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 January 2011 Beyond Asset Allocation Short-Term Decisions and Long-Term Returns
Nevertheless, you probably are. If you’re like most investors or their advisors, you know the benefit of diversification. One way or another, you’re probably building well diversified portfolios to control risk despite changing markets. Part of this process is making sure there’s some sort of balance between equities and fixed income If you’re more aggressive, you might tilt more towards the equity components, but you’ll probably still include an allocation to fixed income – even when you don’t think bonds are appealing. You may be more inclined to populate that underperforming allocation with securities you think will offer greater downside protection than upside potential. In other words, if the sector is going to decline, such a holding will decline less than average. If its sector unexpectedly turns up, you’ll be able to share in the gains as well.
What’s driving all this is the belief that market timing doesn’t work. You’ve constantly heard this and you’ve probably seen some academic research to that effect. That’s why you’re willing to include an allocation to a sector of the market you think will underperform, just in case it doesn’t. But let’s be honest: Doesn’t it seem odd to add – or even hold – assets you believe will be poor performers? When you’re looking for the investment that will “lose the least”, don’t you feel like you’re paying good money for the cream of the crap? Is this really investing?
A Reasonable Alternative This isn’t an approach for small sectors of the market. Focusing in such a universe would be too risky, instead, the broader the universe of potential holdings, the better. In fact, the best approach is to consider the entire range of investable assets, something you can’t do by buying individual securities. The best way to do this is through the use of Exchange Traded Funds (ETFs). Like mutual funds, ETFs are pooled investment funds giving investors a share of the underlying investments. They’re available for a broad range of asset classes from the basic stock and bond categories to more esoteric alternatives such as commodities, currencies, and small market or country sectors. With such a wide array of options, ETFs offer a high level of diversification. This is not a long-term buy and hold strategy. Quite the contrary, one hundred to two hundred percent turnover is to be expected in every year. While that sounds like a lot of trading, it doesn’t have to be. By using ETFs which are already broadly diversified, a solid portfolio can be established with only three or four holdings. Even with two hundred percent turnover, such a portfolio would involve only sixteen trades. If carried out in a discount brokerage account, even this number would result in annual transaction charges under $200. To select the sectors of the market most likely to outperform in the future, the best place to start is to find which have been doing the best in the past. If this sounds like momentum it’s only because it is. As you’ve heard many times before, market timing is a loser’s game. It isn’t possible to foresee the winners of the next five years or even the next twelve months. But it is possible to determine what’s been working in the past three to six months and it’s reasonable to expect their performance to continue over the next one, three, or perhaps even six months. The key is to make sure potential holdings haven’t already crested prior to their selection. Fortunately, BlackRock’s iShares make this simple. The iShares ETFs cover virtually all corners of the market, and the website allows you to sort them based return over differing time periods. Those that appear in the top twenty of both three and one month performers are worthy of consideration. Three to five are sufficient to build the portfolio Once the holdings are selected, it’s time to run them through a mean-variance optimizer. The fact sheets of each ETF (also available at the ETF’s website) will typically give its benchmark index which can be used as its proxy for the optimization. There’s no need to worry about using forward-looking risk and return projections or correlations, historical will be fine. Because the holding period is expected to be less than a year, there’s not much reason to expect statistical relations to stray far from those of the past. And finally, speaking of holding period, there is no specific time for rebalancing. This portfolio will require constant review. When and if any of the holdings begins to fade, the entire optimization process should be revisited. All holdings should be considered for replacement, but it’s not uncommon to find a few returning. Again, don’t be intimidated by the sound of this, rebalancings may occur as infrequently as two to three times a year depending on market conditions..
By following these simple rules, it is possible to outperform a broad market index such as the Russell 3000, S&P 500, or Wilshire 5000. The comparison is somewhat lacking because these are typically equity indexes whereas ETFs enable investment in a wider range of alternatives – which, of course, is the beauty of this approach.
Not Just a Theory Truth be told, it could have – and in fact should have done even better. In several instances manager neglect allowed existing portfolios to run too long before reoptimizing. This was an oversight on our part which would probably not plague investors with real funds invested. Even so, our results are still quite impressive. Currently the model has five holdings: Turkey (TUR), Peru (EPU), Gold (IAU), Silver (SLV), and U.S. Government/Corporate 10+ Year Bonds (GLJ). There was only one reoptimization in 2010 occurring on May 29. Silver and Peru have been included for over a year. The next reoptimization will occur in the next few weeks because U.S. bonds are beginning to fade. Which brings us back to the original question, “Do you really think bonds are the place to be in the coming year?” We don’t and the three and one-month ETF test concurs. As a result, this model won’t be allocating limited resources to what’s expected to be a poorly performing asset class. What about you? Will you add value through your analysis of potential investments or will you simply be a slave to asset allocation? . Search this site! Just enter you key word or words:
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courtesy of E-Line Financials:
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ITH INTEREST RATES HOVERING near historical lows, do you really think bonds are the place to be over the next year or so? Rates are bound to rise and values, which move inversely with yield, are certain to fall. This is a great recipe for capital losses – losses that are likely to wipe out all or most of the bond’s yield. In this circumstance, why would you even consider adding fixed income to a portfolio?
Data Source: S&P ComStock
