Timing of IRA Contributions
asset allocation, market, valuation

With the start of a new calendar year, many investors are considering making 2014 contributions to their individual retirement accounts (IRAs). However, given the recent appreciation of stocks to the perceived point of overvaluation, and poor prospects for bonds in light of an anticipated rise in interest rates, many investors may hesitate to make early contributions. This brings about two questions: What is the historical penalty for such procrastination? What happens if the investor decides to spread the annual contribution over time in the allowable period?

A simplistic answer to the first question is given in an article in The Wall Street Journal:

Contributing $5,500 to an individual retirement account each January, rather than in April of the following year, over 31 years (with an average annual 7% return) could boost the IRA balance by $55,000.

This calculation assumes a constant rate of return on investment in each year, which is unrealistic. In addition, it assumes that the contribution is fixed at a currently allowed maximum amount, even though in recent years the maximum has been revised upwards to approximate inflation (granted, historical maximum contribution was fixed at $2,000 between 1981 and 2001). Also, it does not specify the percentage increase of the terminal balance. Finally, it does not specify the exact nature of the “moderate” portfolio in the IRA.

To provide a more accurate answer to both questions, Alpholio™ conducted a mini study. (Since this post is longer than a usual one, time-pressed or impatient readers may want to skim the charts and navigate right to conclusions at the end of this write-up.)

The Study

To make study results tangible, instead of pure indices, two low-cost, no-transaction-fee investment vehicles with sufficiently long life spans were chosen: the Vanguard 500 Index Fund Investor Shares (VFINX) and Vanguard Total Bond Market Index Fund Investor Shares (VBMFX) mutual funds. The younger of the two, VBMFX, determined the longest feasible study period beginning in January 1987. For both funds, total (i.e. with reinvested distributions) rather than just price returns were used.

Various IRA portfolios, ranging from 100% stocks (all-VFINX), to 60% stocks and 40% bonds (the “standard” portfolio), to 100% bonds (all-VBMFX) were investigated. All portfolios were rebalanced monthly to their nominal asset allocations. Instead of a fixed contribution, a maximum contribution allowed by law in each historical year was assumed. The study did not take into account the higher “catch-up” contributions allowed for older investors, or any withdrawals or mandatory distributions that could trigger taxes or penalties.

The study considered two scenarios. In the lump-sum scenario, the maximum allowable contribution was made in whole at the beginning of a single month ranging from January of the contribution year to the following April (the deadline for making a contribution for the prior calendar year typically falls in mid-April). In the dollar-cost averaging (or “spread”) scenario, the contribution was evenly split and made at the beginning of a number of months starting in January of the contribution year.

The type of scenario determined the terminal year of investment. In the lump-sum scenario, the terminal investment could be made from January 2012 to April 2013 (that is because as of this writing, monthly data through April 2014 are not yet available). To roughly time-align with the lump-sum scenario, the spread investment scenario assumed that the terminal investment would take place in 2012.

For all asset allocations, the penalty was calculated as one minus the ratio of the terminal value of the portfolio with delayed or spread investments to the value of the portfolio when all investments were made as early as possible in January (baseline). For example, if delayed or spread investments resulted in a terminal portfolio value of $93,000 and January lump-sum investments generated $100,000, then the penalty was 1 – 93/100 = 7%.

The Lump-Sum Scenario

As could be expected, due to generally positive returns of stocks and bonds over time, a delayed lump-sum investment carried a penalty. Here is the penalty for a 100% stock and 0% bond (100/0) portfolio:

Lump Sum Penalty for 100 / 0 Portfolio

Generally, the lump-sum penalty had a positive relationship with the investment delay — the longer investor waited, the bigger the shortfall of the terminal value of the portfolio. However, the penalty did not always grow monotonically with the delay, as can be seen by its significant decrease in November and December in the above chart.

This particular case underscores the impact of first years of investing. Here, the almost 22% negative stock market return in October 1987, followed by a negative 8% return in November 1987, caused the penalty to diminish if the investor delayed the contribution toward the end of that year. To further illustrate the importance of early contributions in the IRA life cycle: The $2,000 invested in January 1987 was worth over $27,000, or about 10% of the terminal value portfolio, at the end of 2013.

The trend line in the chart shows that on average a procrastinating investor suffered a penalty of 0.66% of the terminal portfolio value per month of delay, culminating in about 12% of penalty if all investments were made in April of the year following the contribution year.

