Index Investing, Investing

Indirect Effects of Indirect Investment

I can’t say enough about index investing.  The best, perhaps only, free lunch in investing is diversification.  And index funds are superb instruments with which to achieve diversification.  There is, however, a potential dark side.   Don’t worry, this dark side won’t effect you much… not really.  At least not directly.

What has me a bit worried is “giving up the vote.”   Yup, when you buy shares of an EFT, mutual fund, other fund you forfeit your voting rights to the underlying shares.  Say you own 1000 shares of SPY.  Cool.  That means you own a couple shares of Apple and a handful of XOM shares.  But, guess what?  You can’t vote them!

Do I care that I am giving up my votes to iShares?  Not enough not to buy ETFs.  But I care a little bit.  Enough to mention it in my finance blog.

The term “indirect investment” is not precise because saying “direct investment in stock” is perhaps not technically correct.  Nonetheless, I am slightly annoyed at institutions voting my shares.  I’d rather these shares not get voted… so that direct shareholders would not get overridden by institutional votes.  Better yet, I’d like to be able to set some parameters for how my shares should get voted.  Difficult to implement… but I’d like it.

So while index ETFs are the best thing since sliced bread, finding a solution to shareholder disenfranchisement would be a welcome improvement.

finance blog, Index Investing, Investing, options

Options Investing

Some readers have expressed interest in options investing blog topics.  So I’ll pontificate a bit about options investing.

I view options as generally “zero-sum” hedging tools.   When I buy and sell (mostly sell) options my first thought is not making money on the options trades.  My main goal is transforming and reshaping my portfolio.

In my IRA portfolio option trades cost me about $8.00 each.  Since IRA accounts generally cannot be margin accounts, I have only 4 basic ways to play options: 1) write covered calls, 2) write cash-covered puts, 3) buy calls, 4) buy puts.

The tactic I’ve applied in my IRA is a basic covered-call approach applied primarily to SPY.  In a nutshell, I started by buying 100 shares of SPY and selling a single at-the-money call 2 or 3 months out.  That call option either expires worthless or I buy it back just before it gets exercised.  I then repeat every couple months; selling 4-5 option contracts a year.

The primary advantage of this approach is that it provides extra return during sideways markets and softens market dips.  The trade off is missing out much of the upside return during bull markets.  Setting the option strike price near the stock price eats into portfolio upside, but gives larger option premiums.  Choosing a higher strike price, more out-of-the-money, allows you to retain a larger share of market upside but provide you a smaller premium.

The other factor to keep an eye on is implied volatility.  The most common way to track implied volatility is via the VIX.  When the VIX is higher, you can expect to get more money for the calls you “write” (create and sell a call option).  I prefer to sell call options when the VIX is 18 or higher.

So if you are interested in dabbling with options I recommend starting with selling covered calls on a highly-liquid ETF like SPY.  Real time bid/offer quotes are almost essential and allow you to make limit order trades.  I recommend starting near the option midprice when selling a covered call.  For example if the Jan 2011 SPY 125 call has an ask/offer of 2.16/2.20, you can started by offering your call at 2.18. [Depending on the exchange, your brokerage account, and the price you may only be able to bid in $0.05 increments; in other cases you can price options in penny increments.]

To make things a little more confusing, most options are quoted with a 100x multiplier.  So that means that an option quote of $2.18 actually sells for $218.00.  Each option contract transacts 100 shares of the underlying security (the “underlying”).  So exercising one SPY 125 call contract requires paying $12,500 in order to buy 100 shares of SPY at $125 per share.

finance blog, Index Investing, Investing, Low-Cost Funds, options

Portfolio Construction ETFs

Just a quick chart, globally-exposed ETF building blocks with VTI, JNK, IGOV, and  EFA.

GRAPH:  Possible portfolio construction pieces

And on the short-side, ETFs: BIL, BWX, IEI, IEF, ISHG, ITE, and TLO.

GRAPH: Possible short-side (deconstruction) pieces

These ETFs are building blocks I’m considering for a long-short portfolio.  As you can see it would be a US-equity-long,  global-equity long, high-yield (junk bond) long, USD (United States Dollar) short portfolio.

