Tag: backtesting

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2024 Year-end returns of broad index and sector ETFs

With 2024 officially over, it is a good time to reflect on 2024 equity ETF returns. Like our mid-year post from 2024, this post highlights the top and bottom-performing ETFs by sector. We’ve added the Nasdaq-100 ETF (ticker: QQQ) 2024 returns for comparison. We also discuss what themes likely contributed to this performance.

S&P 500 Sector Returns, S&P 500 and Nasdaq ETF total returns, 2024

Top and bottom-performing sector ETFs for 2024

As the chart above shows, communication services (ticker: XTL) was the top-performing sector ETF of 2024, with a nearly 35% return. This may be surprising, given it was the worst-performing sector ETF in the 1st half of 2024. It appears that this ETF’s exposure to artificial intelligence (AI) and data centers contributed significantly to its total return for 2024. The healthcare sector ETF (ticker: XLV) was the worst-performing sector of the S&P 500 index. Considered a more defensive sector, investors were not looking for this approach in 2024. However, lower prices in the healthcare sector, relative to other sectors in the S&P 500, may bode well for healthcare ETF investors in 2025.

The S&P 500 has another strong year in 2024

For ETF investors who selected the broad-based S&P 500 index (ticker: IVV), this was another strong year, with a total return of nearly 25%. The past two years have been the best returns for this broad-market index in the past 25 years. So, investors looking for a diversified equity ETF did well in 2023 and 2024 by investing in an S&P 500 index ETF.

S&P 500 Index performance since 1995. Source: WSJ.

2025 ETF Outlook

As we noted in previous outlooks at the start of the year, there is plenty of uncertainty going into 2025. With a new political party in the White House, and the Fed still considering the potential of future rate cuts, 2025 should be another challenging year for ETF investors.

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ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs
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The biggest ETF may be changing

The largest and oldest ETF is the SPDR S&P 500 ETF Trust (ticker: SPY), with $624 B in assets under management. However, two other S&P 500 ETFs are close behind. The Vanguard S&P 500 ETF (ticker: VOO) and iShares Core S&P 500 ETF (ticker: IVV) have $588 B and $582 B of assets under management. In this post, we discuss the likely change in the largest ETF, what may be contributing to it, and why it matters to investors.

In this post, we discuss the likely change in the largest ETF, what may be contributing to it, and why it matters to investors.
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The oldest ETF, SPY

The SPDR S&P 500 ETF Trust, commonly referred to as SPY, has been around the longest of any ETF. With an inception date of January 1993, SPY created an entirely new way to invest in a passive index that offered greater tax efficiency than mutual funds. As we wrote about a few years ago, the taxable gains between ETFs and mutual funds can be significant. This tax inefficiency makes no difference for Individual Retirement Accounts (IRAs). But for taxable account holders, significant tax drag is drawing investors into ETFs. Several mutual funds are converting to ETFs.

The two other S&P 500 index ETFs

ETFs from Vanguard and iShares also offer ETFs that track the S&P 500 index. This index is very popular with many investors as it diversifies across many equity sectors. But, because of its weighting by market capitalization, some companies hold more significant influence. Nevertheless, it remains a popular index for investors. And, with an expense ratio of 0.03%, these ETFs offer this exposure with very little cost. These expense ratios are in stark contrast to SPY, with its expense ratio of 0.09%. While still small, the expense ratio of SPY is 3X larger, helping VOO and IVV to grow faster than SPY.

Another driver of ETF growth

So, investors seem to be preferring lower expense ratio ETFs. VOO’s unique structure may also be contributing to its popularity. But, this benefit, which Vanguard patented, has expired in 2023. So, IVV and VOO may continue to grow at a similar rate. For individual investors, the small difference between the two ETF structures likely makes little difference in meeting their investment objectives.

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ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs
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Utility ETFs outperforming

Returns of utility ETFs have been particularly strong over the past three months, exceeding the returns of the S&P 500 index ETF by over 10%. Our favorite WSJ writer mentioned this situation recently, along with some explanations. In this post, we explore other aspects worth considering with utility ETFs.

What is in a utility ETF?

