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C.O.S.T.S.

The market was hot again in May. The Dow was up 4.72%, the S&P500 up 5.26% and the Nasdaq up 9%. Government bonds were no slouch either, with long-term treasury bonds up 5.7%. Stocks are rising because investors think the recent government stimulus package and other factors like a falling dollar will help get the economy rolling again, and carry corporate profits along with it. Bond prices were up because investors feel we are going to have deflation and economic weakness, requiring the fed to keep cutting rates, keeping overall interest rates low, and making riskier investments perilous. Confused by the contradiction? Welcome to the world of economics. Sometimes stocks and bonds move for no reason, although reporters, analysts, and economists will always try to tie it to something. Nobody wants to talk about the alternative - that markets sometimes move for no logical reason whatsoever.

We’ve had a remarkable streak of choosing funds for our model portfolios that, soon after our allocating them, were either closed to new investors or were purchased by other fund families and converted to load funds.The main reason funds close or change hands is because they are successful at attracting a lot of investor money. The main reason funds attract a lot of investor money is exceptional performance. Our picks are often victims of their own success.

The latest casualty is the Vanguard High Yield Corporate fund (VWEHX) currently in our Safety, Conservative, and Moderate portfolios. Vanguard decided to close this fund to new investors on Friday June 13th. Apparently they’ve had massive inflows in recent weeks, as the fund is now up 8.42% so far this year and 14% since we added it to the portfolios back in November of 2001. Subscribers that have been around since then will recall that the Vanguard High Yield Corporate was our replacement for our other high yield choice, the Columbia High fund (CMHYX), which converted to load status.

As you are probably aware watching our portfolios, we try to keep trading to a minimum and we especially don’t like it when we have to change a holding on a technicality (versus a re-allocation or a problem with a fund). One thing we can’t do when building our model portfolios is know each subscribers unique financial situation: when they began following a model portfolio, their tax bracket, what their broker charges to trade a fund, etc.

Vanguard says they will reopen the fund when the market cools down for junk bonds. We are not going to change our high yield fund choice again; instead we are going to give investors an alternative fund. We are maintaining our investment, as should existing investors. Our alternative choice is the SSgA High Yield Bond fund [SSHYX]. This fund is available at almost every discount broker for no transaction fee (unlike the Vanguard fund) and the minimum is only $1,000. In fact from now on we are not going to dump funds from out model portfolio just because they close to new investors, we will simply offer alternative choices. We will only dump funds we think should be dumped.

This whole episode raises an important issue about how you should manage your own portfolio given the reality of fund trading costs, fees, and taxes.
Trading and taxation costs are a very real concern when investing, and taking them into account is a very important element to managing a successful portfolio. We wanted to take this opportunity to highlight the expenses to consider when buying and selling funds for your account.

We call these expenses C.O.S.T.S., an acronym for 1) Commissions 2) Other fees 3) Short-term trading fees 4) Taxes 5) Selection

Commissions

When you buy and sell a mutual fund through a broker as many do, there are often commissions on the trades. We are not talking about sales loads (which you should never pay to buy or sell a fund) but the trading commission a broker charges you to buy a fund that is not an “NTF” or no transaction fee fund. This commission can range from $0 way up to over $100. You need to know what your broker charges. While paying $24.95 to put $15,000 into a fund is not deal breaker, paying $75 to invest $5,000 is (in fact it’s 1.5% of your investment). If you broker charges a small fortune to buy certain no load fund and you are not investing enough where the cost is insignificant, you either need to choose another broker or select a different fund that is available for NTF. It is unlikely the “best” choice will outperform the second or third best choice after these fees are taken into consideration. You also need to be aware of commissions on ETFs, which are often hailed as low cost. If you invest $1,000 in an ETF and pay $30 to buy it you just paid 3%, more than the cost of owning even an expensive fund for over a year.

Other Fees

Some funds charge fees beyond the usual operating expenses of the funds. Generally they fall under “small balance fees” for accounts that drop below a certain asset level. The fees can run as high as $24 a year, which is 2.4% of your $1,000 investment – a big enough chunk to spoil your returns. They can also apply to larger account sizes than $1,000. Sometimes brokers charge fees for inactivity or small balances. Be aware of fees beyond the ones you know about (commissions and fund expense ratios) and think about how they could change your outlook on a fund or broker. Even some 401(k)s we’ve come across have additional fees if you buy funds from a certain list but no fees for another list. Read the small print.

Short-term trading fees

Short-term trading fees are extra charges placed on investors who buy a fund and then sell it within a short time frame, usually 1 – 12 months. The fees typically range from .75% - 2% of your investment. There are two places you have to check for short-term trading fees: at the fund and at the broker (if you use one). With funds these fees are called “redemption fees” and will be spelled out in the fund’s prospectus. With brokers, these charges are called short-term trading fees, and are described where the brokers list their fees for fund investing.

Taxes

You could write a book about this complex area (although it would be a very boring book), but the main things you need to watch for are the major difference between how long-term and short-term gains are taxed. Long-term gains are any profits derived from selling an investment you have held for a year or longer. Short-term gains are gains realized from selling something you held for less than a year. The difference mainly comes into play in your regular, taxable account. There has been a gap for a long time in how the two types of gains are taxed, but the recent tax cut takes the long-term capital gains rate down to just 15% for most investors, and leaves the short-term capital gains rate as whatever your income tax rate is, which can still be over 35% federally. If you are even thinking of selling a fund you’ve owned for less than one year at a price higher than you paid for it, don’t do it unless you have a loss to offset the gain. Paying 35% tax on a gain when you could pay 15% by waiting a few months is almost always a bad idea.

Selection

This means trying to select the most tax efficient location for your holdings as well as the act of choosing the best broker.

Assuming you do not have unlimited room in your tax-deferred accounts, you need to be aware of where you place an investment. For example, a fund that pays a high dividend yield from stocks, like a utility fund, but has large losses on the books (such that it won’t pay any capital gains out anytime soon) can be a good choice for a regular account, as dividends are now taxed at very low rates. A fund that invests in Junk bonds or REITs (Real Estate Investment Trusts) is a better choice for a tax deferred account like a 401(k) or IRA as the distributions and dividends are generally taxed as income.

If your broker charges high fees to buy Vanguard funds than consider buying the fund through Vanguard directly for no fee, and if you broker charges no fee for buying say, a T.Rowe Price fund then you may not need to buy that fund directly from T.Rowe Price to keep costs down.

These issues can be more complex but we’ve outlined the big items you want to keep an eye on. We can’t know your exact personal situation; all we can do is chose the best funds and build the best portfolios we know how. It’s hard enough eking out a return in today’s markets - you don’t want to fork what little gains you have over to the government, brokers and fund companies.

If we sell a fund or chose a new one you need to consider these five areas we’ve outlined above when buying and selling funds. What we’re trying to avoid here is you selling a fund that has a 25% gain in 11 months, and possibly incurring a 35% tax hit and a 2% redemption fee. No matter how much we want out of that fund rarely is it not worth waiting 1 more month and reducing your tax bill by half.