Saturday, January 26, 2013

5 ETFs to Fight Inflation

If your grandparents were the kind to bury cash in tin cans out in the yard, the time to cash in that change was yesterday.  Every penny not earning interest is fighting a constant battle with inflation, or the loss of purchasing power over time.  Why inflation occurs is debatable and likely constantly changing, but what investors should always be wary of is how it will affect their portfolios.

The United States Department of Labor calculates the rate of inflation monthly, reporting it as a change in the Consumer Price Index.  There is some contention on if the CPI method truly captures "real inflation", but for the most part its the best official method.

There are also a lot of investments that claim to "hedge inflation": precious metals, corporate bonds, municipal bonds; how these all fair might make a good post for Ulmer Scientific in the future...but any selective investor will always take a guarantee.  How can anyone offer a guarantee against inflation?!  Try the same folks who calculate it:

The U.S. Treasury offers one of the most novel (we think) investments of the past century: Inflation Protected Securities.

Treasury Inflation Protected Securities (or TIPS) are bonds sold by the Treasury with the promise to always keep pace with inflation.  Depending on how generous the Government feels they might even add in an extra base rate.  

I'm Sold, How Can I Buy TIPS?!:
Well, would have you believe you can buy them from the Treasury.  Good luck.  Oh by the way you can't buy paper bonds anymore.  I'll let you try out the website for a minute...

Back so soon?  Okay, luckily TIPS are traded on the open market and the exchange trade fund arena has answered investors' Treasury frustrations.  There are over a dozen TIPS ETFs with tens of dozens of mutual funds; in keeping our analysis brief, lets Google "best TIPS ETFs".  First pick, U.S. News and World Report's Best Fit TIPS ETFs.  Lets examine the Top 5:

  1. Schwab U.S. TIPs ETF (SCHP)
  2. SPDR Barclays TIPS ETF (IPE)
  3. PIMCO Broad U.S. TIPS Index Exchange-Traded Fund (TIPZ)
  4. PIMCO 1-5 Year U.S. TIPS Index Exchange-Traded Fund (STPZ)
  5. iShares Barclays TIPS Bond Fund (TIP)
Take some time to read U.S. News' ranking methodology, notice "yield" isn't considered (HEY!...that's why you're reading Ulmer Scientific).  Two things stand out instantly.  STPZ is the only duration specific fund, and TIP has been trading for years longer than its peers.  TIP is also happens to be the largest of the 5, pulling an order of magnitude more average dollar-volume:

What Does Inflation Protection Look Like:
Given all 5 of these funds have basically the same objective, we could expect their annualized returns to be approximately equal:

What Happened With STPZ?
We know STPZ holds the shortest duration TIPS, whereas the other 4 hold mostly longer durations.  As with most fixed-duration investments the longer you hold them the higher return you can expect to get (see Treasury Rates); the trade-off being your money is now tied up for the entire duration of the investment.  Not necessairly a good thing if you car stops working or an unexpected medical bill arrives.

 HOWEVER, with the advent of ETFs, investors can now actively trade multi-year investments and receive the same rate.  Knowing this, when any long term investor chooses yield over all else, we conclude STPZ is a fund for short-trades and speculation on inflation and not a sound investment.  Lets focus on the remaining 4.  Since these fund's APY-to-Dates are close, lets look at the difference they make from an average of all their yields:

At least according to this chart, IPE is the clear profit winner in the TIPS ETF world, pulling on average 0.15% higher in annualized yields. Conversely TIPZ has barely been able to keep pace with its competitors.  Also note TIP, with the largest share of the TIPS market, isn't always even at average.

The ETF universe is exciting and confusing at the same time.  Just because one article you read ranks a fund over another doesn't necessarily mean it'll earn you the most for your investment.  In the case of TIPS these differences are likely due to each fund's unique holdings, but they could be the result of higher fees, poor management, or any number of market conditions.

Check out how to calculate your own Annualized Percentage Yield charts here.

Read about the potential inflation hedging Gold ETFs here

Thursday, January 24, 2013

Examining Vanguard's Top Dividend Funds

The Vanguard Group operates two of the most invested-in and interesting dividend paying ETFs:

Vanguard Dividend Appreciation (VIG)
Vanguard High Dividend Yield (VYM)

While both funds are focused on providing a dividend, their differing investment strategies and underlying indexes have produced an interesting divide amongst investors.

VIG is designed to follow Mergent, Inc.’s Divided Achievers Select Index, which is comprised of common stocks of companies that have a record of increasing their dividends over time.  This strategy is very alluring to investors who want consistent, ever improving performance while still maintaining a moderate risk for capital gains.