Several ETFs focus their holdings on utility companies. The largest is the Utilities Select Sector SPDR Fund (ticker: XLU), which is over twice as large as the next largest utility ETF, the Vanguard Utilities ETF (ticker: VPU). But, these ETFs track two different indices. XLU tracks the S&P Utilities Select Sector Index, while VPU tracks the MSCI US Investable Market Utilities 25/50 Index. Consequently, XLU has 31 holdings, less than half of the 67 in VPU. However, examining the top ten holdings in each ETF reveals they are very similar. So, not surprisingly, the year-to-date returns for both of these ETFs are identical, at 12.25%.

Top Ten Holdings of the two largest Utility ETFs, as of May 31, 2024. Source: etf.com

What is driving energy demand?

As Jason Zweig’s noted in his recent article, Artificial Intelligence (AI) may be playing a role. Training AI models are very energy-intensive. And, as we’ve written about before, the largest companies in the S&P 500 are actively involved in AI development. But, Maria Pope, CEO of Portland General Electric, believes there are three big drivers increasing electricity demand in the U.S.

  • Manufacturing returning to the U.S.
  • Government support of semiconductor production.
  • Data centers and their need to train and run AI models.

Will this demand remain elevated for the foreseeable future? And, how will the markets respond? ETF investors should consider these points when evaluating sector ETFs like those focused on utilities.

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ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs
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Bond funds continue to challenge investors

Bond funds continue to challenge investors seeking less risk from the stock market, but also retaining buying power. My favorite writer Jason Zweig also wrote about this recently, along with many of his readers’ opinions. In this post, we illustrate what’s been happening over the last year since we last wrote about bond ETFs.

Bond funds and their time to maturity

Bond fund performance over the last year appears to still be heavily dependent on their time to maturity. As the image below shows, the total return of the shortest-term U.S. treasury bill ETF (ticker: BIL) was gradual and positive. The intermediate-term bond fund (ticker: AGG) nearly broke even for the last 12 months. The long-term bond fund (ticker: TLT) was most sensitive to rising interest rates and had the largest loss and most volatility over the past 12 months.

Shorter-term bond ETFs continue to perform well with low volatility. Source: etfreplay.com
Shorter-term bond ETFs continue to perform well with low volatility. Source: etfreplay.com

Bond ETFs with shorter terms to maturity

Staying with shorter-term ETFs has become much easier with several options for investors to consider. Here is a short list to consider:

  • 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)

Referring to the image above, we see that the SPDR Bloomberg 1-3 Month T-bill ETF returned 5.3%. And, as we have written about previously, this return is exempt from state taxes. This exemption is significant for states like California and Hawaii, but irrelevant for states like Texas and Florida that have no state income tax. In any case, with current inflation around 3%, these short-term investments are helping ETF investors to maintain and slightly grow their buying power.

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 tax-efficient investing with ETFs
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2023 ETF Year in Review and 2024 Outlook

The 2023 year was generally good for the stock market. We wrote previously about the possible market performance during the 3rd year of a presidential term, and 2023 didn’t disappoint. The total return, including dividends, for the S&P 500 ETF (ticker: IVV) was 26.3%, according to ETFReplay.com. However, 2023 ETF equity returns varied significantly across the eleven S&P 500 sectors. We will dive into these sectors in this post.

2023 ETF Returns by Sector

The chart below shows the total returns in 2023 for the 11 sectors in the S&P 500. As we can see, two sectors beat the S&P 500. These were the technology and consumer discretionary sectors. Artificial intelligence was a big theme in 2023 thanks in part to ChatGPT, which explains why the technology sector did so well. Consumer discretionary returns could be explained by continued pent-up demand as the impact of the global pandemic diminishes.

2023 ETF returns
2023 S&P 500 Index and Sector Total Returns.
Source: etfreplay.com

Unfortunaltely, nine sectors of the S&P 500 performed worse than the overall index. Industrials, materials, financials, and real estate did produce double-digit returns, but still underperformed the index. Also, health care, energy, consumer staples, and communication services all were nearly flat for the year. The worst-performing sector was utilities, likely due to the high levels of debt many utilities carry and how refinancing this debt in 2023 likely became much more expensive.

2024 ETF Outlook

So, where will markets go from here? Referring back to the presidential cycle analysis quoted above, the 4th year of a presidency is the second best for total returns of the S&P 500. The political uncertainty associated with year four of a presidential cycle is likely to blame. Many investors may want to see how elections this fall turn out before making larger investment decisions. And, investors may also be looking for indications from the Federal Reserve on future decisions on interest rates. Regardless of what happens on these fronts, 2024 is looking to be a very exciting year for ETF investors.

