Michael

Since you are with TD Ameritrade, you'll probably want to sign up for their commission free ETFs. About half of commission free ETFs are Vanguard ETFs and most of the others are iShare ETFs. Morningstar picked the ETFs for TD Ameritrade and they did a pretty good job. Vanguard ETFs have the lowest expense ratios of any on the market and iShares also has a reasonably good expense ratio. I noticed that the S&P500 tracking index that they chose was iShare's IVV instead of Vanguard's VOO but realize that Morningstar chose IVV over VOO since IVV is a high volume ETF and VOO is a low volume ETF and the expense ratio difference is only 0.02% (0.07% instead of 0.05%) or $7 per $10,000 per year instead of $5 per $10,000 per year. Many of the other Vanguard ETFs weren't picked because they either didn't have a track record or performed poorly in the past.

The only restriction is that you can't sell a commission free ETF in less than 30 days for it to be commission free.

You can enroll in commission free ETFs by going to "Client Services->My Profile->General->Commission-Free ETFs". If you have multiple brokerage accounts (taxable, IRA, etc.), you must sign up in each account to get the commission free ETFs for that account.

TD Ameritrade Commission-Free ETFs

Since many mutual funds have expense ratios of 1% or more, anything below 0.5% is reasonably good and anything at or below 0.10% is very good. Also for mutual funds, the expense ratios don't indicate the full cost since often they will have about 4% in cash so you are paying an expense on something that you aren't making money on, there may be trading fees when people redeem or buy the mutual funds, there may be unexpected tax consequences, you may pay a premium to buy or sell at a discount since the stocks in the mutual fund are bought and sold at the end of the day, and typically you have to hold them for at least 6 months to be no transaction fee and if not, the transaction fee is about 5x the commission of an ETF. ETFs don't have most of those issues since they are traded and not redeemed. There are two exceptions where a commission free ETF can be charged a commission if not held for 30 days and the other is a very slight possibility of unexpected tax consequences but the amount would be very small if it ever happened.

Since ETFs are not actively managed, they just follow a defined index. Indexes can be defined by any company and don't change unless they get out of balance (one stock carries too much weight in the index, companies get delisted, the company no longer fits into the criteria of the index, or a new company must become part of the index). For example the S&P500 index is supposed to be the 500 largest stocks in the US but that is not 100% correct. It's probably 500 of about the 750 largest companies with the vast majority in the 1st 500 so the index is flexible and doesn't have to change unless the size of a company falls too far, a company such as Apple grows so quickly that it becomes too big carries too much weight in the index, or a company such as Netflix becomes so large, it has to be added to the index knocking some other company out of the index.

When an index is rebalanced, you won't know except possibly for the major indexes (DOW, S&P500, and NASDAQ 100) since that is news. The rebalancing of the index is what can possibly cause unexpected tax consequences but when the ETF is rebalanced to follow the index, many of the stocks sold are losers which offsets the gainers that have to be sold to reduce stock's weight. Another thing can be done by the manager of the ETF to make sure there isn't any capital gains internal to the ETF which is what can create the unexpected tax consequences. Therefore if you see capital gains on your year end 1099 from the brokerage and you own mutual funds or ETFs, that is caused by internal gains within the fund but you should have had a distribution earlier in the year for those gains and the mutual fund NAV or the price of the ETF was reduced on the date of the distribution.

S&P 500 Index Component Weights - SlickCharts.com

MMcD

And what about Fidelity?

What's your advice with regard to ETFs if one only has a Fidelity Account?

Michael

Fidelity also has commission free ETFs. They are mostly iShares ETFs but there are also 10 Fidelity sector ETFs that are commission free.

Fidelity's iShares Commission Free ETFs

Fidelity Commission Free Sector ETFs

Free commission offer applies to online purchases of 65 iShares® ETFs and Fidelity ETFs in a Fidelity brokerage account with a minimum opening balance of $2,500. The sale of ETFs are subject to an activity assessment fee (of between $0.01 to $0.03 per $1000 of principal) by Fidelity. After September 30, 2013, 65 iShares ETFS are subject to a short-term trading fee by Fidelity, if held less than 30 days. After January 31, 2014, Fidelity ETFs are subject to a short-term trading fee by Fidelity, if held less than 30 days.

The list isn't as informative as TD Ameritrade's commission free ETFs but you can click on a ETF symbol and when the new screen appears, scroll to the bottom of the page and the very last entry is the expense ratio.

Some brokerages are like TD Ameritrade and you have to enroll in the commission free ETFs to get them commission free but others are commission free whenever your trade them and don't require an enrollment.

Since about 70% of domestic mutual funds underperform the S&P500, I'd recommend that the average investor have a S&P500 tracking ETF as part of their portfolio. In the case of Fidelity and TD Ameritrade, the commission free iShares IVV ETF tracks the S&P500. If you want to also track European equities, the S&P Europe 350 Index (IEV) is probably pretty decent except it's expense ratio is pretty high at 0.60%. TD Ameritrade has Vanguard's VGK to track European equities at a 0.12% expense ratio.

