Investment Vehicles

A few weeks ago, I spoke with an American Express Financial Advisor (AEFA), mainly because we had gone through a series of sea-changes in 2004: the start of residency, moving to Cleveland, the apartment sale and what to do with the proceeds. Having a third-party look at things was a reasonable idea, and we got a name from the “welcome to Cleveland” booklet that CCF gives new residents.

Most of what we heard was good advice: we have to set up trusts to protect our assets from, say, malpractice suits; if we were to buy a house in Cleveland Heights, talk to CCF residency coordinators, as residents are leaving and moving in all the time and we can avoid real estate agents; our financial planning has to be cognizant of the high tax rates we’ll see when Grace becomes an attending and we need to defer income as much as possible to the future, when our incomes (and tax rates) will be lower; my hodge-podge portfolio contains overlaps and omissions and can be done with lower expenses. This was worth the consultation fee: we’re now aware of tax issues we hadn’t considered but will become important in a few years.

Of course, there’s a reason why a website called appears near the top of the Google search for these services. The site was in part driven by AEFAs push of variable annuities and other investment vehicles, for which they presumably get high commissions for selling. The allocation plan that AEFA came up with did indeed contain such a variable annuity, as well as a public unlisted REIT. The rest of it was fairly innocuous, concentrating much more on ETFs (replacing index funds) and CDs. Implementing this portfolio (and moving assets into Amex’s management) would also have cost several thousand dollars annually. We didn’t take up this offer, and our AEFA graciously withdrew it, with some advice on managing everything myself through brokerage accounts and the like. I figure that, even if I charge myself my full consultation fee for a full work week to set up accounts and move assets around (and I certainly have enough time on my hands to print out asset transfer forms and mail them off to Fidelity), I still come out well ahead. And the AEFA management fee is in post-tax dollars, I could probably give myself three weeks to do all this and be within shouting distance of the management fee. And this doesn’t touch on issues of control.

In terms of the various investment vehicles that AEFA proposed, the variable annuity (as explained to me) was to be used as an instrument for locking in capital gains accumulated in, say, the ETFs: annually (once the long-term capital gains rates comes into effect), gains could be swept from the funds into the annuity. The annuity has some sort of insurance provision that protects against capital loses. Payouts from the annuity would presumable start during the low-tax-rate period of our lives. This is neat. However, it’s said that annuities are sold, not bought (i.e., if there were no sales force for this investment, no one would buy it). The 2.2% maintenance fee seems very steep for this insurance (similar capital protect can theoretically through options in a brokerage account), and the tax issues won’t be in effect for at least a few years, during which we have time to do more research and set them up properly ourselves (for example, Vanguard’s low-cost annuities). There is a limited case for them, but we haven’t gotten to that point yet, as we won’t max out our other tax-deferred vehicles on a resident’s salary (reminder: set up Grace’s 403(b) soon).

The AEFA also suggested buying into Inland Western REIT, which is focused on shopping centers west of the Mississippi. This is a public unlisted REIT, which, again, may be a vehicle that sold, not bought. Funds would have been locked in for at least four years with something like a 6 – 7% return. Given what I’ve read about these, it’s unclear how the fees would have been extracted. Also, one may be concerned about a potential real estate bubble in the US, which would be particularly bad for these REITs. On the other hand, REIT index funds tend to have a fairly low beta (around 0.3 or 0.4), which is good from a diversification standpoint (though there’s an academic study that notes that REIT betas are assymmetric between up and down markets). It’s something to consider, but probably in the form of a REIT index fund or ETF.

Most of the investments the AEFA recommended were in terms of ETFs. This is fine advice: ETFs tend to have lower maintenance costs than equivalent index funds and are more tax efficient (as redemptions by other people don’t cause capital gains distributions as in the case of mutual funds). The idea would be to replace my index funds with ETFs, and I’ve started moving in that direction. The main disadvantage of ETFs vis-a-vis index fund is that there will be brokerage commissions when you buy and sell them. This makes ETFs very inefficient as a savings vehicle: all mutual fund companies offer a service that takes a few hundred dollars out of your savings account monthly to put into a fund — investment then happens without positive action from the investor (commitment savings). Mutual funds don’t charge for this (they make money on standard maintenance), so it’s essentially free. But if you do the same thing with an ETF, even with a discount brokerage charging $10-$20 per trade, you’re basically creating a very steep front-loaded for your fund of 5-10%. ETF purchases for long-term savings should then be done in large batches, so as to make the broker commissions negligible. As we won’t have excess income to investment for the next few years, we can probably do without mutual funds for the time being.

One question, though, is what to do with my actively managed emerging markets fund? The alternative would be an ETF based on the MSCI EMI. Philosophically, is active funds management superior for emerging markets? Or, phrased differently, are emerging markets sufficiently efficient to be captured by the index? Note that the difference in maintenance fees between the actively managed fund and the ETF is about a hundred basis points. Actually, it looks like the ETF beats out the managed fund over a two-year period. This chart doesn’t go back to the various emerging markets crises of the late 1990s, though.

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