Thursday, April 30, 1998
Q. You often speak of tax-managed mutual funds and index funds as good long term investments outside of qualified plans. What about Standard and Poor's Depository Receipts ( SPDRs, listed on the American Stock Exchange, ticker symbol SPY)?
These would seem to offer most of the same advantages, and, if purchased from a deep discount broker with flat fees of $20 or less per transaction, would be essentially no-load. Of course, one wouldnt want to do this on a regular monthly basis but the management fee is extremely low (less than 0.2 percent) and the only capital gains incurred prior to selling the SPDRs would be when S&P changes the stocks in the index, right?
—J.P., Plano, TX
A. Right. These relatively new instruments— SPDRs that allow you to buy a unit representing the S&P 500 Index, WEBs ( World Equity Benchmark Shares) representing units for 17 different national markets, and Diamonds (units representing the stocks in the Dow Jones Industrial Average) all offer the benefit of limited to non-existent capital gains distributions because the represented portfolio is held, not traded.
There is, however, a subtle difference between these shares and those of open end index funds such as the Vanguard Index 500. A rapidly expanding open-end fund has the additional advantage of constantly diluting existing unrealized capital gains over a larger number of shares.
Suppose, for instance, that a fund has $100 million in assets with $50 million in unrealized capital gains on 10 million shares. It will have unrealized capital gains of $5 a share ($50 million divided by 10 million). If the fund attracts additional shareholders and grows to $200 million and 20 million shares but has no further gains, the unrealized capital gains will be diluted to only $2.50 a share ($50 million divided by 20 million shares).
The rapid expansion of index fund assets and shares over the last ten years has contributed to their tax efficiency as well as their low portfolio turnover. When comparing index funds with these new instruments you need to weigh the value of this feature against features the new instruments have that open end funds dont have: intraday trading, easy use of margin debt, and possible short sales.
My personal view is that the new American Exchange units represent a very nice way for people with portfolios of individual stocks to achieve broad diversification while still holding something as tradable as a common stock but they are less useful for people who concentrate their investing in mutual funds.
Q. I've recently been wondering how much cash I should keep available.
Standard response is 6 months supply. Is that valid? What exactly is cash? Some answers are easy. But what about stock? As long as I'm willing to sell it, can I still consider it cash? In a tight labor market, can the cash supply be lowered? Do I still need 6 months supply if I work in a field where I can go out today and get another job?
When is it more important to hold cash? Example: Say I have two cars with a car payment on each, and $10,000 in cash. Should I wipe out my cash to pay off a car, or hold the cash and continue to pay off the car with the standard payment each month? Which will serve me better in a sudden recession or job loss with poor employment prospects; a paid off car, or a larger reserve of cash?
— D. L., Dallas, TX
A. The size of your cash reserve depends entirely on how long it would take to replace your job. If you work at a fast food restaurant, you'd only need a few days because there are "Help Wanted" signs in every franchise window. If you have a special skill you need more of a reserve even when jobs are plentiful because it takes time to match the jobs with the skills. Computer programming is a good example. There are plenty of programming jobs but finding a good place to work that needs particular skills might take several months. If you are an executive you need to allow even more time— personnel experts start talking about a year of reserve.
Most people have a comfort zone in which they feel secure. Having a cash reserve can also be crucial in a major part of getting a new job, the salary negotiation. If you're on the ragged edge, not having the confidence of cash can cost you thousands that you will never make up.
Cash and "cash equivalents" are any investment that has little or no fluctuation in value and that can be liquidated and used in a few days. This means bank deposits, bank money market accounts, money market mutual funds, and short term Treasury obligations.
Cash does not include common stocks because their value can fluctuate greatly. While stocks can be your "deep reserve", they aren't very good for dealing with immediate problems— you dont want to be in a position of having to sell a stock.
I'd hold the cash over paying off the car loan. If you need to sell a car to raise cash you are immediately in the victim position. Youll be overwhelmed with lowball offers. No one should ever, ever underestimate the value of cash.