Stop losing value from a declining price

March 4, 2017

background

The market value of your stock equals your principal (i.e., the amount you invested) plus any profit or loss from price fluctuation. The market price that moves below what you paid to purchase the stock will produce a loss of principal if you sell the investment. Here are several risk factors that may drive stock prices downward:

  1. Company performance. ‘Good’ companies attract investors. Conversely, ‘distressed’ companies repel investors.
  2. Industry performance. Business cycles can affect the sales of products from an entire industry. For example, sales of new automobiles declined during the Recession of 2008.
  3. Market cycles. Aside from business performance, the entire stock market is subject to periods of declining prices due to massive selloffs by investors.

The risk of an extreme loss can be prevented by setting a stop-loss price (“stop”) to sell part or all of your shares.

ways of setting the stop

The systematic way is quite simple. If the market value is below your invested principal, then select an absolute loss or a fraction of the principal. Examples:

  1. Absolute loss. Suppose you invest $5,000 in 100 shares of stock (i.e., $50/share) and you can tolerate a loss of $1,000 should the price start to fall. Regardless of future prices, you choose to stop the decline at $1,000 below the original $5,000 value. In this example, the stop would be $40/share [stop = (value – loss)/shares = ($5,000 – $1,000)/100].
  2. Fraction of value. Suppose you can tolerate a 10% loss from an investment originally valued at $5,000 for 100 shares.  Ten percent is one-tenth of 100, which is equivalent to a decimal number of 0.10. The stop would be $45/share [stop = (1.00 – decimal)*value/shares = (1.00 – 0.10)*$5,000/100].

The technical way is based on the stock’s historical prices. If you want to minimize the chance of a sale, set the stop at the lowest price from the past 5-10 years. Beware that setting the stop at a historical low may incur a steep loss. Other ways involve the more complicated analyses of trendlines, moving-average lines, or price statistics.

Another way is to adjust the price gap (gap = market price – stop) to the growth of capital gains. As the market price increases over time, choose a narrow gap to protect the capital gain or a wide gap to reduce the chance of a trade. Generally speaking, widening the price gap will reduce the chance of a trade at the risk of incurring a bigger loss.

add a limit price (“limit”) for extra protection

A brokerage firm will enforce your stop order for 30-90 days depending on the firm’s trading platform. The firm’s computer activates the order when the latest market price reaches the stop. The order is then filled at the next available price. In a chaotic market, the price could plunge below your stop to an exceptionally low value at the next available trade, resulting in a bigger loss than you planned. You might be able to prevent this result by setting a limit slightly below the stop. The trading order would be filled somewhere within the stop-limit price zone unless the transaction is cancelled, unfilled, when the next available price dips below the limit. The limit helps protect the extent of your loss.

who should worry about an extreme loss?

Nobody’s immune, but long-time investors have the least concern. Investment strategies such as dollar-cost-averaging and automatic-dividend-reinvestment plans will help protect against damages from periodic bear markets. Short- and intermediate-time investors are at greater risk for incurring an extreme loss from market down-cycles. For example, families who are saving to pay college fees or to buy a home risk big losses from a bear market.

conclusion

Stop orders are used to set the price for buying or selling exchange-traded products such as stocks, ETFs, and REITs. This article discussed the use of a stop-limit order to sell a stock in a declining market. Brokerage firms may restrict the duration of stop-limit orders to 30-90 days after which the order is cancelled without a transaction until you renew the order. Periodic renewals allow you to reconsider your strategy in light of the prevailing price trend. In a downtrend, simply renew the order. In an uptrend, you may wish to protect a growing profit by resetting the stop-limit order to higher prices. Click on this link to skimming a profit for another perspective on protecting a growing profit.

Copyright © 2017 Douglas R. Knight


2016

January 14, 2017

My SmallTrades portfolio holds stocks and four classes of exchange-traded index funds (ETFs).

chart 1

chart 1

Investment plan

The goal is to outperform a reputable benchmark, the Standard & Poors 500 Total Return Index, on a sustained basis.  The ETFs are diversified and rebalanced in order to partially offset the losses of a declining market. A small group of stocks are used to boost the investment returns.

