Dion Money Management Blog   Money Management for Retirees and Their Families

Energy prices resumed their role as the driving force behind the stock market yesterday, and the major market gauges finished mixed as oil surged on hurricane fears. The Dow Jones Industrial Average added 27 points, or 0.2 percent, to close at 11,413. Large-cap financials and energy companies provided a boost to the index of 30 blue-chips; Citigroup and JPMorganChase each gained 1.3 percent, while shares of ExxonMobil rose 1.6 percent. The broader market gauges were mixed. The S&P 500 gained 5 points, or 0.4 percent, to 1,272, while the Nasdaq Composite Index slipped 4 points, or 0.2 percent, to close at 2,362. A 6.6 percent decline in chipmaker Marvell Technologies Group dragged on the tech-heavy Nasdaq, and the benchmark for the semiconductor industry, the Philadelphia Semiconductor Index, was off 1 percent.

Financial shares made gains yesterday, despite a new report from the Federal Deposit Insurance Corporation—the entity that insures U.S. bank deposits up to $100,000—that revealed a spike in the number of institutions on its troubled banks list. According to the FDIC, there were 117 banks on the list at the end of the second quarter, a 30 percent increase since the end of March. More troubling for investors, however, is the amount of assets represented by the expanded list: nearly $80 billion, as opposed to just $26 billion at the end of the first quarter. Some market observers see a silver lining in the FDIC’s new data: The failure of weaker banks could provide an opportunity for larger, better-capitalized institutions to grow their markets.

The Federal Reserve yesterday released the minutes of its last interest rate-setting meeting on August 5. According to the minutes, most members of the Fed’s policy making body, the Federal Open Market Committee, see both the rate of inflation and economic growth slowing in the second half of the year. The minutes also revealed that the FOMC members are in general agreement about the direction of monetary policy—the next move will almost certainly be an interest rate increase—but they will let economic conditions dictate the timing of any rate hike. FOMC left the key federal funds rate unchanged at 2.0 percent at its last meeting.

Another piece of the gloomy housing picture fell into place earlier this week. According to the Case-Shiller home price index, the measure most economists believe provides the best picture of the overall residential real estate market, housing prices fell nearly 16 percent over the past year in the 20 largest U.S. cities, although 9 metropolitan regions reported price increases. In a separate report, the Commerce Department said that sales of single-family homes grew by 2.4 percent in July, although the median price of a home fell 6.3 percent on a year-over-year basis. The increase in seasonally-adjusted sales of single-family homes combined with the falling median price is an indication that banks are resorting to foreclosure sales to clear their inventory of non-performing properties.

The price of oil rebounded in trading on the New York Mercantile Exchange as futures traders eyed Hurricane Gustav, which gained strength yesterday as it passed over western Haiti. The benchmark grade of light, sweet crude settled at $116.27 a barrel, a gain of 1 percent. The contract for September delivery of natural gas spiked 5.8 percent. Meteorologists have placed Gustav on a track to enter the Gulf of Mexico Sunday; if the storm continues to gain strength, it could force oil and natural gas platforms to shut down for several days.

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While it’s never pleasant to contemplate the annual scramble at tax time, there are some important steps mutual fund investors can take to minimize their tax profiles. Tax time presents special challenges for investors in actively-managed mutual funds that throw off hefty dividends and capital gains several times a year. Even if taxes are the “dues” we pay for membership in society, that doesn’t mean you should be paying more than you owe. Yet many mutual fund investors do just that every year, either because they don’t know their rights under the tax code, they keep faulty records, or both. Below, we review some of the biggest pitfalls for mutual fund investors and how to avoid them.

Double-Paying on Dividends

Capital gains taxes are assessed on the difference between the amount you paid—sometimes called your “cost basis” or just “basis”—for an investment and the amount you received when you sell it. If you made money on your purchase, then you have a capital gain and will owe taxes. (If you lost money on your investment, you have a capital loss, discussed below.)

Keeping the basic principle above in mind, it’s easy to see how you might overpay capital gains taxes if you have been routinely reinvesting your dividends over the years. This is why so many investors in mutual funds with automatic dividend reinvestment programs wind up giving Uncle Sam twice his cut when they pay capital gains taxes on that investment.

Consider the following example: Let’s say you invested $4,000 in a fund a few years ago and received $800 in dividends during the period you held it. Your basis in the fund is $4,800—not $4,000. Why? Because you paid taxes on the dividend payments when they were made, even though they went directly back into new shares of the fund instead of your bank account. If you report your initial investment as $4,000 instead of $4,800, then you will wind up overstating your capital gain or understating your capital loss. In either event, you’ll wind up paying taxes you don’t owe.

