Financial Tips Archives

Low Cost Index Funds

June 3, 2016 by Justin M. Follmer, MBA, CFP®, AIF®

Low cost index funds are an innovative solution for investors that provide diversified investments at low fees. On any given day, an investor can observe the performance of indices from providers such as MSCI,¹ S&P,² or Russell³—and that means it’s easy to monitor whether or not an index fund manager replicated the index’s performance (gross of fees and expenses). However, an index fund manager’s strict adherence to an index comes at a cost in the form of reduced discretion around trading.

Most indices revise their list of index constituents periodically (e.g., annually or quarterly), at which time securities may be added or deleted from the index. This process is commonly referred to as index reconstitution. For example, the annual reconstitution of the widely tracked Russell indices will occur on June 24, 2016. Russell index fund managers will need to buy additions and sell deletions for the indices they track in order to minimize tracking error⁴ relative to the index. Any deviation of the fund from the index, over days or even hours, could result in different returns from the index.

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

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

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

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

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

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

Exhibit 2: Effect of Delaying Reconstitution Month

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

Low Cost Index Funds: Summary

Low cost index funds may be a good option for investors seeking investments with low fees. However, in an attempt to match the returns of an index, a low cost index funds manager sacrifices trading flexibility. Because of high liquidity demands around index reconstitution dates, low cost index funds may incur high trading costs that do not appear in expense ratios but do affect net returns. The funds’ goal of minimizing tracking error may come at the expense of returns. Investors should consider the total costs, both in terms of expense ratio and trading costs, when evaluating investment options. Working with our Johns Island Investment Advisor can help you build a low cost portfolio using non-index funds in favor of evidence-based portfolios. Give us a call for a free consultation today!

Morgan Stanley Capital International.
Standard & Poor’s Index Services Group.
FTSE Russell is wholly owned by London Stock Exchange Group.
Tracking error is the standard deviation of the return differences between a fund and its benchmark
Source: Dimensional Fund Advisors LP.

Stock Market News

December 7, 2015 by Justin M. Follmer, MBA, CFP®, AIF®

Why don’t the media run more good stock market news? One view is bad news sells. If people preferred good news, the media would supply it. But stock markets don’t see news as necessarily good or bad, rather in terms of what is already built into prices.

One academic study appears to confirm the view that the apparent preponderance of bad stock market news is as much due to demand as to supply, with participants more likely to select negative content regardless of their stated preferences for upbeat stock market news.¹

“This preference for negative and/or strategic information may be subconscious,” the authors conclude. “That is, we may find ourselves selecting negative and/or strategic stories even as we state that we would like other types of information.”

So an innate and unrecognized demand among consumers for bad stock market news tends to encourage attention-seeking commercial media to supply more of what the public appears to want, thus fueling a self-generating cycle.

Insofar as consumers of stock market news are investors, though, the danger can come when the emotions generated by bad stock market news prompt them to make changes to their portfolios, unaware that the stock market news is likely already built into market prices.

This is especially the case when the notions of “good or bad” are turned upside down on financial markets. For example, stocks and Treasuries rallied and the US dollar weakened in early October after a weaker-than-expected US jobs report. Some observers said the “bad news” on jobs was “good news” for interest rates.²

Conversely, a month later, stocks ended mixed, bonds weakened, and the US dollar rallied after a stronger-than-expected payrolls number. While an improving job market is good news, it was also seen by some as cementing the case for the Federal Reserve to begin raising interest rates. In both cases, the important thing for markets was not whether the report was good or bad but how it compared to the expectations already reflected in prices. As news is always breaking somewhere, expectations are always changing.

For the individual investor seeking to make portfolio decisions based on stock market news, this presents a real challenge. First, to profit from news you need to be ahead of the market. Second, you have to anticipate how the market will react. This does not sound like a particularly reliable investment strategy.

Luckily, there is another less scattergun approach. It involves working with the market and accepting that stock market news is quickly built into prices. Those prices, which are forever changing, reflect the collective views of all market participants and reveal information about expected returns. So instead of trying to second-guess the market by predicting news, investors can use the information already reflected in prices to build diverse portfolios based on the dimensions that drive higher expected returns.

As citizens and media consumers we are all entitled to our individual opinions on whether stock market news is good or bad. As investors, though, we can trust market prices to assimilate news instantaneously and work from there.

In a sense, the work and the worrying are already done for us. This leaves us to work alongside a Johns Island Investment Advisor to build globally diverse portfolios designed around our own circumstances, risk appetites, and long-term goals.

There’s no need to respond to stock market news, good or bad.

