A Loose Plan for the Summer

After the mildest Spring in recent memory here in Central Texas, Summer has arrived in oppressive yet familiar fashion over the past couple of weeks. I can attest to that first hand as I’ve spent most afternoons and weekends for the past month on the softball field coaching my daughter’s All Star Team. With the temps rising, thoughts of cool vacations also increase.

Due to the uncertainty of not knowing exactly when softball season will end, coupled with my son’s first summer job as a lifeguard for the City of Austin, we have not scheduled any travel or vacations as of yet. That’s not to say that we aren’t going anywhere, it’s just going to be a little more impulsive than our normal meticulously planned sojourns.

This may not seem to be much of a topic for an investing blog, except to illustrate that a “plan” doesn’t have to be inflexible or so detailed that the journey is no fun. In our case, we have written down a few ideas of things we may like to do, but none are on the calendar or part of a larger agenda. If we can grab a day or two or six along the way, we plan to take advantage of any deals or incentives that come along to scratch some of these off of our Texas Bucket List.

Stating an objective is perhaps the most important part of any plan, whether it’s summer travel or some financial outcome.  Just as we seldom get in the car just to drive (at least in the Austin gridlock also known as the failed strategy of “Don’t build it and they won’t come”), having an objective can have many benefits. By being flexible and having several goals, you may even save a few bucks waiting for last minute deals as they come available.

This approach can also help you handle unexpected windfalls. If you get an unexpected raise at work, a big tax refund, or a nice birthday check from Grandma, it can be tempting to blow it on booze and cigarettes, but just giving some forethought to what you’d like to accomplish in life can make it easier to take full advantage when the unexpected arises.

There is also the benefit of reducing the chance of missing an opportunity that you will regret later in life, such as the time I passed on driving to Houston with some college buddies to see The Highwaymen at the Houston Livestock Show and Rodeo. No tickets, no money, and only about a half tank of gas persuaded me to stay home, but those that went wound up getting in for free and seeing Willie, Waylon, and the boys (Johnny Cash and Kris Kristofferson).

So here is my list of travel objectives for the summer, maybe it will inspire you to make one too. Travel, personal, financial, whatever…

Blue Hole, Wimberley, TX. – Blue Hole is a natural swimming hole located on Cypress Creek that is surrounded by large cypress trees. The water is clear and cold and there are chain swings to keep the more adventurous ones busy. Word is you have to get there early to beat the crowds on weekends, so this will probably be a midweek day trip.

Photo by robert thigpen

Marfa’s Mystery Lights, Marfa, TX – The lights appear in the southwestern night sky between Marfa and Paisano Pass when the weather is clear. The first reports of the lights reportedly were in 1883 and they have been drawing crowds ever since. If lights aren't your thing, there is also quite an art scene and a disproportional number of good restaurants for a town this size.  

Photo by steve baxter

Colorado Bend State Park, Bend, TX – Colorado Bend State Park is on the Colorado River above Lake Buchanan and west of Lampasas. It boasts over 5000 acres of hiking, camping, mountain biking, as well as fishing, swimming, and kayaking. Caves and waterfalls are the highlights with Gorman Falls being the star of show.

Photo by Randall Chancellor

Palo Duro Canyon State Park, Canyon, TX – The “Grand Canyon of Texas” is the second largest canyon in the US. Highlights include hiking, biking, and horse trails as well as camping and the outdoor musical drama, TEXAS.

Photo by Steve Rainwater

Rockport, TX – Rockport Beach is known as the only “Blue Wave Beach” in Texas. Beach activities, golf, and bird watching are also huge draws to this charming coastal community. But it’s the world class fishing for trout and redfish that has me excited about heading to the bays.

Photo by Vincent Lock

Since all of the destinations on my list are within a few hours drive of Austin, we will probably forgo the interstates and take the scenic routes, stopping along the way at whatever looks interesting.

Now that’s a plan.

Business Owners: Time to Cash Out? There's a Plan for That

Photo by www.stockmonkeys.com

When I founded ATX Portfolio Advisors, there was a fairly straightforward concept that I had in mind. ATX would be an independent, fee based investment advisor, that specializes in managing unplanned wealth. I am often asked what is the definition of “unplanned wealth”. The short answer is that you have accumulated some money, but now don’t really know what to do with it.

That’s not to say that I’m not very happy to help someone that has been diligently planning their savings and investments for specific goals since they graduated high school, it’s just that I believe I add the most value when someone really needs help creating a plan to manage their wealth, as well as the actual implementation of the plan.

