Commentary

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Is direct indexing better than buying an ETF?

Direct indexing may be gaining popularity soon, thanks to a continued fee war between several large brokerages. Both Schwab and Ameritrade recently announced commission-free stock trades, in addition to their commission-free ETF trades. This may sound like an appealing alternative, but direct indexing is far from simple.

What is direct indexing?

Direct indexing creates a portfolio that tracks an index through buying individual stocks. So, in the case of the S&P 500, you would invest in common stock from the 500 companies that make up the index. By eliminating the commission for each trade, the cost barrier of buying and selling each stock goes down significantly. However, it still requires many trades. In the case of the S&P 500, there are actually 505 common stock listings for the 500 companies in the index. It turns out that a few companies, like Google, have two share classes. So, one could eliminate the expense ratio of 0.04% currently charged by the iShares Core S&P 500 ETF (ticker: IVV). For a $100,000 portfolio, that is a savings of $40 a year. For portfolios of this size, I would argue that the convenience of trading a single ETF is worth $40 a year.

Tax benefits of direct indexing

When an investor builds a portfolio of common stock with direct indexing, they get more control over its holdings. While ETFs are known to be very tax efficient, tax loss harvesting is not possible at the individual security level. This benefit doesn’t make a difference in retirement accounts that aren’t paying taxes on selling stocks, but can be significant in taxable accounts for high income earners.

Conclusions

I am happy to see commissions for stock trades hitting $0, but I’m not convinced that for most investors, direct indexing makes sense. There is a cost savings, but the additional effort could be significant. And, if your larger investments are in tax-deferred or exempt retirement accounts, there aren’t any tax benefits available anyway. Tax loss harvesting appears to be the most compelling reason to direct index. It is most beneficial to individuals paying the highest marginal tax rates.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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October Portfolios and Third Quarter Market Summary

The October 2019 optimal portfolios are now available to subscribers of ETFMathGuy. So, please log in and select your discount broker to see the effect of current market conditions on our optimal portfolios. Here, we also summarize the market dynamics in the third quarter.

Third Quarter Market Summary

Today’s issue of the Wall Street Journal had several articles that nicely summarized the latest quarter for ETFs. Today, I discuss two articles. The first deals with investing in precious metals, and the second with preferred stock.

Precious Metals

The first article discusses the opportunity of investing in precious metals in a rate falling environment. The author points out that holding precious metals, like the popular gold ETF (ticker: GLD) or sliver ETF (ticker: SLV) don’t produce a yield like stock and bond ETFs. Then, the article goes on to suggest the “safe haven” aspect of precious metals may be driving their demand. The image below shows that the opportunity for large gains is possible, if investors are willing to accept a high degree of volatility.

Returns of three precious metals in the 3rd quarter, 2019. Source: WSJ, October 1, 2019.
Returns of three precious metals in the 3rd quarter, 2019. Source: WSJ, October 1, 2019.

Preferred stock

The second article discusses a hybrid stock-bond fund that tracks preferred stock. This investment has characteristics of both common stock and bonds, as seen by its performance shown below for a preferred stock ETF (ticker: PGX). Because the riskiness of preferred shared typically falls between stocks and bonds, it is not surprising its returns do too.

Returns of preferred shares ETF vs. stock and bond markets. Source: WSJ, October 1, 2019.
Returns of preferred shares ETF vs. stock and bond markets. Source: WSJ, October 1, 2019.

Conclusions

The financial markets continue to exhibit very dynamic behavior. But, ETFs continue to offer an opportunity to reach parts of the markets in a cost and tax efficient manner. So, we hope this article helps to inform your decision making when selecting ETFs.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

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Making sense of ETF Liquidity

In my last post, I discussed ETF liquidity risk. After the post, a subscriber to ETFMathGuy asked me to talk more about this risk and how it relates to the wide variety of commission-free ETFs now available.

