Sunday Morning Coffee

The Barron's interview this week was with Marty Whitman who is probably most known as the manager of the Third Avenue Value Fund (TAVFX). The fund is 20 years old and since inception it has absolutely clocked the broad market. According to Morningstar $10,000 at inception would have grown to $112,949 versus $43,800 for "World Stock" and $30,772 for "MSCI EAFE NR USD." When the market dropped 44% ten years ago TAVFX only went down 17% (per Google may not include dividends). However at the March 2009 low when SPX was down 55% TAVFX was down 62% as he got caught in a lot of the "wrong" stocks during the meltdown.

There are several quotes from the interview that I think are very instructive. As I cast a critical eye here I would note that no single method of portfolio construction and cycle navigation can be the best for all times. Whitman is a hardcore value investor. In the interview he says that things like MPT and diversification are "absolute garbage." Diversification to protect against the downside is "worse than useless."

When asked how he protects against risk (the better word would have been volatility) with a concentrated portfolio he said that "we get protection by being price-conscious and by being extremely knowledgeable about our holdings. And diversification is a surrogate—and a damn poor surrogate—for knowledge, elements of control [of a company] and price-consciousness. If you are really a value investor and do deep research, how many investments can you be involved in at the same time?"

Given the financials he held onto and how the fund performed in the last three years the comments about price conscious and knowledgeable don't really ring true. Not implying he is lying of course but from the standpoint of seeing who is naked when the tide goes out it would be reasonable to wonder whether TAVFX got caught with its pants down. Was he overconfident in his price consciousness, knowledge and ability to understand what was happening?

In looking at the since inception chart on Morningstar the fund had a really big pop when it first debuted. Taking that out, unscientifically, the outperformance is still huge but much less. Another huge boost in performance came during the tech wreck as it is unlikely that a deep value fund owned internet stocks with no earnings and little to no revenues. Sectors where you might find value stocks did not do anywhere near as badly as tech and telecom back then.

Clearly a large portion of the long term result is attributable to stock picking skill but some measure of the result is also attributable to right place right time. I am not critical of right place right time as I'll take any good luck on the way that I can but the totality of this does take credibility out of his "extremely knowledgeable" comment.

I come at this sort of thing completely differently. However knowledgeable one can be about one of their holdings they can always be wrong. However much you know about a stock you hold I guarantee you there are other holders who know more than you and other holders who know less than you and chances are some portion of the other holders who know less than you think of themselves as extremely knowledgeable. Whitman asks how many stocks can you be extremely knowledgeable about I would ask how many stocks can you be right about?

In a portfolio of 35-40 holdings I know that not every stock or ETF will work out as I expect. I also know that a holding that doesn't do much this year might be the best performer next and vice versa. The idea of assuming every holding will work out exactly as hoped for seems crazy to me and this is exactly what someone is doing when they believe that their knowledge can supplant the need for diversification.

The next time the market has a ten year run like the 1990s most of your stocks are going to go up a lot and the next time we have a ten year run like the oughts most of your stocks will not. I doubt you are the stock picker that Whitman is (I certainly am not) and even he was blindsided by the financial crisis. Just because he is a great stock picker does not mean he is immune to the various biases and fallacies that affect most investors.

You can sort this out for yourself and draw your own conclusions but I think it is more conservative to realize you will be wrong at least part of the time and diversification mitigates a portion of the consequence of being wrong.
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The Big Picture for the Week of October 31, 2010

Morningstar posted a short interview with Jack Bogle that is worth discussing (hat tip to ETF Trends for posting this). Most noteworthy are Bogle's comments about why he is not a big believer in foreign investing.

The general tone of this post will be to disagree with Bogle's comments but I would make a couple of points before I do. As I have said many times here, despite Bogle's belief that no one can predict the what the market will do he is actually pretty good at recognizing market extremes. Not something he does often of course but he has been correct at several important points in the past. Given who he is it is not too shocking to me that he would have some ability to assess the big picture for equities.

To this most recent interview. Bogle believes that foreign markets will perform about the same as the US market over the next ten years. He notes risks associated with foreign markets include "unforeseen risks, currency risks, sovereign risks and more that could equalize the markets." Because of this equal performance he sees coming he would not allocate more than 20% to foreign.

Based on what I know of Bogle I doubt this is a new conclusion he has drawn. I cannot recall him saying 20% foreign before but assuming this is not new from him then it turned out to be very wrong, as in not enough, during the last decade. I've made a point of referencing the data from Bespoke Investment Group that shows the S&P 500 going down in the last decade by 24% on a price basis versus many other countries that had normal returns for the decade.

Bogle notes that Great Britain is in "poorer shape" than the US and that Japan is still in the same trouble from 20 years ago. So he is pointing countries that should be avoided and of course there are others. He did not mention any specifics as to what he looked at to make those comments but he obviously has some understanding of these countries and for all we know his knowledge could be vast.

If someone can look at the data and conclude a country is on shaky ground I believe they can also look at the data from another country and conclude that it is on firm fundamental ground. I think it is obvious that a country that either has lower debt levels than the US, better growth prospects that the US, has something the world needs (be it resources or labor) or any combination of the three offers the opportunity of being a superior long term investment. This sort of conclusion is a far cry from needing to be correct, from a portfolio standpoint, about what the S&P 500 will do this year.

One way that I might agree with Bogle about foreign doing the same as the US is in terms of the broadest foreign indexes which are heaviest in the the countries he feels are worse off than the US. A long running theme here has been that the broadest foreign funds are an inefficient way to add foreign to a portfolio because they tend to be heaviest in the wrong countries and blend away the various attributes of the smaller countries.

It is not clear to me why if Bogle can recognize that the UK and Japan are hurting why he does not see that for the US. While he has always been skeptical of ETFs because they facilitate speculation (not sure why he does not direct that to the speculators instead) but between iShares, Market Vectors, GlobalX and Emerging Global there are many ways to build a portfolio that includes country by country analysis and selection. As I've been writing for a long time, this made sense during the last decade and makes sense still, going forward.

Unfortunately easy access does not mean less of a work load in terms of analysis and follow up. I used to be a big fan of Ireland as an investment destination. It had a very low corporate tax rate, high per capita income and was becoming increasingly more important in the world economic order. We owned a bank stock that was a very good performer for quite a while but the story on the ground changed in an obvious way and so we sold, down from the peak but a long way from implosion territory. Where this sort of thing can happen in one country it can happen in other countries too and recognizing this requires work. If this is plausible to you then you need to be open to the US' deterioration as an investment destination--although it is nowhere near the magnitude of Ireland.
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Fad, Mania or Bubble?

A very short post as we are taking the overnight flight back to Phoenix from Kauai.

A reader asked for my take on a new Rare Earths ETF that is supposed to start trading today with ticker REMX. I have not looked at this at all so for now I can only talk from a big picture viewpoint.

There are quite a few stocks in the space but most of them seem to be foreign stocks with five letter ticker symbols. The name that gets the most attention is NYSE traded Molycorp (MCP) which operates the Mountain Pass site in California which was shut down a while back due to being uneconomical but is apparently going to reopen soon. There are other pockets of rare earths here and there that will come on line and probably make a dent in China’s strangle hold.

