Why You Shouldn’t Bet on Higher Oil Prices Using the USO ETF

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Does this sound familiar? Perhaps you’ve heard it around the water cooler, or considered it yourself?

  1. Crude oil has dropped to $50 a barrel.
  2. You just know oil prices will go up eventually.
  3. The futures market is kinda complicated… I know! I’ll buy an ETF like USO.
  4. Profit!?!?

Here are a few things you should know first about the United States Oil Fund (USO) and similar oil ETPs.

You aren’t the only one who’s thought of this. Over $7 billion dollars have already gone into oil ETFs in the last two months alone. Read this series of Businessweek articles on the subject, all by different authors:

The usual market timing questions apply. Sure, the price will go up, but how long is “eventually”? It might be 1,3,5, or 10 years. If you have a specific time-frame in mind, then you can go out on the futures market and then buy a specific contract. But if oil hasn’t risen enough at that time – maybe it peaked earlier and dropped, or it peaks further in the future – you’ll have lost money.

If you buy the ETF, when is a good time to sell? $80 a barrel? $100? $120? What if you sell and then it rises another 50%?

What if it takes a while? The longer you have to hold these ETFs, the less likely they will track the price of oil (see below). Meanwhile, the ETF provider is happily collecting their annual expense ratios of 0.50% to 1%. At the current asset level of $1.28 billion times the 0.45% management fee, that’s $5.8 million a year in fees.

Your commodities futures ETF may not track the price of oil very well at all. To properly track the price of oil, you’d need to buy some oil and store it somewhere (and pay storage and security costs). These ETFs don’t do that, instead they buy oil futures contracts and keep rolling them over into new ones when they expire. That’s not the same thing. USO is designed to track daily price movements in the price of oil, not long-term movements!

Visually, here are a chart from Attain Capital that compares the change in USO share price (purple) as compared to the spot price of crude oil (red) when oil prices doubled between the start of 2009 and the end of 2010 (blue line adjusts USO underperformance for roll costs):

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Further, consider these stats from Businessweek (emphasis mine):

Since USO launched in April 2006, it has returned -71 percent, while the spot price of oil returned -26 percent. The last time oil roared back from a bottom was in 2009, when it returned 78 percent on the year. USO returned just 14 percent.

If you don’t understand the terms “backwardation”, “contango”, and “roll costs” then you don’t understand commodities futures. If you don’t understand something, you probably shouldn’t buy it. Take it straight from a USO executive:

John Hyland, chief investment officer of USO, says the fund is a “tactical trading vehicle predominately used by professional traders,” and not meant to be a buy-and-hold investment.

In the end, such a play is a speculative bet and it may just pay off, who knows. But it certainly isn’t a wise investment, especially if the tool you’re using doesn’t even do what you want it to do.

This Is Why My Retirement Portfolio Is Simple and Balanced

Via The Reformed Broker, investment manager Research Affiliates shares how a simple, balanced 60/40 portfolio (specifically 60% S&P 500 stocks, 40% 10-Year US Treasuries) did pretty darn good in the past 100, 50, and 25 years:

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It even did well over the last 10 years, considering that “blip” we had in 2008. The 60/40 portfolio outperformed 9 of 16 core asset classes, all while maintaining lower-than-average volatility.

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Of course, they also predict (using sound reasoning, in my opinion) that the same 60/40 portfolio will only produce a 1.2% inflation-adjusted return for the next 10 years. Still, I don’t know of any better options.

529 College Savings Plans Now Allow Two Investment Changes Per Year

529Here’s a quick note about a change in 529 college savings plans. Up until recently, you were only allowed one investment change per year, per beneficiary. Starting in 2015, a change in federal law means that you are now allowed two investment changes per calendar year, per beneficiary.

Specifically, this is due to a provision of the new ABLE (Achieving a Better Life Experience) Act. For those that like history lessons, this Fairmark article has more background on why 529s restrict investment changes at all.

Now, the rules have always permitted a change in investment options any time you change the account’s beneficiary, so people have also used this as a workaround although it may not be wise to abuse it. Changing your asset allocation all the time usually isn’t a good idea either, but now you have a little more flexibility (i.e. you can undo a change you regret making!).