Bid-ask Spreads

Bid-ask spreads are an excellent way to measure liquidity. Less liquid ETFs generally have higher bid-ask spreads. But, the liquidity of the securities held by the ETF also affects bid-ask spreads. The image below shows the distribution of bid-ask spreads for Fidelity commission-free ETFs, which I updated from my April 2019 post.

Bid-ask spread of Fidelity Commission-Free ETFs, as of 9/22/2019. Source: ETF.com, Fidelity.com
Bid-ask spread of Fidelity Commission-Free ETFs, as of 9/22/2019. Source: ETF.com, Fidelity.com

Minimizing costs

As we see from these results, there is a wide variation of bid-ask spreads. So, about half have spreads under 0.1%, and about 80% under 0.3%. For ETFs traded commission-free, these spreads are likely the largest contributor to cost of ownership. To reduce this cost, an investor can either buy-and-hold for extended periods, or choose ETFs with lower bid-ask spreads. Investors should also avoid trading ETFs close to the market open and close. Higher volatility over a typical trading day can often occur close to the market’s open and close, and can produce higher bid-ask spreads.

What about ETF liquidity during high market volatility?

It is very likely that, during periods of high market volatility, bid-ask spreads will grow. This growth is simply the result of finding a balance between supply and demand. Or, in the case of ETFs, this balance occurs when an ETF seller finds a buyer. Remember that, due to liquidity risk, we can expect a return premium over risk-free investments. If market volatility is a concern, investors should seek lower volatility investments (e.g. bonds over stocks), and/or seek lower volatility in their portfolio through diversification.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Is there a bubble in ETFs?

The “hero” of the movie “The Big Short”, Michael Burry, has made some claims recently about a bubble in ETFs and market risks. Here, I discuss his concerns, and provide an alternate perspective.

Price discovery

One of the risks Michael Burry identifies is so-called price discovery. He claims that index funds have removed price discovery from the equity markets. I must disagree with this claim. For example, when an investor buys an S&P 500 index ETF, they are agreeing to pay the seller some price. This transaction is an implicit agreement on the value of the underlying securities. So, this is the very definition of price discovery, where supply and demand are in equilibrium.

” Simply put, it is where a buyer and a seller agree on a price and a transaction occurs. “

Definition of Price Discovery, Investopedia.

Liquidity Risk

Michael Burry also identifies liquidity risk, which occurs when an investor has trouble selling an investment at a desirable price. Liquidity risk is very real. ETF investors often realize this risk during significant market corrections through larger bid-ask spreads.

“…liquidity risk stems from the lack of marketability of an investment that can’t be bought or sold quickly enough to prevent or minimize a loss.

Definition of Liquidity Risk, Investopedia

While I agree that there is liquidity risk in ETFs, there is also liquidity risk in just about any financial investment. For instance, homeowners often face liquidity risk. So, you may wish to sell you home next month to move for a new job, but may not able to find a buyer willing to pay your asking price. In stock and bond ETFs, liquidity risk also occurs during times of market corrections. But, this risk occurs whether you own the individual stock, bond, or a fund that contains them. Taking this risk is part of the risk-reward payoff. That is, by taking additional risk, the investor realizes the possibility of higher returns.

Conclusions about a bubble in ETFs and market risks

So, how should an individual investor treat this opinion? Michal Burry’s solution is to be “…  100% focused on stock-picking.” My choice is to stick with ETFs, thanks to their simplicity and efficiency. Markets corrections will occur, so it’s not a matter of if, but when they occur. If, as an investor, you are not comfortable with these market risk, perhaps you should re-evaluate your risk tolerance and move to lower risk investments.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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September portfolios and year-to-date returns

The September 2019 optimal portfolios are now available to subscribers of ETFMathGuy. So, please log in and select your discount broker to see the effect of current market conditions on our optimal portfolios. In this post, we discuss the year-to-date returns of my personal account using the ETFMathGuy portfolios.

Year-to-date returns

Although there are still four months remaining in the year, I thought this would be a good time to talk about my year-to-date returns. I have personally been using the moderate risk level portfolios in my Fidelity brokerage account since the beginning of the year. Monthly returns, based on the balance in my account, appear below.

