Indexology^® Blog

We explored the topic of building a 30-year TIPS portfolio in a previous blog.  If the numbers we threw around seemed too big (USD 5,000 or USD 10,000 per year over a long period of time) for a Millennial, don’t lose heart.  The U.S. Series I Savings Bonds (or I Bonds) provide an easy way to save for beginners.  Currently, any investor with a social security number can buy up to USD 10,000 per year in I Bonds, with minimum purchase of USD 25 per transaction.  This makes it much easier for a Millennial to put aside, say, USD 31.33 if he wants to save only that much.  Yes, you read that right, you can buy an I Bond to the penny, as long as it is over USD 25.00.

There are some basic differences between TIPS and I Bonds, but essentially both are financial instruments that allow one to hedge against inflation over time.  For a good illustration, please visit the TreasuryDirect website, https://www.treasurydirect.gov/.

Why bother with putting away such a small amount (in this example, USD 31.33)?  This gets at the heart of retirement readiness.  To be retirement ready, one needs to pay attention to three drivers: (1) contribution, (2) investment strategy, and (3) spending goals.  Savings are directly related to the first driver—contribution.  Whether or not retirement has been funded adequately, funding has to begin somewhere.  A thousand-mile journey begins with the first step, as does the wealth accumulation for one’s retirement income, by modest savings.  Once the amount saved has reached some critical mass, more finely calibrated investment strategy can be adopted to further grow the investment assets.  We will leave the last driver—spending goals—alone, for the time being.

I Bonds can be useful in this undertaking of funding for one’s eventual retirement many years down the road as a supplement other funding schemes.  They are meant to be long-term investments, and they continue to earn interest for up to 30 years.  Interest on an I Bond is a combination of two rates: (a) a fixed rate of return, which remains the same throughout the life of the I Bond, and (b) a variable inflation rate, which is calculated twice a year, based on changes in the nonseasonally adjusted Consumer Price Index for all Urban Consumers (CPI-U) for all items, including food and energy (CPI-U for March compared with the CPI-U for September of the same year, and then CPI-U for September compared with the CPI-U for March of the following year).

Currently, the fixed rate of return is close to zero, due to the historically low level of interest rates.  If you were to buy an I Bond now, in the month of April, the April 2017 I Bond issue would have a fixed rate of zero and a semiannual inflation rate of 1.38%, providing an annual composite rate of 2.76%, good for the six months from April to September.  For the six months between October 2017 and March 2018, the semiannual inflation rate would be based on the CPI-U for September 2016 compared with the CPI-U for March of 2017 (which was announced on April 14, 2017 to be 0.98%).  Thus the composite rate for the six months from October 2017 to March 2018 would be 1.96% [=0.0000 + (2 X 0.0098) + (0.0000 X 0.0098) = 0.0196].  So, here is the final tally: an investor who buys the USD 10,000 yearly limit in April 2017 would get a fixed rate of 0.0% and earn USD 138 in the first six months and then a bit more than USD 98 the next six months (due to compounding on the interest accrued), for a total of slightly more than USD 136.

Those who invest in active funds may expect portfolio managers to deliver excess returns over their benchmark indices for the fee they paid.  However, results from the SPIVA^® (S&P Indices Versus Active) India Scorecard suggest this may not always be the case.  The scorecard, which is a biannual report, attempts to capture the performance of active funds (both equity and debt funds) domiciled in India against S&P BSE benchmarks over different time horizons.

In our extended study of Indian Equity Large-Cap and Indian Equity Mid-/Small-Cap fund performance, we found that fund managers did not deliver persistent outperformance across market cycles.  We divided the ten-year period ending December 2016 into three market regimes, including bear (peak to trough), recovery (first 12 months after the trough), and bull phase (from recovery to the peak), based on the S&P BSE Sensex total return performance, and examined performance of the Indian Equity Large-Cap and Indian Equity Mid-/Small-Cap funds in different markets (see Exhibit 1).  We also compared asset-weighted and equal-weighted excess returns versus the benchmarks for these two categories, in order to understand how the larger funds (by assets under management) performed against their peers.

Source: S&P Dow Jones Indices LLC.  Data from December 2006 to December 2016.  Table is provided for illustrative purposes.