Tax-Free 529 Savings Plans For Disabled Children and Young Adults

This won’t apply to everyone, but it could be significant if it does. I didn’t know about this until recently.

The Achieving a Better Life Experience (ABLE) Act used the structure of 529 college savings plans to create similar tax-sheltered accounts for the benefit of caring for disabled children and young adults. In addition to healthcare, qualified expenses would include education, housing, transportation, and employment support. The legislation has passed, but it doesn’t look like any states have actually created plans that you can open yet. More info here.

Investment Returns Ranked Annually by Asset Class 1995-2014

Every year, investment consultant firm Callan Associates updates a neat visual representation of the relative performance of 8 major asset classes over the last 20 years. You can find the most recent one below (view as PDF), which covers 1995 to 2014. For each year, the best performing asset class is listed at the top, and it sorts downward until you have the worst performing asset. You can find previous versions here.

callan2014full

The Callan Periodic Table of Investment Returns conveys the strong case for diversification across asset classes (stocks vs. bonds), investment styles (growth vs. value), capitalizations (large vs. small), and equity markets (U.S. vs. international). The Table highlights the uncertainty inherent in all capital markets. Rankings change every year. Also noteworthy is the difference between absolute and relative performance, as returns for the top-performing asset class span a wide range over the past 20 years.

I like focusing on a specific color (asset class) and then visually noting how its relative performance has bounced around for a few years. The ones that enjoy a stint at the very top are usually found on the bottom eventually.

So instead of trying to predict one asset class that will outperform this year, why not commit to holding a multiple, productive asset classes that will balance each other out over time. Pick ones that will have a long-term positive return, but in any given year might perform poorly. Hold them in a low-cost manner, and rebalance your holdings if they get out of whack.

Back to Basics: Simplify and Automate Your Savings

automateLet’s take a step back and focus on some actionable tips to simplify and automate your savings. Think of it as knocking out your New Year’s Resolution in just 10 minutes or less.

New Year’s resolutions fail because willpower is like a muscle. If you keep having to choose the “right thing” that does not provide immediate gratification, your willpower muscle starts to fatigue. Eat the healthy kale thing instead of the nachos? Yes for a few times, but after a month no no no. Take 15% of your paycheck and set it aside? You’ll forget. The key is to take away the decision = no willpower fatigue.

First, consider your paycheck. Is it bi-weekly, semi-monthly, or monthly? Let’s say it is biweekly and you get paid this Friday, January 9th. That means you know you’ll get paid on January 23rd, February 6th, and so on. You just need to schedule a transfer for 15% of your paycheck for each of those days directly into an online savings account. Here are screenshots and tips for some specific providers:

Auto-save with your 401(k) plan.
This allows you to get any company match, grow your money faster with tax advantages, and also takes the money out before it even reaches your paycheck. Our provider is TransAmerica, which like many others now offer an option for annual auto-increases as well. The only frequency option is every pay period.

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Auto-save with Ally Bank Savings Account.
This is my go-to savings account, and it has the most flexible list of frequency options: weekly, bi-weekly, every 15 days, weekly, every 2 weeks, every 4 weeks, monthly, every 2 months, every 3 months, every 6 months, every year, the first business day of each money, or the last business day of each month. With a competitive interest rate, no minimum opening balance, and no monthly fees, and other features – see my Ally Bank Savings Account Review for details.

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Auto-save with Capital One 360 Savings Account.
Formerly ING Direct, this is the original no minimums, no monthly fee online savings account. The frequency options include weekly, bi-weekly, semi-monthly, monthly, or quarterly. You can even set up special sub-accounts and name them things like “Vacation” or “Next Car”. See my Capital One 360 Savings Account Review for more details.

save_capone360

Auto-save with Vanguard IRA and mutual funds.
The best place for low-cost investing in an IRA. Under “Automatic Investments”, you can schedule investments for mutual funds in either IRA or taxable accounts. You’ll need to have the fund already established with the minimum initial investment. The frequency options include weekly, monthly, bi-weekly, or semi-monthly.