Performance

In FY2016 the portfolio’s market value increased by 8.3% due to a 9.1% gain in stock value and 8.1% gain in ETF value. Charts 2 and 3 illustrate the nominal (solid lines) and real (dashed lines) growth in unit value for shares of the portfolio, ETF group, stock group, and benchmark. The number of shares for each entity was the initial market value divided by $1 of U.S. currency.  Assume that the initial unit value of $1 was a real value unaffected by inflation.

Chart 2 shows the pattern of unit-value growth for the benchmark (black lines) and portfolio (blue lines) since December 31, 2007.

chart 2

chart 2

The unit value of both entities declined in year 2008 and began to recover in year 2009. The benchmark (black lines) recovered in year 2011 while the portfolio (blue lines) is still struggling to recover [notes 1,2]. The effect of inflation was to devalue real growth (broken lines) compared to nominal growth (solid lines). The real unit value signifies the purchasing power of the investment. The investment has greater purchasing power than uninvested money when the real unit value exceeds $1.

Chart 3 shows the result of implementing the current investment goal [note 2] with a small group of stocks (red lines) and large group of ETFs (blue lines). In chart 3, the initial unit value was re-calculated on December 31, 2013.

chart 3

chart 3

Since 2013 the stock group clearly outperformed the benchmark (black lines) and ETF group. The success of the Stock group is attributed to investing in ‘good’ companies for the long term [note 3].

Stock group

Chart 4 shows the market sector and market cap diversity of the stock group defined in chart 1.

chart 4

chart 4

Several stock trades were made during FY2016 to improve the chance for success.
Closings:

  • Alibaba Group (BABA), for 10% capital gain, to exit the Chinese market.
  • Geely Automobile (GELYF), for 14% capital gain, to exit the Chinese market.
  • Corning Inc. (GLW) for no gain.
  • iRobot Corp. (IRBT) for 10% capital gain.
  • ITC Holdings (ITC) for 14% capital gain, due to the stock’s delisting.
  • Stericycle (SRCL) for 34% capital loss, to stop further loss.

Purchases:

  • Biogen (BIIB), an innovative biotechnology firm.
  • Cal-Maine (CALM), a leading producer of shelled eggs.
  • Express Scripts Holdings (ESRX), a large mail order pharmacy
  • Royal Bank of Canada (RY), a well-capitalized bank.

ETF group

Chart 5 shows the distribution of asset classes among the ETFs. All asset classes drifted from an allocation plan of 30% stocks, 30% REITs, 20% bonds, and 20% gold [note 4].

5-etf-distribution

chart 5

The SmallTrades portfolio’s primary strategy for risk management is holding a large group of diversified ETFs that are rebalanced to correct a significant allocation error. In theory, a significant drift of asset classes occurs when one asset class surpasses a 28% allocation error.  At the end of FY2016, the existing allocation errors (blue bars) were within 24% error limits (red dashed lines) as illustrated in Chart 6.

chart 6

chart 6

Chart 6 reflects the portfolio’s response to an incline in equity markets compared to decline of the bond and gold markets. History has shown that a decline in equity markets tends to be offset by a rise in the bond and gold markets.

Plan for FY2017

The SmallTades portfolio will continue to be actively managed for long term success. The ETFs will be rebalanced anytime there’s a 24% allocation error or a modification of the ETF holdings. I would like to own fewer large cap stocks in favor of small- and mid-cap stocks issued by good companies with potential growth of earnings.