Forgetting to Apply Capital Losses to Ordinary Income

When you sell an investment that has lost money, you are entitled to book a capital loss. And while it’s never pleasant taking a loss on a poorly-performing mutual fund, those capital losses can come in extremely handy during tax time. Most investors know that they can apply an unlimited amount of capital losses to offset any capital gains they took during the year. In addition, up to $3,000 of those capital losses can be used to reduce ordinary taxable income. For taxpayers in high tax brackets—and particularly for those subject to the alternative minimum tax—that $3,000 can make a big difference.

Running Afoul of the Wash Sale Rule—And How ETFs Can Help

Savvy investors know that “harvesting losses” at the end of the year is a good tax strategy, but many investors are often surprised to discover—occasionally during an audit—that the IRS has a rule designed to prevent investors from manufacturing artificial capital losses solely for the purpose of reducing capital gains. It’s called the “wash-sale” rule.

Imagine that you hold a fund that has lost some ground during the year, but you expect it to go back up. As you look over your brokerage account statement, you decide that you could really use some capital losses to offset the gains you’ve made recently, but you hate to part with your losing fund just because it’s had a bad quarter. Could you sell the fund, book the loss, and then buy it back again?

According to the IRS, you cannot sell a security for the purposes of booking a capital loss and then immediately repurchase the same—or a substantially similar—security within 30 days. If you do, the IRS will deem the sale to be a “wash” and will disallow the capital loss.

Under the current tax code, however, replacing an actively-traded mutual fund with a similar ETF does not violate the wash-sale rule. So, for instance, if you sold Fidelity Select Medical Devices (FSMEX) at a loss, you could maintain the same kind of sector exposure by replacing it with the iShares Dow Jones U.S. Medical Devices Index Fund (IHI). While the two funds don’t overlap precisely, they are similar enough to keep your portfolio balanced while you wait out the 30-day wash-sale period.

Start Thinking About Tax Time Now

Although there are still a few more days to go before summer draws to a close, it’s not too early to start thinking about end-of-the-year tax planning. Many investors put off year-end tax planning until it’s too late to make the smart moves that can meaningfully reduce their tax bills. As always, if you have significant assets in your taxable brokerage account—more than $200,000—consult with a CPA or financial planner sooner rather than later. By one estimate, investors with large taxable accounts can lose up to 40 percent of their total returns to Uncle Sam due to poor tax planning.

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Stocks slumped for the second straight day on Tuesday as investors digested the latest data on inflation and oil rebounded off a three-month low. The Dow Jones Industrial Average fell 131 points, or 1.1 percent, to 11,349. Financials once again led the blue-chip index lower. American International Group lost 5.9 percent in the wake of an analyst report that suggested the insurance giant’s top management may not fully understand the extent of the company’s vulnerability in the current tight credit environment. The S&P 500 declined 12 points, or 0.9 percent, to 1,267, and the technology-focused Nasdaq Composite Index slipped 33 points, or 1.4 percent, to close out the session at 2,384.

According to the Labor Department, wholesale inflation increased 1.2 percent in July and is currently running at an annual rate of 9.8 percent. The core PPI, which strips out food and energy costs, grew by 0.7 percent. The Labor Department’s report also revealed that the cost of “crude goods,” the raw materials producers use to manufacture their products, jumped 4.2 percent, a sign that further increases in the PPI could be in store.

Along with the consumer price index, the Labor Department’s gauge of consumer prices, the latest PPI data paints a picture of soaring inflation and sluggish economic growth—the main ingredients of “stagflation.” Ebbing energy prices, however, may provide some relief to consumers in the third quarter, and analysts who follow the Federal Reserve closely believe the central bank is still on track to leave interest rates unchanged at its next scheduled meeting on September 16. The consensus is that the Fed would need to see a sharp increase in wages before bringing the federal funds rate back up from its current level of 2.0 percent.

Most energy analysts credited a weaker dollar—it slipped against a basket of foreign currencies yesterday—with oil’s rebound. The front-month contract had declined to just under $113 a barrel on Monday, and oil’s month-long slide has sparked a mini-rally in the stock market. The Energy Information Administration reports today, however, that domestic stockpiles of crude jumped to 9.4 million barrels last week, a sign that demand for petroleum-based products continues to ebb. Analysts had been expecting a build of just 1.7 million barrels. Oil traded lower on the news.