Michael

Taxes on Dividends

Dividends for domestic common shares and ETFs that track domestic common shares are taxed at a maximum rate of 15% (20% if total income is over about $450,000) if held for at least 62 days since all US common share dividends are qualified. Dividends from preferred shares may also be qualified and will be taxed at the lower rates but investors have to be selective when selecting preferred shares since some will have dividends taxed as normal income.

Income from bonds or bond ETFs are "interest" and therefore are taxed as normal income.

Some foreign common shares are qualified and other are not. It is very difficult if not impossible to tell if a foreign common share is qualified or not.

Vanguard gives out that information for all their mutual funds and ETFs. Click on the "ETFs" tab for that information.

Vanguard Qualified Dividend Percentages

iShares also gives a year end report for the percentage of qualified dividends paid for each of their ETFs.

iShares Qualified Dividend Percentages

If you are holding the ETF in a tax free account (IRA, 401K, etc.), it doesn't matter whether the dividends are qualified are not since taxes aren't due until distribution and if distributions are taxable, they are taxed as normal income.

When purchasing a foreign equity, sometimes dividends are taxed in the foreign country. If the equity is in a taxable account, it probably isn't big deal since you get to use those tax credits to offset taxes owed in the US but if the equity is held in a tax free account (IRA, 401K, etc.), that is just lost money since those accounts are not taxable until distributed and you can't use foreign taxes paid as tax credits.

For example, Royal Dutch Shell is listed on the NYSE as an ADR (American Depository Receipt) and is sold under two different symbols (RDS.A and RDS.B). RDS.A is an ADR that bundles Royal Dutch Shell shares from the Netherlands so they can be sold on the American market but the Netherlands withholds taxes on dividends. RDS.B shares are issued out of London and the UK does not withhold taxes on dividends.

If you hold an ETF with RDS.A or the actual shares that are traded in the Netherlands, taxes will be withheld on dividends by the Dutch government but if the ETF hold RDS.B or the actual shares traded on the FTSE, no taxes will be withheld on dividends.

Unfortunately I can't find any information concerning the percentage withheld for taxes on dividends for foreign Vanguard or iShares ETFs.

The above links may help you decide whether you may want to purchase certain foreign ETFs or not.

Michael

Morningstar

The Morningstar web site has more information about equities than any other web site but is primarily geared towards mutual funds and ETFs.

Fees

There is a Expenses tab for mutual funds and Fees & Expenses tab for ETFs.

PACLX T. Rowe Price Capital Appreciation Adv Expense

IVV iShares Core S&P 500 Expenses

The first link is for the PCALX mutual fund at it indicates there are no initial or redemption fees for this fund. Some mutual funds have an initial fee which is commonly referred to a "Front Load" fee and some may have a redemption fee (may be applicable only if sold before a specific holding period). Commonly a front load fee is about 5% of your investment and is commonly used to pay financial planners that directs investors to that fund. A redemption fee is commonly used to dissuade investors from selling the fund typically for 2-3 years.

The net expense ratio which is 1.02% which is above the fund category of 0.95%. Included in the net expense ratio is a 12b-1 fee of 0.25% which is fee to pay for advertising the fund.

For the iShares Core S&P 500 (IVV) ETF, the net expense ratio is 0.07% which is far below the category average of 0.34%.

Tax Cost Ratio

Tax cost ratio is a calculation by Morningstar that determines the effect of taxes caused by distributions made by the fund. The distributions could be dividends and/or capital gains assuming the investor was in the top marginal tax bracket.

Morningstar's Tax Cost Ratio Explained

Although the above article doesn't specifically indicate it, I believe the calculation also includes average state income taxes at the highest marginal tax bracket in the calculation.

The Tax tab gives the investor that information.

T. Rowe Price Capital Appreciation Adv (PACLX) Fund Tax Analysis

iShares Core S&P 500 (IVV) Fund Tax Analysis

We can see that PACLX mutual fund reduced the return by 1.82% last year due to taxes but the IVV ETF only reduced the return by 0.45%.

It appears that IVV reduced the return by 0.45% since there was a dividend distribution of 1.80% and that would be a maximum effective tax rate (federal and state) of 25%. There wasn't any long or short term capital gains distribution for IVV as can be seen in the following link.

iShares Core S&P 500 (IVV) Distribution

For the PACLX mutual fund, the dividends were only 0.81% so of the reduced return of 1.82%, taxes on dividends probably played a very small role of less than 0.20% and the majority of the reduction were probably caused by capital gains distributions. For mutual funds, there doesn't appear to be a tab for distributions so it is not possible to determine how the tax liability occurred.

Potential Capital Gain Exposure

In the expenses tab is a percentage for Potential Capital Gains exposure and for PACLX it is 21.1% and for IVV it is 12.08%.

Capital Gains Exposure (CGE) Definition | Investopedia

A mutual fund or ETF is treated as if the investor was making the trades and tax liabilities would occur if gains occurred during the year for those trades. Unfortunately if you are holding the mutual fund or ETF at the end of the year when gains are distributed, you get the tax bill even though the gains may have occurred over a 10 year period and you only owned the fund for 1 year. Therefore with a high potential capital gains exposure (especially in a mutual fund), you could get hit with a very high tax bill if the fund manager decides to sell off the winners.

