Wednesday, January 30, 2008

Word o’ the Day: Exchange Traded Fund (ABC’s of Financial Planning)

“Tryin' to make it real — compared to what?”
- Les McCann (“Compared To What?”)

Exchange Traded Funds, commonly referred to as “ETFs” are usually defined as “compared to what”. This is because ETFs are unlike almost any other investment vehicle. I usually start my ETF discussion with “Compared to mutual funds…” but that presumes a depth of knowledge in the listener that they usually have yet to attain. And I like to keep discussions of investment esoterica down to earth in language that doesn’t require an immediate consultation of the dictionary. Let’s see if we can “make it real”.

Exchange Traded Funds are baskets of securities -
OK, what’s a “basket of securities”? Where does “basket” come from? Maybe “bucket” would be a better analogy. So, a “bucket of securities”. In one hand you carry the bucket and with the other hand, you select securities to put in the bucket. “Securities” (usually) means stocks or bonds. If you want to construct an ETF that follows the US stock market, you would put stocks of large US companies in the bucket. Examples would be GE, IBM, Microsoft, Boeing, Wal-Mart, ExxonMobil, etc. The individual stocks and the amount of each that you would put in the bucket would be based on an index – a 4-bit word meaning “list” - such as the Standard & Poor’s 500 Index.

Exchange Traded Funds are passive investments constructed to follow the performance of an index -
What is a “passive investment”? A passive investment is one that is not actively managed i.e., a money manager is not reviewing what’s in the bucket and making changes based on what he thinks. The issuer of the ETF decides what index it will follow and the bucket is filled with stocks or bonds that are intended to replicate the performance of the chosen index. Stocks or bonds are removed from or added to the bucket only when there is a change in the index the ETF is following.

Exchange Traded Funds are inexpensive to own -
Because the money in an ETF is not actively managed, the management fees are low. A quarter of a point here, a quarter of a point there – pretty soon we’re talking about a lot of money – your money. Like stocks, you will usually pay a trading commission to buy and sell ETFs.

Exchange Traded Funds are tax-efficient -
Investors do not like paying taxes on their investments, especially when they don’t have control over when the taxes are to be paid. An investor who owns shares in Microsoft can decide when to sell those shares and thus decide when to pay the taxes on any capital gain realized as a result of the sale. An investor who owns a mutual fund can’t do this, because the manager of the mutual fund is in charge of when to buy and when to sell – and the manager doesn’t care about your taxes (he’s not going to pay them – you are). Owning an ETF is like owning an individual stock in that the investor decides when to sell and thus decides when to pay the taxes on any capital gain realized as a result of the sale. This is not to say that owning an ETF is entirely tax-free, but it’s pretty close. Because of the passive design, securities owned by the ETF are only bought and sold when the index being followed changes so there is very little buying and selling and thus, very little in the way of taxable gains over which you had no control. (ETFs will distribute dividends and interest received on stocks and bonds so some taxable income is inevitable). The tax angle gets better though. Most ETFs allow investors to sell their shares and take distribution “in-kind”. This means instead of selling for cash, the investor receives shares of the stocks owned by the ETF – for tax purposes, this is not a sale. (This is definitely esoteric and most people don’t do it this way, but they could).

Exchange Traded Funds are transparent –
You can find out at any time what stocks or bonds your ETF owns. Mutual funds report their holdings on a trailing schedule (often by 90 days or more) so by the time you get the list of what they own it is not current.

Exchange Traded Funds can be priced, bought, or sold at any time during the trading day -
Most people don’t know it, but when you look up a mutual fund price, it is a day old. This is because mutual funds don’t price their portfolios until the markets close – they are not priced in real time. When you buy a mutual fund you won’t know what you will pay for a share until the market closes – that’s why buy orders for mutual funds are only accepted in dollars, not # of shares – no one knows what the share price will be until the fund prices its portfolio at the end of the day. So if the market is moving up sharply and you want to go along, you can do so – today - by buying an ETF just as you could by buying an individual stock.

