Mar

7

Building Your Investment Portfolio, Part 4

By Teresa | Filed Under Knowledge Base | Start a Discussion

In Part 3, we showed readers that volatility of returns is a critical statistic when it comes to avoiding funds whose performance might vanish overnight: “those who live by leverage can die by it too. Some hedge fund investors deliberately steer clear of funds that earn 87% returns; they prefer those who aim for a steadier 10-12%.”

All else being equal, rational investors prefer low volatility of returns and use leverage to increase the amount of returns where appropriate.

Smoke and mirrors (and worse) are found all over the financial services landscape. In this installment, I cut through the crap and show you how I created my own portfolio. It may not be suitable for everyone, but the principles will apply to most individuals.

Stay with Traditional Asset Classes

Let’s just keep it simple and start at the top. Investment management practitioners divide asset classes into two broad groups: traditional and alternative.

Traditional = marketable securities (stocks and bonds)
Alternative = absolute return, real estate, private equity, credit derivatives, commodity and managed futures (depends on whose book you read)

Purity of asset class represents a rarely achieved ideal. Carried to an extreme, investors define dozens of asset classes, creating an unmanageable multiplicity of alternatives. While market participants disagree on the appropriate number of asset classes, fewer tend to be better. Portfolio commitments must be large enough to make a difference. Committing less than 10 percent of a fund to a particular type of investment makes little sense; the small allocation holds no potential to influence overall portfolio results. Investors trade off the benefits of precise definition of an asset class with the costs of employing large numbers of classes.

Functional attributes play the dominant role in defining asset classes, with structural and legal characteristics taking secondary positions. Asset class distinctions rest on broad sweeping differences in fundamental character; debt versus equity, private versus public, liquid versus illiquid, domestic versus foreign, inflation sensitive versus deflation sensitive. Ultimately investors attempt to group like with like, creating relatively homogenous groups of investments that provide fundamental building blocks for the portfolio construction process. — David Swensen, Pioneering Portfolio Management

The recent trend has been the creation of new alternative asset classes such as art and infrastructure, much like the proliferation of exchange traded funds to cover every possible investment nook and cranny. Perhaps these niche investments provide ways to diversify within an asset class, but fads and fashion are not for my nest egg.

Which Assets Do We Choose?

In Part 2, we demonstrated the power of compounding dividends and interest over time to produce total return. All assets in our core investment portfolio MUST earn interest or dividends; therefore, stick to traditional asset classes (stocks, bonds) and for U.S. investors, protect purchasing power with currencies. Asset classes that pay no dividends or interest can be actively traded for capital gains.

1. U.S. Equities
The outlook for U.S. stocks has been negative for a long time, but the fact is that factors favorable for investment are entrenched in this country. Investors rarely reflect on the economic framework and the stability of the United States:

Why is this relationship between the rule of law and material well-being seemingly so immutable? In my experience, it is rooted in a key aspect of human nature. In life, unless we take action, we perish. But action risks unforeseen consequences. The extent to which people are willing to take risks depends on the rewards they think they may gain. Effective property and individual rights in general decrease uncertainty and open a wider scope for risk taking and the actions that can produce material well-being. Inaction produces nothing.

Rational risk taking is indispensible to material progress. When it is impaired or nonexistent, only the most necessary actions are taken. Economic output is minimal, driven not by the calculated willingness to take risks but often as a result of state coercion. The evidence of human history strongly suggests that positive incentives are far more effective than fear and force. The alternative to individual property rights is collective ownership, which has failed time and time again to produce a civil and prosperous society. — Alan Greenspan, The Age of Turbulence

2. International Equities
I only invest in top-tier international stocks. Emerging markets that pay few dividends and “frontier markets” not suitable for the core investment portfolio.

3. Treasury Notes and Bonds
7-10 year U.S. Treasury bonds are ideal:

By holding portfolios of high-quality, long-term, noncallable instruments, investors emphasize the attributes of bonds that provide the greatest protection in times of financial crisis. When investors seek refuge from the volatility induced by panics, securities backed by the full faith and credit of the U.S. government outperform risky assets, sometimes dramatically. — David Swensen, Pioneering Portfolio Management

4. Cash
Cash can be very useful, but those holding U.S. Dollars know that it is not always king. What role does cash play in my portfolio? Well, cash can be denominated in many currencies. Investors can choose from a tight list of reasonably well-managed countries to achieve several aims. For example, currencies such as the Canadian and Australian dollars are good proxies for commodity exposure. Other currencies may yield attractive interest rates.

The balance sheet of the U.S. has been deteriorating for a number of decades. Everyone knows it, but few did the right thing. In December 2001, I did a couple of e*Trade radio shows and “discussed the Dollar’s test of the 120 level. We didn’t think that it would pass the test and our strategy for the long-term was to shift into gold and the Swiss Franc.”

This position was reiterated at my old website on July 28, 2003 and January 7, 2004. Until something drastic changes in Switzerland or the U.S., or a massive depegging of Chinese and GCC currencies take place, the Swiss Franc will remain the core hedge for those earning or saving in U.S. dollars.