Confusion

Now that I thought I had it all figured out, I compared the ETF IVV to the ETF VOO. Both track the S&P500 index so both should show similar tax cost ratios but that is not the case.

iShares Core S&P 500 (IVV) Fund Tax Analysis

Vanguard S&P 500 ETF (VOO) Fund Tax Analysis

Last years total return for IVV was 24.53% and for VOO the return was 24.56% which is very close. However the tax cost ratio was 0.45% for IVV and 0.84% for VOO. To try to determine why, I looked at the distributions and discovered that neither had any capital gains distributions for 2013 and VOO had slightly less dividend distributions than IVV not only for 2013 but all previous years. Therefore the only assumption I can make is that even though both track the S&P500, they are weighted differently so that VOO will give slightly more capital gains and IVV will give slightly more dividends which seems to be the case since their total return is almost identical.

iShares Core S&P 500 (IVV) Distribution

Vanguard S&P 500 ETF (VOO) Distribution

However I cannot figure out why VVO is nearly 1/2 as tax efficient as IVV.

Another thing you'll notice is that VOO has a very high Potential Capital Gains Exposure of 37.98%.

Why Morningstar Picked IVV or VOO for TD Ameritrade

It is now clearer why IVV is superior to VOO and was picked by Morningstar for TD Ameritrade commission free ETFs. IVV has over 3x the daily volume, has a Tax Cost Ratio of nearly half, and has a potential capital gains exposure that is about 1/3rd of VOO. If you were trading in a tax free account, only the volume would make a difference.

Comparing Performance on Charts

When comparing performance on a chart, VOO should probably slightly outperform IVV since dividends aren't included in the chart. However the amount is so small, the charts don't show a difference. The charts are after fees and before taxes. Most often the fees are taken from the dividends (reported dividends for an ETF or mutual fund are usually different than the received dividends by the fund) so the charts usually don't include fees unless the fees exceed the dividends paid.

Chart Comparing VOO to IVV

Michael

Mutual Fund Performance

As I stated earlier, at least 70% of domestic stock mutual funds underperform the S&P500. One of the few mutual funds that significantly outperformed the S&P500 was the Fidelity Magellan fund in the late 1970s. In 1977. Peter Lynch took over management of that fund and started outperforming the S&P500 so Fidelity charged a 5% front load fee as well as a redemption fee. During the time Lynch managed the fund, he purchased Fannie Mae, Ford, Philip Morris, MCI, Volvo, General Electric, General Public Utilities, Sallie Mae, Kemper, and Lowe's.

All of those companies were good performers at the time but since that time Fannie Mae and MCI have gone bankrupt and Volvo keeps changing hands as automobile companies don't know what to do with that brand.

From 1977 until 1990, the Magellan fund averaged a 29.2% return and as of 2003 had the best 20-year return of any mutual fund ever. Lynch was described as "legendary" by Jason Zweig in his 2003 update of "The Intelligent Investor".

However if you look at a comparison of Fidelity Magellan (FMAGX) and the S&P500 from 1977 to 2014, FMAGX has significantly underperformed the S&P500.

Chart Comparison Between FMGAX and S&P500 1977-2014

I'm not sure how Peter Lynch could be considered "legendary" since if we move the starting date 4 years forward to 1981, FMAGX started to underperform the S&P500 and became worst as the years passed. So unless an investor purchased the fund between 1977 and 1981 and got out in 1981, the fund would constantly underperform the S&P500.

Chart Comparison Between FMGAX and S&P500 1981-2014

Vanguard

Vanguard initially only sold mutual funds direct to investors with low expense ratios and no transaction fees. Eventually you could purchase Vanguard mutual funds through brokerages but there was always a transaction fee (now about $50) since Vanguard wouldn't pay the brokerages to handle dividends or other administrative tasks. In 1976, Vanguard introduced the first indexed mutual fund based on S&P500 companies called the Vanguard 500. Well after the introduction of ETFs in 1993, Vanguard became a full service brokerage in 2001 and introduced it's first ETF.

Oldest Exchange-Traded Funds (ETFs)

Although Vanguard is currently a full service brokerage, it is very vanilla much like Capital One's Sharebuillder. Sharebuilder doesn't have Level II quotes, it may take a long time (possibly years or never) for preferred shares to be listed for trading, and is much less sophisticated when trading securities (doesn't have any of the "Tax Lot ID Methods" when selling securities to save on taxes) and for me that is not good.

List of Vanguard's Domestic Stock ETFs

List of Vanguard's Domestic Stock Mutual Funds

You'll notice that all their domestic stock ETFs have an expense ratio of less than 0.12% but only the Admiral mutual funds has an expense ratio of less than 0.12%. All of the Admiral mutual funds are index tracking funds and most have an equivalent ETF such as the mutual fund VFIAX is the same as the ETF VOO and the mutual fund VLCAX is the same as the VTI ETF. Looking at the following charts, it is obvious that they are the same. For VFIAX, it appears that the mutual fund is not holding cash reserves since it tracks exactly the same as VOO but VLACX may be holding cash reserves since it tracks slight below VTI. Many mutual funds hold cash reserves so that the fund manager doesn't have to trade everyday as purchases and/or redemptions occur.

