Archives for February 2014

Gus Sauter, former CIO at Vanguard, talks about the need to focus on after-tax investment returns in an interview with the WSJ (found via Abnormal Returns). He answers the question What’s your most important tax advice for mutual-fund investors?:

For equity investors with a long time horizon, it is important to search for funds that have low annual distributions of capital gains. Grinding through the math, it turns out that a fund that realizes and distributes most of its capital gains annually would have to outperform a fund that distributes minimal capital gains by as much as 2% per year in order to provide the same long-term, after-tax return. Funds that have lower turnover are a pretty good place to start looking for low capital-gain distributions. Index funds are an obvious candidate.

For fixed-income investors in higher tax brackets, municipal-bond funds can be an attractive alternative to taxable bond funds.

In 2013, many successful active funds that trade frequently (high turnover) distributed sizable capital gains. Resources like Morningstar.com can provide information about turnover ratio and after-tax returns for specific funds.

Here are the 2013 capital gains distributions for all Vanguard funds. Both Vanguard’s Total US Stock and Total International Stock funds distributed zero capital gains for 2013. For your own holdings, you can check your tax statements to compare the relative size of the capital gains with the share price (NAV).

Carol Loomis of Fortune has just posted the 6-year update in Fortune of the $1,000,000 index fund vs. hedge fund bet between Warren Buffett and a successful hedge fund manager. The hedge funds were in the lead early on, but started lagging behind last year. Over 2013, the index fund lead widened further. 60% of the way through the 10-year bet (1/1/08 to 12/31/17), the Vanguard S&P 500 index fund backed by Buffett is up by 43.8%. The group of hedge funds hand-picked by Protégé Partners are up by 12.5%, a gap of over 30%.

Will this collection of hand-picked hedge funds be able to outperform a simple, low-cost index fund over the long run? Hedge funds employ the smartest minds but also charge hefty fees of roughly 2% of assets annually + 20% of any gains. 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%. But lots of funds have good performance when looking backwards. It is much harder to pick out winning managers ahead of time (and harder on those managers when everyone is looking).

Read the story of how the bet came to be in the original 2008 Fortune article “Buffett’s Big Bet”. Read the terms of the bet and each side’s opening arguments at LongBets.org. This carefully-tracked bet was part of the inspiration for my transparent Beat the Market experiment. Too often, people are not honestly and accurately tracking the performance of their portfolios… again, starting ahead of time. It is natural to point out your winners and conveniently forget the losers.

You can read my original 2008 blog post and halfway 5-year update here.

At a major ETF industry conference, Vanguard CIO Tim Buckley shared a preview of an upcoming report from by Vanguard Research. The general idea is that a good financial advisor should be able to affect the performance of client’s portfolio by three full percentage points. That’s a really big number, and I’m sure it has many advisors excited. Here’s how that 3% breaks down:

• 1.5% – Controlling client behavior. Avoid market timing. Don’t chase performance. Stick with asset allocation. Stay the course and keep investing during market downturns.
• 0.60% – Efficient tax management. Maintain optimal asset location (not allocation) to minimize tax costs. When money is needed, determine which assets and when to sell.
• 0.50% – Keeping costs low. You have the ability to choose investments with low expenses.
• 0.40% – Rebalancing. Rebalance regularly back to target asset allocation.

Buckley used the terms “controlling alpha”. Alpha is defined as excess risk-adjusted return above a benchmark, usually involving things like timing asset class movements and careful stock selection to make the difference. In contrast, the four factors listed above are less about being smarter than everyone else and more about avoiding simple mistakes.

This is still helpful advice, as these are the areas in which you should realistically expect assistance when looking for a financial advisor. It’s quite unlikely that the friendly person in the office building downtown is the next Warren Buffett. However, he or she may be the calming voice that you need to stay the course. I don’t know about 3%, but I do think a good advisor can invest better than many people on their own. As long as the advisor costs less than their “advisor alpha” benefit, you’ll come out ahead. The hard part, as always, is to find one of these “good” advisors.

Of course, being a DIY investor I feel I can do all these things myself. I also can’t help but notice again that many of these aspects are already rolled up into a nice balanced fund like the Vanguard Target Retirement 20XX Funds. By being all-in-one, the fund discourages trading and encourages doing nothing. The funds rebalance back to their target asset allocations automatically. The costs are extremely low. The only area where they come up short is tax-efficiency. However, for many individual investors the vast majority of their retirement assets are located in tax-advantaged accounts like IRAs and 401ks. In those cases, the benefits of tax-management are minimal.

It will be interesting to read the methodology behind the full report when it is published.

Sources: InvestmentNews (registration req’d), ETF.com