Monthly returns using commission-free Fidelity ETFs and the moderate ETFMathGuy risk level.
Monthly returns using commission-free Fidelity ETFs and the moderate ETFMathGuy risk level.

To better understand the returns in my account that maximizes return for a portfolio with volatility half-way between stocks and bonds, I created the next table. Here, you can see that the ETFMathGuy portfolio return so far in 2019 is 14.1%, with a monthly volatility of 2.1%. To one decimal place, the same volatility is seen if an investor had simply maintained a 50% stock and 50% bond fund, re-balanced each month. But, the 50/50 portfolio would have seen a return of only 13.7%

ETFMathGuy portfolio returns are higher than a 50/50 stock/bond portfolio, with the same volatility.
ETFMathGuy portfolio returns are higher than a 50/50 stock/bond portfolio, with the same volatility.

Key takeaways

The ETFMathGuy portfolios appear to be behaving as expected. That is, they have about the same amount of volatility as their benchmark. However, I realized an additional return of about 0.4% in my brokerage account. For a $100,000 portfolio, that is an additional gain of about $400. I will revisit my portfolio’s performance again at the end of the year, so please stay tuned!

The future of ETFMathGuy

For the near future, I will continue to provide the optimal portfolios without a fee. But, in the meantime, I decided to begin accepting donations, if you are so inclined. Please find the donate button at the bottom of the “Join Us” page. For your convenience, it also appears below.

Thanks for supporting ETFMathGuy!

Thank you all for your interest and support in 2019. I hope you all had a wonderful labor day weekend!

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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ETF Investments and inverted yield curves

In this post, I discuss a very popular topic in the financial news recently. The term “inverted yield curve” has come up quite a bit. Many consider it as a good indicator of a recession. So here, I will review the fundamentals on what a yield curve is. Then, I’ll comment on its relevance to ETF investors.

The Yield Curve

The yield curve visualizes U.S. treasury bond yields at various times to maturity. As of August 20, 2019, the yield curve looked like this.

Yield curve on August 20, 2019. source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield
Yield curve on August 20, 2019. source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

I’ve highlighted with asterisks (*) the yield on the two and ten year treasuries. So, these bond maturities had yields of 1.50% and 1.55%. These two maturities are often picked to represent short-term vs. long-term investments in U.S. treasury bonds. That spread, or difference in yields, is 0.05% as of August 20, 2019. Of course, if we chose “short-term” as 1 year, then indeed we would have an inverted yield curve with a spread of -0.17%. In any case, the two-to-ten year spread is very small, as compared to what has been seen so far in 2019.

Spread between two and ten year U.S. treasury bonds. source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2019
Spread between two and ten year U.S. treasury bonds. source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yieldYear&year=2019

What does a smaller (or negative) spread mean?

The general argument is that demand for longer term bonds is growing as investors flee the volatility of the stock market. This flight to bonds, or preferably bond ETFs, does seem to be prudent, particularly for investors with high concentrations of stock investments seeking to better manage stock market risk. So, I would argue that, if you have a well diversified portfolio of stocks and bonds, one can largely ignore all this discussion of the inverted yield curve. Instead, investors should focus on their own risk tolerance and long-term goals, as all markets correct themselves from time to time.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Taxation and your ETF investments

Taxation of your ETF investments is an important consideration. As we discussed in our previous post ETF Tax Efficiency vs. Mutual Funds, ETFs are quite tax efficient. Here, we summarize taxation of your ETF investments when held in a taxable account.

ETF taxation occurs in two ways. First, taxes occur when an ETF issues a dividend. Also, taxes occur when an investors sells their ETF for a gain (or loss). So, let’s first look at the preferred (lower) level of taxation available for ETFs.

