Category: mutual funds

A Broader Inclusion

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November 27, 2022

by Stephen Stofka

Hope everyone had a good Thanksgiving. This week’s letter is about a type of income that we don’t often think about, how that affects asset values and a proposal to increase homeownership. With left over buying power, people purchase assets in the hope that the buying power of the asset grows faster than inflation. There are two types of assets: those that produce future consumption flows and collectibles whose resale value increases because they are unique, desired and in limited supply. An example of the first type is a house. An example of the second type is a painting. Let’s look at the first type.

House Equals Future Shelter

A house is a present embodiment of current and future shelter. The value of that utility depends on environmental factors like schools, crime, parks, access to recreation, shopping and entertainment. These affect a home’s value and are outside a homeowner’s control. A school district’s rating in 2042 may be quite different than its current rating. Our capitalist system and U.S. tax law favors home ownership in several ways. The monthly shelter utility that a home provides is capitalized into the value of a property. Every consumption requires an income, what economists call an imputed rental income. Two thirds of homes are owned by the person living there (Schnabel, 2022) and a little more than half are mortgage free. Unlike reinvested capital gains in a mutual fund, this imputed income is not taxed to the homeowner. Let me give an example.

If the market rate for renting a similar home were $2000 a month, that is an implicit income to the homeowner. Because there is no state or federal tax on that income, the gross amount of that $2000 would be about $2400. That’s almost $30,000 a year. After monthly costs for taxes, insurance and maintenance, the annual implicit operating income of the property might be $25,000. At a cap rate of 5% (to make the math easy), the capital value of the property is $500,000. Each year, Congress requires the U.S. Treasury to estimate the various tax expenditures like these where Congress excludes certain income items from taxes. The implied income on owning a home is called “imputed rental income” and in 2021 the Treasury (2022) estimated that the income tax not collected was $131 billion. How much is that? A third of the $392 billion paid in interest on the public debt. If we did have to pay taxes on that imputed income, it would lower the value of our homes. For many decades, Congress has not dared to include that implied income.

Mutual Fund Capital Gains

Let’s return to the subject of reinvested capital gains in a taxable mutual fund held outside of an IRA or pension type account. Some of what I am about to say involves tax liability so I will state at the outset that one should consult a tax professional before making any personal buy and sell decisions. When some part of a fund’s holdings are sold, a capital gain is realized from the sale and paid to the investor who owns the mutual fund. If the investor has elected to have dividends and capital gains reinvested, the money is automatically used to repurchase more shares of the mutual fund. The balance of the account may change little but there is a taxable event that has to be included in income when the investor completes their taxes for the year. Many mutual fund holdings recognize capital gains in December.

Mutual fund companies provide the tax basis or unrealized gain/loss for each fund but often do not include that information on the statement. The unrealized gain is the price appreciation has not been taxed yet. For example, the dollar value of a fund may be $50,000 and the unrealized gain $5,000. This is more typical of a managed fund than an index fund which does not adjust its portfolio as frequently as a managed fund. If an investor were to sell the fund to raise cash, they would pay taxes on the $5,000, not the $50,000. The unrealized gain in an index fund might by 70% of the value of the fund. If the fund value is $50,000, the unrealized gain could be $35,000 and the investor would owe taxes on that amount. An investor can minimize their tax liability with a judicious choice of which fund to sell. Again, consult a tax professional for your personal situation.

Affordable Homeownership

Let’s visit an imaginary world where people do not have to pay property taxes outright. Each year they can elect to sell a portion of their property to the city or other taxing authority. Cities sometimes place tax liens on properties when a tax is not paid. This would be like a voluntary lien making the city a temporary part owner of the property until the homeowner sells it.

Imagine that a homeowner owns a home worth $400,000. For ten years, they have elected to have the city deduct an annual $2000 average property tax from the value of the home. Over the ten year period, the accrued sum is $20,000 plus an interest fee that is added to the principal sum of the tax. These voluntary tax liens would be visible to a lending institution so that the sum would lower the home’s value for a HELOC, or second mortgage. The city would report that annual amount each year as an imputed income to the homeowner and the homeowner would have to pay income taxes on it. At a 20% effective federal and state tax rate, the out-of-pocket expense would be about $480 on $2000. After the 2017 tax law TCJA, property taxes are no longer deductible so the homeowner has to earn $2400 to pay the $2000 tax outright. There is a slight change in income tax revenue to the various levels of government. When a home is sold those tax liens would be paid back to the city.