Notes

  1. On 12/31/2007, the portfolio held a group of actively managed mutual funds in a tax-deferred Roth account. Since then there have been no cash deposits or withdrawals and the portfolio still resides in the Roth account. During 2007-2010 the mutual funds were traded for stocks in an attempt to earn a 30% annual return by process of turning over short term ‘winners’. Several mistakes led to a big loss:  A) after a couple of short term capital gains from Lehman Brothers Inc., I ignored the dangers of that company’s large debt and lost $45,000 during its decline to bankruptcy.  B) substantial long term profits from good companies were lost by selling holdings for short term profits. I was trying to earn a quick 30% annual rate of return and immediately re-invest in the next set of winners. It was too difficult to identify the next winners.  C) day trading also prevented a 30% return.  It was a game of chance that I played without a strategy and I was fortunate to break even.  D) a trial of investing in leveraged ETFs resulted in losses due to negative compounding.  Leveraged ETFs were very high-risk investments that I made without a sound strategy.
  2. I abandoned the goal of a 30% annual rate of return in 2012 by adopting a more realistic, but still aggressive, goal of outperforming the benchmark. That same year, I changed my investment strategy to that of holding a mixed portfolio of 80% broad market ETFs and 20% stocks for the long term.
  3. ‘Good’ companies attract and retain investors for many years. I search for profitable companies with growth potential that are undervalued by the stock market. My search methods include reading reputable sources of business news, participating in investment club discussions, using stock screeners, and attending investor conferences.  I include and exclude stocks by reading analyst reports, financial statments, SEC filings, and market analyses. Valuation critieria help me decide if the stock price is worth paying.
  4. Prior to March, 2016, five ETFs were allocated to four asset classes with each asset class holding 25% of the combined market value. Since I don’t depend on making withdrawals from the SmallTrades Portfolio, I increased my exposure to global stocks and REITs by decreasing my exposures to investment-grade bonds and gold bullion. The new allocation rule was 30% stocks, 30% REITs, 20% bonds, and 20% gold. Any drift in allocation to a 24% error will be rebalanced.

Copyright © 2017 Douglas R. Knight


Beta is the incline of a straight line

December 10, 2016

Beta (which is symbolized as β) is the incline of a straight line. Mathematicians would say the same thing another way, that beta is the slope of a regression line. Either way, β describes the tendency of investment returns to move with market returns. The investment is a security (e.g., stock, bond, mutual fund) that has a unit price. The market is a trading place for a large group of securities. The combined value of all securities is measured by a market index.

Returns

Trading causes security prices to change during the passage of time, a process called price movement. Calculations of β require price movements to be measured as percentage returns. In table 1, the daily closing prices of a security and its market index are listed under the column heading “close”. Percentage daily changes in closing price are listed under the column heading “Return %”.   Equation 1 is the formula used to calculate a return:

Return % = 100 x (current price – past price) / past price  (equation 1)

Notice in table 1 that all prices are a positive number and that the market’s close is bigger than the investment’s close. However, the calculated returns are positive and negative numbers of similar size. The positive and negative returns represent up and down movements of prices. Table 1 has 3 pairs of investment and market returns with corresponding dates.

table-1

Beta (β)

β may be calculated directly from a table of returns, but it’s more meaningful to analyze a scatter plot of returns. The scatter plot in figure 1 has a solid blue line derived from 5 years of daily returns represented by more than a thousand black dots. Each dot has a pair of corresponding returns on each axis.

fig-1
The blue line offers the single-best comparison of investment returns to market returns. The incline of the blue line is β, which is calculated as a ratio of the lengths AC and BC of the dashed lines. Since AC and BC have equal point spreads of 5%, β is 1.00, which means that the investment and its market TENDED to move together at the same rate of return.

Notice that the black dots are closely aligned to the blue line, therefore excluding the random movement of returns. Consequently, the blue line is highly predictive of this particular investment’s past performance.

Significance

β is a measurement that literally means for every percent of market return, the percent investment return TENDED to change by the factor of β.  This is illustrated in figure 2.

fig-2
The colored performance lines in figure 2 represent different investments. Each line offers the single-best comparison of investment returns to market returns. For the sake of graphic clarity, a large cluster of paired returns was not plotted as data points.