You probably know that despite the moniker the minerals in question are not that rare. There are 17 of them and apparently where there is one there is all 17 (I know this from my reading not from firsthand knowledge.

MCP’s stock has gone berserk, upward, since it listed a few months ago and was up a bunch on Thursday, maybe because of the fund, but either way it looks to me like the stock has caught a pretty substantial tailwind as it is the only easily traded (meaning non pinksheet listed) rare earth stock—or at least that is the perception.

So we have a great story and not much supply so the one popular name is up a ton. The behavior has of course happened man times before even if the details have been different. It certainly seems like the world needs rare earths, but that is the case with every mania that has ever existed. A little more supply in terms of an ETF (assuming the reader in question is correct and the fund lists) is not likely to alter supply and demand dynamic in a meaningful way which means it is not obvious that this event is an important top.

Two viable choices is not indicative of a mature fad. At such a point where this fad does burn out it seems unlikely that bubble will ever be the correct word although many will use it. I was asked on CNBC a couple of years ago whether solar stocks were a bubble. My answer was no because the entire industry was only worth about $100 billion (at the time) as opposed to dozens of individual internet stocks with market caps that big.

Rare earths may lose all sense of proportion for all I know but I would be shocked if the entire industry made it to half the $100 billion that solar was making any price implosion in the rare earths more of a mania or fad.

Again this seems interesting to me, for now I have no exposure but if I ever do go in it will be at 2% of the portfolio. At that weight a tripling would help the portfolio but a price implosion will not decimate it.
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Narrow Leadership

Yesterday on CNBC David Faber and Gary Kaminsky did a bit about how five stocks have accounted for 27% of the S&P 500's performance this year. As I am in a Tivo-less environment I could not pause to get all five but two of them were Apple (AAPL) and Berkshire Hathaway. Kaminsky made a comment that per S&P the leadership had never been that narrow before.

Beyond the point of narrow leadership like this being a negative harbinger, which was not discussed, Kaminsky made a comment that if you don't own the five stocks you are lagging the S&P 500. The comment is peculiarly narrow in focus. While there are probably money managers who can only operate in the SPX universe, that does not apply to a lot of people and certainly not you.

There is a lot of value in terms of performance, both nominally and on a risk adjusted basis, that can be added with country selection and avoidance and in certain years domestic sector avoidance (tech in 2000 and financials in 2007). Kaminsky's comment seems to be very much a bottoms up point of view which I think is a more difficult way to go.

In this context I've been writing about several investment destinations over the years that offer a different economic makeup than the US, are on firmer economic footing than the US and are likely to play an increasingly important role in the world economic order than they currently do. One example is Chile which, as measured by the iShares Chile ETF (ECH), is up 32% YTD versus 6.33% for the S&P 500. ECH is a client and personal holding.

The conclusions drawn above (makeup, footing and so on) would seem like an easier task than guessing when, if ever, the mania surrounding Apple will fade (should it grow bigger than Exxon Mobil (XOM) I think that would be a very loud bell ringing) or get caught off guard in Berkshire god-forbid Warren Buffet has a health event.

To be clear I am a huge believer in using individual stocks, I just believe getting to the picks via a top down process makes more sense (for me anyway). One way to think about top down is that a lot of time can be spent on what to avoid as well as what markets are healthiest in the context mentioned above. If the net result of a broad based index is the results of the worst performer, the best performer and everything in between then figuring out what looks the worst, fundamentally, and avoiding it can at the very least smooth out the ride. From there figuring out that a country like Chile offers a lot as a long term investment destination should add value over some reasonably long period of time like the duration of a stock market cycle--remember that in any given year your "favorite" investment destination can go down which is one reason to focus on the entire stock market cycle.
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Risk Versus Volatility

This morning I wanted to explore the idea of risk versus volatility, as mentioned in yesterday's video, in a little more detail. The context yesterday was an article in Smart Money Magazine (beach reading) where the word risk was used repeatedly where I think the better word would have been volatility.

You may have heard yesterday that JP Morgan has filed for a physical copper ETF, so it will hold metal in a vault as opposed to using futures to capture the exposure. If you look at any reasonably long term chart of copper you will see a lot of ups and downs in the price. Part of copper's volatility (or maybe all of it?) can be attributed to the extent to which copper is an indicator for economic health; you no doubt have heard some say that copper has a PHD in economics.

I am not one to buy into the idea that the bullion/physical ETFs are frauds holding nothing or holding less than they are supposed to hold in some sort of malfeasant situation. So in terms of removing any reasonable chance of a fund from JP Morgan failing, buying a physical copper ETF does not really become a risky endeavor it becomes a matter of altering the volatility characteristic of current holdings.

For most people I would imagine that buying a physical copper ETF would increase the volatility of the portfolio. There certainly is "risk" of losing money by holding this fund, should it ever list. Invariably people will buy at the high and copper is a commodity that is capable of falling a lot and whether a sale at a loss where to come from a panic sale or a sale based on a predetermined trigger point losing a lot of money is well within the expected probable outcomes.

What is not well within the expected probable outcomes is the price of copper going to zero. Contrast this to a company that is grossly over levered operating in a segment with dramatically deteriorating fundamentals. In this case we are talking about true risk taking. The easiest examples to make this point could be Fannie Mae and Freddie Mac. Before the real crisis started there were warnings in the headlines about these companies (various restatements) and it did not take a background in forensic accounting to understand the gross overleverage--government guarantees notwithstanding.

Other examples of risk could be single-property resource companies where resources are believed to be but have not yet been proven or a single-drug biotech stock that has promise but nothing in the way of FDA approval. These types of stocks rely on a single outcome and are almost a zero sum game (depending on the finances a company with a failed outcome might be able to move on to another single outcome).

The above will cover the vast majority of potential portfolio holdings but there are other variables that might create risks that are not easily managed. One is political risk. Whatever the reality of the Yukos situation several years ago the net result is that the shares are gone and shareholders were essentially wiped out. There was some warning as news unfolded but Yukos unraveled very quickly.

People offer up similar concerns about China although I am not aware of a circumstance where China moved in on a company like that and investors ended up getting wiped out (apologies if I have that wrong).

So to the extent you do have volatility in your portfolio, that needs to be understood. To the extent you have risks in your portfolio it is crucial to understand the risks. Where both risk and volatility co-exist, a diversified portfolio should have some of each, it is important to understand how to mitigate adverse consequences that each can bring.

Where volatility is concerned I think the answer is to understand the current state of the market cycle. Taking a cue from John Hussman, do conditions favor the upside or the downside? If you believe the upside then volatility is probably your friend. If you believe the downside is favored then you should want to reduce the portfolio's volatility one way or another (selling stock, inverse funds, put options).

Where actual risk is concerned then paying attention to how various situations you own makes sense and does not have to be very difficult. One example of this I have referenced a few times over the years was Worldcom. In 1999 and 2000 there were several references to Bernie Ebbers have a $100 million margin loan against his holdings in the stock, I believe the symbol then was WCOM. I never owned that stock but the idea of the CEO have a margin loan at all let alone one that big made no sense to me. This sort of thing may not be a warning of going to zero but should be taken as a warning of something. Back to Yukos, regardless of who was right or wrong the management was ticking off the government. Maybe not a warning of going to zero but a warning of something.

