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2024 Mid-Year Review of Stock-Based ETFs

Welcome to our 2024 mid-year review of stock-based ETFs. Like our previous mid-year reviews, we will discuss here how various sectors of the market performed in the last six months using ETFs. Consequently, we will show a significant performance difference between various sectors of the S&P 500.

Review of the 11 Sectors of the S&P 500

To review, recall that there are 11 sectors in the S&P 500 as shown below. So, while some of these sectors have several ETFs tracking them, we choose the ETFs in parentheses due to their long history in the markets.

  • Information Technology (XLK)
  • Health Care (XLV)
  • Financials (XLF)
  • Consumer Discretionary (XLY)
  • Communication Services (XTL)
  • Industrials (XLI)
  • Consumer Staples (XLP)
  • Energy (XLE)
  • Utilities (XLU)
  • Real Estate (IYR)
  • Materials (XLB)

Then, using this list and reinvesting dividends, we see that some sectors had total returns that did very well in the first half of 2024. However, a couple sectors, such as the Real Estate and Communication Services, lost value in the first six months of 2024.

2024 Mid-year review of S&P 500 sector ETFs. Total Returns. Source: https://www.etfreplay.com/charts.aspx
2024 Mid-year review of S&P 500 sector ETFs. Total Returns. Source: https://www.etfreplay.com/charts.aspx

Best ETF investment performers of 2024

As the chart above shows, the technology sector continues to outperform the broader index. As our favorite WSJ writer recently described, the three largest stocks in the S&P 500 (Microsoft, Apple, and Nvidia) contributed more than 20% of the total market value of the index. In fact, eight of the top ten stocks in the S&P 500 index are technology stocks. This outperformance still appears to be attributable to the substantial investor interest in artificial intelligence (AI) and how this interest is impacting other sectors, like utilities.

Outlook

While we won’t try to estimate where markets will go from here, it does seem reasonable that stock-picking to beat the S&P 500 will continue to be challenging. Thus, the high concentration of technology stocks in this index continues to propel the performance of this market cap weighted index. As a result, if the technology sector does falter, the diversification of this index may help reduce volatility.

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AI and the S&P 500

Artificial intelligence (AI) continues to impact markets like the S&P 500 in 2024. If you are already invested in broad-based ETFs, you may be invested in AI, whether you realize it or not. In this post, we discuss how AI companies are influencing cap-weighted indices.

close up photo of monitor
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Fear of Missing Out

Jason Zweig at The Wall Street Journal recently wrote an article about one of the leading AI companies Nvidia. In his article, he noted how this company was now more than 4% of the S&P 500 index, thanks to its recent rise in share price.

And, other companies working in the AI space are also seeing very positive share price increases, like Microsoft. In fact, according to this page on ETF.com, Microsoft and Nvidia now account for about 11.5% of the S&P 500 index. This weighting of AI in the S&P 500 is due to the S&P 500 being a “cap-weighted” index.

A stock market index wherein each component is weighted relative to its total market capitalization

What is a Capitalization-Weighted Index? source: Corporate Finance Institute (CFI)

So, even if an investor thinks they may have “missed out”, they have not if they owned an S&P 500 ETF or some other cap-weighted index fund.

Other firms in the S&P 500

Because the S&P 500 is cap-weighted, the firms in this index become more (or less) significant as their market capitalization increases (or decreases). The image below shows the current top-10 holdings in the S&P 500 ETF (ticker: IVV). Note that over half of those in this list are tech firms that are at the forefront of AI. In fact, for investors in Apple, there may not be enough investment in AI.

Top 10 holdings in the S&P 500 ETF IVV. Source: etf.com
Top 10 holdings in the S&P 500 ETF IVV. Source: etf.com

ETF investor options to embrace or avoid AI

Hopefully, ETF investors realize that they may already have AI investments, if they are invested in one of the ETFs tracking the S&P 500, like VOO, IVV, or the oldest ETF SPY. Alternatively, ETF investors wishing to embrace AI more may seek tech-centric ETFs, like XLK. Or, by seeking dividend-paying stocks not seeking growth from AI, an ETF investor may seek funds like DVY or VTV. Investor preference for growth in the AI space will likely affect investments for many years to come.

