Webcast replay: Managing your portfolio in uncertain times
April 06, 2017
Replay and transcript from a recent Vanguard webcast
In this replay of a recent webcast, Francis Kinniry, CFA, of Vanguard Investment Strategy Group and Todd Bechtel, CFP®, of Vanguard Personal Advisor Services, discuss why it's important to maintain your perspective when dealing with economic and political unknowns, and how you can avoid undermining your long-term strategy.
Amy Chain: Hello and welcome to Managing Your Portfolio in Uncertain Times. I'm Amy Chain and this is the first in a series of live, interactive wealth management webcasts produced exclusively for our Flagship Select clients. We are thrilled that you have joined us this evening.
In a recent blog, our CEO, Bill McNabb, stated that we are living in unprecedented times and we really are. In just the last year or so there have been a number of surprising economic and political events around the world. Investors are concerned about their portfolios, and that's why we're here tonight.
Joining us to discuss investing in today's climate are Fran Kinniry of Vanguard Investment Strategy Group and Todd Bechtel from Vanguard Personal Advisor Services®. Gentlemen, thank you for being here.
Fran Kinniry: Thank you, Amy.
Todd Bechtel: Thanks, Amy.
Amy Chain: Now, we'll spend most of our webcast this evening answering your questions, but before we get started, there are two items I'd like to point out. First, there's a widget at the bottom of your screen for technical help. It's the blue widget on the left. And if you'd like to read some of Vanguard's thought leadership material that relates to tonight's topic, or view replays of past webcasts, you can click on the green resource list widget on the far right of the player. All right, shall we jump right in?
Fran Kinniry: Sounds good, let's do it.
Amy Chain: Okay. The first thing we're going to do is we're going to ask our audience a question this evening. So audience, for you we have a question. It should be appearing on your screen now. And that question is, which of the following concerns you most: interest rates, market volatility, or investment tax strategies? We'll give you a few minutes to weigh in on some of the topics you'd like us to talk about tonight. And in the meantime, why don't we jump in with a question we got ahead of tonight's webcast, and we'll answer that while our audience weighs in.
Fran I'm going to toss this one to you. This one comes from David in Berkeley, California. David, thank you for the question. David said, "Is there anything in the economic or political environment that's causing Vanguard to reassess its recommendation, its recommended asset allocations, and domestic or international allocation recommendations?" Fran, go ahead and give it.
Fran Kinniry: Thanks, Amy, and thanks, David for the question. It's one of the most common questions we're getting. Obviously the news cycle is fast and furious. With the news cycle also comes a lot of different economic news and political news. And so the natural question is that what does that mean for me and my investment portfolio.
We've done a lot of research here, so this is not just us thinking about things. We've studied different economic environments, whether it be a recession or a strong economic environment. We've also looked at different political regimes, depending on how the political environment is. And what we see there is that mostly, while it can be very in the moment, and drive a lot of attention, it really does not have a major impact on the capital market returns, whether it be returns or risk.
And so our advice is really to try to make sure that you're not allocating your portfolio differently because of the economic or political environment. And certainly that doesn't mean you wouldn't change your allocations, but that should be really something personal, something changes in your life, new goals and objectives, but really try to let the economic and political uncertainties stay in the news and not highjack your investment portfolio.
Amy Chain: In other words, you should be thinking about how changes in the political or other environmental climate, how changes there might allow you to stomach, or not stomach, things in your portfolio. If you can't sleep when the political environment is rocky, maybe then you should think about whether or not you're allocated correctly?
Fran Kinniry: Yes, that's right. And I think I would be a little cautionary of predictions. So obviously what was expected to happen did not happen in the market. And also a lot of people were saying, if this did happen, you would see a lot of volatility. Just today is the 50th day that we have had the markets not go up or down 1%. So we're actually in record low volatility, even though it may seem like political chaos. And so really not making the jump from political news cycle to capital market influence.
Amy Chain: Talking about market volatility is a great transition to our poll results. It looks like about 60% of our viewers this evening are most concerned, or at least most interested, in our discussion about market volatility this evening. So that's great.
I'm going to toss another question out to our audience, and then Todd, I'm going to come to you and ask you to tackle a question we got ahead of time as well. So you out there viewing, we'd love to hear from you again. Tell us how confident you are in your ability to manage your portfolio. While you think about that and weigh in, Todd, let's take a question from Rosalyn from California, who asked us a similar question to the one we asked Fran, but this one is more to the individual client level. "With such uncertain political times, how should an individual be setting their investment goals?" Let's talk about your process and how you apply that to clients.
Todd Bechtel: Sure, and again thank you, Rosalyn, for the question. And yes, it looks like we're going to be talking about politics today to some degree. I don't think many people would disagree with Rosalyn's assumptions that we are in uncertain political times. It's in the news, it's unavoidable, even my wife is telling me, it's in Facebook, and it's unavoidable there.
I would also say that past presidential candidates would agree that there's uncertainty here. There was a lot of surprises that happened, and we're still dealing with that spill-out, at least politically. But thankfully, developing one's portfolio and defining one's goals, which I think was Rosalyn's question, is more personal than it is political. In fact it's almost all personal and no political.
As a financial advisor with Vanguard Personal Advisor Services, that's exactly what my role is, initially is I partner with clients at Vanguard who want to work with an advisor. It's to take it to a personal level. To find what their goals are, determine where they've been, how they've generated their wealth, take stock of their assets, where they're at now, and then start to develop strategies. Start to develop goals. Less on money, more on values, more on legacy, more on what you want to accomplish, what concerns you, where do you want to go.
And ultimately it's really to take it to the next level and to put it into a plan, a written plan that we can hold ourselves to and use that to ride through that uncertainty.
