A number of you were not pleased with my recent comment on the Motley Fool’s “Dogs of the Dow” strategy.

Under the subject heading, “Bad Calculations!!!” Mohammad Samiullah wrote, “It seems that you are doing inconsistent calculations. See response to your answer by Robert Seard. You should disclose your real motives rather than do haphazard calculations to misguide people.”

While I can’t imagine what secret motive Mohammed thinks I might have, I certainly read the article by Robert Sheard (it’s Sheard, not Seard) with interest. (If you haven’t visited the Motley Fool site, you should —http://www.fool.com)

Rather than make you click to find it and go back and forth between Robert’s comments and mine, I hope the Fools won’t object to my cutting and pasting his remarks here [with my responses in brackets, like this]:

FOOL GLOBAL WIRE by Robert Sheard (MF DowMan)

LEXINGTON, Kentucky (January 23) — A reader asked me to comment on today’s Andrew Tobias column (available at www.ceres.com), which was itself a response to a question about the Motley Fool’s beloved Foolish Four approach. And as I have no desire for this to be seen as the start of a flame war, let me point out that I agree with many things in his column.

[Ah, if the Democrats and Republicans could only be so civil. Needless to say, I much appreciate Robert’s approach, not to mention the plug.]

First, we all know that past performance is no guarantee of future performance, but since it’s the only thing we can measure, it’s what we talk about. That said, though, when you’re talking about decades of performance, most investors feel a little bit of security that the approach is sound, as Tobias mentions.

He also asserts a long-held Fool belief that most managed mutual funds just can’t beat the index funds, so as a first step, if you have to be in funds, at least check out index funds.

But his comparison between the Foolish Four approach and an index fund after taxes is where we part company. His claim is that if one rotates every year with the Foolish Four, and thus incurs capital gains taxes each year, then the buy-and-hold approach with an index fund, which defers taxes, is more attractive. Not so unless you cook the numbers as he has in his example.

[Just before we get to the cooking, or lack of same, I should point out to new readers what the Dogs of Dow strategy is: namely, that at the start of each year, you buy the second through fifth highest-dividend-paying of the 30 stocks that make up the Dow Jones Industrial Average. It’s a strategy that has some underlying logic but also some potential flaws, as I wrote last week, and to which Robert is responding.]

First of all, he reduces the Foolish Four return to 20% because he doesn’t believe the rate it has posted since 1971 (23%) is sustainable. Fair enough. But then he declares a tax rate of 40%, including federal and state taxes and a mixture of long- and short-term capital gains. Un uh! This approach only generates long-term capital gains if you update a year and day after your last update. No short-term penalties here, which means the federal rate can’t go higher than 28%.

[Fair enough. I should have used something more like 32% instead of 40% in my example. My motives were pure, but my thinking was sloppy.]

Then he declares a 15% annual return for the index funds. But that overstates the actual return of the Vanguard Index 500 fund since its inception in 1976 (14.2% according to the Vanguard representative I called). Now if you’re going to declare that the Foolish Four can’t possibly sustain its historical 25-year growth rate, isn’t it a little bit unfair to overstate the actual historical growth rate you calculate for the index fund?

[Well, here’s where we begin to disagree. In my comment, I said I thought both rates I was using in my example — 15% for the index fund and 20% for the Dow strategy — seemed wildly optimistic. So the real question is simply, by how much, if at all, the Dow Dog strategy will outperform an index fund. I still think I was being generous by saying 20% versus 15%. I’m not sure it will continue to outperform the index at all.]

But a more glaring disparity is that Tobias uses only a 35% combined federal and state tax rate for the index fund. That won’t do either. Both approaches are taxed each year on dividends and both are taxed upon any sale at the long-term tax rate. So those rates have to be the same or the comparison is meaningless. Choose 35% or 40% or whatever rate applies to you, it doesn’t matter, but the rate must be the same for both investment approaches.

[Again, fair enough. Let’s use 35% for both.]

Let’s compare apples to apples using actual historical return rates and the same tax rate (say a combined federal and state rate of 35%). After you take 35% out of the annual growth rate for the Foolish Four of 23%, you’re left with an after-tax rate of 14.95%. And that assumes the entire portfolio turns over every year, which of course doesn’t happen. Compound that for 25 years and a $10,000 portfolio grows to $325,630, after taxes.

Put the same $10,000 into an index fund at Vanguard’s long-term return of 14.2% and let it grow tax-deferred for the 25 years. That comes out to $276,473. Now take out the deferred taxes you owe on the gains from the original $10,000 at 35%, and the total value after taxes is only $183,207. That’s only 56% of the value of the Foolish Four portfolio after 25 years.

[Yes. As long as you assume the Dow strategy will blaze along at 9% a year ahead of the market — 23% a year instead of 14%, in this example — then you should certainly follow it, regardless of taxes. No question. But can it really be that the second-through-fifth highest-paying slots on the Dow are so magic that they will outperform the broader market at all in the future, let alone by 9% a year? Maybe, but I think that’s a very aggressive assumption. Robert is well within his rights to use a 35% tax rate. And he is of course right that with hindsight, you would have done great using this strategy. But can you really use historical returns to predict the future this way? I can say with some certainty that the index fund will perform just slightly worse than the index (because of the management fee). Can the Motley Fool predict with any reasonable certainty how the dogs of the Dow will do? Might the market of the next 25 years act somewhat differently in this regard from that of the last 25 — especially now that so much attention is being focused on this strategy? The attention itself could be self-fulfilling and make it work even better for a while . . . but in the long-run it could make it work worse.]

So while I agree with Tobias that taxes are important and that index funds beat out the vast majority of managed funds, I don’t at all agree that taxes render the Dow approach a weaker alternative than buying-and-holding an index fund. The numbers, when you compare actual rates of return and equitable tax rates, simply don’t support that conclusion.

*

Listen. You could certainly do worse than to try this. It’s not a crazy speculation, because the stocks in the Dow are not crazy speculations. And the historical pattern could continue unabated, and unaffected by the fact that a million extra eyes are focused on it now. But backtested systems rarely are the winners going forward that they were when “discovered” by looking back. And selling most of one’s holdings once a year, exposing the gain to tax, really is a weighty handicap. Consider: Warren Buffett has managed to compound his money at something like 26% a year for four decades. At that rate, $1 grows to $10,000. But chop taxes out of that 26% annual return (using a 28% tax rate, which cuts the return to a “mere” 18.7%), and that same $1 grows to just $950. Big difference: $10,000 versus $950. Not that any of us can do as well as Buffett. But I do think it makes the point. Because the Dogs of the Dow strategy entails considerable annual turnover, it must appreciably outperform the index funds (unless you’re investing through tax-deferred accounts) just to keep up.

 

 

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