Keeping Expenses Low While Building Your Portfolio (2007-07-30)

Keeping Expenses Low While Building Your Portfolio

(2007-07-30) by David John Marotta

Q: I enjoyed reading about your "Rocks and Sand" technique to keep expense ratios low. I own iShares EAFE (EFA) for my foreign rock. What no-transaction fee foreign mutual fund that tracks the EAFE index do you recommend for monthly deposits until I purchase another "rock?" - Steve

A: The "Rocks and Sand" technique comes from the following analogy: Imaging you have several buckets that represent different asset classes you want to invest in. Purchasing large rocks costs money (transaction cost), but they have a lower expense ratio after you have purchased them. Since rocks cost money to be broken up, they aren't as cost-efficient when you need to move funds from one bucket to another. Buckets can be filled in with sand with a higher expense ratio, but it doesn't cost any money to move sand from one bucket to another.

The transaction cost of building a portfolio of ETF "Rocks" is more than compensated by the fact that ETFs have lower expense ratios. IShares MSCI EAFE (EFA) is the most popular ETF for foreign stock investing. Its expense ratio is only 0.35%, an entire percentage less than the typical foreign stock funds. Lower expense ratios are saved every year, while transaction costs are only incurred in the year the investment is purchased or sold.

To reap the benefits of monthly additional investments and lower expense ratios, we use a combination of ETFs and no-transaction fee mutual funds. We invest large amounts in ETF shares that provide the rough asset allocation "Rocks" we are seeking to save on expense costs. These positions aren't bought and sold to take advantage of lower expense ratios without incurring transaction costs. Smaller monthly amounts are invested in no-transaction fee no-load mutual funds on a regular basis, like "sand" filling in around the "Rocks". These funds have slightly higher expense ratios, but the amounts are small compared to ETFs, so the overall portfolio expenses remain small.

Then, when a significant amount of "sand" dollars collect in the mutual fund of one asset class, that fund is sold and a lower expenses ratio ETF "Rock" is purchased in its place. Conversely, if an asset class needs to be reduced, some of the ETF is sold and the smaller portion of the proceeds is reinvested in a similar mutual fund.

The lowest cost method for keeping an asset allocation model balanced is to buy mostly rocks for each of the buckets of a diversified portfolio, and then add the sand of a no-transaction-fee mutual fund into the bucket that needs rebalancing. Whenever too much sand has accumulated in one of our 6 buckets, we sell the sand and replace it with another rock. If the weight of the rock(s) in one bucket gets to be too much, we sell a piece of rock and replace it with some sand which can be easily moved into one of the other buckets.

This "rocks and sand" technique can enhance your portfolio returns by as much as a full percent each year. This is especially true for portfolios between $500,000 and $1 million. There are even more powerful techniques that can be used for amounts in excess of $1 million. For large accounts, engaging a Fee-Only financial planner often pays for itself in lower expense ratios alone.

An analysis of efficient markets suggests that even a random collection of individual stocks can provide an adequate approximation of an index. If a random collection of stock can approximate the index, then stocks in a mutual fund can do the same. For our sand and in small accounts we will sometimes use the following funds: Artisan International Value (ARTKX) up 23.77% over the last year, Artisan International (ARTIX) up 26.75%, Artisan International Small Cap (ARTJX) up 37.13%, and Excelsior Emerging (UMEMX) up 40.54%.

Some of the funds we use may be closed to the average investor and available only to institutional investors. But you should be able to substitute other funds with good characteristic for the sand in your portfolio.

While the EAFE index returned 27.00%, the iShares EAFE exchanged traded fund returned 26.85%. Some years the actively managed funds we use as sand will beat the index funds and some years they will fall short. So long as you evaluate the funds you use carefully I would not worry if they are index funds or actively managed. The amounts you are investing in sand are small compared to the amount you have invested in the rocks of index funds. So long as your sand is in the ball park, they can provide a good holding place until you get enough assets to justify purchasing a larger rock.

Sand also doesn't need to be in exactly the same index as your rock. Sand can also be used to further diversify your portfolio. Perhaps you are only purchasing rocks in the EAFE Index. You can use the sand of a no-transaction fee index or actively managed fund to add emerging markets, foreign value or foreign small cap to increase your diversification and boost your returns while waiting to buy another rock. So you can be less concerned about finding no-transaction fee mutual funds that exactly track you exchange traded funds and focus instead on selecting the best funds in the general category.

from http://www.emarotta.com/article.php?ID=242

Blending Index Funds to Achieve Higher Returns (2007-07-23)

Blending Index Funds to Achieve Higher Returns

(2007-07-23) by David John Marotta

If you have been following my investment advice closely, you can probably guess that I don't favor stock-picking as the best way to meet your financial goals. But even if you favor index funds, as I do, that doesn't mean you have to use them exclusively.