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What if I need the money? Well, if you put in an online savings account, if you really need the money, you can transfer it back. But even transferring back out of your savings account will take a conscious effort, so you’re less likely to do it. You can’t easily withdraw from a 401k or IRA, so you’ll just have to make the commitment.

The key here is to combat laziness. If you like this idea, take action today and you’ll be on autopilot the rest of the year!

Early Retirement Portfolio Income Update, Year-End 2014

When investing, should you focus on income or total return? I like the idea of living off dividend and interest income, but I also think it is easy for people to reach too far for yield and hurt their overall returns. But what is too far? That’s the hard part. Certainly there are many bad investments lurking out there for desperate retirees looking for maximum income. If possible, I’d like to invest for total return and then live off the income.

A quick and dirty way to see how much income (dividends and interest) your portfolio is generating is to take the “TTM Yield” or “12 Mo. Yield” from Morningstar quote pages. Trailing 12 Month Yield is the sum of a fund’s total trailing 12-month interest and dividend payments divided by the last month’s ending share price (NAV) plus any capital gains distributed over the same period. SEC yield is another alternative, but I like TTM because it is based on actual distributions (SEC vs. TTM yield article).

Below is a close approximation of my most recent portfolio update. I have changed my asset allocation slightly to 60% stocks and 40% bonds because I believe that will be my permanent allocation upon early retirement.

Asset Class / Fund % of Portfolio Trailing 12-Month Yield (1/5/14) Yield Contribution
US Total Stock
Vanguard Total Stock Market Fund (VTI, VTSAX)
24% 1.76% 0.42%
US Small Value
WisdomTree SmallCap Dividend ETF (DES)
3% 2.68% 0.08%
International Total Stock
Vanguard Total International Stock Market Fund (VXUS, VTIAX)
24% 3.4% 0.81%
Emerging Markets Small Value
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
3% 3.17% 0.09%
US Real Estate
Vanguard REIT Index Fund (VNQ, VGSLX)
6% 3.60% 0.22%
Intermediate-Term High Quality Bonds
Vanguard Limited-Term Tax-Exempt Fund (VMLUX)
20% 1.68% 0.34%
Inflation-Linked Treasury Bonds
Vanguard Inflation-Protected Securities Fund (VAIPX)
20% 2.24% 0.45%
Totals 100% 2.41%

 

The total weighted 12-month yield was 2.41%, as opposed to 2.49% and 2.31% the previous two quarters. This means that if I had a $1,000,000 portfolio balance today, it would have generated $24,100 in interest and dividends over the last 12 months. Now, 2.41% is significantly lower than the 4% withdrawal rate often recommended for 65-year-old retirees with 30-year spending horizons, and is also lower than the 3% withdrawal that I prefer as a rough benchmark for early retirement. But in theory the total return will be much greater due to share appreciation.

As noted previously, a simple benchmark for this portfolio is Vanguard LifeStrategy Growth Fund (VASGX) which is an all-in-one fund that is also 60% stocks and 40% bonds. That fund has a trailing 12-month yield of 2.09%. Keep in mind that the muni bond interest in my portfolio is exempt from federal income taxes.

So how am I doing? Using my 3% benchmark, the combination of ongoing savings and recent market gains have us at 91% of the way to matching our annual household spending target. Using the 2.41% number, I am only 73% of the way there. Consider that if all your portfolio did was keep up with inflation each year (0% real returns), you could still spend 2% a year for 50 years. From that perspective, a 2% spending rate seems like a very conservative lower bound.

Early Retirement Portfolio Asset Allocation Update, Year-End 2014

Here’s a final update on my investment portfolio holdings for 2014. This includes tax-deferred accounts like 401(k)s and taxable brokerage holdings, but excludes things like physical property and cash reserves (emergency fund). The purpose of this portfolio is to create enough income to cover all of our household expenses.

Target Asset Allocation

aa_updated2015

I try to pick asset classes that will provide long-term returns above inflation, distribute income via dividends and interest, and finally offer some historical tendencies to balance each other out. I don’t hold commodities futures or gold as they don’t provide any income and I don’t believe they’ll outpace inflation significantly. In addition, I am not confident in them enough to know that I will hold them through an extended period of underperformance (i.e. don’t buy what you don’t understand).

