Improving your diversification

I’ll start by assuming that you are invested in individual stocks and bonds, saving mutual funds for the next section.

Unless you are really rich, like several millions rich, you simply cannot have a truly well-diversified portfolio of individual securities — not nearly as well-diversified as even the simplest ETF or mutual fund portfolio. Where would you even start? To have a portfolio as well diversified as even a simple ETF portfolio, you’d have to hold a bevy of large company stocks (both growth and value), small company stocks (again, both growth and value), foreign stocks (Asia and Europe and emerging markets, growth and value, large and small), and real estate investment trust (REIT) stocks. And that’s just on the equity side!

On the fixed-income side of your portfolio, you would ideally have a mix of short-term and long-term bonds, government and corporate issues, and perhaps (especially if you are several millions rich and find yourself in the northern tax brackets) some tax-free municipal bonds.

Get real. Examine your portfolio. If you, like so many U.S. investors, have the large majority of your equity holdings in large company U.S. stocks, then you can diversify in a flash by adding a small-cap ETF or two (see Chapters 7 and 8) and a couple of international ETFs (see Chapter 9). If you are simply too heavily invested in stocks, then you may want to tap into some of the more sedate bond ETFs (see Part 3).

Minimizing your investment costs

Now, let’s assume you’re basically a mutual fund kind of guy or gal. You’ve been reading Money magazine and Kiplinger’s for years. You believe that you have winnowed down the universe of mutual funds to a handful of winners, and goshdarnit, you’re going to keep them in your portfolio.

You may or may not have heard the terms core and satellite. They refer to an investment strategy that has been very much in vogue lately. Core refers to a portfolio’s foundation, which is basically invested in the entire market, or close to it. Then, you have your satellites: smaller investments designed to outdo the market. It isn’t such a bad strategy.

Suppose you have four mutual funds that you love: one tech fund, one healthcare fund, one energy fund, and one international growth fund. Each, we’ll say, charges you a yearly fee of 0.63 percent (the active mutual fund average right now, according to Morningstar). And suppose you have $250,000 invested in all four. You are paying ($250,000 × 0.63 percent) a total of $1,575 a year in management fees, and that’s to say nothing of any taxes you’re paying on dividends and capital gains.

Consider trimming those investments down and moving half the money into an ETF or two or three. Turn your present core into satellites, and create a new core using broad-market funds, such as the Vanguard Total Stock Market ETF (VTI). It carries an expense ratio of 0.03 percent. Your total management fees are now ($125,000 × 0.63 percent) + ($125,000 × 0.03 percent), or $787.50 + $37.50, which totals $825. You’ve just saved yourself a very nifty $750 a year, and you’ll likely save a considerable amount on taxes, too.

Using ETFs to tax harvest

Regardless of whether you hold individual stocks or mutual funds, you should hope for nothing but good times ahead but be prepared for something less. Historically, the stock market takes something of a dip in one out of every three years. In the dip years, ETFs can help ease the pain.

Say it’s a particularly bad year for tech stocks, and you happen to own a few of the most beaten down of the dogs. Come late December, you can sell your losing tech stocks or mutual funds. As long as you don’t buy them back for 31 days, you can claim a tax loss for the year, and Uncle Sam, in a sense, helps foot the bill for your losses. Ah, but do you really want to be out of the market for the entire month of January (typically one of the best months for stocks)? You don’t need to be.

Buy yourself a technology ETF, such as the Technology Select Sector SPDR Fund (XLK), and you’re covered should the market suddenly take a jump. Although I’d much rather you simply hold onto your ETF as a permanent investment, if you want, at the end of 31 days, you can always sell your ETF and buy back your beloved individual stocks or active mutual funds.

Please discuss the strategy with your tax adviser before proceeding next year, okay? Especially today, with the tax rate on capital gains expected to go up (perhaps depending on your income bracket), this whole business is trickier than ever.

Adding mutual funds: The most popular of all investment vehicles

Despite the phenomenal growth in ETFs in past years, there are still many more mutual funds out there. If you want to invest in one, I can certainly understand. Many people who hold mutual funds and not ETFs have no choice in the matter… . That’s what their company 401(k) plans offer. Others who hold mutual funds may prefer active management, and there are many more actively managed mutual funds than there are actively managed ETFs. For now. (I discuss actively managed funds in Chapter 18.) But then there are still a few small holes in the ETF universe. For now. By “holes,” I mean asset classes that can’t yet be tapped with ETFs.

