>Moderate Asset Allocation Portfolio – January 15, 2012

January 15, 2012 Leave a comment

     In this post, I show the results of maximizing the Sharpe ratio (with risk calculated as defined here) using a risk-free rate of return of 3.4%.  Some might argue that this return is too high, but I do not.  You can find very secure nearly risk-free instruments that pay at about this rate, and 3.4% is roughly the long term inflation rate in the United States (although it has been lower recently).  The 100 most actively traded ETFs were considered for this portfolio.  The resulting portfolio had a Sharpe ratio of 2.51 (which is very good), an average return of 15.48% and a standard deviation of 4.81%.  Percentages have been rounded to the nearest 1%.

  • AGG – 4%
  • BGU – 1%
  • BND – 1%
  • DBA – 2%
  • DBC – 2%
  • DIA – 1%
  • DVY – 2%
  • EDZ – 6%
  • ERX – 4%
  • EWM – 2%
  • EWY – 1%
  • FAZ – 3%
  • GLD – 3%
  • HYG – 2%
  • IAU – 3%
  • IWD – 1%
  • IWF – 1%
  • IYR – 1%
  • JNK – 2%
  • KRE – 1%
  • QLD – 2%
  • QQQ – 1%
  • SCO – 2%
  • SKF – 2%
  • SMN – 2%
  • SPY – 1%
  • SSO – 1%
  • TLT – 22%
  • TQQQ – 3%
  • UPRO – 1%
  • VNQ – 1%
  • VTI – 1%
  • XLE – 2%
  • XLI – 1%
  • XLP – 2%
  • XLU – 4%
  • XLV – 2%
  • XLY – 2%
  • XOP – 1%
  • XRT – 4%

Of particular interest to me is the high allocation to TLT (22%).  ALso there is a very high allocation to QQQ instruments.  Even though QQQ is only allocated 1%, TQQQ (3x leveraged) is allocated 3% and QLD (2x leveraged) is allocated 2%.

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>High Yields Provide High Returns

January 15, 2012 Leave a comment

     One of the best investments available today is high-yield bond ETFs.  There are a number of reasons for this.

     First, many baby boomers had their retirement accounts devastated by the last recession.  They do not have enough money to retire as they expected to.  Or, they are already retired and are seeking a way to keep the retirement income flowing with fewer available assets.  These people are forced to find riskier fixed income investments, and are investing in high-yield bonds.

     Second, the general population is aging.  As people age, the proportion of one’s assets allocated to fixed income securities (such as bonds) increases.  The result is money flowing out of equity and into fixed income investments.

     Third, to keep the economic recovery going, the Federal Reserve is keeping treasury bill and bond rates down.  This makes them relatively less attractive, and drives assets away from treasury bonds toward corporate bonds.

     Fourth, high-yield sovereign debt is quite risky.  Sovereign bonds that pay 6-7% are much more likely to default than corporate bonds with the same yields.

     Fifth, diversified investment in a basket of high-yield bonds is very easy now, with the advent of bond ETFs.  The explosion in these funds has been phenomenal.  High-yield bond ETFs have grown from $2 Billion to $22 Billion over the last three years.   Bond ETFs grew $180 million over just the last week.   Bond ETFs that I particularly like include:  iShares Barclays Aggregate Bond (AGG), Vanguard Total Bond Market ETF (BND), iShares iBoxx HY Corp Bond Fund (HYG), and SPDR Barclays Capital High Yield (JNK). 

Bottom Line:  Long domestic high-yield corporate securities

When to Sell:  When Federal Reserve increases interest rates

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>Small Caps Provide Big Bangs

January 12, 2012 1 Comment

     The United States is coming out of a recession and small businesses are leading the way.

     There are a myriad number of statistics that point to this.  Small business borrowing in the United States is up 18%.  55% of small business owners indicated that business would be better in 2012 than in 2011, and 64% said that the year-end 2011 figures would be better than they originally thought. Small business hiring has picked up.

     Large businesses, however, are reducing their labor force.  Layoffs were up 31% in 2011.  Large corporation profit growth is at a two year low.  Recruitment specialists are being hit with a collapse in (large) corporate confidence, due in part to the Euro crisis.

     What does this mean?  The economy is shifting from large companies to smaller firms.  It also means that domestic small businesses should outperform domestic large businesses over 2012.  In fact, small cap equity is the single largest equity sector in my model Sharpe ratio maximized portfolio, making up a whopping 15% of the total assets.  There are a number of ETFs that provide exposure to the ETF sector while providing lower expense ratios.  Heavily traded unleveraged small cap ETFs include iShares Russell Small Cap Growth (IWO), iShares Russell Small Cap Index (IWM), and iShares Russell Small Cap Value (IWN). 