Why don’t we have such a system in place now? In the U.S. private entities own most of the capital. Some people would be uncomfortable knowing that a government authority had some legal claim to their property but they could opt out. In a pre-computer age, the accounting would have been a nightmare. Such a system is feasible today. Mutual fund companies have demonstrated that they can track the complex capital positions of their customers. Cities can do the same.

Such a system would make home ownership more affordable for a lot of people without affecting those homeowners who preferred to pay the property tax outright as we do under the current system. Investment companies would be eager to amortize those voluntary tax liens held by city governments. In the event of another financial crisis, a decline in housing prices and a rise in foreclosures, the city would be first lienholder, first in line to get paid when the property is foreclosed. Interest groups that advocate for affordable housing would be joined with investment and pension companies who wanted to underwrite the bonds for such a program.

A Capitalist System of Greater Inclusion

Some blame our capitalist system for the inequities in our society. The fault lies in us, not the capitalist system. Feudalism, mercantilism, capitalism, socialism, communism and fascism are systems of rules that embody a relationship of individuals to 1) property and the manner of production, both current and future, 2) the society, our families and communities, 3) the government that recognizes those relationships. The capitalist system is the most versatile ever invented and yes, it has been used to exclude people just as the other systems have been used to weaken some classes of people. The capitalist system can be extended to include and strengthen more of us. This homeownership policy could broaden that inclusion.  

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Photo by Hannah Busing on Unsplash

Schnabel, R. (2022, August 19). Homeownership facts and statistics 2022. Bankrate. Retrieved November 24, 2022, from https://www.bankrate.com/insurance/homeowners-insurance/home-ownership-statistics/

U.S. Treasury . (2022, October 13). Tax expenditures. U.S. Department of the Treasury. Retrieved November 24, 2022, from https://home.treasury.gov/policy-issues/tax-policy/tax-expenditures. Click FY2022 for the current year PDF estimates.

Expectations

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by Steve Stofka

December 3, 2017

What can I expect from my portfolio mix? Portfolio Visualizer has a free tool  to analyze an asset mix. We can also get a quick approximation by looking at a fund with that mix.
An investor with a 40/60 stock/bond mix might go to the performance page of Vanguard’s Wellesley Income fund VWINX. It’s 50-year return is close to 10% but that includes the heady days of the 1970s and early 1980s when both interest rates and inflation were high. The ten-year performance of this fund includes the financial crisis and is close to 7%.

An investor with a slightly aggressive 65/35 stock bond mix could look to Vanguard’s Wellington Fund VWELX, which has a similar weighting. It’s 90-year return is 8.3% but that includes the Great Depression and WW2. It’s 10-year return is – wait for it – close to 7%.

Two funds – a conservative 40/60 and a slightly aggressive 65/35 – both had the same ten-year returns. All it took was one bad year in the stock market – 2008 – to even up the returns between these two very different allocations. On a year-by-year comparison of the two funds we see a trend. During the two negative years of this fifteen period, I charted the absolute value to better show that trend. Also, compare the absolute values of the returns in 2008 and 2009. The collapse and bounce back was about the same level.

VWELX-VWINXComp

During this fifteen year period, the cautious mix earned 88 cents to the $1 earned by the slightly aggressive mix. Looking back thirty years, cautious made only 75 cents. In the past fifteen years, the difference between positive and negative years was important. In good years, cautious earned 20 cents less. But in negative years, like 2002 and 2008, cautious made 73 cents more by losing that much less.

