Directly-owned real estate is a popular alternative investment.  While there is no right answer for every situation and different people will weigh the factors differently, here are some items to keep in mind (in no particular order):

• People like real estate emotionally. The fact that it is tangible and substantive, gives them comfort.  The danger is, however, that these emotions will get in the way of an objective decision.

• Behavioral finance research has demonstrated that people tend to overweight recent data. Long-term returns on real estate (longer than the past few decades) have been just above inflation (0.4% above inflation according to one study), though this ignores income or expenses of the real estate.  Income-producing investments can have very high returns (similar to stocks) if unleveraged (no debt) and potentially even higher if levered (debt financed), but flipping is probably not a successful long-term strategy.

• Real estate is a good inflation hedge particularly when financed with a long-term, fixed-rate mortgage. Thus it can be a risk-reducing part of a prudent financial plan, though it is difficult to get proper diversification due to limited personal resources except for the very wealthy.  Also, people typically don’t diversify because of comfort with “known” types of real estate and the local area (e.g. they tend to buy single-family residential rentals in their area rather than warehouses in another part of the country).

• High leverage (debt) frequently used exacerbates cash flow issues if properties are vacant temporarily. (This is ameliorated of course by not using leverage.)

• There are some tax advantages to real estate as an investment.

• It can be more work than people realize, and they rarely factor the value of their time into their basis when computing their returns. It is also generally illiquid, and transaction costs are generally high.  Because of these factors, publicly traded REITs may be a more appropriate alternative.

• It is a relatively inefficient market (i.e. mispricing can happen and can be large); so there is opportunity to outperform based on skill. Even assuming skill exists however, it is difficult to have the requisite number of transactions for it to evidence itself.  See the detailed explanation of this below.

• The riskiness of real estate is frequently not recognized due to artificial smoothing of prices reducing the standard deviation of the data as mentioned below.

I would like to dilate further on the last two points because they are important in areas other than real estate as well.

It is not enough to have skill; there must be adequate opportunities to evidence that skill.  This is one of the primary problems with attempting market timing with traditional investments – even assuming some people have skill, they don’t get to exercise it often enough.  To illustrate, suppose I have a coin that has a 60% chance of coming up heads and a 40% chance of coming up tails.  Would you bet $1,000,000 on one coin flip that it would be heads?

If the flip comes up tails you pay $1,000,000 and if it comes up heads you get $1,000,000.  The expected return is $1,000,000 x 0.6 – $1,000,000 x 0.4 = $200,000.  Few people would be willing to make that wager, even though on average you would win $200,000.  However, you would almost certainly be willing to bet $1 on that coin flip and do so 1,000,000 times, even though the expected return is the same.  The difference is the outcome becomes practically guaranteed because of the volume of wagers.  You will almost certainly have a profit of close to $200,000 at the end (99% of the time you would be between $197,476 and $202,524).  In real estate, even presupposing superior skill, many transactions are necessary to eliminate bad luck and evidence that skill with high certainty.

Real estate may look less volatile than it actually is for two reasons:  First, properties don’t trade every day, so prices between trades are estimated.  These estimates tend to be based on the last transaction and/or the last estimate, which tends to smooth the volatility (hedge funds with illiquid holdings have this same artificial reduction of volatility).  Second, when prices “decline,” many people exhibit typical loss aversion, and pull the property from the market until it recovers rather than selling.  Thus, while the true price is a loss, volumes simply slow dramatically rather than showing up as a loss in the data.

On a related note, we occasionally have people ask about purchasing real estate in their IRAs (individual properties, not REITs).  We wouldn’t recommend buying real estate in an IRA for the following reasons:

• The fact that someone is using an IRA for the investment generally would indicate they don’t have the financial resources to buy it without using retirement funds. Since frequently the vast majority of an individual’s non-retirement assets are tied up in their primary residence (i.e. real estate), investing retirement funds in a similar asset in most cases would mean they are very undiversified (and possibly leveraged).

• Individually owned real estate (the buildings, not the land) can be depreciated for current tax savings and capital gains (above depreciation recapture) get a special (low) tax rate. Neither of these benefits are available within an IRA.