     I do not believe that foreign small cap stocks make a good investment at this point in time.  Note my previous posting that emerging markets are too risky at this point in time.  Also, the Euro crisis makes European stocks too risky (due to potential bank insolvency).  If you absolutely must invest overseas, try the iShares MSCI Malaysia Index Fund (maybe that will be the topic of another post).  So stick with domestic small caps for now.

     Bottom Line:  Long domestic small capitalization stocks.

     When to sell:  Stay long until the domestic credit market begins to contract again.

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>Emerging Markets Will Continue to Sink

January 6, 2012 Leave a comment

     The MSCI emerging markets index fell 22% last year, and although I do not believe it will fall as much this year, the coming year for emerging markets will likely still be bleak.  There is no shortage of reasons for this pessimism.

     Europe is on the brink of a serious credit crisis, initiated as a result of a crisis in the Euro.  Shrinking credit availability disproportionately hurts emerging markets.  Furthermore, Latin American banks are heavily exposed to Europe, which “poses a risk” to the region, as an official for the IMF reported recently. 

     Commodity prices have also mostly been in decline.  For example, the RBA commodity index has declined for four consecutive months.  The same IMF official mentioned earlier also reported that this thread could be “toxic” for Latin America.  Commodity exports are the staples of many emerging markets economies.  Declining exports means reduced cash flow for businesses and countries.

     An exception to the decline in commodity prices is oil, which has been on the rise.  Increased oil prices affect the entire globe, but disproportionately affect emerging markets.  Cheap fuel fosters economic growth.

     China, which is seen as a stalwart consumer if commodities, has had four consecutive quarters of growth erosion.  Recently, Chinese officials reported that they were prepared to continue to “moderate growth”.

     The turmoil in North Africa and the Middle East have put a crimp on their economies.  Egypt, for example, is on the verge of economic collapse.

     For all of these reasons, emerging market funds should continue to flounder in 2012.  A favorite investment of mine is the Direxion Daily Emerging Markets Bear 3X Shares (EDZ).  Or, you could just short the iShares MSCI Emerging Markets Index (EEM).

     Bottom Line:  Short Emerging Markets

     Close the position: When commodity prices rise, Europe resumes growth

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>The Golden Rule

January 6, 2012 Leave a comment

     No, I am not one of those wild guys you see on TV or hear on the radio who promise that Gold is about to break out to $10,000 an ounce.  The only investments many of these guys sell are gold and silver.  I am not even willing to predict that gold will enter record territory in 2012.  

     In fact, it may well drop.   The current market conditions for gold are far from ideal.  Gold imports are down in India, and there is speculation that European countries may be forced to sell gold to help finance their debts (which would drive prices down).  Furthermore, the current price of gold may be being artifically propped up by a surge of worried Iranian citizens buying gold as a safe haven, and Chinese purchases in advance of the pending Lunar new year.

     But my model portfolio is 4% gold, and it makes a lot of sense to have gold in one’s portfolio.

     First, gold was a very good investment last year, yielding a greater than 10% return over 2011.  And, on top of that, it is almost completely uncorrelated to the S&P 500 index.  Over the last 250 trading days, the correlation coefficient between the S&P 500  and gold was effectively zero (-.02).  This is a risk hedger’s dream, a rising asset that is completely uncorrelated to stocks.  Adding gold to your portfolio decreases its overall volatility.

     Second, more and more investors (large and small) are realizing that neither the Euro nor the Dollar are secure monetary instruments.  More investors will move to gold (what else is there?) as this trend continues.  Indeed, we are also seeing gold’s correlation to the Euro-Dollar exchange rate moving to zero (indicating no correlation).

     Gold holds a winning streak of 11 straight years, and it may not make it to 12 in 2012.  However, that should not deter one from buying the bright metal.  It is a hedge against inflation, reduces portfolio risk, and will go up as demand for Dollars for Euros drys up.  I hold both the SPDR Gold Trust (GLD) and the iShared Gold Trust (IAU).

When to sell:  Never, as long as the correlation with stocks stays low … or until someone starts mining gold on the moon.

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>Power Up Your Portfolio

January 5, 2012 Leave a comment

     Would you believe it if you were told that the United States is a net exporter of fuel?  It may seem hard to believe, but it is true.

     Of course, I did not say that the United States is a net exporter of oil.  We still import much more oil than we export, but our per capita consumption is decreasing.  What I said was that we were a net exporter of fuel. 