At β = 1.00 (black dashed line) the investment and market TENDED to move together at the same rate. At β >1.00 (yellow line), the investment performance was amplified by trading activity in the market. The yellow line’s β infers that the investment’s return was 1.72 times the market’s return. At β <1.00 (green line), the investment performance was diminished by market activity. The green line infers that the investment’s return was 0.86 times the market’s return. At β <0 (red line), the investment performance was reversed by market activity. The red line infers that the investment’s return was -3.86 times the market’s return.

Thus, β is a ‘pretend’ multiplier of market performance. Higher β ‘amplified’ the market performance, lower β ‘diminished’ the market performance, and negative β ‘reversed’ the market performance.

Risk

Risk is the chance for a capital gain and capital loss. Betas greater than 1.00 tend to be riskier investments and those lower than 1.00 tend to be safer investments compared to performance of the market. Negative β infers a reversal of investment outcomes compared to market outcomes.

Summary and advice

β is a statistic for past performance that describes the tendency of investment returns to move with market returns. When comparing the β of different investments, be sure to verify the time periods and market index used by the analyst. β is typically measured with weekly or monthly returns for the past 3-5 years.

Copyright © 2016 Douglas R. Knight


Choosing an ETF

August 16, 2016

Investing in an exchange-traded fund (ETF) begins with screening many funds to identify a few candidates, then rating the candidates. My preferred open-source screeners are XTF.com and ETF.com, both of which have inclusion criteria for selecting desirable ETFs and exclusion criteria for rejecting undesirable ETFs.  Aim to find a reputable low-cost ETF that best matches the performance of its category.

Asset class

Assets are potential sources of income to investors.  Consequently, an asset class is a group of assets that earn income the same way.  The ETF portfolio holds assets consistent with the fund’s investment strategy, which is either to copy a market index by process of passive management or compete with a market index by process of active management. The index measures the performance of an asset market.

Competing ETFs are typically grouped in one of the following asset classes:

  1. EQUITY is a share of ownership claimed through the purchase of a company’s stock. Equity ETFs earn capital gains and dividends from stocks.
  2. REIT.  The real estate investment trust (REIT) is a company that owns and manages income-producing real estate. The REIT earns money from rent, mortgage interest, or other real estate investments. At least 90% of the REIT’s taxable income must be given to shareholders in the form of dividends. REIT ETFs earn capital gains and dividends from REITs.
  3. FIXED INCOME securities pay an expected amount of interest (e.g., bonds) or dividends (e.g., preferred stock).
  4. COMMODITIES are raw materials sold in markets for use in making finished products. Commodities are sold for cash or traded in futures contracts.
  5. CURRENCY is a system of money in the form of cash or notes. The currency market trades different currencies to profit from trading fees and differences in interest rates.

Inclusions

The following inclusion criteria direct the search for reputable candidate funds desired by most individual investors:

  1. Passively managed ETFs typically charge lower fees than actively managed ETFs and likely outperform actively managed funds over long time-periods.
  2. U.S. listed ETFs comply with SEC regulations, U.S. stock exchange rules, and the U.S. tax code.
  3. One of these Asset classes: Equity (stocks), REIT (real estate), or Fixed Income (bonds).

Refine your inclusion criteria by selecting reputable indices and desired market categories.

Exclusions

The following criteria should be excluded by all but the most adventurous investors!

  1. Exchange-traded notes (ETNs) are not ETFs.
  2. Closed-end funds (CEFs) are not ETFs.
  3. Leverage and inverse ETFs are very tricky investments.
  4. Actively managed ETFs charge higher fees in order to create porfolios that outperform or underperform a market index.
  5. These asset classes:
    Alternatives (imitation hedge funds)
    Asset Allocation (actively managed mix of assets)
    Multi-Asset/Hybrid (diversified asset classes)
    Volatility (exposure to volatile market)
    Commodities (potential tax burdens)
    Currency (potential tax burdens)

Reputable index

All ETFs compete on the basis of an Index they use to design an investment portfolio. Some Indices make better measurements of market performance than others. Beware that some Indices measure untested markets. Generally speaking, the best-in-class ETFs use reputable market indices. One way of choosing a reputable index is by selecting a long-standing, oft-quoted Index provider or Index name.