This sort of thing is not the same a missing an earning estimate or giving bad guidance but are more along the lines of threats to the business which is a different kettle of fish. Holding a stock through a fundamental downturn is not the worst thing you can do as deathblow is not reasonably on the table. Understanding the differences should help avoid the real deathblows.
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ETF Warnings From Smart Money Magazine

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Sunday Morning Coffee

Our waitress at dinner made a reference to her grandkids. I know some people genuinely enjoy waiting on tables but based on the service I would say she is not one of those folks.

I have nothing against waiting on tables or doing hard work in pursuit of achieving something but a retirement reality that awaits too many people is working very hard at a task not enjoyed.

Obviously no one says "yeah I want to do something I hate for very low pay in my 60s" but due to things like displacement, pockets of structural unemployment, poor savings combined with poor stock market index results will leave a lot of people doing work they hate for very low wages in their 60s.

This blog is not going to solve the world's problems, and this seems like a big one, but this is where people can solve their own problem or more correctly create their own solution. If you read blogs you are probably self-aware enough to understand this, realize some of what your financial limitations might be and begin to plan to mitigate your limitations.

Personally I am not a risk taker. This manifests itself by having a low weight in equities. This is mitigated by a high savings rate and living below our means. Additionally I hope to make a living managing money and writing forever although they may not be lining up to hire me to manage money when I'm 90.

A common limitation is one of spending way too much money. Figuring out how to solve this dilemma is easy; simply spend less. The difficulty is recognizing that too much is being spent--this is usually about not being honest with oneself. Someone with this issue who can admit this shortcoming at age 50 will be much better off than the person who doesn't realize it until they are in their 70s and down to $150,000 left in the bank.

I become more pessimistic about Social Security as time goes on and believe this will not be part of the solution the way many people need it to be. This calls for not planning on it and being ready to proceed financially without it.

Some folks hate when I talk about pulling yourself up by your own bootstraps, not relying on anyone but yourself and tailoring your own solution. I can't figure it any other way and while I did not think in the same terms in my 20s the idea of having no debt and socking away some money in case there is ever a real problem just seemed obvious. The stress of enduring some scenario of waiting on someone else to decide my financial fate (qualifying for some sort of program maybe) is a position I never want to be in and do my best to avoid this ever being an issue.

Not having to worry is not the same as being rich. If your expenses are low then your money can go a long way. How much do you have put away? How long can it last under moderately adverse conditions? How long would it last if you cut your expenses by one third?

The picture is from the Kalaulau Lookout down to the Na Pali Coast. We hiked up from the ocean you see in that gorge to the Hanakapiai Waterfall where yesterday's video was shot.
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The Big Picture for the Week of October 24, 2010

Hanakapiai Falls
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Yet More Narrow, Foreign Bond ETFs Coming

After the respectively successful launches of the Market Vectors Emerging Market Bond ETF (EMLC) and the WidsomTree Emerging Market Bond ETF (ELD), both denominated in local currencies, there have been several announcements of other related funds including Brazil bonds, a vague hat in the ring from GlobalX and now IndexUniverse is reporting that WisdomTree has filed for some very specific funds.

Per IU WisdomTree has filed for an Asia bond fund, one covering Latin America and a third for Europe-Middle East-Africa aka EMEA.

The Asia fund will cover the usual suspects but exclude Japan. The Latin America fund will cover most of the usual suspects but also a couple of not so usual, those being Uruguay and Panama (the US dollar is the currency in Panama). The EMEA fund will cover the most unique ground including Czech Republic, Egypt, Qatar and Slovakia.

Realistically it will be a long time, if ever, before a do-it-yourselfer can click on the bond tab of their broker's website and put $5000 into Indonesian bonds, $10,000 into Colombian and another $20,000 into bills from Singapore. With that understanding, the specialty funds become much more important. Quite possibly the only thing that US debt has going for it is that it is from the US. I do not think the US will default, they will just print enough to ensure that doesn't happen but when you consider all the stats there is not much of an investment case for US treasuries.

If you disagree then you are a buyer of treasuries and if you agree you are looking for alternatives. Superior debt ratios, better growth prospects and better demographics all make for a pretty good starting point for picking sovereign debt from other countries.

One relevant anecdote that I have mentioned before; several years ago I was on a panel that included someone in the ETF business in Turkey. I asked him what the typical allocation is for Turkish market participants in domestic (that is Turkish) equities and said 15-20%. Whatever the characteristics of the Turkish market (intentionally vague), they are the same for everyone including people in Turkey. It is prudent for Turkish market participants to have a lot of foreign exposure.

The US is not Turkey. However the US is not modern day Norway either. The term for this topic is of course home bias. In hindsight the best thing for the last ten years would have been no US equity exposure (bonds did pretty well obviously). Personally I do not believe that US stocks will be down on the decade again but I do not think they will be relatively compelling either. Additionally, the prices of bonds are now very high and people are trying to guess how big the second round of quantitative easing will be (repeated from the other day). Maybe you will disagree but I think people need access like the funds proposed above.
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Swap Executed

As mentioned a few days ago the latest event in the financial crisis is the foreclosure mess and at this point we do not know how significant it will be and is frequently my preference I am not hanging around to find out.

Our only exposure to to domestic banks is with preferred stocks, one of which we sold and swapped into the PowerShares Emerging Market Debt Portfolio (PCY).

The reason behind picking this part of the market to rotate into is the extent to which many of the countries captured are on much firmer footing right now than the US, Europe or Japan. The reason for a dollar denominated fund for now is that the dollar has moved down very quickly of late and so I'd rather wait for the dollar to correct some either in price or time before increasing our non dollar fixed income exposure.

My past comments about about increasing foreign exposure slowly over several years also pertains to fixed income as well as equities although possibly in different proportions.

This morning we are flying to Kauai for a week but the blogging should be the same as always.
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If SPY Falls, Will Anyone Hear It?

When I got back from the gym yesterday there was a comment on the blog asking for my take on the out of range prints on the S&P 500 SPDR (SPY) at the close. You can go to ETF Central for what looks to me to be good recap with plenty of updates. The very short version is that there were prints at the close with a $106 handle while the real price had a $118 handle. Per ETF Central the bogus prints were to be canceled.

Some immediately thought uh-oh another flash crash. Um, not quite. Earlier in my career I was an institutional equity trader for quite a few years and while things have evolved since then this sort of thing, our of range prints as a one-off, are not that uncommon and not particularly important in the grand scheme of things.

While there are never any guarantees, out of range prints for individual stocks or ETFs, once realized, are corrected one way or another. The Flash Crash from last May was much more of an all encompassing event effecting countless stocks and funds. As far as know this was simply a mistake of some sort that looks like will be corrected (repeated for emphasis).

Someone left a related comment about needing to use limit orders, even for SPY. My reply to this is that limit orders are a good idea more often than not but I don't believe that a mistake that then gets corrected affects the argument. I think limit orders are a good idea but no more so than I did before I found out about this event.

