There have been some great comments left about using ETFs or OEFs for portfolio construction. There have been comments about how to study these products, where to get info and some well thought out opinions.
No methodology is absolutely right or wrong but hopefully readers can pick up up some points that they had not thought of before.
One thing that seems to be missing from the comments is an acknowledgement of the flaws of these products. Stocks, OEFs, ETFs, etc all have flaws. I think you need to be in touch with the flaws of the products you use and the strategy you deploy. This does not make any of this bad but by knowing the weaknesses of what you are doing, you might be able to mitigate a portion of the flaws.
The biggest drawback, IMO, to an all ETF, all OEF or any combo is the lack of dividends. When the market is flat, a higher dividend yield can matter a lot. The broad-based ETFs all have fairly low dividend yields. Lately there have been several dividend-centric ETFs created and it seems like they all concentrate in the same sectors and the yield has a three handle. That is a fine yield but I would expect the dividend ETFs to all lag when the market is up a lot.
So the last paragraph isolated flaws in two popular types of ETFs. This does not mean they should be avoided but perhaps the flaws can be mitigated to some extent?
I think the 3% yield available in the dividend ETFs can be matched with a diversified portfolio that blends together stocks with 4%-5% yields and some stocks that provide the chance for growth. Here is a simplified example of what I mean. Let's say a moderately conservative investor has a two stock portfolio. He puts 70% into Consolidated Edison (ED-client holding) and 30% into Google (GOOG). The yield on this combo would be 3.7%, about 200 basis points more than the S&P 500. Google offers the potential to go up a lot. If Google goes up by 50%, it would add 15 percentage points of growth to the overall portfolio, plus the yield and it would be close to 19% total return.
This example is an extreme but makes the point. The consequence of not enough growth is somewhat mitigated with Google and the consequence of Google's volatility is somewhat mitigated by the dividend.
So now apply the concept in a manner that actually makes sense. There are plenty of stocks that yield 4%-5%. There are plenty of stocks that offer the chance for growth. There are plenty of narrow products that offer yield or growth.
My approach is to blend together all of the above but to be clear I do not like broad-based products. I am not sure how well I can communicate this but if you have enough money to diversify, I think you are shortchanging yourself when you don't diversify. The goal of diversification doesn't have to be to beat the market. It is possible to construct a portfolio that by and large just keeps pace with the market but with less volatility. A portfolio that does not capture dividends very well may have a tougher time with the market equaling/less volatility idea.
Additionally being too broad means you will probably miss some themes. Here I am thinking about themes I have (and have been writing about forever) like Norway, Australia and India. Norway does not really have a big enough presence in any broad-based foreign product that I am aware of yet it has been a huge winner for reasons written about previously. In the last few days Australian ADRs are up a lot but Australia only has a 5.6% weight in EFA. In the last ten days EFA is up about 3.75% while iShares Australia (personal holding) is up 7%. India only makes up 5.3% of EEM but, again, in the last ten days EEM is up 5% vs. 9% for India as measured by IIF which is a client holding.
Again this merely points out potential drawbacks. The drawback to EWA and IIF is that they lag instead of lead. I have researched the narrower themes that I have tilted to and have confidence in them. You may be comfortable doing this for yourself or you may not but I am convinced that you can be a better investor by applying an introspective analysis to what you are doing.
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9 comments:
Is there a list or index of non-financial sector companies that have large derivatives / hedge fund exposure?
I'm wondering if there is an easy way to take a small position against a mix of non-financial companies that have significant derivatives / hedge fund exposure?
-Alex The Average
Broad based total market index funds in the USA beat the lions share of mutual funds and portfolio managers over the long haul. So if you are interested in good returns that beat most managers at low cost they are terrifc addition to a portfolio.
Broad based funds for international markets are frequently beaten by individual mangers. There are lots of bad companies and countries out there that need to be avoided.
The future from my view favors heavier investments internationally. Good managers and targeted funds are the key.
