Do ETFs belong in Tax Advantaged Accounts?

5/3/2022

Most advisors are aware of the advantages of Exchange Traded Funds (ETFs) over equivalent mutual funds (MFs) for taxable accounts. These include:

• Lower taxable capital gains due to the structure of the vehicle (creation/redemption mechanism).
• Lower taxable distributions, for the same reason.
• Lower fees for equivalent funds, due to reduced overhead expenses in both the way the fund is maintained and compliance requirements.
• Lower ticket fees or platform commissions for trading ETFs vs some MFs.
• Additional transparency of holdings for many ETFs. Index ETFs report holdings daily. Active non-transparent funds may be as opaque as mutual funds, reporting only semi-annually.

To see these advantages in action, look at the differences in fees, distributions, and returns for VOO vs. VSPVX.  These are the Vanguard funds tracking the S&P 500.  (Data from Morningstar as of 5/2/22)

Symbol	TTM Yield	Fees	Total Return, 2021
VOO	1.46%	0.03%	28.78%
VSPVX	2.01%	0.08%	24.81%

As expected, fees and distributions are lower for the ETF. But why the difference in total return? It looks like part of it is that some cash flows are distributed rather than reinvested. But there must be more to it. And this is the biggest reason to use ETFs in tax advantaged (TA) accounts, like IRAs and HSAs.

The share creation/redemption mechanism is the root cause of the difference in performance. When shareholders buy or sell shares of MFs, the fund must invest or divest those funds rapidly, rather than hold cash or maintain a cash negative position. The NAV is calculated at the end of each business day, and this is the price that investors pay and receive. However, the fund company transacts at market prices during each trading day, buying and selling shares of the underlying investments to balance out inflows and outflows of funds.

Shares of ETFs are bought and sold on the open market throughout the day, trading at market prices, which may reflect a discount or premium to the actual value of the underlying. When the ETF is trading at a premium, the Authorized Participant (AP) will buy a quantity of the ETF (typically 50,000 shares) and trade them as an even in-kind exchange with the ETF provider for a basket of shares of the underlying, equivalent to the holdings of the ETF. The AP pays most of the taxes on the gains and losses of these transactions, while the fund simply creates or destroys shares. The transactions are made during the trading day with both the ETF and underlying holdings being exchanged at actual market prices.

The tax benefits of this arrangement are evident, but how does this impact performance? Let’s say a bear market is beginning. Many investors decide to sell. The mutual fund will receive redemptions that settle at that afternoon’s price. The fund trading desk may get notification of this overnight, or as late as mid-morning the next day. They must then sell positions out of the MF, into a declining market, for which they paid the previous day’s closing price. For rising markets, the reverse is true, and funds must purchase shares that have been rising.  

The impact is clear. Now consider less liquid securities, like municipal bonds or foreign holdings. ETFs will reflect this illiquidity cost by trading at a discount because the APs determine how much risk they are comfortable taking to make the in-kind exchanges of shares. MFs, however, may be forced to trade at less advantageous prices. Index MFs will need to trade some portion of most or all of their holdings, regardless of price or liquidity. Actively managed MFs will select the securities to buy and sell, and in times of volatility, this may result in style drift.

The biggest downsides to using ETFs in tax-advantaged accounts are operational for the advisor. Mutual funds allow for set-it-and-forget-it automatic periodic investments, and rebalancing can be accomplished to the dollar. Use of ETFs requires more effort in rebalancing, investing, and trading, although the advent of fractional share trading may be helpful in this regard.

Exchange Traded Funds started with SPY in 1993. 30 years later, the advantages over mutual funds have proven to be overwhelming. Innovations continue, to include ETNs, active ETFs, and other exchange traded products. Advisors have a duty to understand the technical differences between funds that can lead to significant impacts on client results.

Compliance for Digital Assets

2/1/2022

One year ago, my topic was “Cryptoassets and Advisors,” which gave an overall look at the investment space and how advisors might begin to think about allocating client funds to digital assets. This article expands on the regulatory requirements for advising clients on digital assets.

For those of you who hold fiduciary certifications or are registered as RIAs, it is becoming a fiduciary responsibility to understand digital assets and be able to determine if they are appropriate in client portfolios. Onramp Invest has produced a 55-page review of how cryptoassets might be incorporated into the CFP® Curriculum (report can be requested here: https://onrampinvest.com/cfp-professional-conduct-and-regulation/).