     Japan imports raw material – steel – and manufactures automobiles.  It is a net importer of raw material, but a net exporter of automobiles.  The United States imports oil (a raw material) and exports fuel (a finished product).  Cars do not burn oil (well, some do, but this is not a blog about car maintenance), they burn fuel like gasoline or ethanol.  And for the US, the fuel industry is booming.

     Here is another interesting fact.  Foreign countries, particular China, are investing heavily in energy.  China recently paid $570 million to invest in US Oil Shale reserves.  Who can blame them?  They want to put their hard earned US dollars to good use, and those dollars will eventually diminish in value if they continue to hold on to them.  Energy assets, however, will continue to increase in value.

     You have probably heard the expression “Don’t fight the market”.  China is investing heavily in energy.  As long as that trend continues, energy company valuations will continue to climb.

     Another reason to like the energy sector is the rising price of oil.  It has had a nice run up, and as the recovery continues, most pundits are predicting further gains in the price of oil.  As oil prices increase, the valuation of oil company assets also increases.  Furthermore, alternative energy sources become more viable, and companies specializing in them become more profitable.

     Heavily traded ETFs to consider if you expect the energy sector to continue to do well for the next year include: Direxion Daily Energy Bull 3X shares (ERX), Energy Select Sector SPDR (XLE), and SPDR S&P Oil & Gas Exploration and Production (XOP).

Bottom Line:  Long Energy Sector stocks. 

When to Exit:  Start of the next global recession.

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>Sharpe Investing

January 1, 2012 Leave a comment

In this blog I describe how my model portfolio is built.  It’s a bit mathematical, but I will try to keep it simple.

I maintain a database that contains a history of a great many (over a hundred) exchange traded funds (ETFs).  My goal is to select the right percentage of each fund that minimizes the selected portfolio’s risk to return ratio. 

 The technique is quite similar to maximizing the Sharpe ratio.  The Sharpe ratio is computed as

                                    Sharpe = (R – r)/S

where R is the portfolio return, r is the risk-free return rate, and S is the standard deviation (e.g., volatility) of the portfolio.

In my case, I set r to the minimally acceptable rate of return (unique for each individual’s risk tolerance), and S is the maximum of:

  • Portfolio standard deviation over the last year
  • Average of one-year standard deviations during the last year
  • Best current estimate of current portfolio standard deviation using linear extrapolation.

What does the resulting “optimum” portfolio look like?  Here is the breakdown:

  • 27% long corporate and sovereign bonds
  • 64% long and 28% short in corporate equity (e.g., stocks)
  • 6% long and 7% short in commodities

 You will note that there is no way to make these numbers add up to 100%.  The overall portfolio is net 27% long in bonds, net 36% long in stocks and net -1% long in commodities.  This is possible because with ETFs one can be long in some markets and short in others at the same time, and can be leveraged 2x, 3x or more.  For example, one could be long financial stocks and leveraged 3x, while short in health care stocks and leveraged 2x at the same time.  This sounds highly speculative, but remember, we’re trying to find the optimum portfolio composition that minimizes risk while maximizing return.

This technique is very similar to what many hedge funds do.  They use different values for r and S, but the techniques are the same.  And when you apply these techniques and track them over time, you discover what the market is really doing, which is not always what the pundits say it is doing.

You will note that I said to “track them over time”.  The optimal market portfolio will change as market conditions change.  Buying horse buggy stocks may have been a good investment at one point in time, but it’s not anymore.

One final note – and it’s an important one.  I don’t believe that one should make an investment strictly from mathematical principles.  The investment must make sense as well.  Do not be blinded by math – it is just a tool.

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>Don’t Bank on It!

January 1, 2012 Leave a comment

Today let’s discuss financial stocks.  My model portfolio is solidly short in the financial sector – short financial ETFs make up 13% of the total.  ETFs Direxion Daily Financial Bear 3X Shares (FAZ) and ProShares UltraShort Financials (SKF) are good options for those who wish to copy me and short the financial markets.  They are both heavily traded and therefore have low bid-sell spreads and reasonable expense ratios.

One reason to be down on the big banks is the Euro crisis.  Sovereign debt fears in Spain, Portugal, Italy, Greece and Ireland will not affect just those countries.  The entire global economic environment is enmeshed so that if you pull the string on one loose end, the whole ball of yarn becomes unraveled.  The large US banks are heavily interdependent with the large European banks.  If one or more of the European banks fail, it will affect the entire global economy.