Exchange Traded Funds can be sold short –
How do you make money when the market goes down? Sell short. Short selling involves the sale of securities you don’t own. Without getting bogged down here, essentially you borrow stocks or bonds from another investor and you sell them. The proceeds from the sale are deposited into your account. If you are right and the price goes down, you then buy the stock or bond in the open market – for less than you sold it for - return the stock or bond to the lender and you keep the difference. You can do the same thing with ETFs. A good way to make money recently would have been to sell short one of the many ETFs that track the financial sector - banks and stock brokerages. Sell short at $60, buy it back at $40 and keep $20 minus the cost of borrowing the stock. You cannot sell mutual funds short. You can't sell short in a retirement account.

In portfolios, I use ETFs for broad asset classes and to make tactical sector bets. We’ll talk about that another time.

(complete lyrics here:


Monday, January 28, 2008

Saver, Investor or Speculator?

“A penny saved is a penny earned.”
- Ben Franklin

“A penny invested has a chance of beating inflation.”
- Kim Miller

Americans are great at speculating, mediocre at investing and terrible at saving. See which camp you fall into:

Savings are funds you put away for a future purchase or obligation or for an unforeseen event such as unemployment. You expect your savings to grow, albeit modestly without capital risk. You expect your savings to be available when you want with a minimum of trouble and without any dickering over its value (a dollar saved is always worth a dollar upon withdrawal). Savings are never investments. The prudent saver is patient and rarely disappointed, except on occasion when the yield offered across the street is ¼ point higher. The Saver has a plan and while he may be motivated to save out of fear, he is logical in his approach and is able to defer gratification. EVERYONE should be a saver.

Investments are funds you put into a venture in the hope of a future income or capital gains – i.e., that you will receive an income from the invested capital or be able to sell the investment for more than you paid in at the beginning (or both). You expect your investment to grow commensurate with the risk. Investments are never savings. The prudent investor is patient and is rarely disappointed – she knew what she was getting into at the beginning. The Investor has a plan and while she may be motivated to invest out of greed, she is logical in her approach and is able to defer gratification.

Speculations are funds you put into a venture with the certainty that it is going only in one direction: sharply up in value. Savings are frequently used for speculation (“I know this stock is going up – I’m going to put the household rainy day money in – it can’t miss!”). Speculators are never patient and are frequently – if not always – disappointed. They have unrealistic expectations going in. The Speculator doesn’t have a plan and is primarily motivated by greed – he is emotional in his approach and would have to look up “defer” and “gratification” in the dictionary. Think back to the late 1990’s when the US stock market did nothing but go up – do you recall reading a lot about “buyer’s regret” as the markets fell from their highs? Was that Investing or Speculating?

In my career I have met very few Investors but I’ve sure met a lot of Speculators. Most people think they are Investors, but they are really Speculators – “investing” on “hot tips” or buying “5 Star” mutual funds and then rending their garments when the reality doesn’t match their vision. Regret is such an ugly thing.

Investment entails the acceptance of risk – the dollar you put in today may not be worth a dollar upon withdrawal. If one expects an investment to appreciate by 10%, one has to accept the chance that it could decline by 10% (or more). The theoretical lowest value of a share of common stock is ZERO. The Speculator dismisses this absolute as “nay-saying” or “balloon piercing” or “boring”.

Let’s be clear: markets don’t care what we think! Stocks don’t care what we think! Mutual funds don’t care what we think! Bonds don’t care what we think! Invest all the emotion you like, it won’t make any difference. Think about your favorite sports team – if it mattered what you thought, wouldn’t they be champions every year?

The only way to win – with any consistency – is to have a plan. Use asset allocation to diversity your portfolio. Know the risks you are accepting and be comfortable. If you’re not comfortable, reduce the risk. Don’t accept more risk than you need to reach your goal. A good advisor will have you complete a Risk Tolerance Questionnaire before investing your money.

So which camp do you fall into?


Thursday, January 24, 2008

Word o’ the Day: Exchange (ABC’s of Financial Planning)

Investments are primarily traded – bought and sold – on an exchange. An exchange (commonly called “stock exchange” even though other investments are traded) is simply a marketplace that serves as a central venue to bring together buyers and sellers. In today’s world, the venue can be physical (a place) or virtual (electronic).

