ETF Swap in Mutual Fund Accounts

The portfolios recently sold shares in the iShares MSCI EAFE Index fund (EFA), which invests in companies in the Morgan Stanley Capital International Europe, Australasia, and Far East markets.  With the proceeds, we purchased the iShares Dow Jones International Select Dividend fund (IDV).

Swapping from EFA to IDV is a bit more arcane than our normal portfolio move and we wanted to explain the (very simple) rationale behind the switch.

Fidelity Investments has had a small number of exchange traded funds which trade no-commission, much like the no-transaction-fee mutual funds which we typically use.  EFA has been on that list, but very few other ETFs (including IDV) were included as NTF exchange traded funds.

About a month ago, Fidelity inked an agreement with Blackrock, the company that sponsors iShares, to broaden the number of exchange traded funds that trade without commission on the Fidelity platform.  Importantly for us, there were several ETFs which we do normally use to track alternative asset classes that are now included.

We are believers in actively managed mutual funds, but at times the advantages of ETFs are large enough that they make sense instead.  One of the disadvantages, particularly with the international mutual funds, is that we are locked in for a minimum 90-day holding period.  If clients need those funds for any reason, or if the market starts breaking down and we would like to get out, which definitely happened in the 2008 crash, the ETFs have the advantage of less onerous minimum period holding fees.  Instead of charging 2% of principal for selling a mutual fund early, as is the case with our Matthews Tiger Fund (MAPTX), with the ETF selling before 30 days costs us, at most, $17.95 per trade.  If the markets are indeed starting to crash, $17.95 is nothing.

So, as a result of the new deal between Blackrock and Fidelity, the EFA iShare was being removed from the No-Transaction Fee platform (I have no idea why), and IDV is being added to the NTF platform.  We had until April 30 to get out of EFA, commission-free.  I’ve been holding on, trying to determine whether the international fund can hold its position in the portfolio, but thus far it has been doing fairly well and we simply are running out of time to make the swap on a transaction-fee basis.

Small changes in trading fees don’t often trigger portfolio changes, but it did in this case.  Every $17.95 helps. 

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.

Tax Smart Retirement Strategies

The January 2013 tax hikes make tax planning more important than ever. Two strategies we’ve identified are of particular interest to retirees trying to make their savings last as long as possible.

The higher tax rates and lower deductions already passed by Congress, along with new “means testing” of entitlement programs which is likely to come, make it more important than ever to smooth out income sources. Spikes in annual income result in onerous tax rates and, more than likely, will result in reduced benefits from Social Security and Medicare during the high income years.

Retirees need to think about smoothing earnings to the degree that is possible. Having money in an Individual Retirement Account (IRA) is good because gains aren’t reported until money is distributed from the IRA. Outside of the IRA, gains tend to be more “lumpy.” However, all money taken as a distribution from a traditional IRA is taxable at ordinary income rates, so retirees who are taking $60K to $80K in traditional IRA distributions are pushing themselves up into a pretty high tax rate. It would be better, if possible, to spread money between a Roth IRA (which is “after tax” money, so distributions aren’t taxable) and a traditional IRA. A retired person taking out $30K to $40K from each may be in a much better tax situation than if it all comes out of a traditional IRA.

So make Roth conversions during low income years, and take advantage of that funding source as a non-taxable source of cash during the normal years.

Similarly, pre-funding charitable giving could also help smooth taxable income. During big income years, if cash flows allow, a person could put several years’ taxable donations in a Charitable Giving account and get a large deduction to offset the large amount of income. Then, in later years, rather than giving a portion of taxable income, less (taxable) income can be recognized while still meeting charitable giving obligations through the charitable giving account. For tithers, rather than having to earn $111K in order to maintain a $100K spending lifestyle, and paying high marginal tax rates on the extra $11K, the year’s tithe could be paid from the pre-funded tax-deductible charitable giving account.

A community foundation is a great place to establish a charitable endowment fund as a legacy planning strategy, however the Western Colorado Community Foundation (WCCF) is best suited to provide a long term philanthropy strategy. To create a bucket to build up giving for 1 to 5-year stretches, it will likely become necessary to use the charitable giving organizations set up by Schwab or Fidelity Investments to help donor giving strategies.

A charitable giving account could also be useful as part of a college financial planning program as well, although it is really only useful for people who maintain some control of their reportable income. For salaried workers, there’s not much that can be done. On the other hand, salaried employees tend to have much smoother income streams than entrepreneurs, who often enjoy very lean years that will hopefully be offset by the occasional windfall.

