ITA Wealth Management

How frequently should one rebalance a portfolio? David Swensen does it every day with the Yale endowment fund, but that is an exception. Bernstein recommends no more than once a year and it does not hurt to let asset classes run longer. Arnott, on page 40 of his book recommends rebalancing annually.

“The annual rebalance ensures discipline and avoids the return-chasing behavior inherent in traditional cap-weighted indexes. Outperformers are rebalanced back to their economic size, with the proceeds invested in shares that have recently fared poorly relative to their operating results.”

From studies done on the eight asset classes for which I have 18 years of data, the optimum rebalancing takes place when an asset class exceeds the target by +/- 35%. From experience, rebalancing can almost always be accomplished by reinvesting dividends in asset classes that are under target. It is even easier for investors who continue to add new money to the portfolio each month. Just keep purchasing shares that are under the target percentage.

Lowell Herr

Photograph: Look closely and you will see a “Snake Bird” as it looks like a snake when it is swimming. It was drying its feathers when this photo was taken. Image by Dennis Dean

A financial ETF limit order was struck when the market dipped down below 200 points on the DOW the other day. That financial was purchased for one of the two Mosaic portfolios. I don’t have all the data available, but I will update everything when the July broker statement arrives. I am “on the road” and do not have all data at my fingertips.

I only mention this in passing as it may be getting close to taking a good look at the financial sector. Generally, I am not a buyer of any specific sector, but rather stick to specific asset classes. This is one of those times when I will make an exception. The financial sector will fit into the Large-Cap Value asset class if you want to know where to slot it in the portfolio.

Lowell Herr

Photograph: The Little Grill, a Co-op restaurant in Harrisonburg, VA. Photograph taken this morning.

Here is the link to an interview with Richard Ferri. Click on one of the player options to listen to the interview. I think investors interested in ETFs will find Ferri’s comments of use.

Lowell Herr

With all the entries available on this blog, beginning on Valentine’s Day of this year, it now is time to recap some of the fundamental ideas behind this blog. It is best to start with the first entry if one wishes to pick up summaries of the academic research used to build the philosophy behind ITA Wealth Management. This brief summary will need to suffice. Here are a few of the key ideas for the investment philosophy of ITA Wealth Management.

• Follow “The Golden Rule of Investing.” Save as much as you can as early as you can. Search these words on this blog for useful examples.
• Construct a portfolio around a series of asset classes rather than sectors of the stock market.
• Skew or tilt the portfolio toward value and mid to small-cap stocks. The value tilt is even more important than the small-cap tilt.
• Include international (developed countries), emerging markets, REITs, and commodities in your portfolio.
• If you include bonds in your portfolio, know they are generally a drag on the portfolio even though they will reduce overall risk. Search the word “Bond” on this blog for more discussions.
• Rebalance when the asset classes exceed target percentages by more than 35%. That goes for both the upside and downside of 35%. The 35% target limits are built into the spreadsheet we use to track portfolios.
• Do not chase high flying index funds or ETFs. Stick with your asset allocation plan.
• On rare occasions it may be appropriate to apply some Tactical Asset Allocation (TAA) to the portfolio. This is not something one should do if you are a new investor.
• When looking for entry points or when to purchase an ETF, give some attention to the technical analysis sections of this blog. Again, do a search for technical analysis or click on that theme.

The above ideas will get one started on the basic philosophy of this blog. The best move is to go back to the very beginning entries of the blog and work your way forward. The academic research summaries are found in the early posts.

Lowell Herr

Photograph: Remains of the original Fitzcarralda boat, located in the jungle of Peru.

Why do we continue to advocate a portfolio tilted toward value and away from growth oriented stocks? Let me begin by quoting from Arnott, page 4 of his book, “The Fundamental Index,” where he writes, “In the two-year period from March 2000 through March 2002, the average U.S. listed stock returned more than 20 percent, whereas the S&P 500 lost more than 20 percent.” How is it that the average stock did so well during what many of us remember as one of the worst bear markets in our lifetime? Arnott also provides the answer to that question. Hear what he has to say.

