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What have I been up to since the last newsletter in May? Thanks for asking!

  • I spoke to graduate students at UCLA Anderson School of Management about my prior career--managing CDOs and credit derivatives. There's no better example of investor over-confidence than all the institutional portfolio managers who invested in these products without fully understanding them. Those of you that think you can beat the market by buying a few stocks after work, you have company.
  • Perhaps you already noticed, but I guest posted on a popular personal-finance blog, Get Rich Slowly. The post was a guide to choosing a target-date fund, comparing options from Fidelity, T. Rowe Price, and Vanguard. They're decent options for 401k's and investors who are just starting out.
  • And one suggestion I've been getting about the website and blog is to use more pictures. Well, I'm starting to do that on the blog and this newsletter. If you're a photographer and have photos that might work on the blog, let me know.

The topic for this newsletter is Roth IRAs, which I've been asked about a lot recently, and Morningstar ratings. Enjoy!

Edwin

An Introduction to Roth IRAs

It almost seems like the US retirement system was designed to keep people like me employed. There are no less than four major types of accounts people can use for retirement--and there are plenty more out there. Of these, the Roth IRA is this year's hot topic, because now everyone can convert Trad IRAs into a Roth (high earners were previously excluded). However, the income limit for contributions still applies.

Account Type On Contributions On Earnings On Withdrawal Similar Accounts
Taxable No deduction Income or capital gains tax Capital gains tax  
Roth IRA No deduction None None Roth 401k
Traditional IRA Deduction None Income tax SEP IRA, 401k, 403b
Non-Deductible Trad IRA No deduction None Income tax on earnings Tax-deferred annuity

Looking at these account types, here are some quick observations:

  • Roth IRAs are better than taxable accounts and non-deductible Trad IRAs. Contributions to these accounts do not provide a tax deduction, however a Roth IRA avoids all future taxes.
  • Non-deductible Trad IRAs are better than taxable accounts if you're willing to convert it to a Roth IRA. If you don't convert, you need to weigh the benefit of tax-deferred growth vs the downside of paying income tax on earnings--currently a much higher rate than capital gains tax.
  • In general, Roth IRAs are better than Traditional IRAs if you expect your future tax rates to be around the same or higher than today's rates. If you expect your tax rate to drop in the near term, you can contribute to a Trad IRA today, then convert when your tax rate drops. If your tax rate stays roughly the same, the Roth IRA is better because it's economically bigger, so more of your money is growing tax-free.

Based on that, here are some rough guidelines for using Roth IRAs.  Use the income table at the bottom to see where you fall.  And as always, consult your accountant before doing anything serious, like a Roth conversion.

  • If you qualify to deduct Trad IRA contributions:
    • If you expect your tax rate to drop in the future (the longer your wait, the more it has to drop), contribute to a Trad IRA and convert to a Roth then.
    • Otherwise, contribute to a Roth IRA.
  • If you qualify to contribute to a Roth IRA, but not the Trad IRA deduction:
    • Contribute to a Roth IRA.
  • If you don't qualify for either, you should call me at 323-393-0250 right away.  It's an emergency!
    • If you don't have existing Trad IRAs, contribute to a non-deductible Trad IRA then immediately convert to a Roth IRA, you cheater.
    • If you already have Trad IRAs (including Rollover IRAs, SEP IRAs, etc), then it gets tricky because you cannot convert just the non-taxable portion of your Trad IRAs. The IRS aggregates all your Trad IRAs and then calculates the taxable portion pro rata. The answer here unfortunately is "it depends."
Income Bracket or Phase Out Single Married (Joint)
25% bracket begins (taxable income) $34,000 $68,000
Trad IRA deduction phase out (modified AGI) $56-66,000 $89-109,000
28% bracket begins (taxable income) $82,400 $137,300
Roth IRA phase out (modified AGI) $105-120,000 $167-177,000
33% bracket begins (taxable income) $171,850 $209,250

If you can't get enough of Roth IRAs, here are more resources:

The Mariposa Blog

In case you missed them, here are a few recent blog posts:

Choosing a Target-Date Fund
A follow up to the guest post on Get Rich Slowly, this expands the comparison to include funds from Principal and TIAA-CREF.

