Hello, Dear Readers.
You may have noticed that my roundups haven’t included any guest posts for a while. That’s because I haven’t been writing any. 
Instead, I’ve been hard at work on a new book. This one will be the retirement planning guide in my “100 Pages or Less” series. It’s still got a long way to go, so don’t hold your breath. I just thought I’d explain why I’ve been doing less guest blogging.
As always, if you’re a blogger, you’re welcome to submit a post here for consideration in next week’s roundup.
Investing Articles
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Blog Carnivals
Thanks for reading!
One of the articles submitted this week to my roundup was an interview with a fellow who works as the co-manager of a new micro-cap value hedge fund. After taking a look at the fund, I thought I’d use it as an example of why I suggest that most investors stay away from such investments.
But first, let’s dispel a myth. One of the reasons commonly given for not investing in hedge funds is that they’re high risk. That’s not necessarily true. As with mutual funds, there are many different types of hedge funds. Some invest in high-risk assets; others invest at the low-risk end of the spectrum.
My primary reason for steering investors away from hedge funds is the same as my reason for staying away from any actively-managed fund: High costs. And, with hedge funds, boy can they be high!
“2 and 20″
The typical hedge fund expense structure is the “2 and 20″ model, whereby the fund charges an annual fee of 2%, plus 20% of any gains. This is, as you might imagine, quite the hurdle to clear.
Very few investors have shown an ability to consistently outperform their passive benchmark by more than 2% per year, as would be necessary to justify the use of such a fund in place of a low-cost index fund. (In fact, because of the 20% performance fee, they’d have to outperform by well over 2% per year.)
A Low-Cost Hedge Fund?
Interestingly, this particular fund from the interview actually had much lower costs than many hedge funds:
- It charges no flat annual fee,
- Its performance fee is only calculated on returns above 6%, though it’s calculated as 25% of those returns, and
- Its losses are carried forward to offset future gains prior to any fee being paid.
In short, as hedge funds go, this is actually fairly reasonable.
Still, it’s anything but low-cost. By way of illustration, if a small-cap value fund with that expense structure had simply tracked the results of its index over the last ten years, here’s how much it would have charged per year:
- 2000: 3.72%
- 2001: 1.76%
- 2002: No fee.
- 2003: 3.77%
- 2004: 4.43%
- 2005: 0.07%
- 2006: 3.36%
- 2007: No fee.
- 2008: No fee.
- 2009: No fee.
Even with four years out of ten having no fees at all, such a fund would still have been charging more overall than the typical actively managed small-cap value fund, which in turn would be charging far more than a good, cheap index fund.
Given the usefulness of expenses as a predictor of performance, I’d suggest that most investors stay away from any investment that promises to take such a large share of your returns.
Vanguard recently released a new mutual fund: Vanguard Target Retirement 2055. As you might imagine, it’s basically the same as their existing 2050 fund, but with each of the asset allocation changes scheduled to occur five years further into the future.
For the most part, I like Vanguard’s target retirement funds. But I’ve got one big question, especially regarding this new one: Why not get rid of the $3,000 minimum investment?
If you’re not planning on retiring until 45 years from now, you’re obviously quite young. In fact, there’s a very good chance you’re still in school.
It’s been a few years since I was in school, but I suspect that one aspect of college hasn’t changed: Most college students (even those interested in investing) don’t have $3,000 sitting around.
What’s the Point of the $3,000 Minimum?
Was the $3,000 minimum initially intended to discourage people from trying to pick a whole slew of different funds rather than a simple, 3-4 fund portfolio of diversified, low-cost index funds? If so, that seems like a non-issue in this case. Most investors interested in target retirement funds like the idea of investing in just one fund — that’s the whole point.
Or, perhaps, does the $3,000 minimum exist simply to ensure that Vanguard receives a certain level of revenue per new investor?
Would You Pay $4.75 for a New Client?
Vanguard Target Retirement 2055 has an expense ratio of 0.19%. That means that an investor with $3,000 in the fund would provide Vanguard with $5.70 in annual revenue. If Vanguard were to cut the minimum investment down to, say, $500, the revenue per new investor would decline by $4.75. And in the process, they’d become accessible to many more student-investors.
Yes, Vanguard would almost certainly be losing money on each investor who only invested $500, as there would still be administrative expenses associated with their accounts.
But Vanguard would have a new customer — one interested in hands-off, index investing. (Essentially the ideal Vanguard client, no?) And, in just a few years, that investor will likely be out in the workforce. She’ll have more money to invest. And she’ll already have an account with Vanguard.
I could be wrong, but I’d suspect that Vanguard’s current marketing strategy (i.e., advertising in mainstream media) results in an average cost of far more than $4.75 per new client.
I like Vanguard a lot. Most of our own retirement savings are invested through them. But with that $3,000 minimum, Vanguard seems to be saying that they’re not particularly interested in having the business of young investors. Instead, when I get emails from college-age investors, I typically recommend Schwab because of their no-commission, low-cost ETFs.
Aside from the hullabaloo about Philadelphia’s “new blogger tax” (which, as TaxGirl explains, is neither new, nor specific to bloggers), perhaps the most exciting thing in the world of personal finance blogs this week is that Craig from Money Help for Christians just released a new ebook about successful budgeting.
If budgeting is something you’re struggling with, it might not be a bad idea to check it out, as it’s been well-reviewed so far, and its introductory price will be going up at the end of the month (from $12 to $17).