• Investors should avoid using leverage on IRA investments because it creates UBTI (Unrelated Business Taxable Income) which is taxed at trust (i.e. high) rates in the IRA. Further, this taxed income does not create any basis in the IRA and thus will be taxed a second time when it is distributed from the IRA to the owner.  This is very unfavorable.

• Investors cannot use any “sweat equity.” Doing work on the property is an IRA contribution and prohibited since IRA contributions may only be made in cash.

• Using the property personally constitutes an IRA distribution and is taxable.

• Enough liquidity must be maintained within the IRA for unexpected expenses. Because the investor needs to avoid debt and thus UBTI and because they can’t just arbitrarily contribute extra funds to an IRA when needed, an adequate cushion of liquidity must be maintained.

• A similar need for liquidity exists in retirement when RMDs (Required Minimum Distributions) must be taken. There must be enough cash or other investments to make the distribution, or the taxpayer has to distribute a portion of the property.  For example, suppose a house is worth $548,000 and the taxpayer turns 70 ½.  There is a 3.65% RMD so $20,000 of the house is distributed from the IRA and put into different (individual) ownership.  Every cash flow is now split 96.35% and 3.65% between the two entities.  Needless to say, this creates a great deal of complexity.

• Related to the previous point, since RMDs are based on the value of the IRA, each year a qualified appraisal will have to be done each year to determine the current value.

For most people Real Estate Investment Trusts (REITs) would be a better investment option.  Here I am discussing equity REITs as opposed to mortgage REITS or hybrid REITs:

• REITs invest in a variety of commercial real estate ventures and the correlation between commercial real estate and residential property (which many investors already are overexposed to through their residence) is trivial.

• REITs are most highly correlated with small value stocks and also somewhat correlated with high yield bonds.

• The tax-efficient REIT structure is now available in enough other countries for international REIT funds to exist.

• In theory, REITs should serve as a reasonable inflation hedge as they own real property and the duration of the tenant’s leases should be shorter than the duration of the mortgages giving them the ability to raise rents faster than financing costs increase.

REITs are among the most popular alternative investments but they are actually not strong alternative candidates.  Nonetheless, given their widely accepted position and the ability to invest in international REITs (which should give a great deal of diversification) they may have a place in portfolios.

There are three types of investments in commodities, investing in the physical commodity itself, investing in a derivative instrument, and investing in natural resources stocks.  First, we have the physical asset:

• The expected return on the physical asset is roughly inflation, but the historical return on the spot price is actually slightly less than inflation because technological improvements in growing, processing, refining, extracting, etc. have trumped increased scarcity and increased demand over time.

• With the exception of precious metals, it is extremely difficult and/or costly, if not impossible to hold the actual commodity.

• The volatility is extremely high.

• They aren’t a particularly good inflation hedge.

Most investors do not invest directly however, but rather invest in a commodities futures fund:

• Investing in derivatives is a zero sum game.  For every winner there must be a loser, and it is irrational to expect to be on the winning side more often than not.  On average, the return to all investors will be the return on the collateral (typically Treasury bills).

• The historical out-performance of commodities futures is due to the short history of the relevant indexes, the fortuitous extreme over-weighting of energy in those indexes, and a supply/demand imbalance that caused normal backwardation of the contracts.  Currently contango is the norm, turning what has been a historical tailwind for long investors into a current headwind.  (I apologize for the technical terminology, but in the interest of brevity the explanation of normal backwardation and contango is outside the scope of this paper.)

• The volatility is about a third higher than the volatility of stocks.

Occasionally investors buy stock in natural resources companies as a proxy for the commodities themselves, but they are a very imperfect proxy because:

• Wise managers of such a company should attempt to reduce their exposure to the commodity with hedging contracts.  They seek to profit from skill in their business rather than the vagaries of current market prices.

• Business issues and factors can account for a great deal of their performance (competition, prices of things they need such as supplies and personnel, etc.).

