Questions from the Mailbag - Segment 1

Below are some questions and answers based on e-mails or users' web searches that led them to the site:

Q: Should I hold TIPS in a taxable account?

A: Since bonds and bond funds are not very tax-efficient, they are best placed in tax-advantaged accounts such as a 401(k) or IRA. For tax efficient placement, consult this bogleheads article. Stock index funds tend to be the most tax efficient, while high yield bonds, REITs, and actively managed small caps lead to the most negative tax ramifications. Having said that, there are situations in which holding TIPS in taxable accounts makes sense. You should consider your portfolio as a single entity and determine your desired asset allocation. If, for instance, you decide that you want to dedicate 10% of your assets to Vanguard HY Corporate (VWEHX), 15% to Vanguard REIT Index (VGSIX), 10% to Vanguard Total Bond Market Index (VBMFX), and 10% to TIPS in the form of Vanguard Inflation Protected Securities (VIPSX), yet your retirement accounts only account for 30% of your total assets, then you have no choice but to place TIPS in a taxable account. Being the most tax efficient as possible is not nearly as important as maintaining your desired asset allocation based on your investing objectives, time frame, and risk tolerance. In the above hypothetical situation, High Yield Corporate Bonds and REITs are even more tax inefficient than TIPS, so it is the most logical to place those in tax-advantaged accounts first and purchase TIPS in taxable accounts. To make a long story short, ideally it is best to purchase TIPS in a tax-advantaged account if possible since they aren't the most tax efficient asset. However, there are certainly even more tax-inefficient investments and your asset allocation takes precedence. If the space in your tax-advantaged accounts don't allow for TIPS to be wholly purchased in them, then it is certainly a wise decision to purchase them in a taxable account over not purchasing them at all.

Q: How many assets should I have before investing in REITs?

A: There is no correct one size fits all answer to this question. I personally like REITs as a portion of one's portfolio as historically they have not been heavily correlated with other equities and returns have also been very strong. It's just a diversification argument; the more diversified you are, not only do you have greater protection against the downside, but the upside also has greater prospects. First, determine you desired allocation to REITs. Most plans allocate anywhere from zero to 20% of total assets. With a small amount of assets, I would recommend diversified REIT index funds as opposed to a single company. Vanguard REIT Index (VGSIX), for instance, requires a $3,000 minimum initial investment. For argument's sake, let's say you chose to dedicate 10% of your portfolio to REITs. In order to invest in this fund with your desired allocation (10% in this case), you need $30,000 in total assets. Further complicating this matter is the fact that REITS are incredible tax-inefficient and pay out 90% of their income in the form of dividends taxed at the normal income rate (i.e. not the 15% long-term capital gains tax rate). Thus, if you have no tax-advantaged accounts at all and a small amount of assets, I personally don't think the increased diversification is significant enough to overcome the tax burden and would just increase my allocation devoted to equities.

There are certainly other diversified REIT investments out there available besides the Vanguard fund. ETFs require no minimum investment and thus you could essentially have less than $100 and still devote some of your money to REITs. In that case, though, transaction costs would be prohibitively expense and ETFs make little sense for small purchases. Charles Schwab also offers the Schwab Global Real Estate Investor Fund (SWAIX) with just a $100 minimum. Thus, if you targeted a 10% allocation, your total assets just need to be $1000. And if you targeted a 20% allocation, you need just $500. That is certainly a viable alternative, although note that it has a fairly high 1.05% expense ratio and its performance has been largely different than Vanguard's "equivalent" fund (i.e. their investment choices are quite different than the index fund alternative; compare the charts and holdings information). Now, with such small amounts, it's not really going to make a big difference either way (i.e. choosing to invest in REITs or not), but getting invested in a diversified set of assets early could make sense to enforce good habits as long as you're keeping expenses low.

To that end, I typically recommend getting involved in REITs through a diversified index fund such as VGSIX with an allocation of 5-20%, so the absolute minimum assets that one should have before investing in REITs seems to be around $15,000, assuming you are comfortable with a 20% allocation. This is certainly not a set number for everybody and you should take your own personal circumstances into account, but it is a starting point at which I think diversifying with REITs will truly make a significant impact.

Q: Should I purchase a Total Bond Market Fund or TIPS?

A: I encourage the purchasing and allocation of funds to both. Just as advisers preach diversification across sectors and types of stock, it is important to diversify across the bond market. One might argue that the Total Bond Market (VBMFX) is enough diversification, but I personally believe TIPS (VIPSX) are also an important component of one's portfolio. If you don't have enough assets to invest in both, however, I'd most definitely start with the Total Bond Market fund. Many people encourage 2/3 of the bond allocation going towards Total Bond, while the remaining 1/3 goes to TIPS. Others say a 50/50 allocation makes more sense. Decide what makes the most sense for you. Another alternative to the Total Bond Market/TIPS split, is a Treasury fund (short-term or intermediate-term)/TIPS split in similar proportions. Some believe only Treasury bonds are fully dependable and thus avoid the corporate and mortgage related bonds. If somebody's bond portfolio was 50% Vanguard Intermediate-Term Treasury Fund (VFITX) and 50% Vanguard Inflation Protected Securities (VIPSX), I'd give that the go ahead most likely depending on their personal circumstances. Likewise, 2:1 or 1:1 Total Bond:TIPS ratio is also a well-rounded strategy as a play on the bond market.

