The following is from the subscriber discussion with me regarding this year’s Note 4 of The Kelly Letter, which was sent on Sunday, January 26, 2014. It showcases typical interplay within this intelligent investment community, which is a helpful benefit of becoming a subscriber.
STEVE, posted 1/26/14
Regarding the Signal Strategy:
Many readers are probably investing in a taxable account. Frequent selling is going to trigger taxes, often at higher short-term rates. This is going to drag on results, and the money to pay the taxes may have to be withdrawn. All of this also incurs transaction costs as well.
Taking this into account, I wonder by how much this Strategy’s potential advantage will be mitigated? How might it compare to simply holding a tax efficient ETF for the long term, with less frequent rebalancing. Transaction costs would be minimized; and any taxes due could be delayed indefinitely into the future, allowing the investment to compound all the more, and finally paying the lower long term rate.
Have these two approaches been compared?
JASON, posted 1/26/14
No doubt, Steve, the quarterly trading schedule of the plan makes it more suitable to tax-advantaged accounts, such as IRAs and 401(k)s. However, tracking lots makes it fairly simple to sell those held for more than one year, thereby reducing the tax burden to 15 pct rather than the short-term rate, which is usually higher than 25 pct for investors. This helps, but remains a burden.
The plan has outperformed buying and holding an efficient index ETF, even when taking taxes into account. However, I’m not sure the plan as it’s being run in Tier 3 will do so, and probably can’t be sure because it will differ in all environments given the many moving pieces involved in the tier’s portfolio. I’ll keep an eye on making sells worthwhile by skipping signals that don’t lock in significant strength that brings high odds of a reversal, etc.
Also, bear in mind that the higher a person’s income tax, the harder it is for this or any plan to clear the tax consequenes on short-term trades. It’s possible that a high-tax-bracket investor making all short-term trades could fail to achieve enough outperformance to offset the tax burden in a future market. It’s probably unlikely, however, because the 3 pct hurdle each quarter is actually fairly demanding of the market. Particularly if a person is adding more cash every month, most signals will be buys, not sells, and the sells will almost always be worthwhile eventually when their proceeds are reinvested at lower prices on later buy signals.
Luckily, most people manage the bulk of their lifetime savings in tax-advantaged accounts. In their taxable accounts, the Signal Strategy will almost certainly outperform any active approach they’re taking, which would incur tax consequences of its own, and has in the past provided enough extra performance to more than offset the tax burden.
CJ, posted 1/29/14
First I want to say I love the 3% plan. I’ve been applying it in my IRA for a few years now.
I was wondering if the tax implications could be limited by shorting the individual stock or ETF instead of selling them. This way you would build a short and long position over time with the net amount equaling the required hold position. Then as you build over time you could theoretically sell for taxable losses. Please let me know what you think.
JASON, posted 1/31/14
Thank you for the positive, real-world report, CJ!
You could indeed mitigate taxes with a shorting strategy, but I think suggesting so would be inviting danger into the lives of people who, for the most part, are interested in the strategy for its stress-reducing aspects. For more sophisticated investors, however, shorting could work better than selling for the reasons you cited. It might even produce the series of tax write-offs you mentioned, all the while growing the account balance — quite a coup!
See you Sunday,
ARON, posted 1/26/14
I need clarification about specific points on the new 6% signal strategy for Tier 2. Is this a fair interpretation: 50% of Tier 2 capital is going into BOND and 50% is going into MVV?
What Jason means by: “60% as the percentage of safe capital at which a rebalance back to 50% is triggered” is that once your Tier 2 capital in BOND grows to be 60% of the total capital in Tier 2 you’re going to sell enough to bring it back to 50%?
Should we keep that money as cash or invest it into MVV? Also, why did Jason choose BOND (Tier 2) and CMBS (Tier 3) as safe investments?
Good questions, Aron, and I’ll be sure to run them by Jason when I see him next. Oh! Here he is now…
Yes, the target allocations in Tier 2 are 50/50 MVV/BOND. When the BOND balance hits 60 pct of the tier’s capital, we’ll move all of the excess into MVV on the next quarterly buy signal, not before and not when there’s a sell signal.
The three bond funds offer different expense ratios, different yields, but similarly competitive resilience in stock sell-offs. From the feature article of last year’s Note 53 sent Nov 3:
Our portfolio consists of three tiers, and we’re going to use BND, BOND, and CMBS for the respective cash balances in them.
BND is broadly diversified and very cheap, consistent with the goal of Tier 1, which is to achieve steady growth over time by rebalancing the stock portion of its value averaging plan to a quarterly 3 pct signal line by either buying or selling. Rather than using a zero-interest cash fund for the proceeds of the sales, we’ll begin using BND next year.