VYM on the other hand is programmed to follow FTSE’s High Dividend Yield Index, which measures the investment return of common stocks of companies characterized by higher than average dividend yields.  Excellent for investors seeking a greater payout while still maintaining the stability and consistency of a large diversified fund.

Thus the divide is forged.  High yield/slightly higher risk vs. consistent yield/slightly lower risk.  It would be easy to simply take these descriptions and run, but to us these two strategies produce a couple of must-answer questions:

  • Does VIG’s dividend actually and consistently appreciate as promised?
  • How much higher is VYM’s yield than VIG’s, if at all?
  • Could VYM’s dividend be appreciating at the same rate, or faster, than VIG’s?
  • How well do these funds’ portfolios weather market crashes?

Luckily for us there already exists a dividend paying benchmark for essentially all large diversified funds.  Any guesses?!  Yes…the S&P 500, however the closest we can get to owning all 500 stocks without devoting all day to trading is SPDR’s S&P 500 ETF (SPY).

Dividend Appreciation:
In order to fully gauge VIG’s degree of dividend appreciation we need to plot its yield versus the S&P 500’s and against its “moral” competitor:

Note: Spikes in yield are the result of overlapping dividend payments within a time-range, Ulmer Scientific chooses not to modify raw data or smooth out these spikes.

To determine “appreciation” we’ve fitted a linear regression to each plot, shown in the table below:

Dividend Yield Analysis as of 23JAN2013
Fitted Linear Dividend Growth:

We can see VIG’s dividend has indeed appreciated, faster so than the S&P 500’s and with less volatility!  However, notice VYM for almost the same period has appreciated 0.08%/yr more; and done it with only slightly more volatility.  This could mean trouble for VIG, not enough dividend growth will keep it forever lagging behind higher-yield funds, even when the markets are down.

Recession Proofing:
Given the fundamentals of these funds there is probably some ugly calculus we could attempt to figure at what point either fund would come out on top given some recession scenario… Or lucky for us, we can just look back at late 2008.  Measuring the APY-to-Date for these funds produces an interesting plot:

When market conditions are favorable (i.e. post-2008), VYM’s higher yield allows it to shine above the rest.  However when the market dips, it appears VIG’s conservative strategy and solid dividend allows it to better weather the storm; yielding higher returns than either the market or VYM.  Where the hard math comes in now is figuring how long between market pull-backs will it take for VYM to outpace VIG in the long run?  Interesting indeed.

Monday, January 21, 2013


In the world of U.S. gold Exchange Trade Funds an investor really only has three options:

iShares' Gold Trust (IAU)
SPDR's Gold Shares (GLD)
ETFS' Physical Swiss Gold Shares (SGOL)

The contrasts are well documented and debated (1)(2)(3).  All of these funds are backed by some level of physical holdings, thus exclusive of any day trading the differences can be boiled down to three things: market share, liquidity, and management fees.

Market Share:
Some investors must just feel more comfortable with a larger fund, here's how the gold ETF market looks in terms of daily dollar volume:

GLD is the juggernaut, moving an order of magnitude more than its competitors:

Management Fees:
GLD - 0.4%
IAU - 0.25%
SGOL - 0.39%

Here the long term advantage of lower management fees begins to pay off:

Okay, so the APY-to-Date chart is almost identical, however GLD's management fee keeps it constantly trailing IAU.  SGOL's marginally lower fee perhaps hasn't had enough time to make a break into the positive.  Interestingly, IAU only lowered it's fee in 2010, prior to then the fund still somehow outperformed GLD (2):

SGOL may still be struggling with liquidity issues which affect price, but all things being equal, that 0.01% should eventually pay off.  For the long term investor choosing GLD over IAU, a 0.05% APY-to-Date difference since mid-2004 in a $10k portfolio would represent a loss of almost $150.  Not necessarily large, but not a necessary punishment for seeking split-second liquidity.

Saturday, January 19, 2013

Dispelling the Income Tax Bracket Myth

One of the more notorious myths associated with tax season is that by earning more money in a tax year an individual could get pushed into a "higher tax bracket" and thus earn less money.  This simply isn't the case with a progressive tax system.  There are scenarios where an individual can end up paying more in taxes over multiple years, but we'll explain one simple trick to help minimize the total amount an individual has to pay.

Income Tax in the United States:

For the sake of keeping Ulmer Scientific a blog and not a book, we examine raw income tax only (exclusive of any credits, dividends, capital gains, etc.) for the single filer.