Amy Chain: Fran, I'm going to ask us to come back a level on this a little bit. Both Rosalyn and David have asked us particularly about domestic versus international. Maybe you could spend a minute and talk about Vanguard's view on the role of international in a portfolio?
Fran Kinniry: Yes, sure. We've always been at the forefront of what we would say having a global portfolio, meaning not having all of your assets in U.S. equities, or U.S. fixed income. So we've long believed in having non-U.S. equity and non-U.S. fixed income to the extent we really believe that having the exact amount is less important than having some. So whether you would have 20, 30, 40% of your allocation or even 50%non-U.S. equities, most of the diversification is at the very front end, from zero to 20 to 25, 30.
We saw in the late '90s it was all U.S.-dominated, and the ten-year ending 2011 it was all non-U.S. And now we're in a period where the U.S. is dominating. The worst thing an investor can do is trying to rotate around them based on past performance.
Amy Chain: Good, and I'm seeing some of the questions coming in and I think we're going to touch on some of this again in a bit. But in the meantime, let's talk about our poll results. Looks like about 60%, slightly over 60%of our clients this evening are either somewhat confident or not confident with about 35%, 36% saying that they are fairly confident. What do we think? Does this surprise you? Todd, you're talking to clients all day, what are you hearing?
Todd Bechtel: It does actually surprise me a little bit, in other ways not so. But to stay with the surprise component, we are in a positive market. Clients tend to be more confident when they're making money and doing well and seeing positive results and watching their equity allocation creep up above their targets, which we'll probably touch on later. So I would say that I would expect if we did that poll in a down market it would even be more favorable or I should say less favorable to managing your own portfolio. But I am surprised at that result.
Amy Chain: Fran, how about you?
Fran Kinniry: Yes, I think selling after a very long bull market can be tough too. So while it takes a lot of conviction to go in in February of '09, after the market was off 55%, we find it equally challenging to sell into a rising bull market. And let's face it, we're in an eight-year bull market, up pretty significantly in low volatility where bonds are offering very low yields. So it takes real conviction and discipline to sell out of equities here. Not because you think equities are overvalued, but just in the spirit of rebalancing back to your target.
And so we find that to be difficult especially when markets are extreme at the bottom as Todd had mentioned, or at the top. Not that we are at the top, but we're certainly at the long-running bull market.
Amy Chain: Good.
Todd Bechtel: And I'll just add a component to that. It, yes, one of the things that freezes clients up is taxes and trying to weigh, making a decision to sell, for whatever reason, whether it's because the markets are elevated and they feel they're overpriced, or that they're actually following a strategy and they're overly invested in equities based on that strategy.
Taxes do tend to freeze people up, understandably so because it's a tough call when you've accumulated investments over the course of possibly decades and you have massive amounts of embedded capital gains. How do you do it? It is a hard thing to do for a lot of people. And I guess that would probably contribute to your point, why even in an up market people are at some point concerned about how to do things right.
Amy Chain: I think you both make great points, and I think the fact that we had responses to all three of those answers sheds light on the fact that all of our clients have very different needs. And I think it speaks to the well-roundedness of our Flagship offer. I think we have a visual if we want to show it. Depending on what your questions are, there's lots of different ways to get answers to them. So those that are more comfortable with their portfolios may still have questions about tax planning or estate planning and those who are looking for maybe more direction in an uncomfortable investing environment might be looking for advice. Fran, why don't you spend a minute and talk to us a little bit about advice and our view on the value?
Fran Kinniry: Yes, sure. Several years back we created Vanguard's advisor outfit. And it was really around what the advisor through Personal Advisor Services can actually deliver. The original, let's go back a decade or two, the role of an advisor was traditionally hire me as your advisor, I'll outperform a benchmark. And you would do that through security selection, mutual fund, hire/fire, or tactical allocation. More international, less, buy stocks and bonds.
But what we really found is the real value of an advisor, and Todd touched on this, when he meets a client, getting to know them. What are the interests of the family? What is the family trying to achieve? Developing a plan and putting that plan in writing. Making sure that plan's in writing so you do not abandon that.
And so what we have found is that the cost of advice is extremely marginal relative to the benefits that advice can have in tax planning, rebalancing, gifting of assets…
Amy Chain: Can you talk about the behavioral coaching?
Fran Kinniry: The behavioral coaching alone. We look at our funds and we have, we know is the behavioral gap. It measures, and not to get too technical, the dollar-weighted return of our funds to the time-weighted return of our funds. And what we know is that our own Vanguard investors do a lot better than the industry, but they still trail the funds that they invest in by 75 to 100 basis points because they tend to buy after good performance, or sell at the bottom.* So we really believe in the value of advice. But it's advice under that tenor of wealth planning, financial planning, behavioral coaching.
*Source: Morningstar. Data as of January 31, 2017.
Amy Chain: You mentioned basis points. Let's quick define that for some that might not understand what we're talking about.
Fran Kinniry: Yes, so 75 basis points would be three-quarters of 1%. So when you're starting to think about 100 basis points would be 1%, 75 basis points would be three-quarter of 1%.
Amy Chain: Very good. Okay, Todd, let's take a question from Jean. Jean is asking, are we again seeing irrational exuberance, and is now a good time to harvest gains and maintain cash?
Todd Bechtel: Irrational exuberance, wow, we're pulling that one out. I like it.
Amy Chain: It's early in the hour and we're going that fast.
Todd Bechtel: Yes, let's go with it. I'm not going to comment as much on the irrational exuberance. I haven't heard that in quite some time. But I will say, it really comes back to the question, and hopefully the questions coming from the audience member who has a plan. And that's the key. And then we, and you're going to hear that over and over again today, but it's not just something we say and feel good about and describe that you need goals. But do you really have them? Have you really written them down? Do you have a strategy? Is it 60%stock and you're at 60%stock and you're at 67%stock.
