Taxable Or Tax-Deferred?

With domestic REITs this is an easy one: you should always own REITs in a tax-advantaged account if at all possible. This is because REIT dividends are taxed as regular income instead of the lower tax rates afforded qualified dividends from most other kinds of corporations. However, the foreign tax credit clouds the issue somewhat. Mutual funds owning the stocks of foreign companies are generally required to pay income taxes on dividends received to the stock’s host nation. Normally, you (the investor) can then claim a foreign tax credit to recoup at least some of the taxes paid to foreign governments. The catch is, you can only do this if you hold the fund in a regular taxable account. If you hold the fund in a 401k, IRA, or other tax-advantaged account this tax credit isn’t available to you at all. So you have to choose: do you pay foreign taxes or do you pay domestic taxes? With foreign real estate, you can’t avoid both. Of course, this is true with all foreign stock and it hasn’t stopped me from whole-heartedly recommending foreign stocks. Still, it’s something to keep in mind.

Is It Worth The Higher Expense Ratio?

The Vanguard fund is reasonably priced with an expense ratio of just 0.50%. Still, that’s more than twice the price of domestic REIT exposure. Are the additional diversification benefits of owning foreign real estate worth the price? I have no idea, which leads me to my next point…

Just How Much Diversification Would You Gain, Anyway?

To the best of my knowledge, there is no comprehensive source of data on foreign real estate as an asset class (please correct me if I’m wrong). Would these securities correlate well with domestic real estate?  Or maybe move lock-step with foreign stocks?  If so, there’s not much diversification benefit to be had. The problem is, there’s not enough data to make a reasonable judgement one way or another. Foreign real estate could end up being a great diversifier. Or not. For this reason alone, I probably wouldn’t advocate more than a token 5% allocation to this asset class. For now.

The Inclusion Of Real Estate Related Companies

The REIT legal structure doesn’t exist in many countries, meaning you would also probably own stocks in a few real estate development companies, property management companies, and the like. There’s nothing wrong with owning stock in these kinds of companies, but they don’t exactly provide pure exposure to foreign real estate values. This factor would lead me to believe most foreign real estate funds would tend to be more or less correlated with other more general foreign stock mutual funds. Again, there’s nothing wrong with that, but it’s not really what you signed up for.

So should you own foreign real estate? For me, the negative factors outweigh the positive for the time being. I will definitely revisit the decision after I have a few more years of data to look at, though.

For the purposes of this article, “easy-to-own” means there is at least one low-cost mutual fund or ETF available (preferably an index fund).

Easy-To-Own Alternative Asset Classes

Real Estate

Real estate is an obvious one, but until relatively recently only the wealthy could afford to own a diversified portfolio of income-producing real estate. Then REITs came along in the 1960′s. Now, pretty much anybody can own an interest in commercial real estate all over the country in the form of one of several very good REIT mutual funds, the Vanguard REIT Index Fund (VGSIX) being my favorite. My personal belief is that at least a token 5% of most people’s portfolios belong in REITs. I devote a full 10% of my portfolio to REITs.

International Real Estate

Okay, so international real estate rightfully belongs under the “real estate” category above; however, I’ve listed it separately here for two reasons.

1. Until very, very recently there weren’t many reasonably-priced mutual funds that focused on owning the stocks of foreign real estate companies. It’s only been a few months now since Vanguard launched its Global ex-US Real Estate Index Fund (VGXRX).
2. Most foreign countries don’t have the legal equivalent of the Real Estate Investment Trusts so popular with American investors. Because of this, it remains to be seen whether international real estate, as it is currently available to American investors, will behave more like real estate or more like stocks.

I’m not suggesting you go out and buy the new international real estate fund. In fact, I would lean towards advising against it (for now). But it is a traditionally alternative asset class that is now easily owned by small individual investors and so I’ve included it here.