Kenneth Rogoff, the former chief economist for the International Monetary Fund, made waves yesterday when he told Reuters that a large U.S. bank will likely fail in the coming months, and investor concern over the state of the financial system has been driving most of the big market moves in recent weeks. Shares of Lehman Brothers, the fourth-largest Wall Street firm, won’t announce its third-quarter earnings in mid-September, but investors are already preparing for another dismal profit report. Since last Friday, shares of Lehman have plunged 17 percent, and some prominent analysts are speculating that the firm will need to raise more capital in order to stay afloat.

On the earnings front, Hewlett-Packard, the world’s largest manufacturer of personal computers, reported better-than-expected second-quarter results. It looks like consumers in Asia were behind H-P’s stellar quarter. The company reported that sales of laptops were up 26 percent on a year-over-year basis, while growth in sales of desktop machines grew by just 6 percent. H-P noted, however, that business customers—a key segment for most of the tech sector—are delaying their purchases of new equipment but are spending more heavily on tech services to keep their existing machines running.

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Whether you call it “green,” “greentech,” or “cleantech,” analysts and investors alike believe that environmentally-friendly funds could be the next big thing. While mutual fund and exchange-traded fund managers have been marketing green investment vehicles for years, serious investors up until fairly recently tended to view such funds as niche or even novelty products that didn’t merit a prominent place in a well-diversified portfolio. That appears to be changing.

With the price of oil hovering around the $115 per barrel mark and evidence of the human causes of global warming mounting, the number of green investment vehicles has grown—as has the amount of money investors have committed to them. According to the Social Investment Forum, an industry research group, the number of socially and environmentally screened funds rose from 201 in 2005 to 260 in 2007. During that same period, total assets in these funds increased from $179 billion to nearly $202 billion.

Clearly, green investing is big business, but what does it really mean to invest green? And more importantly, is green investing just a salve for guilty consciences, or does it actually pay off for investors to park their money in green funds?

Green investing is a subcategory of socially responsible investing, a practice that came of age during the 1980s when individual and institutional investors began to divest their portfolios of companies that did business in South Africa, in a protest against that country’s apartheid regime. By 2007, socially responsible investments accounted for $2.71 trillion—nearly 11 percent—of total assets under management in the U.S. To put that number in a bit of perspective, that’s about 4.5 times bigger than the entire U.S. market for exchange-traded funds.

When picking a green investment for your portfolio, what should you look for? Green investors tend to use one of two approaches when selecting a green fund. “Deep green” investors worried about the sustainability of our fossil fuel-based energy infrastructure are partial to alternative energy funds, such as the PowerShares WilderHill Clean Energy Portfolio (PBW). This fund seeks to deliver the performance of the WilderHill Clean Energy Index, a list of 40 or so clean energy companies developed by Dr. Robert Wilder in the 1990s. Since we first profiled this fund in the June 2007 issue of the ETF Report, assets under management in PBW have grown by nearly 50 percent. The performance of this fund, however, has been less spectacular; it’s currently trading at about the same level it was last summer.

The performance of the PowerShares WilderHill Clean Energy fund illustrates some of the problems with “deep green” investing. First, these funds tend to mirror the energy markets. Wind and solar power installations—the heart of the alternative energy sector—require significant up-front investment, and power generators have historically been hesitant to make a commitment when cheaper alternatives, such as coal and natural gas, are readily available. The bottom line is that when the market for fossil fuels is low, alternative energy funds are less attractive.

To overcome the problem of high start-up costs, the federal government, along with many states, provides tax rebates and other incentives for individuals and businesses that want to make the switch to wind or solar. Like any other industry that is heavily dependent on government subsidies, the alternative energy sector’s fortunes rise and fall with the political tides. Right now, for instance, a bill that would extend vital tax credits for alternative energy producers is stuck in the Senate after passing the House earlier this year.

In contrast to the “deep green” approach, “light green” investors take a more pragmatic view of the marketplace. The goal of the light green investor is to reward companies for instituting eco-friendly practices and reducing environmental liabilities—even though those companies may themselves be polluters.

Light Green Advisors, a Seattle-based asset management firm, has made light green investing the centerpiece of their business. Together with ETF sponsor Claymore, Light Green Advisors created the EcoIndex, which analyzes the companies in the S&P 500 (excluding tobacco firms) using environmental criteria and then picks the “greenest” companies from each industry segment. According to Light Green Advisors, the EcoIndex was “the first environmental-performance-based ‘best in class’ environmental leadership index in the United States.”

Unfortunately, Claymore abandoned the ETF it had created around the EcoIndex in February, due to light trading volume and competition from other funds. But light green investors can still use the “best in class” approach to green investing by seeking out funds that invest heavily in companies that have implemented eco-friendly policies.

