Bob’s Journal for 1/25/23

Happy 30^th Birthday to the ETF

The first exchanged-traded fund (ETF) began trading on January 22, 1993. The relatively low-profile event began a revolution in investing that continues.

Before the ETF, individual investors had two choices. They could buy individual stocks (and pay brokers’ commissions or trading fees). Or they could buy shares in mutual funds.

The first ETF was the SPDR S&P 500 Trust (SPY). Investors could buy the entire S&P 500 Index by purchasing one share of SPY.

When SPY went public, the opening bell to the American Stock Exchange was rung by the heads of State Street Bank and McGraw-Hill Publishing. State Street Bank continues to manage SPY and is one of the largest issuers of ETFs.

At the time, McGraw-Hill owned Standard & Poor’s, which constructs the S&P 500 and other indexes. McGraw-Hill divested most of the businesses it owned at the time and now focuses on being a major education textbook publisher.

Index mutual funds were and still are available. An advantage of ETFs is they trade on the stock exchanges just like company stocks. You can buy and sell at any time during the day when the markets are open. Traditional open-end mutual funds can be purchased and sold only at the end of the day and will be priced based on the day’s closing prices for stocks.

Also, ETFs generally have lower fees and expenses than comparable mutual funds. In recent years, most brokers created another advantage by allowing clients to buy and sell ETFs with no trading fees or commissions.

For years, almost all ETFs sought to track market or sector indexes. Today, most ETFs still are index-tracking funds.

But the ETF industry is innovative.

Many ETFs allow low-cost niche investing by creating unique, customized indexes to track.

Others slice and dice existing indexes in different ways. An investor can find multiple ETFs that invest in individual sectors or industries. Or an ETF might buy only growth or value stocks or follow some other investment factor or style.

ETFs also make available to any investor very low-cost strategies that previously were accessible only to institutional investors and wealthy investors.

A small investor now can invest in a stock index of a particular country or group of countries. International stocks can be hedged against currency changes or be invested in without a currency hedge.

International bonds can be purchased in similar ways.

ETFs also allow low-cost investments in commodities, either through a broad commodity index, an index sector, or an individual commodity. The commodity ETFs generally invest through futures contracts, though some own physical commodities.

More recently, the number of actively managed ETFs has increased. The managers of these ETFs buy and sell stocks (or other assets) during the day using their own strategies instead of trying to track an index.

The story of the first 30 years of ETFs includes some failures. A number of ETFs didn’t attract enough investors for them to be financially viable and were liquidated or merged into other ETFs. Some years, more ETFs disappear than are created.

Some ETFs follow strategies or investments that can be labeled “exotic.” Sometimes these have worked out for investors, but other times such ETFs lost substantial value.

Investors continue to move money from traditional mutual funds to ETFs. In 2021, ETFs had a record net inflow of funds, and 2022 was close behind with almost $600 billion in net inflows.

Traditional mutual funds in 2022 had net cash outflows of almost $1 trillion.

Even so, ETFs have a long way to go. At the end of 2022, ETFs had about $6.5 trillion in assets, while traditional mutual funds had $16.3 trillion. SPY, still the largest ETF, has about $370 billion in assets.

Look for more innovation in ETFs. About 95% of ETFs still are index-trackers. But more than half the ETFs launched in 2022 had active strategies, and about 15% of dollars flowing to ETFs in 2022 went to actively managed funds.

Why TIPS Didn’t Protect Against Inflation

In 2022, we had the highest inflation rate in more than 40 years. Yet, traditional inflation hedges delivered negative returns for the year.

Topping the list of disappointing inflation hedges in 2022 were Treasury Inflation-Protected Securities (TIPS). As the name indicates, TIPS were designed specifically to protect investors against inflation. Each year, the principal value of the bonds is adjusted for higher inflation (but not deflation). That in turned increases the annual interest payments.

In most of the Retirement Watch portfolios, we added TIPS in August 2020 because I believed inflation was headed higher. We sold TIPS in February 2022. That was months before inflation peaked. But TIPS prices were falling and seemed likely to continue declining.

My recommended TIPS fund, SPDR Portfolio TIPS (SPIP), had total returns of 11.41% in 2020 and 5.79% in 2021. SPIP lost 12.82% in 2022, despite the high inflation of that year.

Several factors caused TIPS to lose value in 2022 despite rising inflation.

One factor is that TIPS are designed to provide long-term inflation protection. The principal value and interest payments of TIPS rise mechanically over time as inflation rises.

But daily market prices of TIPS are different. They rise and fall based on investor expectations of future inflation. In 2020 and 2021, investors generally expected inflation to increase above what was reflected in TIPS prices. Indeed, TIPS prices increased faster than inflation.

But throughout 2022, investors expected inflation would recede quickly. The long-term expectations for inflation were low despite rising inflation in the short term, and that caused investors to put lower values on TIPS.

Real interest rates were another factor. Real rates are nominal market interest rates minus inflation. When real rates rise, investors are willing to pay less for all types of bonds, including TIPS.

Real rates rose throughout 2022 as the Fed steadily increased interest rates. Even as the 12-month inflation rate began to decline in the second half of the year, the Fed continued to raise rates. This caused real interest rates to continue rising.

