Tag: backtesting

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The latest news on proposed tax changes

There is good and bad news on the latest proposal for tax changes on investments. In this post, we summarize the latest in a developing set of changes to future taxes on long-term investment gains.

Good news on proposed tax changes

According to the WSJ, the House Ways and Means Committee will not raise taxes on long-term capital gains to over 40%, as proposed by the Biden administration. So, an ETF investor should hopefully not see their long-term capital gains tax nearly double by realizing them.

Instead, the current rate of 23.8% would increase by 5% to 28.8%. This rate typically applies to qualified dividends too, such as those produced by an S&P 500 index fund like IVV. Additionally, lawmakers appear to be preserving the step-up in cost basis for inherited assets. This is good news for ETF investors, as we noted previously.

quote box ontop of stack of paper bills
Photo by Karolina Grabowska on Pexels.com

Bad news

Unfortunately, the proposed tax changes can have a significant impact on the windfall resulting from the sale of a home or business. Home sellers do have an exemption, but these limits can easily be exceeded for those living in high cost of living areas. And, since some home sellers may be recently widowed, these individuals would be even more adversely affected. Recently widowed individuals will see their exemption cut in half as they can no longer file their tax returns as married. For business sellers who may have invested much of their nest egg into building their business, this additional tax could significantly reduce the after-tax value of their sale.

Updated optimal portfolios

For subscribers of our ETF optimal portfolios, we encourage you to log in to see the latest updates. Note that, based on our latest backtesting, monthly portfolios change more quickly now to respond to market dynamics.

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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Retirement tax alpha and optimal retirement drawdowns

Tax alpha refers to the additional rate of return generated by making tax-efficient investment decisions. For retirees, we provide an optimal retirement income calculator that models the U.S. tax code and determines an optimal drawdown strategy. Here, we discuss a recent upgrade to this calculator that quantifies your potential retirement tax alpha using an optimal drawdown strategy.

retirement tax alpha and your optimal retirement income strategy
Retirement tax alpha and your optimal retirement income strategy
Photo by Nataliya Vaitkevich on Pexels.com

What is alpha?

In the investment world, the return not captured by the movement in the broad market is alpha. Thus, for many investors, it means a risk-less return. In fact, we’ve even talked about it before in the context of CAPM and its counterpart, beta. Alpha and beta provide portfolio statistics important for consideration by any investor.

What is tax alpha?

Tax alpha is a relatively new term and may differ based on the source. We like the following definition.

If “alpha” is the return generated by an advisor’s skill in picking and managing investments, then “tax alpha” protects that return and generates a boost by making sure that taxes don’t eat away more of a client’s wealth than absolutely necessary.”

Source: https://www.atstax.com/p/what-is-tax-alpha

What about in retirement?

In retirement, tax alpha focuses on tax-efficient drawdowns. In addition, the industry standard for retirement income drawdowns from taxable, tax-deferred, and tax-exempt accounts is the Common Rule. The image below shows a summary of the default case used in our optimal calculator, which compares its results with those from the Common Rule.

Summary of Optimal Retirement Calculator. Source: https://app.etfmathguy.com/

This last line (line 4) indicates the value of tax-alpha of 0.57%. That is, a retiree would need to generate pre-tax returns 0.57% higher using the Common Rule to generate the same after-tax inheritance for their heirs. Therefore, by making optimal drawdown decisions in retirement, a retiree can expect to increase their investment returns using the Common Rule. Interested in seeing the details of this example or inputting your own assumptions for retirement? If so, please try our free online calculator.

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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Backtesting for 2021 and ETFMathGuy portfolio enhancements

Due to portfolio performance not meeting our recent expectations, we revisited our backtesting results from August 2018 and produced important new insights and portfolio construction enhancements. We discovered that a longer sample period, identified previously, no longer applied. The image below shows that a three-month sample period produced the best returns from January 2020 to August 27, 2021. Each point on this line plot represents annualized backtested performance for 19 monthly portfolios over this testing period.

Backtesting for 2021 to find the optimal sample period (months) for ETFMathGuy Portfolio Construction
Backtesting for 2021 to find the optimal sample period (months) for ETFMathGuy Portfolio Construction

What performance predictions occurred with this shorter sample period?

