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Implications of Investments in Equities versus Treasuries [CPA Journal, The]
[November 01, 2014]

Implications of Investments in Equities versus Treasuries [CPA Journal, The]


(CPA Journal, The Via Acquire Media NewsEdge) Focusing on Fundamentab in a Rbky and Uncertain Environment, 2002-2013 Individual investors often lack an understanding of investment risks. As a result, many take either insufficient or excessive risk, rather than the reasonable investment risk likely to help them reach their financial goals. From a long-term perspective, ultraconservative investing with insufficient risk has proven to be a mistake. While history is no guarantee, investors can adopt better investment tactics if they have a strong understanding of basic investing tenets. CPAs can help by guiding clients to sound approaches using broad types of investment vehicles, with better underlying investment attributes.



This discussion compares returns from Treasury notes and the Standard and Poor's (S&P) 500 from 2002 (and 2007) until 2012. The unusually high equity returns of 2013-the S&P 500 was up 29.6% (32.4% with reinvested dividends)-are then incorporated. The 2008-2009 financial crisis makes this time period all the more relevant for investing consequences. Alternative investment strategies, such as gold and municipal bonds, are examined through this Treasury versus equity benchmark lens.

CPAs can help individuals make better investment choices by advising them to focus initially on two basic investment pillars. The first preliminary option is U.S. Treasury securities (as close to risk free as possible), and the second is a quality broad-based, low-cost stock index fund. Comparing returns available from a Treasury note to an equal investment in the S&P 500, centered on the 2008-2009 financial crisis, is a salient mechanism to explain basic investment alternatives. Even legendary investor Warren Buffett has directed in his will that his spouse's assets be placed 10% in U.S. Treasuries and 90% in an S&P 500 stock index fund.


By focusing on sound investment fundamentals instead of ignoring them, one can develop better investment strategies. Investors today are typically still too focused on investment choices in an often-unsuccessful effort to maximize returns. Many remain in the "market euphoria and panic trap," entering the market near its euphoric high and panic selling on the way down, virtually ensuring poor performance. CPAs often recognize when clients are employing poor investment strategies that will hinder their ability to meet reasonable longterm financial goals. These advisors can-and often do-play a central role in guiding their clients to better investment strategies, even if they do not recommend specific investments.

Treasuries versus Equities The effect of investing $100,000 in a 10-year U.S. Treasury note at the end of 2002 and in a 5-year U.S. Treasury note in 2007 is compared to an equal investment in the Vanguard 500 Index Fund (VFINX) in Exhibit 1 and Exhibit 2. (See the sidebar, Returns of U.S. Treasuries versus the S&P 500, for a more detailed breakdown.) VFINX is utilized as a proxy for the S&P 500. VFINX technically does not invest exactly in the S&P 500 index, but invests in 500 of the largest U.S. companies and has a very low annual expense ratio of 0.17%. Thus, VFINX closely tracks the S&P 500's performance. These after-tax results show that those invested in the VFINX from the end of 2002 to 2012 have been rewarded for taking reasonable additional risks. Exhibits 1 and 2 assume that the investor was in the top marginal tax bracket for that time period, and that dividends and interest were not reinvested.

The striking implication of this comparison is that, despite one of the worst financial crises in U.S. history during 2008 and 2009, equity investors who simply bought and held the market would have made positive returns over the long term. While the results for those who invested at the end of 2007 were not as favorable, index investors did not lose money when dividends are considered. While many investors are inevitably fixated on beating the market or picking the right stock at the right time, the vast majority would simply be better off investing in an index fund and holding this position long term. Terrance Odean, professor of finance at the Haas School of Business, University of Califomia-Berkeley, stated that research indicates "less than 1% of individuals who trade frequently can consistently outperform the market through skill. Over the long run, the rest would be better off investing in low-cost index funds benchmarked to the broad market" (Mark Hulbert, "Don't Be Fooled-This Is No Stock Picker's Market," Wall Street Journal, Sept. 27, 2013). The low-cost fee structure of many equity index funds is a critical advantage.

