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Book Review and Warning on Commodities

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Book Review and Warning on Commodities

The book is THE BET: Paul Ehrlich, Julian Simon, and Our Gamble over Earth’s Future by Paul Sabin.  A quote from the dust jacket summarizes the story:

“In 1980, the iconoclastic economist Julian Simon challenged celebrity biologist Paul Ehrlich to a bet.  Their wager on the future prices of five metals captured the public’s imagination as a test of coming prosperity or doom.  Ehrlich, author of the landmark book The Population Bomb, predicted that rising populations would cause overconsumption, resource scarcity, and famine—with apocalyptic consequences for humanity.  Simon optimistically countered that human welfare would flourish thanks to flexible markets, technological change and our collective ingenuity.”

The bet ran for ten years, the 1980s, and was essentially five bets of $200 each on the price of five basic metals.  If the price of the metal rose faster than inflation, then Ehrlich won that part of the bet, otherwise Simon won it.  Chromium, copper, nickel, tin, and tungsten were the metals.  Simon won the bet because each of the metals prices, net of inflation declined during the decade.

Simon’s rationale is important for investors.  He reasoned that, in the long run, if any commodity is getting more expensive, people and businesses will react to the price increase by, for example, consuming less of it and/or trying to invent substitutes.  When commodities prices are high, gold has been the example for several prior years, investors are tempted to purchase the commodity reasoning that scarcity will get worse as the world’s population and/or total wealth increases.  The bet is strong proof that economic systems, such as capitalism, work to reduce the costs of products, and so commodities tend not to be good long term investments.

Another problem with investing in commodities is that the costs to invest and to stay invested are generally high.  A contract for the future purchase of a commodity (a “future”) is a wasting asset.  The contract has a limited lifetime and every day the contract, like an insurance policy, comes closer to the date at which coverage has ended and a new premium must be paid.  If, instead of purchasing a future, the investor purchases the metal itself, then there are purchase and selling costs plus storage costs.  You don’t generally keep a gold bar or a pile of tungsten around the house, you have to pay to have it stored for you.

A better approach is to purchase, not the commodity itself, but the stock of a manufacturer or miner of the commodity, e.g. purchasing shares of gold mining stocks rather than gold itself.  Commodities fluctuate widely in price and the shares of the mining firms fluctuate even more widely in price.  Mining stocks are, generally, a highly risky investment.  When we own broadly diversified stock index mutual funds or ETFs, we own our share of such mining ventures and spread the higher risk of these shares across the entire range of our portfolio.

What Are OUR and THEIR Asset Allocations?

Each of us has a different ability to live with uncertainty (risk) and so our investments will be different:

As of December 31, 2013 Clients The Smartts

Money Market Funds

2.1 0.6%
Bond Funds 27.0 6.5%
Stock Funds 70.9 92.9%
Totals 100.0% 100.0%

Remember each of us has different goals and needs and our asset allocation should fit us and our family.

Over long years stock investments generally perform much better than bonds.  But when the financial news is bad we can be afraid to purchase stock investments, and when the news is good, stocks are so high in price that they may not be quite as good an investment.

If you have questions about your asset allocation, or your retirement plan investments, I’d be pleased to assist.

Vanguard Rates of Return (through Latest Quarter End)

Performance percentages are per Morningstar.  Amounts in parentheses are percentile rankings

(1= best and 100= worst) within category.

Periods ended December 31, 2013 Yr.-to-date 5 Years 10 Years
Total Stock Market Index Admiral 33.5% (31) 18.9% (16) 8.1% (16)
Tax-Managed Capital Appreciation Admiral 33.7% (29) 18.8% (17) 8.0% (19)
Tax-Managed Small Capitalization 41.0% (21) 21.3% (32) 10.7% (16)
REIT Index Admiral 2.4% (27) 16.9% (23) 8.6% (35)
Tax-Managed International Admiral 22.1% (24) 12.0% (57) 7.1% (41)
Balanced Index Admiral 18.1% (38) 13.3% (39) 7.0% (16)
Total Bond Market Index Admiral -2.2% (67) 4.4% (83) 4.5% (43)
Interim-Term Investment-Grade Bond -1.4% (72) 8.5% (77) 5.3% (51)
High–Yield Corporate Bond 4.5% (92) 14.9% (78) 6.9% (66)
For comparison, here are several stock and bond benchmarks:
Periods ended December 31, 2013 Yr.-to-date 5 Years 10 Years

S & P 500 (large stocks)

32.4% 17.9% 7.4%
Russell 2000 (small stocks)

MSCI World Index

38.8%

26.7%

20.1%

15.0%

9.1%

7.0%

Barclays Aggregate Bond Index

-2.0% 4.4% 4.6%
BofAML US High Yield Master II TR

(bond index)

7.4% 18.7% 8.5%

 

Vanguard mutual funds and ETFs continue to perform as expected.  I expect each Vanguard fund or ETF, for each ten-year period to be in the top 1/3 before taxes based on low cost, and they ought to be in the top 1/4 (stock funds) after income taxes.  