ETF taxation of qualified dividends and long-term capital gains

ETFs issue two types of dividends, called qualified and non-qualified. As shown below, ETF investors prefer taxation of qualified dividends, due to their lower capital gains rates. Many stock-based ETFs issue these types of dividends. For example, the iShares core S&P 500 index ETF (ticker: IVV) currently distributes a qualified dividend yield of 2.05%. Investors who buy an ETF and sell it at least one year later also realize these preferred rates.

Tax rates for qualified dividends and long-term capital gains. source: https://taxfoundation.org/2019-tax-brackets/
Tax rates for qualified dividends and long-term capital gains.
source: https://taxfoundation.org/2019-tax-brackets/

ETF taxation as ordinary income

Unfortunately, ETFs can also be taxed at the higher rate of ordinary income. The tables below shows the current rates and income brackets for unmarried, married, and head of household tax payers.

Tax rates for non-qualified dividends and short-term capital gains. source: https://taxfoundation.org/2019-tax-brackets/
Tax rates for non-qualified dividends and short-term capital gains.
source: https://taxfoundation.org/2019-tax-brackets/

ETF investors face these taxes when either the ETF issues a non-qualified dividend, or is bought and sold in less than one year. Most bond-based ETFs issue non-qualified dividends. For example, the iShares Core U.S. Aggregate Bond ETF (ticker: AGG) generates non-qualified dividends, currently with a yield to maturity of 2.52%.

Don’t let the “tail wag the dog”

While taxation is an important aspect of ETF investing, it should not be the sole consideration. Indeed, Federal taxes could be minimized if one only needs the interest payments from municipal bond ETFs, like the iShares National Muni Bond ETF (ticker: MUB). But, a diversified portfolio should have a variety of asset classes. Instead, consider holding your portfolio of ETFs in a retirement account like a traditional or Roth IRA.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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August 2019 portfolios are now available based on our current low volatility markets

The August 2019 optimal portfolios are now available to subscribers of ETFMathGuy. So, please log in and select your discount broker to see the effect of current market conditions on our optimal portfolios. In this post, we highlight the effect of the recent low market volatility on portfolio turnover.

Low volatility is here, for now…

As discussed in yesterday’s Wall Street Journal article entitled “Markets are Eerily Quiet Right Now“, market volatility has been quite low recently. For the past 35 days, the S&P 500 hasn’t changed by more than 1%. Consequently, the August 2019 portfolios won’t differ much from the previous month. For instance, consider the Vanguard moderate portfolios generated over the past two months.

Vanguard optimal portfolios the Month of July, 2019, Moderate Risk Level
Vanguard optimal portfolios the Month of July, 2019, Moderate Risk Level
Vanguard optimal portfolios the Month of August, 2019, Moderate Risk Level
Vanguard optimal portfolios the Month of August, 2019, Moderate Risk Level

As these simpler portfolios demonstrate, low volatility produces less turnover. Here, none of the portfolio weights changed by more than a few percent.

Where will the stock and bond markets go from here?

Frankly, we don’t know, as we believe that markets are generally efficient. Market volatility will certainly return to a more typical level at some point in the future. But, when will this occur? Perhaps volatility will pick up when many professional traders return from summer vacation? Or, perhaps markets will stay quiet until the start of the next earnings season?

In any event, when market volatility does return, our monthly portfolio updates will pick up these dynamics and generate a new set of optimal portfolios. We hope you will stay tuned!

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Stocks and Bonds in an ETF portfolio over the long-term

Stocks and bonds carry many benefits when held over the long term. In this post, I highlight a few aspects that are important to individual investors.

Two of the largest stock and bond ETFs analyzed each month by ETFMathGuy follow the tickers symbols IVV and AGG. IVV tracks the S&P 500 index, which consists of large U.S. companies. The top 10 holdings of IVV appear below.

Top 10 holdings of the iShares Core S&P 500 ETF. Source: etf.com/ivv
Top 10 holdings of the iShares Core S&P 500 ETF. Source: etf.com/ivv

The ticker symbol AGG tracks the Bloomberg Barclays U.S. Aggregate Bond Index. As we discussed in our previous post on the “Fundamentals of Fixed Income ETFs“, quality and maturity are two important components. The quality component of this ETF is largely influenced by its 40% of holdings of U.S. government bonds, and over 20% of mortgage backed securities. Top sector holdings appear below.

