I spoke to customer service when the rates were first revised and they agreed to grandfather me to the more-friendly rate schedule. This more-friendly rate schedule is still available at their sister brokerage Investrade.com.  The current rate is as follows:

Anyway, I started taking advantage of their low margin rates but in the first quarter, I was hit with a substitute dividend payment in an ETF I was holding in that account. This is the definition of a substitute payment from Fidelity:

Substitute Payments
Substitute payments are payments received in lieu of dividends, interest, or other payments. They may be generated, for example, where a security has been lent to a third party (such as a broker) over a dividend record date. When an investor has a debit balance in a margin account, securities in the account are often eligible to be lent. If the shares are lent over a record date, the investor should receive a substitute payment equal to the amount of the dividend. Although the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) introduced lower federal tax rates for qualified dividend income, substitute payments are not taxed as qualified dividends but are instead taxed as ordinary income. Substitute payments in lieu of dividends and tax exempt interest are reportable in Box 8 of Form 1099-MISC.

So basically, with a substitute dividend payment, you get taxed at the full income tax rate instead of the preferential (15% for most tax payers) qualified dividend tax rate (if the dividend was originally qualified).

The negative consequence of this could be huge. For an ETF like VEA, I could get a year-end dividend in the range of a few thousand dollars. If it gets disqualified, my additional taxes could run into several hundred dollars.

There are a few ways to avoid this

1. Move the assets to a brokerage that “gross-up” the dividends to compensate for the additional taxes you have to pay. I only know of two brokerages that have this voluntary program — Fidelity and TD Ameritrade. As far as I know, VBS (Vanguard) and WellsTrade do not offer this. eOption also does not offer this. Edit: Schwab also offers this voluntary “gross-up” program.
2. Move the assets to the cash position. Some brokerages let you specify the “account type ” of each asset, whether it is “cash” or “margin”. eOption offers this and I moved the assets that potentially produce qualified dividends to “cash”. I left the non-dividend producing assets in “margin”. I don’t believe VBS lets you do this though; all the assets in each account must be the same “type” in VBS.
3. Do not keep a debit balance. If we read Fidelity’s definition carefully, it says that if “an investor has a debit balance in a margin account, securities in the account are often eligible to be lent”. So technically if there is no margin balance, no shares should be loaned out. Personally, I do not regard this method as a fail-safe method. When you sign on the dotted line for a margin account, you are already giving permission to the broker to lend out your shares. It could be possible that the broker will refrain, as far as possible, from lending out your shares in this scenario, but I think there is no guarantee that this would never happen.

Note: FWIW, my experience is that method 3 seems to be true. Until the eOption experience, I have never received a substitute payment with the many margin accounts I have had over the years. The reason could be simply because I have never kept a margin balance except at eOption.

Reference

[1] http://www.fool.com/personal-finance/taxes/2003/12/05/dividend-tax-breaks-at-risk.aspx

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The following figure shows the trading premiums of the two types of ETFs.

Clearly allowing cash creations helped to reduce the trading premiums.

It sure looks like there is yet another factor to consider when purchasing ETFs, especially if the underlying assets are illiquid.

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For example, if an asset class has an allocation of 2.5%, even if it were to gain 20%, its overall impact on the portfolio is going to be only 0.5%.

Recently, this question came up on the Bogleheads’ forum Why allocate less than 5% to anything? Roy crunched some numbers for illustration:

Since 1972: 100% S&P 500:
CAGR 9.26%
Standard Dev 18.59%

Since 1972: 97.5% S&P 500 and 2.5% CCFs:
CAGR 9.35%
Standard Dev 18.17%

Since 1972: 95% S&P 500 and 2.5% CCFs and 2.5% REITs:
CAGR 9.43%
Standard Dev 17.97%

There appears to have supporters on each sides. Yet, the resident experts both seemed to be OK with the idea of less than 5% allocations:

Larry Swedroe has about 3% in CCFs in his personal portfolio and Rick Ferri suggests only 2% or so in microcap.

For me personally, my current minimum allocation is 4%. Larry sums up this issue with the following statement:

It is not an issue of doing much, if the cost is effectively zero if it adds anything it should be done.