The more the IRA portfolio tilted towards bonds, the smaller the penalty. Here is a chart for a standard portfolio:

Lump Sum Penalty for 60 / 40 Portfolio

With this asset allocation, the penalty reached just over 10% and accrued at 0.63% per month.

For a 40% stock and 60% bond portfolio, the maximum penalty was just below 10% and grew at an average rate of 0.60% per month:

Lump Sum Penalty for 40 / 60 Portfolio

Finally, for a bond-only portfolio, the penalty peaked at just over 7.5% and increased by 0.52% per month on average:

Lump Sum Penalty for 0 / 100 Portfolio

According to the article:

An analysis of traditional and Roth IRA contributions made by Vanguard Group customers for the 2007 through 2012 tax years showed that, on average, 41% of the dollars contributed to IRAs for any given tax year are invested between January and April of the following year. Half of those dollars are contributed in the first half of April—the final weeks when contributions for the previous year can be made. The study found only 10% of dollars are contributed in January of the corresponding tax year, the earliest month contributions can be made.

This means that the majority of investors pay a significant price for delaying their investments. Granted, many investors may find it hard to come up with a lump sum for the entire contribution each January. Others may want to spread their investment over two or more months to minimize the risk in fluctuating market conditions. Let’s take a look at the effects of the latter scenario next.

The Spread Scenario

For a stock-only portfolio, uniformly dividing the annual contribution carried an average penalty of 0.53% per each additional spread month. When the contribution was dollar-cost averaged over the entire year, the total penalty was just over 5.5%:

Spread Penalty for 100 / 0 Portfolio

For a standard portfolio, the penalty accrued at 0.41% per additional spread month to reach almost 4.5%:

Spread Penalty for 60 / 40 Portfolio

For a more conservative 40% stock and 60% bond portfolio, the penalty increased on average by 0.34% per month and peaked at almost 4%:

Spread Penalty for 40 / 60 Portfolio

Finally, for a bond-only portfolio, the penalty rose by 0.22% per spread month to reach a maximum of just over 2.5%:

Spread Penalty for 0 / 100 Portfolio

The above findings are consistent with those of a Vanguard study on outcomes of lump-sum and dollar-cost averaging of investments. That study used fixed 10-year intervals, sliding by one month in a longer period of 1926 to 2011. It found out that for a standard portfolio, in 67% of cases a lump-sum investment outperformed dollar-cost averaging over the first 12 months of each 10-year interval. The terminal value of the lump-sum portfolio was on average 2.3% higher than that of the dollar-cost averaging portfolio.

Conclusions

Not surprisingly, delaying or spreading IRA contributions within the allowable 16-month window for each contribution year resulted in a penalty of a lower terminal value of the portfolio. The per-month average accrual rate and the magnitude of the penalty depended on asset allocation in the portfolio: The more tilt toward equities, the higher the rate and magnitude. Contributions in early years had a dominant impact on penalty distribution due to compounding of returns.

Clearly, investors pay a substantial price for procrastination in a lump-sum contribution scenario. Therefore, the investment for a given contribution year should generally be made as soon as possible. However, in many cases a full contribution amount may not be available early in the year, the investor may be averse to taking the risk of a lump-sum investment in given market conditions, or may not have a complete view of his/her income and tax situation until later in the contribution time frame. In that case, dollar-cost averaging with smaller sums can help lower the risk of a one-time investment and penalty for a delayed contribution.

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Investors Leave Money on the Table
mutual fund

An article in The Wall Street Journal claims that many investors earn lower returns than their investments do. This is caused by buying and selling mutual fund shares at a wrong time. The author cites an example of the PIMCO Total Return Fund:

In the year ended Sept. 30, its largest share class lost 0.74% — a respectable result, considering that the bond benchmark the fund seeks to beat, the Barclays U.S. Aggregate index, lost 1.89%.

According to people familiar with the fund, its investors incurred an average loss of 1.4% over this period, nearly double the loss of the fund itself. That is because investors bought high and sold low, locking in the fund’s interim losses and missing its later gains.

First, the largest share class of the fund, returning -0.74% in one year to September 30, is institutional (PTTRX). This share class requires a minimum initial investment of $1 million, which is impractical for most individual investors. Therefore, for further analysis this post will use the class A shares (PTTAX) with a minimum initial investment of $1,000.

