Ask The Expert with Larry Swedroe, August 2008 Issue

This is the 8th issue of the Ask The Expert column by Larry Swedroe. You can see Larry’s full biography and important disclaimer below. If you are interested in having your question answered by Larry, please send me an email via the contact page.

Now, let’s get to the questions and answers (please note that the emphases and links are mine).

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Question from Chris:

Can I use funds from my existing rollover IRA to open another IRA at a different bank without tax consequences? Reason? The second bank offers world currency CDs that I would like to buy. If it can be done, is there a dollar limit?

Chris, all you have to do is transfer from one custodian to another. The custodian can give you the paperwork needed to do that. There are no tax consequences and no dollar limits (though I would be concerned about FDIC insurance limitations). You can also liquidate the account and have them send check to you (not my recommendation). But you must then be sure to reinvest them in a new IRA within the required IRS timetable.

Note I would be careful you are investing in these currency CDs for the right reason. My guess is that the only reason you are buying them is a case of recency (buying yesterday’s winners high). And that is usually a losing strategy that leads to buying high and selling low. What I call convex investing (discussed in my book Rational Investing in Irrational Times). What you want to do is to simply adhere to your investment plan, which should include an asset allocation table and then rebalance. Rebalancing leads to concave investing, buying yesterday’s losers (low) and selling yesterday’s winners (high), a far superior strategy.

Most importantly, if you don’t yet have a plan (those that fail to plan, plan to fail) that is the very first thing you should do — develop one. And it should include a rebalancing table, listing the minimum and maximum tolerance ranges for each asset class and major asset class group (stocks vs. bonds, domestic vs. international and individual asset class).

Another reason to consider not investing in these CDs is that it is likely that the bank is taking a significant spread out of the transaction, though you won’t see it unless you know how to analyze the transaction properly.

I hope that is helpful,

Best wishes
Larry Swedroe

Question from Mariam:

Dear Larry,

I recently finished reading your book What Wall Street Doesn’t Want You to Know (the 2001/2002 edition).

First, I’ve read quite a few financial books and must say this is the best. It was a total pleasure reading it and I couldn’t put it down (I am not joking). In reading more about the various index fund choices that you propose, I became really interested in the DFA funds and their quantitative / objective approach to building their funds. I find I like the DFA funds better than the Vanguard funds, which are market-cap-weighed and thus contain an element of subjectivity. However, it turns out I cannot buy the DFA funds through my Charles Schwab accounts and have to buy them through a registered investment advisor.

1) Given all the talk about avoiding high management fees, what is the point of buying the DFA funds through an advisor and paying an average of 1% yearly advisor charge on top of the funds’ fees ? Wouldn’t this wipe out the benefits of buying such passively-managed funds and if so, why does DFA force their would-be clients (whom I think are mostly intelligent) to go this route?

The most important point here is that you should not confuse the two issues, but, instead, separate them. A good financial advisor can add value in many ways, including developing the right investment plan in the first place (making sure the investor does not take more risk than they have the ability, willingness or need to take), making sure assets are in the right location and making sure that the plan is implemented (adhered to).

Having a well-thought out plan is only a necessary condition for investment success. The sufficient condition is to have the discipline to adhere to that plan through the tough times (easy to stick to plan when things going well). That means disciplined rebalancing in the most cost and tax efficient manner as well as disciplined tax loss harvesting in the most cost and tax efficient manner. It also means integrating that well-thought-out investment plan into a well-thought-out estate, tax and risk management (all types of insurance) plan. And it means keeping up with the latest innovations in products and the latest academic research. A good advisor would likely run a Monte Carlo simulation to help you choose the right allocation.

As to fees, while the average fee might be 1% there are many that charge more and many that charge less. But price should only be one consideration. In other words, while good advice doesn’t have to be expensive, bad advice will almost always cost you dearly no matter how little you pay for it.

And each advisor offers different services. Some do all the financial planning while some only do investments. Some also offer the building of individual fixed income portfolios at no manager fee (providing the benefits of separate account management — providing tax efficiencies while avoiding the manager fee). And there are a wide variety of skill levels, as there is with any profession. I teach advisors all over the country how to be good advisors and I assure you that there are huge differences in both service levels and skill levels. So you have to be careful to do your due diligence.

As to DFA and their strategy, DFA does this for a few reasons:

1. It lowers their costs dramatically, and they pass those savings on to investors in the form of low fees. They don’t have to support a client service operation on the scale that retail mutual funds do.
2. They don’t want the active management of undisciplined retail investors driving the costs of managing the funds up, imposing incremental costs on the existing clients and incremental taxes for taxable accounts.
3. They don’t have to advertise at all.
4. Their strategies are very complex, not simple indices, and they don’t want to have to spend the dollars explaining the many complex issues.

The role of the advisor is to keep the clients disciplined. Interesting study supporting the importance of this issue done by Morningstar. They studied the time-weighted returns of mutual funds (the kind funds report) vs. the dollar weighted returns actually earned by investors. What they found was that in all but one single case, the returns earned by investors (dollar weighted) were below the returns reported by the very funds those investors owned for the period they owned them. That included Vanguard funds.

The reason is that the vast majority of investors tend to be convex investors (see first question). The sole exception was the funds of DFA. Of course the funds have no role in this. The differences are solely related to investor behavior. The DFA investors actually outperformed the very funds they invested in because the advisors kept them disciplined. They bought low and sold high through disciplined rebalancing, while the typical retail investor was doing the opposite. Perfect example of how an advisor can add value.

