Client Newsletter Volume XVIII Number 3 February 1, 2013Download as PDF
I. Searching for Income from Your Investments
Inflation in the US is running around 2% per year, a rate which is not expected to change very much in the
next year or so.
The interest income being paid presently on ten-year US treasury bonds is less than 2%. So if one is relying
on government bond interest income, one is falling behind inflation; net of inflation, there is no investment
income left to spend. And, unless the bonds are owned in a tax-deferred account (an IRA or 401(k)), there
is income tax to pay too, even though there is, after inflation, no net income on the bonds.
Intermediate-term, investment grade corporate bonds are paying about 2.5 to 3% interest, better than
government bonds but not the “inflation plus 2% to 2.5%” that we expect bonds to provide over long
periods of years.
As I write this, the stock market, represented by the dividend yield on VTI, the Vanguard Total Stock
Market Index ETF (exchange-traded fund), is yielding a dividend rate of 2.13%. So, stock, as represented
solely by its current income, its dividend, is not helping provide income which would run much ahead of
inflation, is it?
When confronted with this situation, many are tempted by products which promise higher rates of return.
For several years we have seen advertisements for annuities with guaranteed interest rates, say of 5% or 6%
per year. These rates are generally offered not forever, but for periods of three to six months. Again, not
much of a solution, especially because once purchased, such “guaranteed” annuities have a high exit cost,
often 6% to 10%. The anticipation is that the “guaranteed rate” will last only a few months and then a rate
of interest will be provided which is “bond-like.”
So many investors have been purchasing high yield (“junk”) bonds that the Vanguard fund, which many of
us own, has been closed to new investors since May, 2012. Vanguard closes its mutual funds when there
are more demands from new investors than Vanguard believes are available for fulfillment; that is, the
managers of the mutual fund cannot find enough reasonably priced bonds to buy in relation to investors
requesting to purchase new shares of the fund. For new clients in the interim, until the fund reopens, I have
been using a junk bond ETF which takes more risk than the Vanguard fund and which was chosen for its
relatively low cost of operation. When the Vanguard fund re-opens, the ETF will be sold and the Vanguard
Income through a widened perspective:
“Never dip into principal,” is an invest adage many of use have heard. If we never dipped into principal, we
could not have been living on our investments for the last several years, years in which interest rates have
been kept artificially low by governments in order to attempt to stimulate the economy and encourage
increases in business activity. Dipping into bond principal really does not work long term, but may be a
short term solution.
I believe that as investors we must widen our view. The stock market’s return on investment is comprised
of both the dividend income paid and on anticipated, but not guaranteed, increases in the value of our
investments. To live on our investments, it is allowed to spend part of the principal of our investments in
stock, because that principal, long term, grows in value. So we don’t just spend interest and dividend
income, we also spend some of the gains we have realized from owning investments which are based on
How much can we spend?
I believe that spending 4% of the value of our investments each year provides assurance, but not a
guarantee, that we will be able to spend more dollars but the same percentage next year in order to keep up
with inflation. There is no guarantee of this, but it is a rule of thumb which has been reasonably reliable in
So, owning investments and receiving part of our income from our investments requires both (a) a wider
perspective of what is permissible to spend, income includes capital gain income, and (b) owning stock as a
significant part of our investments.
If we spend less than 4%, we can have more confidence that our investments are growing in their ability to
provide future income; if we spend more than 4%, we can have less confidence.
II. 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, 2012 Clients The Smartts
Money Market Funds 2.3 0.9%
Bond Funds 31.9 4.3%
Stock Funds 65.8 94.8%
Totals 100.0% 100.0%
Remember each of us has different goals and needs and our asset allocation should fit us and our family.
