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Computerized Investing > Third Quarter 2011

New Weekly Email

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by Wayne A. Thorp, CFA

At the end of April we launched a new weekly CI email to give our readers more timely and frequent reviews of useful websites, software and tech gadgets. In addition, each week we delve into CI’s archives to find timeless articles that you might have otherwise missed. Our reader survey questions give you a chance to interact with us and answer questions related to your computer, technology and investing habits. We will still publish periodic online exclusive articles, including our popular annual PC Buyer’s Guide and our annual comparison of comprehensive financial websites. If you had already signed up for the former monthly CI email, you should be receiving the new weekly CI email, which is sent out each Saturday morning. If you are not receiving the CI email, log into your account at AAII.com and go to “My Account.” There you can sign up for a number of AAII emails, including the weekly CI email.

Sharing AAII Content

Recently a comment was left online regarding a CI article discussing the sharing of CI and AAII Journal articles with non-members (you can find the comment in the Messages section on page 3). The reader voiced concern that such sharing dilutes the value of AAII membership and subscriptions to Computerized Investing. I am a proponent of social media, being an active participant through my Twitter feed and the CI Facebook page. While it is true that article sharing gives non-members access to members-only content, such sharing is an excellent way to spread AAII’s message of unbiased investor education. The hope is that through this sharing we will be able to increase our subscriber base, which gives us additional resources to build upon AAII’s mission to the benefit of all members and readers. Since there is the possibility of abuse, we do monitor the sharing of articles. If the need arises to discontinue article sharing to protect the value of membership, we will not hesitate to do it. In the meantime, if you read an article in CI or the AAII Journal that you think a friend would be interested in reading, don’t hesitate to pass it along by using the “Share this article” links.

Risk Minimization Using Excel

This issue’s Spreadsheet Corner, which begins on page 12, gave me an opportunity to learn something while, I hope, educating my readers. The article discusses using the Solver function in the Microsoft Excel spreadsheet program to find the weightings of a two-stock portfolio that minimizes the portfolio’s overall risk. While many people have Excel installed on their PCs, I wonder how many realize the investment applications of this software. We start out slow with this article, discussing a simple two-stock portfolio. In the Fourth Quarter 2011 issue, I will expand on this foundation for more real-world use.


Discussion

Jon from MN posted over 3 years ago:

—06/25/11
This is something that was just forwarded to me by my corporate tax adviser when questioning me on why I was holding the ETF ALMP the limited partnership fund that is listed on your website. I was unaware of the K1 forms that will most likely be required to be filed and may well outweigh the benefit of the diversification one is in hopes of achieving it. I thought you might want to share this for those who are interested in following some of your model portfolios. I certainly was unaware of this.