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Personal Saving Rate

The savings rate is near all-time lows. We’ve seen a similar lack of caution in 2000 and 2006. As housing and equities rise, families may count those gains in their mental piggy bank. Asset gains are not savings. Asset prices, particularly equities, will decline during a recession. Jobs are lost. Without an adequate financial cushion, families struggle to weather the downturn. The rise in bankruptcies and foreclosures further exacerbates the downturn.
SavingsRate1998-2017

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Annuity

A good explanation of the various types of annuities.  The graphics that the author presents might help some readers understand the role of annuities, and the advantages of deferred vs. immediate annuitues.  I have also posted this on the Tools page for future reference.

http://www.theretirementcafe.com/2017/11/income-annuities-immediate-and-deferred.html

The Volatility Scare

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January 24, 2016

Last week I wrote that I smelled capitulation.  When the Dow Jones (DJIA) dropped more than 500 points on Wednesday, I smelled burnt barbeque.  Historically, there is a weak correlation between the price of oil and the stock market.  In the past few weeks the 20 day correlation between the oil commodity ETF USO and the SP500 is .97, meaning that they are chained to each other in lockstep.  If that relationship continues throughout the month, investors can expect a continued bumpy ride.

Several factors helped indexes recover in the latter part of the week. After dropping near $26 a barrel, oil rebounded above $30 at the end of the week.  Mario Draghi, head of the European Central Bank (ECB), indicated that the bank was prepared for additional stimulus.  Sales of existing homes climbed in December, indicating a level of confidence among U.S. families.

Since the first of the year, investors have withdrawn $26 billion from equity mutual funds and ETFs (Lipper), offsetting the $10 billion inflow into equities in the last week of 2015.  Fund giants Fidelity and Vanguard report that their customers have been net buyers of equities despite the turbulence.

Volatility (VIX or ^VIX at Yahoo Finance) in the last half of the week dropped to the 8 year average of about 22.  We have enjoyed such low volatility in the past few years (mid-teens) that investors are especially sensitive to price swings.  For a long term perspective, here is a chart showing some multi-year averages of volatility.

A few weeks ago, I noticed an acronym for the 2008 Global Financial Crisis – GFC.  The memory wound is still fresh for many. Older investors with their working years largely behind them may feel even more vulnerable in times of higher market volatility.

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Fund Fees

Employees in 401K plans may not know how much money they are paying in fees each year.  One of the charges is what is called a 12b-1 fee, and you will need to breathe slowly into a paper bag while you read about this one.  Each fund has an investment advisor to administer the fund’s investments and the fund pays a fee for this service.  In addition, under some plans, the advisor charges the fund holders a separate marketing and distribution fee, the so called 12b-1 charge, to promote the fund through sales materials or broker incentives.  Wait, you might ask.  Shouldn’t marketing expenses be part of the advisor’s fee? Well, you would think so.

The Annual Report that accompanies your 401K statement might list one of the funds you are invested in as “Blah-Blah-Blah Growth Fund, Class R-1,” hoping you are going to sleep.  The R-1 class means the fund is charging you 1% for marketing and distribution fees. Here is a glossary of the classes of mutual funds and the percentages of 12b-1 fees.  In addition, funds have  varying sales or redemption fees which are denoted by a letter class for the fund, i.e. Class A, B, C.  The Securities and Exchange Commission (SEC) explains these here.

The  SEC has a FAQ sheet explaining the various fees.  These charges might seem small but they add up over a working lifetime.  The SEC provides an example  of the 20% difference in value between a fund that charges 1.5% fee each year and one that charges .5%.  FINRA, the industry group that certifies and regulates financial planners, has a mutual fund expense calculator that enables an investor to compare fund expenses by their ticker symbols.

I compared an American Funds Class A Balanced Fund ABALX that might be found in a 401K with a Vangard Admiral Balanced Index Fund VBIAX over a ten year period.  Taking the default assumptions of a 5% return on an initial investment of $10K, I had $1670 more in the Vanguard fund after the ten year period, or an additional 3 years of return.

Some 401K plans make it more difficult to compare performance or fees.  They may list a fund whose ticker symbol is not listed on any exchange but is a “wrapper” for a fund that is listed.  The only way to find out that information would be to look at the prospectus or other materials for the 401K fund or visit the web site of the 401K plan administrator.  How likely are many participants to do that?  That’s the point.