ITA Wealth Management

Historical Portfolio Data: July 3, 2009

With the market closed for the holiday, I am posting information on the historical performance of ten portfolios.  Six of the ten portfolios are active and all transaction details are available to ITA Premium subscribers.  Note the performance difference between the VTSMX benchmark and the IRR values for the individual portfolios.  As of 6/30/2009, all portfolios were besting the VTSMX benchmark, a rather remarkable performance.

Portfolios tracked using the TLH spreadsheet generally started at a later date and the portfolio was switched from a stock dominated portfolio to an index oriented portfolio.  The PP and Projects portfolios were built on ETFs from the start.   A few, but not all of the portfolios contain some individual stocks.

Lowell Herr

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This entry is the first of three where we break down the Fama-French (FF) study into smaller digestible bites. While the main thrust of the FF study concentrated on the Price/Book ratio and market risk, beta was also considered.  Remember that FF “could determine with 95% accuracy how a portfolio performed in relation to the stock market without knowing the actual return of the portfolio.”

Ferri, in his book, “All About Asset Allocation,” writes; “On average, about 70 percent of the return of a broadly diversified portfolio is explained by beta, making that factor the most influential in explaining portfolio returns.”

Ferri does not explain where the 70 percent figure comes from, at least I was not able to find the source, but we have all experienced the movement of our portfolio with the gyrations of the total stock market. I was surprised the figure was not higher as most portfolios have a beta values around 0.90 to 1.3. This means the portfolio will move up or down somewhere between 10% and 30% faster or slower than the benchmark.

Market risk is always with us and one of the ways to modify it is to hold a larger percentage in cash and/or bonds so as to lower the beta of the portfolio.  There are ETFs that short the market, but we have yet to use that approach to reduce portfolio volatility. Expect to read more about risk in the months ahead.

Lowell Herr

Photograph:  Photograph by Ivan Hoding taken in Phuket, Thailand

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Should we fear socialism or governmental intervention in business?  Government certainly has its hands in AIG, many banks, and General Motors (GM), to name a few businesses.  The socialism “fear card” is certainly on the table.  Are there facts to back the anti-socialism rhetoric and will these intervention moves hurt our economy over the long run?

Yesterday, I ran across an interesting article that projects light on this subject, only this article has some facts to back up their thesis.  Check out graphs such as “Government Intervention and Stock Returns” here on my favorite investment web site, Index Funds Advisors. Read the article carefully and draw your own conclusions.

Lowell Herr

Photograph: Nice, France

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When you see a reference to the “Big Six,” it refers to the core U.S. equity holdings of a portfolio.  In any given cell, the ticker on the left is the iShare from Barclay, while the right-hand ticker is the ETF from Vanguard.  In most cases I will invest using the Vanguard ETF as they tend to have lower expense ratios. Reducing costs for ETFs works right to the bottom line. Approximately 50% to 60% of the AA-Mosaic Portfolio will be allocated to these six asset classes.  This will change depending on market conditions.  Premium readers will see these changes in action on that side of ITA Wealth Management.  These are the first of the ten to twelve asset classes that will make up our portfolio.

Remember the Fama-French study. It is important to hold investments in the small-value asset class or ETFs, IJS or VBR.

Big Six

In a later post we will discuss the percentage to allocate to each of the six asset classes.  We now have new software tools to help us with our asset allocation percentages.

For investors not interested in breaking up the U.S. equities market into these six asset classes, it is fine to select one ETF, VTI, to represent the “Big Six.”  The “Big Six” ETFs are highly correlated with VTI.

One can set up a diversified portfolio using equal percentages in VTI, EFA, VNQ, AGG, and DBC. These ETFs cover domestic equities, international stocks, REITs, bonds, and commodities respectively.

Lowell Herr

Photograph:  Image captured by Ivan Hodiny - Palace of the Elephants Phuket, Thailand

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Data for ten different portfolios is shown below in the historical performance table.  The 7/1/2009 data is from a mid-day capture.  The 6/30 distributions for VFINX and VTSMX are included, but none of the second quarter dividends have been added to the portfolios.  When the June statements are available those ETF dividends will be added, slightly enhancing the IRR portfolio values.

Lowell Herr

Photograph:  Eze, France

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Historical Portfolio Data: July 1, 2009

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During the month of July I am going to scale back my writing on ITA Wealth Management and take a much needed break.  In place of new information, I am picking up prior posts of note and “tweaking” them or updating where needed.  Below is one such post.