Index providers are companies that specialize in measuring market performance and selling the information to financial institutions. Table 1 provides a sample of reputable Index providers.

Table1

Category and Index names

Asset Classes have unique categories. Each category may be measured in a variety of indices listed in Tables 2-4.

table2

 

table3

 

table4

Rating the candidates

By now you should have several ETFs that could satisfy your investment goal. Verify that they belong to the same category, then assess their suitability based on the following critera:

  1. Net assets, Total assets, Assets Under Management (AUM), or Market cap AT LEAST $1 BILLION.
  2. Inception date AT LEAST 5 YEARS AGO
  3. Expense ratio BELOW 1%, LOWER IS BETTER AMONG COMPETITORS
  4. Legal structure PREFERABLY “OEIC” OR “UIT” (table 5)
  5. Number of holdings CONSISTENT WITH THE MARKET INDEX.
  6. Tracking error, LOWER IS BETTER AMONG COMPETITORS
  7. Premium (Discount), LOWER IS BETTER AMONG COMPETITORS

The finishing touch

It’s a good idea to review the Annual Report of your selected ETF.  Your potential tax burden is determined by the ETF’s legal structure, its portfolio turnover, and your tax accountant’s hourly fees.

table5

Copyright © 2016 Douglas R. Knight


Book Review: Blue Chip Kids, what every child and parent should know about money, investing, and the stock market.

April 24, 2016

Blue Chip Kids, what every child and parent should know about money, investing, and the stock market. David W. Bianchi. John Wiley & Sons, Hoboken, 2015. 234 pages.

Author David W. Bianchi wrote this book for young people who are interested in spending money. He wrapped the uses of money into 3 important topics: 1) All about money; 2) Ways of investing money; and, 3) Stock markets.  Gambling was excluded from the discussion.

I was interested in learning to coach my granddaughter on ways investing money. Bianchi exposed me to very low-, very high-, and mid-range risks of investment (I wouldn’t advise my granddaughter to invest at either end of the spectrum!). Here’s my synopsis:

All about Money. “Rule #1: live within your means”.

Chapter 1 has one of the best sections in the book which describes ways of earning money throughout life. Money is a “currency”. Don’t be surprised to learn that there are many different currencies with constantly changing values. Chapter 2 describes ways of paying for things.

The best ways of borrowing money are discussed in Chapters 9-11. If you want to avoid a penalty, repay your debt on time. Payments of interest on loans are called coupons. Coupons are a cost to the borrower that are paid to the lender. Some borrowers must pay simple interest and others pay compound interest. Lenders usually prefer payments of compound interest.

Borrowers are expected to show that they are reliable (“credit worthy”) people. For example, bankers will ask to read your financial statement before giving you a loan. Your financial statement is a document that lists the total value of assets (things that you own) and liabilities (money that you owe). The difference between total assets and total liabilities is your net worth.

Governments earn money by charging taxes and selling bonds. Everybody has to pay taxes. Failure to pay any of the many taxes described in chapter 12 may lead to a government audit and penalty. Chapter 13 reveals that the U.S. Government owes 17 trillion dollars to lenders from around the world! All of us face serious consequences if our government fails to pay its debts! Meanwhile, we can protect our personal financial reputations by avoiding default and bankruptcy. Better yet, don’t borrow money. Create a budget to “live within your means”.

Chapter 15 explains the challenge of retirement, which is to continue paying bills after you stop working for a living! After you graduate from school to begin a career in early life, start saving for retirement later in life at age 60-75 years. The author wisely advises to “give yourself the ability to retire if you want to”. Your retirement income will come from retirement savings, social security, pension plans, and annuities.