Using this shorter sample period, we produced the plot below of total return since January of 2020. We chose this time period to include the full pre and post-term effects of the coronavirus on the world economy. In addition, and based on subscriber feedback, we now exclude ETFs that issue K-1 tax forms to investors. We made this decision because these 22 ETFs had a marginal effect on backtested performance that used over 1,000 other ETFs that do not issue K-1s. We also increased our ETF filter threshold of median volume to improve liquidity for future portfolios that will likely have a higher turnover rate. The consequences of these decisions on backtested performance appear below.

Backtested Returns from 2020-2021 of the ETFMathGuy Optimal Portfolios
Backtested Returns from 2020-2021 of the ETFMathGuy Optimal Portfolios

Future ETFMathGuy portfolios

Given the improvement potential identified from this updated backtesting for 2021, all portfolios published in September 2021 and later will follow these updated findings. This update for the September portfolios will likely indicate a significant change from the August portfolios. However, future monthly portfolios will change less significantly. So, we encourage subscribers to log in and see the September ETFMathGuy portfolios that are based on this evidence-based analysis.

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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Recap of the first half of 2021

Greeting ETFMathGuy subscribers! This post is a reminder that the latest free and premium optimal portfolios are now available for your review. So, please log in and see how the latest market conditions have affected these ETF portfolios. To begin, we discuss value versus growth ETFs and recent trends in their returns.

Recent returns on value investing leveling off?

A few months ago, we wrote about how value-driven ETFs returned about 5% more in the first quarter than growth ETFs. Revisiting the returns of the ETFs IVV, VUG, and VTV for the first half of 2021 shows this gap has shrunk to 3% after growing to more than 10%. In fact, as the chart here shows, the value ETF is below its early May high, while the growth ETF appears to have begun a new upward trend.

Total returns of value and growth ETFs.
The total return of value and growth ETFs in the first half of 2021. Source: www.ETFReplay.com

Is the relationship between value and growth ETFs typical?

The relationship between two variables can be directly measured using correlation which varies between 1 and -1. So, a correlation of 1 between two investment returns indicates their returns are identical. Traditionally, the correlation between value and growth investments was around 75%. However, as this Wall Street Journal article highlights, the current correlation between growth and value is now below 25%.

Correlation between value and growth returns.
Source: Wall Street Journal, June 28, 2021, by James Mackintosh

Performance of the ETFMathGuy Premium Portfolios

Based on actual investment performance, the risk and return of the moderate and aggressive portfolios over the last 18 months appear below. Consequently, this period includes all of the calendar year 2020, and the first half of 2021.

ModerateAggressiveS&P 500 (IVV)
volatility (risk, annualized)19.5%22.5%21.2%
total return23.9%32.7%36.4%
Annualized risk and total return of the ETFMathGuy portfolios, 2020-2021 (18 months).

We will continue to update our ETFMathGuy portfolios with current market conditions using our updated backtesting calibration results. So, time will tell if value ETF investing continues to outperform growth ETF investing.

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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Three Tips on Your Retirement Drawdown Strategy

Below are a few excerpts from my recent article published on the Pepperdine Business Blog. I hope you find these tips helpful when developing your retirement drawdown strategy, whether you are nearing or already in retirement.

Sources of Retirement Income

Your retirement income will differ in several ways from your working income. For many retirees in the U.S., social security will provide a “base” of income, and starts between ages 62 and 70.  Since the U.S. government keeps track of life expectancy, it is not surprising that retirees will receive smaller monthly social security payments if they begin drawing down social security at a younger age.  So, one drawn strategy could be to delaying social security until age 70, which can provide more income if the retiree expects to significantly outlive their peers.

Retirees often have many sources available to meet their retirement income needs.
Retirees often have many sources available to meet their retirement income needs.

To supplement social security, many retirees also employ a drawdown strategy to their taxable, tax-deferred (e.g. 401(k)s) and tax-exempt accounts (e.g. Roth IRAs). The Common Rule is the most common strategy, that begins by taking Required Minimum Distributions (RMDs). Then, the Common Rule draws funds from one account until no assets remain. This strategy then moves to the next account

Your heir’s tax rate

Extending portfolio longevity or increasing your heir’s inheritance requires some thought to your heir’s tax rate. Why? Tax-deferred accounts are more valuable when drawdowns occur at lower tax rates. So, if your heirs expect to have a high amount of taxable income, then it is usually more tax-efficient for you, the retiree, to draw down the tax-deferred account each year up to, but not exceeding, your heir’s tax rate. This drawdown strategy, which includes an assumption of your heir’s tax rate, is embodied in our free online calculator.