I’m also very interested in call option writing to blunt some of the equity exposure, whilst still remaining equity-long.

finance blog, Index Investing

The Art of the Deal

Perhaps more difficult to embrace than financial planning is the art of negotiation.

Growing up, I saw two very different approaches to personal finance.  Both of my parents were good savers, but that is were any similarity between their approach to finance ended. Dad’s investing style:  calm, disciplined, balanced, thoughtful, intuitive, enthusiastic, and confident.  Mom’s investing style: undisciplined, impulsive, emotional, intellectually-detached, and timid.   Over the years I saw another difference:  Dad’s approach was extremely successful and Mom’s was, well, not.

One quick example.  Dad was buying a new SUV.  He found one he wanted and was negotiating on price.  He was making headway getting a $1000 off then another $1000.  The sticker price was a joke.  They started perhaps $4500 apart and whittled the difference to about $2000. The car salesmen was starting to make pained expressions, but I could tell that they were not genuine.  Dad would walk away and the salesman would chase him down like a puppy, only his tail wouldn’t wag.  Then Mom lost it. She got mad and told Dad to quit beating up the poor salesman.  She said, “Our SUV is shot; we’re stuck here and we need a vehicle today.”  OMG, Dad dutifully took the current salesman’s offer.  I was stunned.  In 30 seconds Mom had managed to turn Dad’s hard-earned position of strength 180 degrees.  I had seen my Dad negotiate before and I wanted to see if he would get the full $2000 or just settle for $1500.  On the way out the door, while Mom was out of earshot, Dad said, “You know, Mom just cost us $1500?”  I nodded yes.  I was still in mild shock, but I knew he was correct.  I was attending a 12-round prize fight and Mohammad Ali’s corner had just threw in the towel — in the 3rd round!

To be continued…. So many stories.   Next story:  Making personal finance personal.

P.S. — Cover your eyes, a tiny bit of math.  Let’s say that in 30 seconds $1500 was lost.  That $3000 in a minute, or $180,000 lost in a hour.  Perhaps an odd way of seeing things, but that’s how my mind works.  And there is a kernel of Gestalt truth to it.

bonds, finance blog

To Make Finance Interesting

I went to a get together tonight with some friends, and talked about all sorts of topics.  The least popular, by people’s reactions, was personal finance.

People, in my experience, find Madoff somewhat interesting.  They sometimes find a bit of Wall Street bashing a bit entertaining.  And they find John Bogle and ETFs plain boring.

My issue is that I find the details of ETFs, markets, exchanges, and bonds fascinating.  I want to get inside of people’s heads to understand just why is finance boring or even vaguely repulsive?  My first thought is that somehow people feel that making money from investments is less morally redeeming than through work.  Another thought is that “respectable people don’t talk about money.”  Perhaps they find finance and all its jargon overwhelming.  Perhaps they have other more important things to focus on than their portfolio.

My mission with this finance blog is to find ways of helping people make better financial decisions.  A secondary goal is to bolster confidence in these financial decisions; to help people sleep easily at night with their financial strategy.  Finally, if possible, I would like to help people see finance through my enthusiastic eyes… as the minor miracle that it is.

The first two goals seem very achievable, while the third seems ever remote.  Really making sound financial decisions, and feeling secure in those decisions is important.  Perhaps, making finance interesting is not so important.  There are a handful of people, like myself, who find finance intrinsically interesting, while the vast majority of people could care less about money, investing, stocks, commodities, ETFs, options, futures…. hey, you in the back, quit snoring… mutual funds, gold, ETNs, annuities, insurance, loans, equities… oh, crap I think I might have dozed off a bit myself.

bond funds, bonds, funds, Index Investing, Investing, Low-Cost Funds, money, options, Small Business

More Hypothetical Proprietary Fund Ideas

While the Σ1 Fund is currently a real 100% privately-held investment vehicle, all language and speculative plans about its future are currently (9/28/2010) STRICTLY THEORETICAL.  There is currently no SOLICITATION or even OPPORTUNITY for anyone other than Balhiser LLC shareholder(s) to invest in the fund.  Further, there is currently no SOLICITATION nor OPPORTUNITY to invest in Balhiser LLC at present. Thus the HYPOTHETICAL and SPECULATIVE language is merely just words at this point and time.  It is entirely possible that outside investors NEVER be given the opportunity to invest.