1. Marc Trussler and Stuart Soroka, “Consumer Demand for Cynical and Negative News Frames,” International Journal of Press/Politics (2014).
2. Mark Hulbert, “How Bad News on Wall Street Can Be Good News,” WSJ MarketWatch (October 5, 2015).
3. Author: Jim Parker, Vice President, Dimensional Fund Advisors with some edits by Coastal Wealth Advisors, LLC. Original article here.

Financial Tips for Graduates

August 17, 2015 by Justin M. Follmer, MBA, CFP®, AIF®

We thought it appropriate to give you 5 Financial Tips for Graduates because we know when you’re just beginning to gain your independence in the world, the thought of managing your finances is a terrifying. For most of us, our parents were there to help us along the way with paying bills, rent, and college tuition. But when graduation rolls around, the reality and panic begins to set in that you’re officially an adult. Although this is an especially difficult time for young adults, it also can be stressful on parents as you completely let go and allow your child to enter the real world. For these reasons, we thought it would be helpful to discuss 5 financial tips for graduates and their parents to feel comfortable during this life transition.

5 Financial Tips for Graduates:

Create a Budget

Although this may seem obvious, it is extremely important, and RARELY done! This is probably the first time in your life that a large, steady paycheck is being deposited into your bank account. For this reason it can be very tempting to impulsively spend, but this is when a well-organized budget comes into play. It’s okay to treat yourself occasionally, but just remember to budget for those guilty pleasures. Even though, creating a budget may seem like a burden, there are countless resources, such as financial smart apps, to help you easily manage your budget. Using a budget now will create healthy financial habits down the road making life much easier for you.

Start Saving for an Emergency Fund

Saving is the key to financial success, so why not get a jump-start on this at a young age? Saving is a habit and the earlier you develop this habit the better, especially due to the volatile state of our current economy. Life throws you curve balls, so it’s important to have an emergency fund. You never know when you may be laid off, are involved in a car accident, or have costly medical expenses. We suggest saving six to nine months worth of expenses into your emergency fund, so you can be prepared in the event of one of these worst-case scenarios.

Begin Funding a Retirement Plan

You just graduated college and retirement is probably the last thing on your mind. Numerous studies show that it’s crucial to start contributing to your retirement fund as early as possible. This is definitely not the most glamorous way to use your paycheck, but it will be beneficial for you in the long run. Many employers match a portion of what you contribute to your 401k. This is an exceptional perk that employer’s offer and if yours does then take advantage of it! If you can swing it, contribute the maximum amount that they match. It’s pretty much like getting free money. You’ll be thankful you did many years down the road. If your company does not have a retirement plan, then don’t worry, you’ll just have to start an IRA.

Start Paying off Student Loans

After four years of college, most of us will likely accrue some student loan debt. While we are of the belief that this would be considered “good” debt, if there is arguably such a thing, it’s important to understand how paying this down consistently benefits you in the long-run. We know you’ve seen them…the countless ads on your Facebook feed about student loan consolidation help and other various debt programs out there. We’ll get to the bottom of these in future posts but know that a simple phone call to your loan servicer (the company that mails you the statement) is all you’ll likely need to consolidate all of your student loans. No need to pay another company to consolidate your federal loans into private loans. There are countless options to consolidate with various terms – all designed to fit your lifestyle. How awesome is that?! Keep in mind that different loan types have varying consolidation opportunities and rules. We suggest you do whatever you can to choose a fixed rate repayment plan and make it a line-item in your budget. Try to automate the payment each month too that way you’ll help your credit score by showing consistently on-time payments. The other benefit to federal student loan debt is the debt forgiveness in the event of your death – your spouse or family won’t be liable; basically the debt will die with you.

Protect your Credit Score

It can be tempting to swipe the credit card whenever you get the desire to make a purchase, but take caution! Be sure to pay all bills on time because even if you miss one payment your credit score could take a plunge. There are many dangers associated with poor credit that can make it difficult to get a good job or approval for an apartment lease, not to mention paying higher interest rates for years to come just because you missed a payment. To avoid these problems and to ensure a high credit score, set up automatic payments for your regular expenses, such as rent and insurance. If you can swing it, choose to use a software solution like Credit Karma to help you monitor your score and to ensure items reported to your report are accurate.

During this monumental time of your life, we want to help guide you towards financial independence. We’re a Johns Island Financial Advisor that specializes in financial planning and investment advice. We’re also pretty laid back and genuinely fun to be around, ha! Let us help you get off to the right start as you begin the next chapter of your life. Contact us today to set up a complimentary appointment.