Inflation Protected Securities

Inflation Protected Securities (TIPS) have been around for almost 15 years now and are widely owned, so it may seem odd at first that I would include it in a list of alternative asset classes. There are a number of very good inflation protected securities funds out there (Vanguard’s is excellent) and governments all over the world have been jumping on the inflation-protected bandwagon. Still, I think TIPS are under-owned and since they have explicit inflation protection, they tend to behave differently from nominal bonds, making them an excellent team. Like REITs above, I believe TIPS belong in most portfolios.

Commodities

Commodities are still the most difficult-to-own of the asset classes listed not because there are no options but because there are no truly low-cost options. This is one asset class that Vanguard has yet to offer, probably because it involves investing in futures contracts rather than equities. Yes, they do offer a Precious Metals and Mining fund (VGPMX), but that’s not quite the same thing. The best options in this asset class currently are probably the iShares S&P GSCI Commodity Index ETF (GSG, ER: 0.75%) and PowerShares DB Commodity Index ETF (DBC, ER: 0.85%). Expenses would need to be about half what they currently are before I would unequivocally recommend them for most investors. Still, investors with very large portfolios (we’re talking $500k+) would probably benefit from a small 5-10% allocation to this asset class. Just enough to gain some mild long-term inflation protection and to hopefully capture the occasional rebalancing bonus.

What About The Rest?

There are plenty of other asset classes out there:  hedge funds, private equity, foreign currencies, and venture capital just to name a few. But all of those other asset classes suffer from either high expenses, lax regulation, low transparency, or all three. In a world where the best investment advice anyone could ever receive is “never invest in something you don’t understand,” these alternative asset classes are just too dangerous for small investors. Besides between the four asset classes mentioned above and the more traditional domestic/foreign stocks and bonds, you really don’t need any more diversification.

An Investment Made For The Rich

Traditionally, real estate has been an asset class mostly restricted to the wealthy.  To this day, the costs involved in buying, selling, and leasing real estate can be prohibitively expensive, nevermind the difficulty of acquiring enough properties to be sufficiently diversified across both property types and geographical regions.  A portfolio like that would cost tens of millions of dollars in invested capital, an amount well outside the means of the middle class.

REITs For The Rest of Us

Fortunately, Congress saw fit to foster the proliferation of Real Estate Investment Trusts, or REITs, as a way for the middle class to participate in the benefits of real estate ownership.  REITs are required by law to pay out 90% of their net income as dividends to shareholders, and in return are allowed not to pay any corporate income taxes.  These securities routinely yield between two and three times more than the overall stock market, making them ideal for income investors.

REITs Vs Rental Properties

Income

The income return of REITs is relatively straight-forward to measure:  the Vanguard REIT Index (VGSIX) currently yields 5.81% (and is my REIT fund of choice).  The income potential on investment real estate, on the other hand, depends entirely on the specifics of each individual deal.  It’s difficult to generalize across all property types, but a reasonably-priced, responsibly-leveraged small residential income property (1-4 units) can yield between 8-12% on your invested capital.  However, during the go-go days of the real estate bubble, cash yields were often much lower and in some cases negative in many markets.

Winner: Rental Properties

Appreciation Potential

Since REITs are required by law to pay out 90% of their net income to investors as dividends, they aren’t able to retain much cash to grow their real estate portfolios.  Small individual investors, on the other hand, are free to re-invest 100% of their earnings back into income-generating properties.  On the other hands, large REITs are often able to borrow on much more favorable terms than small investors (once they exhaust owner-occupied financing opportunities) and have teams of professional analysts scouring the market for deals, an effort small investors just can’t match.  Overall, the appreciation potential of individual investment properties versus REIT portfolios is a toss-up.  It totally depends on local market conditions and which real estate sector is currently in favor:  commercial or residential.