With that in mind, an understanding of the compliance requirements is also necessary.  The SEC issued two documents during 2021 addressing digital assets. An SEC Risk Alert dated 2/26/21 (https://www.sec.gov/files/digital-assets-risk-alert.pdf) identified 6 categories of risk on which they intend to focus:

• Portfolio Management, including due diligence, evaluation and management of specified risks associated with digital assets, and fiduciary duty.
• Books and Records, to include records of trading activity.
• Custody, which covers controls around safekeeping, business continuity plans, software, and security around software and digital platforms.
• Disclosures, including marketing materials and regulatory brochures and supplements, with a focus on the specific risks associated with digital assets.
• Pricing client portfolios, which looks at valuation methodologies as well as fee calculations.
• Registration issues, which considers AUM calculations and how digital assets are characterized in pooled vehicles and private funds.

Their 2021 Examination Priorities were released on 3/3/21, also selecting 6 areas of focus, but slightly differently. Keystone Compliance Consulting (info@keystonecomplianceconsulting.com) summarizes the requirements in this document as follows:

To date, there is very little clarity around how digital assets will evolve in the future. What we do know, is that the SEC Division of Examinations’ 2021 Examination Priorities calls out digital assets, specifically, as an area of focus. (https://www.sec.gov/files/2021-exam-priorities.pdf).

The guidance highlights six areas that can be expected to be reviewed in an SEC exam. Compliance professionals should take the following actions to address these areas.

1. Investment Suitability – Document investment suitability for each client, specific to digital assets. For example: Digital assets are/are not suitable for the client because (list reasons).

• Portfolio Management and Trading Practices – Establish policies and procedures specific to how digital assets will fit within portfolio construction and management. Establish when and how the assets will be traded.

• Safety of Client Funds and Assets – Discuss the custody of digital assets in your compliance policies and procedures. Consider what documents would be produced to evidence the custody of the assets.

• Pricing and Valuation – Review your current pricing and valuation policies and procedures. Be sure to incorporate specifics about digital assets.

• Effectiveness of Compliance Programs and Controls – Digital assets should be reflected in the inventory of risks. The policies and procedures established for digital assets should be reviewed, at a minimum annually, for efficacy and completeness as the digital asset space changes.

• Supervision of Employee Outside Business Activities – Review Outside Business Activity policies and procedures and make any amendments needed to include digital asset activities. Services related to digital assets offered by employees, outside of their employment arrangement, should be evaluated. Additionally, these arrangements should be assessed to determine if they qualify as securities activity.

The digital asset world continues to change quickly. In these early days the due diligence required to select legitimate investments and evaluate the requirements listed above is ongoing and can seem overwhelming. Newsletters I have found most informative and actionable to stay up to date on all topics relating to digital assets are from Fidelity Digital Assets (send an email to digitalassets@fmr.com and request research updates) and Galaxy Digital (sign up at https://www.galaxydigital.io/newsletter/). To stay current on SEC requirements, bookmark the SEC examinations page https://www.sec.gov/exams  and check the Priorities Memos and Risk Alerts on a regular basis.

Portfolio Protection: At What Cost?

11/1/2021

Although interest rates have risen from their generational lows, real rates are still negative. In fact, due to inflation (whether “transitory” or not), real rates have fallen off a cliff in mid to late 2021. As a result, many investors who would prefer a conservative investing approach have invested much more than they would ideally prefer into equities. This includes people who are in the accumulation phase of their careers and some who are approaching or already in retirement.

Market valuations, by all measures, are approaching or at all-time highs. As of early November, Shiller’s P/E 10 is over 39, which is a value only eclipsed by the irrational exuberance of 2000 (data from https://www.gurufocus.com/shiller-PE.php). Advisor Perspectives provides a variety of metrics updated monthly at https://www.advisorperspectives.com/dshort/updates, all of which are currently showing highly overbought conditions. And if you really want to be terrified, read John Hussman’s latest piece (https://www.hussmanfunds.com/comment/mc211015/).

These conditions together are causing clients and advisors a great deal of discomfort. How can portfolios be protected from the next drawdown? We’ll look at two types of protection.

The first line of defense has traditionally been diversification. To protect against equity losses, keep a position in bonds. The 60/40 portfolio (example data is from Kwanti.com, and assumes annual rebalancing, where the bond allocation is represented by the Treasury 20+ index). The cost of diversification is lower expected long-term performance, since expected bond returns are lower than expected equity returns. What is the price you pay, and what kind of protection does that buy?