A well-known example of a physical exchange is the New York Stock Exchange (NYSE) in New York, NY. Traders gather on the trading floor of the NYSE and conduct business in person on behalf of their customers. As technology progresses though, the NYSE is performing more and more electronic trades. The NYSE has traditionally specialized in listing large U.S. companies.

A well-known example of a virtual exchange is the NASDAQ Stock Market also headquartered in New York but spread all over the world. NASDAQ operates an electronic system that enables its member firms to provide prices and availability for securities they are buying or selling for their customers. NASDAQ has traditionally specialized in listing smaller U.S. companies.


Tuesday, January 22, 2008

“Don’t Panic!”

Arthur remained very worried. “But can we trust him?” he said.
“Myself I’d trust him to the end of the Earth,” said Ford.
“Oh yes,” said Arthur, “and how far’s that?”
“About twelve minutes away,” said Ford, “come on, I need a drink.”
- “The Hitchhiker’s Guide to the Galaxy” (Douglas Adams)

Readers of the Hitchhiker’s Guide to the Galaxy will recognize the soothing words (“Don’t Panic!”) found on the cover of each copy. They are intended to subdue the feeling one would get upon realizing that the world is coming to an end before lunch. Today.

Investment markets around the globe fell out of bed over the last two days with a domino-like series of bumps. The U.S. followed suit today (January 22). You probably heard a little bit about it. Screaming headlines and talking (shouting?) heads magnify the valleys even more than they magnify the peaks.

Now is a good time to review one’s personal investment time horizon. Do you need the money you have invested (“invested” as opposed to “saved” – one doesn’t put funds one has “saved” in the markets) in the “near future”? Each person’s definition of “near future” is different. For our purposes, let’s say it’s the next 12 months. If the answer to that question is “yes”, then the money should be “saved”, not “invested” [see previous writing: Word o’ the Day: Cash (ABC’s of Financial Planning)]. If you have “invested” money you will need in the next 12 months you are speculating, not investing.

If the answer to this question is “no”, then the best advice I can give you is: go for a walk. Review your asset allocation [see previous writing: Word o’ the Day: Asset Allocation (ABCs of Financial Planning)]. Add different asset classes to your portfolio.

“Don’t Panic!”


Monday, January 21, 2008

Word o’ the Day: Cash (ABC’s of Financial Planning)

“Cash for the merchandise, cash for the button hooks.
Cash for the cotton goods, cash for the hard goods.
Cash for the fancy goods, cash for the noggins and the piggins and the firkins.
Cash for the hogshead, cask and demijohn. Cash for the crackers and the pickles and the flypaper.
Look whatayatalk, whatayatalk, whatayatalk, whatayatalk, whatayatalk?”
- “Rock Island” (“The Music Man”)

We’re talkin’ ‘bout cash! When the stock market is in a correction, i.e., the world is falling apart, CASH IS KING. You can always exchange a dollar of cash for a dollar of goods or services. Try exchanging a dollar of any other asset for a dollar of goods or services and you have to deal with that pesky question: “What is your asset worth?” And then you (the seller) start up a dance with the merchant (the buyer). Ever trade in a car? Then you know exactly “whatayatalk”. There are no arguments about cash. The merchant will smile and make your change.

But what exactly is “cash”? Cash is any asset that can be easily converted into spendable dollars without prior contemplation of the asset’s worth on the part of either party to the transaction. The worth of the asset to be converted is understood.

Common types of cash: savings accounts, checking accounts, U.S. Treasury Bills (at maturity), FDIC-insured CDs (at maturity), money market accounts, money market funds, Guaranteed Investment Contracts (GICs – a popular funding choice in retirement plans) and “mattress funds”. Anything else purporting to be cash or “near-cash” or “just like cash” is something else – “not cash”. Of course, the value of these cash instruments depends on orderly and efficient markets. If things get really bad, then “mattress funds” are about the only cash one will have.


Friday, January 11, 2008

New Year, New Fear?

“Meet the new Boss, same as the old Boss.”
-The Who (“Won’t Get Fooled Again”)

So far, the new year is looking a lot like the old one:

The subprime mortgage debacle continues to unwind through the world financial system, forcing many of the big Wall Street players to seek outside capital to shore up their balance sheets (Merrill Lynch, Citibank et al). Significantly, most of these capital infusions were provided by non-U.S. corporations or governments.