Click here to launch the Optimal Retirement Income Calculator by ETFMathGuy.
Click here to launch the Optimal Retirement Income Calculator by ETFMathGuy.

June 2021 ETFMathGuy Portfolios

As a final note, thank you to all of our premium subscribers! You can now access the June optimal portfolios, based on data through May 28th, 2021. Please note we built these ETF portfolios using our latest backtesting results.

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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Backtesting ETF portfolios

Backtesting ETF portfolios is a very important part of validating any investment strategy that uses them. At ETFMathGuy, we backtest our optimal portfolio construction strategy periodically. Doing so ensures that our quantitative methodology stays calibrated to the highest performing portfolios. Here, we discuss the key findings from this recent analysis.

Backtesting methodology

Our backtesting methodology follows the same approach we used in our previous backtesting analysis. The key distinction now is our time period begins in 2014 and runs through April of 2021. Also, we focused on one-month holding periods this time. Why? Based on our previous results, we found holding periods between 1-3 months had little impact on returns.

Backtesting ETF results over a longer-term

Firstly, the chart below shows the result of changing the duration of the sampling period on the out-of-sample returns. Note that there are two local maximums, with the first occurring and the 6-9 months, but a second more substantial maximum occurring at about 39 and 45 months.

Annualized returns from backtesting differing sample sizes. Source: ETFMathGuy.com
Annualized returns from backtesting differing sample sizes. Source: ETFMathGuy.com

However, when a risk-adjusted return is considered, we can improve this calibration. In the next figure, we show the annualized return divided by the annualized volatility. Thus, it’s clear that the 39 month sample period is superior with this measure for the moderate and aggressive portfolios. For the conservative portfolios, there is only a slight degradation in risk-adjusted return over these 7+ years of backtesting.

Annualized returns / volatility from backtesting differing sample sizes. Source: ETFMathGuy.com
Risk-adjusted returns from backtesting differing sample sizes. Source: ETFMathGuy.com

Backtesting ETF results over a shorter term

We also backtested our quantitative strategy over a shorter interval of the last 15 months, from January 2020, through April 2021. Ideally, our backtesting results over the long-term, shown above, should agree with this shorter time frame. And, in fact, they generally do.

Annualized returns and risk-adjusted returns from backtesting differing sample sizes. Source: ETFMathGuy.com
Annualized returns and risk-adjusted returns from backtesting differing sample sizes. Source: ETFMathGuy.com

Once again, with the slight exception of the conservative strategy, the 36-39 month sample size provided the largest annualized returns and risk-adjusted returns.

Key takeaways

  • Backtesting provides an estimate on how our quantitative strategy would have performed based on historical time periods.
  • The best calibration for the sample period occurs around 39 months based on both absolute return and risk-adjusted return.
  • Longer-term and shorter-term backtesting provided similar calibration results.
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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Value or Growth ETFs?

Investors continue to debate the benefits of value versus growth investing. The recent rotation into value stocks has only heightened this discussion. But, what is the difference between these two investment approaches when using ETFs?

photo of person holding ceramic mug
Photo by Anna Nekrashevich on Pexels.com

How a firm uses its earnings

While there can be many ways to categorize an ETF as a “growth”, one very simple approach is to look at what the firms in the ETF do with their earnings. Businesses like banks, utilities, and well-established firms like Disney or Johnson & Johnson generally pay a dividend. Back in the days of high-priced commissions to buy and sell an ETF, these dividends were very convenient, because they provided cash to investors without requiring them to sell a portion of their shares. Of course, with most brokers providing $0 commission trades, this aspect of dividends is less compelling. Perhaps more importantly though, firms issue dividends when they prefer to return some earnings to the shareholder, rather than reinvesting it into the business.