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Required Minimum Distributions in 2024

Happy New Year! In this post, we discuss some of the salient features of required minimum distributions (RMDs) for those in or nearing their retirement. We also provide a proactive tax-efficient strategy to help reduce the impact of RMDs.

required minimum distributions
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What is an RMD and how does it apply to me?

As their name implies, required minimum distributions (RMDs) are amounts that need to be withdrawn, or “distributed”, from a retirement account. The retirement accounts that impose RMDs typically include those with pre-tax contributions and gains, such as 401(k), IRAs, and 403(b) plans.

Required Minimum Distributions (RMDs) are minimum amounts that IRA and retirement plan account owners generally must withdraw annually starting with the year they reach age 72 (73 if you reach age 72 after Dec. 31, 2022).

U.S. Internal Revenue Service FAQs

The amount of the RMD depends on the account holder’s age, assuming they did not inherit the retirement account. As the retiree ages, the proportion of RMD distributions, relative to their total account value, increases. For example, a retiree expected to live another 20 years based on the IRS life expectancy tables must withdraw 1/20th (or 5%) of their account value to satisfy RMDs. 

Note:  This post has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Implications and Strategies for Tax Efficiency of Required Minimum Distributions

As this recent WSJ article articulated, there are several implications to RMDs on a retiree’s tax liabilities. First, after a strong year of market returns, RMDs will be even higher due to larger retirement account balances. These higher account values and subsequent RMDs could also push the retiree into a higher tax bracket. Lastly, RMDs could also trigger Net Investment Income Tax (NIIT) as well as higher Income-Related Monthly Adjustment Amounts (IIRMA).

A simple strategy to increase tax efficiency in retirement income is to plan for the future, and not always defer distributions from tax-deferred accounts, like IRA and 401(k) plans. We demonstrated in our award-winning peer-reviewed published manuscript how such a tax-efficient approach can produce 0.3% to 0.6% of additional return for a variety of retirees. Is similar planning beneficial to your situation? To find out, we encourage you to try out our retirement income planning tool recently updated for 2024 tax brackets.

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Inflation trends

The Federal Reserve’s recent announcement to hold short-term interest rates at 5.25-5.5% was well received by the markets this past week and was clearly influenced by inflation trends. After the S&P 500 recently fell into a “correction”, defined as a 10% drop from a recent peak, the index returned over 5% last week. In this post, we highlight recent inflation trends towards lower rates and note that there is still some work to do to reach the Fed’s target inflation of 2%.

Inflation over the last 12 months

According to Statistica.com, the 12-month inflation rate was 3.7%. As the chart below shows, this is a significant reduction in peak inflation of over 9% in June 2022. This reduction was largely due to seven quarters of increasing short-term interest rates, which should reduce economic activity by increasing borrowing costs. But, the Fed also has a mandate to keep unemployment low.

Monthly 12-month inflation rate in the United States from September 2020 to September 2023.
Monthly 12-month inflation rate in the United States from September 2020 to September 2023.
Source: Statistica

Unemployment and a soft landing?

Unemployment has stayed low, as the next chart shows.

Monthly unemployment rate

It is our opinion that the Federal Reserve appears to be close to reaching its goals of low unemployment and inflation. And, this all appears to be happening without triggering a recession. Our final chart shows GDP, which when its rate is negative for two quarters, is the official trigger for a recession in the U.S. As this WSJ article notes, the U.S. economy is “Improbably Strong”.

Real GDP

We conclude from these macroeconomic indicators that the U.S. economy, inflation, and unemployment appear good for now. With the year nearly over, we will see very soon how consumer sentiment and consumer spending around the holidays may influence these indicators.

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The Federal Funds Rate and ETFs

In early 2022, the U.S. Federal Reserve began raising the federal funds rate in an effort to reduce inflation. According to TradingEconomics.com, this effective rate grew from near 0% to over 5% in the past seven quarters, reaching a 22-year high. In this post, we examine ETF returns during this period of rate increases.

