Road To Independence

When I think about the portfolio construction process it brings to mind a few good books I’ve read over the years. Books like: “Asset Allocation,” by Roger Gibson, “Random Walk,” by Burton Malkiel, and of course there’s Fabozzi’s “Handbook of Fixed Income Securities,” and Ibbotson’s annual edition of “SBBI Yearbook.” But one of my more recent reads, “The Ivy Portfolio,” by Faber and Richardson (Wiley, 2009) was especially interesting as it chronicles the performance of the Harvard and Yale endowment funds’ exceptional period of outpacing the stock market with considerably less risk. It is this latter book which confirmed my already staunch belief in alternative investments, the topic of this week’s blog.

I had been using alternatives for a number of years prior to reading this book but after reading how Harvard and Yale utilized alternatives, I have increased my allocations to this important asset class. It is my belief that as the percentage of stocks in a portfolio rises, alternative investments should also be increased. At the end of this blog, I’ll list the ticker symbols of some of the alternatives I use.

First, I realize there is some disagreement as to what constitutes an investment’s classification as “alternative.” That said, here are some of the investment categories I consider to be alternatives: currency, hedge funds, merger arbitrage, long-short or market neutral, commodities, and real estate. Some are more closely correlated to stock than others—such as real estate—but these are the categories I include.

After reading The Ivy Portfolio, I realized there’s a great difference in what an advisor has available compared to a large endowment. For example, an endowment can invest in the choicest private equity offerings, while the individual advisor probably cannot. Moreover, where Harvard or Yale may buy actual timber land, an advisor may buy an ETF.

Here are a few of the alternative investments I use.
Mutual Funds
• Hedge Fund: Absolute Strategies I (ASFIX)
• Merger Arbitrage: Arbitrage R (ARBFX)
• Long-Short: TFS Market Neutral (TFSMX), Highbridge Statistical Market Neutral (HSKSX)
• Commodities: Prudential Jennison Natural Resources Z (PNRZX)

Exchange Traded Funds
• Currency: PowerShares DB US Dollar Index Bearish (UDN)
• Commodities: iPath S&P GSCI Crude Oil Total Return Inx ETN (OIL), SPDR Gold Shares (GLD)

I use the currency and commodity ETFs in a more tactical fashion. I’d be interested to know how you use alternatives in your practice and which ones you like.

Thanks for reading.

The topic this week is how I use stocks in building client portfolios. First let me say that I do not consider myself a stock picker. I learned years ago that trying to forecast the price of an individual issue in the near term is very difficult, if not impossible.

Around 1997, while working for the “Bull,” one of their stock analysts predicted that Compaq would rise to $47 per share from its current level of $37. Not only didn’t it rise, but it proceeded to fall to $27 and then fell into more trouble (as I recall). Similar stories are innumerable. There are a multitude of potential problems in selecting individual stocks, not the least of which is to understand how investors, as a group, will feel about a company’s prospects. You must predict whether they will be buyers, sellers, or neither.

Because human behavior is such a key factor, but is so unpredictable, I prefer to delegate this task to managers of mutual funds and ETFs. I should mention, in case it wasn’t obvious, that I will use the term “stock” in a categorical sense and not as a reference to individual issues.

During the bull market of the 1990s, an aggressive portfolio might have contained 80% or more in stocks. Even a balanced portfolio was 40% to 60% stocks. Since returns cannot be controlled, but risk can (at least to some extent), here’s how I allocate my portfolios (stocks/bonds/cash/alternatives):

• Conservative (16/68/3/13)
• Moderate (35/43/3/19);\
• Aggressive (50/24/2/24)

At first glance it may appear that the aggressive portfolio is not very aggressive since it has only 50% in stocks. Here’s my rationale behind these allocations.

Premise: Whenever adding a holding to an existing portfolio, the new addition must have a positive effect on the portfolio. I define “positive effect” as either reducing risk or increasing the return potential. Moreover, stocks will dominate the movement of the portfolio unless its allocation falls below a certain percentage, such as 17% (+/-). Since stock fluctuations are so important to the risk or volatility of the portfolio, I assign a substantial allocation to alternative investments.

Ideally, alternatives will help calm the portfolio and reduce its overall risk. Therefore, as the percentage of stocks increases, the percentage of alternatives should also increase to reduce the portfolio’s risk.