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• US LargeCap 11%
• US SmallCap 8%
• US REITs 4%
• US Timber REITs 4%
• US MLP (PIK dividends only) 4%
• INT EAFE 20%
• INT Emerging Market 11%
• PreciousMetal Equity 5%
• Fixed Income 33%

The ranking of the asset classes, in terms of tax efficiency (based on historical dividends), are as follows (most tax efficient at the top):

• US MLPs EEQ & KMR (with PIK paid-in-kind dividends only) : 0% taxed.
• US Timber REITs PCH, PCL & RYN: 0% taxed due to my enormous capital losses accumulated (see related post “Tax-Free Dividends from Timber REIT Investing” HERE).
• US SmallCap (IJS) : distribution yield ~2.0% will be taxed.
• PreciousMetal Equity (GDX) : distribution yield ~2.0% will be taxed.
• US LargeCap (IWB) : distribution yield ~2.8% will be taxed.
• INT EAFE (VEA) : distribution yield ~4.0% will be taxed.
• INT Emerging Markets (VWO) : distribution yield ~5.0% will be taxed.
• Least efficient : US REITs and Fixed Income.

The commonly sprouted ‘wisdom’ of putting International equities and emerging market equity in the taxable account so as to get the foreign tax credit is coming back to bite me now (and probably in future as well) with huge 4% (VEA) and 5% (EEM) distribution yields. This is ironic considering that VEA is simply just another class of Vanguard’s Tax-Managed International stock fund.

On the other hand, US SmallCap Value has a sub-3.0% yield but ‘experts’ usually would recommend putting this asset class into tax-deferred accounts.

Anyway, based on this analysis, I have been re-directing new money in the taxable account to the most tax-efficient assets listed above.

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Background

For tax reasons, it is desirable to place each asset class into the appropriate “investment location” (by “investment location”, I mean whether it is in the traditional IRA, Roth IRA or taxable account). To understand why this is so, we need to first understand the concept of an asset class’s tax-efficiency.

An asset class which throws off a lot of taxable income is considered to have low tax-efficiency. This is because if it is placed in a taxable account, a lot of the return, usually in the form of taxable income, will be taxed (at federal income tax rates of up to 35%  plus state taxes, if applicable) and taken away by the tax man. Asset classes like taxable bonds and REITs comes to mind.

Conversely, an asset class that mostly appreciates in value (capital gain) and gives very little income or capital gains distribution is considered tax-efficient. It is tax-efficient because you do not have to pay any (or very little) taxes on it for as long as you continue to hold the investment. The total stock market index fund would be such an asset class.

If the asset class placement is incorrect, an investor may have to pay significant ongoing taxes on the investment, reducing the total return. Ideally, tax inefficient asset classes should have priority placement in tax-deferred accounts; and tax-efficient asset classes can be kept in the taxable account.

To read further on this, the Bogleheads Wiki has a topic on this issue. The following is a chart taken from the Wiki:

Problem

In my portfolio, I have three main tax-inefficient equity asset classes / vehicles. These are

1. US REITs : Vanguard REIT index mutual fund (VGSIX) and ETF (VNQ).
2. Precious Metals and Mining : Vanguard PME fund (VGPMX).
3. International SmallCaps : Vanguard International Explorer fund (VINEX).

(Note: the rest of my portfolio is shown HERE).

I am currently holding these funds in tax-deferred accounts with Vanguard and Wells Fargo. However, as the portfolio gets larger (especially on the taxable account side), the tax-deferred space for holding these investments is shrinking (in relative terms).

Resolution

I have basically two options: (1) to reduce my allocation to the tax-inefficient asset classes / vehicles or (2) to find tax-efficient vehicles and shift a port of the asset class to the taxable account.

I decided that option (2) is appropriate for me. I set out to look for ETFs which can be asset class substitutes and are also likely to be tax-efficient enough to be held in the taxable account.

For US REITs, clearly there is no good substitute because REITs by law have to distribute their income and so are, by nature, tax-inefficient. (Note: some have suggested that Third Avenue’s TAREX is a mildly tax-efficient substitute).

For the Vanguard PME fund VGPMX, XME (SPDR S&P Metals and Mining ETF, expense ratio 0.35%) is a close substitute. It’s expense ratio is low and has good trading volume. However, my recent experience with it showed that it is extremely volatile, moving perhaps two or three times as much as that of VGPMX on a daily basis. Below is a chart of their price performances for the past six months.

I wanted a fund that behaves similarly to VGPMX, but not two times as volatile! I decided to look further.

For international smallcaps, there are a variety of ETFs that can probably serve as good substitutes. The more promising ones include DLS (ER 0.58%), GWX (ER 0.59%) and SCZ (ER 0.40%). (For a complete list and description, see the Bogleheads Wiki.) Below is the price performance chart of the ETFs versus VINEX for the past six months.

I think I will skip DLS because it is weighted by dividend stocks and  theoretically less diversified than the other two because stocks will no or low dividend yields are excluded from its holdings. It would probably also be less tax-efficient because of its higher dividend yield.