You have probably heard the statistic that most actively managed funds fail to beat their indexes. Here's why. Most mutual funds are laden with loads, fees and expenses. It is nearly impossible to recover from the drag of high expenses. This is why most mutual funds have to be sold by mutual fund salesman. They could never compete when there are funds that are just as good with half the expenses. Most funds have no hope to beat their indexes because they are gouging their investors. But be aware, there are even index funds with high fees.

But, if most actively managed funds fail to beat their index, nearly all 100% of index funds fail to beat their index. Even if an index fund tracks their index perfectly, they too have expenses and even if their expenses are as low as 0.2% then they will still under-perform the index by 0.2%.

Even if you are a die-hard believer in the efficient market hypothesis, that doesn't mean you have to invest only in index funds. If the efficient market hypothesis is correct, then you won't do any worse (on average) with a random collection of stocks within an index than you will by holding the index. If stock picking doesn't matter, then you are free to pick any collection of stocks within the index that vaguely represents the index.

Some index funds perform poorly against the index not because they have high fees, but because they are trying to track the index too closely. When a stock is added to S&P 500, millions of dollars invested in S&P 500 Index funds must all buy that stock in order to track the index exactly. Stocks added to the S&P 500 do very poorly the year after this surge of automated buying. Funds that delay purchasing these stocks can perform better than those who purchase them immediately and pay a premium. Similarly, stocks that are being removed from the S&P 500 will out perform the index over the next year because all the index funds dumping the stock drive the price down needlessly. Delaying the sale of this stock until it has had a chance to recover produces superior returns.

In fairness, there are a few index funds which use these actively managed techniques to purposefully not track the index as closely as they could in order to try to beat their index. Vanguard 500 Index Fund (VFINX) uses some of these trading techniques and has beaten the S&P 500 Index over the past 3, 5, and 10 years. This past year, though, they under-performed the S&P 500 Index by 0.18%, which it just so happens is exactly their expense ratio.

Even if you believe in the efficient market hypothesis and investing in indexes, you have to ask the question "Which index?" Take for example the allocation you invest in foreign stocks. The EAFE Index is a cap-weighted index of a collection of countries that are in Europe, Australia, and the Far East, hence the initials EAFE. EAFE had a return of 27.00% over the year July 2006 through June 2007. The EAFE Index is split into EAFE Value and EAFE Growth. On average Value produces higher returns than growth, so you may want to buy some EAFE Value to provide this emphasis. Over the past year EAFE Value had a return of 28.65% vs. 27.00% for EAFE. EAFE Growth only returned 25.29% over this same time.

If you want to tilt your EAFE investment toward value, you would still want to invest the majority of your investments in the index and then add a portion in value specifically rather than just buying more EAFE Value than EAFE Growth.

The iShares EAFE (EFA) has an expense ratio of only 0.35%, while iShares EAFE Value (EFV) or Growth (EFG) have expense ratios of 0.40%. So you can reduce your expenses ratios by investing the bulk in iShares EAFE (EFA) and a portion in iShares EAFE Value (EFV) in order to keep expense ratios lower and still tilt toward value in order to boost your returns on average.

EAFE, however, does not include Canada. Many investors forget or don't know this, so they only invest in the United States and EAFE. A more sophisticated investor would add an appropriate share of Canada, such as iShares Canada (EWC). Canada is a good investment to include in your portfolio. Canada, not China, is America's biggest trading partner. Rich in natural resources, Canada's oil reserves are second only to Saudi Arabia's. In fact, Canada is the largest foreign supplier of energy to the US. Canada's returns over the past year were 28.3% vs. 27.00% for EAFE.

You may also want to invest in the emerging market countries. These are 26 countries of the developing nations that are not part of the EAFE Index but are part of the emerging market EMU Index. This past year the EMU Index had returns of 36.63% vs. 27.00% for EAFE. The iShares has Emerging Market Index exchange traded fund (EEM) provides an easy way to invest in this index. In addition to EAFE, EMU and Canada, those countries with the most economic freedom produce superior returns. We just finished our analysis and found this collection of a dozen countries produced an average return of 34.02% over the last year vs. 27.00% for EAFE. This technique requires another dozen country specific indexes most of which can be purchased through iShares exchange traded funds.