Commodities are hot, but exchange-traded funds and other vehicles that hold them are causing massive tax
headaches for investors.
Just ask Darren Neuschwander, an accountant in Robertsdale, Ala., with high-net-worth clients around the country.
In April Mr. Neuschwander billed one wealthy executive $3,500 to prepare his tax return—triple the tab from the
year before.
Mr. Neuschwander explained why to his shocked client: He had
to account for investments in 30 ETFs, up from five the year
before. Even though the executive lives in a state with no
income tax, he had to file returns in half a dozen other states for
the first time. The client said, "If my broker had told me about
this, I probably wouldn't have gotten in."
This is the dark side of investors' current rush into the trendiest
investment strategy around: exchange-traded funds and other
hot "alternative investments" such as exchange-traded notes
and master limited partnerships, specializing in commodities
like oil, currencies and gold.
Collectively, the products fall under a new umbrella called "exchange-traded products." There isn't any doubt about
investors' appetite for them: According to data compiled by analyst Deborah Fuhr of BlackRock Inc., which owns
ETF giant iShares, ETFs specializing in commodities, currencies and other alternative assets took in $38 billion in
new money from investors in 2009, $14 billion last year and another $7 billion so far in 2011. Over the same
period, more than $75 billion flowed out of U.S. stock mutual funds.
The largest commodity exchange-traded fund, SPDR Gold Shares (GLD), holds $59 billion, and by the end of May
there were 205 commodity-related ETFs, up from 158 in December 2010.
It is easy to see why investors are enamored. Still rattled by 2008's slaughter of conventional stocks and mutual
funds but hungry for performance and yield, many have turned to commodities and currencies to hedge against the
risks of a rising cost of living and falling dollar.
ETFs can be a cheaper and easier way to invest in commodities than traditional methods such as futures or
options. They trade throughout the day and you can see, in real time, what they own. Most don't have the risk of
leverage, or borrowed money, that can wipe out a position if markets move against you.
But they also carry potential tax traps. Among them: soaring tax preparation bills, odd tax rates, unexpected filings
and tax on some assets in tax-sheltered individual retirement accounts (see "What to ask before buying"). That is
ironic, since ETFs have long been praised for extraordinary tax efficiency; SPDR S&P 500 (SPY), the oldest ETF,
hasn't distributed a capital gain since 1996, three years after it was launched.
Even though ETFs trade like stocks and provide diversification like a fund, they often are structured very differently
from the stocks and mutual funds many investors grew up with. Mutual funds generally aren't allowed to hold
commodities directly, so the firms offering ETFs have turned to less familiar vehicles, such as partnerships, trusts
or corporations.
What to ask before
buying an ETF
If you don't want to wreak
havoc on your tax returns,
start with these useful
questions.
Extreme tax frustration
Commodity ETFs can wreak havoc on your tax bill. Here's what you need to know.
SPDR Gold Shares, for example, holds gold bullion in a "grantor trust." As such, profits and losses aren't claimed
by the trust but "flow through" to holders and are taxed at their income-tax rates.
There is a big difference at tax time: While holders of gold stocks in a mutual fund would pay tax on long-term
capital gains (those held longer than a year) of 15%, long-term gains for Gold Shares holders are taxed at 28%
because physical gold is a "collectible."
Tax advisers and preparers are worried. "Most investors in these products have no grasp of what they're getting
into," says Robert Gordon, head of Twenty-First Securities Corp. in New York. "I doubt if the brokers selling Alerian
MLP ETF [a basket of energy firms] are explaining that it is a corporation that owns parts of many partnerships that
own oil assets and owes an extra layer of taxes."
Confused investors probably won't find much individual help from sponsors on thorny issues like having to file
returns in multiple states or the fine points of mark-to-market rules for funds holding futures.
Although Uncle Sam is phasing in rules requiring brokers to calculate "cost basis" for investors, they often don't
apply to commodity ETFs.
That is why paying your tax preparer to sort it out can cost so much. Here is just one example: Many ETFs are
organized as partnerships for regulatory reasons, and they issue an annual K-1 tax report to each investor. A K-1 is
like the 1099 for your mutual fund, but much longer and far more complex.
CPAs interviewed for this article said each K-1 from an ETF takes up to an hour to put into a tax return, often at
rates north of $150 an hour. That is why Mr. Neuschwander's tax-prep bill for his client with 30 ETFs was so large.
At least the return was correct. K-1 tax information may be spread over many pages—unlike a simple 1099—
confounding many do-it-yourselfers and even some professionals. Mr. Neuschwander also caught a mistake this
year involving ETF K-1 information on a return prepared by another professional that missed a $20,000 deduction.
ETF tax complications have become so notorious, says Chief Investment Officer William Koehler of ETF Portfolio
Partners Inc. in Leawood, Kan., that some investors are insisting on selling funds generating K-1 forms even if they
made money and want to hold the same underlying assets. Instead they are asking for ETFs that don't generate
tax headaches. Mr. Koehler and his partners have a nickname for these clients: "K-1 and done."
For investors in commodity ETFs, tax surprises can dent or even erase the gains you thought you got. With these
new products, the old adage "know what you own" may not be enough. You also need to know what you'll owe.
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