I’m wondering… should I revise my $10K minimum investment.  Perhaps $5K-$9K with a ~2% up-front load ($5000 yields $4900 of principal, $5000 yields $5100).  Increments above $5K are $1K with an up/down choice.  Increments are also $1K for investments over $10K.  Additional subsequent investments for current investors are $2K minimum with $1K increments.  Withdrawals minimums are $5K or %100 plus optional $1K increments.  Additional fund investments are subject to the same early withdrawal penalties as initial investments.  ALL requested redemptions are FIFO by default.

Distributions (realized capital gains, dividends, etc) are annual.  How they are distributed is TDB.  My initial inclination is that there is an ex-dividend date on the last trading day of each month, and dividend income is distributed in proportion to #months held * #shares.  Distributions are re-invested by default. Non-reinvested distributions are held in a non-interest-bearing manner until $500 is reached, upon which the total distribution will be paid in full by ACH or check.  Non-reinvested dividends may be paid, upon request, before the $500 minimum is reached, but a distribution-collection fee of $50 will be assessed.  For shareholders with >= $100K NAV none of these distribution restrictions or fees apply.

75% of redemption fees will be paid to Balhiser LLC, the remaining 25% will be paid to the Fund.

Requirements for potential investors:

  • Minimum of 5 years experience investing in stocks, bonds, ETFs, and/or mutual funds.
  • Acknowledgment that this is an investment of at-risk capital that may be subject to forced liquidation without notice during volatile and illiquid market conditions. This could result in severe or even total loss of investment.
  • Acknowledgment that options WILL be part of the Fund’s holdings/obligations.  While the primary target use of options is “covered-call” writing the notion of “covered” is not strict.  The fund may consider an RNM (Russel 2000 mini call option contract) to be “covered” by ownership of “an appropriate amount” of SPY (S&P500 ETF) shares.
  • Acknowledgment that ETF futures contracts may part of the Fund’s holdings/obligations.
  • Signed (and notarized) legal waiver that specifies that in exchange for participating in this fund, fund participant, fund participant beneficiaries and/or heirs, agree to hold legally blameless the fund manager and Balhiser LLC  for losses sustained by the Fund.
  • Solid familiarity with E-mail and the Internet and Internet-based “paperless” documents and communication.

In exchange for these concessions, the fund manager agrees to the following “skin-in-the-game” and transparency conditions:

  • So long as fund assets (or total net unredeemed funds invested) exceed $50K, the fund manager and/or Balhiser LLC will maintain a minimum of $25K invested in the Fund.
  • So long as fund assets exceed $50K, the fund manager and/or Balhiser LLC will reinvest all fund net distributions and net fund management proceeds into the Fund.
  • So long as FE>$50K. Fund manager and/or Balhiser LLC will be subject to same fees, terms, and conditions as all other investors PLUS will have to provide an ADDITIONAL 60-day advance notice to all fund shareholders (via email or other means) prior to any sale of holdings in the Fund.
  • 100% of Balhiser LLC/fund manager redemption fees (fees incurred for “personal” withdrawals) will be paid to the Fund.
  • End-of-month NAV reports will be delivered by email to shareholders. (delivered within 5 business days)
  • Subject to NDA: Unaudited Annual Report detailing complete fund holdings (delivered within 20 business days). Disclosure to CPA is permitted.
  • Subject to NDA: Upon request unaudited inter-year report (delivered within 30 business days). A $250 fee applies.  Disclosure to CPA is permitted.  Fee is waived once per year for investors with >= $100,000 invested in the Fund.