For most financial firms, the ideal client is someone with a retirement account that is ready to change jobs or retire, and needs to convert savings to income. When you are dealing with a 401(k) or IRA, rolling over a balance and/or making changes to the investment allocation are fairly straightforward and efficient processes. Simplicity and straightforwardness equals scale and profit for the financial firm.

A much more challenging situation is presented by small business owners. Business owners, including doctors, lawyers, accountants, veterinarians, etc., frequently have large portions of their net worth tied up in their businesses. Yes, they may have set up a retirement account (usually a SEP IRA, SIMPLE IRA, or maybe a 401(k)) to help reduce taxes or provide a benefit to employees, but it is the exception when business owners have accumulated a large nest egg in their retirement accounts. Typically, their businesses are their nest eggs.

Take for example an attorney I recently worked with in his early 60’s that has a successful practice. His share of partnership revenues are around $1,250,000. He takes an income of over $250,000 per year, but only started contributing to a SIMPLE IRA about 10 years ago. He has accumulated a respectable $300,000 in the SIMPLE IRA, but estimates needing $150,000 a year to live on in retirement. He still enjoys working but is starting to consider his retirement options.

The 5% rule of thumb would dictate that he needs about $3,000,000 in investment assets to give himself a good probability of producing an inflation adjusted $150,000 over his lifetime. How can he get there? We reviewed a couple of possible avenues.

Option 1 – He can keep saving, the more the better. His $300,000 starting balance in his SIMPLE IRA, with max annual contributions of $12,500 + a catch up contribution for > age 50 of $3,000 + the max employer match of 3%, $7,500, would allow him to add $23,000 per year.

At that rate, assuming a hypothetical growth rate of 8%, he could accumulate $3,000,000 in a little over 22 years. Now there are many other variables (alternative income sources, extra savings, etc) that may allow him to retire earlier than that, but for the sake of illustration you can see that this may not be the ideal plan.

Option 2 – Sell his partnership interest to his partners. No problem, if your partner(s) have the funds to buy you out, right? But what if they don’t?

To get an idea of how his partner(s) could structure a buyout, PlainsCapital Bank Vice President, Rick Lindley, of Austin, TX was kind enough to share some thoughts.

“Many business owners aren’t familiar, or may be intimidated by the perceived hassle, of structuring a business sale to an employee through financing backed by the US Small Business Administration (SBA). The SBA will let the employee purchase the business with little or no money down as long as they meet some qualifying credit requirements and aren’t a convicted felon.

If a business has assets like buildings, land, or equipment, it is fairly straightforward to arrange financing. The assets will serve as collateral and loans can be structured with as little as 10% down. When there aren’t many assets, there is another program known as 7(a) that is more attractive.

Under 7(a), SBA makes loans for acquisition of a business by guaranteeing 75% of the bank’s loan to the buyer. The buyer needs to come up with the other 25%, but it can come from family or a separate loan from the seller.”

In this option, let’s say the lawyer could sell his partnership interests for approximately one year of revenues to his other partners. The buyers could use an SBA 7(a) loan to finance the purchase.

$937,500 of the purchase would be financed by the bank, the seller could finance a portion, say 10%, or $125,000, leaving the buyers to come up with the other $187,500 as a down payment. If he were to net $1,000,000 in the sale, he could reduce the amount of time it would take him to reach his accumulation goal by 10 years assuming he maintained the same savings rates presented in Option 1 if as a salaried employee. Another option would be to reduce his work schedule and augment his salary with earnings from the business sale.

There are other planning considerations that also come into play that could involve life insurance to create liquidity in the event of an owner's premature death to allow for buying out heirs or replacing a key employee. We'll cover some of those considerations in a future Accountable Update.

Of course, he could just continue on as a partner with the knowledge that if he decides to cash out at some point down the road, he knows how he may do it. That’s the value of planning, and why we believe that no wealth should go “unplanned”. If you would like to discuss your plans, get in touch for a complimentary consultation.

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Savings rate targets are hypothetical illustrations, do not reflect actual investment results or actual lifetime income, and are not guarantees of future results. Targets do not take into consideration the specific situation of any particular investor, the composition of any particular account, or any particular investment or investment strategy. Individual investors may need to save more or less than the savings target displayed depending on their inputs for retirement age, life expectancy, market conditions, desired retirement lifestyle, and other factors.

Flingin' It - 6/10/16

In this month's installment of Flingin' It, we look at a couple of topics related to mutual fund management and performance. In the first, we share an article that discusses how being too dogmatic in tracking an index can exact a hidden cost on performance.