Investing at the end of 2007 was just prior to the 2008-2009 financial crisis. On March 6, 2009, the S&P 500 hit its intra-day low of 666.79. Exhibit 3 reflects file principal values of a $100,000 investment in VFINX on March 9,2009 (its lowest closing price in March 2009), as well as on December 31, 2013. It is interesting to note that, in the time period analyzed (2002-2013), the VFINX hit its all-time high on the last trading day of 2013.

Exhibit 3 reflects both the price-volatility risks and returns inherent in equity investing. As of March 2009, $100,000 invested in the S&P 500 at the end of 2007 was worth less than $50,000. In contrast, $100,000 invested in the VFINX at the end of 2002 was worth over $209,000 at the end of 2013. Dividends, historically a significant component of equity investing, would add to both of these values.

By 2013, the equity markets were back in record-high territory, with the S&P 500 returning 29.6% (32.4% with reinvested dividends) and the DJIA 26.5% (29.7% with reinvested dividends). The NASDAQ Composite Index was up even more, a staggering 38.3%. Exhibit 4 shows the daily share price of the Vanguard 500 Index Fund from 2002 to 2013. The last week in July 2014 once again highlighted the volatility of equity investing, in that the DJIA and S&P had each suffered a weekly loss of nearly 3%. Since the beginning of 2014, however, the DJIA was down 0.5%, whereas the S&P 500 was still up over 4%.

A sensible balance between U.S. Treasuries of varying maturities (for essential cash reserves) and a high-quality lowcost index fund is an investment strategy that is hard to beat over the long term. The daily yields available on a 10-year Treasury note from the end of 2002 to the end of December 2013 are shown in Exhibit 5. At the end of 2013, the 10-year Treasury note yield was around 3% (though the yield had fallen to around 2.5% in July 2014).

The 2008-2009 Financial Crisis The 2008-2009 financial crisis was a combination of cascading effects taking hold. In March 2008, the U.S. government engineered a takeover of Bear Steams by J.P. Morgan to prevent its collapse. September 2008 witnessed the nationalization of Fannie Mae and Freddie Mac, the failure of Lehman Brothers, Merrill Lynch's govemment-assisted/imposed sale to Bank of America, and American International Group's (AIG) receipt of significant government aid. Wachovia's stability came under question and the U.S. automobile industry nearly collapsed. Goldman Sachs and Morgan Stanley were quickly converted to bank holding companies as the financial markets started to freeze up. At the same time, the biggest bank failure in U.S. history was occurring (Washington Mutual Bank). In November, the Treasury, Federal Reserve, and the FDIC guaranteed over $300 billon in Citicorp assets.

The U.S. financial system risk was imploding in October and November 2008. As former U.S. Treasury Secretary Henry M. Paulson Jr. pondered at the time, "What if the system collapses? Everybody is looking to me, and I don't have the answer. I am really scared." Ultimately, the federal government responded with three major initiatives: * Takeover of Fannie Mae and Freddie Mac. The federalization of these entities, which guaranteed over $45 trillion in mortgages, averted fears that these entities would default.

* Unprecedented U.S. Treasury Program guaranteeing money market finds. This program lasted from September 19, 2008, until September 18,2009, and suffered no losses.

* Creation of Troubled Asset Relief Program (TARP). This program was initially for the banking industry but was expanded to the automotive and insurance industries. Of the $700 billon authorized, $421 billion was ultimately utilized. As of September 2013, $357 billion has been repaid. Congress authorized TARP on October 3, 2008.