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 tax-efficient investing with ETFs
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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.

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 tax-efficient investing with ETFs
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Tax Loss Harvesting

As 2023 heads to a close, many investors are considering whether to sell investments at a loss, often referred to as tax loss harvesting. In this post, we explain this tax opportunity and the financial benefit possible from it. We also describe a pitfall that investors should avoid to achieve the benefit of tax loss harvesting.

notebook and calculator on green surface
Photo by Nataliya Vaitkevich on Pexels.com

Short-term or long-term?

Why is tax loss harvesting important? To begin, ETF investors must understand the difference between short-term and long-term gains or losses. An investor realizes a short-term loss when they sell an ETF held for less than one year. In general, taxes on losses on short-term investments in securities like ETFs occur at a higher rate than those gains realized from short-term investments. For taxpayers at the highest rates, the short-term rate is 37%, and the long-term rate is 20%.

So, if an investment is below its purchase price within one year of holding it, an investor can sell it and realize a short-term loss. This short-term loss can be deducted from any short-term gains, like those from bond or money market investments. Consequently, an investor’s income tax may be reduced.

Pitfalls

The most obvious pitfall is the wash sale rule. Investors may not obtain a tax benefit if they sell an ETF for a loss within 30 days, and then rebuy it. Consequently, such a violation eliminates the opportunity for tax-loss harvesting. Investors wishing to stay invested in the markets can opt to buy a different ETF that is not “substantially identical” and not wait 30 days.

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 tax-efficient investing with ETFs
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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.

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 tax-efficient investing with ETFs
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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.

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 tax-efficient investing with ETFs
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Funding Roth Conversions

In our post from last week, we highlighted the potential benefit of converting tax-deferred assets to a Roth IRA. We showed that the amount of tax alpha, or the amount of additional return realized from converting, depended on current versus future tax rates. However, we simplified how a retiree may fund the tax liability by using retirement assets. In this post, we show the additional tax alpha when funding Roth conversions without using tax-deferred assets.

Funding Roth Conversions Using Assets in a Taxable Account

The additional tax-alpha from using taxable account assets arises due to these assets no longer generating taxable interest and dividends owed each year. Instead, a retiree could use these assets to pay for funding Roth conversions. Consequently, the benefit of funding Roth conversions with taxable account assets grows over time. But, two additional complexities arise. The return on the underlying asset is the first. The ultimate intended use of the taxable account assets is the second complexity. Markets dictate the first complexity, but not the second.

So, we may not know how the stock and bond market will perform in the future. But, a retiree may know whether they will use taxable assets to supplement their retirement income needs. If taxable assets are used to supplement retirement income and/or for funding Roth conversions, then there will likely be a long-term capital gain that would reduce the tax alpha. Otherwise, taxable assets may pass to an heir with a step-up in cost basis, thereby eliminating the capital gain tax owed by the retiree.

Case Study Results from Over 20 Years

To help quantify the additional tax alpha, we revisited the analysis in the Roth (2020) article for a 20-year period. We added the two complexities mentioned above, that the tax alpha will depend on market returns and if the taxable account assets received the step-up in cost basis. The left panel below shows the tax alpha without the step-up included. The right panel shows tax alpha when the step-up occurs.

Funding a Roth conversion with taxable assets with unrealized capital gains.
No step-up in cost basis
Funding a Roth conversion with taxable assets with no capital gains.
Step-up in cost basis

Key Insights from funding Roth conversions

The results above indicate the importance of the step-up in cost basis on the tax efficiency of funding Roth conversions. The horizontal axis represents the fraction of the cost basis of the taxable account assets used. So, using current interest, dividends or available cash from a taxable account implies a cost basis equal to 1, and highly appreciated assets would have a value approaching 0.

  • From the left pane, the tax alpha ranges from 0.10% to 0.30% per year over twenty years. Lower (higher) tax alpha occurs when markets underperform (overperform) their historical average returns.
  • When the heir realizes the tax-efficient step-up in cost basis, the tax alpha is up to 0.10% per year over twenty years. Also, the breakeven for this additional tax alpha occurs at approximately 0.70, implying that a highly appreciated asset intended for an heir should not be used for funding Roth conversions.
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 tax-efficient investing with ETFs