Chart Comparing VOO to VFIAX

Chart Comparing VTI to VLCAX

Both the Vanguard mutual funds and Vanguard ETFs are commission free when purchased through the Vanguard brokerage. Besides all the other restrictions for mutual funds, the Admiral funds are required to maintain a minimum investment of $10,000 where as only one ETF share can be bought and sold. Therefore I'm not sure there is any advantage in holding Admiral funds instead of it's equivalent ETF since the expense ratio is the same.

Vanguard would probably rather have investors purchase the ETFs instead of the Admiral mutual funds since it is cheaper to manage ETFs than index tracking mutual funds. Vanguard apparently doesn't pass on the cost of commissions for stock purchases and sells to the investors in mutual funds since the stock shares are all bought and sold through the Vanguard brokerage.

Michael

More About AMBS

I'm not sure why AMBS did it, but on August 31, 2010, they did a 25:1 stock split which likely made it a penny stock. Normally companies do a stock split because they want the price of their shares to be in the range of $20-$100 per share since US investors seem to prefer stock prices in that range. An example is Apple which recently did a 7:1 stock split moving the price of it's shares from about $500 per share to about $72 per share with each shareholder exchanging each share they owned for 7 new shares.

Since there is a bug in BE that won't allow me to post the link to the "splits" screen, click on the following link, click on "Events", and the click on "Splits" and a $ sign will appear at the bottom of the chart. If you hover over the $ sign, it will indicate that there was a 25:1 stock split on August 31, 2010.

AMBS - Stock chart - MSN Money

I suspect that the IPO originally floated about 10 million shares @ $10 per share with the founders and investors holding about 9 million shares and 1 million shares were floated to the public which raised about $10 million for the company. I suspect by August 2010, the company was out of cash and needed to raise some capital. Companies can raise capital through the bond market but with no sales and only losses, it is highly unlikely that the company could float bonds. Another way is to issue more shares but again with no sales and only losses, there likely wouldn't be very many buyers. I suspect this split was used to satisfy speculators that would purchase warrants to raise the capital. The purchase of warrants probably occurred several times since 2010 and occurred most recently in February 2014.

A warrant is similar to a stock option but instead of it being a side bet among speculators, it is a bet against the company. Like an option, the speculator buys a warrant for less than the price of a share of stock and has a strike price where the speculator can demand common shares for his warrants. The primary difference between a warrant and an option is the bet is against the company, often there isn't an expiration date, and therefore any time the strike price is hit, the speculator can demand common shares for the warrants. It's a great way for a company to raise capital but if the strike price is hit and speculators demand common shares, the company has to exchange the warrants for common shares.

So how did 10 million shares outstanding turn into 732 million shares? First the stock split increase the outstanding shares to 250 million. Then as warrants were exchanged for common shares over the years, the company had to print more shares. In the February 2014 offering, 80 million warrants were issued to raise about $3-5 million but if the strike price is hit, another about 80 million shares may be added to the 732 million shares outstanding. Since the share price is at $0.17 today, the 80 million warrants were probably already exchanged and dumped on the market. The following is an article putting a good face on the February offering.

New Cash To Help Drive Amarantus Pipeline - Amarantus Bioscience Holdings, Inc. (OTCMKTS:AMBS) | Seeking Alpha

The above link will only allow you to read part of the offering unless you register so to summarize, 80 million warrants were sold at $0.04 per warrant and if the common share price hits $0.12 per share, the warrants could be exchanged. I originally stated that penny stocks can't be shorted but that's not 100% true. Major brokerages won't allow investors to short penny stocks but some other brokerages will.

Total potential proceeds resulting from the exercise of the new warrants equal $4.5 million. Additionally, participants in the warrant exchange agreed to a "no shorting" provision. It's a common practice for hedge funds that participate in private placements to immediately flip the shares and then short the stock, using the warrants as upside protection.

When looking at the stock chart, you don't see the big drop in stock price when the split occurred since the chart is adjusted downward for the split just like you won't see a price on Apple's charts above $100.

If the company gets lucky and produces a product that generates revenue, then the share price could skyrocket but after a while speculators get tired of playing the game and no more money becomes available as the shares become more and more diluted. Since someone can purchase 100,000 or even a million shares of a penny stock, there is a lot of manipulation of the penny stock market. Sometimes speculators sell shares to themselves in another account to cause the price to rise. For example it may be possible for a speculator with a high frequency trading paltform to put an "all or none" ask and an "all or none" bid at the same price and time for 100,000 shares and the speculator can move the market in a specific direction by 10% for the cost of the commission but nobody knows exactly what manipulations are actually happening.

The Art of Trading Penny Stocks - Investment U

What to Avoid

First, avoid any stock trading under $1 dollar that doesn’t have sales and isn’t listed on a major exchange. Over-the-counter stocks, or what some call pink sheets, can put you into a liquidity trap where you can’t get in or out of a stock due to extremely low trading volume. Stick to the major exchanges and make sure there’s adequate volume on the stock. And beware, there are a lot of promoters out there who get paid to recommend extremely risky penny stocks, and you don’t want to get caught up in the hype. Stay away from these stocks, they aren’t worth your time.

