ITA Wealth Management

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

Premium Content readers will find new information on the Value vs. Growth debate in an entry posted this morning.  The evidence to tilt a portfolio toward value is anything but clear cut and I needed to change my prior position where I favored value ETFs over growth ETFs.

New evidence, at least for me, is that the value/growth debate is not where we should be moving to construct higher return and lower risk portfolios.  Instead, one should concentrate in selecting ETFs that have low correlation, low P/E ratios, low Price/Book ratios, and generate high yield.  Look for these developments in the construction and management of the portfolios tracked over on the Premium side of this blog.

Photograph: Mykonos

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In the November issue of the American Association of Individual Investors Journal (AAII) James B. Cloonan provides an interesting portfolio built around the follow ETFs.  They are: FDM (16%), PRF (16%), RFV (16%), RZV (16%), ICF (16%), GWX (5%), RWX (5%), VEU (5%), and VWO (5%). I’m very familiar with ICF, RWX, VEU, and VWO, but the rest are ETFs I have not used or checked their expense ratios.

What I did was run a QPP on this portfolio and here are the results.

• The projected annual return is 11.8%.  I assume this to be only for the next year.  I want this to be at least 10% and preferably 12% or higher.  Eleven percent is acceptable.
• The Standard Deviation is 15.5%.  I prefer this to be lower than 15%, so it is close.
• The Diversification Metric is 49% or an acceptable figure.
• The Portfolio Autocorrelation is 47.2% or a tad on the high side.  I find it difficult to pull this number into the lower figures so this number is acceptable.

A number of these ETFs have a low correlation with the S&P 500, a desirable feature.

Before purchasing any ETFs, be sure to check on the expenses and compare them with what Vanguard charges as Vanguard has the lowest fees.

Lowell Herr

Photograph: Elan Gallery - West Linn, Oregon

Similar QPP analysis is provided for several portfolios on Premium Content.  Subscription is $6.99 per month.

On November 1, 2008, the Gauss Portfolio was launched.  To follow the construction and management of this portfolio, subscribe to Premium Content.  Readers will also find a spreadsheet available for monitoring their own portfolio.

The portfolio is totally in cash at this point, but that will change over the next few months as we slowly invest in a variety of ETFs.

Lowell Herr

Photograph: Benedictine Abbey at Melk.  Unfortunately, it was a very cloudy day so the colors are muted.

Asset Allocation refers to the diversification or the allocation of investments within a portfolio across asset classes or market sectors.  I favor diversification across a minimum of 10 asset classes vs. using market sectors as I think it provides for superior diversification.  For example, one could allocate various percentages of their assets to each of the following asset classes: Large-Cap Growth, Mid-Cap Growth, Small-Cap Growth, Large-Cap Value, Mid-Cap Value, Small-Cap Value, REITs, International (developed) Markets, Emerging Markets, Bonds, Commodities, etc.  Academic studies show that, on average, over 90 percent of the variability of a portfolio’s performance over time is solely attributable to the portfolio’s asset allocation.  This comes out of the Brinson et. al. papers.  That material has been moved over to the Premium Content side of this blog.  Further, on average about 100% of the level of a portfolio’s total return is due to asset allocation.  These results come from the Ibbotson & Kaplan research.  Different research papers answer different questions. Therefore, the asset allocation decision is by far the most important in the financial planning process and it should be the first plank in your portfolio construction plan.  Here at ITA Wealth Management, we consider asset allocation to be fundamental in the investing process.

Lowell Herr

Photograph:  Image is found just above the entrance to the Benedictine Abbey at Melk, Germany

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Seven portfolios are currently available for viewing and study on the Premium Content side of this blog. Oldest is the Passive Portfolio (PP), now closing in on its 8th birthday.  The remaining six portfolios, listed below, are still under construction, even though “Colter” has been operational for many months.  The AEM portfolio is established in that the asset classes are fixed as are the target percentages.  Either of these will only change if the board of directors makes any changes.

• AA-Mosaic
• Mosaic2
• GLW
• Scrappy
• Colter
• AEM

As mentioned before, all these portfolios are built around the concept of asset allocation.  Not all portfolios contain the same body of asset classes, nor are the target percentages identical.  These seven portfolios are set up for different individuals and/or non-profit organizations.  The portfolios vary in size and they were launched at different times providing a variety of “experiences” one might expect to find if one were able to peek into the portfolios of seven different individuals.

The variety of portfolios provides a better test of the asset allocation principles than one could obtain from a single portfolio.  As you look at the different portfolios, you will note that most, but not all, are outperforming their VTSMX benchmark.  For the very new portfolios, this is not significant.  Those that are not performing as well as expected are taking it on the chin due to the poor performing international and emerging market ETFs.