Stock and Bonds ETFs

The chart below shows the last seven quarters of ETF total returns, which includes price appreciation and short-term capital gains. This time frame corresponds to the increase in the federal funds rate. Investors saw positive returns in only two ETFs during this period of increasing rates.

Stock, Bond, and Cash ETF total returns during the recent period of increasing federal funds rate.
Stock, Bond, and Cash ETF total returns during the recent period of increasing federal funds rate.
Source: ETFreplay.com

Stock ETF returns during this period were mixed. As shown in black, the iShares S&P 500 Value ETF (ticker: IVE) was the best-performing stock ETF. During this time, the iShares Core S&P 500 ETF (ticker: IVV) in green and the iShares S&P 500 Growth ETF (ticker: IVW) in red lost 7% and 17%, respectively. Clearly, investors preferred value over growth during this period. Investors may have had concerns about the increasing cost of financing a firm’s growth opportunities. Alternatively, investors may have preferred dividend-producing firms commonly found with value stocks.

Intermediate and short-term Bond ETFs returns and increasing federal funds rate

The iShares Core U.S. Aggregate Bond ETF (ticker: AGG) also had a negative return during this period, consistent with how rising bond yields generally reduce bond prices. However, for short-term treasury bond ETFs like the iShares Short Treasury Bond ETF (ticker: SHV), investors saw a slow and steady climb. As we’ve written before, the increasing federal funds rate contributed to this growth. And, this short-term bond fund also has tax-efficient benefits when compared to money market funds and short-term certificates of deposit.

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Bond ETFs amid rising interest rates

Interest rates continue to rise, with the Federal Reserve recently raising its benchmark rate to a range of 5.25% to 5.5%. While borrowers may face higher costs, new investors in short-term Treasurys now realize these higher annual rates. However, investors in certain bond ETFs could also realize this rate with added liquidity, and convenience, while potentially avoiding state and local taxes.

US Treasury Bills are backed by the full faith and credit of the U.S. Government

Short-term investment options

There are several common approaches for investing in the short term, which we characterize as less than one year. Thankfully, these investments have zero default risk because the full faith and credit of the US Government backs them.

These investments include bank CDs, direct purchases of US short-term Treasury bills, money market funds, and certain Bond ETFs. Firstly, bank CDs and money market funds may be the most convenient for individual investors. Short-term bank CDs are currently yielding over 5%, and money market funds provide similar returns within most brokerage accounts. Unfortunately, both of these short-term investments are often subject to both state and federal income taxes. For residents of California, Hawaii, and New Jersey, the top state income tax rate exceeds 10%.

Bond ETFs for Tax-efficient investing in the short term

Alternatively, similar returns are possible if an investor chooses to purchase short-term Treasury bills from the U.S. Department of the Treasury. Or, an investor may purchase US Government Bonds ETFs. Both of these options are exempt from state taxes. However, treasury bills have maturity dates of 4, 8, 13, 26, or 52 weeks. So, at maturity, the investor receives back their investment plus interest. That means that an investor would need to regularly re-invest in treasuries at TreasuryDirect.gov.

To avoid the need to continually re-invest, and likely avoid state taxes, there are several short-term Bond ETFs to choose from. Here are just a few, that with reinvested dividends have returned 2.5-2.8% so far this year (e.g. from December 30, 2022, to July 28, 2023).

  • SPDR Bloomberg 1-3 Month T-Bill ETF (ticker: BIL)
  • iShares Short Treasury Bond ETF (ticker: SHV)
  • Goldman Sachs Access Treasury 0-1 Year ETF (ticker: GBIL)
  • iShares 0-3 Month Treasury Bond ETF (ticker: SGOV)
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The Arithmetic of Roth Conversions

In our recent posts from March, April, and May 2023, we highlighted some important considerations when making a Roth conversion. In this post, we continue this conversation with a recent article published in the May 2023 edition of the Journal of Financial Planning, entitled “The Arithmetic of Roth Conversions”. I was very fortunate to co-author this article with my colleague Dr. Edward McQuarrie, Emeritus Professor at Santa Clara University.


McQuarrie, Edward F., and James A. DiLellio. 2023. “The Arithmetic of Roth Conversions.” Journal of Financial Planning 36 (05): 72–89.