First, the price (annualized returns shown):

	S&P 500 TR	60/40	Performance difference (cost of bond allocation)
1 yr	41.20%	23.71%	17.49%
3 yr	22.53%	15.87%	6.66%
5 yr	18.91%	12.68%	6.23%
10 yr	15.91%	10.90%	5.01%
20 yr	9.67%	7.95%	1.72%
25 yr	9.85%	8.35%	1.50%

And how much protection against portfolio losses does this provide?

	60/40	S&P 500 TR	1-Ratio of drawdowns (protection provided)
Tech bubble (9/00 – 10/02)	-23.51%	-47.41%	50%
Subprime crisis (10/07 – 3/09)	-33.80%	-55.25%	39%
CoronaVirus (2/20 -3/20)	-20.58%	-33.54%	39%

So the cost (at least in the last 10 years) is quite high, and the protection is incomplete at best.

A more direct hedge against losses is to buy puts on the equity position. Data regarding put strategy is from Harvey, Rattray, and Hemert, Strategic Risk Management, Wiley, 2021. Because puts, unlike equities, are time limited, the mechanics of any given strategy must be defined. This strategy uses front month puts, which are held to expiry.

See below the overall return of at-the-money puts from 1985-2018 as well as selected crisis periods shown above. Although one might expect this to be a perfect hedge from a returns standpoint, due to the roll of the put positions, it is not:

	ATM puts	S&P 500 TR
Tech bubble (9/00 – 10/02)	48.3%	-47.4%
Subprime crisis (10/07 – 3/09)	41.6%	-55.2%
Overall (1985-2018)	-3.9%	10.8%

To hedge your entire portfolio, the cost of the puts is on average more than double the cost incurred from the lower returns of long bonds (-3.9% over 33 years vs. -1.5% over 25 years). Additionally, the returns of the puts are negative during normal market environments (86% of the time in this analysis). And even with the near-constant losses and high expected total cost, there may still be some amount of drawdown in a crisis.

As predicted by theory, the price of safety is lower returns. Behavioral finance should be considered with regard to any specific client – what pattern of portfolio returns would be best tolerated, and why? How can the advisor best construct the portfolio and frame expectations so that the client understands the likely outcomes and will be able to withstand them, both financially and emotionally?

What is China up to?

7/29/2021

According to the IMF, World Bank, and CIA Factbook, China currently produces around 25% of global GDP. Recent WFE data shows that Chinese exchanges (A-shares only) control 11% of global market cap. Any investor interested in a global allocation must include Chinese equities in their portfolio. Even if Chinese equities are specifically excluded, the impact of the Chinese economy cannot be removed from a diversified investment portfolio.

The leap from emerging to developed economy depends on a number of factors that facilitate the flow of capital, and some of these have been seemingly going in the wrong direction recently in China.

Rule of law: An ongoing issue – can investors count on ownership of assets?

• The reach and power of the CCP cannot be overstated.
• The VIE structure used for listing Chinese companies on US exchanges, which has been in place for many years, does not provide the same direct ownership of a corporation as a US stock.

Regulatory crackdown: China recently brought several enforcement actions against Chinese tech companies, which included suspension of new accounts and removal of apps from the marketplace. Different analysts have viewed ascribed varying possible motives to these actions:

• Cyber security issues for the Chinese state and people – this is the official reason stated for action against Didi following its recent IPO in the US.
• Consumer protection from monopoly power – this is the official reason stated for recent actions against Alibaba and Ant, as well as new restrictions on for-profit education sector in China.
• Political power – preventing the founders/owners of these companies from becoming a threat to existing power structure by reducing their wealth and stature within China.
• Realignment of sectors within the Chinese economy – this interesting theory by Noah Smith (https://noahpinion.substack.com/p/why-is-china-smashing-its-tech-industry) proposes that China is purposely removing profits from the consumer facing software industry in order to encourage entrepreneurs to focus resources on hardware and firmware sectors.

Transparency:

• The SEC is currently threatening to delist Chinese companies due to disagreements regarding financial audit practices. Although the companies are audited, China will not allow the auditing firms to release their workbooks to the SEC for inspection. It’s important to note that listing requirements in China and Hong Kong are more stringent than in the US, including profitability and share classes/voting rights.
• State owned enterprises make up 25% of the Chinese economy, but encompass 40% of listed companies. Although all Chinese companies ultimately answer to the government, SOEs have a somewhat different set of risks, and are not going away.

