ITA Wealth Management

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.

In the face of these roiling markets, remain calm and stick with the asset allocation plan. If one were to flee to cash who knows whether or not the market will bottom and begin an upward climb.

This is a time to check the technical indicators for each ETF that represents a particular asset class.  More on this will eventually be discussed in Premium Content.

Lowell Herr

Premium Content access is available for $6.99 per month.

Investors will find the Asset Allocation Performance Spreadsheet of interest.  Move to the right-hand edge of this page, scroll down to Links and click on the second option.  Download the Asset.xls spreadsheet.  If you have questions, post them in the Comments section of this entry.

The spreadsheet includes data on eight different asset classes beginning in 1989. Be sure to check out all three worksheets.  The first includes the RAW data.  Performance shows how the asset classes rank from year to year and the third worksheet shows the “Horizontal Performance” or how well each asset class performed over the period studied.

Lowell Herr

Photograph:  Mark Twain sculpture

Additional portfolio management insights are available via Premium Content for $6.99 per month.

It is time for a refresher on the basics of investing.  So here we go again.

• Open a broker account.  Use a discount broker such as TDAmeritrade.
• Lay out your asset allocation plan.  I recommend using nine to twelve asset classes. Check some of the models posted in previous entries.
• Determine what percentage of your money you want to place in each asset class.  This is going to be your most difficult decision.  Again, use models described in prior posts.
• Begin to populate the asset classes by doing your own on-line purchases through the discount broker.
• Use the spreadsheet available on this blog as a means of tracking your portfolio.

Those are the very basics for getting started in the world of investing.

Lowell Herr

Photograph: Westlake Village, California

The philosophy behind this blog is one of passive portfolio management.  A passive manager is one who lays out an investment plan for the portfolio and this includes what asset classes to employ and what percentage of the money to allocate to each asset class.  As mentioned before, it is easier to establish the asset classes than it is to allocate the target percentages to each asset class.

I recommend every passive manager include at a minimum, the “Big Six” asset classes.  From that base, consider expanding into REITs, International (developed countries), and Emerging Markets.  Now we have nine major asset classes.  How much or what percentage to allocate to each asset class is a very personal decision.  I provide a number of examples both here on the free side of the blog and over on the Premium Content side.

Once a portfolio is fully built and all the asset classes are in balance, the passive manager does little else other than keep records and rebalance the portfolio when necessary.  Don’t rebalance more than once a year unless something very unusual throws the portfolio completely out of balance.  Generally, you will not need to rebalance the asset classes more than once every two or three years.  This is the ultimate in passive management.

For the manager who feels they need to be a bit pro-active when it comes to portfolio management, one might add an individual stock from time to time.  Be sure to keep the asset classes in balance if you are adding individual stocks.  In addition, a semi-active manager may do a little Tactical Asset Allocation (TAA).  This really amounts to market timing, so you better know what you are doing.  Research shows that market timing does not add value to the portfolio.  I do not recommend TAA unless an obvious situation arises.  The REITs situation over a year ago was such an event.

The technical analysis work we do over in Premium Content is something for the semi-active manager.  I don’t spend much time on TA on the free side as it requires a certain level of sophistication.

For the vast majority of investors, it is best to play the role of passive manager and let the markets do their work.  Don’t get fancy and try to outguess efficient markets.

Lowell Herr