Our current ratio is roughly 70% stocks and 30% bonds within our investment strategy of buy, hold, and rebalance. With a self-directed portfolio of low-cost funds and low turnover, we minimize management fees, commissions, and taxes.

Actual Asset Allocation and Holdings

aa_pie_2014final

Stock Holdings
Vanguard Total Stock Market Fund (VTI, VTSMX, VTSAX)
Vanguard Total International Stock Market Fund (VXUS, VGTSX, VTIAX)
WisdomTree SmallCap Dividend ETF (DES)
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
Vanguard REIT Index Fund (VNQ, VGSIX, VGSLX)

Bond Holdings
Vanguard Limited-Term Tax-Exempt Fund (VMLTX, VMLUX)
Vanguard Intermediate-Term Tax-Exempt Fund (VWITX, VWIUX)
Vanguard High-Yield Tax-Exempt Fund (VWAHX, VWALX)
Vanguard Inflation-Protected Securities Fund (VIPSX, VAIPX)
iShares Barclays TIPS Bond ETF (TIP)
Individual TIPS securities
U.S. Savings Bonds (Series I)

Notes and Benchmark Comparison

There was very little activity during the last quarter of 2014. I’ll need to do some rebalancing in the beginning of 2015. I did change my asset allocation tree above to reflect that my bond holdings have a weighted duration of close to 4 years now. It used to say “shorter-term” but really now it is more “intermediate-term”. I’ve been putting my new bond money into VWIUX, which holds intermediate-term high-quality municipal bonds. I haven’t sold any of my limited-term holdings. Overall, it’s a little longer in maturity and a little higher yield, but nothing drastic. I don’t really listen to future rate predictions; they’ve been wrong more than they’ve been right.

I’ve already noted the 2014 performance of each individual fund here along with my overall portfolio total return of roughly 6.5% for 2014.

A simple benchmark for my portfolio is 50% Vanguard LifeStrategy Growth Fund (VASGX) and Vanguard LifeStrategy Moderate Growth Fund (VSMGX), one is 60/40 and one is 80/20 so it also works out to 70% stocks and 30% bonds. That would have returned about 7.1% for 2014. One reason for my portfolio’s relative underperformance to this benchmark is my inclusions of TIPS bonds which returned 3.5% whereas the Vanguard Total International Bond Index Fund (BND) returned 6% for the year. I’m still happy to hold TIPS. If I had more tax-advantaged space and/or a lower tax rate I’d hold BND instead of muni bonds but I’m still happy with my muni funds as well.

In a separate post, I will update the amount of income that I am deriving from this portfolio along with how that compares to my expenses.

Acorns App Review: Automatically Invest Your Spare Change

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Updated. Acorns fee structure updated 1/1/15. Previously I wrote about WiseBanyan, which lets you invest in a basket of ETFs with no minimum opening balance. I remarked that it allowed starter investors to open a complete portfolio with as little as $100. Well, what about investing just 57 cents at time?

Acorns is a new smartphone app that lets you invest your “spare change” into a diversified ETF portfolio of stocks and bonds. For example, if you bought something for $10.43, the Acorns app will “round up” your purchase to $11 and invest $0.57 into a brokerage account. The idea is that these small investments will make it simple and easy for folks to start saving and investing. Thanks to reader Steven for the tip.

How does it work? You’ll need to provide them:

  • Your personal information (name, address, SSN) because this is still a real SIPC-insured brokerage account underneath.
  • Your debit or credit card login information (so they can track your transactions and calculate round ups)
  • Your bank account and routing number (so they can pull money into your investment account)

The app scans your transactions, calculates the round-ups, pulls that money from your checking account, and automatically invests it for you. You can also make one-time deposits or schedule recurring deposits on a daily, weekly, or monthly basis. The app also tries to identify “found money” like rebates and rewards which it encourages you to also invest. YouTube video demo:

Fees. As of January 1st, 2015, Acorns has changed their fees to be either $1 a month (balances under $5,000) or 0.25% of assets per year (balances above $5,000). So on a $10,000 balance that would be $25 a year. No fee on $0 balances. See fee estimator for detailed calculations.