We do not invest in commodities because while it is not “wrong” (particularly in the extremely small doses that are generally used) it is unlikely to be helpful.

While gold is a type of commodity it is popular enough to merit its own details:

• While today’s prices have risen considerably from the recent prices, gold hit $850 per ounce in 1980.  If you had purchased gold as an investment at that time, your average annual return since then would have been about 1.23% (source data here).  Inflation over that period has been 3.14% (source data here). So an investor would have experienced (so far) 36 years of negative real return.  Due to volatility, picking different time periods can give wildly different figures.

• Today, if you are concerned about inflation risk, investing in TIPS (Treasury Inflation-Protected Securities) is a much better option.  TIPS are government bonds that pay returns plus inflation.  Generally (though not as I write this), the yield on 10-year TIPS is between one and three percent plus whatever inflation occurs.

• In times of financial crisis, gold is less correlated to the market, but so are short-term treasuries.  During the 2007-2009 financial crisis, gold was essentially uncorrelated with the stock market, but so were investment-grade bonds, and short term treasuries were negatively correlated, which is actually better.

• Some believe in gold investments as a hedge against some sort of Armageddon scenario.  If we have a worst case scenario with no functioning economy, gold will probably be relatively useless as it has little utilitarian value.  In other words, if you can’t eat it, wear it, or live in it, why would anyone want it?  The best investment for that situation is probably ammunition.

• If we don’t have a financial meltdown, the best gold investment is probably jewelry for someone special in your life.  This will probably have a higher rate of return (albeit not a financial one) than buying bullion.

• Finally, some tax trivia.  Most folks don’t realize that gold is considered a collectible by the IRS and thus has a maximum tax rate of 28% rather than the capital gains rate of 15% most people would pay – and this is true of investments in ETFs that hold the physical bullion as well.

We do not use gold in portfolios as the low expected return is more detrimental than the diversification potential is helpful.

In my last post I discussed the primary asset classes (stocks and bonds) and their various subdivisions.  In this post I will give an overview of some “alternative” investments.  First we should define what an alternative investment actually is.  There isn’t a precise definition, but broadly speaking it is an investment that is not one of the ones mentioned above (stocks and bonds).  As noted previously, common stocks can be large-cap, mid-cap, small-cap, or micro-cap; growth or value or blend; domestic or international; and represent companies located in developed countries or emerging markets; nonetheless those would all generally be considered traditional investments.  Similarly, investment grade bonds can be short term or long term; inflation adjusted or not; callable, putable, or neither; and taxable or non-taxable (i.e. municipals or “munis”) with none of those categories considered “alternative.”

A number of alternative investments are illiquid and don’t trade regularly so the prices are merely estimates.  This leads to two statistical artifacts of note.  First, the standard deviation (volatility) appears lower than it really is, and second, the correlation with other investments (generally the correlation being reported is with stocks) appears lower than it really is.  The investments that are prone to having this issue (and having salespeople present what is in fact bad data as a purported advantage to the investment) include many types of hedge funds, non-traded REITs, timber investments, and directly owned real estate.

Another difference between traditional investments in stocks or bonds and alternative investments is the source of returns.  Companies sell products or services and most of the time make a profit which investors then receive as a dividend, interest, or growth (in the case of government bonds, taxes pay the interest).  Many alternative investments don’t have that tailwind, but rather depend on three things.  First, that some investments are mispriced by enough to yield risk-adjusted excess returns even after transaction costs, search costs (the cost of finding the mispricing), overhead, etc.  Second, that the manager can identify those mispriced securities in advance.  Third, that the market will then recognize the “true” value of the investment and move it to that value over a reasonable period of time.

In addition, these types of investments frequently come with high risk, high correlations with stocks, and a great deal of illiquidity – though none of these may become apparent until there is market stress.  Further, the distributions of returns are typically leptokurtic (extreme events happen more frequently than you would expect) and negatively skewed (those extreme events tend to be the bad ones, not the good ones).

With that out of the way, over the next few posts I will review various alternatives.

