Welcome to the fifth installment of picking up pennies. Last month, we discussed how we trade ETFs by putting our trades in competition to improve the price we buy and sell ETFs for. Although we minimize trading costs, it still costs money to trade. Thus, we want to minimize how often we trade. We only want to trade when it is economically meaningful. This month, we will discuss how we minimize trading by selecting the ETFs we invest in and how we reinvest dividends.

•   Volume 1 – Keep Cash Balances Low (Better Chance for Higher Returns)
•   Volume 2 – Asset Location (Reduces Taxes)
•   Volume 3 – Using ETFs (Reduces Taxes)
•   Volume 4 – Trading ETFs in Competition (Reduces Trading Costs)
•   Volume 5 – Number of Funds and Not Auto-Reinvesting Dividends (Reduces Trading Costs)
•   Volume 6 – Tax Lots and Tax Loss Harvesting (Reduces Taxes)
•   Volume 7 – Summary (Total Impact)

ETFs We Use

The US investment universe has over 3,000 different investment companies. To help investors simplify and organize this vast universe, we generally split stocks into four categories: large, small, growth, and value.

Investment advisors will want to ensure they have some allocation to each of these four asset classes. They will try to find “the best” manager in each category. We could take a similar approach and find the best evidence-based fund in each category, but we take a more nuanced approach.

The world, and the publicly traded companies in it, is not a static place. Stocks often change which category they are in. For example, a small-value company may have significant success with a new product and quickly become a large-growth company. When this happens, a small-value fund, if it follows the fund’s Investment Policy Statement promised to investors, would need to sell that stock, and a large-growth fund would need to buy that stock. Thus, if we were like many investors, the two funds we own in aggregate would buy and sell the same stock and incur trading costs. Is that helpful? No!

This is why HIG uses market-wide solutions in our client portfolios. We use one fund that buys stocks in all four categories. This is beneficial for multiple reasons.

First, the ETF won’t buy and sell the same stock as it moves among various categories. On average, funds that only invest in one category have an annual turnover of around 25%, meaning that fully one-quarter of the holdings held on January 1 are sold by December 31 of that year. A market-wide fund has only about 5% turnover per year. Therefore, by investing in one fund instead of four, we cut the amount of trading down by 80% with the same net economic exposure. The same securities are held with less trading costs. 

Second, a market-wide fund reduces the need to rebalance the portfolio. Ultimately, we want to invest a certain amount of money in each category. The all-in-one ETF maintains those percentages without the need for additional turnover. However, if you use four funds individually, those amounts will shift over time. You may want 25% in each category, but due to performance differences, you may end up with 35% in one category and 15% in another. Over time, you must sell one fund and buy another to get them back in balance. This will result in trading costs and incur capital gains, increasing your tax bill.

On the face of it, using more funds sounds better than using fewer funds. However, less is more when you invest in the correct funds and understand the details. Less trading, fewer taxes, and more money in your pocket. 

Reinvesting Dividends

 Another way we save on trading is how we handle dividends. Every investment (ETFs, Mutual Funds, Stocks) produces dividends. Dividends are simply cash paid to an investor and represent a portion of the return you earn on any investment. Most advisors and investors elect to reinvest the dividends automatically. This means if you own ETF ABC, and it pays a $10 dividend, you will automatically turn around and buy $10 more of ABC. This is an easy way for investors to “set it and forget it.” However, this approach, although easy, is not optimal for investors. Why?

First, when you reinvest dividends, you need to go to the market and buy more shares of the ETF. The custodians that automatically reinvest dividends do not care about execution prices. They want to get the cash spent. They usually execute these trades early the following morning when spreads and trading costs are highest. As we talked about last month, trading ETFs can be costly when you don’t put them in competition. Thus, automatically reinvesting dividends usually results in higher trading costs. 

Second, we want to invest the extra cash in the asset class that you are underweight. Not the asset class that just paid you money. We want to examine your overall portfolio and determine if you need more stock, fixed income, or US or international exposure. By constantly investing the dividends in the most underweight asset class, we reduce the rebalancing needed in the portfolio over time. This reduces trading costs and taxes. Yes, it means that every quarter, when every ETF pays a dividend, we must go into every account and spend that cash. We do it because this approach improves investor outcomes with better trade execution and lower taxes over time.