To many investors, “light green” may not be green enough. Before it folded, the Claymore light green ETF’s top holding was ExxonMobil, the world’s largest oil company. The University of Massachusetts’ Political Economy Research Institute ranked the world’s most profitable public oil company sixth on its “Toxic 100” list of the largest air polluters in the U.S. Although it is certainly possible to make money while doing good with green investing, it’s important to conduct your own research to make sure the product you choose is a good fit with your green investing goals.

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Another round of write-downs from financial sector heavyweights such as Citigroup and Swiss banking giant UBS left investors cold on Tuesday, despite the ongoing decline in oil that has been generally bullish for equities. The Dow Jones Industrial Average lost 140 points, or 1.2 percent, to close at 11,642. JPMorgan Chase, which said it would take an unexpectedly large $1.5 billion loss on its portfolio of mortgage-backed securities, led the blue chips lower with a 9.5 percent decline in its share price. The broader market indexes also lost ground. The S&P 500 slid 16 points, or 1.2 percent, to 1,290, and the Nasdaq Composite Index retreated 9 points, or 0.4 percent, to close out the session at 2,431.

Oil continued to head lower yesterday, although the prospect of easing energy prices and more cash in consumers’ pockets wasn’t enough to overcome the bad news emanating from the financial sector. The front month contract declined $1.44 to settle at $113.01 in trading on the New York Mercantile Exchange. Since hitting an all-time record high over $147 a barrel early last month, oil has declined more than 23 percent, and some energy market analysts are speculating that the price could fall to $100 a barrel by Labor Day.

While the summer sell-off is a welcome reprieve for consumers and has been generally bullish for stocks, the long-term supply and demand picture suggests it’s a temporary development rather than the beginning of a new secular trend. Thus far, the markets have largely shrugged off Russia’s invasion of the tiny Caucasus nation of Georgia, a key transit point between Caspian Sea oilfields and markets in Europe. Although BP, which operates one of the pipelines running through southern Georgia, has shut down the conduit as a precaution, there are no reports of damage. Russian president Dmitry Medvedev announced yesterday that he had ordered an end to military operations there.

While financial firms continue to struggle, U.S. exporters had a banner month in June. The Commerce Department said that the nation’s trade deficit shrank unexpectedly by 4.1 percent, to $56.8 billion as shipments abroad hit an all-time high. The relatively weak dollar has been fueling foreign demand for U.S.-made products. At home, however, the picture turns a bit gloomier. Retail sales decreased by 0.1 percent in July, although economists attributed most of that decline to the soft market for automobiles and parts. Excluding the automotive sector, retail activity increased by 0.4 percent, in line with analysts’ forecasts.

Biotechnology giant Genentech today rejected a $43.7 billion bid from Swiss pharmaceutical company Roche but said it would consider other offers. Roche already owns a majority stake in Genentech and was looking to lock up the remaining 44 percent as competition among big pharmaceutical firms for the next blockbuster drug heats up. Drugmakers like Roche, Pfizer and Merck have been on something of a shopping spree in the small- and mid-cap biotech space over the past decade or so, acquiring companies with promising products in development instead of developing their own drugs in house. Having turned Roche away—at least for now—Genentech becomes the first large-cap biotech company in many years to be “in play,” and some analysts believe a wave of consolidations could soon sweep the sector.

Second-quarter earnings have been coming in better than expected, despite the fact that the financial sector is continuing to struggle with mortgage-backed bond-related writedowns and tight credit conditions. Excluding financials, earnings for the S&P 500 are up about 11 percent over last year, with tech companies and telecoms leading the way. The Federal Reserve’s preferred inflation gauge, the core index of the personal consumption expenditures, remained in line with recent readings—it was up 2.3 percent for the year ending in June. While that figure is slightly above the Fed’s target range of 1 to 2 percent annual growth, it was mild enough to allow the central bank to hold the key federal funds rate at 2.0 percent at its last meeting.

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There’s an investment rule of thumb that says “don’t buy anything you don’t understand.” As investors, we all understand the relatively straightforward concept of stock ownership. In exchange for our cash, we receive an ownership interest in a going business. As owners, of course, we’re entitled to share in the success—and occasionally failure—of that business. (How we share in that success can vary, of course. Some companies distribute profits to their shareholders via regular dividend payments, while other companies reward investors with extensive share buyback programs or even stock splits.) While knowing what you’re buying is obviously important, many do-it-yourselfers may shy away from other types of investments—particularly bonds—because they don’t fully understand them.