So the answer is, I wouldn't as much focus on the irrational exuberance part but hey, what's your plan, and can you get back to it in a tax- and cost-efficient manner. That's where I would drive those type of questions back towards.
Amy Chain: Okay, very good. David has noted that bonds, now we talked earlier about bonds, so let's go back to that. David has noted that bonds are generally considered a stabilizing component of a diversified portfolio: "What is your view on the proper role of bonds today, given that interest rates are low, and the almost-certain increases will impact principle values negatively?" Why don't we pause first, Todd, and talk to us about the role that bonds can play in a portfolio, and then we can talk about what's going on in the environment.
Todd Bechtel: Right, and that question's from David?
Amy Chain: This question's from David.
Todd Bechtel: David. Great question. And your observations, you hit in your observations the two main, in my opinion, the two main benefits of bond investment which is diversification and then within bonds what are you getting out of its interest. And so bonds play an integral part, and I think that was part of the question in portfolios to the extent that you don't want equities. I mean let's be very clear. If you have a long-term time horizon and you believe in the U.S. economy or the world economy, then why would you have bonds? Well, it's because you can't stand the downside risk, and it's not appropriate for your portfolio, so then you fill that gap with bonds.
And so that's the diversification aspect. Interest-rate wise, that's what we want. And we've seen interest rates not spike per se but go up recently. And yes, there's a negative price component to that and I believe most of the audience probably knows as rates go up, existing bond values, or the values of existing bonds that have a lower coupon or a lower yield are going to be worth less, because why would you buy them, they're just not as appealing, so you have to discount the value of the bond in order to entice someone to buy, and that's a mathematical equation.
So interest is important. Diversification is important. And they go hand in hand. And so in this environment, there is pain when interest rates rise, there's a price to pay initially on the share price. But that's okay. And that in fact I would argue that's good because you're increasing the diversification benefits of the portfolio.
The example would be is if you have a negative 10% market equity loss, would you rather have a 4%-yielding bond strategy or a 3? I'll take the 4 because it's going to offset better the loss on the downside on the equity. So interest rates are, have gone up, they may continue to go up. The Fed is projecting that they may continue to do certain things on the yield curve, and maybe Fran would want to speak to about the yield curve and how it actually works. But it's good. We want to see interest rates go up. It adds diversification.
Amy Chain: I'm going to ask you to go there, Fran. We're going to take a question that's come in from Richard, and I'm sure you're answering this on the road quite a bit. "Over the next ten years, what are your expected returns for U.S. stocks, European stocks, emerging market stocks, the whole gambit." Let's talk about expectations.
Fran Kinniry: Yes, so let's start with equities. You know I think back to the question of irrational exuberance and where the equity market's at. They're certainly not at levels that we saw in 1999 when the first term came out towards the end of the internet tech bubble. But let's be clear. Equity valuations are high. They're in their top 15, 20%of historical valuations depending on the metric you look at. So when we would say equities, we would say our long-run returns, a ten-year return forecast is about 1 to 2%below its historical returns.
So let's say 7 or 8%. But I want to be real careful on the caveat there. Even at 7 or 8%, there's a wide distribution of returns even from our outlook from the Vanguard Capital Markets Model*; Joe Davis, who I work with very closely, it still has a very wide distribution.
*IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of January 31, 2017. Results from the model may vary with each use and over time.
In fact, 25%of our observations have double-digit returns, more than 10, and another 20, 25%below 2%. So while people may focus on the 7 or 8 number, it's a wide distribution. International and emerging markets carry higher risk to them, they've historically carried higher risk, and so higher risk should have slightly higher returns. And you get compensated for higher risks, so it's a slightly higher returns on non-U.S. and emerging. But risk-adjusted, probably back to being similar.
Bonds, no doubt. Low interest rates. We're sitting here today at let's say 2 ½% interest rates. I would caution everyone about that interest rates have to rise. I know that's been the feeling, but it's been the feeling for 15 years. Really dating back to 2002. And so 2.5, 2.4%, and then if you look at where U.S. rates are, relative to the world, 2.4 or 2.5 in the U.S., given its credit quality, ability to repay, looks like a pretty darn good bargain relative to most of Europe, which is somewhere around zero and others.
Take it to the high-net-worth crowd of tax-exempt, municipal bonds. After-tax-equivalent. So I would not necessarily, well, bonds do not look with a big smile, they certainly have properties of diversification and the yields look attract relative to their risks.
Amy Chain: We just actually got a live question from Paul, who's asking specifically about tax rates, and whether or not they'd negatively impact municipal bonds. Can we talk about that for a minute?
Fran Kinniry: Yes, sure. I mean there was a little bit of what I would say a tax-exempt scare coming out of the election, and what could potentially happen to changes in tax policy. What tax-exempt bonds of the municipalities. And let's be clear we're talking about states and municipalities offering bonds that are tax-exempt, that for high-net-worth investors that are in the top brackets, especially in state brackets, some states have significantly high brackets, New York and California. But the after-tax-equivalent yield on those bonds are very attractive.
While we don't really forecast where tax policy is going to go, a lot of those earlier risks have seemed to diminish somewhat on the tax-exempt as they could potentially lose their status. While we wouldn't make a prediction one way or the other, we certainly believe that it will have a lot of the positives there for the ultra-high-net-worth crowd in the future than they had in the past.
Amy Chain: Now we've talked a lot about bonds. And we're getting a lot of questions about bonds. Abraham is asking a question that I think is probably on a lot of people's minds. Which is talking about the benefits or the considerations of investing in either an individual bond or a bond fund. If we could talk about it through the lens of municipals, but I think it's a broader conversation. Fran, why don't you get us started and then…
Fran Kinniry: Sure, yes. We've done a lot of research here. So you had mentioned in the beginning a lot of our research is available. We actually have several papers on bond versus bond funds. This gets back to a lot of the behavioral aspects of investing. It's one of the, probably one of the top behavioral things we see. And that is, if you own a bond, whether it's a municipal or a taxable, you get your principal back when that bond matures.