Executive Summary

• Roth conversions continue to vex planners. To clarify matters, this paper submits conventional rules of thumb to a strictly arithmetic analysis.

• The treatment shows that it must be optimal to pay tax outside the conversion with cash, confirming one common rule. But if tax must be paid to raise the cash used to pay the conversion tax, there will be an initial loss on the conversion and a subsequent breakeven point. This paper shows how to determine time to break even.

• By the same arithmetic, the paper refutes the common rule that future tax rates must be higher for a conversion to pay off. Given enough time, conversions can overcome moderately lower future tax rates and still produce a substantial payoff due to the power of compounding.

• Most Roth conversions will show a substantial payoff if the client’s planning horizon stretches over decades; however, shorter time frames may produce only a minimal payoff or even a loss.

• The paper gives practical advice regarding the optimum time to convert, points in the tax structure that favor or disfavor conversion, and the clients most and least likely to receive a substantial payoff from conversion.

Key points to consider when reviewing “The Arithmetic of Roth Conversions”

This article highlights the importance of the following key items:

  1. Current and future tax rates
  2. How time can help a conversion generate a positive payoff
  3. The type of retirees well suited and not suited for Roth conversions

We also encourage you to try our retirement income calculator. It was recently updated to include both optimal account drawdowns and Roth conversion analysis.

We hope you find this latest research article helpful in your own retirement planning or your financial planning practice!

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Roth Conversions with Optimal Withdrawals

In our posts from March and April, we discussed several aspects of Roth conversions. We showed that, if tax rates are higher in the future, Roth conversions can have a positive payoff. For tax-deferred assets, like pre-tax assets in a 401(k) or IRA, a retiree may pass some of these assets to an heir. The heir’s income tax rate determines the after-tax value of inheriting tax-deferred assets. This week’s post highlights the most recent software update made to our Optimal Retirement Income Calculator, which now includes Roth conversions and optimal withdrawals simultaneously!

How to model Roth conversions with Optimal Withdrawals

Roth conversions reduce tax-deferred assets by “converting” those assets in any year to a Roth account. Individuals performing a Roth conversion owe income taxes on the amount converted. But, the converted amount increases the individual’s Roth account assets, which a retiree can often access tax-free in retirement. One goal of generating tax-efficient retirement income is for optimal withdrawals to avoid large “spikes” in ordinary income. Our Optimal Retirement Income Calculator does this automatically and considers the tax rate of the heir under three distinct scenarios.

  1. A retiree has insufficient funds to satisfy retirement income
  2. A retiree has sufficient, but not excessive funds
  3. A retiree has excess retirement funds
Roth conversions and optimal withdrawals from Seeking Tax Alpha in Retirement Income
Source: “Seeking Tax Alpha in Retirement Income“, to appear in Financial Service Review (2023)

Excess retirement funds and the importance of your heir(s) tax rate

In scenarios 1 and 2, the top and middle portion of the image above, our calculator already finds the lowest marginal tax rate to efficiently distribute tax-deferred assets.  Consequently, our Optimal Retirement Income Calculator already provides a withdrawal strategy to utilize your tax-deferred assets efficiently. So, no additional tax-alpha is possible with a Roth conversion.  However, this is not the case in scenario 3 or the lower right portion of the image above.

When a retiree’s assets are far beyond what is needed to support their retirement income needs, many of their assets will eventually be passed to an heir. In this case, our Optimal Retirement Income Calculator previously left a significant amount of tax-deferred assets to an heir. With our latest software update, a new Roth Conversion Analysis includes converting tax-deferred assets to a Roth account “using up” the retiree’s tax brackets that are less or equal to those of the heir. For example, if your heir has an expected income tax rate of 25%, scenario 3 would perform a Roth conversion up to the 24% tax bracket. Doing so typically adds about 0.10% tax alpha. We encourage you to use our Optimal Retirement Income Calculator to evaluate possible situations for you or your clients. You can easily see if a Roth conversion with optimal withdrawals provides an additional benefit.