Just as Value indexes do better than Growth indexes, so also Small Cap indexes do better than Large Cap indexes. There currently isn't an iShares for small cap foreign, though this would also boost your returns, if it existed.

So far I have mentioned several indexes you should be investing in to provide the right mix just for your foreign investments. Even if you use all index funds, we recommend blending dozens of them in an asset allocation aimed at reducing risk and increasing returns to best meet your specific financial goals.

Rather than judging a fund solely on whether it is an index fund or not, funds should be judged by a whole set of criteria. Look for funds with low expenses, a broad collection of stocks, superior execution and low turnover.

And also, judge a fund by what index is follows most closely, does it drift outside that index, and what correlation that particular index has with other investments in your portfolio.

Building an asset allocation which is a blend of dozen indexes based on their expected risk, return, and correlation to other investments in the portfolio is what comprises the analytic analysis even for those who believe in mostly efficient markets.

from http://www.emarotta.com/article.php?ID=241

Managing Your Biggest Asset: Your Career (2007-07-16)

Managing Your Biggest Asset: Your Career

(2007-07-16) by David John Marotta

Your career is your biggest financial asset. Most people determine the value of their work by the dollar amount on their paycheck. However, judging your career based solely on your take-home pay is a short sighted evaluation. Learning to manage the full value of your career will translate into a higher quality of life and a higher net worth.

Two aspects of a career should be evaluated. One is the obvious quantitative measurement of salary and employee benefits. The second is a set of qualitative measurements which are even more important. As you will see, focusing on the qualitative measures is the surest way to maximize your bottom line in the long run.

The quantitative measurements are the easiest to assess but still involve much more than just comparing the base salaries of different career options.

A career's financial value can be determined by computing the net present value of wages and benefits minus the financial cost of the career, which will be explained in a moment. Don't overlook the value of your employee benefits. Employer matching contributions made to a 401k can be considered as valuable as a salary. Other benefits should be evaluated based on their value to you, not simply their cost to your employer.

If you are married with children, and both you and your spouse work, then be sure to account for the added cost of having both parents working. After subtracting child care, work clothes, transportation, prepared foods, and taxes, many two-career families would do just as well without the second career. Reducing household expenses and starting a part-time home business may be a better way to increase the family's bottom line.

The qualitative measurements of a career, although they are more difficult to assess, are even more important in the evaluation.

A job should be evaluated in relation to the new skills you learn and master as part of your employment. One job may pay you more because you are already a master of those skills, but a lesser-paying job may be better for your long-term career because of the skills you will gain.

It is your future skill set that will determine your future compensation. With the increase of project-based employment, longevity and seniority no longer have as much capital. Those who are the most successful at managing their careers are able to work at different jobs to gain the skills needed for each progressive step of their career.

In doing this, they treat their career as their own asset, not that of their employer. By taking ownership of their employment, they accept the fact that they are captains of their own fate. Those who follow this strategy often end up as top executives of large companies or start a business of their own.

A second important consideration is the social connections you will make on the job. Careers are as much about who you know as they are about what you know. No successful person in business functions alone. It is important to respect the value of building and maintaining relationships with other talented professionals as part of your career.

You don't need to be part of the "good ol' boys" club to benefit from a network. Simply knowing who can get a job done properly is a valuable commodity that will pay you back many times over. Every mom with a list of reliable babysitters or competent electricians knows the value of such a network. Just as you would evaluate how much money the company is going to put in your 401k, you should try to determine how much social capital the company will help you build.

Finally, make sure that your job is in harmony with the rest of your life and goals. It does not make any sense to spend the best decades of your life chasing after money so that you can finally do what you really enjoy in retirement. The strange truth is that people who do what they love often make more money that those who are simply after a big paycheck. And if you really love what you do, you'll find you'll never have to "work" a day in your life.

Fitting work into your life often begins by analyzing family constraints. Raising your children isn't worth missing. No matter how much time you spend with them, you blink twice and they are grown. If you are lucky, you will get another chance with your grandchildren, but it's better to not miss a moment with your children the first time around.

Learning to manage your career is every bit as important as learning to manage your money. Doing so will mean you will get to do what you love. And in the long run that should pay big dividends.

from http://www.emarotta.com/article.php?ID=240

Foreign Freedom Investing 2007 (2007-07-09)

Foreign Freedom Investing 2007

(2007-07-09) by David John Marotta

Adding international investments to your portfolio is a good way to diversify for safety while boosting returns. On average, international stocks appreciate more than US stocks. What's more, companies located in countries with the most economic freedom typically appreciate more than the broader international average. Over the past year, countries with the most economic freedom appreciated 7% more than the international index.

