Oftentimes the best place to look for value is in a place few others know to look. That’s certainly the deal for closed end funds… a massively underused and unexplored asset class for most investors.
Go ahead and quote that; I just made it up. Closed end funds are an often overlooked place in the market for your investment funds. CEFs are mutual funds which trade on exchanges and lack the price arbitrage functions of Exchange Traded Funds. This means that Closed End Funds can be (and often are) priced significantly differently from their underlying assets.
What are Closed End Funds?
Closed end funds generally offer shares in the form of an Initial Public Offering or Secondary Offering. These shares cannot be redeemed for the underlying assets; this is what I mean when I say that the shares have no inbuilt arbitraging function (unlike ETFs which allow exchanges which allow investors to benefit from any deviance from the underlying assets). One of the great unsolved mysteries of Closed End Funds is why they are so often priced at a discount to their net asset value (NAV).
Closed end funds exist for all sorts of assets. They are free to employ more exotic strategies than most funds… CEFs exist which offer leverage, invest directly into Mortgage Backed Securities, and many illiquid assets which are generally untouchable by normal funds. In order to assist with price discovery, two prices are quoted:
Share Price – The market price of the security
Net Asset Value – The market value of the underlying securities in the fund.
No Risk? No Reward.
Closed end funds seem to be a good arbitrage opportunity. By shorting the underlying assets in a discounted fund and buying the fund itself, you would be rewarded when the spread between the market price and NAV narrowed. For whatever reason, CEFs tend to keep their premium or discount for long periods of time. Many CEFs started trading in one direction and have continued to this day. The thinly traded nature of the products allow you to find overlooked funds but you also may be punished by ETF quirks. Discounts can increase; during the market’s recent plunge, CEF discounts moved to very high values. CEFs have very unique risk factors you need to consider when doing your due diligence.
Talk it over with your investment advisor and see if there’s a place in your portfolio for some CEF goodness. They are especially useful for generating income… CEFs tend to have very large distributions compared to market average dividends. Get started researching today… ETFConnect and the Closed End Fund Association are great resources. For information on individual CEFs, I like to read through the Yahoo! Message Board or consult the forum at Morningstar. Seriously- take a look at this secretive corner of the market. You may find exactly what you’re looking for…
Disclaimer! Make your own investment decisions. Anything mentioned should only be used as a starting point. Caveat emptor, and carpe diem.
The way the financial community seems to be covering it, we are currently attending the funeral of Asset Allocation. Long live Asset Allocation!
A common topic on financial pages world wide web wide (a cheer for alliteration?) is about the supposed death of asset allocation. Asset Allocation is the idea that the best retirement play for most investors is to allocate financial resources among a number of investment baskets. Supposedly by spreading one’s investments across a diverse set of asset classes it is possible to catch the hot performance in any corner of the market while absorbing any shocks in other corners. Of course, the uninspiring performance of asset classes during the ‘Great Recession’ seem to throw this theory into question. Read on and decide for yourself if we need to find some pallbearers for this financial heavyweight.
Chicago School and the Efficient Frontier
The economist most associated with Asset Allocation is 1990’s Nobel Prize winner Harry Markowitz. Markowitz studied economics at the renowned University of Chicago under lots of economics heavyweights. Milton Friedman, as Markowitz recalled in his Nobel Prize acceptance speech, even went so far as to say that Markowitz’s explorations into portfolio allocations weren’t economics. Regardless, Markowitz gave his name to the Markowitz (also known as efficient) Frontier. Modern Portfolio Theory states that the Markowitz Frontier is the point when a portfolio cannot lower its risk (through diversification) for a given rate of return.
Modern Portfolio Theory is really an outcropping of another idea that came out of the Chicago School (specifically Eugene Fama)- the Efficient Market Hypothesis. The Efficient Market Hypothesis states that when information relevant to a security is disseminated, prices will adjust and price that news perfectly. The EMH is a purposeful simplification framing the discussion for finance classes- not an actual description of the stock market. (Here’s a good post describing the distinction) Regardless, the takeaway point is that most investors will not beat the market in any sort of an active trading roll. (The best summary of why the EMH can’t be true all the time takes the form of this sidewalk joke:
“An economics professor and his student are walking down a sidewalk when the student bends over to pick up a twenty-dollar bill. The professor stops him before he can grab it and says, ‘that can’t possibly be a real twenty dollar bill; someone surely would have picked it up by now!’” )
In a quickly falling market, the correlation of most assets actually increases. This is a strange side effect of quick selling which also manages to turn Asset Allocation on its head. All of the carefully diversified asset classes investors in the AA system bought into years ago (and rebalanced often) all fell simultaneously.