Money Market Tribulations A prime example of investors forgetting or ignoring sound fundamentals is that many investors considered money market funds as risk free before the Reserve Primary Money Market Fund "broke the buck" on September 16, 2008. Incredibly, many investors still consider them risk free. When Lehman failed in September 2008, the Reserve Primaiy Fund held a relatively small portion of its holdings in Lehman Brothers-based assets ($785 million out of $62 billion). As this became known, however, a ran on this money market fund, as well as most all other money market funds, commenced. Only a hasty, temporary, and unprecedented U.S. Treasury guarantee of all money market funds halted the likely collapse of this asset class. Paulson announced this program on September 19, 2008, even though such an action was outside his permissible authority.

Regulators today are still struggling to come up with a method of conveying the message that money market funds are not risk-free. In August 2013, the SEC proposed a floating NAV (for prime institutional money market funds only) and "gates" to restrict investors' access to funds when money market funds are under stress. The presidents of the Federal Reserve regional banks quickly and unanimously criticized this as not going far enough (http://www.sec.gov/comments/ ¿7-03-13/s70313-111.pdf).

While only two money market funds have broken the buck, a 2012 Federal Reserve Bank of Boston report observed that, from 2007 to 2011, sponsors of money market funds had to prevent 78 different funds from doing so (http://bostonfed.org/bankinfo/ qau/wp/2012/qau 1203 .pdf). One last note of caution is that sponsors of money market funds are not legally obligated to support them, and, prior to its failure, the Reserve Primary Fund was file oldest money market fund.

Lingering Apprehension Investors' faith in the U.S. financial markets is suspect at times, given the recurring security and technology issues inherent in a system that handles billions of trades per day. The Flash Crash (May 2010) and the Flash Freeze (August 2013) have added to investors' trepidations. High-frequency trading that attempts to exploit millisecond gaps in information and mispricing are all part of file uneasy investing environment. Another major concern overhanging financial markets is the inevitable end of the Federal Reserve's program of quantitative easing.

Lack of Risk-Free Alternatives While one may question whether U.S. Treasuries are essentially risk free, the real question is: what are the practical alternatives? While a Swiss and German government debt obligation may or may not present less risk, the depth and liquidity of these markets is not the same as in the United States. In addition, U.S. investors would be subject to significant foreign exchange risks in the purchase of any foreign investments. Indicative of this reality is that during the 2011 U.S. debt ceiling debate, investors rushed to U.S. Treasuries in part because of supply concerns, despite the S&P downgrade of the U.S. debt rating at that time.

The U.S. and global financial markets are structured around low-risk or risk-free Treasury obligations. While U.S. equity markets contain considerable risks, they are highly standardized, regulated, and highly liquid. Even with the risks that the Treasury markets will be hurt by a Congressional refusal to raise the debt ceiling (delayed interest or principal payments), investors do not have a better risk-free alternative.

Gold Alternative One alternative investment often touted for safety is gold. SPDR Gold Trust (GLD), the largest gold exchange traded fund (ETF), can be used as a proxy for an investment in gold (see Exhibit 6 for its daily price since 2004). Since its inception on November 2004, GLD has had a cumulative annualized return of 11%. Armored Wolf hedge fund manager John Brynjolfsson was quoted in the Wall Street Journal as saying that gold provides "good insurance against crisis, higher taxes and inflation rides" (Gregory Zuckerman and Tatyana Shumsky, "Gold Bulls Put Last Year's Beating Behind Them," Jan. 13,2014).

For 2013, both the price of gold and GLD were down 28%. At the close of 2013, gold was down 34% from its all-time high on August 2011 ($1,880.70 a troy ounce). The PHLX gold/silver index was down even more at an alarming 49.2% in 2013. While "gold bugs" often tout the investment appeal of this asset class, it simply has not been of the same risk-free caliber as a U.S. Treasury note. Exhibit 6 shows that the price of gold is anything but stable and, despite its proponents' claims, is subject to significant price stability risks.

