Build Your Own Investment Portfolio, Part 5

Teresa, March 19, 2008 @ 8:30AM ET | Link | RSS | Read via Email | 1 Comment  

I had expected Part 4 to be the last of the series, but after it was published, two things happened to warrant more articles:

  1. A (presumably) well-meaning skeptic wrote to me and ended up giving me all sorts of grief about portfolio construction. I didn’t think it was possible for the world of investing is an even bigger sideshow than trading, but then again, there is a lot more commission and advisory dollars at stake so anything goes. In trading, they always use the “well chosen example”; with portfolios, they dazzle and blind ‘em with statistics. Asset allocation is easily infused with the air of scientific precision, making it simple for vendors to pull one over their clients who in turn, hold on to their belief as dogma.
  2. One of my long time clients had trouble implementing the model portfolio because Fidelity provides limited investment options for his retirement plan. We came up with a client profile: professional, owns a house, 15-20 years from retirement, takes full advantage of an employer-matched plan, has 3 dollars in the retirement account for every dollar in the trading account. I then built a core/satellite portfolio combination that accommodates the needs of our archetype client.

In this article, I review two roadblocks that prevent people from reaching their investment goals.

Roadblock #1: Average Annual Return vs. Compound Annual Growth Rate

Figures often beguile me, particularly when I have the arranging of them myself; in which case the remark attributed to Disraeli would often apply with justice and force: “There are three kinds of lies: lies, damned lies and statistics.” — Autobiography of Mark Twain

19-xirr.gifIs it possible for a manager to claim 25% annual return while a client’s account balance remains unchanged after two years? The answer is a resounding YES.

The most egregious lies told in the investment world revolve around performance, the measurement of returns. Games are played with benchmarks, total return vs. nominal, and of course, arithmetic vs. geometric return.

Unscrupulous timing services, funds and managers tend to use arithmetic averages. In our example, the manager loses $50,000 of the initial $100,000 in the first year; the return is -50% for the first year. The manager makes $50,000 to bring the account back to $100,000 by the end of the second year; they count the second year return as 100%.

Using arithmetic averaging, the manager will claim that their “average annual return” is 25% return per year [(-50% + 100%) / 2 years]. In real life, your $100,000 is still $100,000; the compound annual growth rate (CAGR or geometric return) is ZERO.

Had the manager made $40,000 in the second year, the client would only have $90,000 left while the manager could advertise a two-year average annual return of 15% [(-50% + 80%) / 2 years], enough to recuit new clients to replace the burned ones.

Arithmetic averaging always inflates returns. For your money, insist on the geometric average.

Further Reading:

Roadblock #2: Spinoza’s Conjecture

While many people take pride in being contrarians, the thinking man’s skeptic refrains from immediate knee-jerk, tar-them-all-with-the-same-brush reactions. Being contrary is not the same as having an informed contrary opinion.

Michael Shermer recently reported a study by neuroscientists Sam Harris, Sameer A. Sheth and Mark S. Cohen:

Several psychological studies appear to support [17th-century Dutch philosopher Benedict] Spinoza’s conjecture that the mere comprehension of a statement entails the tacit acceptance of its being true, whereas disbelief requires a subsequent process of rejection. . . . Understanding a proposition may be analogous to perceiving an object in physical space: We seem to accept appearances as reality until they prove otherwise.

Let’s use a timely example. We are presently witnessing a tumultuous time in global capital markets. Everyone is bashing the Fed as if they are somehow unique in their understanding of the situation. How would you classify each article on the list below?

Few people possess the insight needed to particpate in a nuanced discussion of monetary policy; therefore, the majority have positioned themselves to simply be contrary, forever consigned to repeat mainstream rhetoric. What’s even more amazing is this: it was only 13 years ago that a strong U.S. Dollar was the devil.

Spinoza must be laughing in his grave.

Further reading:

CLICK HERE to read Part 6.

Build Your Own Investment Portfolio, Part 4

Teresa, March 7, 2008 @ 4:00PM ET | Link | RSS | Read via Email | Start a Discussion  

volatile.jpgIn 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:

  1. 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.
  2. 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.
  3. 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.
  4. 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

07-percentallocation.gif
Percent Allocated to Each Asset Class Changes Over Time

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

07-totalreturn.gif
Steady Growth

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

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

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.

Build Your Own Investment Portfolio, Part 3

Teresa, March 6, 2008 @ 5:00PM ET | Link | RSS | Read via Email | Start a Discussion  

In Part 2, we reviewed the cornerstones upon which an investment portfolio is built: total return, asset allocation policy, Vanguard’s nine commandments, and rebalancing.

05-014.gif
Which fund should we buy?