For anyone who takes this to believe that ETFs are bad and the market manipulated I would say, in a similar fashion as above, ETF are no better or worse than they were yesterday before the close and the market is no more or less manipulated than it was before the close.

Anyone who thinks ETFs are bad probably came to that conclusion awhile ago and hopefully did so for better reasons than a hiccup like yesterday. We talked about the overall market being manipulated last week so no need to rehash that so soon.

I've been saying the same thing for years about ETFs; they are just tools at our disposal. For some segments we wish to capture they will be the best way to go and for other segments they won't. They are not perfect, obviously, but for certain segments or certain people or certain fill in any other variable important to you they will be the best tool.

If Egypt turns out to be the best performing equity market in a given year then a plain vanilla (meaning it just owns the stocks) Egypt ETF will capture the effect even if not every last basis point. If Egypt was to be up 80% one year and the Market Vectors Egypt ETF (EGPT) was up 75% would you feel like you had captured it? What about 70%? While I do not know how EGPT would do if the index in Egypt was up that much I think the point is clear. If the possibility of not capturing every basis point is unacceptable to you then you should not buy the ETF--you need to figure something else out.

You must draw your own conclusion but my beliefs about the importance of sector selection and avoidance and country selection and avoidance leads me to conclude that ETFs, flaws and all, are a useful tool but to repeat from countless other disclosures we use more individual stocks than we do ETFs.
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Monday Randoms

First up is that my wife went to her 20th high school reunion on Saturday (we learned with my tenth how boring reunions are for the spouse so I didn't have to go). A milestone like this (quasi-milestone anyway) can be a good time for a self assessment of sorts.

This can relate to investing in several ways. Presumably someone investing for retirement has some sort of plan with some sense of whether they are ahead of where they need to be or behind and by how much. In talking to a reasonably large sample size of people you knew 20 or 30 years ago you will find people who are healthy, happy and successful and some who are not as fortunate for whatever reason.

Likewise a room of financially-aware 60 year olds would include people very reasonably on track and people in a lot of trouble (and everything in between). When someone is not where they want to be in life or in their portfolio and self-aware enough to realize this they might to want to try to fix it for the better. Fixing for the better can mean a well thought out change in strategy and habits or a desperate path that relies far more on chance than is prudent.

While I acknowledge that some people do need desperate situations in order to come though, I think where investing is concerned the more desperate someone is the more likely they are to do worse, to the point of ending up far worse off than before. Someone who has been a mediocre investor with poor savings habits is very unlikely to catch up in the market, they have a better chance saving more and making serious spending cutbacks.

Next is another follow up on the Market Vectors China ETF (PEK), the A-shares fund that replicates Shanghai Composite exposure with derivatives and is already trading at a large premium to its NAV. In reporting that Van Eck has filed for A-shares sector funds (something I mentioned as probable the other day) IndexUniverse notes that Van Eck is waiting for qualified foreign institutional investor status which would allow the fund to own the stocks directly which could solve the premium to NAV issue although that is yet to be seen.

For people interested in China but who prefer not to use individual stocks I think sectors funds are far superior to broad based funds which tend to be very heavy in financials; a sector in China that I believe should be avoided at all costs. In that light a series of sector funds that represent real differentiation would be a very positive development. I would note that quite a few of the stocks in these Van Eck funds (should they ever list) would no doubt overlap with the already existing GlobalX Funds but there are performance differences between shares listed in Shanghai versus Hong Kong--at least this has been the case in the past.

Yesterday we had a medical call at one of the camp sites nearby on Forest Service land. In addition to Walker Fire (I drove our rescue vehicle with one of our EMTs), the Prescott FD responded along with the ambulance service that contracts with all the local agencies to transport patients. The call was down a windy (as in twists and turns) dirt road which was actually a muddy road because it was pouring rain out. We were fourth on scene (I only mentioned two agencies above) and blocking our way in and everyone else's way out was a Forest Service pick up truck. The ranger in question served no medical purpose by being there but managed to gum up the entire situation and what was funny (in a way) was that about forty feet ahead of him was an enormous area (unoccupied camp site) where he could have parked.

Upon getting to the scene I go straight to the ranger, tell him he's blocking everyone and ask him to move right now. He was a little startled by my directness and gave an indication that he would move on his timetable but then seemed to respond to my almost imperceptible nod of the head to do it now and he actually jogged with me back out to the vehicles and got out of the way.

The reason to mention this in detail is that it seem like there is an analogy here to what other government employees are trying to do for the economy. This ranger thought he was helping out but the manner in which he was participating could only impede the progress of the incident. That he was impeding progress never occurred to him until a stranger (he is new to our area) pointed out the dynamics of the situation.

We are in an economic situation where all measures taken previously came up short of what was expected yet the "best solution" seems to be more of the same, going even bigger if necessary. I've mentioned many times before my belief that time fixes things and any steps taken by the government will either speed up a fix or slow it down. I believe the general strategy is misguided for the low probability of it working and the consequences that will come regardless of the effectiveness. This is yet another reason to increase foreign equity exposure--but not in Western Europe.

For all the times I've talked about my neighbor and his backhoe, we finally ponied up and bought one. What do you think of it? The one that we actually bought will be green not the white pictured above.
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Sunday Morning Coffee

Barron's had this to say about Farmland courtesy of TIAA CREF;

"From a historic perspective, it has delivered a fairly stable 8% to 12% return" annually, said Jose Minaya, managing director for natural resources.

Soybean, corn and wheat prices can be volatile, but farmland is a finite resource and less vulnerable to weather conditions and other factors. It has low correlation to other markets but high correlation to inflation, so it's a good hedge. People are always going to eat, and population growth in emerging markets will mean increasing demand. Minaya notes that buying farmland is also "an efficient way to get exposure to water."

The article half jokingly wondered if there might be an ETF coming at some point. I don't think there is much argument about the niche being important but there is debate on whether it should be part of an equity portfolio and of so how to capture it.

I think this can a place to add specialized exposure to South America or Asia. There are plantation stocks from Asia that for now are not so easy to trade or get information on, but still they exist and in time learning about them and accessing them will only get easier.

A couple of examples of names I have looked at in the past include New Britain Palm Oil Company (NBPOF) which is listed in London but owns plantations in Asia. M.P. Evans (MPEVF) is also listed in London with operations in Asia. The volume on both is rough to be sure but it is access for anyone so motivated. There are also a bunch of related stocks with primary listings in Asia that are even tougher to trade. Whereas the two above are from London, I think trades can get done even if it takes patience and a padded limit.

South American names might be a little easier to access. Most people know about Cresud (CRESY), I exited a personal trade on that name this past week. There is also Cosan (CZZ) from Brazil which is a sugar company. This one is big into ethanol which might change the dynamic, that is up to anyone interested to figure out for themselves.

If you do any research here, looking at one company will lead to others to look at and you might find one that makes sense to you to own. I would suggest anyone going down this path look at a lot of companies even though the most you'd probably own is one. But making an afternoon of it with a football game on sounds like a pretty good day.