Image Credit: Ian Norman

401k Rollover

July 27, 2015 by Justin M. Follmer, MBA, CFP®, AIF®

There’s been a reoccurring theme in the financial services industries surrounding a 401k rollover. A simple Google search of the topic loads thousands of results. Many of the big investment firms spend millions of marketing dollars to rank for the “401k rollover” search term just so they can convince you to perform a 401k rollover to their management platform. And I know what you’re thinking…”aren’t you an investment firm also interested in my 401k rollover?” And the answer is “yes, I am…but only when it’s in your best interests.” Recall that we are a fiduciary and must always recommend what is best for you, even if it means not doing business with us. And there are times when a 401k rollover is not the best option for you just as there are times when it is. The Department of Labor is finally catching on to this long-running practice and is proposing that all advisors on 401k plans act as a fiduciary in their approach, especially when recommending a 401k rollover to a client. The details of their plan are far from being solidified but the good news is that this fiduciary standard is designed to protect you and your hard-earned dollars and we fully support the DOL’s efforts. Can you believe there are advisors who do not have to do what is in your best interests? We can’t either.

The story these investment firms tell to convince you to do a 401k rollover is that of greater investment options, control of your money, continued tax-deferred growth, and unlimited portability. And while these are all true, most of these same benefits are also available inside your existing plan.

I’ll refrain from defining a 401k in this post as you likely understand what a 401k is and how it benefits your retirement plan. What you may not fully understand is what happens to your 401k when you no longer work for that employer. And this unknown is manipulated into uncertainty by investment firms when they market “don’t leave your 401k behind” as if to subconsciously suggest that your 401k would be in jeopardy if you no longer work for the company. This couldn’t be further from the truth. The money you earned and contributed pre-tax to the plan is, and always will be, yours no matter what happens to the company. Depending on the plan structure and vesting schedule, even the matching contributions that you are legally entitled to will be yours no matter what happens to the company. So don’t be misled by this fake fear.

Now that you know your money is safe, as in, not in jeopardy of being consumed by the company in the event of insolvency or similar, in the old 401k plan, let’s outline your possible options and when each may fit your best interests. Please note, if your money is invested in the stock and bond markets, it is still subject to loss of principal and the risks associated with being invested.

401k Rollover Option 1: Transfer the Money into your New 401k

If you’ve moved onto another job that offers a 401k plan, you can combine your old 401k with your new one when you become eligible to contribute to it. Your plan sponsor will be able to give you all of the details and paperwork to accomplish this simple transfer. And here’s why this option may benefit you:

If you’re a younger employee, combining small balances into one account helps you keep everything all together as you build a dollar cost averaging plan into your payroll deductions.
The IRS allows you to borrow against 401k money and set up a payroll deducted loan payment back to yourself versus having to take a straight withdraw from an IRA and possibly incurring taxes and penalties. This rule difference may make sense if you know you might be or are inclined to be in a financial pickle in the future.
Tax deferred growth continues and the transfer is considered tax-free (meaning no taxes are due when you combine the two accounts).
If the expense ratios of the investment options inside of the new plan are cheaper than your old 401k, you may achieve cost savings by combining the accounts.
A higher balance 401k may offer you better incentives when seeking advice from your plan sponsor.
Ability to gain access to additional investment options, if available.

Why combining with your new 401k may not make sense:

Investment selection is more restrictive and/or more expensive than your current plan.
You’re giving up access to a reputable investment firm who you may feel comfortable with.
Your new plan doesn’t allow transfers (this would be rare in our experience).
You lose certain guaranteed benefits when transferring –especially when your 401k is a variable annuity with enhanced living benefit riders (these riders traditionally have expenses associated with them, so it’s important to analyze their value as well).

Most important items to consider:

Fees – always consider both management fees, plan fees, and fund expense ratios. Just because a fund is cheap doesn’t mean it’s the best value for you and the same is true for more expensive funds.
Range of investment options – more options tend to give you greater flexibility to adjust your allocation if the economy dictates, but too many investment options can become overwhelming to new investors.
Loss of benefits or gain of new benefits – comparing the “all-in” costs versus value relationship is a must.
Your new employer won’t make matching contributions to your transferred balance, so don’t think you can game the system, smarty pants.

401k Rollover Option 2: Leave the Money in your Old 401k

I think we’ve made it pretty straight forward in your ability to know that you don’t have to rollover your 401k. Just as you analyzed the option to combine the 401k with your new one above, it may well make sense to simply leave the account alone. The only considerations not mentioned above are:

If you believe your old company has an executive inability (incompetent plan administrators) to adequately manage the investment choices going forward, it may make sense to remove your hard-earned money from their oversight.
If your balance is below a certain level as directed by the plan documents, you may be forced to move your account. We’ve seen minimum balances as high as $5,000 for non-participant, former employees.