The second topic is a video review of Dimensional Funds annual analysis of mutual fund performance that we have discussed in the Accountable Update before. In the short video, you'll see further evidence that there is little reason to ever try and outguess the markets. 

That's all I have this week as I'm off to coach my daughter's softball team in what we hope is the first of several progressive tournaments this summer. Wish us luck!

Index Reconstitution:
The Price of Tracking

June 2016

With the annual reconstitution of the Russell indices approaching, it is a good opportunity to revisit how index reconstitution events affect trading costs and returns.

Index funds are an innovative solution for investors that provide diversified investments at low fees. On any given day, an investor can observe the performance of indices from providers such as MSCI,(1) S&P,(2)  or Russell(3) —and that means it’s easy to monitor whether or not an index fund manager replicated the index’s performance (gross of fees and expenses). However, an index fund manager’s strict adherence to an index comes at a cost in the form of reduced discretion around trading.  

Most indices revise their list of index constituents periodically (e.g., annually or quarterly), at which time securities may be added or deleted from the index. This process is commonly referred to as index reconstitution. For example, the annual reconstitution of the widely tracked Russell indices will occur on June 24, 2016. Russell index fund managers will need to buy additions and sell deletions for the indices they track in order to minimize tracking error(4)  relative to the index. Any deviation of the fund from the index, over days or even hours, could result in different returns from the index.

1.   Morgan Stanley Capital International.
2.   Standard & Poor’s Index Services Group.
3.   FTSE Russell is wholly owned by London Stock Exchange Group.
4.   Tracking error is the standard deviation of the return differences between a fund and its benchmark.

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Exhibit 1: Equal-Weighted Average Trade Volume for Index Additions and Deletions

S&P data provided by StanS&P data provided by Standard & Poor’s Index Services Group. Russell data © Russell Investment Group 1995-2016, all rights reserved.

MSCI data © MSCI 2016, all rights reserved. 

The effect on volume from index rebalance trades is apparent in a huge volume spike on trade reconstitution day. Exhibit 1 illustrates average trade volume for additions and deletions in four major indices during the 80-day period surrounding reconstitution. Each of the charts shows a marked increase in trade volume on the effective date of reconstitution relative to the surrounding days. The effect is pervasive across the market capitalization spectrum as well as geographic region.

For each index, this large liquidity demand tends to drive up the prices of securities with greater purchase demand (generally additions to the index) relative to the other securities in the index. It also tends to push down prices of securities with greater sell demand (generally deletions from the index) relative to the other securities in the index. Thus, for an index being tracked by a large amount of assets, the index has generally added securities at higher prices and deleted securities at lower prices than it would have if no assets had been tracking it. This phenomenon is the result of index managers’ demanding liquidity on or around the index reconstitution date.

After the reconstitution of an index, as the liquidity demands of index managers decline, research shows this price effect tends to reverse. That is, additions tend to underperform the index while deletions tend to outperform. As a result, index managers’ implicit trading costs can result in a performance drag on the index and, consequently, funds tracking the index.
 

Exhibit 2: Effect of Delaying Reconstitution Month

Russell data © Russell Investment Group 1995–2016, all rights reserved. Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

A simple experiment in delaying reconstitution allows us to estimate how much this price pressure has impacted index performance. Exhibit 2 compares average monthly returns for two sets of Russell indices; one set is rebalanced on the June-end reconstitution date and the other three months later. As shown in the final three columns, delaying rebalancing improved average returns between 0.15% and 0.73% per month from July through September—the three months between the rebalance date of the standard indices and their delayed counterparts. For all calendar months, including October through June when holdings are identical for both rebalancing methods, this amounts to a performance benefit ranging from 0.04% to 0.18% per month, or approximately 0.45% to 2.21% per year.

SUMMARY

Index funds may be a good option for investors seeking investments with low fees. However, in an attempt to match the returns of an index, an index fund manager sacrifices trading flexibility. Because of high liquidity demands around index reconstitution dates, index funds may incur high trading costs that do not appear in expense ratios but do affect net returns. The funds’ goal of minimizing tracking error may come at the expense of returns. Investors should consider the total costs, both in terms of expense ratio and trading costs, when evaluating investment options.

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Source: Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

There is no guarantee an investing strategy will be successful

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Research in Focus: Mutual Fund Landscape

Which mutual funds outperform their benchmarks over time? Wes Crill, PhD, walks through Dimensional’s annual analysis of mutual fund performance. You can review the entire report here.