Rising real rates, combined with lower long-term inflation expectations, caused TIPS to lose value in 2022. The same factors caused gold to lose value through much of 2022.

As I’ve often said, there isn’t a 100% reliable inflation hedge. When you expect higher inflation, protect yourself with a basket of inflation hedges.

Another important point is that it’s not enough to accurately forecast what will happen in the economy. You need to accurately forecast what will happen that isn’t already reflected in market prices.

The markets correctly forecast 2022’s higher inflation in 2020 and 2021, then embedded those expectations in prices of inflation hedges. By the time inflation was rising, markets were anticipating it would peak in 2022. That anticipation was reflected in the market prices of inflation hedges.

More Evidence in Favor of Delaying Social Security Benefits

New research adds to the evidence that it often makes sense to delay receiving Social Security retirement benefits as close to age 70 as possible.

Delaying Social Security benefits to age 70 instead of 62 increases monthly benefits by 77% in inflation-adjusted terms, according to a new paper in the Journal of Financial Planning by Wade Pfau and Steve Parrish.

One factor in favor of delay is that the actuarial data used to determine Social Security benefits were designed in 1983. Life expectancy is much higher now, so more than half your age group will live beyond average life expectancy and benefit from delaying benefits.

In addition, interest rates were much higher in 1983. Now, you earn less on your assets, so it makes more sense to spend assets to receive higher Social Security benefits in a few years.

These factors are in addition to the annual, tax-free increases in benefits that are guaranteed each year you delay receiving them.

The study also pokes holes in the strategy of claiming benefits early to invest them.

To benefit from this strategy, the beneficiary has to earn high enough investment returns to more than offset the automatic increases from delaying Social Security benefits. Of course, the investments must be successful. Investment success isn’t guaranteed, while the increases in Social Security benefits are.

For many retirees and near retirees, success from this strategy requires taking more investment risk than they normally would by adopting more aggressive portfolio allocations.

The authors say hat an examination of historic data indicate it isn’t common for investment returns to beat the return from delaying Social Security benefits, especially for beneficiaries who live longer than average life expectancy.

The research is consistent with other research, much of which I cite in my book “Where’s My Money? Secrets to Getting the Most out of Your Social Security” (Regnery Capital).

While there are cases when it makes sense to take Social Security benefits before age 70 and even before full retirement age, in many cases the highest lifetime payments are received by delaying benefits. That’s especially true for the higher-earning spouse in a married couple.

The Data

Existing home sales declined 1.5% in December. Over 12 months, sales declined 17.8%. Sales for 2022 were the lowest since 2014.

Housing starts declined 1.4% in December, the fourth consecutive month of declines. Over 12 months, starts are down 3.0%.

The Philadelphia Fed Manufacturing Index still is negative but improved to negative 8.9 in January from negative 13.7 in December. That’s the fifth consecutive negative reading and the seventh in the past eight months.

The Richmond Fed Manufacturing Index in January tumbled to negative 11. It was positive 1 in December.

The economy improved a little in the first half of January but still is contracting, according to the PMI Flash Indexes.

The PMI Services Flash Index increased to 46.6 from 44.7 at the end of December. The PMI Manufacturing Flash Index rose to 46.8 from 46.2 at the end of December.

Those changes brought the PMI Composite Flash Index up to 46.6 in mid-January from 45 at the end of December.

New unemployment claims declined by 15,000 to 190,000 in the latest week. That’s the lowest level in four months.

Continuing claims, which lag a week behind new claims, increased to 1.647 million from 1.630 million.

The Markets

The S&P 500 rose 0.61% for the week ended with Tuesday’s close. The Dow Jones Industrial Average lost 0.52%. The Russell 2000 increased 0.06%. The All-Country World Index (excluding U.S. stocks) added 1.16%. Emerging market equities jumped 2.41%.

Long-term treasuries gained 1.09% for the week. Investment-grade bonds increased 0.67%. Treasury Inflation-Protected Securities (TIPS) added 1.21%. High-yield bonds lost 0.22%.

In the currency arena, the U.S. dollar declined 0.36%.

Energy-based commodities were unchanged. Broader-based commodities fell 0.39%. Gold rose 1.49%.

Bob’s News & Updates

My next book will be “Retirement Watch: The Essential Guide to Retiring in the 2020s.” The official publication date is Jan. 3, 2023. You can make a pre-publication order or learn more about the book by clicking here and here, respectively.

My latest book is “Where’s My Money: Secrets to Getting the Most out of Your Social Security.” It has received mostly five-star reviews on Amazon for telling you clearly what your benefit options are in different situations and how to determine the best choice for you. You can find it on Amazon.com or Regnery.com.

The number of regular viewers for my Retirement Watch Spotlight Series continues to increase. You should sign up because I make in-depth presentations of key retirement finance topics. You can watch these online seminars from the comfort of your home or office at times you choose. To learn more about my new Spotlight Series, click here.

A recent five-star review of my book, “The New Rules of Retirement” on Amazon.com said, “A complete retirement guide! One of the best books on this topic!” Click for more details about the revised edition of “The New Rules of Retirement.”

If you’re interested in my books, check my Amazon.com author’s page.

I’m a senior contributor to the Forbes.com blog. You can view my contributor page here.