Always remember the advice of Brinson, Ibbotson, Gibson, Bernstein (if you have read his works), and many others to be quoted later.  Asset allocation is the key to portfolio performance.  If you find this difficult to swallow, dig into the academic research for yourself rather than take the word of those who have a financial interest in investors not understanding how Wall Street works.

We will begin by dividing the stock market into six fundamental asset classes. Three of the divisions are based on the capitalization or size of stocks. We slot them into Large-Cap, Mid-Cap, and Small-Cap. These three divisions will be determined by Vanguard and/or Barclay. Do not assume both firms will come up with identical definitions or the same basket of stocks in each asset class.

The next division will be between what is called growth and value. These divisions are even murkier than the size divisions. One common division point is the Price/Book value. If a stock has a low Price/Book ratio, it will fall into the value class, whereas a stock with a high Price/Book ratio will be tagged as a growth stock. The number tends to fall around 2 to 2.5, but that number will float up and down depending on overall market conditions. I have seen the division or cut point hover around a ratio of 3.5. We are not going to worry a great deal over these definitions as Vanguard and Barclay will take care of building the various asset classes as they have ETFs constructed to follow each index of interest.

Our launching point is Large-Cap stocks. From this cap size we will extract value and growth Exchange Traded Funds (ETFs). For more information on ETFs, go to this web site.

http://www.ishares.com/home.htm

or

https://personal.vanguard.com/us/funds/etf/bytype

An ETF is a basket of stocks that fit a particular description or track a particular index.  For example, we might seek an ETF that specializes in nothing except high dividend paying stocks (IDV). For our first moves, we are looking for ETFs that satisfy requirements for Large-Cap Value and Large-Cap Growth. These are the first two asset classes of interest as we begin to fill up the “Big Six.”

We will limit our choices to the two major firms that supply ETFs, Vanguard and Barclay. The choices for Large-Cap Value are Vanguard’s VTV and Barclay’s IVE. These ETFs are bought and sold the same way one would purchase or sell a stock. Instead of one stock, you are buying a basket of 300 to 500 stocks.

https://personal.vanguard.com/us/FundsSnapshot?FundId=0966&FundIntExt=INT Vanguard site
http://www.ishares.com/product_info/fund/overview/IVE.htm Barclay site

In the following steps we will move into the four ETFs that fill out the “Big Six.” They are: Mid-Cap Value, Mid-Cap Growth, Small-Cap Value, and Small-Cap Growth. Remain tuned for details.

Lowell Herr

Photograph: Thais’ ceremony taken by Ivan Hodiny in Phuket, Thailand.  (Note: The colors in the original are much richer and the clarity of the image is reduced by the web compression process.)

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This is a “basic” portfolio for the beginning investor.  It is a simple portfolio for anyone wanting to get started constructing a portfolio and do it without much fuss. This is a seven-factor-model to portfolio building. Listed below are seven asset classes, recommended percentages, and recommended ETFs.

• Large-Cap - VV - 15%
• Mid-Cap - VO - 15%
• Small-Cap - VB - 15%
• International - VEU - 20%
• Emerging Markets - VWO - 15%
• REITs - VNQ - 10%
• Commodities - DBC - 10% 
  
• One can also use GSG for commodities.  One asset class missing in the above example is bonds.  AGG, TIP, and BND are possible ETFs to cover the bond asset class.
  

It does not get much simpler than this. The one disadvantage to this portfolio is that one does not have the flexibility to skew investments to the value side of the investing spectrum, and we all know value outperforms growth over the long run.  At least that is what happened over the last 20 years.  The market may not behave this way over the next 20 years.

Faber and Richardson recommend a 5-ETF portfolio in their book, “The Ivy Portfolio.”  Their five ETFs are: VTI, VEU, VNQ, BND, and DBC.  Note the overlap in the portfolios.  F & R put it this way.  “You can put together a bunch of risky assets (stocks, real estate, commodities) and as long as they don’t all move together in a correlated fashion, the combined portfolio is less risky than the individual parts.”

Over on the Premium Content side of the blog I analyze potential portfolios based on mean-variance analysis.  The idea is to find portfolios with the highest projected return for a given level of risk or the lowest risk for a given level of return.  However, assumptions such a stocks outperform bonds, value does better than growth, and small-caps outperform large-caps may only be true looking back over the last ten to twenty years and may prove to be unreliable over the next five to ten years.