So let's say you have a $1 million bond, and it's a five-year bond, no matter what happens to the interest rates, you're going to get your $1 million back in five years. The concern though of that bond is, if interest rates do go up, let's say interest rates go from 2 to 4%. Let's say they do that in year two. For the next three years, you're still at 2%, when the bond fund would be getting 4.
So really, you're going to get your principal back, but the present value of all cash flows would be identical. So this idea that you can get your principal back is an emotional benefit, it's a behavioral trap if you will. Owning a bond fund, you will lose principal when interest rates go up, but your yields are now higher. The total return, all else being equal, like if you had a bond fund with one fund in it, where the characteristics matched of credit and duration, you would have the same return. The benefit of fund though is you can get more diversification. It's unlikely unless you are really super-high-net-worth that you are going to be able to buy 100 bonds or 150 bonds in the lots that bonds trade at to get diversification outside of the Treasury if you're just doing Treasuries only.
The mark-ups alone on bonds, they don't trade well in the secondary market. So to try and go buy a bond on the secondary market, the bid-ask spread and the impact is very large. So a bond fund has many benefits from the trading aspect. You don't get that emotional benefit, but it is just that, an emotional benefit.
Amy Chain: Todd, I think this is probably a question you get a lot from clients.
Todd Bechtel: We do. So when I start working with a client initially, a lot of times they are more familiar with a laddered bond strategy because it's what a lot of brokers or advisors will do. It's a profitable endeavor for the ones who are selling the strategy, and it's sort of a traditional approach in the past to do so. And so there isn't an adjustment period for a lot of my clients.
But when they realize, and I used to say and sometimes I still do, I say, when we start debating individual bonds versus bond funds, I say great, we're in agreement. What do you mean? Well, we're both talking about individual bonds, right. It's just how do you wrap it up. Do you do it in an individual ladder and incur more costs, and again have issues with liquidity, which we saw in some of the markets in the past years? When people need to raise money they can't sell it. When I start with a client and they have 20, 30 individual bonds, high-quality bonds, we can't sell them.
The bid-ask spreads over 3, 4, or 5% sometimes. And so that's a shock to them. But again, usually the clients that I work with, they ease into that idea, they get used to the idea that they're going to see a more visible share price increase and decrease. And that they start to understand that really it's the same thing. It's individual bonds, we're just managing it within a mutual fund, running at what 10, 12 basis points, versus whatever it cost to do on their own or through a broker. So it, they overcome it.
Amy Chain: Todd, let's stay with you here. Kevin from Greensburg, Pennsylvania, is asking about the sort of dynamics of a high-net-worth investor. He says, "Should a high-net-worth individual have a different asset allocation strategy than, say, some other type of investor?"
Todd Bechtel: Kevin, the answer is possibly. Possibly for two reasons. One, what I've found as I work with high-net-worth investors is, and there's a progression to this. It may not start this way, but many times, by the time my clients, they start working with me in their 50s or 60s, by the time they're in their 60s and 70s, we're not managing one portfolio anymore, we're managing two, three portfolios. They've now created trusts, irrevocable trusts for kids, grandkids, creditor protection, education trusts. There's partnerships involved.
And so the point I want to make is that we go from one portfolio with one allocation to multiple portfolios, typically those other portfolios become more aggressive because they absolutely become more generational in nature. And so that's one aspect that I see. And I'm sure many in the audience will be nodding their head and saying yes, I do have two or three portfolios.
The other part, which may be the point of his question is, okay I have a lot of money, I have $20 million, I'm spending nothing from it. I could on one side justify taking no risk. And I have critical mass. And why take the risk, I'm fine, and my family's fine, why do it? Stay out of the game. And there's justification for that in theory.
The other side, the other extreme is, well, we have a lot more money than we need, we can take a 30%, 40%market decline over a period of time, and still be unaffected in our goals and our legacy and what we're trying to achieve. Justification there.
So it looks gray, it looks cloudy, it looks confusing, but it really isn't. The same process that I walked my $20 million clients through is the process we walk a $2 million client through, which is, bring them back to where they're at, where they want to be, what are their goals, what's their risk tolerance, what's their time horizon, and usually that answer falls somewhere between those extremes.
Amy Chain: Very good. Ann is asking back to our discussion about bond funds. Ann is asking, "With interest rates so low, why shouldn't I consider converting some of my bond funds back to a stock fund that pays dividends?" Fran, you want to kick us off here?
Fran Kinniry: Sure. What we really want to try to emphasize is the risks in stocks, even dividend-paying stocks, are tremendously different from the risks of bonds. So Vanguard does have a few dividend funds. But they are stocks. And they, so if you want to overweight dividend stocks, we would really first try to talk you out of it, second we would say if you're going to do that, take it from other parts of your equity market.
Most of our dividend funds underperformed the market in 2008. Two of them were down more than 50%. The bond market tends to do very well in contagion, meaning when the market is selling off. So yes, interest rates are low, but the risks of bonds we cannot really find episodes where high-quality, intermediate-term duration bonds have ever suffered double-digit negative returns.
That doesn't mean it cannot happen in the future.
Amy Chain: I think what I'm hearing is that the decision about whether to be invested in this investment or that investment comes far later in the decision-making process than maybe where we're talking about. So for example, you should be thinking about what are my goals, what is the best way for me to accomplish these goals, how should I be allocated? And if you're down the path that far you're not going to be led to an equity fund if you need income, if you're investing for income needs. Is that a reasonable…?