Between GWX and SCZ, I am tempted to pick SCZ because of its lower expense ratio. However, its trading volume is also lower. GWX has a higher trading volume but its expense ratio is also higher. In the end, I think I would probably end up shifting a portion of VINEX to the both of them, and using them interchangeably for tax loss harvesting purposes.

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Many investors are aware that when they sell a mutual fund or stock with a gain, they have to pay capital gains taxes for it. On the other hand, if they sell with a loss, they can claim a tax loss on it, as long as the transaction does not run foul of the wash sale rule. Fairmark has an extensive section “Capital Gains and Losses 101” that covers this in detail.

Unless an investor is selling the entire holding, it is usually best to identify specifically which shares are being sold. However, the identification part is somewhat confusing. The following paragraph from Fairmark explains why this is so:

The traditional way to specify the shares you’re selling is in the form of an instruction to your broker:

Sell 50 shares XYZ from the lot purchased on March 12, 2005.

This makes it sound like the broker has to do something special — possibly locate those specific shares, or at least make a record of some kind indicating what shares you sold. Some brokers will tell you “we don’t offer that service.” But in reality the only thing the broker has to do, besides executing the sale transaction in the normal way, is send you a written confirmation that you specified shares from the lot purchased on March 12, 2005.

This post is a review of my experience with specific share identification mutual fund redemption with Vanguard.

The Process

Prior to the day of redemption, I created a list of the tax lots I wanted to sell. These are basically the tax lots which have the highest cost basis and which will give me the maximum capital gain loss which I can claim on my tax return next year.

I then created the following message (which is a variant of the message, as suggested by seugene, from reference [1])

Subject: Specific Identification Sale of Mutual Fund

Dear Vanguard,

This is to inform you that for the following trade(s) placed today in my taxable joint account, I want to use the specific share identification method for capital gains calculation.

(A) Vanguard Total Stock Market Index Admiral Fund VTSAX, redeeming XXX.YYY shares from the following lots:

1) MM/DD/YY XX.YYY shares
2) MM/DD/YY XX.YYY shares

I understand that I am responsible for tracking my cost basis.

Please acknowledge that you have received this message.

Thank you.

Dated MM/DD/YYYY.

On the day of the redemption, I sent the above message via a secure email to Vanguard and then placed the sale of the specified number of shares online as per usual.

A few days later, I received the following confirmation:

Dear indexfundfan:

Thank you for your e-mail regarding your desire to use the specific share identification method (as defined in the Internal Revenue Code) for purposes of determining your cost basis. I am responding on behalf of your Flagship representative, XXX.

We acknowledge receiving your specifications, identifying the particular shares purchased on several dates to be redeemed from your Vanguard Total Stock Market Index Admiral Fund in the account #XXX. To assist you in making an adequate identification of such shares, we are confirming your specifications as outlined below in accordance with federal regulation section 1.1012-1(c)(3) of the Internal Revenue Code.

You are redeeming XXX.YYY shares from the following lots purchased on the following dates:

1) MM/DD/YY XX.YYY shares
2) MM/DD/YY XX.YYY shares

In the event you were using a different method to determine cost basis (for example, average cost method), you may need written consent from the Internal Revenue Service (IRS) to change to the specific share identification method. Consult your tax adviser if you have any questions concerning tax reporting methods or for additional assistance.

Please be advised that Vanguard’s recordkeeping systems support the average cost basis method of basis determination, not the specific share identification method. Therefore, it is your responsibility to keep sufficient records to support your basis determination under the method you have chosen, including but not limited to tracking the cost and related gain or loss of shares [exchanged, redeemed] for purposes of reporting that information to the IRS.

Additionally, since you are using the specific share identification method for tax reporting, any average cost basis statement that you may receive from Vanguard for this fund and account should be disregarded.

I have forwarded a copy of this e-mail to your representative. If you have any further questions, you may contact your Flagship Representative at 1-800-XXX, extension XXX. If your representative is unavailable at the time of your call, the next available trained representative will be happy to assist you. If you prefer, you may ask to be transferred to his voice mail. He will promptly return your call.

Flagship’s business hours are Monday to Friday from 8 a.m. to 10 p.m. and Saturdays from 9 a.m. to 4 p.m. Eastern time. You may also feel free to visit our website at www.vanguard.com, 24 hours a day, 7 days a week.

Sincerely,

XXX
Registered Representative
Vanguard Flagship Services

I printed a copy of the above to PDF and save it together with the secure email I had sent out a few days earlier.

That’s it. I now have a written confirmation that the brokerage had received my instructions to redeem specific shares of my mutual fund.

PS. The Fairmark article linked above has a brief section discussing the “legality” of whether an email confirmation (versus a paper confirmation) is sufficient. For my personal records, I am inclined to think that the secure email is sufficient, but another person’s situation could be different.