Investing

Investing is all about risk and return. Treasury bonds are considered no-risk investments that return about 3% annually. The investment choices that Bianchi offered to his readers were stocks (chapters 3,8), options (chapter 5), funds (chapter 6), bonds (chapter 7), and private companies (chapter 14).

A Stock is a certificate of ownership, also called a security. Brokers don’t issue the certificate, they send a confirmation that serves as evidence of ownership. The market value of the stock usually rises when its company earns profits.

Options are contracts that guarantee the trade of an asset at a fixed price for a limited period of time. The seller earns a fee for guaranteeing the trade. The buyer pays the fee in turn for the right to execute the trade before expiration. The buyer may benefit by 1) using the option as an insurance policy, 2) exercising the option at a favorable price, or 3) trading the option in the options market.

A Fund is a pool of money collected from many investors to invest in a group of assets. The advantages of the fund are that investors don’t spend considerable time doing research and don’t spend large sums of money for a diversified portfolio. Among the types of funds are

  1. Index funds, which copy a security index and charge low fees for the service.
  2. Mutual funds, which don’t copy a security index and do charge several fees for the service.
  3. Hedge funds, which invest in anything and charge very high fees. Hedge funds have strict rules of eligibility and charge “2 and 20” fees (2% annual management fee and 20% management ‘tax’ on investment returns).

A Bond shows that you lent money to the company on condition that it returns the money, with interest, at the maturity date.  The bond’s face value is the original price (printed on the face of the bond); it is the redeemable amount!  The yield is the bond’s annual rate of return; Yield = Interest / Price.

A Private Company does not trade its stock in a public stock exchange. Private company stocks are illiquid because they don’t have an open market. Venture Capital and Private Equity firms buy stocks in private companies. Venture Capital is money invested in start-up companies. Private Equity firms inject money into established private companies in exchange for the companies’ stocks.

Stock market

Advice: It’s difficult to predict the ‘top’ and ‘bottom’ of market prices. Do homework to buy quality stocks at a reasonable price.

Chapter 3 explains that the stock market is a place for orderly buying and selling of stocks (and other securities). There are many stock markets that vary according to listed stocks and total market capitalization (‘market cap’ is the total value of the company’s shares).  Chapter 8 describes how to make stock-buying decisions, how to participate in the stock market, and how the market behaves.  David W. Bianchi, if I misread your book, then I apologize for citing 2 nearly insignificant errors that were made about investing in stocks:

  1. Contrary to statement, there is no P/E ratio = 0.  Ratios of x/0 are undefined.  Financial websites don’t report the P/E as a number when company earnings are negative or 0.
  2. A share buyback doesn’t raise the price per share of stocks; only trading activity in the market can raise the price.   A share buyback raises the earnings per share (eps), which then may raise the share price.

I believe your book is well worth reading.


Lead article: Stock Index Funds

January 16, 2016

The only way an individual investor can quickly invest in hundreds of different stocks is to buy shares of a stock index fund. The tremendous advantage is an immediate ownership of a diversified portfolio in one affordable investment. It’s the surest way of earning the stock market’s returns provided the correct investment is held through a series of ‘bull’ and ‘bear’ markets. Selecting the ‘correct’ fund requires only a few hours of easy research based on the following information:

INDEX. Stock index funds are passively-managed investment funds designed to imitate a stock index. The index measures the investment performance of a hypothetical portfolio of stocks. Some indices are riskier than others by virtue of the underlying securities in the hypothetical portfolio. For example, micro-cap stocks are riskier than all stocks combined by virtue of differences in turnover, liquidity, and diversification.

FUND MANAGEMENT. The investment fund is an actual portfolio of stocks that are managed for the benefit of the fund’s shareholders. Passive management is an investment style that imitates the performance of the selected index. Active management intentionally avoids imitating the index and is a more costly endeavor.