We observed that the fund returns in these two categories had relatively low beta across different market cycles, which may have been driven by allocation to cash or defensive/low beta stocks in their portfolios.  As a result, the active funds tended to outperform by a more significant margin in bear markets and by a relatively modest margin in bull markets.  This also indicates that the alpha generation by fund managers’ stock selection was more limited during bull markets, which may not be expected.

Source: S&P Dow Jones Indices LLC.  Benchmark for Indian Equity Large Cap is S&P BSE 100 and for Indian Equity Mid/Small Cap is S&P BSE MidCap.  Beta calculated using Asset-Weighted Fund Returns.  Data from December 2006, to December 2016 based on SPIVA India Year-End 2016 Scorecard.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes.

Furthermore, active funds outperformed in trend-continuation markets and underperformed when the market regime changed, as active funds underperformed their benchmark indices by large margins and their return betas versus their benchmark remained low during recovery phases.  This implied that most fund managers may not have reduced their cash positions or tilted their portfolios to less defensive stocks when the market recovered from market downturns.

Indian Equity Large-Cap and Indian Equity Mid-/Small-Cap funds did not deliver persistent outperformance across different markets; they underperformed or had limited outperformance versus their benchmark for the 10-year period, as reported in our latest SPIVA India Scorecard.  It is also clear that larger funds in these two categories tended to perform better than smaller funds across different market cycles.

To discover more about the performance of Indian active funds versus their benchmarks, check out the SPIVA India Year-End 2016 Scorecard.

Exhibit 3: Outperformance of Indian Large-Cap Funds Versus the S&P BSE 100

Source: S&P Dow Jones Indices LLC.  Data from December 2006 to December 2016 based on SPIVA India Year-End 2016 Scorecard.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes.

Exhibit 4: Outperformance of Indian Mid-/Small-Cap Funds Versus the S&P BSE Midcap

Source: S&P Dow Jones Indices LLC.  Data from December 2006, to December 2016 based on SPIVA India Year-End 2016 Scorecard.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes and reflects hypothetical historical performance.  The S&P BSE Midcap was launched on April 15, 2015.

In his January blog post entitled “Try a TIPS Mixer in Your Equities Cocktail,” Phillip Murphy described the potential benefits of including Treasury Inflation-Protected Securities (TIPS) in one’s portfolio.  In this blog aimed at Millennials, I would like to propose an easy way to build up a 30-year TIPS portfolio for retirement.

Let us assume that Alice, age 25, wants to create her own do-it-yourself TIPS portfolio to be one of her sources of retirement income when she turns 65, 40 years hence.  Without a lot of investment decision-making experience, what would be an affordable way for Alice to accomplish her goal?

To begin with, it may help for Alice to read “Risk Less and Prosper: Your Guide to Safer Investing,” by Zvi Bodie and Rachelle Taqqu, in which the authors argue for accumulating TIPS in one’s portfolio, because TIPS provide inflation protection and hedge against interest rate risk.  In addition, if the TIPS securities were held to maturity, as would be the case for a laddered portfolio, then there shouldn’t be any risk.

Currently, if Alice has a TreasuryDirect account, she can participate in non-competitive biddings throughout the year.  Some key facts about TIPS are as follows:

1. TIPS are issued in terms of 5, 10, and 30 years;
2. The interest rate on a TIPS is determined at auction,
3. TIPS are sold in increments of USD 100, with the minimum purchase at USD 100;
4. TIPS are issued in electronic form; and
5. TIPS can be held until they mature or, if desired, they can be sold in the secondary market before they mature.

For more details, please visit the TreasuryDirect website at: https://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips.htm.

As described by Wikipedia: “TreasuryDirect is a website run by the Bureau of the Fiscal Service under the United States Department of the Treasury that allows U.S. individual investors to purchase Treasury securities such as T-Bills, TIPS, and others directly from the U.S. government.  Its website allows money to be deposited from and withdrawn to personal bank accounts, and allows rolling repurchase of securities as the currently held items mature.”

