ITA Wealth Management

The link in this blog entry contains some of the most informative reading you will find in the investment world.  Read a few articles and then see if you do not agree with me that this is a launching point for many hours of reading.

Geoff Considine provides a tremendous service to “do-it-yourself” investors.

Photograph:  Central Station in Amsterdam, Holland

By the end of the week all the tax selling will take place in the taxable accounts and the restructuring of these portfolios will begin.  The asset allocation plan will require looking for assets that have low correlation, better than average projected return, and low historical R^2 values as measured against the S&P 500.  The combination of asset will provide for a well diversified portfolio as measured by the Diversification Metric.

Premium Content readers will be able to follow the restructuring of the GLW Portfolio in particular as this is one of the several portfolios that will require reworking.

Lowell Herr

Photograph: Canal travel, Amsterdam, Holland

I would call the following a very conservative portfolio. We will follow Lydon and Wasik’s lead and call it a conservative portfolio.  Below are the holdings and the target percentages.

• SPY = 10%
• RSP = 10%
• EFA = 10%
• TLT = 10%
• SHY = 20%
• IEF = 20%
• TIP = 20%

The conservative portfolio yielded the following projections.

• Return = 4.73%
• Standard Deviation = 5.6%
• Portfolio Autocorrelation = 60.86%
• Diversification Metric = 36%
• R^2 = 76.2%

Readers likely noticed that in no portfolio did an asset target percentage dip below 5%.  That is a common minimum as anything lower has little impact on the portfolio.  Avoid target allocations lower than 5%.

In all five portfolios, the PA value is quite high.  This is due to the short (three-year) period used for the analysis.  Three to four years is the recommend period by the developer of the Quantext Portfolio Planner (QPP) software.

When setting up a portfolio, one of my goals is to see the projected return be similar in value to the standard deviation.  In addition, I want to see the DM value exceed 60%.

Lowell Herr

Photograph:  Villefranche, France - photo by Kenneth Appel

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The moderately conservative portfolio includes more treasury ETFs than either of the last two portfolios. Listed below are the holdings and target percentages for this portfolio, also suggested by the authors of iMoney.

• SPY = 15%
• RSP = 15%
• IWM = 5%
• EFA = 10%
• EEM = 5%
• TLT = 15%
• SHY = 15%
• IEF = 15%
• TIP = 5%

This moderately conservative portfolio generates the following data when a three-year database is used for the QPP analysis.

• Return = 6.16%
• SD = 8.55%
• PA = 57.8%
• DM = 36%
• R^2 = 93.3%

The return is quite low and the diversification is still modest.

Lowell Herr

Photograph:  Fat City Cafe

Below are the details for constructing and managing a portfolio.  The three rules for investing are:  Save, Monitor, and Adjust.

1. Save as much as possible on a monthly basis.
2. Build the portfolio around an asset allocation format, initially using the following 11 Exchange Traded Funds (ETFs).
   VTV    Large-Cap Value
   VOE    Mid-Cap Value
   VBR    Small-Cap Value
   VUG   Large-Cap Growth
   VOT   Mid-Cap Growth
   VBK    Small-Cap Growth
   VEU    International (developed countries)
   VWO   Emerging Markets
   VNQ   REITs
   GSG    Commodities
   BND and/or TIP   Bonds
3. Determine what percentage to invest in each asset class.  Numerous examples are provided on this blog.
4. Use a discount broker such as TDAmeritrade to open up an account.  Set it up for electronic trading.
5. Use the Thomas/Lalla/Herr spreadsheet to monitor the portfolio.  This spreadsheet is available on the Premium Content side of this blog.  Subscribe and download a copy.  If one is not Excel savvy, then manual calculations will be necessary to determine how close the actual investment is to the target.

Example:  Assume 12% is the target for the Mid-Cap Value (MCV) asset class.  Further, assume this is a portfolio with a month end total of $110,234.56.  12% x $110,234.56 = $13,228.15 would be the current target for the MCV asset class.  When the monthly broker statement arrives, you will need to calculate whether the ETF representing this asset class (VOE in our example) is above or below this allocated amount and by what percentage.  Note: If maintained properly, the T/L/H spreadsheet provides this information.