The legal structure of an index fund regulates its style of management. A unit investment trust (UIT) is bound by a trust agreement to manage a portfolio of fixed composition. The UIT has an unmanaged portfolio because there is no allowance for adjustment of composition by the manager. The open-end investment company (OEIC) operates a managed portfolio of adjustable composition. The OEIC is bound by its investment strategy to operate either a passively or actively managed fund. OEIC managers of an index fund are bound to passive management but have leeway to supplement the fund’s income by revising, lending, or borrowing a minor portion of the portfolio. These operations may increase the risk and tax burden of investment.

PRICING. The pricing mechanism of an index fund is closely regulated. Mutual funds are OEICs that trade shares at net asset value (NAV); in other words, they are priced at the fund’s net worth-per-share. The mutual fund’s share price is not quoted until the next day because the NAV is determined after trading hours from closing prices of the underlying stocks. Mutual funds are marketed through an authorized broker and guaranteed to be priced at the NAV. Exchange-traded funds (ETFs) are OEICs or UITs that trade the fund’s shares in the stock market, which means that the share price is quoted by public auction during trading hours. ETFs are traded the same way as stocks. The intraday net asset value (iNAV) and share price are continually updated and reported by the stock market. The fund’s share price is linked to the fund’s iNAV by arbitrage. Individual investors can neither participate in arbitrage nor redeem ETFs at NAV.

FEES. Managers of investment funds are compensated by charging an annual expense ratio that diminishes the NAV. Competition has decreased the expense ratio of stock index funds to only a few basis points (1 basis point = 0.01%), but beware that the expense ratios of bond index funds and actively managed mutual funds are typically higher; read the prospectus. Mutual funds are notorious for adding special fees to trades and imposing minimal holding periods; check with the broker and read the prospectus. New, small index funds are at risk for early termination when the NAV fails to grow above an estimated fifty million dollars. The expense ratios of small funds generate insufficient compensation for the fund sponsors, so they close shop.

TAXES. OEICs and UITs are registered Investment companies (RICs) that pass all income taxes to the shareholders. The amount of tax depends on dividends and capital gains earned by the fund. Managed portfolios incur a higher tax burden due to the more frequent turnover of portfolio securities. Consequently, mutual fund shareholders pay taxes on unrealized capital gains that ETF shareholders don’t have to pay. In theory, UITs are more tax efficient than OEICs.

INVESTMENT PERFORMANCE. During the 10 year period of 2006-2015, the compound annual growth rate of Standard and Poor’s 500 Total Return Index was 7.2%. In comparison, the growth rates of an index ETF (ticker: SPY) and an index mutual fund (ticker: VFINX) were 7.1% and 7.0% respectively. The slight differences in performance were due to an expense ratio, tracking error, and pricing error of the investment funds compared to the index.

OTHER INDEX FUNDS. There are indices to measure the investment performance of bonds, commodities, precious metals, and other assets. Likewise, there are mutual funds and ETFs that track the various indices. Bond index funds are managed by OEICs and require frequent turnover of the underlying bonds. The index funds for commodities, precious metals, and other assets are structured as grantor trusts, partnerships, or debt instruments. Stock index funds are generally less expensive, taxed at lower rates, and less risky than other index funds. Leveraged ETFs are exceptionally risky investments designed for same-day trading.

CONCLUSION. A broad-market stock index fund is the correct investment for earning returns from the entire stock market or a sector of the stock market. Simply choose an established, reputable index for the particular market that interests you. Then choose an established, reputable mutual fund or ETF that imitates the index. Use screeners or reputable fund families to select appropriate funds. Verify the fund’s expense ratio, extra fees (if any), NAV, longevity, and passive management by reading the prospectus and/or research reports. XTF.com is a free and excellent rating service for screening and assessing ETFs. Cross check your research with a trusted broker.