Growth companies and dividends

Alternatively, most growth companies see that their earnings could be better used if reinvested in the firm. Reinvestment can take the form of a new production facility, research & development, or others. Technology stocks are most often referred to as growth stocks due to their often relentless pursuit of innovation. Notable examples of growth companies are Apple Inc., Microsoft, and Tesla.

What is a better investment?

The debate between value and growth investing appears never-ending. Consider the last 3 years of investment in the Vanguard Large Cap Growth and Value ETFs (tickers: VUG and VTV). For reference, the S&P 500 ETF from iShares (ticker: IVV) also appears, which is a blend of both kinds of stocks.

Three year of total return of large cap growth, value and the S&P 500. Source: www.ETFReplay.com
Three year total return of large cap growth, large cap value and the S&P 500. Source: www.ETFReplay.com

From this chart, the growth ETF outperformed the value ETF over the last three years by greater than a factor of two, while producing little additional volatility. However, so far in 2021, this value ETF performed better than the growth ETF by about 5%, as shown below. Additionally, this value ETF achieved this outperformance with lower volatility.

2021 year to date total return of large cap growth, value and the S&P 500. Source: www.ETFReplay.com
2021 year to date total return of large cap growth, value and the S&P 500. Source: www.ETFReplay.com

Diversify the effect away

Not sure if value or growth is right for you? A simple way to avoid this debate is to diversify into both growth and value simultaneously. By investing in an S&P 500 index ETF, you also get access to a single investment that is extremely liquid and very cost-efficient.

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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Risk-seeking investors and the first quarter of 2021

There was plenty of risk-seeking in the first quarter of 2021. So, how did the stock and bond market respond?

A Unique Quarter

This recent Wall Street Journal article summarized this first quarter well. The author identified the following contributors to recent market behavior due to risk-seeking investors.

  1. Meme stocks
  2. Interest rates
  3. Tech rotation

Meme stocks and the Fear Of Missing Out (FOMO)

The most popular “meme” stock was GameStop Corp. for risk-seeking investors. But, what is a meme stock? This source describes it as a stock that exhibits rapid price growth that is popular among millennials. Meme stocks can also be categorized by high volatility, fueled by the so-called Fear Of Missing Out (FOMO) and panic selling. Time will tell if this category of stocks becomes more formalized, as many in the workforce return to their offices, thereby limiting their trading time. Of course, the effect of social media on stock trading isn’t likely to go away anytime soon.

A new trend in interest rates?

The other big news in the first quarter was the increase in interest rates. Long-term bond yields increased in February and March, after starting the year at 0.917%.

U.S. 10 Year Treasury Note Yield in First Quarter of 2021. Source: MarketWatch.com
U.S. 10 Year Treasury Note Yield in First Quarter of 2021. Source: MarketWatch.com

By the end of the first quarter of 2021, the U.S. 10 Year Treasury Note yield rose to 1.745%. As we wrote about before, the price of a bond decreases when yields rise. Consequently, the iShares Core Total US Bond ETF fell, to a year-to-date loss of 3.4%.

Total Return of iShares Core Total US Bond ETF, First Quarter of 2021. Source: ETFReplay.com
Total Return of iShares Core Total US Bond ETF, First Quarter of 2021. Source: ETFReplay.com

Tech Rotation

The first quarter was also characterized by about a 5% return difference between the Dow and Nasdaq indices. For instance, Exxon Mobil Corp. is up 35% this year, while Amazon and Apple have lost 5% and 7.9%, respectively. Of course, no one knows if this rotation out of tech and into energy is a new trend or just a reaction to markets anticipating a future with more energy consumption due to increased commuting. But, these recent changes have been incorporated into our portfolio construction process to produce an update to our free and premium portfolios. We encourage you to log in to see how these ETF portfolios changed due to the latest market dynamics.

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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Future tax uncertainty

The economic stimulus signed this past week by President Biden has many investors wondering if taxes may change in the future. So here, we discuss the possibility of future tax uncertainty. We also show you how to assess this uncertainty in your retirement income plan using an upgrade to our optimal retirement calculator.