Fran Kinniry: Yes, and especially again for a, I'm not sure if we're talking about a taxable investor. But dividends are actually not the most tax-efficient way to draw down money from a portfolio. Not to get too technical, but every stock and then stock fund, goes ex-dividend. So let's just play that through. You have $100 stock or $100 mutual fund that pays a 3% dividend, that tomorrow if that dividend is paid, you now have a $97 stock or fund and a $3 dividend.
So it is giving you back your capital in the word dividend, because your NAV, your net asset value, of the fund or your stock price drops, and then you pay taxes on it. So it is one of the least efficient ways actually to generate income from a portfolio is to do a dividend overweight.
Amy Chain: Let's repeat that again. I want to make sure that our audience understand what that means. You said funds go ex-dividends, let's pause and re-explain what that means.
Fran Kinniry: So let's just say you and I are the only two investors, Amy, and I own a fund that's going to pay a dividend tomorrow. If I sell that to you today, I would sell it to you for let's say, $100. Tomorrow that fund is going to pay a $3 dividend, if you're the owner tomorrow, you now have a $97 fund and a $3 dividend. And if you want to sell it the next day, you sell it for $97 because that $3 stays with you. So we've put out long, don't buy the dividend on most of our communications. But what happens is if you just had the $100 and you didn't get the dividend, you have $100 and you have no tax liability. You now have $97, a $3 dividend, and then you have to pay the tax on the dividend.
So you actually don't even have $100. So it is really an inefficient way to try to generate income. No doubt a lot of clients do do that, very much like the bond versus bond fund. But it carries a lot of risks and it's very tax-inefficient.
Amy Chain: Todd, do you talk to a lot of clients who are considering using equity dividends as income?
Todd Bechtel: I do. And again it comes up initially in relationships. And again we tend to move through that pretty quickly because the saying that I say is, why would you take equity risk for bond return, right. And think about that they're like, yes, why would I do that. Well, you wouldn't. And so the other aspect that comes up a lot, I don't know, Fran, you want to speak to it, is, again there's some out in the investment world who believe that dividend yield stocks simply outperform growth stocks, right. So that's back to the value tilt, back to the Dow, things along those lines.
And so that's probably a harder argument to counter, because now you're digging into statistics and time-period dependent returns and you start to debate that. I mean what do you think on that?
Fran Kinniry: Yes, so we're taking a quintiles just dividing in 20%. So we've quintiled all stocks from their bottom 20% yields, the next 20, all the way out to the highest yields. And you see the returns over a very long time series being identical. Right. So there is no real return premium from overweighting the yielders. So it is much more of a behavioral issue, an emotional issue. A bird in the hand. I know I'm getting—But please remember that stocks, whether it's Walmart or Cisco or Apple, and stock funds go ex-dividend. So whether that an Apple does not pay a divided and Walmart does, the net total return is made up of all capital returns or capital and dividend. And so if you are, if you're in an endowment or a foundation and you're not paying taxes, then it's not a big deal. If you're a taxable client, a high-net-worth client, it is a pretty big deal. Not to overweight the dividend.
Amy Chain: All right, Todd, this is a question for you. All this talk about taxation has our audience asking, particularly Eric is asking if you'll talk about how you talk to clients about building a tax-efficient portfolio.
Todd Bechtel: Building a tax-efficient portfolio. Well, again it's going to be a top-down approach. Maybe the audience has heard this before. Bottom up, which is security selection first, performance based, kind of piecing together something and at some point waking up and saying, how did I get here. That's bottom up.
Top down is again determining your asset allocation through goals, through risk tolerance, through time horizon. Once you do that then you can start to work down. It's almost like a Christmas tree. You start at the top, it's asset allocation, then it's sub-asset allocation, then different types of stock funds, international, domestic.
Index is a big part of that. And so back to the tax-efficient question. Indexing is a huge part. In fact, the bigger the client, sometimes the more questions I get, are you sure this index thing is the right thing? Shouldn't we be doing something more complicated? And I say, you have more zeros and commas so you're paying higher taxes, so we need to do this even more specifically. Trust me, we need to do this, and I show them the numbers and we build the portfolio. So indexing right out of the gate is a huge contributor to tax-efficient investing.
On the bond side, since we've been talking a lot about fixed income and interest rates, municipal bond strategies are very big for our clients. Most of the high-net-worth investors have an overweight towards retail accounts versus IRA accounts. So and there's different kinds of strategies you can apply in bond investments, depending on where you're doing that, whether it's in an IRA or a taxable account.
So in taxable accounts where most of our clients live, it's municipal bonds strategies. And that pays. I mean when I do the tax equivalent and yield for clients and they say okay that 2 ½%intermediate is all of a sudden 3 1/2. That's not too bad, it's not great. But I'll take that. And so what you end up getting then is tax-exempt income that's at least federally tax-exempt and possibly partially depending on the state.
You have a very tax-efficient portfolio on the equity side that's generated in the last few years, no capital gains from the fund, and if you didn't sell it as a client, your accountant, your CPA is loving you and loving Vanguard. And you're keeping all of that at the end of the day, it's a beautiful thing.
Amy Chain: Todd, you talked about indexing; Fran I'm going to ask you to weigh in on a topic that Sarah from Baltimore asked us about. She alludes to some who have advised against index funds because so many people are investing in them, and that can have a negative overall impact on indexing as a whole. Could you just respond to that? Let's talk about our view on indexing.
Fran Kinniry: Yes, I would say you know as the market has become more sophisticated, and I really want to congratulate the internet or transparency, right, so the world grew up 90%active, 10% indexing, I joined Vanguard in 1997. That number really didn't change much from the '70s through the mid-'90s. It was a 90% active, 10% indexing.
And what everyone saw is that it's not that active management can't work. We believe in active management. It's really about low-cost broad diversification. And what happens with indexing is because it's so low-cost, and so broadly diversified, it is such a, you know it outperforms on average 70 to 80%of active managers.* It's not that active managers are not wickedly smart, they are. The best and brightest come into active management.