Reference

[1] Boglehead forum discussion.

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The calculator below will find the breakeven point which will make it worthwhile to perform the mutual fund to ETF conversion. The calculator inputs are as follows.

1. The conversion fee, currently $50. Enter 50.
2. The ETF expense ratio saving. For example, VEIEX ER=0.37% and VWO ER=0.25%. The difference is 0.12%, enter as 12.
3. The investment horizon in years.
4. The expected annual return. If the expected annual return is 8%, enter 8.

When the investment amount to be converted is higher than that calculated, a conversion would be worthwhile (assuming the assumptions are true). Note that as mentioned in the previous post, taxes are not considered in the computations.

ETF Conversion Decision Calculator

Random list of previous posts:

Why convert?

1. The main reason why an investor would want to convert mutual fund shares to the ETF class is because the expense ratios of ETF shares are lower than the investor class mutual fund shares. For example, the Vanguard emerging markets index mutual fund VEIEX charges 0.37% annually while the ETF version VWO charges only 0.25% a year.
2. A second reason is the possibly better tax efficiency in terms of capital gains distributions.
3. The third reason is the redemption fees savings. For certain mutual funds with redemption fees (most notably VEIEX and VTMGX), converting mutual fund shares to the ETF class and then selling the ETF shares would save a bundle on the redemption fees (0.5% for VEIEX and 1% for VTMGX shares owned for less than 5 years), especially if the amount is substamtially more than $1000.

Why not to convert?

1. If an investor already owns admiral shares of the mutual fund, there is little (if any at all) saving in the expense ratio. For example, the admiral class of Vanguard’s emerging market index fund VEMAX and VWO both charges the same 0.25% expense ratio a year.
2. ETFs could trade at a premium or discount, in addition to a trading spread (trading spread is the difference between the bid and asking prices). A person investing in mutual fund shares does not have to be concerned with purchasing or selling shares trading at a premium or discount, nor be concerned with the cost associated with the trading spread. Mutual funds shares are bought and solt at NAV (net asset value).
3. If an investor is contributing regularly, purchasing the mutual fund “generally” has no transaction fee while purchasing an ETF would normally entail a brokerage commission charge (unless the investor is using a free-trade broker). The brokerage fees could add up quickly to a substantial amount. Note: I say “generally” because one mutual fund exception is VEIEX, which charges a 0.5% purchase fee.

The case for VEIEX to VWO conversion

After looking at the pros and cons, let’s examine the specific case for VEIEX to VWO conversion.

Expense ratio saving. If an investor is holding a substantial amount of VEIEX (say from the low four digit range onwards), there is definitely a saving when the holding is converted to VWO. The current expense ratio saving is 0.37% – 0.25% = 0.12% or 12 bps (bps = basis points) per year. This difference, compounded over many years, could become substantial.

To see if this expense ratio saving really does make a difference in the performance numbers, let’s look at the historical performance of VEIEX and VWO for the years ended Oct 31, 2006 and 2007 (values taken from the prospectus):

Clearly, VWO outperformed VEIEX by 0.19% in both 2006 and 2007, the first two full years of its existence.

Trading spreads. There could be a trading spread cost in selling VWO in the future during the withdrawal phase. However, from my observations, the trading volume and liquidity of VWO has been improving through the months. The impact of trading spread cost should be relatively low. Furthermore, a 12 bps expense ratio difference a year would turn into (1.0012^20)-1 = 2.43% difference in 20 years time. This should mitigate any trading spread cost.

Redemption fee. Converting the mutual fund shares to the ETF class is one way to avoid the 0.5% redemption fee.

Conversion fee. As already mentioned, Vanguard charges a $50 conversion fee unless the investor is a Flagship client. Below, we will briefly look at how this fee would affect the conversion decision.

In the analysis, assume that the $50 fee to pay for the conversion comes out from the original VEIEX investment (tax consequences not considered for simplicity). Let R be the approximate investment return a year, X be the original investment amount and N be the number of years the investment is held.

Then the value of the investment after N years, would be given by

• X*(1+R-0.0012)^N for VEIEX
• (X-50)*(1+R)^N for VWO

For VEIEX, the compounding rate is reduced by the expense ratio difference of 0.0012 a year. For VWO, the original investment amount is reduced by $50 due to the conversion fee.

For the conversion to be worthwhile, we require (X-50)*(1+R)^N to be larger than X*(1+R-0.0012)^N. For example, if R = 0.1 (10% return a year), N = 10 years, solving the inequality gives X > 4606. This means that given the assumptions, it is better to convert if the original investment amount X is at least $4606.

Other scenarios are given in the table below.