Conclusion:  It is extremely difficult to put together a portfolio that will provide a reasonable return and perform better than our benchmark.  The best we can do is to set up a well diversified portfolio that covers at least five major asset classes, and then monitor those investments.  The two example portfolios shown in this entry are efforts to aid the beginning investor in the development of a “starter” portfolio.

Lowell Herr

Photograph:  Big Ben in London, England

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Let’s revisit Charles D. Ellis’ 1995 paper, “The Loser’s Game,” where he describes his Break-Even Return (BER) equation. Here is a review of this equation.

BER = [(Turnover percentage x Transaction Cost) + Management Fee + Target Return]/Market Return

It is quite easy to set up this equation in an Excel spreadsheet and play around with different variables. I discussed these variables with an Internet friend and using what we think are reasonable “modern-day” assumptions we came up with this BER value.

It is not unusual for actively managed mutual funds to have a 100% turnover and management fees to run 75 basis points. If we assume Target Return equals Market Return at 9% and the transaction costs are 1.5% going in and coming out of the market, the equation will look like this.

BER = [(1.0 x (.015 + .015) + 0.0075 + .09)]/0.09 = 1.4166 or 1.42. This money manager must then turn in a return 1.42 x 9% or 12.7% to equal the market.  Costs do matter.

Assume you are managing an ETF portfolio and you are able to reduce the portfolio turnover down to 10% per year or a reduction of 1/10 the active money manager. This is not unusual based on my experience working with passive portfolios. Further, assume we can reduce commissions and bid/ask slippage to 1% in and 1% out. If we find liquid ETFs that are not actively managed, we should be able to reduce the management fee to 30 to 40 bases points. Since we are likely to have some emerging markets, let us raise this to 50 basis points. Now the BER equation will look like this.

BER = [(0.1 x (0.01 + 0.01) + 0.0050 + 0.09)]/0.09 = 1.08. This ETF manager must generate a return of 1.08 x 9% or 9.7% to match the market.  That is a 0.7% return to match the market return of 9.0%.  Quite a change.

Here are the important points to remember.

• Reduce trades in order to bring down the turnover percentage.
• Purchase in large enough quantities to lower commissions. Use a deep discount broker. Use limit orders to reduce bid/ask slippage.
• Find liquid ETFs with low expense ratios so as to minimize management fees.  Look for low expense ratios.

Lowell Herr

Photograph: Gaudi art in Barcelona, Spain

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The title of this blog entry is the same as the CD I am recommending this Sunday.  Gateway to Classical Music: The Late Classical Era is an EMI single CD recording so the price should come in around $10 to $15.  The Amazon prices for these CD’s is for the eight CD package.  The Late Classical Era includes composers such as Rossini, Pagannini, Schubert, Mendelssohn, Chopin, Beethoven, and Weber.

Inside the jacket we read these words.

“It is ironic, that the Classical period in music, which generally paralleled the Age of Enlightenment, settled nothing.  Music, like everything else in Europe, simply edged closer and closer to revolution.  The cataclysmic French Revolution and its endless fallout shattered the aristocratic calm of 18th-century Europe, and the principles that inspired it touched every aspect of human existence.  At the turn into the 19th century, with Napoleon on the loose in France and beyond, the future was anybody’s guess.  So it was with music.”

If you are new to classical music, this series of EMI Classics is a great place to break into this genre.

Lowell Herr

Photograph:  Spring flowers in Portland

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Below is the data table showing the relative performance between ten portfolios and their benchmark.  All the portfolios tracked with the TLH spreadsheet are available to Premium Content readers.  This week each of the six portfolios picked up a small amount of ground on the Vanguard Total Market Index Fund, VTSMX.

How is it that we have a batting average of 1000?  All ten portfolios are performing better than their benchmark even though the portfolios are of different size and were launched at times.  Part can be attributed to luck.  The skill part is that the portfolios are constructed based on academic research.  If you have been reading this blog for very long you will know the importance I place on the concept of asset allocation.  How these portfolios are constructed makes up a big part of why all ten portfolios are beating their benchmark.  We are still not satisfied with the relative performance and intend to continue research as to how Tactical Asset Allocation can add more alpha to these portfolios.  That research will be made available to Premium Content readers.  Come check it out.

Historical Portfolio Data: June 26, 2009

Lowell Herr

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