And yes a picture of Fenway Park has nothing to do with farming.
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The Big Picture for the Week of October 17, 2010

Early in the day yesterday Joe Moglia was interviewed about his second career (actually he went back to a career he had when he was much younger). Moglia was was CEO at Ameritrade (current Chairman) and is now an unpaid assistant football coach of sorts for the University of Nebraska Cornhuskers.

The way the interview went Moglia seemed thrilled to have the "job" which was obvious and there was more than an implication that he could get a head coaching job which was not so obvious (to me) even with his experience but maybe he could.

This is a great template (even if unrealistically successful for most of us) for how retirement needs to evolve or more correctly is now evolving. Over the years for all the times he's been interviewed it would be difficult to have missed how much he loved coaching football. He is willing to do it for free and (based on the interview) there could be an opening to a paid gig.

A story like this tying in to sports is an easy one for me to relate to. Depending on where you live there are a lot opportunities, of course the key is willing to do some job for free because you love it that much. When you find something that you feel lucky to be doing for free you will do a great job which then brings the potential for something paid to develop.

On a similar note there was this article yesterday on Yahoo Finance with very short stories about how people are innovatively building their retirement strategy. One little story was about a retired school teacher with no debt who ushers at university sporting events and cultural events which allows her to see things for free and presumably puts a few bucks in her pocket without feeling tethered to a time clock. Also embedded in her story were several references to living below your means.

And as a quick followup from yesterday; the Market Vectors China ETF (PEK). Yesterday I mentioned that the fund is very broad based and heaviest in financials. I also said anyone interested in the fund needs to look under the hood to understand that the exposure is being replicated with derivatives which isn't usually an issue except during times of market trauma. Well PEK appears to be having issues already after only two days and far sooner than certainly I would have expected. With a big tip of the hat to Ron Rowland PEK is trading at a double digit premium to NAV. I mentioned in my post that at times A-shares have traded at huge premiums to shares listed elsewhere in the past (talking the same companies) and at this point I do not know if this has anything to do with that although I doubt it.

This makes for an important reminder about new ETFs that I used to include in just about every article about new funds that I wrote for theStreet.com which is that new funds, especially those that are not plain vanilla, need to be given a little time to trade to let things like this pop up (or not). If this turns out to be an issue with the creation/redemption process (which seems more likely, or maybe it is an arbitrage of some sort that is beyond me) then I would think that this is just a kink to be mostly worked out and if that is correct then the premium would probably suck right out of the price leaving someone holding the bag. Based on the first couple of days trading it does look like PEK will be a very popular trading vehicle.

As I said yesterday I prefer narrow exposure for China.
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An ETF Door Opening, Part Of The Way

Van Eck yesterday listed the Market Vectors China ETF (PEK) which will capture the Shanghai Composite Index AKA the A-share market. If you have any interest in the fund you need to read the particulars, most importantly that the fund will not own the stocks but derivatives to replicate the index.

This sort of composition creates concerns for some that something can malfunction as there have been malfunctions in other non-plain vanilla funds occasionally in the past. While I won't set unrealistic expectations about any potential malfunctions (like counterparty risk or some sort of market seize-up) I will say that fund malfunctions thus far have only occurred during times of extreme market trauma.

The Shanghai market is not really accessible (look up QFII if you want more details) and one day it will be. There are obviously a lot of stocks in China. Many of these stocks have listings on other markets too but the closed nature of the A-share market has caused huge price discrepancies between A-share listing and listings in other markets. This has not had much front burner attention lately but to the extent this issues exists it could be less if that market opens up.

If you've ever looked under the hood of any Chinese indexes you will see some interesting stocks. China funds, including PEK, can be difficult to own because of how heavy they are in financial stocks. We know there is over-capacity in real estate, the provinces have what amounts to off balance sheet debt and there is ongoing real estate speculation that the government doesn't quite know what to do with. These things in varying ways threaten financial stocks and instead of trying to sort this all out I think it makes more sense to seek other parts of the market that are not in the direct line of fire for these issues.

Globalx has six sector funds and plenty of the names in those funds cross list in Shanghai but where there is now one ETF that sort of gets in broadly it makes sense to expect narrower access to the A-share market in the future.

On the road to ruling the world China will have boom times and there will also be mistakes that impede that market. As difficult as it sounds the ideal access to China will include catching the upside while avoiding the parts of the market that are most at risk to total meltdown. This requires work but is not impossible. At its low, XLF was down 83%. How many of your holdings went down less than 83%? Well then you avoided that which melted down the worst with some portion of your portfolio in the US and so could probably so the same with another country. What is a particular country most vulnerable to? Whatever you think that is, avoid or underweight it.
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Seriously, Stay On Your Mat

Charles Kirk had a post up that I thought was particularly useful both for the investment implication but also the philosophical implication too. In the post he answered a reader email who feels that the US equity markets are being manipulated by the US government and the reader believes Charles should comment on this more.

You can get a sense of Charles' reaction from the title of the post which was "Life’s Not Fair – Get Over It!" Charles, taking the trader's viewpoint, believes that devoting a lot of time to the markets being manipulated is likely to come from someone who is not trading well and looking to blame someone or something. Additionally Charles feels it is simply counter productive to dwell on negative energy.

Long time readers will recognize this title of this post from past posts of mine as a yoga reference meaning don't worry about how the person next to you is doing the poses just focus on what you can do with each pose. You can also tell from the title that I generally agree with Charles' take on this although I do come at this as far less of a trader than Charles.

Although I agree with Charles I do come at this issue differently. If you do not believe the market is manipulated then none of this matters. Charles reminds the reader that the market is often/always being manipulated by someone. This has been true before and will be true again. if you agree with Charles about this, then it seems to me that the manipulation is beyond our control.

As a part of my DNA I tend not to worry about things beyond my control and instead focus on things that I can control as a more effective way to solve how something like this might impact me or my clients. As this relates to portfolio management, think about the Quantitative Easing, or more topically QE2. I guess the debate over if is now over and the world has moved on to how big and over what time frame.

That the US is at the point of a second round of QE means we are trying to understand just exactly how bad off the US economy is. QE is an act of policy desperation with very little realistic chance of solving the problem--if nothing else time solves these problems and the government's steps to help solve the problem will either facilitate a faster solution than would naturally occur or serve as an impediment to same (this is a belief of mine).

To the extent that QE is about US economic health then it is also about US economic cyclicality and we know QE2 is an act of desperation to restore normal cyclicality an investor can control the extent to which they are exposed to desperate policy maneuvers. Embedded in this is that part of QE and QE2 is what many people believe is a manipulation of the US markets.

Determining that added all up, the QE2, the manipulation and so forth, US cyclicality is better avoided is a reasonable conclusion and within your control. I think this is different than lamenting over what is wrong or put another way trying to solve the world's problems.

If you are a do-it-yourselfer then you only answer to yourself and can have more regard for solving the world's problems but if you manage other people's money then your job is give your clients' money the best chance possible to grow to the point where they need it to be.

I think it is only logical to avoid or minimize that which relies on QE2 working which is US cyclicality. From the start of this site I've written a lot about the US becoming a less attractive investment destination but current events have exceeded anything I had in mind when this thought first occurred to me. So the task has become finding innovative ways to give whomever you serve (yourself or your clients) the best chance of having what they need when they need it (repeated for emphasis).

