funded organization that provides insurance to customers against the insolvency of broker-dealers. If needed, the SIPC can borrow from the US Treasury to meet its obligations. All broker-dealers are required to be members, including Vanguard (brokerage accounts, not mutual fund-only accounts), Fidelity, Schwab, TD Ameritrade, E-Trade, TradeKing, Robinhood, Betterment, Wealthfront, and so on.

Your assets, for examples shares of Apple stock or an S&P 500 mutual fund, are required by federal law to be held separately from the broker’s assets at all times. Broker-dealers are subject internal and external audits, surprise regulatory examinations, and weekly and monthly reporting requirements. Thus, in the vast majority of cases, there are no missing securities and the primary role of the SIPC is to oversee the transition of assets from the failed brokerage firm to another solvent firm. If there are missing assets, then the SIPC will cover of up $500,000 of missing assets ($250,000 maximum for missing cash), per legal entity.

What is a separate legal entity? Per Wealthfront:

The following would qualify as separate legal entities, each subject to the $500,000 limit: your individual account, your trust, your IRA, your spouse’s individual account, trust and IRA, your joint account, as well as a custodial account for a child. Two IRA accounts held by the same client would be considered one legal entity and thus are combined for purposes of insurance coverage. The same combination occurs when a single client holds two individual taxable accounts.

Another way is to simply hold your assets at two different broker-dealers. If you had an individual taxable account at TD Ameritrade and another at Fidelity, that would be two accounts with $500,000 at each.

How often has SIPC insurance actually been exceeded? Only in less than 0.1% of claims. Here are some stats from a Betterment article based on the SIPC 2014 annual report [pdf]:

Since the inception of SIPC in 1971, fewer than 1% of all SIPC member broker-dealers have been subject to a SIPC insolvency proceeding. During those proceedings, 99% of total assets distributed to investors came directly from the insolvent broker-dealer’s assets, and not from SIPC. Of all the claims ever filed (625,200), less than one-tenth of a percent (352) exceeded the limit of coverage.

Example of meeting and/or exceeding SIPC limits. So for example, you could have $2 million of non-cash assets at a failed firm in a single taxable account. If 75% of assets are recovered from the failed firm, you get $1.5 million back from the firm and $500,000 from the SIPC. If only 50% of the assets are recovered, that’s $1 million back from the firm, $500,000 from SIPC, and you’d be out $500,000 unless there are additional recoveries in the future.

Again, a recovery rate as low as 50% is highly unlikely based on historical failures. Per the SIPC annual report, the average recovery rate for insolvencies is 99%. Most examples that I’ve seen use a 90% recovery rate as a conservative example.

However, if you altered the scenario above to have your $2 million separated in to $500,000 in your individual taxable account, $500,000 in your spouse’s individual taxable account, and $1,000,000 in a joint taxable account, then even in that unlikely 50% recovery rate you’d be made whole.

Situations covered by SIPC insurance

  • Brokerage firm insolvency or bankruptcy.
  • Unauthorized trading. SIPC covers securities may have been “lost, improperly hypothecated, misappropriated, never purchased, or even stolen” by the broker-dealer.

Situations NOT covered by SIPC insurance

  • Market price drops. Fluctuations in the market value of your investments are not covered. In the event of a claim, you will receive the value of the securities held by the broker-dealer as of the time that a SIPC trustee is appointed.
  • Claims in excess of insurance limits. See above.
  • Certain investment types are not covered. As summarized by FINRA:

    Not all investments are protected by SIPC. In general, SIPC covers notes, stocks, bonds, mutual fund and other investment company shares, and other registered securities. It does not cover instruments such as unregistered investment contracts, unregistered limited partnerships, fixed annuity contracts, currency, and interests in gold, silver, or other commodity futures contracts or commodity options.

  • Certain other types of fraud. For example, if a scam artist tricked you into buying a penny stock which is now worthless, that is not connected to an insolvency by the broker-dealer, and is thus not covered by SIPC insurance.

Excess of SIPC Insurance. Many brokerage firms pay for optional, additional insurance on the private market for their clients called “excess of SIPC” insurance in the unlikely situation where a client may exceed SIPC insurance limits. You should contact your brokerage firm or look through their boring annual notices.

For example, I have the majority of my assets held in a new “merged” account at Vanguard Brokerage Services. Looking through their VBS semi-annual notice, you can find the following:

VMC [Vanguard Marketing Corporation] has secured additional coverage for your account, which applies in excess of SIPC, through certain insurers at Lloyd’s of London and London Company Insurer(s) for eligible customers with an aggregate limit of $250 million, incorporating a customer limit of $49.5 million for securities and $1.75 million for cash.

Note the total aggregate limit of $250 million, though. Last time I checked Vanguard mutual funds had over $3 trillion in assets under management. $250 million divided by $3 trillion is only 0.01%. Of course, most of those assets are not held in Vanguard Brokerage Services (but in institutional funds and other mutual fund accounts outside of VBS). Still, $250 million across all of their accounts doesn’t seem like very much. A few big fish with $50 million accounts and most of that would already be used up.

Additional ways to reduce your risk. The basic idea here is that the only way you’ll lose a big amount of money is a spectacular failure. In the past, the brokerage firms that have had spectacular failures have shared a few common traits – bad behavior. Don’t do anything that would foster such bad behavior.

  • Don’t hold your money at a firm that does proprietary trading. If a broker-dealer trades with their own money, there is a greater chance a bad trade will bankrupt them. Also, there may be a greater temptation to “borrow” some client funds to cover any unexpected cashflow needs.
  • Don’t use margin accounts, stick with cash accounts. In a margin account, technically your broker is often allowed to “borrow” your securities for their own purposes (usually loaning it to other broker-dealers). In a cash account, there is no such permission given. This is a bit extreme in my opinion, but perhaps something to consider.
  • Don’t invest in exotic, non-transparent strategies. If your brokerage firm only sells plain vanilla investments, it is much harder to hide any shady business. Mutual funds and ETFs are highly regulated by the SEC. Hedge funds are not nearly as closely-regulated.
  • Keep good records. You should keep copies of trade confirmations. You should keep copies of your latest monthly or quarterly statement of account from your brokerage firm. A trustee may ask you to supply copies of these documents in the case of erroneous statements or trades.

My two cents. Purely my opinion, but this is how I see it:

  • Keeping your accounts to each stay under the $500,000 limit (and not hold cash in excess of $250,000) is the only way to know that you’ll be 100% covered in the cases listed above. Just because something hasn’t happened in the past, doesn’t mean it won’t happen. Unlikely is not impossible.
  • If your account has between $500,000 and $5,000,000 in it, and you’re holding traditional mutual fund or ETFs inside, you’d need a bankrupt firm with less than a 90% recovery rate to lose any money (possibly much less). That is admittedly quite rare. You will have to weigh the risk against the added hassle of splitting your accounts by either institution or legal entity.
  • If you have more than $5,000,000 at a single account type at one broker-dealer, I think it starts to definitely become worth the extra effort to split your assets by either institution or legal entity. The risk may be small, but the potential losses are big. If you have this much, why mess around?
  • I wouldn’t put too much faith into excess SIPC insurance. They usually come with an aggregate limit and you have no idea how close the firm’s current assets are to exceeding that value. The amount of protection you’d receive is not under your control.