An investment in gold will not return any income, unlike a Treasury note or equity index fund. From a U.S. tax perspective, long-term sales proceeds of gold are taxed as a collectible; thus, they are subject to a tax rate of up to 28%, as opposed to 23.8% for a stock sale [also including the 3.8% Net Investment Income tax (NIIT)]. In addition, GLD sells a small proportion of its gold holdings each month to pay its expenses, thereby resulting in an annual taxable event to its shareholders.

While Treasury notes experience price volatility through selling above and below par, at maturity, they will pay off at par. Although the U.S. government could conceivably alter or renege on "the full faith and credit of the United States government," such a possibility would negatively affect almost all asset classes.

Municipal Bonds Alternative Municipal bonds are an alternative asset class that CPAs often recommend, due to their inherent tax advantage. A well-selected municipal bond offers not only a high degree of principal protection but also the potential for avoidance of all federal regular, federal alternative minimum, net investment income, and state and local taxes. CPAs can play a critical role in determining the exact after-tax return of particular bonds, assessing bonds' principal safety, and even obtaining multiple price offers for clients.

Obtaining pricing on a municipal bond after its issuance takes time and effort. The Electronic Municipal Market Access (EMMA; http://www.emma.msrb.org/) allows CPAs or investors to "compare trade prices of municipal securities with similar characteristics." EMMA is a service of the Municipal Securities Rulemaking Board (MSRB), a federally chartered selfregulatory body. Besides pricing, official information on individual municipal bond securities (such as offering documents and disclosure statements) that can aid in assessing quality is available on this website. An individual municipal bond's credit risk can even change during its term and thus should be periodically examined.

For investors in municipal bonds, safe strategies to mitigate risks include laddering bonds (bonds with varying maturity dates to reduce reinvestment interest rate risks), diversifying by investing in several states (at the cost of paying state and local income taxes), and concentrating on bonds with dedicated income streams, such as vehicle tolls. A general obligation bond backed by the full faith and credit of states' taxing authorities can offer a high degree of safety as well. In 2013, MSRB observed that there was $3.7 trillion in municipal securities comprising approximately 1.2 million securities. These bonds come with widely divergent degrees of principal safety.

The appeal of municipal bonds is indicated by their current yield advantage over treasuries. The Wall Street Journal reported that, as the end of July 2014,20-year municipals were yielding over 4% (based on the state and local bond buyer index of mixedquality debt obligations), whereas a 20-year Treasury was yielding 3%. Incorporating the tax advantage (which varies by the particular bond) only adds to the appeal of municipals. The value of municipal bonds and Treasuries will fluctuate during their terms, but they will pay off at par (assuming a default does not occur).

Other Alternative Investments While a Treasury note and stock index investment approach would be a simple and effective approach for many, investors can easily evaluate other investment options. Investors can potentially earn above equity market returns by investing in alternative investment classes, such as real estate or commodities. Furthermore, the incorporation of loss mitigation strategies, often with the aid of a financial advisor, can potentially enhance returns as well.

Further out on the risk-and-reward scale are products like hedge funds, leverage and inverse funds, emerging market securities, junk bonds, European debt issues, and even subprime mortgages. All come with material risks and costs. Investors should not forget that in 2008-2009, investments in hedge funds were not easily liquidated and that "auction rate securities" that were sold as safe investments proved to be anything but safe.

The key for CPAs is not to recommend a particular investment vehicle but to emphasize a complete analysis of a potential investment from its risk and return attributes. Prior to 2008, investors actively sought increased returns by investing in exotic and confusing investment products (e.g., structured mortgage products). Often these products came with hidden commissions, overstated credit ratings, and unstated risks. Better investment products become apparent based upon characteristics that are often not highlighted by the financial advisers pushing them, and this is even more likely when there is a commission component. Low-cost and simple equity products have proven themselves over time. Since its inception in 1976, for example, Vanguard 500 Index Fund Investor Shares have seen an average annualized return of over 10% in a highly taxefficient manner.