The bottom line is that while costs are important, it is value added that matters. And, unfortunately, there are millions of people that know the cost of everything but the value of nothing. So you have to look at the cost of the advisor, but also the value added they bring and the value added the use of DFA brings. If you look at the historical evidence without question the average investor (and almost all investors) would have been better off paying for the advice of a good advisor if they also used DFA funds than if used Vanguard funds and no advisor.

And finally, my book, Wise Investing Made Simple: Larry Swedroe’s Tales to Enrich Your Future, has several stories in it about investor behavior (buying high and selling low and the results) and how advisors can help clients. I am sure you would enjoy it. You can check out the reviews on Amazon.

2) At about the same time, I found out (on my own, not through my Charles Schwab representative) that Charles Schwab offers a type of index fund called “Fundamental indexing” built on the research of a person named Rob Arnott. Based on a very quick reading, it seems that fundamental index funds are funds based on quantitative research and appear to be similar to DFA funds. The gross expense ratios of these Charles Schwab fundamental index funds vary from 0.77% to 1.08% which are not too high, but certainly not as low as Vanguard’s.

What do you think about these “fundamental index” funds ? Are they similar to DFA funds and are they worth buying ? Or should I just stick with Vanguard index funds?

The fundamental indexes are not a bad strategy and they are similar to DFA funds, but not the same. They are mostly marketing hype. They are really nothing more than a midcap value strategy but with much higher expenses, way too high in my opinion. The best funds now in my opinion are by far the new core funds of DFA. They are the latest evolution in fund management as they lower internal trading costs (raising returns), reduce the need for investor rebalancing (saving you costs and taxes) and improving tax efficiency. That is what I personally would recommend should you decide to go that route. But you need to find a good advisor.

The following is a list of attributes that a good advisor should have. It will help you perform a thorough due diligence.

A good advisor should adhere to these principles:

• The best interest of the client — Our guiding principle is that we will provide investment and wealth management advisory services that are in the client’s best interest.
• Fiduciary standard — We provide a fiduciary standard of care ­the highest legal duty that we can have with a client.
• Fee-only — We are a fee-only advisor ­avoiding the conflicts and lack of objectivity that commissioned-based compensation can create.
• Products: They’re not-for-sale here – We are client-centric. We don’t sell any products, only advice.
• Full disclosure — All potential conflicts are fully disclosed.
• Use scientific research — Our advice is based on the latest scientific research, not on our opinions.
• Practice what you preach — We invest our personal assets, including our profit-sharing plan, based on the same set of investment principles and in the same or comparable securities that we recommend to our clients.
• Advisory team for each client — Each client is assigned a team of professionals. Our comprehensive wealth management services are provided by individuals who have the CFP, PFS, or other comparable designation.
• Attentive, individualized service — We provide a high level of personal attention. Developing strong personal relationships is central to our ability to provide appropriate advice and service for each client.
• Customized, integrated planning — We develop investment and wealth management plans that relate to the whole person­that are integrated into to each individual’s unique strategy and personal situation.
• Strategic advice for long-term success — Our advice is goal-oriented. We evaluate each recommendation, not in isolation, but in terms of its impact on the likelihood of success of the overall plan.

3) I know you don’t believe in sector funds in general but what do you think of also having a portion of my savings in commodities. It seems like the return on commodities is not very closely linked to that of other asset classes such as equities and bonds. Can you suggest a good commodity (precious metals, oil, etc…) vehicle for my IRA/brokerage account?

First, my book, The Only Guide to a Winning Investment Strategy You’ll Ever Need, does have a detailed appendix (H) on commodities. And I do recommend them for disciplined investor, though only for tax advantaged accounts. My choice is the one I own, the PIMCO fund (PCRIX). I suggest considering allocating about 10% of your equity allocation as a starting point. The more risk averse you are, the higher the allocation should be. And then treat this investment as an insurance policy, and hope you don’t have to collect (as with all insurance).

The reason is that commodities have negative correlation to stocks and bonds. That means they tend to produce their best returns when needed most — when stocks and bonds are producing their worst returns (and vice versa). And I am sure you would rather have 95% of your portfolio doing well and 5% doing poorly than the other way around.

Also note that the third in my “Only Guide” trilogy: The Only Guide to Alternative Investments You’ll Ever Need: The Good, the Flawed, the Bad and the Ugly (the first I mentioned above, the second was The Only Guide to a Winning Bond Strategy You’ll Ever Need) is due out in November. It will cover commodities among 20 alternative investments. You can preorder on Amazon.

Thank you very much for your great book.

Glad you enjoyed it and hopefully the above was of help.

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Past Issues of Ask The Expert

• 06/2008 - Ask The Expert with Larry Swedroe, June 2008 Issue
• 05/2008 - Ask The Expert with Larry Swedroe, May 2008 Issue
• 04/2008 - Ask The Expert with Larry Swedroe, April 2008 Issue
• 03/2008 - Ask The Expert with Larry Swedroe, March 2008 Issue
• 02/2008 - Ask The Expert with Larry Swedroe, February 2008 Issue
• 01/2008 - Ask The Expert with Larry Swedroe, January 2008 Issue
• 12/2007 - Ask The Expert with Larry Swedroe, December 2007 Issue

His Books

• The Only Guide to a Winning Investment Strategy You’ll Ever Need
• What Wall Street Doesn’t Want You to Know
• Rational Investing in Irrational Times
• The Successful Investor Today
• The Only Guide to a Winning Bond Strategy You’ll Ever Need
• Wise Investing Made Simple
• The Only Guide to Alternative Investments You’ll Ever Need

Disclaimer

• Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.
• Not all questions will be answered
• By submitting a question, you grant us the right to publish your question.
• The answer is given based on the information provided in your question. Please seek professional assistance for more personalized advice.

If you are interested in having your question answered by Larry, please send me an email via the contact page.