3 Money Tips for Entrepreneurs
3 simple money tips for entrepreneurs, self-employed workers, or anyone going through a career transition.

Investment Options: Foreign Developed Market Stocks
This is the first of a new series of posts covering investment selection, by highlighting selection factors to consider and listing filtered investment options. The series starts with foreign stocks in developed markets.

Edwin's Market Commentary

The financial industry certainly places more emphasis on style than substance. So when their work is actually evaluated, it tends to be disappointing. Wall Street's earnings forecasts? They suck. Performance of mutual fund managers? Quite embarrassing. Do Morningstar ratings also belong in the same category? You probably see them all the time; mutual fund companies love using Morningstar ratings in their marketing materials. But is there any value in a 5-star rating?

Luckily for us, researchers recently looked into these ratings and published their results. They compared Morningstar ratings vs. fund expense ratios as a predictor of future performance. The expense ratio is one of my favorite metrics. If you assume that mutual fund managers have no value, which I find to be a very good approximation, you would expect lower costs to predict better performance. The report found just that:

Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.

And how about Morningstar ratings? 5-star ratings predicted better performance vs. 1-star ratings in 13 of 20 observations, a success rate of just 65%. That sounds pretty good on its own, but it's still worse than a metric that anyone can look up in seconds.

Since Morningstar ratings use prior performance (after fees) to calculate its ratings, they already include information about (past) expense ratios indirectly. So what is Morningstar adding with its fancy algorithm? Let's use a little high-school algebra to find out (Warning: Geek Alert!):

Rating = Expense Ratio + Morningstar's Analytics

And we just found out that:

Expense Ratio > Rating

Finally, using my graduate degree in math, I get this:

Morningstar's Analytics < 0

Yes, its algorithm is horrible. And that's not all. Morningstar reserves its 1- and 5-star ratings for the top and bottom 10% of funds. However, expense ratios were split into quintiles, or as normal people would say, 20% buckets. That's just so sneaky. So expense ratios were handicapped by using 20% buckets instead of 10%, and still beat Morningstar ratings. Ouch.

Why would the researchers do that? Well, there's one thing I forgot to tell you. People have done this evaluation many times with similar results, so it's not news to serious students of investing. The interesting part of the report I quoted is the publisher: Morningstar. If you read its report, it sounds like a politician answering a tough question -- uncomfortable. Independent thinkers can go directly to the results here (pdf).

Note: After writing this, I noticed that Morningstar tried to clarify that ratings are indicators of past performance, and should not be used to predict future performance. If Morningstar were concerned about substance, it would tailor its ratings to how investors actually use them -- as an indicator of a good investment. If it did that, most 5-star rated funds would just be index funds. But Morningstar unfortunately emphasizes style (and money), so it ends up with an imperfect rating system that benefits one of its biggest clients, mutual funds.

Upcoming Seminar: September 14, 2010

Using Roth IRA’s for Fun and Profit

Date Tues, Sept 14, 2010 at 7pm
Location Blankspaces
5405 Wilshire Blvd, Los Angeles, CA 90036
(323) 330-9505

Whether you’re just starting to invest or you’ve already accumulated a sizable nest egg, using Roth IRA’s can be a smart investing and tax move. And starting this year, Roth IRA conversions are allowed for everyone, making them even more interesting. Come learn how to use Roth IRA’s the smart way to improve investment returns and save on taxes.

Light snacks will be provided (probably brownies or cupcakes).

Register

Seats are limited, please register here.

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About Mariposa

Mariposa Capital Management is an investment advisor to individuals looking for a different kind of advisor.  Our approach to investing is to use simple yet effective strategies that are based on research and empirical data.

Mariposa does not earn commissions or other hidden financial incentives. Our compensation is completely fee only, paid directly and transparently by clients.