Summary

It appears that for my situation, it makes a lot of sense to convert my VEIEX holding to VWO. This is especially so given that the investment is in the mid five digit amount and the conversion will be free for me. For investors who have to pay the conversion fee, the table above may help to decide if paying the $50 fee is worthwhile.

Random list of previous posts:

Usually you would hope that bond prices would hold up when equity prices were dropping; and this was indeed the case for treasury bonds. But not for muni bonds: their prices were dropping along side with the equity markets last month. The divergence of muni bonds from treasury bonds can be observed from the figure below.

The figure above shows that from the middle to the end of Feb 2008, the Vanguard Intermediate Tax Exempt fund (duration 5.5yr, average quality AA+) and Vanguard Intermediate Treasury fund (duration 4.9yr, average Aaa) were on a diverging path as equity markets were falling.

If an investor had held treasury bonds in the portfolio as a safety anchor, the portfolio would have held up much better than another investor using muni bonds, even though the muni bonds were also of very high credit quality. Fortunately, the prices of muni bonds have recovered somewhat (but not fully) in March.

The above occurence could be just an one time event or it could happen again with a longer duration. Nobody knows for sure. But if muni funds are intended to be the safety anchor of a portfolio, I think it is prudent for the investor to remember that the relative illiquidity of muni bonds could magnify their price fluctuations from any major trading activity, and thereby possibly resulting in undesirable price movements.

Related information:

I also posted the above view on the Bogleheads forum in a post/poll. This is reproduced below:

Time to re-think muni’s as safety anchor?

For many people, the fixed income or bond portion of the portfolio is designated as the safety anchor of the portfolio during market turbulence (basically Larry’s viewpoint, not Rick’s).

The recommendation has been to use very high grade and short term debt instruments like treasury bond funds or even VG’s invest-grade bond funds. And for investors in high tax brackets, it has been generally recommended to use municipal bond funds.

However, the recent municipal bond turmoil shows that muni’s are not working as they should. Just as you hope municipal bonds can help soften the losses on the equity side, it does exactly the opposite, tanking along with equities.

Is it time to re-think the usage of municipal bond funds as part of the safety anchor?

It seems that the fact that the municipal bond market is rather illiquid and often subject to hedge fund’s trading activities might make municipal bonds unpredictable during market turmoil.

What do you think?

The poll result shows that most (currently 32 out of 34 votes) people do not think that there is need to rethink about whether muni bonds are good options as a portfolio’s safety anchor. It appears that my view belongs to the minority only.

PS. For an investor looking for income in bonds (as opposed to a safety anchor), then NAV drops might not of major concern.

For my own reference:

http://www.diehards.org/forum/viewtopic.php?t=15385&mrr=1206592981

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(1) The danger of holding company stock – by Taylor Larimore

Last year investment bank Bear Stearns stock was valued at $170/share. I doubt if anyone anticipated that today the stock would be worth only $2/share. How does this affect its 14,153 employees?

According to the Wall Street Journal, “The pain could be most acute for Bear Stearns’s (14,153) employees, who are steeped in a culture of personal ownership, and hold about a third of the firm’s shares outstanding.”

Bogleheads often warn newbies about the danger of overloading their portfolios with company stock. What’s happened at Bear Stearns is a good example.

(2) Managing your “Gambling” Money Allocation – a reply by hollowcave2

I am going to come clean today just to cleanse my soul and perhaps someone else can learn from my experience.

I had a 5% allocation in a mad money account that had 5 individual stock holdings. Not a big amount of money to each holding, 1 to 2% each. I was doing pretty good. I was beating the market in this small account and getting some good gains. I was getting pretty confident. I wondered why I had 95% in my fund holdings.

Well, unfortunately, Bear Stearns was one of the holdings. I really hate to post this, but I guess I just need some therapy. I thought it offered a compelling buy last week when it traded around $50. So I actually got 100 shares.

Well, you know what happened. This evens out my gains from the rest of the year.

I have a very high risk tolerance, but this experience really rocks my emotions. It makes me rethink my entire investing life. I never experienced such a loss in a matter of 2 days. It is definitely the worst investing mistake of my life.

So I hope to learn from the experience, and one of the things to learn is single stock risk. I”ve always known the risk, in theory. But to really experience it is something else. Life is a good teacher.

Both posts carry a great lesson for all investors — the risk of individual stocks should be avoided whenever possible.

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A thought came to my mind — since unqualified distributions from the 529 plan are taxable, is it possible to tax harvest from the 529 plan?

