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We have quite a few questions related to portfolio strategy and trading tools in the mailbag.

James
I had a question on how the InVivo Universal Stops handles extreme moves in the markets. An example is the daily chart on my TradeStation account for Freddie Mac (FRE). The buy stop on July 10th was 11.23 but then it reverted to a sell stop on July 11th at 4.49 without the buy stop price of 11.23 ever having been hit. Is this some quirk in the program or do I have something wrong here?

Teresa
Let’s take a look at the chart.

The mortgage crisis might have broken FRE, but it has not broken InVivo Universal Stops. This is what happened: the gap down at the open on July 11 dragged the blue buy stop down to $7.75. The day before, the buy stop was at $11.23. If you had been watching this daily chart during the day, the buy stop would have been visible. FRE closed at exactly $7.75, 82% higher than the open price, triggering the buy stop. The code tells the indicator to plot the stop that is in force, and therefore, you can only see the pink one since price closed above $7.75 at the end of the day.

CLICK TO ENLARGE CHART

How do we know this for sure? I applied the trading system version of it to the daily chart and we can see that the short position was closed while a new long position was opened at $7.75.

Mark
I’ve been searching the website and can’t seem to find literature on WHY the specific ETFs that are implemented for the Strategic Portfolio are used. I swear that I did see something written about this subject but I just can’t find it anymore. Basically, I just want to know why, for example, the VXF was chosen over the SPY or why TLT was used instead of IEF which is the iShares Lehman 7-10 Yr Treasury Bond Fund.

Teresa
The short answer is that I had to balance diversification against commission for accounts < $250K. For high net worth clients, we would use more ETFs per asset class AND also include more asset classes. The rest of the information is filed in the Knowledge Base.

Mark
That is sort of what I’m looking for; however, what I really want is the reason why the specific ETFs chosen were actually chosen. You write that “we selected a single ETF that best embodies the characteristics of each asset class “. For example why did you choose FXF over another Currency ETF, or why did you choose the VXF instead of the SPY? Not sure if I missed something here, but any insight would be appreciated.

Teresa
In Building Your Investment Portfolio, Part 4, I outlined the case for using traditional asset classes as a starting point. This is a good idea because many people participate in employer-matched plans that tend to offer investment choices only among these traditional asset classes.

Virtually all retirement plans offer the equivalent of the S&P 500 index fund, the EAFE index fund, Treasury Bond and Treasury Inflation Protected Securities. Therefore, we used these four ETFs to construct the core portfolio outlined in Building Your Investment Portfolio, Chapter 8.

The following diagram comes from The Art of Asset Allocation by David M. Darst. He is a strong believer in matching asset classes with wealth levels and income needs. He illustrates the progression from the wealth-seeding, wealth-building to wealth-realization phases of a client lifecycle and suggests appropriate asset classes for each phase.

You can see that a core portfolio that uses the four traditional asset classes is just right for the wealth-seeding phase.

Next, we created a satellite portfolio that builds upon the core portfolio. We added VXF so that clients own most of the stocks from the DJ Wilshire 4500. We added emerging markets (EEM) to that clients own a more-complete range of international equities. We added TLT to further diversify the bond portfolio, to provide additional protection against unanticipated deflation and market shocks.

We also added two new asset classes — currencies and commodities — to further diversify the satellite portfolio for clients progressing from the wealth-seeding to the wealth-building phase. CurrencyShares offers a limited number of options, and given we have to contain transaction costs, Swiss Francs were chosen for the reasons stated in Building Your Investment Portfolio, Part 4.

For U.S. dollar-based investors, there is some agreement amongst academics that if an investor is to hold a basket of currencies, they should look to funding currencies of carry trades, but that is outside the scope of this discussion. Since we already have exposure to commodities via GSG, currencies from relatively high interest, commodity-producing countries such as Canada, Australia and Mexico are unnecessary.

To sum it up, each client should determine the appropriate allocation to the core and satellite portfolios based on their personal financial situation.

In the next read mailbag, we will answer a number of questions related to trading.

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