Before proceeding to portfolio construction, let’s do a crash course on performance evaluation using a real-world example with three famous funds. If you are a quant, please avert your eyes. ;-)

Slow and Steady Wins the Race

The point of this exercise is to raise awareness among investors that — all else being equal — low volatility of returns is preferable to high volatility of returns. In other words, a lucky jackrabbit might dodge a few bullets but in all probability, only the tortoise will finish the race. Regardless of how attractive the “track record” of a stock or a fund may appear on the surface, it is the volatility of its performance from month to month that seals the fate of their investors.

The three funds we will analyze are listed below, including their policy regarding the use of leverage (borrowed money):

  1. Warren Buffett’s Berkshire Hathaway: BRK.B
    Leverage: BRK is an operating company that generally uses low levels of financial leverage. Bruni & Co reported that, in 2004, Buffett said “people tend to underestimate low probability events when they haven’t happened recently, and they tend to overestimate low probability events when they have happened recently.” He noted that it was his nature (and Munger’s) to think about low probability events, and that a ‘transformative’ catastrophe is less likely to come from natural causes (earthquakes, etc.) than from man-made causes, especially in financial markets. He also noted that “almost anything can happen in financial markets . . .[but] the only way really smart people can get clobbered is through the use of leverage . . . [because leverage] can keep you from playing out your hand.” Buffett added that, unlike some hedge funds, “we just don’t believe in lots of [financial] leverage.” A financial calamity may be painful for those affected by it, but it can also provide opportunities for others. Buffett noted that “Wall Street is awash in high IQ talent, yet extraordinary things [in financial markets] happen.” He noted that in 2002, when junk bond prices fell to ridiculous levels (and represented amazing bargains), some of the high-IQ Wall Street types wouldn’t buy them; yet now, when they are much more expensive, these same people are buying.
  2. Bill Miller’s Legg Mason Value Trust: LMVTX
    Leverage: “When cash is temporarily available, or for temporary defensive purposes, when the adviser believes such action is warranted by abnormal market, economic or other situations, the fund may invest without limit in investment grade, short-term debt instruments, including government, corporate and money market securities and repurchase agreements for such investments. If the fund invests substantially in such instruments, it will not be pursuing its principal investment strategies and may not achieve its investment objective.”
  3. Ken Heebner’s CGM Focus Fund (PDF): CGMFX
    Leverage: “The Fund may borrow for the purpose of purchasing portfolio securities and other instruments. The Fund may borrow from banks in an amount not to exceed one-third of the value of its total assets and may borrow for temporary purposes from entities other than banks in an amount not to exceed 5% of the value of its total assets.”

Analyzing weekly and monthly returns

On the surface, it would appear that investors would prefer CGMFX over BRK.B over LMVTX. Let’s crunch the numbers and see what they say. We took the weekly and monthly closing prices of the funds from Yahoo Finance and calculated the weekly and monthly percent change to obtain the return for the respective periods. We started in October 1997, the first month that all three funds were in existence. We compared the three funds against the S&P 500 Index.

We calculated the standard deviation of the monthly returns since 1997. This simple statistic indicates the percentage by which a fund’s performance has varied from its average performance in any given month since that time. The higher the standard deviation, the greater the range of performance, indicating greater volatility.

Monthly Returns and Standard Deviation
We can see that the S&P 500 Index has the lowest SD; the worst one-month performance was about -15%. The worst month for BRK.B was about the same while LMVTX was nearly -20%. CGMFX, with their use of leverage, had a number of -20% months.

We also looked at the dispersion of the dots to determine if the fund is a jackrabbit or a tortoise. Are they spread all over the graph? Are there a lot of down months?


Standard Deviation = .0425


Standard Deviation = .0590


Standard Deviation = .0591


Standard Deviation = .0845

Weekly Returns and Standard Deviation
We zoom down to weekly returns and the data tells much the same story as the monthly data. We can see that CGMFX has been down as much as -20% in a week with many -10% weeks ; if an investor had owned this leveraged fund on margin, the losses would have been stunning.


Standard Deviation = .0235


Standard Deviation = .0340


Standard Deviation = .0298


Standard Deviation = .0391

Weekly Performance Since 2002

We zoom in on weekly performance since 2002 for two reasons. First, we can see recent performance up close. Second, we illustrate visually the point of building a portfolio — to combine asset classes — is to diversify with the goal of reducing the volatility of returns:

In conclusion, even though CGMFX was by far the best “performer”, the investor might not have enjoyed much performance if he had purchased the fund at certain times. Its roller coaster performance makes it hard for a shareholder to stay the course.


Standard Deviation = .01753


Standard Deviation = .021265


Standard Deviation = .023011


Standard Deviation = .034741

The InVivo Model Portfolio

Our unleveraged model portfolio began in late-2002 when the ETFs required for our chosen asset classes became available. As we can see, diversification and a little engineering brought down the volatility of returns to a very narrow band.


Standard Deviation = .00756

In the next article, I will show you how we put it all together.

Additional Reading

CLICK HERE to read Part 4.