The MSCI EAFE Index of international developed markets gained 27.0% (in US dollars) during the one-year period ending June 30, 2007 and has averaged 22.2% annually for the past three years. Compare that to the stock indexes of the twelve most economically free countries which gained 34.0% during the past year and returned 25.4% annually for the past three years.

For small accounts, investing in a good international mutual fund is usually sufficient foreign diversification for your investments. However, greater diversification and returns can be gained by putting some money into the "emerging markets" category. Emerging markets, as measured by the MSCI Emerging Markets Index, appreciated 36.6% (in US dollars) over the past year and has averaged 26.5% over the past three years. Although emerging markets have a higher appreciation rate, they are also inherently more volatile than the markets of more developed nations.

To balance investment performance and volatility, a simple foreign asset allocation might invest two-thirds in the MSCI EAFE Index and one-third in the MSCI Emerging Markets Index. Using this technique, you would have gained 30.2% for the past year and averaged 23.7% over the past three years.

For larger accounts, a more complex asset allocation can be used for further diversification. This asset allocation strategy takes advantage of the fact that economic growth is often better in those countries with the greatest economic freedom. We use the Heritage Foundation's measurement of economic freedom to emphasize those countries that combine the greatest economic freedom with large investable markets.

Since its inception in 1994, the Heritage Foundation Index of Economic Freedom has used a systematic, empirical measurement of economic freedom in countries throughout the world. The conclusions from this study clearly demonstrate that countries with economic freedom also have higher rates of long-term economic growth. This makes the study useful for investors to use to decide which countries should be emphasized in their country-specific foreign stock allocation.

According to the Heritage Foundation's study, "Economic freedom is defined as the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself. In other words, people are free to work, produce, consume, and invest in the ways they feel are most productive."

A country's economic freedom score is based on fifty measurements that fall under the following categories: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and foreign investment, banking and finance, wages and prices, property rights, regulation, and informal market activity.

A number of the countries ranked high in economic freedom have exchange-traded funds (ETF's) which track the market indexes of these countries and provide an easy, convenient, and inexpensive way to invest in each country. Exchange-traded funds combine the liquidity of individual stocks with the diversification of an index fund. The ETF's also typically have lower expense ratios than most mutual funds.

For larger accounts, we recommend investing half of the assets using the simple technique described above. As such, one-third is invested in the MSCI EAFE Index fund and one-sixth in the MSCI Emerging Markets Index fund. The other half is divided among the twelve countries with the most freedom that also have markets large enough to have a country-specific ETF.

All of the top twelve most economically free countries, except Japan, beat the United States's 20.6% return over the past year as measured by the S&P 500. In descending order, the past year's investment returns for the top twelve countries are as follows: Singapore 60.7%, Germany 48.8%, Sweden 44.3%, Australia 43.6%, the Netherlands 38.4%, Austria 36.4%, Belgium 33.2%, Hong Kong 29.5%, Canada 28.3%, the United Kingdom 27.4%, Switzerland 22.5%, and Japan 7.23%.

Over the past year, ten of these countries beat the broad MSCI EAFE Index and only two Switzerland and Japan) fell short. Of the twelve countries, Japan and Belgium were only ranked high enough by the Heritage Foundation's Freedom index this past year to warrant being added as country-specific investments. While Belgium's index had nice returns, Japan has not yet contributed as much.

Averaged together, the top twelve free countries gained 34% this past year. This is a full 7% above the MSCI EAFE Index which gained 27%. Excluding Japan, the other economically free countries beat the MSCI EAFE by a full 11%. Over the past five years, investing in countries with the most economic freedom is a strategy that has beaten the MSCI EAFE Index by an average of four or five percentage points annually.

Diversifying your foreign investments is just one important component of an optimal asset allocation. Building balanced portfolios that are more likely to meet your financial goals doesn't happen by accident or by working with someone whose interests are in conflict with yours. Visit NAPFA at www.napfa.org to find a Fee-Only advisor in your area or call NAPFA at 1-800-366-2732.

from http://www.emarotta.com/article.php?ID=239

You too can become a billionaire 2007 (2007-07-02)

You too can become a billionaire 2007

(2007-07-02) by David and George Marotta

There are 946 billionaires in the world according to a recent survey. Half are in one country, the United States of America! The others are scattered throughout 53 other countries. Because of the surging world economy, 195 newcomers were added to the list last year and only 32 dropped out. Learning how billionaires amass their wealth may expand your financial horizons and possibly stimulate some ideas that could lead to your name being added in the future.