While I can appreciate that people may not come at this the same way it is the only conclusion I draw about how to move forward in the portfolio; that is seek out the healthier parts of the world or themes where money will flow (presumably stocks in themes where money will flow would benefit) and avoid countries or market segments relying on desperate measures (also repeated for emphasis).
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Portfolio Innovation

We are back from our annual trip to the Grand Canyon. I shot a video at the North Rim but somehow it failed to upload to YouTube. It was short so I'll just recap what I said in writing.

At some point I heard a Tony Robbins commercial on CNBC on satellite radio and believe it or not he said something interesting about innovation in trying to sell whatever it was. He asked a question like what have you done that is innovative that will help your clients?

If you manage your own portfolio you then are your own client and obviously if you are an adivisor of some sort then you really do have clients. Either way what are you doing that is innovative that will help you have enough money when you need it? Clearly the recently ended decade required innovation to avoid being down twenty whatever percent. It seems as though the new decade will require innovation. That does not have to be a prediction of another down decade but what if ten years from now the S&P 500 is only at 1402--20% above yesterday's close? That wouldn't get it done for most folks.

I think it is fair to say this site has devoted a lot of time to exploring innovative ways to build a portfolio and I think this exploration has hit on some interesting things some of which have helped our clients. And while any innovative ideas that might have contributed to our result is all well and good the process of seeking innovative ways to construct the portfolio must continue by necessity. It cannot be assumed that just because some product or country or niche worked in the last five years that it will work for the next five years. This makes the task both exciting and possibly daunting but either way I am convinced innovation in portfolio construction will continue to be crucial.

One point I made in the video was that diehard indexing, though it worked in the 1980s and 1990s, is not innovative. This is an interesting take on all of this. In business do you believe in innovation? That might be framed in a way where saying no is impossible but in a very serious manner, is do-it-yourself portfolio management a business? If it is, then what role should innovation play?

You know how I feel about this so this becomes a chance for you to look yourself in the mirror and decide for yourself.
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Australia and Beyond

Barron's had several references, in different articles, this weekend to investing in Australia, Canada and New Zealand. There were a couple of quotes here and there from Kathleen Gaffney from Loomis Sayles and this article in the mutual fund section.

The primary focus of the feature article was that China is creating a tailwind for Australia because China imports a lot of resources from Australia. I would add that there is visibility for other countries to need more resources over the course of the new decade similar to China even if in smaller magnitude.

The bigger idea behind the comments about Australia and Canada (New Zealand is in a different situation being more of an agricultural economy as opposed to mining stuff out of the ground) is the often referred to ascending middle class. The quality of life has been improving in quite a few countries for a while now and this will spread to many other countries in the coming years. That this will happen is indisputable although the vast improvements that will occur should not be thought of in US terms. For people who don't have it now, getting access to solid housing, running water, reliable electricity and protein for a couple of meals a day is a dramatic improvement that most of us probably could not relate to.

The investment possibilities that stem from this are vast. In no particular order we've mentioned the resource suppliers, companies that are part of the food solution, utilities providers, builders of the infrastructure, services like phone (probably wireless) and TV (maybe not 500 channels like we might get), EG shares thinks mall operators/real estate companies can benefit, aspirational items like Nike shoes (we own this stock for clients), day to day products like toothpaste and shampoo and there are others. All this can happen, IMO without US banks, Japanese companies or many companies from big Western Europe.

In the past I have mentioned Kazakhstan as having the potential to be an interesting investment destination for the vast resources in the ground while noting some serious corruption obstacles. If it can ever happen for Kazakhstan it will be because of the above. It could also be the catalyst for Mongolia to become an important and more easily accessible investment destination one day as well. Both countries have a couple of individual stock choices with companies listed on other exchanges (Hong Kong, London and Toronto).

The path of how it could happen is very easy to see. The world needs more resources, these countries have them, they either address and solve their obstacles or they don't. If they do then the quality of life for (almost) everyone there will improve lifting the fortunes of the nation. The work now, for people willing to take the time, is a little bit of understanding of the current situation and then a fair bit of ongoing monitoring.

If you agree with me that Australia, Chile and Norway are useful investment destinations then maybe you will agree that there will be other countries that in time will serve the same role in a diversified portfolio. You will help yourself by isolating these countries early on and figuring out what they can do for you. Some of this can be done with ETFs but not all of it.

This post was the second of two "time bomb" posts. We've been at the Grand Canyon since Sunday night for our annual trip (we live two hours from the South Rim). We are driving home from the North Rim this morning.
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Delayed Reaction

For fear of having my own Jerk Store moment (albeit without the animosity)...

Back in March I wrote a post questioning David Kotok's Cumberland Advisors being and ETF-only shop. Per his comments in numerous TV appearances they are not ETF-centric they are ETF-only. I did not know this until yesterday but apparently he replied to me a couple of days later in a commentary posted on his site titled "Thank You to Roger Nusbaum, Melissa Lee, Eugenio Moreno." Hey, I'm Roger (silly humor attempt on my part)!

The general tone to my post was ETFs solve a lot of problems but cannot address every single issue, this is a recurring theme here. Kotok leads off with "there is no LEGAL informational advantage with a single stock." He goes on to talk about opinions being potentially wrong and there being consequences when opinions are wrong. He also mentions something near and dear to my thought process that "either you are totally current all of the time on every item concerning a company, in which case you have informational neutrality, or you are missing something for some reason that others have not missed and you are at an informational disadvantage." I take this comment to be about time available to spend and I agree that the manner in which one constructs his portfolio is largely a function of time.

Kotok seems to place more weight on the competitive nature of the information one investor has versus the information that another investor has about the same stock or different stocks in the same industry which is much different than my approach of thinking that if I want exposure to Denmark then what is the single best way I can come up with to do that. And of course my conclusion about the best way to access New Zealand could turn out to be incorrect.

I don't know much about the specifics of how Kotok constructs portfolios. I know they are done at the sector level and I know he is very cognizant on global markets (he has had very specific views on the euro for months for example) but I do not know whether individual countries are used or whether themes are sought out like emerging consumer stocks which are now easy to access in ETFs. My hunch is that one way or another these ideas do make their way into their portfolios.

My original comment back in March was to be surprised that this firm is ETF-only as opposed to ETF-centric or heavy. Kotok seemed to make the case for ETFs in his reply to me as opposed to explaining ETF-only but that is of course subject to interpretation.

In wanting to build the most useful portfolio possible I want to make use of every resource available to me which includes common stocks. Kotok's point about information is correct but I am not sure it is more important than access forgone.

As an example I have been writing about Chinese toll road stocks for several years. The liquidity for now (until Schwab allows direct access to Hong Kong) is such that I am not confident about getting over 100 clients out at once if I had to but I have held Jiangsu Expressway (JEXYY) personally for several years and have had good luck with the price action and the yield. I have come to believe this space is a very good way to access China for reasons I've written about many time before. As far as Kotok's point about information, this is something I have talked about many time before. I would expect that in a given year one of the Chinese toll roads (there are quite a few of them) will be the best performer and that in the next year it would be one of the others. This is not universally true but generally speaking no one stock in a group will be the best one every year for the rest of time.