Various geopolitical struggles: The US/China relationship can be viewed as adversarial, although the two economies are interdependent. According to ustr.gov, China is the third leading export destination for US goods, while the US is the top export destination for Chinese goods and services. Any difficulties or disagreements must be viewed through this lens. Ongoing issues include:

• The assimilation of Hong Kong and Taiwan into China, eliminating their independence while still keeping their developed economies status.
• Border and ownership disagreements in the South China Sea.
• Human rights abuses, which have resulted in blacklisting of Chinese firms in the US.

What is actionable here? The large, dynamic and growing Chinese economy must, in theory, be included in a globally diversified portfolio. Whether or not an investor decides to maintain an explicit position in Chinese equities, we are all exposed to this large economy indirectly. Decisions to be made include:

• Share classes to include in any allocation to China. This may be a way to limit exposure to specific risks.

Share Type	Where traded	Currency	Notes
A-shares	Mainland China (Shanghai and Shenzhen)	Renminbi (Chinese Yuan)	Ownership by foreigners still somewhat limited
B-shares	Mainland China (Shanghai and Shenzhen)	US Dollars or HK Dollars
H-shares	Hong Kong Exchange	HK Dollars	Often correspond directly to A Shares
Red Chips	Hong Kong Exchange	HK Dollars	State owned companies
P-chips	Hong Kong Exchange	HK Dollars	Non-state owned companies
S-chips	Singapore	Singapore Dollars
N-shares	USA	US Dollars
ADRs	USA	US Dollars	ADRs of H-shares and red chips are often called N-shares
	Taiwan	Taiwan Dollars

Notes: A, B, and H Shares consist of companies that are primarily Chinese and are incorporated in China.  The other share types are incorporated in foreign countries, although the businesses exist within mainland China.  Many companies are traded using more than one of the share classes listed above.  Taiwan has a complex relationship with China, but economically, it is a separate state, and like Hong Kong, is a developed market. 

• Amount to allocate specifically to China. Emerging market indexes vary in China exposure, as well as share types.
• Active vs. passive exposure. Fund managers bring their own perspectives. Every index is a result of the decisions of a committee. All of these must be examined carefully.

Social Security Planning

Social Security income is often a substantial part of a retiree’s income. When deciding when and how to claim benefits, there are many consequential choices to be made and data to be gathered:
• Age of retiree when social security is claimed
• Age and claiming status of spouse
• Earned income during retirement
• How long the claimant worked, and amount earned during working years
• Earnings that were not subject to social security taxes
• Any government pension benefit
Benefits can be claimed starting at age 62. Claiming benefits earlier results in lower payments, and these differences can be significant. The maximum benefits are paid out starting at age 70, and can be more than 75% higher than the benefit received starting at age 62. Waiting to get the maximum dollar benefit per month, however, often does not result in the maximum amount of benefits received over a full retirement. Various claiming strategies are compared using the break-even age. This is the age at which total payments of any two strategies converge. Note that not all calculators include time value of money in the calculations.
The rules governing benefits are so complex that the Social Security Administration website includes a dozen different benefits calculators (https://www.ssa.gov/benefits/calculators/). These calculators are helpful but do not provide all the information needed to make these difficult filing decisions, and neither the SSA website nor SSA employees will provide any recommendations as to best strategies for an individual. SSA does provide links to other benefits calculators that are more comprehensive than their own (https://www.ssa.gov/policy/docs/rsnotes/rsn2016-03.html – this is 5 years old and not all the tools are still available). Internet searches result in additional tools. Using a combination of tools will result in a range of likely benefits amounts that the financial professional can use for planning purposes.
Situations that are in any way complicated should be evaluated by a consultant or specialized software package. Many planning software packages include social security calculators within the package, but these vary greatly in terms of extensiveness. Be sure you understand the underlying considerations and calculations in the software you are using.
When making a recommendation for claiming age(s), total benefits received is not the only consideration. If a person wants to retire at 62, but the benefits-maximizing age for them to claim benefits is 67, then they will need to fund the intervening years in some other way. As the break-even age of various strategies increases, expected longevity becomes more of a factor. Comprehensive planning software should factor in these important considerations. Social security planning is best not left to rules of thumb or assumptions, but is a multi-step process for the financial professional.