*Source: SPIVA (Standard and Poors Indices Versus Active). Data as of June 30, 2016.
But they're trading against other really, really smart people. So you can't just be smarter than the average person, you have to be smarter than your counterparty who is equally as intelligent, has all of the information. And so you know I would turn it around and I've asked this question a lot of times, because we get it. What should the best-value product in the market have? Should it only have 30 or 35%? I mean I think indexing, if you look at the numbers that it out performs 70 to 75%consistently, we talked, Todd and I talked about after-tax. Morningstar has done a great job, we've done a great job. Only 10% of active managers outperform after-tax.*
*Source: SPIVA (Standard and Poors Indices Versus Active). Data as of June 30, 2016.
So we would, I think investors are getting more intelligent. The media's getting more intelligent, and like any mature business, people are voting with their feet. They are going to low-cost funds and a lot of that going into index funds.
Amy Chain: Is there any risk to too many people indexing?
Fran Kinniry: There's a lot of things. Can indexing get too big? You have to first, I mean you have to understand what the incentives are in the industry, right. So the incentives are the industry is dominated by higher-margin, active funds, who have an incentive to say maybe there's too much in indexing, right.
The bottom line, if we were the last three active managers around, and we only controlled 5% of the assets, 95%of the assets would not move. But if I wanted to get rid of Amazon because I thought it had run its course, I would have to sell it to one of you two. Amazon would not move unless I wanted to sell it to one of you two. So as long as there is some small cohort of people actively managed, whether that, we could debate that number, is it 2%, 5, or 10? Is it 15?
Amy Chain: But we're nowhere near that even, right?
Fran Kinniry: Nowhere near that at all. And I think you have to understand that the mutual fund industry is only a small sliver of the total capital mortgage structure. There's hedge funds, there's endowments and foundations. So the number of 30 or, first of all the sophisticated institutional audience has been at the 40 to 50%indexing for two decades. Whether that's 50 to 80 or 90%. But we see that number elevating and really, really good news for investors.
Todd Bechtel: I would add ETFs, it's something that's really grown in the marketplace and Vanguard as well has really grown in their offerings on ETFs. ETFs are indexes at the end of the day. And I don't want to use the word "sexy" but I will. You know it's sexy to people and I can't tell you how many times I've had a conversation with an investor. Whether they're a client of mine or not, and they'll say, well, I don't like the S&P 500 but I will take the S&P 500 ETF. And I'm like, well, okay, do I tell them? Yes, of course I tell them.
So ETFs have really added to the, I think the growth of not only Vanguard, in the interest and indexing, but industry-wide brokers are using it. They're using our platform, right. Financial advisors services, right. They're using ETFs and they're essentially indexes.
Fran Kinniry: So what ETFs did is they brought indexing to the masses. And so now you're seeing everybody own and for a very good reason. Broadly diversified, very tax-efficient. So I would say that the next 10 to 20 years will look more like the last 5 to 10 than it not.
Amy Chain: Very good. Let's bring it back to some of the current environment that we're living in. Bill from Vero Beach, Florida, has asked us about the impact of potential tax law changes on investment strategy. Fran, I think I know where you're going to go with this. But how might changes in tax policy change what we might recommend to investors?
Fran Kinniry: Yes, so I mean first I would caution everyone to forecast changes in tax policy. But once a change would occur, you're going to have to re-evaluate, right. So maybe your relationship of taxable to tax-exempt bonds may not be the same as it once was. If they simplify the brackets and your tax comes down, maybe a taxable bond, after-tax, is higher than a tax-exempt bond. That could very easily happen. Or maybe you change your asset location. We didn't really touch on asset location too much.
Amy Chain: Define that.
Fran Kinniry: So we talked a lot about asset allocation, how much you have in stocks versus bonds, sub-asset allocation, which would be international, domestic, growth, and value. Location is where you would place those between your tax-qualified. So a Roth or a traditional IRA or a 401(k) versus your taxable.
Now our audience, demographics, and Todd did touch on this, we look at a lot of demographic information. And the high-net-worth crowd, because you can only see a smaller portion in your 401(k), it ends up being where the multi-millionaire has much more in the taxable, so asset location can add a lot. But it still can, you know, you can put corporate bonds right now in your tax-qualified plans. And pick up a nice yield over having municipals, even in the after-tax.
So it's something to definitely keep your eye on. It's another reason why working with a tax professional or an advisor can easily add the value that you pay for it, unless you're keeping track of it on your own every day.
Amy Chain: Todd, are you talking with clients a lot about this topic right now?
Todd Bechtel: Asset location?
Amy Chain: Asset location, tax policy, you name it.
Todd Bechtel: Tax policy. Yes, it's coming up in conversations regarding municipals and whether or not you know that tax and yield that we all, that our clients look at, that we look at and says, is it justifiable, should you be in munis versus taxable. Again it's still where it's at. The law hasn't changed. There's still a wide disparity between ordinary income rates and other rates. And it still favors municipals. So that's coming up.
Asset location, I thought that was your question. That's coming up every time I work with a client. It has to, it's a part of what we do. It is a major, not as major as asset allocation, but major decision in building portfolios and you have to do it, it's a tax-free endeavor. So you, I always say you do the best you can in the markets, you can't control them. You plan for them. You plan around them. You try to forecast as much as you can.
But man, if you can make a couple percentage points in your portfolio just by doing things in a smart tax-efficient way, such as again putting, to expand on Fran's comments, putting stocks in a retail account you get the capital gain treatment, you get a return of basis on your original investment. There's estate planning benefits, currently, that I won't get into. And then on the other side, on the bond side, a co-worker, a peer of mine once used to say that you have a partner in every IRA account that you own, and that partner's name is the IRS. You don't own 100%of that $1 million IRA, you own 70%, they own 30%or maybe 40%.