I asked this question on the Bogleheads forum, and here’s a reply from LH2004 (who had previously demonstrated to have very good knowledge on tax matters):

Yes. See “Losses on QTP Investments” in Publication 970. You’ll be subject to the 2% of AGI floor, though, so you’ll need to have really extreme losses, or a big account, or low AGI, or other miscellaneous itemized deductions to reach that floor.

Alternatively, under the IRS’s new theory regarding wash sales, you could take the position that a sale of an individual portfolio in the 529 plan at a loss, followed by a purchase of a substantially identical fund in your taxable account, is a wash sale, increasing your basis in the newly-purchased fund, which you could then immediately sell at a loss; that would be an aggressive position to take.

Taylor Larimore kindly found the link to the relevant section in Publication 970 — http://www.irs.gov/publications/p970/ch08.htm :

Losses on QTP Investments

If you have a loss on your investment in a QTP account, you may be able to take the loss on your income tax return. You can take the loss only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis. Your basis is the total amount of contributions to that QTP account. You claim the loss as a miscellaneous itemized deduction on Schedule A (Form 1040), line 23, subject to the 2%-of-adjusted-gross-income limit.

If you have distributions from more than one QTP account during a year, you must combine the information (amount of distribution, basis, etc.) from all such accounts in order to determine your taxable earnings for the year. By doing this, the loss from one QTP account reduces the distributed earnings (if any) from any other QTP accounts.

At this point, it doesn’t look like something I would do.

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I responded by manually buying into WFGXX (Wells Fargo Government MMF), which is listed as an NTF (no-transaction-fee) mutual fund. This fund has an expense ratio of 0.64%, with a current 7-day yield of 3.87%. This is definitely better than the 1.01% APY from the default cash sweep option.

Recently, I became aware that there is another option. According to this post from FWF, Wellstrade also offers the RMMXX (Frank Russell Institutional) MMF for no transaction fee. This MMF has an expense ratio of 0.15% and a current 7-day yield of 5.05%. This yield is an improvement of almost 1.2% from WFGXX. A buy or sale transaction also does not appear to count towards using one of the free trades (see the messages that follow from the FWF link).

One issue in general with using MMFs in the above fashion for non-margin or IRA accounts is that since MMF trades typically settle on the next business day, I cannot purchase a stock or ETF on any day I want. I always need to plan ahead by liquidating the MMF one business day before the planned purchase. This could sometimes be inconvenient. However, the interesting thing is that unlike MMF sales, the proceeds from a stock or ETF sale is available immediately to purchase another stock or ETF.

With the above in mind, I think my new strategy will be to keep most of the cash balance in RMMXX. I will however keep a small portion in a very short term bond ETF, like SHV (iShares Lehman Short Treasury Bond ETF). This ETF can be liquidated whenever needed to allow me to purchase a stock / ETF on any day I want. The income distributions from SHV will be reinvested into RMMXX once a month. The minimum initial and subsequent investment for RMMXX appears to be just $1.

One possible issue is the trading cost associated with this short-term ETF. It appears however that the impact on any trading spread of this ETF is very small. Currently, the spread is only one cent out of ~$110, giving a spread of less than 1 basis point (0.01%). With a spread this small, I would not worry about it. However, nevertheless, there is a disadvantage; and that is it will use up one of the free trades.

Oh, well, you have to give up something.

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Dr. Bernstein was quoted in several comments in “The Globe and Mail” article “Investing smart is a ‘no-brainer,’ at least to this neurologist”. The following are some of the interesting excerpts from the article:

Smart investors ignore the economy, market sentiment and all strategists employed by investment firms, said Dr. Bernstein, who has long been a thorn in the side of active fund managers, Street analysts and peddlers of exotic exchange-traded funds and other vehicles designed more to enrich their architects than to reward their investors.

“I recommend a passive approach,” he said the other day in an e-mail exchange. “That is, I do not believe that there’s such a thing as skill in security selection, and I favour vehicles that transact as little as possible.”

His “no-brainer” portfolio of indexed funds regularly beats the market by a wide margin. Why? “Because it’s well-diversified, biased towards small and value stocks and passive.”

He doesn’t pull any punches when talking about such pet peeves as hedge fund managers and investment bankers, prospects for commodities or the current mania for the BRIC countries – Brazil, Russia, India and China.

On hedge funds: “The best vehicle known to man for separating country club members from their wealth.”

On bankers: “Bankers seem to have the attention span of a kindergarten class. I give them another five years before they’re back to playing the same melody with different instruments.”

On BRIC investing: “A wire-house gimmick. The correlations of these four nations to the returns of U.S. equities aren’t any different from Argentina, Turkey, Indonesia, Malaysia or the Philippines. If someone makes the point that the BRIC nations have high growth rates, they might as well be wearing a bright red neon sign on their foreheads that flashes ‘I can’t read,’ since the correlation between economic growth and stock returns is negative.”