Winner: Tie

Leverage

REITs typically carry loan-to-value ratios of between 50-70%, making them moderately leveraged by real estate standards.  By contrast, the norm for small investors is 80% and sometimes even 90% or higher for ultra-aggressive investors.  Sure, you could buy REITs on margin, thus bridging the leverage gap with direct real estate investment, but the interest rate on a margin account is likely to be significantly higher than a mortgage on an investment property.

Winner: Rental Properties

Safety

Rental properties are very expensive, and true diversification is far beyond the means of any middle-class real estate investors.  Additionally, individuals rarely have the opportunity to invest in non-residential real estate sectors such as industrial properties, hotels, shopping malls, and even large apartment complexes.  By contrast, a top-quality REIT mutual fund owning hundreds of REITs spanning tens of thousands of properties in every sector imaginable spanning the entire globe can be bought for as little as a few thousand dollars.  Direct control over small rental properties helps mitigate the risks of direct somewhat, but still fall far short of the safety promised by broad diversification.

Winner: REITs

Cost

Anybody who’s ever owned their own home knows real estate is expensive to buy, sell, and maintain.  By contrast, the Vanguard REIT Index charges a miserly 0.21% of assets, or many times less than the cost of direct real estate investment.  Closing costs alone would amount to more than 0.21% of any real estate deal you’d be likely to find, nevermind the costs of actually maintaining the thing and keeping it leased.

Winner: REITs by a mile

Effort Required

The ultimate goal of most investors is to be able to generate enough income from investments to be able to retire.  Thus, passive income is key.  Direct real estate investment, however, is not even remotely passive.  You have to find tenants, handle repairs, and keep track of accounting details.  If you own more than a few properties, the effort involved can easily turn into a full-time job.  Sure, you could hire a property manager to do the dirty work, but that would take a significant bite out of your profits and you’d probably lose some valuable tax benefits to boot.  REIT mutual funds, on the other hand, couldn’t require less effort.  Buy once and then cash your dividend checks until the day you die.

Overall Profit Potential

Overall, direct real estate investment has far greater profit potential than REITs due to higher amounts of leverage and lower borrowing costs;  however, it is also much riskier in many (if not most) cases.  With high returns comes high risk.  In the long run, REITs are unlikely to return more than they have in the past, which is about 10% per year since inception.  A properly-leveraged direct real estate investment program, on the other hand, could easily return 20-30% per year indefinitely as long as you were willing to put the work in.

Winner: Rental Properties, but with higher risk as well

The Choice Depends On You

It goes without saying that real estate belongs in every investor’s portfolio, but in the end the choice between REITs and direct real estate investment depends entirely on your individual needs and wants.  If you want to earn excess returns and retire a millionaire at a young age, direct real estate investment is probably the best choice for you.  If you just want to set it and forget it, however, REITs offer an ideal balance of return, risk, and required effort.  In the end, the choice will probably boil down to how much work you’re willing to do.  As always, hard work pays off.

Where To Learn More

The bookstore is the best place to learn the ins and outs investing in Real Estate and REITs.  Here are a few books I highly recommend.

• Investing in REITs: Real Estate Investment Trusts by Ralph Block
• Investing in Real Estate by Andrew McLean and Gary Eldred
• The No-Nonsense Real Estate Investor’s Kit: How You Can Double Your Income By Investing in Real Estate on a Part-Time Basis by Thomas Lucier
• Investing in Duplexes, Triplexes, and Quads: The Fastest and Safest Way to Real Estate Wealth by Larry Loftis

Sources:

** Domholf, Willam Who Rules America:  Wealth, Income, and Power.  September 2005

Criteria For Selecting The Best IRA Funds

• The best IRA funds usually derive a significant part of their long-term return from interest or dividend payments taxable in the current year such as taxable bond and REIT funds.
• Funds with high portfolio turn-over that tend to generate a lot of capital gains every year
• Most actively-managed mutual funds belong in a tax-advantaged account due to their inherent tax-inefficiency.

One last thing:  when comparing mutual fund performance, make sure you are comparing apples to apples.