Asset Allocation Vehicles

Next, we determine how to deploy our assets. My vehicles of choice are exchange traded funds because they allow us to invest with low administrative costs and help reduce transaction costs upon rebalancing. In fact, our model U.S. core portfolio requires only four ETFs:

The SPDR S&P 500 (SPY) allows us to invest in the S&P 500 Index. I prefer this traditional cap-weighted index because, in effect, it buys stocks as they rise in price and sells them when they falter. Over time, the cap-weighted index functions as a Darwinian mechanism, ensuring that irrelevant companies are continually eliminated from my holdings.
The MSCI EAFE Index Fund (EFA) allows us to invest in publicly traded securities in the European, Australasian and Far Eastern markets, as measured by the MSCI EAFE Index.
The Lehman 7-10 Year Treasury Bond Fund (IEF) seeks to approximate the total rate of return of the intermediate-term sector of the United States Treasury market as defined by the Lehman Brothers 7-10 Year US Treasury Index.
The CurrencyShares Swiss Franc Trust (FXF)** is designed to track the price of the Swiss Franc net of Trust expenses, which are expected to be paid from interest earned on the deposited Swiss Francs.

**Some investors may be in position to hold Swiss Francs in an interest-bearing account, which is a fine alternative so long as transaction fees are competitive with brokerage fees.

As an aside, there has been a multi-decade argument going on since the publication of the Determinants of Portfolio Performance (DOWNLOAD PDF) by Brinson et al. Rather than wade into the debate, I shall let David Swensen have the last word:

Investors often treat asset allocation’s central role in determining portfolio returns as a truism. It is not. The Brinson, Singer, and Beebower study describes investor behavior, not finance theory. Imagine a buy-and-hold portfolio consisting of one (particularly idiosyncratic) stock; portfolio returns follow largely from security selection. Or consider the strategy of aggressively day-trading bond futures; market timing dominate returns.

Obviously, institutional portfolios usually consist of more than one stock and rarely engage in day-trading strategies. Instead, investors hold broadly diversified portfolios and avoid market timing, causing portfolio asset allocation targets to be the most important determinant of investment results. Given the difficulties in timing markets and selecting portfolios of securities that will outperform, such behavior provides a rational foundation for investment management. By avoiding extreme portfolio shifts and holding diversified portfolios, investor behavior causes asset allocation to account for the largest share of portfolio returns. — David Swensen, Pioneering Portfolio Management

Deployment and Rebalancing

The percent of assets to be allocated to each asset class can be determined using discretion or a formula or something in between. My view of classic rebalancing — selling winners and buying losers — is that the practice is probably acceptable so long as the allocation to stocks is invested in a quality cap-weighted index.

The best problems, like the best toys, are hard to exhaust. You can approach them from a variety of different angles, each new angle making the problem fresh again, and bringing the opportunity to discover something new. Any idea, no matter how crazy seeming, might work and can be worth exploring. Indeed, the harder the problem, the more degrees of freedom one can allow in tackling it. Fischer relished hard problems because he relished that freedom, but in practice he did not try just anything. In his view, if a problem does not yield to known methods, that doesn’t mean we need more sophisticated methods, indeed probably just the opposite. Usually problems are hard not because our technique is deficient but because our understanding is deficient. — Fischer Black and the Revolutionary Idea of Finance

Having been a trader for 20 years, it was my preference to sell both winners and losers under certain circumstances. With that in mind, I crafted a quantitative rebalancing algorithm that has served me well. Applied to the model portfolio, the performance has been very good indeed. Furthermore, the model portfolio displays many desirable characteristics:

1. Highly Defensive

Percent Allocated to Each Asset Class Changes Over Time
CLICK TO ENLARGE IMAGE

The rebalancing algorithm is dynamic; that is, the percent of funds allocated to each asset class is recalculated on a weekly basis. This is also convenient as it allows clients to fully implement the portfolio at any point in time, knowing that the algorithm has accounted for current market conditions.

As you can see from the chart above, the Model Core Portfolio has historically held a significant amount of Treasuries and cash. This serves as a ballast against the stocks in the portfolio since most public companies are quite leveraged.

2. Low Volatility of Return

Standard Deviation = .00756

As seen in Part 3, proper asset class selection, deployment and rebalancing results in a model portfolio that experiences only a fraction of the volatility of returns found in the S&P 500 index or the famous funds.

3. Slow and Steady Wins the Race

Steady Growth
CLICK TO ENLARGE IMAGE

The portfolio is balanced once per week to reduce transaction costs. Steady growth makes it easy to stay the course. Roller coaster rides are best experienced at amusement parks.

In Conclusion

Standard Deviation = .01753

A core portfolio achieves the investor’s goal of reducing the volatility of returns through disciplined and diversified investing in traditional asset classes. We avoid fads and fashion. No rear view mirror was used to dress up returns by adding commodities, considered an obsure institutional alternative asset class as recently as … 2006! Our proprietary allocation and rebalancing mechanism further enhances returns and decreases the volatility of returns of the portfolio.

Unleveraged Model Core Portfolio vs. S&P 500 Index Total Return
CLICK TO ENLARGE IMAGE

The characteristics of our core portfolio make it possible for those with risk appetite to use leverage to boost returns.

Leveraged Model Core Portfolio vs. S&P 500 Index Total Return
CLICK TO ENLARGE IMAGE

Consider the fact that the S&P 500 Index experienced 231% more volatility of returns than our Model Core Portfolio. Clients willing to endure that level of volatility could use margin to “gross up” the Model Core Portfolio to match that of the S&P 500 by using margin. For example, using 1:1 leverage (50% margin), the returns are doubled for the Model Core Portfolio while maintaining lower volatility of returns than the S&P 500 Index.

CLICK HERE to read Part 5.

Questions and Comments

Portfolio Strategy clients: Please log in to join the discussion if you do not see the text box below.

Our Services

Read Blog by Category

Recommended Reading

Mar

7