An asset class is a group of investments that have similar behavior and characteristics. When selecting investments it is vitally important to have estimates of three statistics for each asset class:

1. Expected Return – the rate of return anticipated on average.
2. Standard Deviation – the variability likely in those returns.
3. Correlation Coefficient – the manner in which two classes move relative to each other.

Very safe investments tend to have very low returns and very low chances of much volatility in those returns. More speculative investments tend to have both higher average returns and a higher chance that actual experience will be vastly different from that average. The third factor, correlation, is extremely important but frequently overlooked. With investments that move in different directions from each other, the portfolio will have a lower standard deviation of returns than its components. This is the rare case of a free lunch – diversification works.

We believe there are only two primary asset classes – stocks (equity) and bonds (debt). There is overwhelming evidence that the primary determinant of gross portfolio performance will be the portfolio allocation between these two classes. Net performance can be greatly enhanced by accessing these classes efficiently, though this is not often done. Within these two main categories, a number of sub-classes, while they may be useful, are vastly less important than getting the “big picture” right. The precise sub-classes used and the level of use will vary by client. Following are some typical subdivisions:

Equities (Stocks). Some exposure to stocks is the only way most people can reach their financial goals. We believe the risk of a portfolio losing money in a given year is far less important than the risk that the portfolio won’t last as long its owner. The following are common ways to classify stocks:

• Geographic location: Domestic, Foreign, Emerging Markets, Frontier Markets. We believe foreign exposure may reduce portfolio volatility, but investors frequently prefer low exposures to foreign companies and are willing to endure potentially higher volatility to be more aligned with domestic markets.

• Market capitalization (size): Micro Cap, Small Cap, Mid Cap, Large Cap. Though it appears smaller companies may perform better than their larger brethren over long periods of time, the effect seems less pronounced now than it once was and may not exist at all after adjusting for the higher risk level. Because of the often high transaction costs with these smaller companies, it is important to get exposure to them as efficiently as possible.

• Valuation: Growth, Value. A fair amount of academic research indicates that value stocks have higher returns and lower volatility over time. This appears to be true because investors irrationally prefer growth stocks and therefore systematically misprice growth vs. value investments. This effect appears to be larger for smaller companies.  For this reason we tend to tilt portfolios toward value in general and small value in particular.

Fixed Income (Bonds). We believe the primary function of bonds in a portfolio is to reduce risk. For this reason we do not attempt to seek out incremental returns by adding risk in this area. We believe that if you need higher returns, the appropriate approach is increasing equity exposure rather than attempting to get higher returns from the fixed income portion of the portfolio.

• Duration: This sophisticated measure incorporates the magnitude, timing, and discounting of future cash flows to give a measure of volatility. It is related to, though not synonymous with, the more familiar “maturity.” Because we believe the purpose of the bond allocation is to reduce risk, we have a large bias toward short duration instruments. Long duration fixed- income investments have higher volatility levels but not commensurately higher returns. At the other extreme, the shortest duration is simply a cash equivalent.

• Taxability: Some fixed-income instruments (Municipal Bonds or “Muni’s”) are tax free. We tend not to use these investments much because 1) marginal rates appear to be in a long-term (not short-term) declining trend, 2) bonds are optimally held in tax-advantaged accounts, 3) Muni’s only make sense for taxpayers in the highest tax brackets, and 4) they are riskier than U.S. Government bonds.  However, for high tax bracket investors without the “room” in their tax-advantaged accounts to accommodate their fixed income holdings Munis can make sense as a portion of the fixed income holdings.

• Credit Quality: High Yield, Corporate, Agency, Treasury. We strongly advocate only investment grade bonds in the fixed income allocation of the portfolio and therefore consider High Yield (aka “junk”, “non-investment grade”, or “speculative bonds”) to be inappropriate.

• Inflation Protection: Treasury Inflation Protected Securities (TIPS) are a relatively recent innovation (1997) with no appreciable credit risk or inflation risk. We generally use these instruments in significant quantities.

This has been a much abbreviated and simplified overview of the two primary asset classes and some of the sub-classifications you will frequently see, but so-called “alternative” investments are becoming increasingly popular. My next post will delve into those areas.