The Four Best Mutual Funds For Your IRA

Vanguard Total Bond Market Index Fund (VBMFX) – Here’s your one-stop intermediate-term bond fund. It invests about half its portfolio in Treasury and agency bonds and the rest in corporate bonds. With a current effective duration of only about 4 years, this fund should perform decently even in periods of moderately-rising interest rates.

Third Avenue Value (TAVFX) – This fund has taken a hit along with the rest in the past year, but it’s 10-year performance record is still well above-average. Veteran value hound Marty Whitman (author of the investment classic The Aggressive Conservative Investor) is a slave to his “cheap and safe” investment philosophy, which above all else aims to minimize loss. No strategy works all the time, but over the decades Whitman’s has worked far more often than it hasn’t. The one caveat is that at 1.11% of assets, expenses are a bit high. Still, in the past Whitman has more than earned his fee.

Dodge And Cox Stock (DODGX) – Dodge and Cox employs a conservative, team-based approach to value investing that has served it well over the years. Started in 1965, this is one of the older and more successful funds around thanks to its strong performance. Unlike Whitman of Third Avenue, Dodge and Cox employ a more traditional value approach and often hold more dividend-oriented portfolios. While this fund is quite tax-efficient for an actively-managed fund, it’s 20% turnover is still higher than is preferable in a taxable account, especially when you have such high-quality index funds to choose from. At 0.52% of assets, expenses are extremely reasonable for the caliber of management.

Vanguard REIT Index Fund (VGSIX) – Real estate has taken quite a beating of late, but this funds 7+% 10-year returns are far, far, far greater than you’d have gotten in the broader market. Since REITs are required by law to distribute 90% of their earnings to shareholders each year and those distributions don’t qualify for the favorable 15% dividend tax rate, this REIT fund definitely belongs in a tax-advantaged account. That said, real estate provides powerful diversification benefits and should be a part of every balanced and diversified portfolio.

What Is a Variable Annuity?

According to Investopedia, a variable annuity is an insurance contract that usually guarantees a minimum payout at the end of some pre-defined period, with the rest of the payout being variable depending on the performance of a managed investment portfolio.  The hook here is the word “guaranteed”.  Unsophisticated investors saving for retirement, wary of the gyrations of the stock market and fearful for their future, understandably latch onto guarantees.  They think “what do I have to lose?  If the stock market does well, I get the rewards.  If not, at least I get my money back plus a little extra”.  What’s so wrong with this?  What’s wrong with it is that variable annuities are burdened by layer after layer of fees so that even if all goes well in the best of times, you don’t stand to gain much.  And if things go poorly, you may end up with a 20 year investment that ends up growing a measely 2% per year.  That’s not going to pay the bills in your old age.

Peace of Mind is EXPENSIVE

According to Morningstar, the average Variable Annuity sub-account expense ratio is roughly 2% (including insurance policy expenses).  But that’s not all.  Most VA’s  also carry surrender charges if you try to get access to your money within a certain period of time after buying in, typically at least 5 years but it can be longer.  Surrender charges can run up to 10% of the value of your account depending on when you make your withdrawal.  But that’s not all!  Many VA’s also carry annual policy contract charges of another 0% – 0.79% per year.  But that’s not all!  Variable annuities also have some of the highest sales commissions around, which explains why they are often pushed so hard.  All together, it’s not unreasonable that you would end up paying close to 3% or 4% per year in expenses to own a VA, all for a tax benefit that probably amounts to at most 2% or 3% per year!  Quite realistically, you’d be better off just paying your taxes.

But Don’t I Get a Tax Benefit?