Second, if there’s little or no data about a stock listed on yahoofinance.com or googlefinance.com stop right there, go no further and avoid this stock.

Orangepants

This all great information Michael thank you. I'll need time to take it on board!

Another stock I have been watching is ACRX - they expected to get FDA approval on Friday for Zalviso - a pain management drug device. But they didn't get approval so the stock has dropped about 35% this morning. FDA haven't requested new trials just more info implying that approval may be just held up for a year or so. All the analysts are Sell or Reduce. I want to buy!

Surely this is a good time to buy as it is undervalued?

MMcD

The stock or the device?
You may need the latter if you buy and you're wrong

Then you're up s***'s creek cause no FDA approval for device = no pain relief for you!

Michael

When talking about stocks and someone refers to "value", they are referring to the fact that the stock has a low p/e ratio (price to earnings ratio) or forward p/e ratio (expected p/e ratio for this year if the stock remains at the current price). Other factors also affect value such as growth. Therefore if a company has a forward p/e ratio of 8, the expected earnings per share of stock will be about 12.5%. Amazon has very little "value" with a current p/e of about 500 and a forward p/e of about 70 but has a lot of assets, sales, good growth, and a great concept so it may have a lot of "potential" but unless it can get the p/e to reasonable levels, it won't create that "value" that will keep the company healthy over the long run.

As far as ACRX, it's moves in share price are probably due to the well know phrase of "buy on rumor, sell on news" and the speculator probably bought as soon as he heard the rumor and sold "before" the news came out but the average investor probably also bought on rumor but probably well after the rumor so paid a high price for the stock and held it through the news and got burnt. The rumor was that they "discovered a drug that they are going to try to get FDA approval" and the news was that "they didn't get FDA approval".

To know if there is "potential" with ACRX, I'd have to believe that the drug will eventually get approved, believe their business plan is sound, and really understand the financials of the company and ability to raise capital. This is way over my head so I don't play the stock market primarily based on "potential" but primarily based on "value". By playing the market for "value", I miss out on the Amazons, Netflixes, and other companies that have had their share prices soar but I also missed out on most of the companies that disappeared into obscurity. Even if the drug is approved and the stock price rises, it's anybody's guess as to whether that drug will lead the company to being another Pfizer (very long shot) or disappear into obscurity (much more probable) since it is still a long haul from approval to making the company profitable.

You have to look at the stock market as a game and if you want an intense game, you play the role of a speculator but you have to have a knack to know when to buy and when to sell and constantly watch trends. As a value player, you are not going to make the very big gains but you can possibly beat the market.

As an example, in September of 2011 I thought there was a lot of value in Home Depot at $29 per share plus potential so I bought some and my return is about 190% but that is not normal since most of my stock picks have performed similar to or slightly better than the market.

My portfolio consists of about 40% preferred shares, 30% common stocks, and 30% ETFs. For me, that appears to be a good balance but I wouldn't necessarily recommend that for anyone else.

The assumption that the market will always rise over the long term is not an "absolute". Probably the best example is the Japanese market (Nikkei 225) which hit a high in 1990 of about 39,000 and is currently at about 15,000 but has the least value of any developed market at a p/e of about 35.

Japan's Nikkei 225

The Japanese market has been so bad over the past 25 years that most mutual funds that invest in Asia will indicate "excluding Japan". Although there has been recent changes in monetary policy in Japan that has caused the Japanese market to rise from about 10,000 to 15,000, in my opinion, it is a "bear trap" and will probably hit new lows in the future since there are major structural problems in the Japanese economy that hasn't been attempted to be fixed.

Believe or not, another problem child is the current Chinese market.

Shanghai Composite Index

Even though the p/e for the Shanghai Composite Index is good and China is still growing at about 7% annually, there is over production, competition from other countries, and the economy is based on exports. Unless China becomes more of a consumer oriented market, the problems will likely persist.

The best performing markets over the past 7 years have been the US and German markets. Most other markets have yet to return to their 2007 highs. The UK market has performed better than other European markets (except the German market) and recently passed it's 2007 high. It's not that the European markets don't have value (they have more value than the US market) but lack of growth has hampered stock prices from rising.

Michael

Preferred Shares

As I stated earlier, I play the preferred share market directly and not through an ETF. I want a certain portion of my portfolio in fixed income securities and believe that playing the preferred share market is the best option for me. Preferred shares may not be a good option for others but for me, I think I understand them and their potential risk.

Disadvantages of the Bond Market

• Income from bonds are taxed at normal income.
• Picking individual bonds is very complex with hundreds of thousands on the market.
• In my opinion, high yield bonds are more risky than preferred shares.
• If playing the bond market through an ETF, fees are paid and unexpected capital gains may occur.
• The return on bonds compared to preferred shares is normally lower.

Preferred shares are primarily issued by utilities, banks, and REITS. I don't care for utilities since even though they pay a reasonably high dividend, common shares for utilities also pay a reasonably high dividend but preferred shares lack the higher potential of capital gains of common shares. I don't trust REITS so I don't invest in those. I don't trust small banks so I don't invest in those. So the only thing left is large banks which is what I invest in.

Large bank preferred shares pay a high dividend which can be either be qualified and taxed at the long term capital gains rate or non qualified and taxed as normal income. If I played the preferred share market through an ETF, they generally play a mixture of all of the above. They may yield 6.5% on dividends but with management fees and tax implications, my after tax return may only possibly be 4%. By playing the market myself, I can guarantee that the dividends are taxed at the long term capital gains rate, don't have the management fees, and in my opinion the risk is lower.

For bonds, interest must be paid but for preferred shares a company can stop paying dividends for up to 2 years and if the company goes bankrupt, bonds take precedence over preferred shares for repayment so therefore at first glance, it appears that bonds are safer than preferred shares. However for a company to pay 7% coupon on a 30 bond, the financials of the company would probably be pretty bad and if the company files for bankruptcy, the bond will likely be useless since liabilities exceed assets. On the other hand, a large stable bank like JP Morgan, Wells Fargo, Barclays, or HSBC are unlikely to default on preferred shares but may still pay a coupon of 7%.

The following are the main reasons that banks like to issue preferred shares.

• Most preferred share are an equity instrument and bonds are a debt instrument.
• They are an equity instrument since the bank doesn't ever have to call the preferred shares at par value but only has to continue to pay the coupon.
• Since it is an equity instrument, the preferred shares can be used as capital requirements for the bank.
• Preferred shares can be called typically any time after 5 years of issue for par value.

Convertible preferred shares have different rules and it is possible that the bank could never be able to call the preferred shares.

One of the reasons that preferred share are rated lower than bonds from the same bank since the bond payments will be made unless the bank becomes insolvent but dividends on preferred shares can be suspended for a period of time. However during the financial crisis, of the major banks, only RBS and Citigroup suspended dividend payments for preferred shares. Also if the bank goes into insolvency, there is a slim chance that bond holders will get back some of their investment (maybe 20 cents on the dollar) but preferred shares will be useless just like the common stock. For a bank to suspend dividend payments for preferred shares it must first eliminate dividends for common shares. Large bank preferred shares are typically rated at the bottom of investment grade (BBB) or at the top of junk status (BB) but if the same philosophy was used to rate common shares, most would be rated as junk status since dividends could be stopped or reduced for any reason and if the company becomes insolvent, common shares are useless.

Probably the biggest risk of preferred shares is that the market value can move up and down just like common stocks and bonds. For preferred shares and bonds, the market value is more based on treasury rates than common shares but preferred shares are not tightly tied to 30 year treasury rates. Today a 6.3% coupon large bank preferred share may be trading at par value but if 30 year treasury bonds rises to 4%-5%, what effect will that rise have on the market value of the preferred shares? In my opinion, that is the biggest risk.

Probably the safest preferred shares I have are Barclay's BCS-D (coupon 8.125%) and BCS-C (coupon 7.75%). For the past several years, they were trading well above the par value of $25 since they were paying a very high dividend and they were in the period that they couldn't be called. But last year, that period called ended and the speculators thought that Barclays would call those preferred shares and drove the price down to about par value. When I saw the price, I thought I'd take the risk since the worst thing that could happen is I lost the $9.99 commission to buy the shares but even that wouldn't occur since there is one more quarterly dividend payment except for possibly a two week window and when I purchased those shares, I wasn't in that window. A year later, Barclays still hasn't called either BCS-D or BCS-C. If interest rates raise, an 8% qualified dividend will still be pretty good and unless interest rates climb very high, the market value will not likely drop below par value. If Barclays calls the shares, I still made 8% for the year but they are currently trading at about $26 per share so I will lose that $1 per share capital gain (actually only about $0.50 per share since one more quarterly dividend of about $0.50 per share will be paid).

I hold quite a few preferred shares that were purchased quite a while ago that were purchased below par value yielding 7% or more. Now they've risen above par value so the average yield is about 6.4% on dividends.

Recently JP Morgan had a new preferred share issue JPM-B that has a par value of $25, a coupon of 6.70%, and can't be called until 2019. It originally sold for less than $25 per share and by the time I realize that a new issue was on the market, it was $25 but I bought it since it was paying 6.70% and assumed that speculators would push the price up so that the yield would be below the current average yield of about 6.3% since it couldn't be called until 2019 and JP Morgan is a very strong bank financially. However I was a little surprised since the share price only very slowly moved up but is now $26.14 with a yield of $6.41%. I suspect the price will eventually hit about $27 per share. From that experience, I discovered that speculators don't jump into the market just because the preferred shares are undervalued but jump in primarily when they see movement in the price. As an example, Deutsche Bank's DXB with a coupon of 6.55% keep constantly being pushed up in price (currently $26.29) and the shares will almost certainly be called by 2016 even though information about DXB indicates it can't be called until 2017. There is a question mark following the date and that indicates it can be called due to the Dodd/Frank financial reform which made that particular issue no longer an equity instrument but is phasing to 100% debt instrument by 2016.