Second, the problem with this assessment is that it is solely based on the general cash inflows and outflows of the fund, and not the analysis of circumstances of individual investors. This subject was already covered in a previous Alpholio™ post, which found a problem with

…a notion that there exists an “average investor” whose investments into and withdrawals from the fund precisely mimicked the inflows and outflows generated by all of the fund’s investors in both time and relative scale (for one, there is no proof that these same investors who cashed out later reinvested into the fund).

To illustrate that point, let’s analyze a situation of a hypothetical market timing investor who invested into PTTAX on September 28, 2012 (the last trading day of that month) and did not pay the front load of the fund. In May 2013, the investor was observing rising interest rates, which caused the NAV of the fund to fall, and decided to terminate the investment on May 31, 2013, i.e. in the middle of the May/June massive withdrawal period quoted by the article. According to Morningstar’s “growth of $10,000” figures, which assume reinvestment of all fund distributions, the investor realized a return of +0.502% in that period. Had the investor instead retained the investment in the fund until September 30, 2013, the total return would have been -1.128%. This clearly shows why doing an “average investor” return calculation solely based on fund inflows and outflows is misleading.

Furthermore, the above scenario does not take into account what the investor did with the proceeds from the May 31 sale. If the investor kept the proceeds in a money market fund with a typical annual yield of a few basis points, then the return through September 30 would be only slightly higher than the +0.502% calculated above. However, the investor certainly had many other investment possibilities, both in fixed income and in equities.

For example, let’s assume that in the face of rising rates (the duration of PTTAX is approx. five years) the fixed-income investor decided to invest the proceeds in a short-term taxable bond fund, such as the PIMCO Short-Term Fund (PSHAX, class A shares), again without paying a front load. From June 3, 2013 to September 30, 2013, the total return of PSHAX was -0.057%. Therefore, this hypothetical market-timing investor would have realized a total return of (1 + 0.502%) x (1 – 0.057%) – 1 = +0.445%, still better than the -1.128% for PTTAX alone. This again illustrates that estimating fund investors’ returns without taking into account follow-up investments (into which an analyst may not have visibility) is misguided.

In sum, while a buy-and-hold strategy can certainly produce good long-term results for most investors, in a case of prolonged rock-bottom interest rates, some market timing may be warranted.

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Cash Cushion in Equity Funds
mutual fund, valuation

An article in The New York Times describes a recent build-up of cash positions in equity mutual funds:

Many fund managers have quietly been raising their cash positions. In their latest reporting periods, according to Morningstar, the average equity mutual fund held 9.7 percent in cash, up from 8.8 percent in the previous three-month period.

The article discusses the following funds with high cash positions:

Name Ticker % of Cash
Pinnacle Value PVFIX 44
Fairholme Allocation FAAFX 14.8
Tweedy, Browne Global Value TBGVX 17
FirstEagle Overseas SGOVX 23.1

Managers of these funds cite several reasons for keeping substantial cash cushions:

  • Inability to find sufficiently undervalued stocks
  • Paramount need for capital preservation in market downturns
  • Ability to get in on best buying opportunities during market sell-offs
  • Global markets currently being fully valued.

The argument of a full- or over-valuation of stocks backfires when applied to the existing equity holdings of a fund: If at present the manager does not want to use the surplus cash to add to these positions, this implies that they have a limited appreciation potential, are fully valued or even over-valued. With that diminished reward-to-risk ratio, the fund should sell these equity holdings and increase its cash position even further.

The other arguments hinge on an assumption that a major market downturn is imminent and will have a significant magnitude, which justifies a high cash position. This leads to market timing, at which, statistically, most managers fail. Meanwhile, such funds do not realize their full potential in a rising market. Investors end up paying the price both ways.

As Alpholio™ stated in previous posts, the decision about the percentage of cash should really be left to the investor at the portfolio level rather than to a manager of each mutual fund. Otherwise, the investor is forced to constantly monitor cash positions in funds and make offsetting portfolio adjustments to stay on the overall asset allocation track. Alpholio™ helps with that by providing a visibility into the equivalent exchange-traded product (ETP) positions of a fund in between its periodic regulatory filings.