The United States uses a marginal tax rate to generate an average progressive, or effective tax rate, on one's income.  Plotting this rate against income generates this neat bunny-hop chart:

 Take special note of the tax bracket ranges and resulting effective tax rate.  Because of the marginal way taxes are calculated, individuals in the 28% tax bracket actually pay almost 3 percentage points less in total tax.  In theory, individuals could earn an infinite amount of income, and never fully pay the maximum rate of 35.6%.

Okay, so effective tax rates are cool, but most individuals would just like to know what that means in dollars.  Below are the total income tax owed and resulting take home pay for 95% (<$100,000/yr) of Americans:

2013 Estimated Tax & Take-Home Income for Single Filers
Notice the plot for Take Home Income After Tax never goes down as income increases.  In no way could earning more money in a year result in an individual taking home less money.

Now, fear of the "next tax bracket" isn't completely misplaced, income in the next bracket is taxed at a higher rate.  Having one's income break into the next bracket is never a bad thing, however if it can be avoided there is a way to save more and pay less in the long run.

The Trick:

To pay the least amount in total tax, earn the lowest average income over multiple years.

For example, say Sally Smith knows she'll earn $24k this year, $34k next year, and $44k the next year.  If she has a $10k bonus, it would be wisest to take it this year.  Taking it next year would result her in bonus being taxed at a higher rate ($775 more).  Taking it the third year would force a loss of an additional $225!

In conclusion, its not possible to earn less money in a year by crossing into the next tax bracket (Myth Busted); albeit, if an individual has a varying income, it makes sense to spread that income evenly over multiple years.

Thursday, January 17, 2013

Understanding Annualized Percentage Yield (APY)

Ulmer Scientific frequently compares the historic performance of actively traded securities like stocks, bonds, and exchange trade funds using an “Annualized Percentage Yield-to-Date” methodology.  While this might sound like a string of complicated finance jargon, understanding the basics of this relatively simple method is key to performing any financial or investing comparison.

Most financial websites like Yahoo! Finance and Google Finance will often provide a table of annualized returns (1 year, 3 year, 5 year) which make for great stock-to-stock comparisons.  However in depth analysis between multiple investments or analysis of multi-year trends demands the ability to calculate these returns from historical prices.

The following is intended to provide the basics for calculating annualized returns and should help explain the APY-to-Date charts used on Ulmer Scientific:

First the Math:

The premise behind calculating returns is that all the trades, dividends, distributions and on-goings with market securities generate some net change in value.  Typically, this change is represented by a percentage; or more appropriately, since investors are out to make money, “percentage yield”.

Market analysts frequently rely on the exponential growth formula:

Where P(t) is the present value, P(0) is the initial value, e is Euler's Number, r is the exponential growth rate (usually a decimal), and t is time.  Note: r is not the same as the percent change (i.e. r of 0.07 ≠ 7% growth), but we’ll take care of that.

In finance, the most common basis for comparison is the year; its quick, easy, and gives the investor a pretty clear idea of how their investment would have faired if they picked this security 365 days ago.  The standard year also allows for easy comparisons between multiple securities.  Rather than trying to relate the S&P 500’s gain of 142 points to the DOW Jones’ 12, investors just convert the change into a percent.

To calculate this annual percentage change, or yield, we rearrange the exponential growth formula to solve for r (and convert r to an actual percentage):

You’ll notice, if you plug in the prices of your favorite stock the percentage change is just the same if you were to simply divided the two.  Why the extra math?  

In short, investors want to know how their investments perform over multiple years.  20% in one year is far more productive than 20% in 100 years.  So to keep things simple, investors prefer to keep everything on the same time scale, aka one year.  Thus we need to convert 20% in 100 years to some percentage per year

(Hint: it won’t work with simple division)

Give up?  We need to modify the annual percent yield formula to average (or annualize) our change over multiple years:

Now whither we use stock prices from last year, or last decade, we can easily compare multiple investments with a single %.  

What Ulmer Scientific Does

This blog uses the APY method to calculate investments’ yield from any time (or value) in the past to the time of publishing; essentially producing an APY-to-Date Chart.  These charts can be used to compare similar investment products (GLD vs IAU), investment classes (bonds, equities, etc.), or anything we can think of.  Here’s an example:

Annualized Percent Yield on the y-axis, dates to the present on the x-axis.  The true power of these charts comes into play when you can see the effects of major financial events, like the market crash of late 2008, or the difference dividends and distributions make over the long run.