Over the next several months, efforts will be made to populate asset classes that are under target.  In some cases this will happen with new cash.  With the more mature portfolios, we will need to rely on dividends to provide cash to upgrade those asset classes that are below target.  Limit orders are in place for several portfolios.  When those are triggered, I will report on the shares purchased.

Lowell Herr

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Photograph: Chinese dancers

Action has been the name of the game as the market declined.  A number of limit orders were struck.  These purchases plus all the portfolio updates combined to generate considerable reporting, particularly over on the Premium Content side of the blog.  It is time to take a deep breath over this weekend.

Here are a few things to focus on over the coming weeks.

• If you have not made the move to set up an investment plan, begin to lay out your long-term goals.
• An investment plan should begin with an outline of what asset classes you want to use.  Do you want to use index funds or ETFs?  If you are making small monthly deposits, be sure to use index funds so commissions do you eat up a significant percentage of your investments.  If you are investing larger amounts, then ETFs will serve you well.
• Once you have the asset classes identified, go to Vanguard as they are the standard in offering low cost investment vehicles.  If you cannot find an ETF or index fund to meet your asset class of interest, then check out Barclay’s iShares.  Don’t get fancy and fall into the trap of investing in actively managed ETFs.
• Before you make any purchases, lay out what percentage you want to invest in each asset class.  This is going to be your most difficult decision.  To aid in this decision, I highly recommend investors check out the IFA web site.  Be sure to take the Risk Capacity Survey.  Take the time to complete the survey of 25 questions.  It is also a good idea to have Mark Hebner’s Index Funds book in your hands so you can look through the portfolio you will be assigned as a result of taking the survey.  Note: The survey is free.
• At this point, your investment plan shows the seven to fifteen asset classes you are going to use to construct the portfolio.  Also, you came up with target percentages for each asset classes.  Don’t become paralyzed over the target percentage decision as you will most likely change these over time as your career or financial situation changes.  You will want to revisit your target percentage asset allocations each year.  It is a good idea to completely review the portfolio each year.
• Set up an account with a discount broker.  I happen to use TDAmeritrade, but there are others.  I happen to like TDA’s monthly broker statements and their commissions are low.
• It is now time to begin buying index funds or ETFs to populate the portfolio.  From time to time you will likely want to add a specific stock that you have analyzed and feel quite comfortable adding to the portfolio.
• How are you going to monitor the performance of your portfolio?  What benchmark are you planning to use?  Check out our spreadsheets over on Premium.  I recommend the benchmark be VTSMX.
• Now go do it.

The C & D Portfolio has a history of approximately five years, so it is still a relatively young portfolio.  This portfolio was initially built around individual stocks, but those picks were not keeping pace with the broad stock market.   Given a green light, I was asked to rework the portfolio using the principles of asset allocation.  I’ve gradually been selling off stocks to where the portfolio now only holds Johnson & Johnson (JNJ) a very high quality stock, and one that is in one of the Mosaic portfolios.

Recently, the Internal Rate of Return (IRR) for the C & D Portfolio moved ahead of its VTSMX benchmark, 2.6% to 2.3%.  That is not a significant lead, but it is still better than reversing the numbers.  Over the history of the portfolio, the Information Ratio is negative and will likely remain that way for a long time.  When a portfolio digs a major hole, it is very difficult to climb out of it.

There are still several asset classes to populate in this portfolio and there is some available cash to make that happen.  This portfolio is just another example of how asset allocation can work to the long-term investors advantage.

Lowell Herr

Data is available through Premium Content on the Scrappy, the most recently launched portfolio using the principles of asset allocation.  For anyone just launching a portfolio, this is a good SS to download as there are not many entries.  One can easily tell what is going on.

Several asset classes need to be populated before this portfolio is set on automatic pilot.

Premium Content available for $6.99 per month.

Lowell Herr

Photograph:  Fish Hatchery at Bonneville Dam, Oregon

Below is a table showing the asset allocation targets for the Passive Portfolio.

Note how the targets are skewed or tilted toward the value side of the investing spectrum.  That worked very well during the bear market of the early 2000s but not as well in recent years.  However, we will stick with the plan as we do not know which asset classes will perform best over the next year.  REITs normally make up 10% of the portfolio, but with the housing and banking markets not doing well, we trimmed 5% off this asset class.  Reducing the percentage in REITs is a decision we made well over a year ago.  Such a decision is called Tactical Asset Allocation and something not recommended for beginning investors.

More details on the PP are available on Premium Content.  Cost is approximately three cups of coffee per month.