Amy Chain: That's a great way to put it.
Todd Bechtel: Yes, it's, I didn't copyright that, I'd like to say I did. So back to asset location, bonds are necessary for diversification and they do add an investment component to it in the form of income. But you don't want that investment growing on the outside, you want it in the IRA because every dollar that comes out is taxed pretty severely right now.
Amy Chain: Now we've talked a lot about bonds tonight; Jeffery's asking us to talk about high-yield bonds, or high-yield bond funds. And how we consider their behavior, are they more like equity, are they more like bonds, what sort of roles should they play in a portfolio? Todd, you want to kick us off?
Todd Bechtel: Yes, we've looked at that. We used to actually incorporate high-yield at one point. And we found, and I'm sure Fran will expand upon that that high-yield does show, exhibit equity-like characteristics. They tend to react to markets. They tend to pay their dividends and be solvent in up markets and then depending on the quality and if you really get into the deeper depths of credit quality there, they start to default. They start to fold. And then you start to lose principal.
And so they tend to exhibit similar characteristics from what I can gather from equities. And we don't incorporate them in our portfolios anymore.
Fran Kinniry: Yes, I would say just a couple things. One, I'm a big believer of the word that only tells you a very superficial level of what something is. And you really need, vanguard.com is a great resource, because not even all high-yield funds are the same. And not to get into our funds, but our high-yield funds, both taxable and tax-exempt, look a lot different than the category average that's out there on Morningstar. We tend to have a very high-quality low-quality bias. If that makes sense, right. So we're not buying the real junk part of the bond market…*
*Source: Vanguard. Data based on Vanguard High-Yield Corporate Fund product description as of December 31, 2016.
Amy Chain: We buy the best junk on the market.
Fran Kinniry: Exactly. You said it. A couple things, though. High-yield, taxable bonds have high correlation to the equity market. So in 2008 you know, and that's why we don't include them. They did not protect you nor would we expect them to protect you in the future.
The high-yield tax exempt is a little bit different, you know and if you go look at the credit quality of the two, they're very different. So I would encourage everyone to use second-level thinking, right. Instead of saying it's high-yield or its emerging markets or its small-cap, look at, if you want to look at two things in bonds, look at the duration and the credit quality.
And that will tell you a lot. High-yield taxable is a more traditional correlating with equities, very tax-inefficient. If you're going to own that you have to almost own it inside your tax-qualified plan. But the tax-exempt is something that whether you want to include it or not is really up to the investor. But looking underneath the details rather than just the fund name, I think it adds some benefit.
Amy Chain: Very good. Todd, let's talk about some investors who are concerned about preserving their capital. Charles from Haverford, Pennsylvania, which is right around the corner, is asking what he should be thinking about if he's interested in preserving capital but also earning more than money market rates.
Todd Bechtel: Okay, well, I would take the second part of that question first and try to define what earning something more than money rates is. I mean let's just assume for a moment, I think prime money market is at 81 basis points.* Let's call it a percent. So you have a percent as your first benchmark that you're trying to exceed. What is that? Is it 1%, 3%, 5%? And I think that's important to do that by doing that. And it's not necessarily how we back into portfolios by looking at what we want to be, I'm just focusing on a percent return. There's the other aspects which we discussed about goals and risk tolerance and such.
*Prime Money Market Average Annualized 7-day yield—0.79%. Data as of March 14, 2017. AVERAGE ANNUALIZED INCOME DIVIDEND OVER THE PAST 7 DAYS.
But to answer the question, define what something is and then start to use your own resources or Vanguard provides a lot of great resources that give you the historical average for different portfolios and that would hopefully lend back to the first part of this question, which is what is the purpose of the goal, or how do you achieve that result. And that's through asset allocation.
But also keep in mind inflation. So money markets are already below inflation. If we're saying inflation's 2 ½% and money markets are yielding less than 1%, you're already under water. So you might want to add inflation components to that calculation along the way to keep it honest.
Amy Chain: Now Fran, a few minutes ago you mentioned emerging markets, let's talk about international investing for a couple of minutes. George is writing in, he's particularly concerned about whether or not anybody should be investing internationally at all right now, given some of the geopolitical issues that we're seeing. And he doesn't want to let us off the hook easy on this one. You have to give us a real answer on our view on the geopolitical environment, and what that means for international investing.
Fran Kinniry: Yes, first off, I would say that while we read the news, or we make our own perceptions, the investment community already traded on, even if you are dialed in, watching the news 24/7, the investment market is a 24/7 business. So there's hedge funds around the world. We have traders around the world. So by the time we're reading the news, it has fully been priced in and the markets have been reset.
And so I really would not worry about, you know, that doesn't mean that the markets cannot sell off tomorrow and emerging markets could sell off with it, but the fact that any of us sitting here, or anyone in the audience that would have unique news that's not priced into the emerging markets because of any future policy of geopolitical risk or maybe global trade or tariff, anti-globalization. I really wouldn't put that at the top of my risk levels.
So U.S. 60, international 40.* Of that 40 all you would have to do is go look at what our total international portfolio looks like in emerging. It's somewhere around 80% developed, 20% emerging. So you think about 20 of 40, you're talking about an investor to have about 8% of their overall equity in emerging markets.
*This hypothetical example is for illustrative purposes only.
And some of the best ways to do that is to own it through a single fund. Whether you own Total Stock and Total International, you then own the world. If you own that in a 60/40 split that's a really great way to own the world. You now own the world with two funds. I think when I last checked you have over 8,000 individual securities by those two funds together. So you don't need more diversification, it's actually hard to get more diversification. Very low cost. And it will eliminate how often you have to rebalance it if you bought each underlying component.