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Roth Conversions that Payoff

Roth conversions for retirees and individuals nearing retirement often confuse financial planners and individual investors. In this post, we discuss the pros and cons of converting a portion of tax-deferred assets to a Roth IRA. The insights I share here reflect early results from a recently conducted research initiative.

Why Convert to a Roth IRA?

Converting funds from a tax-deferred account, like a 401(k), 403(b), traditional IRA, or rollover IRA, may seem counterintuitive to many. Indeed, in my recent award-winning article on Seeking Tax Alpha in Retirement Income, which will soon appear in the Financial Services Review, I highlighted how many tax professionals, like CPAs, generally advocate deferring taxes for as long as possible. Converting funds to a Roth IRA imposes a current tax liability, contradicting this conventional wisdom. However, the communicative law of multiplication suggests otherwise for funds converted at the end of the year. A positive payoff occurs when the current marginal tax rate is less than the future marginal tax rate. Stated more simply:

Always seek the lowest marginal tax rate, either now, or in the future, when converting, or distributing tax-deferred assets.

Adapted from DiLellio and Ostrov (2017) “Optimal Strategies for Traditional versus Roth IRA/Roth 401(k) Consumption During Retirement”, Decision Sciences Journal. 48(2).

Tax Alpha from Converting to a Roth IRA

In my recent unpublished research results with Ed McQuerrie, we propose to show the benefit of Roth conversions in terms of tax alpha or the additional annual return realized by converting. If a distribution from the Roth IRA then pays the taxes, the figure below shows the tax alpha over a number of holding periods, from five to 40 years. We see that when future tax rates are higher, there is a significant benefit, but that tax alpha diminishes over time. Similarly, if an investor converts their tax-deferred assets and the future tax rates are lower, the negative payoff can be significant initially, but the loss will also diminish over time.

Tax Alpha from Roth Conversions if future marginal tax rates are 50%, 95%, or 150% of the current marginal tax rates
Tax alpha if future marginal tax rates are 50%, 95%, or 150% of the current marginal tax rates

The Challenge to Roth Conversions

The U.S. Congress sets tax rates. So, we can’t know future tax rates with certainty. But, a retiree is able to control the amount of ordinary income generated by distributions from tax-deferred accounts. Also, the results above assume the investor is at least 59 1/2 so they can avoid the tax penalty on early withdrawals to fund the tax liability. In our next post, we will highlight some beneficial results if an investor pays conversion taxes with a non-retirement account.

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A Presidential Cycle and the Markets

The stock and bond markets are off to a great start for 2023. This news is especially notable after a difficult 2022 for stock-based ETF investors. Including dividends and interest, the iShares Core S&P 500 ETF is up 6.3%, and the iShares Core Total US Bond ETF is up 3.3%. While a strong start can be helpful against losses later in the year, what may be more relevant is that we are now in the third year of a presidential cycle. In this article, we discuss this unusually strong relationship.

Data since 1933

According to a researcher at Charles Schwab using data from 1933 to 2015, the S&P 500 had average returns in the first, 2nd, 3rd, and 4th years of a presidential cycle of 6.7%, 5.8%, 16.3%, and 6.7%, respectively. So, in the third year of the presidential cycle, there was nearly a 10% increase in average returns. We revisited this data to include the end of the Obama administration, as well as the four years of the Trump administration and the first two years of the Biden administration. The results appear in the table below, which indicates that, even with the impact of the global coronavirus pandemic, the relationship still holds.

Presidential YearAverage Return (%)Sample Size
16.724
23.324
313.523
47.523
Average Returns of the S&P 500 from 1928 to 2022. Data Source: www.macrotrends.net

Clearly, we find that correlation is at play here, although the sample size is not very large. But, what could be the cause of this outperformance?

Possible Causes

A 2013 study at the University of Chicago attributed the effect of the 3rd year of a presidential cycle to increased future uncertainty of what a change of administration may cause. Others have argued that in the third year, the current administration has some momentum to start seeing the impact of their policies being implemented. But, it is always important to note that correlation is not causation, and there are likely many other factors at play that are producing this unusual market behavior. By the end of this year, we will see if the 3rd year of the Biden administration continues this outperformance.

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