2014

February 4, 2015

The SmallTrades Portfolio holds investments in five financial markets.  Tax expenses are reduced by trading the Portfolio’s underlying holdings in a tax protected brokerage account.  For tax reasons, any stock or exchange-traded index fund (ETF) issued by a partnership is excluded from investment.

The Portfolio has two subgroups:

  1. Established ETFs that are traded infrequently in the markets for global stocks, global gold, U.S. real estate, and U.S. bonds.
  2. Common stocks that are traded frequently in the U.S. market.

Both subgroups contain high risk investments which are expected to outperform a benchmark index called the Standard and Poors 500 Total Return Index.

The investment performances of the Portfolio and its benchmark index are measured graphically by plotting changes in the market value of an invested dollar (chart).

performance2014

For every dollar invested on the inception date of 12/31/2007, the market values of the Portfolio and benchmark index dropped by nearly half during the Recession year of 2008.  Recovery from the Recession left the performance of the Portfolio lagging behind the benchmark due to the underperformance of a large subgroup of stocks.  Starting in 2013, the Portfolio’s investment capital was gradually shifted from stocks to ETFs and the result was a gradual rise in market value.   Starting in 2014, the ETF for emerging-market stocks (VWO) was replaced by one for global stocks (VT).  At the end of 2014, the market values of the holdings were distributed into a 79.4% portion from ETFs and 19.7% portion from stocks (table).

 portfolio2014

The Portfolio’s performance is measured statistically by its compound annual growth rate (“CAGR”) of market value since inception.  The performance improved during 2014 (CAGR -3.3%) compared to 2013 (CAGR -5%), but still lagged the benchmark index (CAGR 7.3%) and U.S. inflation of prices (CAGR 1.8%) by considerable margins.

Calendar year 2014 was the inaugural year for graphing the performance of the ETFs and Stock subgroups.  The following chart shows that stocks outperformed ETFs during the first year of assessing subgroups.

subgroups2014

ETFs subgroup

The ETFs subgroup is designed to match the performance of financial market indices for global stocks, U.S. investment-grade bonds, U.S. real estate, and global gold bullion when equal amounts of cash are invested in each market.  The market indices for global stocks and U.S. real estate are expected to outperform the U.S. bond index.  The gold index is expected to fluctuate according to changes in investor sentiment for stocks, bonds, currencies, and commodities.  The gold index typically moves moves up when investors seek the gold market and down when investors seek other markets.

The main risk of losing money from established ETFs is derived from a large decline in market prices.   Consequently, the risk management strategy is to rebalance every asset class to 25% of total market value when any asset class drifts below 18% or above 32% of the total market value.  Drifts did not trigger a rebalance of asset classes during 2014 (chart).

ETFassets2014

Stocks subgroup

The investment strategy is to buy stocks at a discount price and sell them at a premium price.  Discount prices are selected from undervalued companies in several ways:

  • Use of a stock screen
  • IPO’s of potentially successful companies after the first day of public trading
  • Media disclosure of good companies
  • Previously owned stocks

Premium prices are discovered by setting alerts for rising prices and placing conditional sell orders in the broker’s trading platform.

The typical holding is selected by a stock screen, held less than one year, and sold with a conditional sell order.  Small-cap stocks characteristically offer better growth potential and higher returns – but at a higher risk – compared to large-cap stocks.  Consistent with the Portfolio’s high-risk investment goal, the total market value of the Stocks subgroup is divided into portions of 22% for large-cap stocks and 88% for lower capitalizations (chart).

MktCaps2014

Conclusions

The SmallTrades Portfolio is an unleveraged, diversified collection of high-risk securities that are traded in the U.S. stock market.  The Portfolio continues its gradual improvement in performance following the 2008 Recession, but its performance still lags that of the benchmark index.  Acceleration of the Portfolio’s performance will depend on the future resurgence of stocks in the emerging markets coupled with high performance of the U.S. real estate market.  Rebalancing the Portfolio’s holdings is expected to partially offset the potential loss from a future declining market.

Copyright © 2015 Douglas R. Knight


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