401k Rollover Option 3: Cash it out (take a Lump Sum Distribution)

This option is the one that will likely hurt the most when the tax man comes in April. If you’re under age 59.5, you’ll pay ordinary income taxes plus a 10% early withdraw penalty. High income earners could see close to half of their retirement savings wiped away by choosing this option. In addition to giving large sums of money to the IRS, you lose out on future tax-deferred earnings benefiting from compound interest growth. In our experience, no matter how you look at it, this option rarely makes sense. Even if you are in severe debt and the taxes you’d pay are better than whatever situation you’re in, you could still avoid the 10% penalty by rolling the account to an IRA and then set up what’s called a 72t distribution. There is a lengthy list of rules regarding this specific IRS rule so please give us a call if you think this may make sense for you. We’ll work with your accountant to develop a plan that fits you.

401k Rollover Option 4: Rollover to an IRA

Let’s say that you’ve determined that the other 401k rollover options aren’t that attractive. Now it would be time to analyze rolling over your 401k to an IRA. This is where you’ll want to look at various companies and what they may propose. Just as you reviewed your new 401k, you’ll want to consider:

Fees – management fees, expense ratios, trading costs, commissions, mortality & expense charges, loaded funds, etc. Some or all may apply depending on who you’re speaking with. If the fees are significantly higher in one company versus another, ask why. Do your research before committing and don’t be afraid to ask – all advisors must disclose how they are compensated and what your “all-in” fees will be. If they don’t tell you or it’s still vague, run far and fast. Stick to the old adage: if it sounds too good to be true, it usually is.
Management approach – how will your account be managed? Passive, top down, bottom up, active, cyclical, etc. When will trades occur and how often? How often will review meetings occur and what can you expect during those meetings? Will the account be managed on a discretionary basis or will they need permission to make adjustments each time?
Investment allocation – what mix of stocks and bonds, sectors, styles, and approaches will you take? Will alternative asset classes and commodities (rarely offered in 401k plans) be a major component of the mix? How about structured products and limited partnerships? IRAs have the ability to invest in many types of asset classes that can’t be found inside of typical 401ks. Even investing in hard assets like real estate and physical metals such as gold and silver can be accomplished given the right, qualified custodian. Keep in mind the more non-traditional your selection, the more rules there tend to be.
Value added services – if fees are higher, are additional services included to justify the increased costs? Is a financial plan, budget guidance, or debt management included? How often advice is rendered – unlimited or certain number of times per year? Is the management approach the reason for higher fees? It can often make perfect sense to pay higher fees when the value of services offered is considered. Having an advisor that you can trust to help you manage your financial life can be a huge relief to the burden this may cause.
Type of advisor – not all financial advisors are the same. Some earn commissions on trading activity while others are fee-only. Some tend to be a hybrid of both types and how they operate at different capacities can be vague (think of the DOL rule we talked about earlier in this post). Not to tout ourselves, but we believe it’s best to work with a fiduciary; a person who must keep your best interests at the forefront of every decision they make.
Special tax considerations – if you own the stock of the employer you work for, you may want to consider leaving the stock in the 401k. There are special tax considerations to analyze with a qualified CPA that allows this type of stock to be taxed when withdrawn at a rate lower than ordinary income taxes. We’ll help you work with your accountant in analyzing if this fits your situation.

The decision you make with your 401k rollover is very important and shouldn’t be taken lightly. Don’t assume that because it seems like everyone rolls over their 401ks to an IRA, that it’s the best option for you. Your situation is drastically different than your friends and family. You are unique and so too should your money management plan. Outside of your personal home, your 401k is most likely the largest asset you own and will naturally become the cornerstone to your retirement income. We want to be your trusted financial partner to help you determine which option is best given your unique circumstances. We are a Johns Island Financial Advisor who builds financial plans and investment strategies for our clients. Anywhere you want to go; we’re here to help guide you along the way. Let’s start a conversation today.

Image Credit: Flickr

Creating a Budget

July 8, 2015 by Justin M. Follmer, MBA, CFP®, AIF®

Who says you can’t budget for your guilty pleasures? Well, we believe you can! Of course your budget may include things such as utility bills, gas, and groceries, but don’t be afraid to incorporate the fun things when creating a budget. Whether it’s a weekly case of beer or your next vacation to the Caribbean, don’t deprive yourself when it comes to your budget. It’s all about how you budget for these things, which can be difficult, but that’s why we’re here to help! Contact us today and let’s talk so we can help you create the perfect plan.