Finally, entrepreneurs selling a business can also structure a business sale to smooth reported income. Rather than taking a large lump sum, it may make sense to retain real estate assets that can be leased to create a smooth long-term revenue stream, or the entrepreneur may want to set in place a consulting contract that stretches out several years in order to reduce the size of a lump sum payment income spike that would push them up into the high tax bracket, or consider an installment sale instead of a large up front payment.

Most importantly, don’t succumb to the temptation to over-emphasize tax planning, however. It is an important consideration, but certainly not the most important thing to consider. After all, planning for retirement isn’t about the money. It’s about your life!

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.

Market Uptrend Under Pressure

Today the Investors Business Daily changed its market scorecard to “uptrend under pressure.”  IBD has been whipsawed as many times as we have, in recent years, but it still makes sense to pay attention to what the overall market is doing.  Stocks and commodities “go up like an escalator and down like an elevator.”  Trying to avoid a big drop doesn’t make sense, and then doesn’t make sense again, and then doesn’t make sense, until suddenly it’s the only thing that does make sense.  Trying to reduce risk in highly risky markets is at the core of our “Flexible Beta” strategy, so we haven’t stopped paying attention when the markets raise warning flags.

IBD’s scorecard isn’t the only thing that makes us worry about whether 2013 will be as good of a year as we’d been expecting.  A quick study of which asset classes and sectors are doing well, and the most recent update of our May-Investments Leading Economic Indicator, also gives us pause for thought.

Bonds and defensive stocks, especially utilities, often do best during tough times.  Bonds recently took a breather from selling off and yesterday the moving average convergence-divergence (MACD) signal just turned positive.  That’s a concern because bonds are not cheap.  The primary reason for them to do well is if the economy is heading for a downturn.  Ditto for utility stocks.

International stocks also seem to be moving from strength to weakness.  Unemployment in the Eurozone hit a record 12 percent in February.  While rates in Greece and Spain are above 26 percent, the recession is evidenced throughout the continent.  In Greece and Spain, half of the young adults under the age of 25 are unemployed.

Commodity stocks have been hit hard, too.  Gold stocks are selling at prices equivalent to where they sold at the height of the financial panic in the Spring of 2009.  Flows out of gold bullion exchange traded funds are down 20 percent in recent months.  Investor sentiment is extremely negative.  While normally this is a contrarian sell signal, it hasn’t signaled a turnaround thus far.  We don’t think that people have to get excited about gold stocks for them to do much better.  We just need to see an end to the “dumping” of shares.  After all, the last time that gold shares sold at current levels, in 2009, the price of gold was about $900, well below today’s price of $1,550.

At the beginning of each month, we update our Leading Economic Indicator inputs.  Of the ten variables that make up our LEI, about half are updated at the beginning of each month.  When we input the most recent data, it appears that our LEI chart is turning down again.  The pattern looks very similar to 2007-8.  (Note, however, that the market conditions are quite different than in 2007, so my overall level of concern is not the same.) 

Our technology sector indicator, as well as the Institute for Supply Management (ISM) “New Orders” index, both turned negative for the first time in several months.  We’ve been thinking that 2013 would be a year of modest continued growth, but the factors that often point to which direction the economy is headed are beginning to tell a different story.  Unfortunately, the story being told is consistent with weakness that is beginning to develop in the stock market.

May-Investments response to increased risk is to reduce our holdings of stocks owned in exchange traded funds to quickly and cost effectively reduce overall stock exposure.  Because the U.S. market retains its “most favored” status among global investors, most U.S. sector ETFs have yet to hit what we consider to be “sell” signals.  This is a good thing, partly because we are still in sectors that enjoy relatively better performance than the rest.  Our positions in financials, healthcare, and consumer cyclicals are still doing better than average.  If this market trend turns down, however, we don’t expect them to somehow avoid the trend.

Most portfolios still have about 10 percent invested in cash equivalents.  We have said before that we’re not sure if that 10 percent represents our last investment “in” to the market as it recovers, or the first 10 percent to come “out” of the market in the next downturn.  After spending the first quarter of 2013 looking for what to buy with that money, this past week we’ve been forced to turn our attention to the fact that maybe we ought to be looking at what we next need to sell, instead.

We’ve been on an escalator for four years now.  The current bull market is already longer-than-average, if not “long in the tooth.”  Investors need to remember that sometimes markets feel more like an elevator (down) than an escalator (up).  We certainly haven’t forgotten.

Douglas B. May is President of May-Investments, LLC and author of Investment Heresies.