“In the first two years after the tech bubble burst, the traditional indexes–and the index funds tracking them–were down, while the average stock was up, precisely because the indexes had loaded up on the pricey high-flying growth companies. Many of the companies getting higher allocations were trading at multiples of earnings–or for those with no earnings, multiples of sales–which were without precedent. At the peak of the bubble in March 2000, almost 30 percent of the Russell 2000 Index, the popular small-cap market index, consisted of companies that had no earnings. Most of these companies had never had earnings in their entire history.”

The indexes that declined in price were populated by companies with high multiples and it is precisely these high multiples that factored into the very market capitalization that determines the make up of the index. As stocks become less attractive, by the very makeup of the index, they begin to take on a greater role in the index. This is precisely Arnott’s argument as to why one should construct an index around such metrics as sales, cash flow, book value, and dividends rather than capitalization.

Market capitalization is a fancy term for a straight forward concept. It simply means multiply the price of the stock times the number of outstanding shares. It is easy to see that if a stock runs up in price its market capitalization increases without improving any of the fundamentals such as sales, earnings, cash flow (or better, free-cash flow), book value, or dividends.

When we tilt our portfolios toward value ETFs such as VTV, VOE, and VBR, we are moving the portfolio toward companies that have lower Price/Book Value and they pay, on average, higher dividends. Arnott wants to take this one step further and construct ETFs based on the fundamentals of sales, cash flow, book value, and dividends. The big problem, as I see it, is that he also lays on significant fees to build these indexes. Only time will tell if the performance of the fundamental indexes merits the high fees.

Lowell Herr

Photograph:  Art at Elan Gallery & Gifts, West Linn, Oregon

Lowe

This 1961 recording of Eine Kleine Nachtmusik plus other works is one every classical music lover should add to their collection. Bruno Walter conducts the Columbia Symphony Orchestra in several of Mozart’s well known compositions. This is a CBS Masterworks CD, No. MK 42029.

Other selections included on the CD are:

• “Impresario” Overture, K. 486
• “Cosi fan tutte” Overture, K. 588
• “Marriage of Figaro” Overture, K. 492
• “Magic Flute” Overture, K. 620
• “Masonic Funeral” Music, K. 477

Lowell Herr

No. 9

The Fundamental Index hypothesis has its critics and one is none other than John Bogle. While Bogle will concede cap-weighted indexes such as the S&P 500, as represented by VFINX, will allocate more money to over-priced stocks, he also contends that we do not have the foresight to determine which stocks fall into that category. Therefore, it is better to stick with low-priced cap-weighted index funds.

Paying higher fees for index funds constructed around fundamental principles of sales, cash flow, book value, and dividends is my primary concern. Is it possible to engineer a portfolio by over weighting mid-cap value and small-cap value through the use of inexpensive ETFs or index funds, thereby capturing the value tilt at lower cost?

Photograph: Elan Gallery & Gifts, West Linn, OR

This weekend I will be updating the three “passive portfolios” we are tracking closely over on Premium Content. As noted this morning, shares of VOT and VOE were added to the GLW Portfolio yesterday. The spreadsheets are available to PC subscribers.

Tomorrow, I expect to update the “Top Ten” for those interested in specific stocks. The “Creme List” will also be posted. Over the next month I also hope to add additional comments as continue to slowly work through Robert Arnott’s book, “The Fundamental Index: A Better Way to Invest.” This is one of the more interesting investment books I’ve read in some time.

Beginning next week, the number of entries will diminish for about ten days as I need to attend to family affairs.

Premium Content is available for $6.99 per month. Trial offer available through this weekend.

Lowell Herr

Photograph: Elan Gallery & Gifts, West Linn, Oregon

While we use either VFINX or VTSMX as benchmarks as comparison tools for measuring the performance of our “passive portfolios,” our preference is the VTSMX index as it is a higher bar to hurdle. The VFINX is a match for the S&P 500 and that index includes stocks that are a drag on the portfolio. In fact, both the VFINX and VTSMX funds suffer performance drags do to overvalued stocks. Let me extract a few paragraphs from Arnott’s book, “The Fundamental Index.” I will be surprised if this material does not carry a shock value to readers.