Base Management Fee Rates (similar, but not identical, to an expense ratio)

  • 7.8 basis points per month (0.078%) of previous close-of-month fund NAV.
    [~0.95% in simple interest, or ~0.9772% compounded annually]
  • Base management fee reduced by:
    • 10% for investors with >=    $50,000 NAV (or $50K net unredeemed investments).
    • 25% for investors with >=   $100,000 NAV (or $100K net unredeemed investments).
    • 33% for investors with >=   $250,000 NAV (or $250K net unredeemed investments).
    • 50% for investors with >= $1,000,000 NAV (or $1M net unredeemed investments).
bond funds, bonds, finance blog, Index Investing, Low-Cost Funds, options

Small Investors: The Best of Times

The small investor has some truly excellent options these days.  Two in particular are just this side of awesome.  The first is index ETFs (exchange-traded funds).  The second is low-cost online trading.  ETFs and cheap online trading form a powerful combination for the small investor.

In addition, the wealth of online investment information is voluminous, and in many cases free.

So for the small investor (whom I define as someone with < $1,000,000 of net assets to invest), 2010 is a pretty great starting point to get serious about personal finance

I recommend that before you embark, that you have at least a 3-month emergency fund and little to no credit-card debt.  If this doesn’t describe your financial situation, this article doesn’t currently apply to you.  [Please consider paying down those credit cards and then saving up a modest rainy day fund!]

However, if you meet these basic criteria consider the following suggestions:

  • Open a Vanguard account with a minimum of $3000.  Put those first funds in either the Prime Money Mkt Portfolio or the Tax-Exempt Money Market
  • Keep putting spare money into Vanguard.  Once you hit $10,000 to $25,000, consider other Vanguard offerings.  If you are unsure of what to invest in, call a Vanguard adviser.
  • Consider maxing out your 401k contribution, if your income permits.  Keep that “rainy day” fund in mind.  A rainy-day fund is cash, money market, or diversified short-to-intermediate AA or better rated bonds or CDs.  Stocks, mutual funds, etc. don’t count for rainy day cash.
  • Keep that Vanguard account.  If your tax situation permits, consider making Roth IRA contributions.  Vanguard is a good place to hold these, Fidelity is another.
  • Once you’ve got your rainy-day fund to 9 months or more, and can maintain solid 401k and Roth IRA contributions, congratulations.  You may be read to become a “big-time small investor”.

Enough preamble.  Let’s assume you are ready.  Now what?

You can select any number of online brokerages and invest for less than $9 per trade.  That includes option trades.  Some even allow futures trades.  So, the world is your oyster.

However, prudence is crucial.  There are just so many opportunities, options, pitfalls.  May I make a few suggestions?

  1. Start by investing in ETFs.  Consider, SPY, VTI, BND, VEU,  and, now, VOO.  These are excellent diversified ETFs with very low expense ratios.
  2. Want to dabble in individual stocks?  Diversify.  If you buy some tech stocks, also buy some consumer goods, or basic materials, or utilities.
  3. Want to dabble in options?  Try starting with writing (selling) covered calls on your ETFs.
  4. Futures?  Think once, think twice.  Do some research and think a third time.  The just maybe you might given them a try.  But, please, please do so with caution. [Note futures contracts require a margin account… please tread carefully with margin (aka leveraged) investing.]

That is just a start.  Might I also point out that an investor today could construct an excellent life-long portfolio with just VTI, BND, and VEO… re-balancing annually as age and situation dictate?  As age 60 approaches, mixing in a few laddered CDs (bank certificates of deposit) is not an unreasonable option.  Owning and paying-off a home is also a reasonable retirement goal.

I, however, am now content to fully adopt a reasonable and prudent approach.  I also dabble with a small Crazy Ivan Account (CIA), and with (limited) option strategies.  I also incorporate rental real estate into my investing mix.

The point I want to emphasize is that there are so many opportunities for the modern small investor.  It is easy to feel overwhelmed by the choices.   But, by starting with the basics — Vanguard mutual funds, low-cost diversified ETFs, and online investing — it is possible to construct and manage very solid personal portfolios.

Best wishes.