Topping the list for the past thirteen years is Microsoft founder, Bill Gates, the richest person in the world with $56 billion. Investor Warren Buffet remains in second place with $52 billion. They are followed by three foreigners: Mexican telecom executive Carlos Slim Helu; Swedish Ingvar Kamprad, the founder of the Ikea stores; and Indian steel magnate Lakshmi Mittal

Germany is the next country with 55 billionaires, but probably not for long. Russia with 53 is moving up fast having been freed from the shackles of communism and benefiting from rising world oil prices. In fourth place is the "emerging-market" country of India with 36 billionaires overtaking the "mature" economies of Japan and the U.K.

How does one become a billionaire? If you are lucky, you are born into the right family. The fifteenth richest person in the world Karl Albrecht ($20 billion) inherited his mother's corner grocery store and grew it into the giant supermarket chain Aldi. In the U.S., he owns the fast-growing Trader Joes gourmet food shops.

Do what you're good at, work smart, invest wisely and you too may be pleasantly surprised.

If you are a "geek" in college, start a business in your dormitory. That's what two billionaires did: Larry Page and Sergey Brin. They were graduate students at Stanford University when they conceived the idea that has become the most popular computer internet search engine -- Google. When the company went public in 2005, they were each worth $7 billion. Now each is worth double that: $16 billion. Earlier, Michael Dell started his business while a student at the University of Texas.

Devise a method to sell good products at the lowest cost. That's what Sam Walton did by starting Wal-Mart. His five heirs are each worth about $17 billion. If Papa Sam were still alive, he would easily be the richest man in the world with $85 billion. Sam was a smart man who had six basic rules for his business: think small, communicate, keep your ear to the ground, push responsibility and authority down, force ideas to bubble up and fight bureaucracy.

Is it possible to get rich while you are on welfare? Well, one single mother in England did just that. Billionaire Joanne Kathleen Rowling started writing stories about "Harry Potter" while on "the dole" during the time her child was sleeping.

Is it possible to get rich collecting waste paper? Yan Cheung, China's richest woman with $2.4 billion did just that. The waste paper she collects in the US goes to China to be made into cardboard that then brings back to us the goods we buy from China.

How does one get rich? We analyzed the top fifty billionaires in the United States and found that most of them gained that stature by starting their own business. The next best (and easiest) way to become a billionaire is to have billionaire parents – inherit wealth. The third best way is to entertain people – be in the media business. Fourth, be a good investor (common stocks earn an average of 11 percent annually and at that rate you can double your money every six and a half years). Buying and owning real estate is the fifth best way as it earns an average of eight percent annually, and at that rate you can double your wealth every nine years.

Is a billion dollars a lot of money? Think of it this way. Just to COUNT to a billion would take over 32 years. The wealthiest people today are not like the "robber barons" of a century ago. Most are honest, good citizens, who worked hard to create their wealth, but also did well for society in general. Eventually, most of the wealth is gifted to charity.

Bill Gates, the wealthiest person, and his wife Melinda, set up the world's largest private charitable trust worth $33 billion that is dispensing funds for medical research, education, etc. Last year, Warren Buffet announced that he would give $31 billion of his Berkshire-Hathaway stock to charity; most of it to the Gates Foundation. Guided by the belief that every life has equal value, the Foundation seeks to reduce inequities and improve lives around the world.

If you want to be rich, be prepared to pay more taxes. The wealthiest people in the US, the top one percent of earners, pay 36% of all federal income taxes. The top 5% pay 57% of all federal income taxes. If the government wants to continue doing "good," a lot of tax revenues needs to come from the wealthiest families. When the wealthy do well, the government is able to afford to "do good" for society.

With the victory of capitalism over communism, the "democratization of wealth" is becoming more commonplace in Russia, Eastern Europe and China. Deng Zhao Ping, the architect of China's transformation, was smart. He told his fellow politburo members that in order to advance. China had to let some people get rich.

But, just where does one start? First, you need to accumulate some capital. If you work for someone else, save enough to quit your job and start your own business. It is a long shot to becoming a billionaire, but it's worth the try. On your way to becoming a billionaire, the million markers become commonplace.

Over seven million households now have a net worth of over $1 million. That is five times the number that existed in 1989. The odds of someone becoming a millionaire through personal efforts are good -- about one in five. Do what you're good at, work smart, invest wisely and you too may be pleasantly surprised.

from http://www.emarotta.com/article.php?ID=238