Category Archives: Finance

Finances, investing, and money management.

How to Lease a Car

I have never leased a car for myself, but since interest rates crashed a decade ago I have considered it several times. (I generally prefer to buy new cars, and when you have cash to cover the purchase one drawback to leasing is that you have no choice but to pay interest on the residual value of your lease for the full term of the lease. With lower interest rates that’s a less significant cost.)

I just helped another friend arrange a lease and realized I haven’t published my guidance on this. Since dealers often use the complexity of lease contracts to pad their margins, here’s all you need to know to cut through the charade:

The three numbers that matter in a lease

1. Purchase price. This is pretty much the only thing you can negotiate. Unless the car you want is in extremely high demand, you should demand the dealer set the “sale price” no higher than dealer invoice minus any factory discounts currently applicable. (If you’re a good negotiator, or you hire one, you can often get the dealer to sell below invoice. But invoice is usually considered “fair.”)

While dealers try to mix the two to confuse buyers and increase their profit, the lease agreement is done after you have a purchase agreement. (You can actually shop around for financing, but whenever I have checked I have found the best lease terms come through the manufacturer’s finance arm, which means you’ll probably end up talking to the same dealer about the lease agreement.) This is where the other two numbers that matter come up:

2. Residual value. This is entirely a function of how long you want the lease to run and how many miles you want to be allowed to drive. Usually the best residual values are given for standard leases (e.g., 36- or 39-month with 12k or 15k miles/year.) But sometimes manufacturers want to push other lease terms to control their resale inventory, so if you’re flexible it’s worth asking about those.

3. Money factor. This is the interest rate you are paying (quoted, oddly, as the annual rate divided by 24). This is almost entirely a function of your credit score. But often a higher initial payment can reduce this, so if you have cash available you should look at options to reduce the money factor by increasing your up-front payment.

Time to leverage real estate equity

Bubbles and crashes in real estate over the last few years taught homeowners a few lessons: For one thing, don’t expose yourself to interest-rate or credit risks with exotic mortgages on your primary residence, unless you have liquid reserves to cover that debt if things go against you. For example, interest rates really can cause the cost of an ARM to go up. Balloon mortgages really do have to be paid off, regardless of how difficult it is to refinance when that time comes. And not only can the value of a home decrease, but there may even be periods when it’s impossible to sell for any reasonable price.

Lenders and owners of mortgage-backed securities learned a few lessons of their own, which for a time made it more difficult and expensive to take equity out of a home. However, most of them have by now taken their lumps and learned their lessons: No more liar loans, and no more rigged appraisals. The mortgage origination market is once again hot, and loans are being made at record low interest rates.

Government, the one entity that never seems to learn, is still out there subsidizing loans: not only via the tax credit for mortgage interest, but also through its patrons Fannie Mae and Freddie Mac (can you believe those are still around?). Consequently, if you have good credit this is the best time to leverage your home equity. Today’s WSJ article on the subject notes:

[P]eople who have a potentially profitable use for that money—preferably an investment—could come out ahead using this strategy. A borrower who takes out a mortgage at 4.5% is essentially borrowing money for free on an after-tax, after-inflation basis, assuming he is in the 33% marginal tax bracket and inflation returns to its long-term average 3% or more.

If you were thinking of moving to a better house this may be a doubly excellent time to do so: The higher end of the market was hit hardest and has been slowest to show signs of recovery. I am trading up to a better house that is selling below its build cost and, thanks to some aggressive mortgage shopping, I am financing the purchase with a 3.5%, zero-point, 5/1 conforming ARM.

Top Investment Priority: Beating Inflation

Nominal investment performance numbers give us a false sense of how hard our money is working for us. Real returns, which are adjusted for inflation, look much worse over the long term.

One analyst also factors in the effects of taxes and fees to produce “real-real returns,” which are even more pathetic:

Garrett Thornburg, founder of Thornburg Investment Management in Santa Fe, N.M., calculates what he calls “real-real” returns, adjusting stock performance not only for inflation but also for real-world drags such as taxes and fees. Nominally, a dollar invested in the stocks of the Standard & Poor’s 500-stock index at the end of 1978 had blossomed to $22.88 at the end of 2008, including dividends, a sweet gain even after the 2008 meltdown. But once estimates of inflation, taxes and costs are removed, he figures, the investment was worth $3.76.

All of this might be enough to put investors off stocks entirely, until they consider the long-term alternatives. Measured over the 1978-2008 period, rather than over just one decade, stock performance in real-real terms actually is better than that of just about any other major investment class, Mr. Thornburg found: 4.5% a year. Stocks’ ability to keep up with inflation over the very long haul may be their best selling point.

In real-real terms, stocks did better over that period than municipal bonds (2.5% a year), long-term government bonds (2% a year) and corporate bonds (0.2% a year). Real-real home prices were unchanged over those 30 years. Both short-term government bonds and commodities suffered losses.