On commodities: In theory, a good portfolio diversifier. “But in practice, I don’t trust any of the vehicles currently available, and I’m also generally skeptical of any ‘asset class du jour,’ which commodities certainly are. The time to expose yourself to an asset class is when no one else is interested.”

I tend to agree with him. His book — “The Four Pillars of Investing” remains my all-time favorite investing book.

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Three hours later when I logon to the Fidelity website, I noticed that the bonds were succesfully sold. The trades will settle tomorrow. There were no transaction fees.

What prompted my sale was partly due to the recent troubles with the bond insurers, but the main reason was that I am getting closer to the time when I need to use the money. I will be moving the sale proceeds into the Fidelity CA AMT-tax free money market fund in the mean time. I intend to sell off the rest of the bonds when they reset next week.

Update 12/06/07:  All my municipal reset bonds have been liquidated. There were no issues with “failed auction”.

Random list of previous posts:

In my opinion, this ETF appears to be the closest thing to the “emerging market” “smallcap” and “value” asset class available currently to retail investors (I do not consider DFA funds to be easily available to retail investors). According to the fact sheet [PDF], this ETF has an expense ratio of 0.63%, which I think is quite reasonable considering the equity markets it is targetting.

The top 10 countries, as of Oct 26, 2007, were

This ETF has a dividend yield of more than 4%. From my experience with the VWO ETF, a significant portion (say 40%) will probably be considered as not “qualified” for the lower dividend tax rate by the IRS. As such, this fund will not be very tax efficient in held in a taxable account.

At the time of this post, this ETF is trading with a spread of four cents, with the asking price at $51.62 and bidding price of $51.58. Taking the NAV to be $51.60, the “spread cost” is a very reasonable 0.02/51.6 = 0.039%.

The figure below shows this morning’s trading action (up until the time of this post):

I will be watching this ETF closely to see if it fits into my existing portfolio.

The related Bogleheads discussion can be found HERE.

Random list of previous posts:

• Issuers in different areas of the economy.
• Issuers backed by different insurers.
• No federal, state, local taxes. No AMT.
• 7-day resets.
• AAA-rated by both S&P and Moody’s. Additionally, they passed Fidelity’s “Risk Test” and are ated as “Tier 1″.
• Have both “sinking fund” and “call” protection.

The bids were successful, and returned with an average coupon yield of about 3.8%, paid every week. This computes to an APY of (1+0.038/52)^52 – 1 = 3.872%.

For comparison, the table below shows the yields of various cash management vehicles as of September 5, 2007:

Clearly, the municipal reset bonds give me a 15 basis points increase in after-tax yield over the next competing product (Fido’s CA AMT-free MMF). The advantage over Vanguard’s CA Tax-Exempt MMF is around 26 basis points.

PS. The numbers are specific to my particular tax circumstances, which includes AMT; your numbers would differ.

Random list of previous posts:

Many people keep their liquid holdings in the bank or in a money market fund. If you are in a high tax bracket, municipal reset bonds represent an attractive alternative vehicle in place of money market funds. The main advantage with municipal reset bonds is that typically you can get yields that are the same or very close to that obtained by institutional money market funds. The disadvantage is that you lose some liquidity and have some diversification risk.

For various reasons, I am keeping quite a big chunk of cash in MMFs (money market funds). These are mostly invested in FSPXX (Fidelity’s CA AMT-free MMF) and VCTXX (Vanguard CA MMF).

Recently, I started looking into using municipal reset bonds (resets for short) for cash management instead of using MMFs. For those new to resets, resets belong to the class of Auction Rate Security (ARS). This information page from Fidelity is a good starting point to read up more on ARS. Here are some excerpts:

Municipal resets belong to a class of bonds known as Auction Rate Securities whose coupon rates are periodically reset through auctions held every 7, 14, 28 and 35 days. Some bonds even reset daily although in these cases interest is paid out monthly with accrued interest.

Although the rates are reset frequently through an auction process, the underlying municipal bond may be issued with a maturity lasting anywhere from 5 to 30 years. Municipal resets were introduced primarily as an institutional product and over time more retail investors have begun to participate in the auction process.

Investors should pay close attention to the minimum required investment which is typically $25,000.

Benefits of Municipal Resets

• Issued at par, sell at par – only when selling on the reset date.
• Frequent and predictable windows to enter and exit the position.
• A product whose coupon automatically regularly adjusts in keeping with the increases and decreases of short-term market interest rates.
• Frequent stream of coupon payments.