The European crisis is far from over.  The solutions proposed by the Germans and French will take years to fully enact, and will likely require modification of current EU treaties.  England is balking at some of the major changes that are being proposed.  It will take years to resolve these problems, and in the interim, European (and American) banks will languish.

As if this was not enough, there is a growing public sentiment against bankers and investment advisors in this country.  “Occupy Wall Street” is not a protest against the top 1% of income earners.  It is a protest against the top 1% of income earners who are in the banking industry.  Expect more Banking regulations (and lawsuits) against the big banks, not fewer.

Finally, let’s remember that the big banks are also embroiled in massive lawsuits, both for illegal foreclosures and for “causing” the 2008 crisis. 

An exception to this rule may be smaller, regional banks that are profitable and not interdependent with European Sovereign Debt.  For those that insist on being bulls in the Financial Services industry, I suggest the SPDR S&P Regional Banking ETF, KRE.

Bottom Line:  My model portfolio is short the financial services industry.

Condition needed to close the position:  Euro crisis resolved, lawsuits and protests against banks no longer in the hedlines.

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>You Win if You TLT

December 31, 2011 Leave a comment

Long term treasuries were a sleeper in 2011 that made a lot of money for those “in the know”.

Some of you may think that long term treasuries are an extremely conservative investment, unlikely to yield significant returns. On the contrary, funds like TLT enjoyed a 37% return over the last year. Over the longer term, the returns have not been as good – The returns over three years have not been that good – only 4% per year on average. What made these ETFs pop in 2011, and will it continue upward in 2012?

What makes these investments particularly attractive, even at these inflated rates, is that the Federal Reserve is actively buying long term debt instead of short term debt, driving long term rates down. As a recent Chicago Tribune article stated, they are doing this to stimulate the economy and “the Fed hopes to push long-term borrowing costs lower for consumers and businesses to facilitate the economic recovery”. This buying by the Federal Reserve will result in continued high prices for long term treasuries. For now, as long as the economy is seen as weak, investing in these notes is a no-lose proposition in my mind. The Feds will not let long term interest rates rise anytime soon.

There are some that say that T-Bonds are ready to decline, and that we are in a bubble. Perhaps we are, but big money can be made in bubbles, assuming you get out in time. If you keep your money in T-Bonds and do not reallocate regularly, over the long term your return will be pretty mundane (1-4%). I do expect T-Bonds to crash, but not until the Fed starts tightening money supply. That has not happened yet. They have reduced near term interest rates to nearly zero percent – reducing long term interest rates is the only tool left in their arsenal.

The problems with the Euro are also propping up the dollar, which in turn are propping up both the short-term dollar denominated T-Bills and longer-term T-Bonds. Nobody who is paying attention thinks that the Europeans will be out of the woods anytime soon, either.

Bulls in 20+ year T-Bonds can buy TMF (3x bull), TLT, TLO, EDV, DLBL, or LBND (3x bull). I prefer TLT myself.

Bottom Line: I’m putting my money in TLT … but watching it carefully.
Exit Strategy: Leave when Fed stops easing monetary policy.

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>Manage Your Risks

December 31, 2011 Leave a comment

An investor seeks to control his risks, balancing opportunity against risk. This is what hedge funds do – they “hedge” their investment bets. To do this, they typically spread their investments across a number of asset classes, including commodities, stocks, real estate, and bonds. They can be long one position and short another. The fund managers and their “quants” (quantitative analysts – the Ph.D.s from MIT and Caltech) may use fancy language like “Seeking Alpha” or “Maximizing the Sharpe Ratio” but really they are all doing the same thing – balancing opportunity against risk.

To invest in a hedge fund, you must be a “qualified investor” or “well qualified investor”, which means you have at least $1 million or $5 million ready to invest. This excludes a lot of people. Even if you had that kind of money, the hedge fund will probably charge you an outlandish fees, such as 20% of your profits per year, or perhaps 2% of your investment per year.

However, with the advent of Exchange Traded Funds, anyone can invest in the same things that the big hedge funds and investment banks invest in. You can be long the dollar and short the Euro. You can be ultra-short on silver and ultra-long on gold. You can invest in real estate companies, and short the financial sector. You can take long or short positions on nearly any commodity, bond sector or stock sector.

The purpose of this blog is to help people who want to invest on their own, balancing opportunity versus risk just like the big banks and hedge funds do.  I maintain a database that contains a history of a great many (over a hundred) electronically traded funds. My goal is to select the right percentage of each fund that minimizes the selected portfolio’s risk to return ratio.

I believe we’ll have a lot of fun together.

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