$1.9T of economic stimulus

On March 11, 2021, President Biden signed the $1.9T stimulus package. There are many elements to this aid package, including how it will be paid. However, the level of debt held by the U.S. government continues to grow relative to total economic output, as measured by Gross Domestic Product (GDP). One simple solution to reducing this debt burden is to increase individual and/or corporate taxes. And, in 2026, the Tax Cuts and Jobs Act (TCJA) expires. So, what plans should an individual investor be making today if tax rates change significantly in the coming years?

Our optimal retirement income calculator now models tax uncertainty

Since we don’t know what the U.S. Congress will decide in 2026, nor what a future president may sign into law, future tax uncertainty is important for retirement planning. To this end, we recently upgraded our optimal retirement calculator to include this future uncertainty.

Now, under section “Other tax-related information“, you will see two inputs to model this uncertainty. First, there is new input for a percent increase or decrease of future income and capital gains tax rates after the TCJA expires. The 2nd entry is the year this higher or lower rate will occur. The default input values assume that the TCJA will be extended throughout your retirement horizon.

Future tax uncertainty inputs for optimal retirement income planning. Source: app.etfmathguy.com
Future tax uncertainty inputs for optimal retirement income planning. Source: app.etfmathguy.com

A simple example of rising tax rates on a retirement income plan

So, what happens if tax rates increase by 20% in 2026? A retiree using the Common Rule strategy can expect their bequest to shrink by about $92,000, from $1.227M to $1.135M. However, the Optimal Rule only expects to shrink the inheritance by about $36,000, from $1.638M to 1.602M.

What can we conclude from this? First, and most obviously, higher tax rates will reduce an heir’s inheritance. But, more importantly, optimal drawdown strategies become even more important when tax rates rise, since there is more of an opportunity for tax efficiencies.

Acknowledgments

We would like to thank Mr. Phil DeMuth at Conservative Wealth Management LLC for suggesting upgrading our calculator to include future tax uncertainty. Additionally, we wish to thank Mr. Noah Beecher at Cipolla Financial & Insurance Services for noting a discrepancy in our calculator’s pension income, which has now been corrected. For the many others who have sent us suggestions on other improvements to our online calculator, please stand by. More enhancements will be appearing in the coming months. Thank you for your suggestions and your patience!

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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Bond Markets Fell in February 2021

ETFMathGuy optimal portfolios are now available to free and premium subscribers. Please log-in to see them now. In this post, we discuss how the bond markets fell with rising interest rates this past month, and its effect on the stock market and our ETF portfolios.

Bond markets fell. What is happening with interest rates?

The recent reaction of the bond markets appears to be due to investors being less convinced that U.S. Government interest rates will remain low for the long-term. Based on recent Wall Street Journal reporting, demand for the 10-year U.S. Treasury note has been “tepid”. With lesser demand come lower prices to stimulate buying. And, when prices go down in a bond, its interest rate goes up. How so? One simple way to think about this relationship is from the bond seller’s perspective. If the demand for bonds goes up, the bond seller can set a lower fixed interest rate and still find a buyer. Conversely, the bond seller must provide higher fixed interest rates, thereby compensating the bond investor more, if demand is low. If all this sounds confusing, please take a look at the nice visual representation below.

The seesaw relationship between bond prices and interest rates. Source: Securities & Exchange Commission
The seesaw relationship between bond prices and interest rates. Source: Securities & Exchange Commission

Why is demand low for U.S. Government bonds?

The most obvious explanation for the low demand for bonds is the large amount of debt the U.S. Government is expected to sell to fund the ongoing stimulus efforts. One measurable effect of this stimulus is to continue to keep the U.S.’s debt-to-GDP ratio above 100%. Servicing this debt will slowly become more expensive as interest rates rise.

How did ETFMathGuy Premium Portfolios do in February 2021?

Our portfolios gave back some of their gains in January, in part due to the increased chance that interest rates may be on the rise, increasing corporate borrowing costs. The chart below shows the year-to-date returns of stocks, bonds, and ETFMathGuy premium portfolios held at Fidelity and Schwab. Notice how the low demand for bonds has reduced the total return for the iShares Core U.S. Aggregate Bond ETF (ticker: AGG).

Total returns for ETFMathGuy premium portfolios for January and Februrary, 2021

We hope this post provided you with some helpful perspectives on why the bond markets fell, and how the stock market, ETFs, and the overall economy are all dependent on one another.

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.