Risks and Considerations

• Limited diversification: Although short-term securities are typically associated with less volatility and risk, they rarely provide the same return opportunities as longer-dated bonds over an extended period.
• Limited liquidity: Orders must be placed from 7am – 11am ET on the day of reset. With bonds that reset daily, the time is reduced to between 7am – 10am ET. Orders cannot be accepted before these times and if sent will not be considered for the auction.
• Failed auctions: Can occur when the auction agent does not receive sufficient bids below the maximum rate. When an auction fails, the rate is set at the maximum rate. The maximum rate is often a multiple of a reference rate such as LIBOR or an index of Treasury securities.

Pros and cons (my take)

Basically, from what I can gather, the main pro in using resets is the higher yield. On this date, the yield after AMT using MMFs is around 3.5% APY while I can get an after AMT rate of ~3.6% rate for resets. This is equivalent to an APY of ~3.7%, i.e. I gain around 20 basis points in after tax yield. Note: resets are quoted in “coupon rate” and must be converted to APY to compare with MMF yield.

Intuitively, I expect there will always be a spread of around 20 to 30 basis points in yield from MMF to resets, because of the following reasons:

• expense ratio of the MMF, which typically ranges from 0.15% to 0.4%,
• compensation for the slight loss in liquidity and diversification, and
• because resets as a whole is a relatively unknown and “more complex” cash management vehicle for retail investors.

The cons are :

1. Less liquidity (if I need to liquidate on a non-reset day, I might experience a loss in principal or it might not be possible at all). Also I don’t have the convenience of writing checks against a MMF. But if I were to buy, I would typically go for 7-day resets. A 7-day reset is a very short time that I can live with.
2. Less diversified than a MMF since typically a minimum of $25k is allocated to one issuer.

Factors that help to mitigate diversification risk

1. If there is a downgrade in credit quality, I can get out in not more than 7 days. Defaults typically happen only following a series of downgrades and this can only happen in a much longer time period than 7 days.
2. Pick issues backed by different insurers and bonds in different sectors of the economy.
3. According to quotes from the FWF post (see resources below), there has never been a default in VRS in the 20-year history.
4. Many finance writers feel safe with using AAA municipal bonds, especially those that are ‘natural’ AAA, and not inherited due to insurance. Also, in general AAA municipals are many times safer than AAA corporates.

Purchasing information

Unless you have a private banking relationship with a bank, the best place for retail investors to get resets is probably through Fidelity. According to a reply from a Fidelity, there is “no fees/commissions for purchasing and selling municipal resets. You can do this through your Fidelity Account at no charge.”

One thing to note though is that at Fidelity, currently “orders may only be placed on the day of the auction between the hours of 7am – 11am ET and for those securities that reset on a daily basis between 7am – 10am ET.” Also, only buy orders may be placed online; sale or hold orders must be done through a representative on the phone at 800-544-5372.

Things to consider

Since my intention is to use resets to replace the bulk of my MMFs, the following are the considerations I have.

1. Only AAA-rated resets and try to diversify across different insurers in different badges.
2. Only federal, state and AMT tax free resets.
3. Only 1-day or 7-day resets.

Additional web resources

Link to Fidelity’s inventory of municipal resets.

Link to Smith Barney’s ARS page.

Dolmar’s post on ARS at FWF — this is the post that got me started on municipal resets. Thanks Dolmar!

My post on the Bogleheads forum.

InvestingInBonds.com CUSIP search.

Random list of previous posts:

Today, I sold off a portion of my fixed income in two funds : Vanguard Intermediate-term Invest-grade bond fund, VFICX (up 0.42% today) and Vanguard TIPS bond fund, VIPSX (up 0.59% today) and intended to rebalance (buy) into the Vanguard Precious Metals and Mining fund, VGPMX and the Vanguard Emerging Market ETF, VWO.

The order purchase for VGPMX went through all right but the ETF order was not filled, mostly because I set the limit price too low at $79. The price of VWO did hit an intraday low of $77.72, but when I submitted the limit order, its price had already rebounded.

I might get better luck tomorrow.

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Today, it occurred to me that the recent credit crunch and the “flight to quality” of investor funds might have caused VFITX to outpace VFICX in terms of total returns. I looked up the YTD returns of the two funds and I was correct: YTD return of VFICX is 1.56% and that for VFITX is 2.65%.

The 6-month price history (does not reflect dividends) is shown below:

Evidently, the “flight-to-quality” phenomenon has bidded up the price of treasury bonds versus non-treasury bonds.

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The following charts show the historical and recent real yields. Data is obtained from the U.S. Treasury website.

According to Larry’s “rule-of-thumb“, TIPS are now very attractively priced and might actually be a good time for accumulation.

Random list of previous posts: