One of my online friends, Nomadic Matt, approached me for some investing advice. Matt changed his career path and now travels around the world and writes about it for a living. Not a bad gig, eh?

Matt and I had a short chat about his goals and situation, which he agreed to open up to outside advice as he has some specific investment ideas and leanings that he’d like to explore. I believe he is single in his late 20s or early 30s, and he also has an MBA so he’s not starting from scratch.

MMB: So roughly how much money are we talking about here? How is it currently invested and in what types of accounts (bank, IRA, brokerage, etc)?

Matt: I have a small five figure sum invested in a SEP IRA.

MMB: What is your timeline and goals for this money? Are you looking to save for retirement, a house, or something else? Would you want access part of it if needed? If retirement, are we talking at age 40 or 65?

Matt: It’s in an IRA, so retirement. I just want it to grow. I wouldn’t need to before 65.

MMB: Approximately how much additional money are you going to be able to contribute in the future?
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Update: Check out the monthly updates on this experiment.

Do you think you’re a below-average driver? Of course not. Everyone thinks they’re above-average. This is why I’m a big proponent of the “Core and Explore” or “Play” portfolio. You should set aside a small percentage of your portfolio and try your best to beat a passive benchmark. If you track things carefully, chances are that after a few years you’ll discover you really aren’t so good and hopefully end up settling into the slight-but-guaranteed outperformance of low-cost, passive investing. Or, you’ll find you’re meant to be a rich and successful hedge fund manager. Win-win!

I’ve been running a little side portfolio for years, but I haven’t been following my own advice about tracking my relative performance. I think it’s time. I’m taking $30,000 and using it for my “Beat the Market” experiment. This is less than 5% of my actual portfolio, which is still overwhelmingly in low-cost index funds rebalanced to a target asset allocation. I’ll track the balances monthly with actual screenshots starting today, November 1st, 2012. Here’s how I’m breaking it down.

$10,000 “Good Boy” Passive ETF Benchmark Portfolio

My real portfolio is held primarily at Vanguard and Fidelity but also includes non-index funds due to limited 401k choices. To create a separate benchmark, I opened a new account at TD Ameritrade as they offer 100 of the most popular ETFs commission-free, including the Vanguard and iShares ETFs that I use. My benchmark portfolio will be based on my usual target asset allocation, except fully-invested in 100% stocks (details coming). As the portfolio will consist of commission-free ETFs and there are no maintenance or service fees, the overall cost drag should be very, very low.

I will not make any deposits or withdrawals to this account, and will report the total balance on a monthly basis. I suppose I could also track after-tax efficiency, but that sounds like too much work and most people invest predominantly in 401k’s and IRAs anyway.

(I know, it has $15,000 in it right now, I already submitted a withdrawal request for $5,000.)

$10,000 “Bad Boy” Beat-the-Benchmark Portfolio

In this account, I’ll be able to buy whatever: individuals stocks, ETFs, options, and even short stocks as needed in my attempts to crush the Benchmark portfolio above. I liquidated the holdings in my existing TradeKing account and left $10,000 in there. This will serve as a low-cost, no-fee brokerage account with $4.95 trades and 65 cent options contracts. (TD Ameritrade standard pricing is $9.99 a trade.)

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Tax-loss harvesting (TLH) is a technique used to minimize taxes on your taxable investments – without altering them significantly – by “harvesting” capital losses during market declines. There are many lengthy articles about TLH out there, but Wealthfront recently released a brief video about tax-loss harvesting that is a good intro to the subject:

Wealthfront is now including tax-loss harvesting in their 0.25% advisory fee for clients with taxable accounts of $100,000 or more. (Advisory fee is on top of ETF and/or mutual fund expense ratios.) I think it’s great that they are offering tax-loss harvesting at a reasonable price, but I don’t know about their contention that tax-loss harvesting is “traditionally only available to accounts in excess of $10 million”. Respectable portfolio managers, include low-cost passive portfolio managers, have been providing tax-loss harvesting to all their clients for a long time. It is true that other online portfolio managers like Betterment currently don’t offer this, however.

(I’m also skeptical about their finding that TLH boosted returns by a full percentage point, I’d be worried about data mining. I mean, sure, if you harvested losses perfectly during every little decline, maybe, but 1% is a lot.)

Indeed, if you’re a DIY investor with a portfolio of a 2-6 index ETFs, you can harvest losses on your own. Here’s an tax-loss harvesting example with ETFs from an old blog post. Wealthfront’s materials suggest that their own method is to sell a primary ETF (ex. Vanguard/VEA) when it’s down and buy the low-priced secondary ETF equivalent (ex. Schwab/SCHF) to replace it. Then, you sell the secondary ETF again after 30 days to get your Vanguard ETF back with a lower basis while avoiding IRS wash sale rules. They believe that their pairings satisfy the IRS requirement that the ETFs can’t be “substantially identical”. You’ll have to decide for yourself if you want to do those extra two trades to swap things back (and paying extra commisions) every time you TLH, or if you should just keep holding the secondary ETF until the next time you want to sell for whatever reason.

Update: I received the following message from Wealthfront:

I wanted to point out when reading your post is that we offer continuous tax-loss harvesting as opposed to year end tax-loss harvesting. We agree with you that the expected benefits on year end tax-loss harvesting is not 1% a year but rather that is for continuous tax-loss harvesting where you are continually harvesting throughout the year.

Here is their whitepaper on the subject, although I should note that the 1% alpha is based on the assumption that you are in the highest 35% tax bracket (while long-term gains are at 15% tax rate). The continuous algorithm deciding when to harvest is interesting, being based partially on “each ETF’s volatility parameter estimated over a rolling time window.”

The Vanguard Total Bond Market Index Fund is designed to track the entire spectrum of US bonds (well, those that are publicly-traded, taxable, and investment-grade). It is the second-largest bond fund out there, with $160 billion in assets and behind only the PIMCO Total Return Fund. It is available to retail investors as a mutual fund (VBMFX/VBTLX) or ETF (BND). If you own a Vanguard Target Retirement or LifeStrategy fund, you own some version of this fund. Let’s take a closer look.

Vanguard founder Jack Bogle wrote an article called The Bond Index Fund which talks about how the Vanguard Total Bond Index fund got started and its subsequent performance:

It’s now 25-year lifetime rate of annual return averaged 6.9 percent, a nice margin of 1.2 percentage points over the average 5.7 percent rate of return of its taxable peers. That superiority comes despite the Fund’s assuming far less credit risk, for the fund (and the bond market index itself) typically hold more than 70 percent of assets in securities backed by the U.S. Treasury and its agencies, including mortgage pass-through certificates. Compounded, the appreciation of a $10,000 investment made at the close of 1986 was remarkable: average actively-managed bond fund $29,900; Vanguard’s passively-managed bond index fund, $42,600—an enhancement in profit of more than 40 percent. This stunning advantage once again reaffirms the timeless truism: Never forget either the magic of long-term compounding of returns, nor the tyranny of long-term compounding of costs.

You have to admit, this historical growth chart looks pretty good:

So, what’s inside this bond juggernaut? For that, we look at the popular benchmark Barclays US Aggregate index, which started in 1986. As it is a market-cap weighted index, the composition shifts constantly over time. The iShares blog has an illustrative chart:

What do all those acronyms mean?

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In my initial review of new brokerage firm Motif Investing, I wanted to use this new brokerage structure to create cheap, custom ETFs – specifically, baskets of dividend-oriented stocks that for example match the S&P Dividend Aristocrat or Dividend Achiever companies that have raised dividends for 10-25 consecutive years or more. Motif asked if I had any specific questions, I sent some over, and here are the answers as provided by Tariq Hilaly, Motif Investing’s Co-Founder & Chief Investment Officer:

MMB: I’m specifically interested in dividend-oriented strategies. Do you offer any motifs that offer high dividend yields?
A: We sure do. As you know, a motif is a portfolio of up to 30 stocks reflecting a specific idea or theme. For starters, we have the Energetic MLPs motif, which is made up of master limited partnership stocks that have a current composite dividend yield of 7.20%. This motif comprises more stable MLPs because those with the highest debt-to-equity ratios were screened out. Motif members can find each company’s dividend yield by logging in to view the motif’s Overview page, clicking on the Detail Table, then clicking “Add Columns” and checking the dividend yield box. Like all motifs, this motif can be customized in order to meet the needs of the investor’s particular investment strategy.

Another motif, Office Space is made up of commercial real estate investment trusts (REITs) that have a current composite yield of 3.88%. This motif avoids REITs with more than 30% of their debt maturing in the next three years to control for refinancing risk.

Our Recession Resistant motif screens for companies with a low debt-to-equity ratio, high dividend-coverage ratios, and positive dividend growth, then ranks them by dividend yield – those stocks have a current composite dividend yield of 3.21%. These companies are known to carry the potential to survive even a deep recession without having to cut their dividends as quickly as many companies had to do during the recession of ‘08-‘09 (dividend cuts can often result in stocks taking a big hit). Note: The dividend yields provided above are as of August 29, 2012.

MMB: Are there plans in the future for me to be able to “share” a custom motif with others? Or at least name them and save them locally in my own account?
A: Yes, we plan to launch a feature later this year that will let our members share a motif they’ve customized by adding or deleting stocks– or change a motif’s weightings. In the future, they’ll also be able to name the custom motifs any way they want.

MMB: I figured a reason why Motif doesn’t really venture into this is that you can’t mention specific indexes without paying royalties, is that partially correct?
A: Yes, you’re correct. For us to replicate or mention an established index we have to license it. So at this point, we don’t mention specific indexes.

MMB: Does the motif ever “rebalance” in the future back to the original weightings to prevent drift?
A: Yes, we rebalance most motifs on a quarterly basis. On rare occasions, with longer-term investing strategies that take longer to play out, we rebalance once a year.
Since the motifs are designed to represent an idea, we update them according to the rebalancing schedule as the idea evolves, so that they continue to best represent the idea. For example, companies may enter or exit a market – this was the case in tablets, where Amazon entered and Research In Motion and Hewlett-Packard left. So in our Tablet Takeover motif, Amazon was added, and RIMM and HP were removed at the last rebalance. Another example is our Onward Online Ads motif — both Facebook and Yelp were added after their IPOs. That’s how we work to prevent idea drift in our base motifs.

Follow-up

I’m still not interested in any of their current motifs, but I am glad they are open to sharing custom motifs as that can encourage the making some good ones. I looked into the S&P 500 Dividend Aristocrats, but there are 51 of them. With a limit of 30 stocks, I’d have to do some additional screening (or make two baskets, but that would be double the commissions). I just think something could be done here to take advantage of the ability to trade 30 stocks at a time for only $9.95, with no ongoing ETF expense ratios eating into returns. Perhaps someone else can come up with a better idea.

Current Sign-up Bonus

Right now, Motif Investing is offering a $150 cash bonus when you open a new brokerage account with $2,000+ and make 5 trades. If you make 1 trade, you’ll get $50. 3 trades will get $75. Limit one account bonus per household.
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