Investing for Inflation Protection

Last year I recommended TIPS funds as particularly attractive for tax-exempt investment accounts.

TIPS have gained substantially since then, but from a historical perspective the current 10-year TIPS break-even rate of 2.1% is still low. (“Break-even” is the realized inflation rate above which an inflation-protected security will pay more than its non-inflation-protected equivalent. In the case of TIPS that would be regular treasury bonds. A break-even rate of 2.1% means that ). Since inflation protection is valuable insurance in a market like this, with low current inflation but exploding money supply (which could easily lead to surprisingly high inflation in the next few years), one might expect TIPS break-even rates to run above the long-run expected inflation rate, which is around 2% per year. Indeed, it is still cheaper to buy TIPS than to buy treasuries and hedge against inflation with options.

However, as I noted earlier, TIPS aren’t a perfect inflation hedge. Bill Tedford, a successful treasury bond portfolio manager and inflation bug, has other ideas on investing for protection against inflation:

In his own portfolio, Mr. Tedford has begun shorting 30-year Treasurys, expecting the prices to fall as interest rates begin to rise. For clients, however, Stephens is encouraging the use of exchange-traded funds to own exposure to real assets. Mr. Tedford says a 5% or 10% position overall “is big enough to protect a larger portfolio.”

Among ETFs, Stephens likes the U.S. Gasoline Fund, the iShares Dow Jones U.S. Oil & Gas Exploration & Production Index, SPDR Gold Trust, PowerShares DB Base Metals Fund and the PowerShares DB Agriculture Fund. The firm also likes Plum Creek Timber Co.

Though Treasury inflation-protected securities, or TIPS bonds, would seem a natural bet, Mr. Tedford says his group just this month sold off its TIPS investments. Real yields on TIPS are barely above 1% now and Mr. Tedford expects those yields will increase as inflation mounts, hurting prices, which move in the opposite direction.

The likely result: “The return on your TIPS could fall 10% or 15%,” basically wiping out the bond’s inflation protection.

I would personally steer clear of gold as an inflation hedge because it is particularly prone to speculative bubbles, and has less intrinsic value than most other commodities. But diversified investments in energy, industrial metals, and the agricultural sector should also serve as good long-term inflation hedges.

Avoid “Hedge Fund Clones”

I suppose you can’t fault Wall Street for catering to demand, but as I explained a few years ago hedge fund clones are ridiculous investments. Nevertheless, the WSJ reports investors are still lining up for these offerings and banks are still rolling out new ones.

While most clones have so far generally kept pace with broad hedge-fund indexes, their performance has been all over the map. Between March 2008 and Sept. 30 of this year, clones studied by researchers at Haute Ecole de Gestion in Geneva and Bank Julius Baer & Co. delivered annualized returns ranging from -21% to 6%. And some clones this year have sharply underperformed broad hedge indexes. State Street’s Premia Fund was up less than 2% in the first 10 months of this year, compared with a 10% gain for the HFRI Fund of Funds Composite Index.

Even Andrew Lo, one of the originators of the “clone” concept, and current manager of a replication fund, has to admit that this concept is missing a big piece of the game:

Being restricted to easily traded holdings, replicators may not capture a big chunk of hedge-fund performance. Anywhere from 10% to 60% of hedge-fund returns may come from a premium earned by holding illiquid assets….

Investment Advice: Swensen Update

The always sensible David Swensen has an interview with the Yale Alumni Magazine that everybody with capital should read. (He has written two books on investing: One for institutional investors, and one for individual investors.)  Naturally, it concords with my general investing advice here.  He slams the actively managed mutual fund industry (“The mutual fund industry is not an investment management industry. It’s a marketing industry.”) and urges individual investors to focus on index investing.

The investor is bombarded with staggering amounts of information, staggering amounts of stimuli that are designed to get the investor to buy and sell and trade, to do exactly the wrong thing, to create excessive profits for these intermediaries that aren’t acting in the investor’s best interests.

Continue reading

Life Insurance

Only buy guaranteed-renewable term life insurance from A-rated insurer. “Whole life” insurance, which accrues value over time, combines savings and investment with insurance. I have heard of no good reason to bundle those activities. But there are good reasons to avoid whole-life insurance, including:

  1. The insurer can embed higher fees.
  2. You expose yourself to credit risk of the insurer.  If the insurer fails then you could potentially lose the value of savings in your whole-life policy.  In contrast, if a term-life insurer fails you have only lost your most recent premium payment.  (Either way you are at risk of not being able to get a new policy in time.)

The purpose of life insurance is to protect those who depend on you being alive against catastrophic consequences of you not being alive.  Therefore, it never makes sense to insure child who does not produce income on which you depend.  It is not necessary to insure a homemaker if you can fall back on extended family in the event of their death for the essential services they provide.