Top 10 sector holdings of the iShares Core U.S. Aggregate Bond ETF . Source: etf.com/agg
Top 10 sector holdings of the iShares Core U.S. Aggregate Bond ETF . Source: etf.com/agg

The bonds in AGG have an average maturity of about 8 years. Consequently, interest rate changes generally affect its price more than similar bond ETFs with shorter maturities.

Long term returns of stocks and bonds

The fundamental information about stock and bond ETFs is important, but doesn’t really address long-term investment performance. For that, consider the following chart that shows the total return of $100,000 invested in either the stock (green) or bond (blue) ETFs mentioned previously.

Total return of $100,00 invested in IVV (green) and AGG (blue) from January 5, 2004 to July 19, 2019. source: ETFReplay.com
Total return of $100,00 invested in IVV (green) and AGG (blue) from January 5, 2004 to July 19, 2019. source: ETFReplay.com

As this chart shows, much better returns are possible with stocks, provided investors are willing to accept the higher volatility. Annual growth rate of the stock ETF (IVV) is more than double (8.7% versus 4.0%) than the bond ETF (AGG). But, the volatility of the stock ETF is nearly four times (4X) larger than the volatility of the bond ETF.

Asset allocation basics

So, what is the correct allocation between stocks and bonds using ETFs? Generally speaking, investors seeking less risk will seek more bonds and less stock exposure. One simple rule of thumb is the “120-age” formula for stocks. So, a 30-year old investor would be 90% in stocks and 10% in bonds. Similarly, an 80-year old investor would be 40% stocks and 60% bonds. A more conservative approach is the “100-age” formula for stocks. In any case, investment risk typically increases with a higher allocation to stocks, and decreases with a higher allocation to bonds.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Fundamentals of Fixed Income ETFs

A recent Wall Street Journal article nicely summarized the fundamentals that define fixed income ETFs. Understanding these fundamentals can be very helpful in using them in a portfolio seeking the stability of bonds.

Quality, maturity and pricing of Bond ETFs

Two fundamental components that define a fixed income ETF are credit quality and maturity. Remember that fixed income ETFs are a collection of individual bonds. Also, a bond is a loan with fixed payments. That is why bonds are often referred to as “fixed income” investments. Credit rating firms, like Moody’s or Standard & Poor’s, evaluate the riskiness of the loans. Maturity measures the time until the original loan amount is due.

So, there is a strong relationship between a bond’s yield and these two fundamental components. Generally speaking, when a bond is first created, yields are higher under either (i) a lower credit rating or (ii) longer maturity. Once a bond is issued and makes its way into a bond ETF, the price of the bond ETF can then change. But, the underlying bonds continue to issue a stream of constant payments. The only significant exception occurs when the corporation making the bond payments enters bankruptcy protection.

Consequently, prices tend to decrease when demand is low, and investors prefer riskier assets. Conversely, prices of fixed income ETFs generally go up when investors seek less risky assets.  Yields are then inversely related to bond prices, so higher prices lead to lower yields.

What else can affect a bond’s price?

Interest rates can also affect bond prices. Short term rates set by the federal funds rate appear in the image below. As this chart shows, short term rates continue to climb steadily. But, these rates remain below typical levels seen in the past 20 years.

Federal funds rate for the past 20 years.
Federal funds rate for the past 20 years.

So, are bonds a bad investment as short-term rates go up?

This is an important question with no easy answer. But, few would argue that a diversified portfolio benefits from having some bond investments. So, the question should be “what part of the bond market is most suitable to your goals? ” Given there are bond ETFs covering a wide range of maturities and riskiness, there is no shortage of fixed income ETFs for investors to pick from. To this end, we encourage you to subscribe to ETFMathGuy to see how we use a wide variety of commission-free bond ETFs in efficient portfolios.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

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