The most salient one is state-specific tax-free municipal bonds. You might want to invest in a muni bond fund in your own state in order to side-step not only federal tax, but state and local tax, as well.

There are a handful of state-specific muni funds for New York and California — for example, the Invesco New York AMT-Free Municipal Bond ETF (PZT) and the Invesco California AMT-Free Municipal Bond ETF (PWZ). There’s also the iShares California Muni Bond ETF (CMF) and the iShares New York Muni ETF (NYF). And there is, as it happens, one such fund for Minnesota: the Mairs & Power Minnesota Municipal Bond ETF (MINN).

But if you live in a state like Pennsylvania (as I do), Ohio, Maryland, Missouri, Arizona, Delaware, Colorado, Michigan, Connecticut, Virginia, Georgia, or a handful of other states that have state income tax, then you are going to have to go with a non-ETF. For now.

I own shares in Vanguard Pennsylvania Long-Term Tax-Exempt Admiral Shares (VPALX), a mutual fund, and the Nuveen Pennsylvania Quality Municipal Income Fund (NQP), which is not a mutual fund or an ETF but a closed-end fund (see the sidebar, “A few odd ducks,” later in this chapter).

Other than that, I own several mutual funds issued by Dimensional, but I won’t get into these in any depth because Dimensional is currently turning their mutual funds (one by one, it seems) into ETFs, as are several other mutual fund companies. These mutual funds will, before long, become part of my ETF portfolio.

I also own one market-neutral mutual fund, the Merger Fund (MERFX). Yes, there are now market-neutral ETFs, but I like the Merger Fund. It has a longer track record than any of the comparable ETFs, it has a reasonable expense ratio, and it uses a strategy that I understand and that makes sense. (Long track records don’t matter so much when you’re investing in index funds; with actively managed funds, they certainly do.) If the Merger Fund, like Dimensional, were to move into an ETF shell, I’d like it even more!

Are there other asset classes missing from, or otherwise underrepresented in, the ETF universe? If there are, there won’t be for very long, I’m sure.

Adding I Bonds: An Uncle Sam bond with a twist

Like TIPS (see Chapter 14), I Bonds are inflation indexed. Unlike TIPS, they are available as individual bonds in very small denominations — as small as $25.

On the upside: The interest earned can be greater than TIPS (and that has very much been the case lately). The correlation to inflation is also more closely matched, as I Bonds change their yield to adjust for inflation every six months. Also, you don’t pay tax on the interest on I Bonds until you cash them in, making them often a better option for taxable accounts.

And — a potentially very sweet bonus if you have young ones — if you use the I Bonds for higher-education expenses, that interest, along with any inflation adjustments, may be yours to keep and spend tax-free.

On the downside: You must hold I Bonds for at least one year, and you forfeit three months’ interest if you redeem them before they mature in five years. Also, Uncle Sam lets you buy only as much as $10,000 a year in I Bonds.

You can buy I Bonds direct from the government, with no transaction fees, by visiting www.treasurydirect.gov. I just went on a few days ago to buy my allotment for 2021. I Bonds are not essential, but are a welcome part of just about anyone’s fixed-income portfolio.

Do Consider Annuities, Preferably Fixed

For older people especially, and almost definitely for those with no heirs, an annuity can make enormous sense. With an annuity, you give up your principal, and in return, you enjoy a yield typically far greater than you would likely get with any other fixed-income option.

There are many horrible annuities out there. I can’t tell you how often a new client has walked into my office, thrown their annuity papers on the table, and said, “Why did I ever buy this stupid thing?” Most of the really bad ones are variable annuities, not the fixed kind that I prefer. Fixed annuities are very simple. Variable annuities are very complex.

If you are interested in an annuity, you might start with Fidelity or Vanguard. In general, brokerage houses offer better deals than you would get going directly to an insurance company. (Actually, the insurance company usually comes to you, with a heavy sales pitch filled with mind-numbing charts that could confuse even Albert Einstein.) The brokerage house annuity products can be cheaper, less complicated, and easier to back out of should you change your mind. Check out the following brokerage houses for more information.

• Vanguard: www.vanguard.com
• Fidelity: www.fidelity.com

I also like the website www.immediateannuities.com. You can shop many companies at the same time, and if you want to talk to someone from immediateannuities.com, you’ll get straightforward advice without a hard sales pitch.

Note that there are two different kinds of fixed annuities: immediate and deferred. If you don’t need cash flow today, then consider a deferred annuity that only starts paying out when you do anticipate needing cash flow. The longer you defer, the higher payout you’ll get.