Category: Investment Planning

Your Diversified Portfolio vs. the S&P 500

How global returns and proper diversification are affecting overall returns.  

“Why is my portfolio underperforming the market?” This question may be on your mind. It is a question that investors sometimes ask after stocks shatter records or return exceptionally well in a quarter.

The short answer is that even when Wall Street rallies, international markets and intermediate and long-term bonds may underperform and exert a drag on overall portfolio performance. A little elaboration will help explain things further.

A diversified portfolio necessarily includes a range of asset classes. This will always be the case, and while investors may wish for an all-equities portfolio when stocks are surging, a 100% stock allocation is obviously fraught with risk.  

Because the stock market has advanced so much over the past decade, some investors now have larger positions in equities than they originally planned, and that may leave them exposed to an uncomfortable degree of market risk. A portfolio held evenly in equities and fixed income ten years ago may now have a clear majority of its assets in equities, with the performance of stock markets influencing its return to a greater degree.

Yes, stock markets – not just here, but abroad. U.S. investors have more global exposure than they once did. International holdings represented about 5% of the typical investor’s portfolio back in the 1990s. Today, they account for around 15%. If overseas markets struggle, the impact on portfolio performance may be noticeable.

In addition, a sudden change in sector performance can have an impact. At one point in 2018, tech stocks accounted for 25% of the weight of the S&P 500. While the recent restructuring of S&P sectors lowered that by a few percentage points, portfolios can still be greatly affected when tech shares slide, as investors witnessed in late 2018. 

The state of the fixed-income market can also potentially impact portfolio performance. Bond prices commonly fall when interest rates rise, which presents a short-term concern for an investor. If a bond is held to maturity, though, the investor will receive the promised principal and interest (assuming no default on the part of the issuer). Moreover, a rising interest rate environment may help the fixed-income segment of the portfolio’s long-term performance. New bonds issued in a rising interest rate environment have the potential to generate more yield than the older bonds of similar duration that they replace.

This year, U.S. stocks have done well. A portfolio 100% invested in the U.S. stock market in 2019 would have a year-to-date return approximating that of the S&P 500. But who invests entirely in stocks, let alone without any exposure to international and emerging markets?

Just as an illustration, assume that there actually is a hypothetical investor this year who is 100% invested in equities, as follows: 50% domestic, 35% developed foreign markets, and 15% emerging markets.

In this illustration, the S&P 500 will serve as the model for the U.S. market, MSCI’s EAFE index will stand in for developed foreign markets, and MSCI’s Emerging Markets index will represent the emerging markets. Through the end of July, the S&P was +18.89% year-to-date, the EAFE +10.31% YTD, and the Emerging Markets just +7.38% YTD. As foreign and domestic stocks have equal weight in this hypothetical portfolio, it is easy to see that its overall YTD gain would have been less than 18.9% as of the July 31 closing bell.

Your portfolio is not the market – and vice versa. Your investments may return less than the S&P 500 (or another benchmark) in a particular year due to various factors, including the behavior of the investment markets. Those markets are ever-changing. In some years, you may get a double-digit return. In other years, your return may be much smaller.

When your portfolio is diversified across asset classes, the highs may not be so high – but the lows may not be so low, either. If things turn volatile, diversification may help insulate you from some of the ups and downs that come with investing.

 

Citations.
1 – money.com/money/5481891/this-is-how-much-money-you-should-have-in-stocks-at-every-age/ [12/18/18]
2 – forbes.com/sites/simonmoore/2018/08/05/how-most-investors-get-their-international-stock-exposure-wrong/ [8/5/18]
3 – cnbc.com/2018/04/20/tech-dominates-the-sp-500-but-thats-not-always-a-bad-omen.html [4/20/18]
4 – fidelity.com/viewpoints/investing-ideas/fed-rate-hike-worries [4/23/19]
5 – investopedia.com/ask/answers/12/beating-the-market.asp [6/25/19]
6 – us.spindices.com/indices/equity/sp-500  [7/31/19]
7 – msci.com/end-of-day-data-search [7/31/19]

Mutual Funds vs. ETFs

Similarities and differences.

The growth of exchange-traded funds (ETFs) has been explosive. In 1998, there were only 29; at the end of 2018, there were over 1,900 investing in a wide range of stocks, bonds, and other securities and instruments.

At first glance, ETFs have a lot in common with mutual funds. Both offer shares in a pool of investments designed to pursue a specific investment goal. And both manage costs and may offer some degree of diversification, depending on their investment objective. Diversification is an approach to help manage investment risk. It does not eliminate the risk of loss if security prices decline.