I prefer Value over Growth and overweight Large-Cap over Mid- and Small-Cap. I also allocate a larger percentage to domestic over foreign. I might get a little tactical with the mix of domestic and foreign depending on the strength or weakness of the dollar.

Obviously, there is so much more to discuss, but I’ll have to leave it there for now. Next week, I’ll discuss alternative investments.

Last week I discussed the first stage of my portfolio construction process. Clearly, this was a difficult task to complete in a 400-500 word essay as it omits many important issues from the discussion. Before I move on to this week’s topic, let me make one thing perfectly clear, I do not believe I (nor anyone else) can predict market returns. However, I do believe it’s fruitful to determine the return needed to reach the goal. Then at least you have a benchmark against which to measure your progress. This week, we will begin to build the portfolio starting with bonds (I could have said “fixed income,” but I eliminated jargon from my vocabulary a long time ago).

My Approach: Core and Stability
With bonds, I use a “Core & Stability” approach. In general, bonds are primarily affected by interest rates which will rise, fall, or remain static. The worst environment for bonds is when interest rates are rising since as rates rise, bond values fall. There are other factors which affect bonds such as money flows (with mutual funds) and credit quality, but let’s stay with the topic of interest rates. First, I avoid long-term bonds. Even though there are periods when long-term bonds outperform, over longer periods of time, the returns in this category are similar to intermediate-term bonds, but intermediate-term bonds contain much less risk (as measured by standard deviation). Next, I will typically avoid bonds with embedded options (call features). This is because of their negative convexity (a discussion for another time). Finally, I am not a big fan of high-yield bonds, but do hold them on occasion. Finally, I will normally use mutual funds of ETFs. However, I will buy some individual issues if the portfolio is large enough.

Core
Here I include intermediate-term bonds, mortgage-backed bonds, and inflation protected bonds (TIPS). If interest rates are falling, intermediate-term bonds will perform well (as will most bonds). When interest rates are rising, I like TIPS because of their increasing floor (par value increases with inflation or CPI). If interest rates are rising, the economy must be growing and CPI will be positive. Finally, in a “static” environment, mortgage-backed bonds will fare well. I should note that I use GNMA’s here, and that mortgage backeds receive the smallest allocation of the three. Currently, I am overweight in TIPS.

Stability
Depending on the client’s willingness to assume risk, I will add some or all of the following: ultra short-term, short-term (government or corporate), and bank loan. These will help stabilize the portfolio which is my ultimate goal.

Summary
The intent is to achieve a positive return from the bonds regardless of interest rate movements.  As long as rates aren’t rising in large increments, this should be achievable. I should note that I’ve been using this approach since 1999. So far, so good.

When I started this blog back in May 2007, the intent was to write about the day-to-day issues I faced as an independent advisor. Now, after 140 postings, we’re going to try something a little different. Though I will still write about my weekly adventures, the topics will coincide with the focus of the magazine and will change on a monthly basis. This month’s topic will be investing. The topics are as follows: Portfolio Construction Overview; Bonds; Stocks; and Alternative Investments. Let’s get started.

Portfolio Construction (Overview)
First, let me say that there are a number of good ways to manage money and I do not claim to have cornered the market on this. What I can say with a high degree of certainty is that I have discovered a method which has worked well and will share it with you this month.

Actually, it was during the bear market at the beginning of this century (2000-2003) when I stumbled upon it. Here’s where it begins. Perhaps the most important question I can answer is this, “What’s the required rate of return my clients need to earn to make their goals a reality?”  Then, “How much risk will we need to assume to get there?” I only know of one way to arrive at the required return and that’s through financial planning.

After creating the plan, and assuming it is successful, I will “stress test” it by reducing the return until the probability of running out of money materializes. At this point, I know approximately where the threshold is, that is to say, the minimum return which will allow my client to live the lifestyle they desire.

Once this is known, I will begin with one of my model portfolios, and by running 1,000 or more trials with Monte Carlo simulation, I can forecast the probability of achieving this return for annual, five-year, and 10-year periods. It’s important to target an expected return which is higher than the required return. Let’s say the required return was 7.5%. If the expected return were the same, then I would likely have a 50/50 shot of success. Therefore, I target a return which is slightly higher than the required return so the probability of success will be higher.

Next week I’ll share how I build a portfolio which starts with the bond category. Stay tuned.