In theory, bonds couldn’t be much simpler. They are IOUs—typically from large corporations or governments—to investors. When you buy an individual bond—for example a $10,000 corporate bond that pays 6% annual interest (sometimes called the “coupon rate”) that matures, i.e. will be repaid, in 10 years—and hold it to maturity, you will receive annual interest payments of $600 (typically distributed semi-annually), plus your original $10,000 when the 10 years is up.

In practice, however, bonds can present a host of challenges for the do-it-yourself investor. First of all, buying individual bonds can be expensive, as the example above illustrates, and it can be risky, because of the high cost of diversification using individual bond issues. Moreover, with very few exceptions, bonds are not listed on exchanges. To buy and sell bonds, then, you must get quotes and execute orders through a brokerage.

The proliferation of bond mutual funds and exchange traded funds has removed many of the obstacles to bond investing for do-it-yourselfers. The price of admission for bond ETFs, for instance, can be as little as the cost of a single share, and most actively managed bond mutual funds have similarly low minimum initial investments. Along with a lower price of admission, bond funds also provide much greater diversity than most individual investors could achieve on their own. A bond fund or ETF typically holds hundreds of different bonds with different maturities and thus provides greater protection against non-payment of interest and outright default—two of the biggest risks bond investors face.

In addition to the advantage of diversity, bond mutual funds and ETFs also have greater liquidity than individual bonds. In other words, redeeming shares in a frequently traded bond fund is typically much easier than selling an individual bond. And investors who aren’t looking for income benefit from bond funds because dividends are reinvested automatically. For do-it-yourselfers, the biggest advantage of owning an actively-managed bond fund may be the portfolio manager, who handles all the details, including analyzing credit ratings to determining which bonds to buy and sell.

Indeed, the “details” involved in trading bonds successfully can be mind-boggling. Most investors do not hold bonds to maturity but rather trade them on the secondary market. To do this successfully requires an understanding of the factors that affect a bond’s yield, which is best understood as the fixed annual interest rate (the 6% from our corporate bond example above) divided by the ever-changing current market price of the bond.

Many investors know that bond prices have an inverse relationship to interest rates, but perhaps not every investor knows that bond prices also have a similar inverse relationship to inflation. Another important factor affecting bond prices is the issuer’s credit rating. The recent spate of credit ratings downgrades—particularly of financial sector firms struggling with the subprime mortgage meltdown and tight credit markets—is a reminder that even seemingly rock-solid bond issuers can present serious and sometimes unexpected risks to investors. A bond’s price thus reflects the prevailing interest rate, the rate of inflation, and the bond issuer’s current credit rating at any given moment. Depending on these factors, the bond may be trading at a discount or a premium to its face value.

While credit ratings are obviously key to pricing a bond, the most important determinant of a bond’s risk is known as duration. Think of duration as the number of years required to recover the true cost of a bond, taking into account the present value of all coupon and principal payments to be received in the future. As a general rule, the longer the duration, the riskier the bond. Why? A long duration makes a bond more vulnerable to inflation or higher interest rates, both of which cause bond prices to decline.

Although the Federal Reserve recently left interest rates untouched at their current level of 2.0 percent, many Fed watchers believe the central bank could begin raising rates within the next several quarters to combat rising inflation. In a potentially rising interest rate environment, investors can mitigate risk by investing in bond funds with average maturities in the 1 to 5 year range. Investors seeking moderate growth should increase exposure to high-yield and short-term bond funds and decrease exposure to longer duration issues. High-yield funds offer high income through investment in lower-rated, lower-quality corporate bonds. Companies that issue high-yield bonds have to offer investors attractive returns in exchange for the attendant higher risk.

For more conservative, risk-averse investors, investment-grade bond funds with shorter average duration are a good choice. In addition, shorter-term high-yield bond funds may help to reduce the level of inflation risk in one’s portfolio. It is important to choose a bond fund whose yield has the potential to exceed the inflation rate.

Investing successfully with bonds often means taking into account a host of factors—including interest rates, credit quality and duration—and choosing the fund or ETF best suited to your particular circumstances is far from a “no-brainer.” But that doesn’t mean you should avoid bonds. As with stock market investing, remaining diversified is crucial, but bond investors must also be able to respond to changes in the interest-rate environment quickly.

If you have questions about investing with bonds, call us at (877) 432-7447, Ext 191. Based on your investment goals, we can help you decide what types of bond funds and ETFs are be appropriate for you today and, more important, what percentage of your overall portfolio should be exposed to bonds.

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