Another hook variable annuity salesmen use to reel you in are the fact that VA’s are usually tax-deferred, just like your 401k (also like a 401k, you will owe a 10% penalty to the IRS if you withdraw money from your qualified VA before age 59 1/2).  HOWEVER, and this is a very big however, you always pay regular income tax rates on income from a Variable Annuity, even if that income comes primarly from long-term capital gains of a stock portfolio.  Basically, you are converting capital gains that would be taxed at a maximum of 15% in a taxable account into income that can be taxed up to 35%.  That’s not exactly a great deal considering you don’t get a nice tax-deduction up-front like you do with a 401k.

So Is There ANY Reason To Ever Buy a Variable Annuity?

Yes.  There are certain situations where a VA can be the perfect investment vehicle assuming that you have:

1. Maxed out all other tax-advantaged retirement options like your 401k and Roth IRA
2. Built a taxable portfolio of low-cost, tax-efficient index mutual funds or tax-managed mutual funds
3. Carefully weighed the cost benefit of the tax deferral against the illiquidity problem and higher expense ratios inherent in variable annuities
4. Chosen the absolute cheapest VA option (Vanguard has annuity portfolios with expenses of less than 0.5% per year inclusive of all insurance and policy fees while Fidelity and T Rowe Price both offer excellent options only marginally  more expensive)
5. You are investing for retirement and are absolutely certain you won’t need these funds until you turn 59 1/2

Assuming the above five points are all true and you still have money left over to save for retirement, there are a few ways you can use variable annuities to round out your portfolio.

Taxable Bonds in a Variable Annuity vs Municipal Bonds

First off, you never want to put anything in an annuity that gets its gains primarily from long-term capital gains because of the previously-mentioned tax penalty.  This includes most stock funds, both foreign and domestic.  Bond funds, on the other hand, most definitely have a place inside a variable annuity.  Since practically all the return from a bond fund over time comes in the form of interest payments (which are taxed at regular income tax rates anyway), it makes sense to put them in a variable annuity.  Think about it:  in a taxable account, you have two choices for bonds.  You can either buy tax-free municipal bonds, which have significantly lower yields than taxable bonds, or buy taxable bonds in a tax-deferred VA.  So long as the added expense ratio of buying a bond fund inside a variable annuity is smaller than the tax advantage of owning a municipal bond fund (and with Vanguard, this is practically always true), you will almost always come out ahead owning taxable bonds inside a variable annuity due to its ability to compound at a higher rate without the drag of taxes.

REITs in a Variable Annuity

Another asset class well-suited for a variable annuity are REITs (see: Are REITs a Buy?).  REITs are publically-traded companies that invest in commercial real estate and are required by law to pay out more than 90% of their taxable earnings as dividends to shareholders every year.  Since REIT dividends are taxed at ordinary income rates and the majority of REITs’ long-term return comes from re-investing these dividends, it can make good sense to buy them inside a variable annuity in order to defer taxes as long as possible.  Again, since most of the return from these securities comes from non-qualified dividends, you aren’t subjected to a tax penalty for holding them inside a variable annuity as opposed to a regular taxable account.  Fortunately, Vanguard sells a variable annuity based on its REIT Index Fund with expenses of just 0.6% per year.

That’s All, Folks

That’s it.  Those are the only two situations I can think of where a variable annuity would be appropriate for a long-term investor.  I’m sure there are a few others I haven’t thought about, but the fact that I can only think of two to begin with says a lot about what I think of their usefullness to most investors.  Can you think of any good uses I missed?  Please leave a comment and share your wisdom with the group.

UPDATE:  I forgot to mention if you’re already stuck in an expensive variable annuity, it is possible to do what’s called a 1035 exchange to transfer it to Vanguard or another low-cost providers without any penalities from the IRS.  However, you still owe surrender penalties.  You should do the math to figure out which is cheaper: paying the surrender fees now and transferring to Vanguard or living with high expenses until the surrender fees expire.  Thanks to Consumerism Commentary’s  Get Rid of Your High-Cost Variable Annuity Easily for jogging my memory

UPDATE:  Variable annuities also have a place in some peoples’ portfolio as a way to shield assets from creditors.