And now the final step and a very important one.  Once cash in the broker account exceeds $1,500 (selected to keep expenses below 1%), invest the cash in the asset class that shows the largest percentage below target.  By doing this each month, one is always feeding the asset class that is the “weakest” in the portfolio.

Photograph:  Visitor to Istanbul, Turkey

If you are building a portfolio from scratch, are you better served using Vanguard or Barclay (iShares) ETFs?  That is the question I posed to myself now that I have access to the Quantext Portfolio Planner. What I did was to populate a portfolio using the “Big Six” ETFs plus developed international, emerging markets, and REITs.  For Barclay or iShares I used the following ETFs.

Barclay

• IVE
• IJJ
• IJS
• IVW
• IJK
• IJT
• EFA
• EEM
• ICF

I invested 11% in each asset class with exception of international.  For that asset class, I invested 12%.  The time of examination was from 10/8/03 through 10/8/2008 or a five-year period.  Here are the results.

• Return = 10.90%
• Standard Deviation = 20.18%
• Diversification Metric = 12%  (See definition below)
• Portfolio Autocorrelation = 26.51%  (See definition below)

Vanguard

From the Vanguard ETF garden I plucked identical asset classes.  These are the ETFs I selected.

• VTV
• VOE
• VBR
• VUG
• VOT
• VBK
• VEU
• VWO
• VNQ

Again, I invested 11% in each asset class with exception of VEU, the international asset class.  I invested 12% in VEU just as I invested 12% in the international iShare, EFA.  Here are the Vanguard results.

• Return = 12.32%
• Standard Deviation = 9.11%
• Diversification Metric = 61%
• Portfolio Autocorrelation = 7.91%

It is obvious Vanguard is the better choice based on this analysis.  The return is greater with lower SD.  The Diversification Metric is much higher and the Portfolio Autocorrelation is closer to zero.

What is portfolio autocorrelation?

QRP and QPP both calculate an historical statistic called portfolio autocorrelation.  This is a recent feature and is not yet included in the user manual / textbook.  Portfolio autocorrelation is the correlation in portfolio returns from one month to the next.  If it is positive then high returns tend to be followed by high returns and vice versa.  If portfolio autocorrelation is negative, then the portfolio returns tend to be ‘mean reverting’ which means that very high return months tend to be followed by returns closer to the mean–the portfolio tends to damp out periods of very high or very low returns.  Portfolio theory generally assumes that autocorrelation is zero–the random walk.  QPP and QRP model the market as though autocorrelation is zero, and the metric shown is for historical performance.  If you have a portfolio that shows a lot of positive autocorrelation, this is a flag–this means that big swings get amplified.  These effects are widely debated, but there is evidence that they can be meaningful:

What does the Diversification Metric (DM) mean?

In our latest release of the software, we have added a new analytical function that accounts for non-market correlation between portfolio components.  This is important because many asset classes have correlation to one another beyond what can be captured by Beta.  This is a major challenge for many portfolios, but especially those with concentrations in a sector.  This problem is described in a recent article. (Go to QPP site to find active link.) Our software generates a statistic that measures how effectively the non-market component of returns actually diversify one another.  In the best possible case, the non-market component of returns would be totally uncorrelated with one another.  In the worst case, they would be highly correlated.  The diversification metric (DM) measures how un-correlated the non-market returns are across the portfolio.  Higher values of DM mean that the non-market component of returns shows low correlation across the portfolio.  Higher DM means that your are getting more real diversification out of your portfolio.

One service I am considering for Premium Content clients is portfolio analysis.  I can do this so long as the requests are reasonable in number.  How would this work?  In investor would send in 20 or fewer tickers and the target percentage for each investment.  Then I would run an analysis on the portfolio to determine the projected return and risk.  These values would be compared with projected return and risk values for the S & P 500.

The idea is to increase potential return while reducing portfolio risk.  If there is interest in such a service, please post a comment to this effect.

While I don’t want to begin this service in full force until the middle of November, I would be willing to examine a few portfolios as a test to see how this would work.  I would be willing to look at one portfolio this week if someone wants to list their investments and what their targets are for each investments.  No money amounts should be discussed.

