ITA Wealth Management

Back on March 17th of this year, I published a Portfolio for Dummies. At that time I did not have access to the Quantext Portfolio Planning (QPP) software so I was unable to examine the projected return, portfolio risk, and portfolio diversification.  With QPP in hand, I decided to analyze the sample portfolio of eight months ago and here is the “movie” of that analysis.

The next move is to find investments, be they individual stocks or other ETFs, that will reduce the standard deviation while maintaining an acceptable return.

Lowell Herr

Photograph:  Victoria Hotel - Amsterdam, Holland

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In this movie you will pick up the projected returns for the different ETFs mentioned in the prior post, the average projected annual return, and the standard deviation for the portfolio.

One will soon see that this is a conservative portfolio and therefore not the best choice under the current market conditions, unless you think the market will sink even further.  If you are one that thinks we will pull out of this financial funk before many months pass, then watch for another scenario over on the Premium Content side of the blog.

Lowell

Photograph:  Another image to get one into the spirit of Thanksgiving.

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Sorting through over 700 ETFs is a daunting task no investor wants to tackle.  Despite the large number of available ETFs, it is possible to keep it simple if you have a little help narrowing down the choices.  Some basic divisions to consider are the following.

Consider what ETFs will make up your core U.S. equity holdings.

Will you include international equities and do you want to separate emerging markets from the developed nations?

• Are you going to include REITs and if so, will international REITs be part of the mix?
• Will bonds be part of the portfolio?
• Should one include commodities or any precious metals?
• Do you want to participate in the movement of the U.S. Dollar?
• Will treasuries be part of the portfolio mix?

Once the basic questions are answered, then one can begin to break the vast number of ETFs into smaller and manageable groups. Here is a list of broad-based or macro ETFs.

• VTI - Vanguard Total Stock Market
• EFA - MSCI EAFE Index or Total International ETF
• VWO - Vanguard Emerging Markets
• DJP - Dow Jones Commodities Index
• VNQ - Vanguard REITs
• RWX - DJ Wilshire Int’l REITs
• USO - United States Oil
• GLD - SPDR Gold Shares
• AGG - Lehman Aggregate Bonds
• TIP - Lehman TIPS Bond
• IEF - Lehman 7-10 Year Treasuries
• UUP - Power Shares US Dollar Index Bullish

The above 12 ETFs cover a wide section of the world market.  The list is not a recommendation, but an example of how one might narrow the broad array of ETFs into a manageable number of holdings.

My personal preference is to break VTI into at least six separate asset classes in order to break away from S&P 500 dominance.  This can be accomplished by selecting ETFs such as VOE, VOT, VBR, and VBK.  Check these out using Yahoo Finance.  ETFs for oil, gold, treasuries, and the dollar are alternative investments and may not be what one wishes to hold, at least in large percentages.  An alternative I did not list above is timber or the PCL ETF.

Cutting the list of 700 plus ETFs down to a manageable number is one of the features of Premium Content.  There one can see how actual portfolios are constructed using core ETFs.

Lowell Herr

Photograph:  Preparation for Thanksgiving

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Risk has become an important word in the nasty bear market.  One solution to reducing risk is to build a portfolio using investments that do not track the S&P 500 or at least deviate from the standard benchmark.  If one is using ETFs to construct a portfolio, this Yahoo site is one place to go to troll for assets that have low R-Squared (R^2) values as measured with respect to the S&P 500.

Using the reference cited above, one can sort ETFs to find those that have a low R^2 value.  Of course one will want to know a lot more about each ETF other than the R^2 value.  Will the ETF enhance the projected return, what is the expense ratio, and will adding the ETF increase the diversity of the portfolio?  The R^2 value is one one factor to consider.  It is an important one so spend time with this Yahoo reference.

Over the next few weeks, Premium Content readers will find examples of portfolios designed to reduce risk.  These ideas will be incorporated into portfolios still under construction.

Photograph:  Time to make Thanksgiving cranberry relish.

Check out this “movie” and make your own judgment as to whether or not a portfolio can be called diversified when it is built around sectors.

Photograph:  Marksburg Castle

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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