If in the case of Chinese toll roads the group generally does well and I am at least a mediocre stock picker (not a particularly high bar to set) then the value is added by making the decision that "I need to own a Chinese toll road" not when the particular stock is chosen.

For another country the best solution might be a cement stock, for another maybe an ETF is the best answer. ETFs are a fantastic tool to have at our disposal but there are other tools available as well and for people able to spend the time they should make use of all the resources at their disposal. Marc Faber has talked many times about Thai Tap Water and it has turned out to be a great performer while paying a monstrous yield. There is nothing wrong with assessing multiple options and assessing the best way for you to get into something you think should be owned. Chances are you, investing for yourself, are far less constrained because something only has a dollar volume of $30,000 per day.

Before anyone adds one plus one and gets eleven a portfolio full of names like this is probably a bad idea but one or two at a 2-3% weight will mean you only need to focus on the company not worry about the portfolio being illiquid.
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10/10/10 Morning Coffee

Was real estate a bubble? What about gold and treasuries? The word "bubble" is hideously overused. Bubbles don't come a long very often but after what happened with tech stocks ten years ago and what has been going on with real estate for the last three years many people are looking for the next bubble like it is going to happen any day now.

I am far less concerned about labels as I am about sidestepping some segment that might go down a lot. I have been saying for ages that treasuries are not a bubble but they are very expensive and that I have no plans to buy high and take the risk that goes with buying high on the fixed income portion of the portfolio. We target 2-3% in gold it has grown a little larger than that and if that goes down a lot the current weighting will simply create a drag (maybe) not a portfolio meltdown.

You make think bubble is the correct word for all of these things but either way I think there is utility in the chart above. It captures Yahoo (YHOO) down 83% from March 2000, Intel (INTC) down 69% since March 2000, Microsoft (MSFT) down 50%, Cisco (CSCO) down 66% since March 2000 and Juniper (JNPR) down 76% since March 2000. I have referred to bubbles in the past as all encompassing events for the magnitude of the decline and the extent to which people went to great lengths to take on too much risk to get a piece of the action. This applied to tech stocks IMO and real estate but not gold and treasuries. To be clear this is not to say treasuries and gold can go down a lot, just that declines here would not have the fallout like with tech stocks and real estate.

If real estate was a bubble then the chart above might give some indication of what to expect with housing. I tend to think that the vast majority of the decline is in for real estate prices but there is a reversion to the mean argument out there that calls for them going much lower. What I think is a more instructive lesson from the chart is the time needed before things start to turn up. There are tech stocks that are higher than where they were ten years ago but the names above are "important" stocks and there has been a whole lot of lingering with them and many others since their respective peaks.

Due to what looks like a bleak outlook for jobs, demand for home purchases could also be bleak for a long time not to mention what appears to be a lack of movement of money and even after ten years tech stocks don't offer a lot of encouragement same with Japan after 20 years.
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The Big Picture for the Week of 10/10/10

A big deal, rightfully so, is being made over the news that TD Ameritrade will offer no commission on 100 ETFs provided they are held for at least 30 days. Matt Hougan has been writing about ETFs having no commissions or expense ratios (instead they would make money lending stock out Matt says). I believe four discount brokerages offer some form of commission free ETF access and more and more funds have expense ratios under 0.10% (these are broad based funds) so Matt is on the way to being correct.

This commission free business represents part of an evolution in the space that I started talking about a long time ago--I would note this was and is a very obvious conclusion to draw. The path I saw was the access to many parts of the market that for one reason or another are not easy to access and there is plenty of potential new access in the pipeline (like fisheries) and new strategies (hedge fund replication and so forth) still to come. I never really thought about commission-free or zero expense ratio but these developments are all the better.

There are drawbacks of course. ETFs drew a lot of criticism in late 2008 when various markets were seizing up, there was also criticism in the face of the flash crash in May, we've gotten a hint of problems, more like proper expectations so far, with commodity ETFs due mostly to contango but whatever past issues have popped up anyone using the products should expect future issues. Useful though they may be they are investment products and throughout history investment products have encountered difficulties. I've made a point out of reminding people of this.

"Encountered difficulties" does not mean deathblow, IMO. At least one of the ETFs we use printed at a penny during the flash crash. To use an example I've used before it was obvious that a fund with a $50 NAV at 2pm was not worth a penny 40 minutes later--I had no concern that the fund was worthless. During some future market malfunction something similar might happen again (or not) but if it does the people that will get hurt are the people who panic. During the flash crash it was only a matter of minutes for prices to right themselves. Even if the next malfunction takes longer to right itself, a fund zeroing out one day is not a realistic concern.

Hopefully by now we have had enough ETF closings (PowerShares announced ten more on Friday) that everyone realizes that the consequence is simply a taxable event (depending on the account). If you own a fund that is announced as going to be closed it is probably better to sell right away but if you don't you will simply get cashed out at the NAV.

To reiterate the positives as I see them, a bunch of broad based equity exposure has not cut it in quite a while and will not cut it again until the next 17.6 year up cycle (or whatever you might believe in along these lines). For fixed income I don't think treasuries have cut for an investment for a while for being very expensive (they have been great trades for people looking for that) and there is a good chance that yields will stay low for a while (not my base case but many very smart people say otherwise). To repeat about treasuries; they are very expensive but of course could stay expensive for a long time.

On the equity side I write about about specialized or narrowly focused or niche funds for building equity exposure. At a minimum I think people need to figure out how to use broad based sector funds. Here decisions can be made about foreign versus domestic, cap size (remember PowerShares has small cap sector funds) and of course sector weightings versus your benchmark. If you can be comfortable with these types of decisions then it is not too big of a leap to something like using a defense contractor ETF as part of your industrial sector exposure (as an example from our portfolio--we prefer a common stock however).

This topic has been covered many times here with similar examples but I believe it is that important. The various countries, segments, themes and so on offer enough opportunity for "normal" returns over the course of the new decade that domestic broad indexes may not. Plenty of countries, and I would add individual stocks, offered normal returns from 2000-2010 and if the US is way below normal again I promise you there will be countries that again offer "normal" returns even if the countries in question are different from the ones who did the job in the last decade.

The other day I mentioned that Van Eck filed for one bond fund for Latin American countries and another for Asia ex-Japan. GlobalX is also thinking about getting into the fixed income space and while there is no detail from them yet given that they offer equity access to lithium and Chinese energy stocks I doubt their first bond fund will be a me-too ten year US treasury fund.

For many years I've been talking about foreign fixed income and hoping for single country access. While we are not there yet the news from Van Eck and Globalx is a big step in that direction. Over the last few years we have had good luck with Norwegian and Australian sovereign debt and while this is difficult for individual to access it should be made available in ETF form one way or another. Also important I think, are the Guggenheim BulletShares--these are the corporate bond ETFs where the funds target maturity of a specific year like 2015. With rates low in the entire bond complex it makes sense to manage duration very precisely. While anyone can buy individual US corporates not everyone may want to.