Lowell Herr

Over the last few weeks I note that we are picking up new readers and there has been an explosion in readership from outside the United States.  With nearly 500 entries on the free side of the blog and another 170 over on Premium Content, where does one begin to gain an understanding of the investment philosophy behind the asset allocation strategy.

The obvious and best starting place is to go back to Valentine’s Day (February 14) of 2008.  That is when I started posting investing information.  If you don’t wish to start at the very beginning, at least you are not ready to do that right now, then mover over to “Categories” and click on “Beginning Investors.”  This will get you started.  Then do a search from Fama, French, Hebner, Bernstein, or Ibbotson.  Such searches will bring up a number of entries that are fundamental to this approach to investing.

Serious investors will look up some of the books I recommend.  Authors such as Bernstein, Gibson, Ferri, and Hebner are critical.  Over under “Links” you will find a link to a long list of books to consider.  Also identified are a number you can easily skip.

I am a strong advocate of saving as much as you can as early as you can.  Develop a plan for your portfolio and that plan should center around the concept of asset allocation.  Many examples are given and the Premium Content goes into more depth of both construction and management of the portfolio.  Learn what it means to rebalance.  While we stress using ETFs for valid reasons, we will use some individual stocks.

I want to extend a special welcome to readers from Poland, Hong Kong, Dubay, Italy, South Africa, Spain, New Zealand, Australia, Canada, Russia, United Kingdom, European Union, Japan, Malaysia, India, Viet Nam, Singapore, Turkey, as well as many cities here in the United States.  Thank you for checking in on this blog.  We appreciate your readership.

Lowell Herr

Photograph: Art hanging above a garage in Central Oregon.

Why do investors fail to outperform one of the most common benchmarks, the S & P 500?

• As stock pickers they think they can cull out the best companies.  However, the best companies do not necessarily turn out to be the best stocks.  Research argues against stock picking for the average investor.
• The portfolio is not well diversified.  How many times have I heard investors argue that they are invested in all sectors of the market.  But investing in all sectors does not necessarily cover all asset classes so one can easily end up with a non-diversified portfolio.
• Investors do not have an investment plan.  There is little if any logic behind why the portfolio looks the way it does.
• Investors are not aware of research that would aid them in portfolio tilting.
• Investors do not keep accurate records.  Ignorance leads to under performance.
• Even if investors do keep accurate records, the software they use does not provide an accurate record of how well they are performing with respect to an index.  Without proper information the investor does not have a clue how well they are doing vs. an appropriate benchmark.  The spreadsheets available on Premium Content will take care of this problem so long as the investor maintains the spreadsheet.
• Investors do not understand the risk they are taking to achieve their returns.  This requires an additional software program and these programs are very difficult to find.
• Investors are not inclined to keep on top of their portfolio as it does take time.  Neglect can lead to under performance.

Clients following the construction and management of the seven portfolios over on Premium Content get a picture of what is involved if one is trying to outperform the S & P 500.  We set our sights a little higher and use the VTSMX as our benchmark.  Thus far we are succeeding in six of the seven portfolios.  However, four of the portfolios are very young and we need more data to make our case.  The older portfolios support our contention of the importance of asset allocation.

Lowell Herr

Photograph: St. Paul, France

Premium Content subscription is only $6.99 per month.  Learn portfolio construction and management.

Over on Premium Content I am beginning a series of entries on Exchange Traded Funds (ETF) web sites.  The first one is the granddaddy of sites, the American Stock Exchange (Amex). I consider this site to be a starting point, but there are errors in the database as pointed out on Premium Content (PC).

As I mentioned on PC, be wary of all the different ETFs.  Don’t be overwhelmed with the vast number.  Rather, stick with the basic ETFs and above all, keep in mind the expense ratio.  We want them as low as possible.  We use Vanguard ETFs, for the most part, for this reason.  In some portfolios we hold iShares as Vanguard did not have ETFs when we first began constructing portfolios around ETFs.

Premium Content subscription available for $6.99 per month.

Lowell Herr

Photograph: The Sagrada Familia or the Antonia Gaudi Cathedral in Barcelona, Spain.  It was impossible to photograph the spires without capturing a construction crane.