This information is educational and does not intend to make an offer for the sale of any specific securities, investments, or strategies.  Investments involve risk and, past performance is not indicative of future performance. Return will be reduced by advisory fees and any other expenses incurred in the management of a client’s account. Consult with a qualified financial adviser before implementing any investment strategy.

Happy tax season! I realize that’s probably an oxymoron for most people, but I have a confession: I like it. Suppose you’re obsessed with numbers and details like me. In that case, digging through diligent records in your file cabinet at home, ticking and tying every dollar of income, dividends, and interest, and accounting for every possible deduction is not a bad day, in my opinion (and it just might be how I spent my Sunday afternoon this weekend. There’s no more football, what else am I supposed to do?). And when the amount due matches precisely what you had calculated six months earlier… boy, does that feel good.

I know I’ve lost most people by now, but to anyone who has read this far, I reward you with some last-minute reminders as you gather up your tax documents to send to your CPAs (or for the brave, as you fire up your preferred tax preparation software and do it yourself!).

1. You probably hear this every year, but there is still time to make a 2023 contribution to an IRA or Roth IRA! You have until the date that you file your 2023 taxes to contribute. We generally prefer the Roth IRA if you’re below the gross income limits for 2023 (single filers: $138,000 / joint filers: $218,000). If you’re above the income limits, you can still choose to make a Backdoor Roth contribution. This would involve making a nondeductible 2023 IRA contribution and then immediately converting that amount to Roth. These rules can vary from person to person, so please reach out to us if you’d like to discuss this!
2. Don’t forget about Roth IRAs for your kids! The only requirement to contribute to a Roth IRA is “earned” income. Babysitting, mowing lawns, washing cars…it all counts, even if no W-2 or 1099 is issued. There is no age limit as long as there is real earned income. I emphasize real because doing chores around the house or babysitting for siblings one night doesn’t count. As a general rule of thumb, the Roth IRA is fair game if you have your kids file a tax return for their income. Each child is limited to the higher of $6,500 or their earned income (so if they earned $1,000, the limit is $1,000). Another great benefit is that they don’t have to use their money. You can make the contribution on their behalf.
3.   If you have a high-deductible health plan with a Health Savings Account, ensure you and your employer contributions have hit the 2023 maximum ($3,850 for self-only coverage and $7,750 for family coverage). Add an extra $1,000 to that if you’re over 50. You have until your tax filing date to top off those contributions with after-tax funds.
4.  If you live in a state with no state income tax (where two of our three Hill offices reside – sorry, St. Louis), you will likely get a deduction for sales taxes you paid in 2023. You could collect every receipt and total the sales tax on every item you purchased in 2023 (and I would not judge you), or you can do what most people do and take the IRS’s estimated amount. Most people don’t realize, however, that you can also add sales tax from significant purchases on top of the estimated amount. If you bought a car, boat, or Super Bowl tickets (really anything that made you wince when you swiped the credit card), don’t forget to tell your tax preparer! Unfortunately, state and local taxes are limited to a total deduction of $10,000, so there’s a good chance your property taxes already exceed that limited amount anyway.
5.  If you have self-employment income (as reported on Schedule C), don’t forget to make a SEP-IRA contribution. The limit is based on your amount of self-employment income, but the contribution itself will also count as an “expense” against your self-employment income. Your tax preparer can tell you how much you can contribute to a SEP IRA.
6. Lastly, here’s a list of a few pesky little forms that can be missed. Don’t forget to send these to your tax preparer!

• Form 5498: If you have an IRA, you have a 5498! This is an informational form that tracks contributions and distributions from IRAs and Roth IRAs. You can file your taxes without it, but giving these to your CPA will ensure that your IRA cost basis information is kept accurate year over year, especially if you’ve ever made nondeductible (after-tax) IRA contributions.
• Form 1099-SA: If you took money out of a Health Savings Account in 2023, this form will report that amount. A copy of this is also sent to the IRS, so you might get a letter in the mail if you forget it.
• Qualified Charitable Distributions (QCD): If you sent any portion of a required minimum IRA distribution directly to a 501c(3)charity, your form 1099-R will NOT specify that. It’s the tax preparer’s responsibility to note any QCDs. If HIG facilitated a QCD for you in 2023, you have nothing to worry about. We’ll let your tax preparer know.