“The performance of the top 10 stocks in the S&P 500 illustrates the magnitude of the performance drag problem. …,on average, only 3 of the top 10 companies in the S&P 500 outperformed the average result for all 500 companies in the index over the subsequent 10 years, while 7 of the top 10 underperformed. That’s a darned lopsided coin toss, especially given 81 years and 800 coin tosses! Also, owning these top 10 names (equally) gave an investor an average of nearly 30 percent less wealth than owning the 500 stocks in the S&P 500 (equally) in just a 10-year span. This is a huge performance drag: With a cap weighted index, investors have an average of 20 percent to 25 percent of their money tied up in these underperformers.”

“Clearly, most of the top 10 companies lag the performance of the average stock in the S&P 500 most of the time. Why does this matter, and what does it mean? Maybe it’s a time-specific phenomenon for many of these 10-year spans. To test this possible explanation, we evaluated how often a majority of the top 10 companies bucked the trend and beat the average stock in the S&P 500. The most startling aspect of this lopsided behavior for the top 10 list is its consistency. Over the past 81 years, how often did the majority of the top 10 companies in the S&P 500 outperform the average stock in the S&P 500? Zero. Zilch. Nada. It never happened.”

Going back to Arnott’s original hypothesis, cap-weighted stocks carry high PE ratios due to optimist outlook on future growth. Overpriced securities are overweighted in broad indexes such as the S&P 500 and these overpriced stocks are a drag in cap-weighted index funds.

The question still remaining to be answered is this; is it possible to skew a portfolio toward value, mid-cap, and small-cap stocks, thus engineering a portfolio to do what PowerShares is doing but do it with lower fees?

Lowell Herr

Photograph: Peruvian child

Back in the mid 1990s, I heard about a company named Cisco Systems. At that time I knew little about routers, but I had a sense they were going to be big as the Internet grew. With very little information and analysis, I purchased shares, only to watch them rise in price almost daily. A relative was working in the bay area so I called him and asked him about Cisco. Yes, he was very aware of the company. In fact they were in the process of expanding their campus and expected to double their workforce within a short period. With no more analysis, I added shares to my holdings despite the higher price.

The price of CSCO continued to climb. This stock did so well it was soon the stock of choice for charitable contributions. With that background, let me shift to a long quote from Rob Arnott’s book, “The Fundamental Index.”

“Having a clear and informed belief regarding price efficiency is one of the most critical elements to fomulating an investment strategy. Consider this: $500 billion lost in only 30 months. It is a staggering amount of money–more than 50 times the collective annual casino takings from Las Vegas tourists and two-and-a-half times the estimated losses domestic airlines and associated travel industries suffered after September 11, 2001. Shockingly, it’s more than 100 times the losses incurred in the collapse of Long-Term Capital Management (the most spectacular hedge fund collapse in history) that many knowledgeable people–including former Federal Reserve Board chairman Alan Greenspan–thought could potentially bring down the entire global economy.”

“This massive wealth destruction wasn’t the result of rogue traders with leveraged balance sheets. It occurred in the stock market–in the 30 months following the collapse of the technology bubble in March 2000. The $500 billion figure isn’t even the total stock market loss over this dreadful stretch. This astronomical loss resulted from one stock: Cisco Systems, the largest stock in the world based on market capitalization at the peak of the tech bubble. This stock was valued at nearly $600 billion at a time when its sales were less than $20 billion, its trailing 12-month operating earnings were less than $3 billion, its cumulative profits since inception were well under $8 billion, and it had never paid a dividend. Additionally, Cisco’s workforce numbered fewer than 30,000 people.”

“Index fund investors as a group–people who believe in market efficiency and who do not believe in betting on single stocks–lost nearly $100 billion in Cisco. An average 401(k) participant with $100,000 invested in a Standard & Poor’s (S&P) 500 Index fund lost more than $45,000 in those 30 bleak months, almost $4,000 of which was lost on Cisco alone.”

Why go into such detail about this single stock? Arnott is making a strong case that price alone is a dangerous metric and that even index fund investors, who embrace diversity, can be hurt when funds are built around cap-weighted stocks. He is making the point one would not be hurt the same way if the funds are constructed around fundamentals such as sales, cash flow, book value, and dividends.

Just to complete the story, I still hold shares of Cisco with a rather nice IRR value since the shares purchased many years ago were bought at very low prices.

Lowell Herr

Photograph: Image by Dennis Dean