Housing values and sales in the U.S. continue to fall, although “fall” may be too mild – in many areas, “plummet” is probably more accurate. Countrywide Financial – one of the largest mortgage companies in the U.S. - just sold out to Bank of America to avoid bankruptcy.

The U.S. stock markets are now in official “correction” territory (defined as a decline of 10% or more).

The December ’07 retail sales numbers are out and they are not pretty – this is a major indication that the U.S. consumer is cutting spending. (Armageddon hint: consumer spending in the U.S. is 2/3rds of the economy).

Prices for agricultural commodities are hitting all-time highs and oil remains within spitting distance of $100 a barrel. Gold is near its all-time high (in nominal dollars).

The Federal Reserve was forced to state publicly that they will be lowering short-term interest rates this month (January). The Fed is between a rock (lower growth) and a hard place (inflation).

Can you spell r-e-c-e-s-s-i-o-n? Can you spell s-t-a-g-f-l-a-t-i-o-n? Sure you can.

Did we get fooled again? Uh yeah, we did. We fooled ourselves. Again. The securitization of receivables – turning mortgage payments into derivatives – was supposed to reduce risk in the world financial system. Instead risk was increased, exponentially by many accounts. The effect of subprime mortgagees not making their payments has been like the proverbial flick on the last domino in a long row of dominos. And the really good news is that the full extent of the subprime mortgage fallout still isn’t known and probably won’t be for many more months if not years.

If you’ve read this far, you are probably starting to think about where you hid the key to the trigger lock on your 9mm. Don’t just sit there – go look for it! Now.

Just kidding. Take a deep breath. Call your financial advisor for a therapy session.

Short-Term Thinkers
In the coming months, cash will be king. Eliminate debt. Hoard cash. In a taxable (non-retirement) account, buy short-term bank CDs or T-Bills. You could get a little more sophisticated and ride the yield curve by buying long-dated U.S. Treasury Bonds – the coming interest rate cuts should produce some nice capital gains. [Remember: when interest rates go down, bond prices go up.] Reduce your spending. If you are thinking about buying a house, wait – they’ll be cheaper in a year. A painless method of raising cash is to have all mutual fund dividends and capital gains paid in cash as opposed to reinvesting them in the fund. If you are at risk of being laid off, consider reducing your 401k contribution.

Long-Term Thinkers
If you are investing long-term such as in a retirement account (IRA, 401k, etc) review your asset allocation and get more diversified: add commodities (agriculture, energy, metals, currencies, etc), increase non-U.S. stock holdings (decrease U.S. stock holdings), reduce small cap companies in favor of large cap companies, add a long-short fund, add bonds.


Friday, January 4, 2008

Word o' the Day: Bond (ABC’s of Financial Planning)

“The name is Bond, James Bond”.
- James Bond, “007” (numerous books and films)

What exactly is a bond?
A bond is a legal contract between you (the lender) and the issuer (the borrower). It says something like “in exchange for your loan of $X, we promise to pay you interest of Y% every six months on the principal until the maturity date, at which time we will return the amount of your original loan”. The key word here is “loan”. When you buy a bond, you are loaning money to a government or corporate borrower. You may say “But I bought my bond in the market, not from the government – how could I be loaning them money?” When you bought the bond, you stepped into the shoes of the seller. Every time a bond changes hands, the buyer becomes the registered owner to whom interest payments (and the maturity value) are made by the issuer (borrower). Trust me, you are a lender.

Bonds are sometimes referred to as “loanership” assets as distinguished from stocks which are “ownership” assets. Bonds are also often referred to as “fixed income” because the interest payments are (usually) fixed and do not change over the life of the bond.

What is “par value”?
Par value = face value. Bonds are usually issued at “par” meaning a $1,000 bond is sold for $1,000. There are exceptions of course, but most of those are beyond the scope of today’s lesson. One worth mentioning though is Treasury Bills (“T-bills”). T-bills are short-term bonds issued at a discount to their face (par) value by the U.S. Government. The difference between the purchase price and the face value is the interest e.g., a T-bill may be issued at $950 and matures at $1,000 – the $50 difference is the interest earned.