Therefore I closely watch the Federal Reserve, the economy, job creation, and many other indicators that can give me an idea whether interest rates will be rising and hopefully predict the right point to sell. However if I sell, I'm not sure what I'd do with the money since the only thing left is common shares and less than 1% interest rates in money market accounts. So therefore if I do sell, I need someplace to park the money until I feel comfortable getting back into preferred shares. However even if I don't get it right and the preferred shares drop 15%, in about 2 1/2 years I'll be back to even due to dividends. The risk is better than keeping the money in a money market account earning less than 1% or 30 year treasuries ay 3.25% that would take about 5 years to recover a 15% drop.

The following is a list of all the preferred shares. If you are interested, you have to register to use the income tables but once you register, click on "Preferreds eligible for the 15% Tax Rate" and you'll get about 10 pages of preferred shares. You can look for large bank names and then click on the symbol to get more information. To see the current yield, select "Click for MW ExDiv Date".

QuantumOnline.com Home Page

Michael

Disadvantage of Owning Common Stocks

Initially you may be able to pick stocks that outperform the market but eventually most stocks plateau. When they plateau, you could sell them and pay the long term capital gains and pick another stock that has value and potential. By selling a stock and reinvesting, you're investment is smaller because of the taxes paid so the new stock has to perform better than the old stock for you to come out ahead.

If you are trading in a tax free account, there isn't any problem and when you spot the plateau trend, you can sell the security and purchase a security that you think will perform better.

I use the MSN Money portfolio manager to track my portfolio since it is very clean, you can enter commissions, and you can enter dividends (most others don't track dividends) so I can compare securities on a "Total ROI" (Total Return on Investment) and "Annualize Returns". Also when you sell securities, you can change the portfolio settings to show all securities including securities that you sold.

You need a msn live or Hotmail account to use the portfolio manager. You can select the portfolio manager from this link.

Stock quotes, investing & personal finance, news - MSN Money

Whenever a security goes ex-dividend, the amount of the dividend is subtracted from the price of the share in the wee hours of the morning before the ex-dividend date and when the stock opens, it will show no loss since if you own the stock on the opening bell of the ex-dividend date, you will get the dividend on the dividend pay date. Therefore if a stock closed at $23 per share on the day before the ex-dividend date, a $0.25 quarterly dividend was indicated, and the stock opened at $22.75, the stock would indicate no loss or gain. All the information about dividends including past history can be acquired from the following link.

Dividend | Dividends | Dividend Stocks | Preferred stock | Best Dividend Paying Stocks

Normally I try to enter the dividends in the portfolio on the ex-dividend date instead of the dividend pay date since it reflects a more accurate representation of the "Total ROI" and "Annualize Returns" (I have a lot of time on my hands).

Since dividends can have a significant impact on the "Total ROI" and "Annualize Return" of a security, without them it is hard to get an accurate picture of how well your securities are performing. Dividends will normally be very significant portion of your total returns during a relatively flat market but even with the very strong bull market of the past several years, dividens accounted for over 15% of my returns for the DIA ETF (DOW tracking ETF) and for stocks such as Verizon, significantly more.

Since I have an accurate picture of how my securities are performing, I can make decisions. I have several examples where securities have plateaued in my taxable account but I didn't sell because I didn't want the tax burden. I bought Dupont and it shot up about 60% in 9 months but then it pulled back and plateaued. I bought Home Depot and it went up 170% in two years and plateaued. I bought Verizon and it rose 60% in two years and plateaued. I bought Pfizer which has been a very good performer but I'd like to get rid of it. I bought Chevron which has been a good performer but I'd like to get rid of it.

In my tax free account, I sold the stocks that I wanted to sell when I wanted to sell them.

With a good ETF such as the core S&P500 ETF, the problem is handled automatically for you. As a stock price plateaus and others continue to rise, the stocks that plateau start carrying less weight in the index and the rising stocks carry more weight.

I have a more complex issue with taxes than many people. I have social security, a small pension, and dividends from my securities. Since all my dividends are qualified, I don't pay any income tax on the dividends until I hit the 25% marginal tax bracket and then I'll pay 15% tax on any dividends in the 25% marginal tax bracket. A 15% tax rate isn't a big deal if I sell securities and get taxed at 15% long term capital gains rate. However the amount of social security that is taxable income is a complex formula and in my case with social security, a small pension, and qualified dividends, only about 15% of my social security benefits are taxable income and the combination of the taxable portion of social security, the pension, and other income that is taxable as normal income, normally I'm at or near the standard deduction and my qualified dividends are mostly tax free because I may not hit or just hit the 25% marginal tax bracket.

So everything is very nice since I have a decent income but pay little income taxes. If I add about another $5,000 of qualified dividends or long term capital gains to my income, I'll get taxed at about 15% which is fine but once I exceed that threshold, all kinds of strange things happen and I can get taxed at up to a 45% effective tax rate on income over that. The reason that the effective tax rate can get that high is that for each $1 of qualified dividends or capital gains above the threshold causes $0.85 more of social security benefits to be taxed which pushes $0.85 of my qualified dividends or long term capital gains which were previously not taxed into the 25% marginal tax bracket which will be taxed at 15%. This process will continue until 85% of my social benefits are taxable income and then the tax rate will drop back down.