Preferential Characteristics of Equity Indexes Investing in equities generally has material tax advantages over taxable bonds and collectibles. Despite the 2013 increase in the top preferential dividend and long-term capital gains rate (to 20% for the top bracket), equities still receive highly favorable tax treatment. From 2003 to 2012, the maximum preferential dividend rate and long-term capital gains rate was 15% and the top tax rate was 35%. Even the NET of 3.8%, which took effect in 2013, does not fundamentally alter this equation, as it applies to most investment income (interest, dividends, short and long-term capital gains). It does mean that municipal bond income has more of a tax advantage because it generally avoids not only higher marginal tax rates but the new NET.

Furthermore, equity index funds are readily available with rock-bottom fee structures that have a material effect on investors' long-term performance. The Vanguard 500 Index Fund Admiral Shares (VFIAX), which requires a minimum investment of $10,000, has an annual expense ratio of only .05% ($50 for every $100,000 invested), which is significantly lower than most actively managed funds and even exchange traded funds (ETF). Actively managed funds typically can have annual fees in excess of 1% per year ($1,000 or more for every $100,000 invested). SPDR's S&P 500 (SPY), the largest ETF in term of asset value, currently has a net expense ratio of .0945% ($94.50 per $100,000).

The SEC advises investors that fees and expenses should be an important consideration and links to the Financial Industry Regulatory Authority (FINRA) fund analyzer (http: / / apps. finra.org/ fundanalyzer/1/fa.aspx), which compares the fees of over 18,000 mutual funds, ETFs, and exchange traded notes.

Basic Tenets of Investing The 2008-2009 financial crisis highlighted the need for investors to follow basic investment fundamentals. Essential cash holdings need governmental protection as only available from U.S. Treasury securities or FDIC-backed funds. Money market funds have not and do not offer this essential protection, as evidenced by the failure of the Reserve Primary Money Market Fund in 2008.

Investors who take a long-term approach to equity investing have made money over the periods studied before and after the 2008-2009 financial crisis. An investor with a diversified approach to equity investments, while suffering severe volatility during the crisis, is better off today for taking the risks, as reflected in the authors' analysis. Even investors who purchased and held a position in a high-quality, low-cost S&P 500 index fund at the end of 2007 (just before the crisis began) are better off today than if they had not made the investment. Furthermore, from an income perspective, while dividend income declined in certain years, overall dividend income has increased over time (see the sidebar).

Investors who panicked and sold equity positions at the height of the financial crisis committed a classic investment mistake. Those who remain underweighted in equities due to fears of the inevitable next crisis are in all likelihood committing a similar mistake. If investors focused on a simpler investment strategy grounded on U.S. Treasuries and a quality broad-based low-cost stock index fund, they would almost certainly be better off today than otherwise. Investing in alternative asset classes, such as real estate or commodities can potentially allow investors to outperform equity markets with an investing strategy that is thought out and implemented well. Investment advisors who aid clients in outperforming markets are worth the resultant costs, but they are a rare find.

The authors' analysis of cash/equity alternatives, focusing on the 2008/2009 financial crisis, shows that the best alternative would have been to invest completely in equities. Nevertheless, the pragmatic choice would be to invest in a mixture of equities and U.S. government-secured cash reserves. Other asset classes, such as municipal securities, individual stocks, or real estate investment trusts, can easily be evaluated within the framework of a stock index and Treasury investment paradigm. A CPA is in an ideal position to guide individual investors to appropriate asset allocations and investment classes with better underlying investment and tax attributes without making specific fund or company recommendations. ? By William M. VanDenburgh and Philip J. Harmelink William M. VanDenburgh, PhD, is an assistant professor of accounting at the College of Charleston, Charleston, S.C. ([email protected]. Philip J. Harmelink, PhD, CPA, is the Ernst & Young Professor of Accounting at the University of New Orleans, New Orleans, La. ([email protected]).

(c) 2014 New York State Society of Certified Public Accountants

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