As you can see, commodities seemed to be uncorrelated with the index. Suddenly, they started to look a lot like stocks and fell just as quick. Note that ‘risk’ in Modern Portfolio Theory is approximated using standard deviation of returns, a backwards looking indicator. There are other ways to look at risk… implied volatility of options, for example. Regardless, there is no way to completely know the risks before a scenario like a ‘Great Recession’ happens.
The Nail in The Coffin for Asset Allocation?
Does this convincingly prove anything about the demise of Asset Allocation?
Of course not. Lots of investing styles lost money in the recession… Warren Buffet’s value investing style (using Berkshire Hathaway as an example) even lost money. There are also some asset classes that did well throughout the downfall of the stock market, like government debt. Perhaps the issue isn’t a failure of Asset Allocation, but an improper selection of the asset classes which investors put their money into (a mistaken belief that certain classes would stay uncorrelated, even)?
I firmly believe that most investors are best off using the simplest possible methods to invest on their own. Diversification, which is the key to a theoretically sound asset allocation, is key. Most people don’t have the energy or the inclination to put in the sort of work successful active investing takes. Asset allocation is a way (sort of like dollar cost averaging) for average people to sock some money away. On this merit alone I feel AA is still alive. Much like any movement (take the infamous Business Week cover, “The Death of Equities“) which declares something in investing dead, this too shall pass. Perhaps the issue was the over-adoption of the strategy? As Felix Salmon states in his take on AA’s demise:
“It’s a pretty solid rule of investing: good ideas tend to become broadly adopted. And once enough people are all doing the same thing, that thing is probably not a good idea any more but rather a bad idea.”
Is it time to invest in real estate? Is it still too soon? Are we near the top?
Regardless of where we are in the cycle, it’s good to know what options are actually out there to invest in real estate… so we’re going to go over a few options you’ve got.
Real estate investing is not limited to house ‘flipping’ or becoming a landlord. There are other ways to play real estate – to the downside or the upside. Real estate investing can cover much more than simply buying residential property to rent or resell. Read on for a look at a few of those ‘other’ forms.
Real Estate Investment Trusts, or REITs, are a method of investing in real estate either through mortgage pools or through direct ownership or property (mortgage versus equity REITs). Companies organized as REITs are mandated to distribute 90% of their profits to investors. REITs can invest in all forms of real estate – Residential, Industrial, Health Care, and many more.
Some of the larger REITs include SPG, the Simon Property Group; BXP, Boston Properties; and PLD, Prologis Trust. Simon invests primarily in malls and retail spaces, Boston invests mainly in office properties, and Prologis invests mainly in industrial properties. A REIT that invests in apartment complexes and residential properties is AIV, Apartment Investment and Management Company. These are some of the larger REITs in the market, there are hundreds of other options.
Exchange Traded Funds
There are a number of indices which track the performance of the real estate market in the United States. Indices are published by Wilshire, Morgan Stanley, and Dow Jones, among others. REIT ETFs allow you to diversify across many REITs in a certain sector by only buying one ETF. VNQ is a popular ETF managed by Vanguard which tracks the Morgan Stanley Capital International US REIT Index. IYR, managed by iShares, tracks the Dow Jones U.S. Real Estate Index. Internationally, RWX tracks a number of international REITs (but no US based REITs), and is managed by State Street.
Alternatively, regular mutual funds are also an option for investing in real estate.
I am not a financial planner. Do your own research and consult some experts if you have questions. Just know that there are a lot of ways for you to get some exposure to real estate in your financial picture without buying housing. Using these options allow you to diversify your portfolio and even hedge against downfalls in the price of your house. Have fun.
Gold, the 79th element in the periodic table, is perhaps the most controversial of any investments. Every investor seems to have an opinion on the metal. Some people, particularly enamored with the constitution, read into it the necessity for the government to only issue gold (and silver) coins. So, investing in gold… is it a good idea in your portfolio?