The Vanguard High Yield Corporate Bond fund takes significantly less risk that the average “high yield” (also known as “junk bond”) fund.  When junk bonds are doing well, the Vanguard fund doesn’t compare as well.  I continue to recommend it as an additional diversification from good quality bonds and am satisfied with its absolute performance exactly because it takes significantly less risk than the average high-yield fund.  

If you have questions about your investment asset allocation, please contact me.

Capital Gains Distributions are Back Again

The late fall of 2013 brought unwelcome news for some mutual fund shareholders.  The combination of a rising stock market and actively managed mutual fund investment management’s habit of selling out of one investment and replacing it with another have combined to make 2013 a big year for realized capital gains for mutual funds.

If, for example, you owned the Lord Abbett Classic Stock Fund, Class A, your capital gains distribution was 26.64% of the then value of the shares of the fund. I located dozens of examples of such estimated distributions on mutual fund websites.  The more specialized the fund, e.g. “small capitalization growth fund”, the higher the rate of the distribution tended to be.

When mutual funds make trades which result in capital gains then, near the end of each year, the net gain must be distributed to the shareholders of the fund.  The distribution is received and is generally taxable even if the distribution is merely invested in more shares (and not accepted in cash, not “spent”).  In Tennessee this is doubly harmful to taxpayers, since the capital gains distributions of mutual fund shareholder are one of the few items of income subject to the state’s income tax.

Owners of index funds and ETFs generally sidestep these distributions since broadly diversified index funds and ETFs don’t make trades, don’t buy and sell securities, unless they are required to.  Further, ETFs have a complicated way of further reducing the potential for taxable capital gains.  In some circumstances, the ETF can distribute low-cost shares of its investments in kind when paying off a seller of the ETFs shares.  Complicated, but apparently it works.

The only capital gains distribution I found which affected the funds and ETFs owned by clients was an approximate 0.5% distribution on one of the Vanguard bond funds/ETFs, significantly lower than most distributions noted.

Other News and Notes

Here are other items of interest noted in a quarter full of reading:

Back-tested ETFs:  The Morningstar ETF Investor newsletter noted in September 2013 that one should beware of some of the new ETFs which follow indexes which the ETF provider has dreamed up.  No index exists so the provider looks at past years data and constructs an index looking backward.  The term is “back-tested.”  A 2012 Vanguard study, notes Morningstar, “looked at a sample of equity indexes with at least five years of back-tested history and five years of live performance.  In the five years prior to index live date, the indexes averaged 12.25 % excess returns above U.S. equity market; five years after live date, they averaged negative 0.26%.  Most ETF back-tests are garbage [emphasis added], in other words.”

The force at work here is that ETFs have become a very competitive business.  Vanguard charges as little as 5/100% annually to run some of its stock ETFs.  Rival ETF providers are looking for so called market anomalies, small portions of the stock or other financial markets which have produced recent high returns on investment.  In order to sell the ETF an index is constructed of the past, higher-than-expected-performance.

Investors should generally stay away from such “made up” investments.

Investment Newsletters:  The same Morningstar publication noted in July 2013 that there is money to be made in the prediction business, because there is a big audience that craves making sense of the unknown (and there is plenty that is unknown in investing!).

Joe Granville made millions selling an investment newsletter in the 1970s but from 1980 to 2005 following his advice (according to newsletter-tracker Mark Hulbert) would have lost investors 20% annualized.

Market analysts give bad advice:  The Economist, January 18, 2014 edition comments on the accuracy of stock market research.  Noting that stock analysts tend to be more optimistic about the stock of companies when the stock market is rising, the hope is that when times are bad, the advice might be less bad.  “New research, alas, suggests this is not so; the advice analysts give in bad times seems to be even worse than the boosterism they peddle in good.”

When times are bad, when the stock market is falling, investors become followers of the recommendations of stock market analysts.  In bad times one in seven of their recommendations are followed enough to move the prices of stocks (only one in ten recommendations move markets in good times).  “Just as drivers value maps more when it its foggy, investors pay more heed to research during periods of increased uncertainty… Unfortunately for them, that is also when their maps are most likely to be wrong.”

Investors in broadly based index funds and ETFs don’t need to be concerned about individual stock recommendations.  I recommend staying fully invested regardless of economic or stock market news and supposed trends, keeping enough investment in bond funds/ETFs (which fluctuate much less in price than do stocks) to cover at least a five year probable level of withdrawals from their investments.

LSU Endowment Tilts Passive In Equities:  An article in the late 2013 Journal of Indexes notes that this endowment, with more than half a billion dollars invested, is following indexing strategies for a higher percentage of its investments.  My reading notes that both institutional and individual investors have been, gradually over the last 25 years, using indexed mutual funds and ETFs for a higher percentage of their investments.

Washington Ruined Christmas:  In late November, 2013, a Yahoo Finance blog post opined that the private sector of the US economy was doing its share to help the economy bounce back but a crisis of confidence in the Federal government, triggered in part by the shutdown last year, has resulted in continuing lower readings of consumer confidence, a sour national mood which continues to hold back growth in the US economy.

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