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Put Cash to Use
mutual fund, value investing

An article on Bloomberg describes major market timing efforts by “value” managers who currently cannot find underpriced stocks and therefore have large cash positions in their mutual funds:

Mutual Fund Ticker % of Cash
Weitz Value WVALX 30
Weitz Partners Value WPVLX 30
Yacktman Focused YAFFX 19
Westwood Income Opportunity WHGIX 16
IVA Worldwide Fund IVWCX 28
GoodHaven GOODX 33
Forester Value FVRLX 25
Cook & Bynum COBYX 40

This problem was already addressed in a previous post. While the managers are attempting to generate returns superior to those of their funds’ benchmarks and to reduce fund volatility, they are also distorting asset allocation in their investors’ portfolios. It should be up to an investor to decide what specific percentage of cash he/she wants in the portfolio, and not up to a manager of the equity portion of the portfolio.

So, how to solve this problem to the satisfaction of both parties? The manager should keep only a minimal amount of cash at hand, and temporarily invest the rest of it in an index instrument, such as an exchange-traded fund (ETF), that follows the fund’s benchmark. This way, the fund would be almost fully invested in equities, and there would be not forgone gains if the market kept going up. (The managers’ argument for keeping cash is not that a collapse of the equity market is imminent; it is that no sufficiently deep value stocks are available.)

This proposal certainly sounds like a blasphemy — after all, these managers want to show off their skill in picking individual stocks, instead of becoming “index huggers.” However, it does keep the best interest of investors in mind — to at least keep up with the market. Since most market timing efforts backfire, staying close to fully invested is the only prudent thing to do.

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Battle of the Market Timers
active management

A recent article in The Wall Street Journal explores a hypothetical market-timing performance of various investment newsletters.

To eliminate the effect of individual stock picks, equity positions in each newsletter’s portfolio were virtually substituted with the Vanguard Total Stock Market ETF (ticker VTI) in the the same dollar amount. In periods when the newsletter eliminated equity positions in the portfolio, VTI would be replaced with a typical money market fund. Then the returns and volatility of the virtual portfolio would be compared to those of a fixed portfolio of 100% VTI. Using this methodology, one of the top newsletters would generate almost twice the return with one-third less volatility of VTI in the five-year period through May 2013.

Unfortunately, such market timing does not generate RealAlpha™. The article underscores that

“It also is worth noting that the best-performing timers primarily focus on market trends of several months’ duration or longer, not trying to profit from shorter-term market gyrations.”

As discussed in the FAQ, this is a classic situation where one fixed benchmark, or even a combination of two fixed benchmarks, is not appropriate. In this case, a fixed 100% VTI benchmark is not applicable to prolonged (multiple-month) periods in which the hypothetical portfolio was invested in a money market fund with practically zero volatility.

A benchmark composed of VTI and a reference money market in fixed proportions in the entire evaluation period is better in that it attempts to match the overall risk of the hypothetical portfolio. For example, if over a five-year period the portfolio held VTI roughly two-thirds of the time and a money market one-third of the time, then a composite benchmark with such weights might be used. (Incidentally, this is similar to devising a proper benchmark for target date funds that consist of multiple types of assets, whose weights change over time.) However, this fixed dual-asset benchmark is also imperfect — at any given time, one part of that benchmark is not applicable to what the “binary” portfolio holds.

In the Alpholio™ approach, the benchmark would dynamically adapt to the holdings of the analyzed portfolio in each multiple-month sub-period. This is necessary for a true risk adjustment of the portfolio. Unfortunately, this would also result in little to no credit given for market timing.

Finally, the article only covers a five-year period starting right after the trough of the recent major downturn, i.e. a rebound portion of the market cycle. A longer period encompassing the entire cycle should have been used to assess market timing strategies.

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What’s in Your Wallet? (Part II)
analysis, mutual fund

Building upon the previous post, here are more indications of how some mutual fund managers attempt substantial market timing, of which investors may not be aware.

A recent article from The Wall Street Journal describes several funds with large cash positions. One of these funds, FPA Capital, was a topic of Alpholio™ analysis published in a prior post. According to the article, the fund held 33% in cash at some date from year-end 2012 to March 31, 2013. Indeed, the fund reported 32.9% in cash and equivalents as of the latter date.

An investor could reasonably expect that a fund with the following investment objective and strategy would be almost solely invested in equities rather than cash:

“The Fund’s primary investment objective is long-term growth of capital. Current income is a secondary consideration. FPA Capital Fund seeks to fulfill this objective through investing primarily in small and medium-sized public companies.”

The Alpholio™ analysis clearly demonstrated that at times the fund’s equivalent cash position was as high as 52%, and that such market timing efforts did not result in generation of any meaningful RealAlpha™ in the analysis period. Caveat emptor!

© 2013 Envarix Systems Inc. All Rights Reserved.

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