Regardless of your viewpoint on the legality of fiat currency, perhaps you have decided to take the plunge and invest some of your hard earned funds into the stuff. There are many ways to approach investing in gold; I will lay out a few approaches to gold investing in this article.
A Brief, Contentious Historical Summary of Investing in Gold
The United States has historically altered between being backed by gold at a fixed rate or a constant rate. Two major events in the history of our currency are pointed at as the most controversial laws our nation has passed with regards to gold and silver backed currency. The first is the “Gold Confiscation Act”, or Executive Order 6102 under President Franklin D. Roosevelt. That act banned the ‘hoarding’ of gold over the amount of $100 for private investors. The second was the August 15, 1971 act by President Richard Nixon to depeg the $35 / oz. gold standard due to excessive spending on Vietnam and President Lyndon Johnson’s ‘Great Society’. Since 1971, currencies of the world have been fiat currencies, and the rate of gold exchange is set by the market.
Widely Held Beliefs on Investing in Gold
Just because beliefs are widely held doesn’t mean they accurately reflect reality. Yes, there is a correlation between the devaluation of the dollar and the increase in the price of gold (it is not 100%, stocks are a better inflation hedge). However, gold tends to perform even better in times of deflation (see here and here). Gold’s highest performance potential would seem to be linked to an emotional event rather than a monetary one. Gold has historically been used as currency, and its perception as currency might keep it valuable in times of great emotion.
Whatever The Reason…
Regardless of the reason why you want to purchase gold, you have decided to take the plunge. The next step you have to consider is how, exactly, you are going to go about that. There are a few options for you to invest in the metal, which I will highlight shortly. It is important to note, that for whatever reason, gold is considered a ‘collectible’ by the IRS. This means that no matter your holding period, physical gold capital gains you receive will actually be taxed at your marginal rate. See a tax professional for more details… I am not one.
Pick a Door
Physical Bullion – Depending on your risk tolerance, (and possibly, paranoia) physical gold is an option. You can buy gold coins, such as the popular American Eagle or the South African Krugerrand, for your own personal storage. You’re going to want a safe… theft is probably the greatest risk to your gold holdings, not confiscation. Alternatively, you could store it in a bank safety deposit box or off site in a vault like with Bullion Vault.
Gold ETFs – A much simpler solution is to invest in a gold exchange traded fund such as IAU and GLD. You can even go long 2x the spot price of gold with an ETF such as [[UGL]]. There are a number of other options, check them out. An ETF like GLD will hold physical gold somewhere. Commodity ETFs are an interesting approach to investing in commodities in general, not just gold.
Gold Stocks– Gold miner stocks, such as companies like Freeport McMoran FCX and Gold Fields, Inc. GFI are another way to play gold. Gold stocks will not correlate perfectly with the spot price of gold, but will realize a benefit. The nice thing about gold stocks (other than the reduction in tax if held in a taxable account for a sufficient duration vs. the ‘collectible’ tax of gold) is they won’t lose as much money on the way down if gold loses its luster.
Derivatives – For a more exotic approach (where you can also apply leverage) to investing in gold you can check out the derivative market. You can buy or sell options on gold, and invest in futures contracts.
Finishing it Off
All of these options are a solid bet for investing in gold. Various options have their own advantages and disadvantages. In a true crisis environment, physical gold would probably be better than any of the other options. However, that sort of situation seems unlikely. In a taxable account, ETFs are the most accessible way to invest in gold. Take a look at CEF, which is the Central Fund of Canada (note CEF also holds silver). In a taxable account, you can save money over the other options. Of course, you could stick it in a retirement account and not worry about taxes.
Full Disclosure: That’s what I did; I’m invested in a mutual fund that invests some of its assets in physical gold in a tax-free account. Consult a financial advisor if you have any questions.
An Employee Stock Purchase Plan (or Program) is an interesting form of compensation offered by some companies which allows participants to purchase company stock at a discount to market price.
A common purchase discount for an ESPP is 15% of the market value on the either of two days: The first day money is locked up (known as the ‘lookback’ date) of a 6-month period, and the last day of the cycle. Two 6-month cycles make up the average ESPP, and each cycle locks up your money for the entirety of that period.
How does that translate to the bottom line?