This year I have a lot of deductions (major dental work, etc.) and will make sure that the deductions occur (pay both portions of my property taxes this year, new hearing aids, new glasses, empty my closets and donate everything, etc.) in this year and this will allow me to sell my preferred shares (about 10% long term gains on the average preferred share) and then buy them back without hitting that threshold. That will put my preferred shares in a place that will allow me to sell them whenever I want to without incurring any significant tax.

At one time I did hold international ETFs. I held FEZ (one of the commission free ETF at TD Ameritrade) which tracks the Euro STOXX50 index which is the Euro equivalent of the DOW and DWX a large cap international dividend ETF. However when the DOW had a total ROI of about 60% and FEZ had a total ROI of 22% with half in dividends and DWX had a total ROI of 12% with more than 100% in dividends (capital loss on the sell) and I was getting hit with non qualified dividends, I decided to sell them. A tracking ETF that tracks the Euro STOXX600 index which is similar to the S&P500 for the euro zone would have performed a little better than STOXX50 but I don't know of any ETF that tracks that index except on the German DAX exchange.

Michael

Dow Jones Industrial Average (DJIA or the DOW)

The Dow Jones Industrial Average is one of the oldest stock indexs in the world dating back to the end of the 19th century. It was started as a way to determine what the overall market was doing but since all calculations had to be done by hand, it is a very simple index to calculate. Originally there were 12 companies in the index and the calculations were very simple by just adding the price of one share for each stock in the index together to get the index number. Over the years the index grew to 30 stocks, stocks were dropped and others added, and splits occurred. To keep the index so that it didn't change when changes were made to stocks that comprised the index, a divisor was added so every time a change is made within the index, the divisor changes. Currently the way the DOW is calculated is by adding the price of one share for each stock in the index together as originally was done and then divide by the divisor. The current divisor is 0.15571590501117 which means that each one point change in any stock in the DOW results in about a 6.42 point change in the index.

The S&P500 is a modern index started in 1957 which requires calculators to calculate (each stock in the index has a weight multiplier). As antiquated as the DOW index is and only tracks 30 stocks compared to 500 for the S&P500, it tracks the S&P500 very closely in total returns. The DOW will usually underperform the S&P500 during a bull market but performs better during a bear market and generally pays higher dividends.

Higher priced stock have more weight in the DOW than lower priced stocks. IBM is the highest priced stock in the DOW at about $200 per share and carries about 7.5x the weight as GE which is a larger company. A 5% move in IBM will cause IBM to increase or decrease in price by about 10 points which will cause a change in the DOW of about 64 points but a 5% change in GE only causes GE to increase or decrease in price by 1.3 points which will cause a change in the DOW of about 8 points. The management of the index would probably like to see IBM do a stock split bringing it's weight more in line with it's size but can't force IBM to do a stock split. However if IBM's weight starts to cause serious tracking problems, the management of the index can drop IBM from the index and replace IBM with another company. One of the reasons that Apple probably split it's shares 7:1 is that it wants to be added to the DOW the next time a company is dropped.

Companies want to be in the DOW since pensions often require that a minimum percentage of pension fund is held with DOW stocks and many also require a minimum percentage of the pension fund is held with S&P500 stocks. Some pension funds require that all stocks in the pension fund are in the in the DOW or S&P500. However with only 30 stocks in the DOW and 500 stocks in the S&P500, it is likely that all DOW stocks will be held by pension funds but not necessarily all S&P500 stocks. If a company is in the DOW, more shares will be removed from the market causing the price of those stocks to more likely rise.

Michael

It's Uncanny

I made a statement in the previous post that the DOW tracks the S&P500 very closely and just did a comparison between the two since inception of the S&P500 index. Over the past 64 years, the S&P500 only outperformed the DOW by about 38% excluding dividends and suspect if dividends were reinvested for both, the DOW would probably have outperformed the S&P500 over that period of time.

The most interesting thing when looking at the chart is that normally for every little rise or drop in the S&P500, there is a corresponding rise or drop in the DOW except when there is about to be a big market crash.

There has only been two big market crashes since 1950 (the tech crash starting in 2000 and the credit crisis crash starting in 2007). Almost a year prior to the start of the tech crash, the DOW went flat while the S&P500 continued to rise. Over 2 years prior to the credit crisis crash, the charts again started to diverge with the S&P500 going more straight up and the DOW with more of a flat rise. I also checked the mini crash of 1987 where the markets pulled back about 25% over a 2 month period but recovered to it's previous high within two years and didn't see any difference between the charts prior to the crash.

The charts for the current bull market seems to be in sync between the DOW and the S&P500 (except the S&P500 is ahead of the DOW by about 10% since the bottom of the market which is more than normal) so hopefully there isn't going to be a major crash in the near future.

Chart Comparing the S&P500 and the DOW

Michael

Four tech stocks that could have hidden values

Hewlett Packard rounds out the list of possible value plays in tech. HP trades at around 12 times earnings, one of the lowest ratios in the tech sector overall. The stock has been an investor favorite after bottoming out last year, up nearly 25 percent year to date. Some investors say the turnaround is underway with Meg Whitman at the helm, who is now chairwoman as well as CEO.