Q: Would it be advisable to place my emergency savings in a short-term bond index fund?

A: Most financial advisers would tell you "no." Emergency savings are there in case disaster strikes, and you need the assets to be available and liquid, they argue. Bond funds do carry risk and you can certainly lose principle. Savings and money market accounts are safe, FDIC-insured, and reliable. I am, however, going to go against conventional wisdom and argue that in this current economic climate (i.e. extraordinarily low interest and money market fund rates), I think it does make sense for certain individuals to invest a portion of one's emergency savings in a short-term bond index fund, assuming the potential losses are acceptable. For example, placing 3-months living expense in a savings account and 6-months living expenses in a short-term bond fund (in which you plan to hold longer than the duration of the bond issues) assuming you can handle a 5% loss on your investment in those months would be an acceptable level of risk for the increased potential for returns, in my opinion. Note that typically advisers encourage a 6-month expenses emergency account, but in the current employment market, most have increased that to at least 9-months.

In taxable accounts, where emergency savings are typically placed (although it's possible to come up with a strategy to place them in tax-advantaged accounts), it might make sense to check out tax-free municipal bonds since other bond funds are typically not very tax efficient. Use a tax-equivalent yield calculator, such as the one found here, to find out if it makes sense based on current yield rates and your tax bracket. If so, I'd stash a portion of emergency savings in Vanguard Limited-Term Tax-Exempt (VMLTX) or something similar. If not, Vanguard Short-Term Treasury (VFISX), Vanguard Short-Term Bond Index (VBISX), or Vanguard Short-Term Investment Grade (VFSTX) are good choices. Jason Zweig argues in this September 19th Wall Street Journal article, that current conditions make Treasuries the riskiest type of bond right now ("If the economy improves and rates rise, [Treasuries] will get hammered. The longer the bond, the harder the hammering") and recommends Vanguard Short-Term Investment Grade (VFSTX), which currently yields 4.17% and has a duration of 1.97. You should not chase yield, however, under any circumstances. And with distributions coming up at the end of this year, you should be cautious when entering a bond fund at this juncture.

Q: Can Mutual Funds be shorted?

A: No, however, there are inverse mutual funds that increase in value when their market benchmarks go down. I do not recommend such funds. But if you're interested, the largest ones are offered by Rydex, ProFunds, and Direxion. There are also inverse ETFs and leveraged ETFs (that go twice the inverse the benchmark on a daily basis). For a list of inverse funds and ETFs, see here. I especially hate leveraged ETFs. They are extremely dangerous and do not behave the way most investors would expect. These should also be avoided. ETFs can be shorted, however. I likewise do not personally recommend such an action.

Q: Should I invest in index funds or actively managed funds?

A: Index funds have outperformed 60-70% of actively managed funds after taking expenses into account year after year after year. Those active funds that do outperform on any particular year, typically perform worse the next year. Chasing "hot" funds proves to be costly and index fund investing has shown to be a better, more cost efficient method. I subscribe to the "dollar cost averaging into diversified low-cost index funds over the long-term based on your objectives and risk tolerance" philosophy of investing.

Q: Should I hold Vanguard LifeStrategy Funds in a taxable account?

A: LifeStrategy Funds are all-in-one fund-of-funds that are designed to simplify investing and designate one's assets to various asset classes based on risk tolerance. Vanguard LifeStrategy Growth (VASGX) is the most aggressive fund, currently allocating 81% to stocks and 12% to bonds, while Vanguard LifeStrategy Income (VASIX) is the most conservative fund, allocating 22% to stocks and 65% to bonds. Since bonds are inefficient from a tax perspective, it does not make sense to hold a fund heavily invested in bonds in a taxable account. Due the simplicity of such a fund, one with an aggressive portfolio (i.e. skewed towards equities), a smaller number of assets, doesn't want to rebalance, or just wants an extremely simplified approach to dollar cost averaging or investing in general might choose a single all-in-one fund. However, because LifeStrategy funds hold the Vanguard Asset Allocation Fund, which adjusts its allocation and thus realize capital gains, these all-in-one funds are not as tax efficient as the Vanguard Target Retirement Funds, which do not hold the asset allocation fund. Thus, for those seeking an efficient all-in-one fund for a taxable account, look into the Target Retirement Fund with your desired asset allocation for the taxable portion of your assets. Ignore the year in the name; just look at the stock/bond percentages. You should still strive to hold most of your bonds in tax-advantaged accounts, but holding some in taxable accounts is okay. In the end, the Target Retirement Funds are better than the LifeStrategy fund for taxable accounts. Just make sure to revisit the allocation in the future as the target retirement funds automatically adjust as they get closer to the end date, unlike LifeStrategy funds. The tax advantages of TR funds, however, outweigh this negative.

Please send any investing questions to theinvestingguy (at) gmail (dot) com!

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