Say a person is making $100,000 a year – $90,000 in base pay and $10,000 in bonuses. They can contribute up to 10%, or $10,000 into the ESPP.
Base Pay: $90,000 Bonus Pay: $10,000 ESPP Contribution: -$10,000 ___________________________
Net Cash (Pre-Tax) $90,000
Say the price of stock on the 20th is $20.00 a share:
If the price stays steady until February: 588 shares purchased, market value $11,760
If the price declines to $15.00 a share: 784 Shares purchased, market value $11,760
If the price increases to $25.00 a share: 588 shares purchased, market value $14,700
Total salary: $101,760, $101,760, $104,700. This person effectively got 1.76% (or even 4.7%) raise, just by participating… not too shabby.
Can you lose money in an Employee Stock Purchase Plan?
Of course… everything in investing has risk. Two specific scenarios stick out in the risk consideration:
1) Your employer can go bankrupt while holding shares (especially during the ‘float’ between the grant and the shares being available to sell, referenced below). Reference Arthur Andersen, MCI Worldcom, Enron, Bear Sterns, Countrywide Financial etcetera for stories of what happens in that case. Yes, you now have bigger problems than stock losses. 2) If you decide to hold your shares, the stock price can continue to decrease AFTER the stock is purchased. Of course, you are continuing to purchase every 6 months, so your exposure is cut by the fact you are averaging down. If you sell immediately, you can avoid this to a degree.
What does a declining stock price mean?
Basically, a declinging stock price means more shares for you in an employee stock purchase plan.
Of course, you can sell immediately and take out all the risk to lock in a 15% profit. Or, alternatively, you can let it ride (and infinite other combinations). However, may I suggest selling immediately?
A key thing to consider in holding onto your ESPP shares is single company risk… if you work at a company that isn’t doing well, not only are your savings (in the form of ESPP granted company stock) at risk, but so is your very employment. You should practice diversification… sell immediately and invest your money elsewhere. However, if you think that you would invest in your company assuming you had free reign to pick to invest anywhere… then by all means, leave your stock in the account.
Full tax advantages of holding onto ESPP shares take two years to take effect. Any sales before two years are considered a ‘disqualifying distribution’, and the difference between the price you paid and the fair market value on the purchase date is considered income. The difference between the price at the time of sale and the cost basis (market value on the purchase date) will be treated as normal capital gains or losses.
There is one case where a large amount of damage can be done. As detailed at this site, if the price of the stock increases greatly between the lookback date and the final date, that difference will have to be reported as income regardless of the selling price! If you end up selling the shares for less than the lookback date’s value, you will owe tax on the income you WOULD have earned had you sold immediately. In this case, ensure you hold onto your shares for two years.
Second, 15% is the discount on the date of the stock grant. Between the date of the grant and the shares actually hitting your brokerage account, lots of things can happen. The stock price can go down, (or even to zero, theoretically) up, and stay flat. This has to be considered in any discussion of ESPPs.
More Math on the ESPP…
A 15% discount translates into a 17.6% gain, just for participating (1 / .85). However, your actual gain and annualized gains are much better than that.
Say you get paid every week, and $100 goes into your ESPP:
$100 * 26 = $2600
Your shares are worth $3058.82, for a gain of $458.82. On the surface, you made ~17.6%. However, look closer. You made 17.6% on a 6 month lockup of your money…. but your money (because of the timing of your paychecks) was only locked up for an average of 3 months. Annualized, this works out to a ~ 90% annualized gain! (1 * (1.176^4))
That’s tough… or impossible… to beat with ANY investment. Also, this is the minimum (other than the ‘float’ discussed above) that you can possibly earn. An employee stock purchase plan can feel like a money printing press.
Conclusion: Sign up for the ESPP Today!
The only real downfall to the program is your money is locked up for 6 months. In 6 months this money will be free to leave in your brokerage or sell, and the next participation period won’t affect you (since the current period’s money will be available). It really will only affect you the first 6 months… so get it over with. You can either sell at that point, or leave it in, but either way you’ve given yourself a raise.
My suggestion? For the vast majority of employers you should max out your employee stock purchase plan… and sell immediately. It’s not worth the uncertainty of waiting for favorable tax treatment, where a small decline can wipe out any gains you got from waiting for the lower tax rates. So, sign up, max out, and invest your gains elsewhere! Happy investing!