Why do my bonds go up and down in value?
If you buy a bond, you may notice that the value reported to you will go up and down. Bonds are valued in the market based generally on three factors: time to maturity (how long it will be before the principal is returned), nominal interest rate (the rate promised by the bond), and credit quality (how likely it is thought the issuer will be able to repay the principal). Of course, bonds are like any other investment in that the price changes in response to demand. When investors are selling bonds, bond prices (values) will decline. When investors are buying bonds, bond prices (values) will increase.

The value of existing bonds changes inversely in response to changes in interest rates. If interest rates go up, the value of existing bonds tends to go down and vice versa. A helpful analogy I’ve used is that of a teeter-totter. Picture the bond on one end, and interest rates on the other end. If the interest rate end goes up, the bond end goes down, and vice versa.

The financial media regularly reports on the price/value relationship of U.S. Treasury bonds. You may hear “Treasury yields are up”. This means bond values (prices) are down and is often the result of investors selling bonds and investing the cash in the stock market. If you hear “Treasury yields are down”, this means bond values (prices) are up and is usually the result of investors selling stocks and buying bonds in a “flight to safety”.

My bonds are rated BBB – are they safe?
Credit quality is also a factor in bond values. Bonds issued by issuers with (perceived) higher credit quality tend to have higher values when compared to bonds issued by issuers with (perceived) lower credit quality. The credit quality of a bond issuer is determined by a rating agency such as Standard & Poor’s, Fitch or Moody’s (the “Big 3” in the bond rating business). Bonds issued by the U.S. Government are considered AAA, the highest rating, because of the perception that the United States cannot and will not default on its obligations. A corporation may go bankrupt and be unable to repay its bonds, but the United States can’t (hint: they just print more money).

Why buy bonds?
Bonds are a financial asset – they have unique characteristics that make them attractive to investors. As part of an asset allocation plan, bonds are added to a portfolio to reduce risk (lower standard deviation) and help provide a “smooth ride”. Bonds are also used to provide income.

Wednesday, January 2, 2008

New (Year’s) Revolutions

“You say you want a revolution,
Well ya know – we all wanna change the world.”
- The Beatles (“Revolution”)

It’s that time of year. Promises to make, promises to break. It’s a time-honored tradition – in America at least – to take stock every January and decide what needs changing. In a mostly futile attempt to break our chains of bondage, many of us tote up a list of those egregious habits we are determined to change. One of the habits we could all change is that of creating such lists every year! Resolution lists mostly serve to just add guilt to our pile of “couldas, shouldas and wouldas”. Change is hard. Research shows it takes 21 days (in a row!) to develop a new habit. In our “do it now, get it now, enjoy it now” culture, 21 days is an e-t-e-r-n-i-t-y. About the only things most of us can do 21 days in a row is eat and sleep.

So here’s my suggestion for a financial Revolution in 2008: pick one thing you want to change and work on that one thing only. Don’t get obsessed, but work on that one thing to the exclusion of anything else you may have thought about. Don’t add another item to your list until you’ve completed the first one. If it takes all year for the first one, then it takes all year. Here are some areas that you may be thinking of:

Budget – make one and follow it
Credit card debt – line ‘em up and knock ‘em down – use one of the snowball techniques* – the real key to success here is to not add to the debt
Rainy day fund – set up an account at an on-line bank and put money in – even if it’s only $5 - every payday
Retirement savings – sign up for the 401k at work; if already in, boost your contribution. If you don’t have a plan at work, set up an IRA.
Less taxing tax season – hire a tax preparer or accountant

* Option 1: pay the minimum on all balances except the smallest – when that is paid off add that payment amount to the next highest one, etc. Option 2: reverse it and pay the minimum on all balances except the largest – when that is paid off, add that payment amount to the next highest one, etc. Option 3: arrange accounts by interest rate, highest to lowest and pay off the highest rate first, then move down to the next highest rate, etc.

Once you start thinking about the financial habits you’d like to change it will be easy to come up with more ideas. PICK ONLY ONE and start your own Revolution.