Thus, for Alice, her TreasuryDirect account would be a cost-effective investment account to accumulate TIPS.  From age 25 to 34, at a relatively modest salary, Alice would buy the 10-year TIPS, at USD 5,000 a year.  From age 35 to 44, as her compensation grew, she would roll over the maturing 10-year TIPS into 30-year TIPS each year, and she would buy an additional USD 5,000 of the 30-year TIPS.  From age 45 to 54, she would buy USD 10,000 each year of the 30-year TIPS.  Finally, from age 55 to 64, she would buy USD 10,000 each year of the 30-year TIPS.  As she turns 65, she would have built up a 30-year laddered TIPS portfolio, with USD 10,000 of TIPS securities maturing in each of the next 30 years.  Since these TIPS securities have coupons and inflation-adjusted principal amounts, the nominal amounts would be much different from the face amount of USD 10,000; but in real terms, meaning on an inflation-adjusted basis, each maturing tranche of the laddered portfolio would provide the same purchasing power of a real USD 10,000.

For Alice, having a 30-year TIPS laddered portfolio of USD 10,000 real income each year would be a nice supplement to her other sources of income from Social Security benefits and defined-contribution retirement savings.  If, along the way to her retirement, she could afford to buy more TIPS, then her TIPS nest-egg could be correspondingly larger.

It may not seem like a big deal to have such a USD 10,000 30-year TIPS laddered portfolio available for retirement income when one is ready to retire.  However, bear in mind that the maximum social security benefits one may get (in current U.S. dollars) is around USD 2,800 per month, or USD 32,600 a year.  In this context, an income of USD 10,000 a year would increase one’s social security income by about one-third.

Equity markets in South Africa, as measured by the S&P South Africa Domestic Shareholder Weighted (DSW) Index ZAR, increase 5% in 2016.  Aside from the GDP contraction experienced in the last quarter of 2016, conditions were generally improving in the country.  For example, the South African rand strengthened during the year and the municipal elections passed without incident.

However, it appears that active managers were not able to take advantage of these more favorable conditions; 72% of South African equity funds underperformed their corresponding S&P DJI benchmark over the one-year period, and 77% underperformed over the 10-year period.

In regard to active funds invested in global markets, funds in South Africa fared poorly during the year and were the worst performers among the fund categories studied in the SPIVA^® South Africa Year-End 2016 Scorecard.

For more details of the report, please click here.

Social Security benefits are the gold standard of retirement income.  As Nobel Laureate Robert Merton commented in his article “The Crisis in Retirement Planning,” published in the Harvard Business Review (July/August 2014): “Ask someone what her pension is worth and she will reply with an income figure: ‘two-thirds of my final salary,’ for example.  Similarly, we define Social Security benefits in terms of income.”  In this blog, I will turn it around and try to put a price tag on this stream of retirement income.

This may be timely, as anyone who has read their Social Security statement lately might agree.  As of March 2017, the Social Security Administration includes the following message in the statement received by current and prospective social security benefit recipients: “Your estimated benefits are based on current law.  Congress has made changes to the law in the past and can do so at any time.  The law governing benefit amounts may change because, by 2034, the payroll taxes collected will be enough to pay only about 79 percent of scheduled benefits.”

If we wanted to provide for ourselves the potential shortfall of 21% in our social security benefits in 2034, how much would it cost us?

To answer this question, we consider that the current cost of a single life income annuity paying USD 1,000 per month is around USD 185,000.  Since social security benefits are adjusted for inflation, the cost of such a single life income annuity would be higher.  Without knowing the pattern of inflation changes over time, most annuity providers assume a 2% annual increase in monthly incomes.  With a 2% annual increase option, the current cost of this single life income annuity is about 23% higher, at USD 227,300.

The next step is to determine the monthly social security benefits one would receive.  Assuming the retiree is currently receiving USD 2,500 per month, the projected 21% reduction by 2034 would mean roughly USD 500 less per month.  Thus, since we know it would cost the retiree USD 227,300 to get USD 1,000 per month for life with a 2% annual increase, in order to replace USD 500 a month, the retiree would need to come up with one-half of USD 227,300, or USD 113,650, to get back up to the USD 2,500 monthly income, in current U.S. dollars.

Looking at this another way, if securing USD 1,000 per month costs USD 227,300 now, that means the value of the USD 2,500 monthly income in social security benefits would be worth about USD 568,255 in current U.S. dollars.