Tier 2 is more aggressive than Tier 1, though you wouldn’t know it recently given its holdout in cash. It does not worry as much about expenses nor as much about long-term yield. The plan wants to be entirely in ProShares Ultra MidCap 400 (MVV $117) most of the time, and should have been in recent times. My overly cautious outlook prevented it from happening. To remedy that, we’ll move cash into BOND, which is Bill Gross’s famous Pimco Total Return mutual fund in an exchange-traded product. The expense ratio is high for this category, but Gross is a superb bond trader and Tier 2 is a place for active management and higher fees in pursuit of higher ending performance.
Tier 3 is another active management zone, where we least expect capital to stay on the sidelines for long. Therefore, price stability is more important than yield here, and CMBS looks about perfect. Its price has held up well in the recent bond market volatility and it pays a decent yield while charging a modest fee.
We’ll make this transition at year end for a fresh start in 2014. I’ll also introduce other changes on the way for the new year in later issues.
Over time, keeping our cash balances in these bond funds should boost overall performance with only a mild increase in risk.
JUDSON, posted 1/26/14
I just wanted to say that I DO enjoy the international perspective your letter offers. I live in Houston, Texas and read your letter with delight every Sunday. China is the second largest economy in the world, so what happens there matters to the rest of the world. I am consistently amazed at the blissful ignorance of my fellow Americans to the world outside our borders. China had a century of humiliation because it turned inward and ignored threats and changes outside, thinking itself the center of the world. Japan, on the other hand, did not and modernized with the Western powers. We must not fall into that same seduction, and I keep a constant eye on different members of the global community. I can say one thing, the citizens of China know more about us than our citizens care to know or learn about them.
Thank you, Judson.
I agree that a global perspective is needed these days, and it would help America’s internal debates if more of its citizens were aware of best practices elsewhere on the planet. The health care reform discussion, for instance, would have gone far differently if a greater percentage of the electorate knew how most of the developed world provides citizens with health care. The amount of disinformation that’s possible in America is breathtaking, and would be mostly avoidable if more people got a visa and hopped on a plane once in a while. I realize that stretched incomes make this hard for many, but you get the point. Barring the ability to travel to other countries, people could at least study up on them.
I’ll keep the international perspective coming. I find it very useful in understanding pressures on the US market, and it will only become more needed as the rest of the world steadily contributes more to global economic activity.
EARL, posted 1/27/14
“If you see something, say something.” This week’s letter was great! My respect and thanks to Jason for his hard work and economic analysis.
At the same time, I find it disturbing to see Climategate fraud participant and fabricator of the infamous “hockey stick graph,” Michael Mann, sourced in this letter’s “sphere of research.” This climate alarmist, IMO, doesn’t add value or credibility to the letter, he detracts from it.
JASON, posted 1/27/14
Thank you for the kind words about Sunday’s letter, Earl! On Mann and climate, however, I have to respectfully disagree.
Climategate turned out to be nothing, and the relevance of Mann’s hockey stick graph is proven. The controversy created by the graph is the very subject of his new book, The Hockey Stick and the Climate Wars: Dispatches from the Front Lines, which you might enjoy even as one of those who dismisses Mann. You’ll find equal time in the book because therein lies its dramatic tension.
FactCheck.org found Climategate claims that man-made global warming is a fabrication “to be unfounded.” Among the reasons: “E-mails being cited as ‘smoking guns’ have been misrepresented. For instance, one e-mail that refers to ‘hiding the decline’ isn’t talking about a decline in actual temperatures as measured at weather stations. These have continued to rise … The ‘decline’ actually refers to a problem with recent data from tree rings.”
SHERYL, posted 1/28/14
Thank you for today’s newsletter. I have a question regarding your new “signal” approach. In Tier I for instance, you mention that you want 20% of safe capital in BND and a max of 30% at which time you will rebalance it back to 20%. However in today’s newsletter I see that there is 33% in BND ($235,836 divided by $715,031). Do you just consider 33% close enough to 30% and I am being too literal?
Thank you very much,
JASON, posted 1/29/14
Excellent observation, Sheryl.
No, 33% isn’t close enough. The situation is that the plan hasn’t issued a buy signal since summer 2012. When the bond balance reaches 30%, the plan waits for the next buy signal to move in all excess back to a 20% bond allocation. It does not move it in on the next quarter necessarily, but on the next buy signal. The plan has been selling on the way up, as it’s designed to do. In most environments, this is fine as the proceeds are later put back into the growth vehicle at lower prices. In a long bull market, however, the 30% is hit and then later rebalanced.
Once we get a buy signal, you’ll see all of the excess bond balance move in at once. In the short term, this looks wrong and it certainly isn’t perfect, but over many years of running the plan this works best.
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For tier 1, if the 2008 depression happens again, the 20% bond allocation is not enough to maintain 3% growth of IJR. Should we invest more money?
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