Many comparisons of vehicles with differing tax treatments are faulty because they don’t start at the beginning and go all the way to the end.  To perform a proper analysis, it is important to start with “Pat earns a dollar” and go all the way to “Pat spends the proceeds.” If the comparison starts with “Pat puts $X in the accounts,” or stops with “the account values are $X,” the conclusions are likely to be erroneous.

Here is a quick mathematical comparison of a Roth vs. a traditional (deductible) IRA.

Assume a 25% marginal ordinary income rate and a 15% capital gains that remains constant.

Scenario 1:

• You earn $1,000.
• You pay $250 in income taxes on it.
• You put the remaining $750 in a Roth.
• The investment grows until it doubles to $1,500.
• You take it out and get to spend $1,500.

Scenario 2:

• You earn $1,000.
• You put it in a deductible IRA (no taxes because it is tax deductible).
• It also doubles and thus becomes $2,000.
• You take it out and pay 25% ($500) in taxes.
• You get to spend $1,500.

As you can see, there is no difference between the two vehicles under those assumptions.  Here are the confounding factors:

1. If the marginal tax bracket is lower in retirement, it will favor a deductible option; if it is higher, it will favor the Roth option.

2. The analysis above assumed that you did not max out the IRA. If you contribute the maximum, it will favor the Roth.  Because the Roth takes after-tax funds, and the limits are the same, you can essentially get more earnings into a Roth.  An example may clarify this:

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Using the same assumptions as above, assume you are going to save pre-tax wages of $8,000 while the maximum contribution level is $6,000 (this doesn’t match current limits of $5,500 or $6,500 if 50 or older, but makes the calculations simple to follow).

Scenario 1:

• You earn $8,000.
• You pay taxes on it ($2,000 in the 25% bracket).
• You place the remaining $6,000 in a Roth.
• It doubles to $12,000.
• You withdraw the funds and get to spend $12,000.

Scenario 2 – IRA Portion:

• You earn $8,000 and put $6,000 in a deductible IRA, (no taxes on that portion).
• The $6,000 in the IRA doubles to $12,000.
• You withdraw the funds paying $3,000 in taxes.
• You get to spend $9,000.

Scenario 2 – Remaining Portion:

• You pay $500 in taxes on the other $2,000 (of the original $8,000).
• You invest the remaining $1,500 in your taxable account.
• It doubles, but has some drag due to taxes (see below).
• At withdrawal, the after-tax amount available to spend is less than $2,775.

(The $1,500 in the taxable account will do less than double because of taxes on dividends, interest, and turnover; but even if we assume it did the full double, it would become $3,000 with a basis of $1,500.  At a 15% capital gain rate, the taxes would be $225.  So, even with a perfectly tax-efficient investment, you would have only $2,775.)

Adding the $2,775 to the $9,000 proceeds from the IRA is $11,775 which is less than the $12,000 from the Roth.  In reality, the difference would be somewhat greater.  (Note:  If you use very efficient investments like an index fund or ETF that has little turnover and small distributions and hold it till death, it receives a step-up in basis to your heirs, and the overall effect is similar to a Roth.  The higher the turnover and distributions, the more inefficient it becomes.)

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3. Some people with access to a qualified plan may still be able to do a Roth even though their earnings are too high to deduct contributions to a traditional IRA.

4. The traditional IRA may be a little better if you are concerned about your children squandering their inheritance. Psychologically, having to pay taxes on discretionary withdrawals may be just the thing to restrain them from taking more than the RMD (Required Minimum Distribution) each year.

5. A major assumption is the tax rate in the future. This depends not only on your financial situation but also on tax policy at that time.  There has been a long-term trend toward lower marginal rates on a broader tax base.  While it seems likely that will reverse at least slightly in the short run, due to modern understanding of the Laffer Curve, rates will probably not rise to the levels many fear.  (For a tutorial, see http://www.youtube.com/watch?v=fIqyCpCPrvU.)  In addition, the deduction for a traditional IRA happens now, while the Roth is merely a future promise.  I am skeptical of government promises, and while it may seem inconceivable that Roth proceeds will incur taxes, at one point it was also inconceivable that Social Security benefits would someday be taxed.