But for domestic investments please name me a couple of dozen managers that can beat Vanguards total market index over the long haul? Buffet beats it but even Bill Miller consistently beats the S&P 500 but not the total market index.
KL
Convertables, or convertable-like derivatives can also work.
GIZ converts into GIS
SGPprM " SGP
MEU into Metlife
...all with decent yields. There are tons of these things.
g
A finance professor of mine once taught us an interesting lesson about portfolio construction. You can create any risk/reward profile your heart desires with just 2 assets: a broad index fund (S&P 500, Total Market, take your pick) and cash.
Want higher returns? Simply jack up your leverage to the equity fund by borrowing money and/or buying on margin. Want less risk? Park more of the money in cash and less in the stock fund. And you can create just about any combination you want in between.
I'm not recommending this strategy, in part because it makes life awfully boring, and would also put guys like me and Roger out of business. But I do think it's an interesting illustration.
As for KL's question: Check out Vanguard Strategic Equity (VSEQX), which is NOT an index fund. It's run by their own in-house quant team. It has absolutely crushed their total market index over the past 10 years (13.7% vs. 9.1% annualized) and over shorter periods as well.
If you ask me, this is a pretty big marketing dilemma for Vanguard. How can they keep preaching the gospel of indexing when they're clobbering the market themselves with this fund?
(Btw, Roger--I think I deserve "partial credit" for Petronius. I read part of the Satyricon for a college history class and watched the extremely weird film version by Fellini. However, I did need to look it up to double-check my memory before posting!)
I don't know why pepople insist on a portfolio encompassing the entire universe. For the past five years, IWN(Small cap value)returned 85%, EFA(world)and IWM(Small Cap Blend)both 75%,far exceeded IYY(total market)and SPY, both 20-25%, not counting distributions. The over-performance of IWN and EFA has been persistent. If I only picked two of the best ETF's from the above list every year for my portfolio, I would have stayed with IWN(small cap value)and EFA(world) for the entire five years. Timing or no timing, "pick and choose" were better than having to spread around everything, unless you still believe in the "Random Walk" theory.
High Alpha
KL,
You seem to be saying that you would use actively managed funds for your international portfolio and passive ETFs for domestic. If so, I agree with your strategy.
Single country ETFs in an intl portfolio may offer opportunities for the likes of Roger who spends 75 hours a week actively researching and managing the portfolio, however, they are not for me. I would leave the country allocation in the reliable hands of my "regional" or "diversified" international mutual fund manager.
Judging by the way things are going in the US, I also agree with your thesis that there are better opportunities overseas, especially Asia. What's your view on Eastern Europe? What Intl funds do you own?
High Alpha:
From 1995-2000 the highest performing asset class was large cap growth. The lowest was small cap value.
Where would you have had your money?
...Because from 2000 to present. the highest performing class was small cap value, the lowest....you guessed it... large cap growth.
Things change.
g
George,
IBD has two graphs showing the relative performance of Growth vs Value and Large cap vs Small cap mutual funds. This gives some idea about which style is favored over the time. The trend does change as you said but is gradual enough to take advantage of.
Personally, I would also consider the volatility of each style. I am looking at the ratio of return/volatility before making decision.
High Alpha
I do use actively managed funds for international investing. Primarily Asia, I think other areas will do well but it is to hard for me to pick the winners.
As for picking an actively managed fund that beats the total market over the last 10 years that is easy. Not to be disrespectful, but any idiot can read the top performing fund from Money or Kiplinger and identify a fund that is better. BTW remember they close the poor performing funds.
Picking a fund that will beat the total market for the next 10 or 15 years is much more difficult. Historical experience is no guarantee of the future etc etc
International is the future and it is where you money managers can out perform. There may be volatility in international but those Asian countries are going to experience mega growth barring some catastrophe IMO. I personally think focusing on Asia will make you look like a genius even if you get mediocre performance.
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