Amy Chain: I'd have to put the disclaimer on there that of course it would depend on your personal circumstances about whether or not that would be the right allocation for you. So Todd, I'm going to ask you to talk to us about how you talk to clients about how they should consider emerging markets in their portfolios.
Todd Bechtel: Proportionality. I think that's what Fran was getting at real clearly is proportionality. And again, we use the total international stock index. We use FTSE All World ex-US, those are, again two broad-based index-based international funds that bring in I think it's 18.5%, close to 20%emerging markets. Done. You did it. And you did it tax efficiently.
Again the markets I mentioned earlier, international markets have improved in their efficiencies, and their cost, and that's why Vanguard has continued to grow in our comfort level with internationals being included in our portfolios because again it's not Vanguard if we don't talk about cost, right. So we're focused on costs, and costs has improved. And efficiencies, reporting, financial disclosures, all those things have improved over the years as the global economy has grown.
So just do it through an index fund. You'd be hard pressed to get me to start to buy individual components. Even Vanguard funds internationally because you got to manage that then, and then two years from now when I have to rebalance the portfolio, now I have a couple of different things I've got to kind of keep straight. And it could actually make more tax issues for the client.
Amy Chain: Now Carl and others have asked about REITs. Fran, maybe just spend a minute and talk about where we think REITs might fit into a portfolio.
Fran Kinniry: Sure. First I would say if you own the market, whether it be through a broadly diversified fund, S&P 500 or total stock market, you own REITs. A lot of people don't necessarily understand that sector funds, whether it be a health care fund or an energy fund, or a utility fund or the REIT fund, they are included in the market. So let's level-set everyone there. Then now if you own the market . . .
Amy Chain: If you're invested in the Total Stock Market Index Fund you have—
Fran Kinniry: You own—
Amy Chain: Some exposure to—
Fran Kinniry: The exact weighting of REITs. So then if you want to buy more of it, first I would say, you are now, that is speculative, or that's an overweight to what the market believes REITs' values are. Whether that turns out to be right or wrong, we won't know. But that is clearly an overweight to what the market believes is its fair value. Because if the market felt that REITs would be more it would be more in the total stock market. Investors would buy it up and it would sell out.
I don't know whether he has them in a taxable or tax-exempt account. Again we're talking to a high-net-worth audience here. Mostly taxable. REITs extremely tax-inefficient. So hopefully they are in their tax-qualified plan because you can see how a REIT fund does on vanguard.com. We have all of your pre-tax and after-tax returns, and the fund gives up a tremendous amount to taxes.
So hopefully it's held in a tax-qualified plan. We would not recommend whether it's in a tax-qualified or not, overweighting it because you already own it. So that's what we would say on the REIT fund.
Amy Chain: Todd, Diane's asking about dollar-cost averaging, is that the right way to enter the market?
Todd Bechtel: Does it make you feel good? Because that's what it comes down to. It's basically emotion versus math. It's a common tool that I use after I've discussed with the client the benefits of simply getting to our strategies. So let me cut to the chase. If I, after many days and weeks working with a client, we've come to a conclusion on a certain allocation, say 60% stock. And they're at 40%right now based on what they brought to me, that's a 20% gap. We all agree 60%'s the target we want to be at, so why would we delay?
Well, we would delay because Murphy's Law, because the markets are priced up. Again these are all things that a client would bring to me as concerns. I would agree to a dollar-cost averaging strategy after confirming with them that it's probably statistically not going to benefit them, historically. The markets are up more than they're down.
Again we can argue where the markets are now and whether they'll continue to go up, which is where inevitably the conversation goes, but if you are going to dollar-cost average, understand statistically it's probably not a performance enhancement, it's more of an emotional allotment or adjustment to allow a client to move forward with a strategy. I would, though, keep it under a year. I wouldn't want to extend it too much. And that's about where I would be on that.
Amy Chain: That sounds good. I think we are about out of time, so I'm going to turn it over to Fran first for some closing thoughts. Anything you want to leave our audience with before we wrap up this evening?
Fran Kinniry: I want to thank you all. I mean it's been incredible. When you think about the last ten years, if you will, and I know a lot of our audience has been with Vanguard a very long time. To see even going back further, they say may you live in interesting times. So you had the internet, five years in a row of 20% returns in the late '90s. Followed by the internet tech bubble down 40%. See the market go up 200%, down 55 and now we're up another 250%. So thank you for your patience. Thank you for your commitment to Vanguard. You're in the right spot according to me, low cost.
Our mission and our values to really give you all the best chance of success. And so I just thank you for being with us and your patience through the last 15 years has been really an incredible ride through all that. And congratulations to yourself, because you've stayed with your program through some pretty trying times.
Amy Chain: Very good. Staying the course. Todd.
Todd Bechtel: Yes, we have a wonderful paper out there called Principles for Investing Success. I believe it's a widget on our tools. And so I'm going to steal from that a little bit, the four main points, and it's a great piece, and I would encourage everybody in the audience to read it.
But the four main points are essentially, develop clear goals, from those goals develop a well-thought-out diversified asset allocation. Point number three, keep costs low, I'll throw in taxes too. And then finally, stay disciplined. Stay long-term focused. And my personal addition to that last point will be, focus not on the money, focus on what the money's accomplishing for you. How is it benefiting your family, what's the legacy? We all, we're not all investment professionals, but we're all professionals in our own lives. So tie your personal circumstances to your investment goals and you will be successful.
Amy Chain: Very good. And that paper that Todd has referenced is available in the resource list widget if you'd like to read more about our Principles for Investment Success. We really hope you've enjoyed tonight's discussion. Our next exclusive event for Flagship Select clients will be in June when our experts will discuss and answer your questions about trusts. Look for an invitation closer to the event.
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