6. Despite the preceding paragraph, given future uncertainty, a traditional IRA should probably be the default choice. If you achieve more financial success and are thus in a higher tax bracket, using a Roth will have been preferable.  In less rosy scenarios, the traditional IRA would be superior because the tax bracket upon withdrawal is modest.  Optimizing the good scenarios isn’t as important as mitigating the less favorable futures, thus favoring the traditional IRA.

7. If you desire to leave funds to charity upon death, a traditional IRA will give a tax deduction now for that future contribution. In other words, a tax deduction is received for putting funds into the traditional IRA.  A charity may be named as beneficiary (or contingent beneficiary) thus essentially receiving a tax deduction for that future bequest.  Not so with the Roth IRA.  Conversely, since charitable deductions that are limited by adjusted gross income (AGI) may only be carried forward for five years or until death, whichever occurs first, doing a conversion to create taxable income and thus avoid losing the deduction may be prudent.

8. If you have a taxable estate, a Roth is more advantageous since the income taxes paid upfront will no longer be in the estate, though there is an offsetting deduction to heirs upon recognition of the IRD so this issue is smaller than many assume. This factor is more important to the extent that heirs will stretch out their distribution and/or have state or local estate taxes since there is no offsetting deduction in those cases.

To recap, when both a deductible IRA and Roth IRA are available, Roth IRAs are superior when:

• Tax rates will increase for you in the future (either because of your personal situation or because tax rates in general change).
• You are trying to save more than the limits (or have other taxable investments to pay the taxes).
• You have a taxable estate.
• You do not want to be forced to take RMDs after age 70½.
• You trust the tax-free treatment of Roth IRAs will continue in the future.
• You will not leave the funds to charity.
• You will leave a portion to heirs who are in a higher income tax bracket.

Traditional IRAs are superior when:

• Tax rates will decrease for you in the future (either because of your personal situation or tax rates in general change).
• You are not trying to save more than the limits (and don’t have other taxable investments available to pay the taxes).
• You don’t have estate tax issues.
• You will need to withdraw funds to live on in retirement anyway.
• You don’t trust the Congress not to change the tax treatment of Roth IRAs in the future.
• You will leave the funds to charity.
• You will leave a portion to heirs who are in a lower income tax bracket.

You and your advisor will have to weigh the relative importance of these factors to decide which vehicle is right for you.

Roth conversions may be analyzed in exactly the same manner as above, and will frequently be advisable to the extent the taxes on conversion can be paid out of funds that are not currently tax advantaged, and the conversion will not place you in a higher income tax bracket.  It may be advisable to perform “opportunistic conversions” by converting the maximum amount each year that will not cause migration into a higher marginal income tax bracket.

Finally, a non-deductible IRA is inferior to both the deductible and the Roth unless you intend to convert it to a Roth in the future.  It should be compared to a taxable account where, given a very long time horizon or very tax-inefficient investments, the IRA has advantages.  However, because of the lack of flexibility (early withdrawal penalties), more difficulty harvesting losses, ordinary income rather than capital gains tax treatment, and loss of the step-up in basis on death, I would generally choose a taxable account over a non-deductible IRA unless there are significant tax-inefficient holdings in the portfolio that exceed the amount of tax-advantaged space.  In other words, your high returning, ordinary income property is being held in your taxable account because there isn’t room in the IRA or Roth.

It may be advisable to initially convert larger amounts than you actually intend to convert in order to exploit the opportunity to recharacterize the “losers.”  For example, you have $100,000 in an IRA and want to convert $20,000 of it to a Roth.  Converting all $100,000 in January into separate Roth IRAs for each asset class may be advisable.  Suppose, in this case, $20,000 is placed in each of five Roth IRAs, each invested in a different type of investment.  Prior to October 15^th of the following year (the tax due date with extensions) the four Roth IRAs that appreciated the least can be recharacterized back to an IRA leaving only the “winner” converted.