Withdrawals are free, but you may incur capital gains on which you’ll owe income tax. I don’t know if they will support asset transfers via ACAT.

Portfolio details. You can choose one of five target portfolios, ranging in risk level from conservative to aggressive. Mostly standard Modern Portfolio Theory fare, not surprising as their “Nobel Prize-winning economist advisor” is Harry Markowitz, who is a paid consultant.

acorns_portfolioma

All portfolios are constructed using the following six index ETFs:

  • Vanguard S&P 500 ETF (VOO)
  • Vanguard Small-Cap ETF (VB)
  • Vanguard FTSE Emerging Markets ETF (VWO)
  • Vanguard REIT ETF (VNQ)
  • PIMCO Investment Grade Corporate Bond ETF (CORP)
  • iShares 1-3 Year Treasury Bond ETF (SHY)

Fractional shares are used. Dividends are reinvested. Rebalancing happens automatically. Their asset allocation has much in common with most other automated portfolios, although it is probably one of the more different ones that I’ve seen in that you have no exposure to any stocks from Developed European and Asian countries like the UK, Japan, or Australia.

I’m a little concerned about all the tax lots created when buying stocks in such small amounts. Dealing with taxes when you sell might be a headache if they don’t import directly to TurboTax or similar tax software.

Availability. Currently available on iOS 7 or higher. iTunes download link. Android and web application “available soon”.

My thoughts. My first reaction was… that it was a great idea. I used to participate in Bank of America’s Keep The Change program, which is similar in that it also rounds up your BofA debit card transactions to the nearest dollar but instead moves the money into a BofA savings account paying essentially zero interest. Acorns takes it further by letting you use any bank and any debit or credit card, and also lets you invest it for potentially higher returns.

In addition, I agree that Acorns will lower the psychological barrier to investing because you don’t even have to commit to $25 a week or $500 a month. You know if you can afford a gizmo or meal at $15.66, you can afford it at $16, so why not invest that spare change? The hurdle can’t get much lower than that.

At the same time, we have to be realistic. With this model how much you save depends entirely on how many purchases you make, with a theoretical average of 50 cents saved per transaction. Even buying five things a day times 50 cents is $2.50 a day or $75 a month. It’s good as a kickstart, but not nearly enough to fund a retirement.

If you want to look at it purely mathematically, a monthly fee of $1 taken out of a $75 investment ends up being like a front-end load of 1.3%. Or you could just look at a buck a month as something you’d otherwise blow on some Candy Crush Saga app.

It bugs me when people call it a “piggy bank” when it isn’t. A piggy bank means you put in a quarter, and you can take out a quarter later on. A piggy bank is a bank savings account. Acorns on the other hand is a long-term investment account that you have to be ready not to touch for at least a decade. Sure the “expected” return is 4-9% but you have a good chance of a permanent loss of money if you withdraw within the next few years.

Finally, will people will keep large amounts of money in this little smartphone app for years and years? Maybe. My bet is that they are eventually bought out by a larger firm in the future (or someone just straight-up copies the idea).

Bottom line: Neat idea, very nicely-designed app. It won’t fund your retirement, but it might be worth a try for those that need a nudge to invest. I think there should an option for an FDIC-insured high-yield savings account.

More: Wired, Techcrunch

Back to Basics: Create Your Own Investing Priority List

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Happy New Year! You want to perform a check-up on your finances. Where should you be putting your money?

I’m searching through my archives and doing a series on classic financial topics called “Back to Basics” . The Vanguard blog recently talked about investing priorities, which compared closely with this 2006 blog post. There is no definitive list, but each person can create their own with common components. Here’s my current list:

  1. Invest in your 401(k) or similar plan up until any match. Company matches typically offer you 50 cents to a dollar for each dollar that you contribute yourself, up to a certain amount. Add in the tax deferral benefits, and it adds up to a great deal. Estimated annual return: 25% to 100%.
  2. Pay down your high-interest debt (credit cards, personal loans, subprime car loans). If you pay down a loan at 12% interest, that’s the same as earning a 12% return on your money and higher than the average historical stock market return. Estimated annual return: 10-20%.
  3. Create an emergency fund with at least 3 months of expenses. It can be difficult, but I’ve tried to describe the high potential value of an emergency fund. For example, a bank overdraft or late payment penalty can be much higher than 10% of the original bill. Estimated return: Varies.
  4. Fund your Traditional or Roth IRA up to the maximum allowed. You can invest in stocks or bonds at any brokerage firm, and the tax advantages let you keep more of your money. Estimated annual return: 8%. Even if you think you are ineligible due to income limits, you can contribute to a non-deductible Traditional IRA and then roll it over to a Roth (aka Backdoor Roth IRA).
  5. Continue funding your 401(k) or similar to the maximum allowed. There are both Traditional and Roth 401(k) options now, although your investment options may be limited as long as you are with that employer. Estimated annual return: 8%.
  6. Save towards a house down payment. This is another harder one to quantify. Buying a house is partially a lifestyle choice, but if you don’t move too often and pay off that mortgage, you’ll have lower expenses afterward. Estimated return: Qualify of life + imputed rent.
  7. Invest money in taxable accounts. Sure you’ll have to pay taxes, but if you invest efficiently then long-term capital gains rates aren’t too bad. Estimated annual return: 6%.
  8. Pay down any other lower-interest debt (2% car loans, educational loans, mortgage debt). There are some forms of lower-interest and/or tax-deductible debt that can be lower priority, but must still be addressed. Estimated annual return: 2-6%.
  9. Save for your children’s education. You should take care of your own retirement before paying off your children’s tuition. There are many ways to fund an education, but it’s harder to get your kids to fund your retirement. Estimated return: Depends.

I wasn’t sure where to put this, but you should also make sure you have adequate insurance (health, disability, and term life insurance if you have dependents). The goal of most optional insurance is to cover catastrophic events, so ideally you’ll pay a small amount and hope to never make a claim.

Investment Returns By Asset Class, 2014 Year-End Review

I don’t always check my portfolio performance, but when I do, I do it at the end of the year. Here are the trailing 1-year returns for select asset classes as benchmarked by passive mutual funds and ETFs. Return data was taken from Morningstar after market close 12/29/14.

2014performance

Stocks. The Total US Stock Market (VTI) went up nearly 15%, while the rest of the world’s markets (VXUS) dropped around 3%. Europe specifically struggled, and Emerging Markets (VWO) only eeked up 1.5% total return. US REITs (VNQ) went on a tear, up 32%.

Bonds. The Total US Bond Market (BND) went up ~6%, even though most market pundits thought rates would go up in 2013. Short-Term Treasuries (SHY) were mostly unchanged, while Long-Term Treasuries (TLT) shot up 27%. Inflation-linked TIPS (TIP) inched up 3%.

Gold (GLD) had its gyrations but ended the year with very little change, down ~3% over the past year.

In the end, nothing really went down that much and a few things did really well. It was another year where half of the predictions were wrong, and new predictions will no doubt sprout up soon. Business Insider has a hilarious post on completely meaningless market phrases that sound smart. On that note, my official position will be “cautiously optimistic” for 2015.

The overall asset allocation of my personal portfolio hasn’t changed much since my October 2014 update, but I’ll probably do a final update once the year is officially over. Some quick calculator work indicates the overall 2014 return to be roughly 7%.

US Treasury Bonds Negative Correlation with Stocks

Here is an interesting chart comparing the correlation of various asset classes to the S&P 500 over the last 5 years. Chart is from Richard Bernstein Advisors, found via The Reformed Broker.

5yearcorr

A negative correlation between two asset classes means that they tend to move in opposite directions. While long-term US Treasury bonds have been the most strongly uncorrelated, it is also worth noting that intermediate-term US Treasuries (5-7 years) were nearly as uncorrelated. Of course, this is the past and correlations can and will change.

Still, this would seem like good news for people who hold a “total” bond fund like the Vanguard Total Bond Market Index Fund (VBMFX, BND) or iShares Barclays Aggregate Bond Fund (AGG) as these contain ~70% US government bonds and have an intermediate average maturity. You want your bonds to serve as a hedge against stock movements, and they did over the past 5 years while still maintaining positive returns (~4% annualized for AGG, ~15% annualized for S&P 500).