If you have questions about your asset allocation, or your retirement plan investments, I’d be pleased to
III. 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, 2012 Yr.-to-date 5 Years 10 Years
Total Stock Market Index Admiral 16.4% (27) 2.3% (16) 7.9% (14)
Tax-Managed Capital Appreciation
Tax-Managed Small Capitalization 16.0% (40) 5.2% (20) 10.5% (20)
REIT Index Admiral 17.7% (29) 6.1% (23) 11.7% (35)
Tax-Managed International Admiral 18.6% (42) -3.3% (43) 8.5% (35)
Balanced Index Admiral 11.5% (62) 4.3% (7) 7.2% (25)
Total Bond Market Index Admiral 4.2% (83) 5.9% (57) 5.2% (46)
Interim-Term Investment-Grade Bond 9.1% (21) 7.4% (18) 6.1% (18)
High–Yield Corporate Bond 14.4% (57) 8.6% (36) 8.1% (79)
For comparison, here are several stock and bond benchmarks:
Periods ended December 31, 2012 Yr.-to-date 5 Years 10 Years
S & P 500 (large stocks) 16.0% 1.7% 7.1%
Russell 2000 (small stocks)
MSCI EAFE Index
Barclays Aggregate Bond Index 4.2% 6.0% 5.2%
BofAML US High Yield Master II TR
16.4% (28) 2.0% (22) 7.8% (16)
15.6% 10.0% 10.4%
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 Balanced Index mutual fund is comprised of approximated 60% stock, the same investments
as the Total Stock Market Index fund, and approx. 40% bonds, the same bonds as the Total Bond Market
Index fund. This 60/40 allocation is very close to the average client allocation, see Section II., above. When
compared with other “Allocation funds” (Morningstar’s caption for balanced <stock and bond> funds), the
Balanced Index fund ranks at the top 1/4, before income taxes, a bit better than expected.
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, as they have for ten years per the above
benchmark, 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.
IV. The Tax Advantage of Broadly Based Index Funds
The last ten years have seen tremendous fluctuations in the value of the stock market. Much of the focus of
the financial media has been on these changes in value. The income taxation of investments has taken a back
seat during most of this decade. However, significant increases in the value of stocks since the February,
2009 low point in the stock market should remind investors that, in regular, currently taxed accounts, there is
another cost of investing, the cost of income taxes. Income taxes are generally levied on both the dividend
income paid by stock and the realized net capital gains of mutual funds.
The March/April, 2012 issue of The Journal of Indexing is subtitled “The Bogle Issue.” John Bogle, the
founder of Vanguard and a pioneer in indexed fund investing is on the cover, testifying at one of the
Congressional Committees. In an article titled: “The Case for Indexing, Revisiting the Foundations of
Passive Investment,” one of Vanguards senior analysts, Christopher Phillips, summarizes the case for the
income tax advantage of index funds:
“From an after-tax prospective, broad index funds and ETFs may provide an additional advantage
over actively managed funds. Because of the way index funds are managed, they rarely realize
and distribute capital gains to shareholders.
According to Bergstresser and Poterba (2002), the typical mutual fund distributed, on average, 50
percent of its annual price appreciation in the form of capital gains. It should be noted that very
few conventional broad index funds or broad ETFs have distributed capital gains in past bull and
bear market cycles. Historically, approximately one-third of the distributions from actively
managed funds have been in the form of short-term gains and two-thirds in the form of long-term
gains. Index funds, on the other hand, distribute far less (an estimated 0.50 percent) as long-term
gains, primarily because selling occurs only when the composition of the market index changes.
This can result in return advantages over the long term because the majority of the investment
compounds over time instead of being lost to taxes.’
When the stock market is diving, no one cares about taxable capital gains, but when the stock market has
gone up in value, rather strongly and rather consistently for several years, then regular, actively-managed
mutual fund owners begin to be hit by “the December Surprise,” distribution, late in the tax year, of net
gains. Shareholders can do little to reduce the income taxes on such distributions.
We who are largely index fund investors have far less worry about income taxes. Generally, the broader the
index fund owned, the less worry about taxable capital gains. Not no worry, but far less worry.
If your Form 1099 from your mutual fund contains taxable capital gains distributions, I’d be pleased to
discuss with you how to change your investments so that this problem is minimized in future years.