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Investing Blog Roundup: Schwab “Intelligent Portfolios”

The big news in the investment world this week is Schwab’s announcement of their “Intelligent Portfolios” platform, scheduled for release in early 2015. They haven’t provided all the details yet, but it looks to be a rebalancing and tax-loss harvesting service (much like the services provided by Betterment or Wealthfront), with one big difference being that it will be free. The Finance Buff has the scoop:

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What Does it Mean for Something to Be “Priced In”?

A reader asks:

“[At the recent Bogleheads event], Vanguard economist Roger Aliaga-Díaz spoke about a number of trends occurring in various parts of the world — things like the slowing of China’s economic growth rate. When asked what we should do with our portfolios because of these trends, he kept saying that all the trends are already ‘priced in.’ What specifically does that mean?”

At any given time, the price of a stock reflects the market’s consensus expectations about the company’s future earnings.

For example, if the market expects Google to have rapid earnings growth going forward, then Google shares will be expensive relative to companies with lower expected future earnings (i.e., Google will have a higher price-to-earnings ratio). One would say that the market’s expectations about Google’s earnings growth are “priced in” — that is, they’re already built into the price.

This is a key point for investors to understand because it means that buying shares of Google stock will only provide you with above-average returns if the company’s earnings grow faster than expected. If the company’s earnings grow quickly, but no more quickly than the market expected them to, the stock’s performance will not be any better than the performance of the rest of the market (and will probably be worse).

In other words, the performance of a given stock is not determined by whether the underlying company performs well or poorly. Rather, it is determined by whether the underlying company does better or worse than the market expected it to do. There is, therefore, little to be gained from picking individual stocks unless you know something that the rest of the market doesn’t — something that isn’t already “priced in.”

And the same thing is true at larger levels. The collective price of the stocks that make up a given industry or country reflect the market’s consensus about expectations in that industry or country. So there is little point in moving your allocation between countries or industries unless you know something that the market doesn’t about those countries/industries.

Investing Blog Roundup: Bogleheads Conference

I’m flying home today from the annual Bogleheads event. As always, it’s been fun to chat with many Oblivious Investor readers face to face. And, as always, the visit to Vanguard and their ask-the-expert panel was very interesting. I’m looking forward to writing about a few of the conversations over the coming weeks.

Investing Articles

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Should I Invest in Schwab’s Fundamental Index Funds?

A reader writes in, asking:

“I currently use three Schwab ETFs for my portfolio: Schwab U.S. Broad Market, Schwab International Equity, and Schwab Short-Term U.S. Treasury. But I’ve been reading about their Fundamental Index Funds and ETFs as well. The idea of allocating to companies according to sales and cash flow makes a lot of sense to me. Do you think it would be prudent to add some of these funds to my existing holdings?”

As a bit of background information: Traditional index funds (and ETFs) are market-cap weighted. This means that each stock (or bond) held in the fund is held in proportion to its market capitalization (i.e., the total market value of the company). For example, if Verizon makes up 1% of the U.S. stock market, a market-cap weighted U.S. “total market” index fund would have 1% of its portfolio invested in Verizon.

In contrast, “fundamental” index funds (and now, in some cases, “smart beta” funds) weight companies according to their “fundamentals” (i.e., metrics such as sales, cash flow, or net income).

While I don’t think its typically useful to compare the performance of two funds in order to see which fund is better (remember, picking based on past performance is often worse than picking randomly), I do think it can be helpful to plot the performance of two funds on the same chart to see how similar they are.

For example, with these various new types of not-so-passive index funds, it’s often enlightening to:

  • Look at where the fund falls in the tic-tac-toe-looking Morningstar style box (i.e., growth vs. value and small-cap vs. large-cap),
  • Find a plain-old Vanguard fund with a comparable position in the style box, and
  • Plot the two funds together on the same growth chart.

With regard to the reader’s question, let’s run through the above exercise with three Schwab Fundamental Index Funds.

Our first chart shows the Schwab Fundamental US Large Company Index Fund (SFLNX, in blue) and the Vanguard Large-Cap Index Fund (VLCAX, in orange), since the inception of the Schwab fund:

Large-cap

The following chart shows the Schwab Fundamental US Small Company Index Fund (SFSNX, in blue) and the Vanguard Small-Cap Index Fund (VSMAX, in orange), since the inception of the Schwab fund:

Small-Cap

And the final chart shows the Schwab Fundamental International Large Company Index Fund (SFNNX, in blue) and the Vanguard International Value Fund (VTRIX, in orange), since the inception of the Schwab fund:

International

You can see periods in each of these charts in which one fund outperforms the other, but the overwhelming takeaway that I see is simply how very similar the funds are.

And that’s typically how it goes when I look at a fund in one of these newer categories. They’re usually perfectly fine funds. (After all, going toe-to-toe with a low-cost index fund from the most respected provider of index funds is nothing to laugh at!) But there’s usually little substance behind the marketing message that these are a distinct improvement over traditional index funds. For the most part, they’re simply a new way of arriving at the same old portfolio (or very close to it).

Investing Blog Roundup: Buying Insurance

This week, I enjoyed three articles about buying insurance. Karen Haywood Queen shares a strategy for saving money on life insurance. Jim Dahle warns against a common (but poorly-reasoned) sales pitch for life insurance. And Michael Kitces offers a guiding overall philosophy on when and when not to buy insurance.

Investing Articles

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When to Tax-Gain Harvest Your Bonds

Last week’s article about tax-gain harvesting with bonds drew quite a bit of correspondence from readers. (To recap, the general idea is to sell a bond that has increased in value since you bought it — and which you have held for more than one year – and reinvest the proceeds in a similar, newly-issued bond with a comparable remaining maturity. In doing so, you effectively convert some of the interest income into long-term capital gain income, which is often advantageous due to the fact that long-term capital gains are taxed at a lower rate than ordinary income.)

The primary question readers had was: Are there cases in which it would not make sense to use such a strategy?

And the answer is that, yes, there certainly are some cases in which it wouldn’t make sense to tax-gain harvest your bonds.

For example, the desirability of the strategy depends on what type of bond we’re talking about.

  • It is most likely to make sense with corporate bonds,
  • It is less likely to make sense with Treasury bonds, because the interest on Treasury debt is free from state income taxes, whereas the capital gain income would, in most cases, be taxable at the federal and state levels, and
  • It is almost never going to make sense with muni bonds, because muni bond interest is tax-exempt at the federal level, whereas the capital gain income would be taxable at the federal and state levels.

In addition, there’s the possibility that something else tax-related would make you want to avoid increasing your income this year. For example, if there’s a particular tax credit for which you currently just barely qualify, but the capital gain would push your income over the eligibility threshold, tax-gain harvesting this year is unlikely to be advantageous. Or, if you’re a retiree collecting Social Security, and your income level is currently at a point where your Social Security is nontaxable — but realizing a capital gain would push you into the range where a significant portion of your benefits would be taxable this year — that’s a point against tax-gain harvesting.

In general, the analysis that you want to do is figure out how big the tax increase would be this year (due to the capital gain income) and how big the savings would be in future years (due to the reduced level of interest income). To get the best analysis possible at a DIY level (i.e., without paying a professional to assess the situation for you), it probably makes sense to do a test-run through TurboTax (or something similar) comparing each approach (selling vs. holding) for the years in question.

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