Structural Differences. Mutual funds accumulate a pool of money that is then invested to pursue the objectives stated in the fund’s prospectus. The resulting collection of stocks, bonds, and other securities is professionally managed by an investment company.

ETFs work in reverse. An investment company creates a new company, into which it moves a block of shares to pursue a specific investment objective. For example, an investment company may move a block of shares to track performance of the Standard & Poor’s 500. The investment company then sells shares in this new company.

ETFs trade like stocks and are listed on stock exchanges and sold by broker-dealers.

Mutual funds, on the other hand, are not listed on stock exchanges and can be bought and sold through a variety of other channels — including financial advisors, brokerage firms, and directly from fund companies.

The price of an ETF is determined continuously throughout the day. It fluctuates based on investor interest in the security, and may trade at a “premium” or a “discount” to the underlying assets that comprise the ETF. Most mutual funds are priced at the end of the trading day. So, no matter when you buy a share during the trading day, its price will be determined when most U.S. stock exchanges typically close.

Tax Differences. There are tax differences as well. Since most mutual funds are allowed to trade securities, the fund may incur a capital gain or loss and generate dividend or interest income for its shareholders. With an ETF, you may only owe taxes on any capital gains when you sell the security. (An ETF also may distribute a capital gain if the makeup of the underlying assets is adjusted.)

Determining whether an ETF or a mutual fund is appropriate for your portfolio may require an in-depth knowledge of how both investments operate. In fact, you may benefit from including both investment tools in your portfolio.

Amounts in mutual funds and ETFs are subject to fluctuation in value and market risk. Shares, when redeemed, may be worth more or less than their original cost.

At a glance. Mutual funds and exchange-traded funds have similarities — and many differences. The lists below give a quick rundown.

Mutual funds:

* Bought and sold through many channels

* Not listed on stock exchanges.

* Priced to the end of the trading day.

* Capital gains within the funds distributed to shareholders.

* Dividends may be automatically reinvested.

Exchange-traded funds:

* Bought and sold through broker-dealers.

* Listed on stock exchanges.

* Price continuously determined during the trading day.

* Capital gains within the ETF reinvested, and the ETF may distribute a capital gain if the make-up of the underlying assets is adjusted.

* Dividends generally distributed to brokerage account.

 

Citations.
1 – ici.org/pdf/2018_factbook.pdf [2018]

 

Fixed Index Annuities

What are they? How do they work?

What is a fixed index annuity? Don’t let the investment jargon put you off, Fixed Index Annuities are simpler than they sound. A Fixed Index Annuity is a tax-favored accumulation product issued by an insurance company. However, unlike fixed deferred interest rate annuities, a Fixed Index Annuity’s annual growth is tied to a market index like the Standard & Poor’s 500 rather than an interest rate.

How do they work? A Fixed Index Annuity can be funded with either a large, one-time sum or regular payments over time. It may be attractive to those looking for an alternate retirement vehicle. That’s because certain index annuities are subject to rate floors and caps. In other words, an index annuity can’t exceed or fall below a predefined return level, even if the underlying market index performs outside of set parameters.

How is this possible? The insurance company that issues the annuity bears the risk of a potential stock market decline. That’s right! With a fixed index annuity, your original deposit can be structured, so it will not decline if the index performs negatively.

Another potential benefit is how fixed index annuities grow over time. Their growth is tax deferred, meaning you don’t pay income taxes until you withdraw money from the annuity. But keep in mind, if you make withdrawals before you reach the age of 59 ½, you may be required to pay a 10% federal income tax penalty.

Fees & Expenses. Sometimes, even the savviest investor could use a little guidance. After all, annuities can have contract limitations, fees, and charges, including account and administrative fees, underlying investment management fees, mortality and expense fees, and charges for optional benefits.

Most annuities have surrender fees that are usually highest if you take out the money in the initial years of the annuity contract.

So, if Fixed Index Annuities sound like something that may interest you, don’t hesitate to reach out to a financial professional soon. Who knows? This may just be the retirement vehicle you’ve been looking for.

Disclosures

  1. The Standard & Poor’s 500 Composite is an unmanaged index that is generally considered representative of the U.S. stock market. Index performance is not indicative of the past performance of a particular investment. Past performance does not guarantee future results. Individuals cannot invest directly in an index. Fixed Index Annuities also can be based on the performance of other stock market indexes.
  2. Fixed Index Annuities also can be based on a participation rate, which is how much of an index increase you actually receive.

3.Withdrawals and income payments are taxes as ordinary income. The federal income tax penalty may not apply under limited circumstances. State income taxes also may apply.