And if you’ve made it THIS far, I applaud you and thank you for sticking it out. I leave you with a quote:  “Of life’s two certainties, there is only one where you will be granted an extension.” –Anonymous.

This information is educational and does not intend to make an offer for the sale of any specific securities, investments, strategies, or tax advice.  Investments involve risk and, past performance is not indicative of future performance. Return will be reduced by advisory fees and any other expenses incurred in the management of a client’s account. Consult with a qualified financial adviser or CPA before implementing any investment or tax strategy.

I had something else planned for my introduction to this month’s newsletter, but that will have to wait until February for reasons you’ll soon understand. 

As I’ve mentioned before, this newsletter is read by more than just our clients. We have 2,000 subscribers and a monthly open rate of 65 to 70 percent. This means every month, 1,400 people are taking a peek at what we share. But there weren’t 2,000 people in the beginning, or even 200. As some may have read in Odds On, we started Hill Investment Group with 0 clients. Rick and I made an agreement with our former firm that allowed us to talk with a small number of relationships, many of whom decided to join us.

One of those “founding” clients passed away recently, and I want to tell you about him. His name was George. 

George was a husband, a dad, a grandfather, a friend to many, a diehard North Carolina Tarheel basketball fan, an avid golfer, a former lawyer for the king of beers, a lover of his dog Maggie Mae, and someone who made a profound impact on Hill Investment Group. He also affected me, creating images and memories in my mind that will stay with me for the rest of my life.

Like most of us, George started as a very different investor. He was an old-school active investor, buying stocks and trading options and spending too much time and energy trying to outperform the market. All he got in return was too much stress and unsatisfying results. 

It took three meetings over six months to convince him to convert to an evidence-based approach. It didn’t hurt that his former employer, Anheuser-Busch, had switched to index funds in the mid-80s, so elements of that story helped push George a little closer to accepting our data-driven approach. Once he made the change, he never looked back and became a raving fan. 

When you had George on your side, he was an unstoppable force–the type to put his arm around you and emphatically introduce us by saying, “These are my guys. You should talk with them.” He suggested his family members work with us, neighbors, friends, golf partners, colleagues, and so on. Because he had both relationships and influence, people listened to him.

George approached everything he loved with that same enthusiasm. We once gave him a basketball signed by the coach of his favorite team. To make it perfect for him, we looked all over town for a plexiglass case to display the ball, then wrapped it and presented it as a special gift for all of his support. George tore open the paper, ripped the plexiglass apart, threw it all away, and carried the naked ball home. We tried to stop him and gather the plexiglass display case, but he didn’t want or need it. He blasted right through it and was on to his next adventure.

That was George’s typical speed. Once, he hollered at a golf marshal that play was too slow. The marshal calmly reminded George that he had just returned to St. Louis from Florida and may have forgotten to adjust his watch. The front nine had only taken two hours (right on time), not three. George laughed, saying, “Well, it felt long playing with these guys!”

Becoming a Hill Investment Group client gave George both peace of mind about his portfolio and more time to pursue the things he loved. He took trips worldwide, had a custom wooden boat crafted and named for his beloved wife, Joanie, and built a house on Martha’s Vineyard. Once the house was completed, he hosted a dinner to thank Hill Investment Group for helping make their dream home a reality. George’s generous toast at the dinner is still one of the highlights of my career. 

George embodied everything we hope for our clients and validated why we started this firm: to improve our clients’ lives. George said it best when he uttered a famous line in Hill Investment Group lore: “The only thing I fear now is a downhill, sidehill three-foot putt. My worries are different thanks to you all.”

In 2019, John Reagan and I took our spouses to visit George and Joan on Martha’s Vineyard (see photo). George created an itinerary that wore us out (and I’m 30 years younger). I slept like a baby on that trip. George did, too, on the final night. He took us to a private club—one he didn’t even belong to (except through an old reciprocal that had long expired)—for a splendid dinner where we were treated like royalty. Afterward, we drank, told stories, laughed, and finally, he fell asleep in his chair with his dog at his side as I tried to keep my eyes open through the remainder of the documentary he had selected.

George lived a rich life. He made things happen. He used his influence for good. He created memories. He helped our firm. He took the long view and was proud of it.

I’m lucky to have known him.