As always, if you’re a blogger, you’re welcome to submit a post here for consideration in next week’s roundup.
Investing Articles
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Blog Carnivals
Thanks for reading! I hope you enjoy your weekend.
Get Rich Slowly recently hosted a post from Motley Fool writer Robert Brokamp about how much money it takes to retire. The article links to the Motley Fool’s “Am I Saving Enough?” calculator, which seeks to answer the question of how long you can expect your retirement savings to last.
I’ve written before about why I don’t trust retirement planning calculators, and this one is a perfect example. Go ahead and take a look at it.
Among other things, it asks you:
- How much you have saved now and how much you’re saving per month,
- What portion of your savings are in which type of accounts (401k, Roth IRA, taxable, etc.),
- How much you expect to spend each year in retirement (and it allows you to provide a good deal of detail for how you expect that figure to change over time),
- Your current tax bracket as well as your projected retirement tax bracket,
- How much you expect to receive from social security or a pension, at what age you expect to begin receiving such income, and whether or not that income is adjusted for inflation,
- How old you are now, at what age you expect to retire, and what age you expect to live to.
You get the idea. It asks for much more information than most retirement calculators. This is a good thing, as it allows for greater precision.
But It’s Still Worthless.
Unfortunately, the answer the calculator gives you is complete garbage.
The reason — and I bet you saw this coming — is that the calculator uses unrealistic assumptions for its calculations. Specifically, it asks you to enter a given rate of return, and it then assumes that your portfolio earns that same return every single year.
Let’s Be Realistic.
In real life, returns vary from year to year — even if you stick with extremely low-risk investments. A calculator that assumes a constant return every single year is going to significantly understate the amount you need saved before you can retire safely.
Said differently, if you expect your portfolio to average a certain rate of return over the course of your retirement, you probably need to set your starting withdrawal rate below that expected return figure unless you want to face a meaningful risk of running out of money.
For example, if you expect your portfolio to average a 6% return throughout your retirement, withdrawing 6% of your portfolio in the first year and increasing the amount withdrawn each year to keep up with inflation would be setting yourself up for trouble.
The reason such a strategy is risky is that a high withdrawal rate is absolutely devastating to your portfolio if you happen to face a prolonged bear market early in retirement. After a few years of “selling low,” you’re left with too small a portfolio to benefit fully when the market does come back.
This poorly-timed-bear-market concept is known in finance as “sequence of returns risk.” Ignoring it completely — as the Motley Fool calculator does — will cause you to significantly underestimate the amount of savings you’ll need in order to retire.
The Takeaways
- Don’t trust a retirement calculator unless you can see all of its assumptions and you judge them to be reasonable. One poor assumption can make an otherwise-great calculator worthless.
- Don’t overlook sequence of returns risk when planning for your retirement.
And just for fun, here’s a screenshot taken when I plugged in a 6% withdrawal rate and a 6% rate of return.
6% withdrawal rate over a 75-year retirement? No problem!
TIPS (Treasury Inflation-Protected Securities) are US government bonds that provide a specific after-inflation return (i.e., “real return”) as compared to traditional “nominal” bonds which provide a specific before-inflation return.
We’ve discussed before when it makes sense to use individual TIPS as opposed to TIPS funds. But we’ve never discussed when to use TIPS at all — as opposed to nominal Treasury bonds.
What Inflation Do You Expect?
The most obvious way to choose between TIPS and nominal treasury bonds is to compare the market’s inflation expectation to your own inflation expectation.
For example, as I’m writing this, the yield on 10-year TIPS is 1.01%, and the yield on a 10-year nominal Treasury bond is 2.64%. What we can conclude here is that the market is estimating inflation will average roughly 1.63% (2.64% minus 1.01%) per year over the next decade.
If you expect inflation to be above the market’s expectation (1.63% in this case), TIPS are a better bet. If you expect inflation to be below the market’s expectation, go with nominal bonds.
What if you don’t have any guesses about inflation?
Of course the above analysis isn’t particularly helpful if, like me, you don’t spend much time pondering what the rate of inflation will be over any given period. If that’s the case, you’ll have to come up with another way to choose your allocation between TIPS and nominal bonds.
In such a scenario, the most important differences between TIPS and nominal bonds are that:
- TIPS make planning easier, but
- Nominal bonds may be more useful as a diversifier of a mostly-stock portfolio.
Using TIPS for Planning
In almost every situation, inflation-adjusted returns are more meaningful than nominal returns. As such, TIPS’ inflation-adjusted yield makes them much more useful for planning purposes.
For example, TIPS can be an excellent tool for retirement portfolios. While they’re not risk-free, TIPS can be used to provide a high degree of safety for sustaining a given (low) inflation-adjusted withdrawal rate (e.g., liquidating 3% of your portfolio in your first year of retirement, then increasing the dollar amount that you liquidate each year in order to keep up with inflation).
Bonds as a Diversifier
If you’re only holding a small amount of bonds, and you’re doing it solely to reduce the volatility of a mostly-stock portfolio, nominal bonds may be the better bet. The reason is that, in crisis scenarios, investors tend to flock toward extremely safe investments — especially nominal Treasuries. As a result:
- Nominal Treasury bonds seem to perform better during market crashes, and
- Nominal Treasury bonds’ correlation to stock market returns has been lower than that of TIPS.
That said, TIPS are still relatively new, so these conclusions are based on a very small amount of data.