As with all insurance, you pay a premium for protection (insurers generally make profits after paying claims and business overhead), so it is irrational to load up on more insurance than you need — unless you know that you are at a much higher risk of dying than actuaries think you are.

How much insurance is reasonable?  If a young family depends on your income, and you have no savings, then you should probably get enough insurance that your wife and kids could maintain their standard of living for 20 years (or until the children are independent) from the proceeds of a policy.  A healthy young man can get a 10-year guaranteed-renewable $2MM insurance policy for around $600/year.  After 10 years, hopefully he will have saved some money and his dependents will be closer to independence so he could drop his coverage to $1MM.

You should not buy insurance to provide independent heirs with an inheritance.  If you play your cards correctly you should Die Broke.  Older people should eventually be able to self-insure out of their savings.  Once they have no dependents they should eventually plan to purchase an immediate annuity to provide insurance against outliving their own savings.

Last time I bought a term-life policy I found the best contract through Zander Insurance Group, an independent insurance brokerage company that made the process as easy as it has ever been.

Tax-Exempt Investments: The Best Opportunity Now

Treasury Inflation Protected Securities (TIPS) are a unique asset class ideally suited to investment in tax-exempt accounts (e.g., retirement accounts like IRAs and 401ks).  TIPS pay interest like regular treasury bonds, but they also appreciate in line with inflation.  The mechanisms by which they pay out are somewhat convoluted and undesirable from a tax perspective, which may contribute to the discount they currently carry in the market.  If you can buy TIPS in a tax-exempt account you don’t have to worry about these nuances.

The clearest way of valuing TIPS is in terms of the “break-even rate of inflation,” which is the inflation rate at which an investor would earn the same from TIPS as from regular treasury bonds of the same maturity.  If realized inflation exceeds the break-even rate then investors in TIPS earn more.  If inflation is lower than the break-even rate then investors in regular treasuries earn more.

Considering the break-even rate, TIPS are extremely cheap.  For example, the break-even rate on 5-year TIPS is 1.12% — well below current inflation, historical inflation, and even the Fed’s target inflation rate.  The dollar faces a number of inflation risk factors, and the current market bailout by the U.S. Treasury only adds to these risks.

Since TIPS are an undervalued, tax-inefficient asset that offer inflation protection they make an ideal investment for tax-exempt retirement portfolios.  Investors who want heightened exposure to these characteristics can buy leveraged CEFs that invest in TIPS: E.g., WIW and WIA.

Where to Invest Now

There is no better time to invest than when lots of other investors need their money back.  During market crises like the present the premium on liquidity skyrockets.  I.e., if you have cash on hand that you can commit to investments for an extended period then the people who don’t will let you scoop up assets at firesale prices.  Hence, the rules for investing in a market crisis:

1. Don’t abandon investments unless you need cash.  If you sell during a liquidity crunch you become one of the people paying the liquidity premium.

2. If you buy during a liquidity crunch you collect the liquidity premium.  Therefore you should revisit your asset allocation and consider reallocating your investments to increase your exposure to distressed assets.  (Don’t try to pick stocks or sectors — the information premium during a market crisis can also skyrocket, which means if you don’t have extraordinary information you are at a heightened disadvantage.)  For example, last week a lot of institutions needed to move into short-term treasuries.  They were dumping corporate bonds, stocks, and just about anything else to do it.  Demand for treasuries got so high that buyers were literally paying out for the right to own them (i.e., interest rates went negative).  If you held treasuries and didn’t need the exceptional margin of security they provide it was a good time to cash them in and buy the things everyone else was selling.

In general your portfolio should reflect your investment time horizon and risk aversion — i.e., how long you can keep your money invested, and how much interim “pain” you can tolerate.  The more pain, the more (potential) gain.  During a liquidity crisis you may perceive that risks have gone up and thus be inclined to sell risky assets and move to more liquid assets.  That is exactly the wrong course of action, because it turns you from a liquidity provider into a liquidity demander.  If you succumb to the urge to pull money from the markets you will find yourself in the notoriously underperforming pool of retail market timers who always buy near the top, when everything seems great, and sell near the bottom, at the point of “maximum pain.”

When you see falling asset prices during a liquidity crisis do not think, “Shoot, those assets are riskier than anyone thought, I had better get out too.”  Instead think, “Wow, the market is willing to pay me even more to move into those assets.  Last time I considered those I didn’t think the extra return was worth the risk.  But since that return potential is even higher maybe now it is worth owning them.”

How can you collect the handsome liquidity premium that exists in the current market?  If you own CDs, consider paying the early-withdrawal penalty and putting the money into corporate or muni bonds, whose spreads over treasuries have spiked to record levels.  If you already own bonds consider moving to higher-risk asset classes, or else consider leveraging up using bond CEFs.