There will be new exposures in foreign fixed income like Australia, Norway and Chile and in equities why not a toll road ETF, airport ETF (or more broadly all types of ports) or a cement ETF?

The tools are there to be used smartly or misused by professionals and do-it-yourselfers. Assuming you need a "normal" return this decade, or something close to it you need to learn more about this than you currently know. This applies to everyone.
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Alaska Permanent Fund

Over the years I've written a few times about the Alaska Permanent Fund (APF) which is akin to a sovereign wealth fund that pays the annual dividend to Alaska residents. Generally I've not been too flattering to the fund for performance issues and benchmark switching. Slightly bigger picture I think they overreact to the short term but do so without a solid strategy for the long term.

The latest bit of news comes via IndexUniverse that the Alaska Permanent Fund is going to put $1 billion (out of $36 billion total) into the FTSE RAFI US 1000 index. This index has of course been available in an ETF from PowerShares with symbol PRF for almost five years. The idea is that companies are weighted by four fundamental factors not market cap which tends to reward momentum as opposed to value. Before the fund debuted the back test was solid and since PRF started trading it has been up 2.4% versus a decline 8.7% for the S&P 500.

The outperformance is meaningful but I would also note the correlation to the S&P 500 is very high; per ETFreplay it has been between 0.94 and 1.00 for the last two years. The value bias did not help much during the worst of the panic as the fund was very heavy in financials (I believe more so than the SPX) and today has 20.78 in financials. From the October 2007 peak to March 2009 low PRF actually dropped more than the S&P 500.

The APF has an unusual target asset allocation;

Company Exposure 53%
Special Opportunities 21%
Real Assets 18%
Interest Rates 6%
Cash 2%

Company exposure can include equity and fixed income and within equity is a mix of passive and active. Within the active management the APF has stuck with some serial underperformers. The results overall have been very mediocre and I think the reason for this is that if you look down the performance report the categories seem to be mostly taken from the Morningstar Style Boxes and the managers benchmark to things like the MSCI EAFE Index and other broad domestic indexes. It is the rare manager who, when benchmarked to the EAFE, is going to seriously underweight all trouble spots I have been talking about (with absolutely no claim of uniqueness) for many years now.

The special opportunities includes a mish mash of managed pools, some names that will be familiar to many people and some not and the returns are a mish mash as well compared to objectives that have consultant fingerprints all over them. The real assets segment appears to have a lot of real estate, both traded and direct.

We often here more about the success stories in this space like Harvard and Yale. You can search for the couple of things I've written about the APF or do some exploring on the APF site, maybe you will disagree but the APF has not been a success story but it is something to learn from.

The fund changed strategies from a sort of normal target allocation to what you see above right in the middle of the crisis which strikes me as one of the worst things that can be done by professionals. Tweaking is one thing, that is merely dicey, but a complete overhaul during the last couple of years leads me to believe the APF will have problems for years to come.

One concept laid out here over the years has been long term planning. This includes developing some thoughts about the future of the world, thinking about how things might evolve and then laying some sort of framework that is consistent with conclusions drawn and the circumstance/purpose of the pool of money in question.

This endeavor represents the building blocks of forward looking analysis perhaps in a similar fashion to a business plan. You may think this is difficult for the typical do-it-yourselfer to do and that might be true (although I think this is more of a function of time spent for most people than anything else) but is should not be the case for the people running the APF or the consultants they use. PRF is intended to add value versus SPX. If SPX goes nowhere for another seven years then PRF will, if all goes well, do a little better than go nowhere--not much in the way of innovative thinking.

There are constraints that are along the lines of peer pressure that have turned out to have bad consequences for many professional pools. For example as financials kept growing relative to the S&P 500 it would have been very difficult to have a substantial underweight to the sector for fear of being wrong. Long before any problems for the sector manifested themselves I talked about what to look for; a weight in the SPX greater than 20% and an inverted yield curve. Either or both would be bad news for the sector but there are certain pools of capital that cannot take the risk of going severely underweight because being wrong about such a thing creates career risk. This is just one example, there are others like zero in Japan or France for international managers but of course you do not have such constraints and can learn from the experiences of others.

I think the APF needs to simplify the target allocation and allow more flexibility of its active managers to deviate away from their benchmarks in terms of things like countries and themes. I am making assumptions on a lot of this but that is based on the published returns which go back five years and don't provide any evidence that I can see of meaningful value having been added. Although the market has been rough for a while, five years is enough time for any value-add to emerge if there was going to be any value-add.

The picture is looking down on downtown Juneau.
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Thursday Tidbits

IndexUniverse is reporting that Van Eck has filed for for a bond ETF that would target Latin American debt and one that would target Asian debt. Per the article there would be a mix of sovereign and corporate paper and will allow for a mix of local currencies and dollar denominated debt. These two along with the Guggenheim (formerly Claymore) Bulletshares, these are the corporate bond ETFs with maturity dates, go a long way to democratizing bond strategies for do-it-yourselfers.

There are plenty of other very useful fixed income ETFs out there, to be clear--iShares really has a thorough offering and several other providers filling some important gaps (WisdomTree and Van Eck among others). Some folks don't like to hear or think about this but that last decade has shown that investing is not getting simpler. People who took the time (this is more about time spent than analytical skill IMO) to understand different investment destinations, asset classes and exposures did better than those who did not and that is very likely to repeat again in the new decade.

I'm sure someone would read that last paragraph and note that a portfolio of 50% equities and 50% bonds did just fine in the oughts and that is true but most people go far heavier in equities than 50%. From here, looking forward, bonds are now expensive and equities cheap. Bonds could get more expensive and equities could get cheaper but the valuations are what they are. While equities may be cheap with the threat of getting cheaper I think there will be far more reward in the decade going more into foreign which is of course a repeat theme.

Sticking with IndexUniverse they posted an interview with Larry Swedroe that is worth mentioning. He had some good one-liners about passive investing that should be explored.

He makes a big deal that "it’s actually mathematically impossible that it (active management) can win in the aggregate." The word aggregate is what makes the sentence correct (probably) but it is an incomplete thought for a couple of reasons. First how do you define win? Also based on other comments along this line what sort of time horizon are we talking about?

In many past blog posts I have mentioned John Serrapere's 75/50 portfolio (75% of the upside with only 50% of the downside as the stated goal). Successful execution by Serrapere would mean lagging on the way up and beating on the way down. Over the course of a complete stock market cycle that would outperform the market. While I do not have performance data from Serrapere the goal is over a longer period of time. This is of course similar to Hussman.

Per Morningstar, since inception in 2002 a $10,000 investment in the Hussman Strategic Total Return Fund (HSTRX) is now worth $18,297 whereas $10,000 in the S&P 500 Total Return Index (so price plus dividends) would be worth $15,354 and it has been a dramatically smoother ride. There have been plenty of short periods in there of course where he trailed but assuming the data is correct is eight years enough track record? What about Lynch, Buffet or Druckenmiller? What about all the people you've never heard of? Our firm has a six year track record that I think stands up well and I'm not that bright--but I do spend a lot of time.

The notion that outperformance is impossible is incorrect and the way Swedroe framed it in the interview incomplete. Part of an effective financial plan is understanding time horizon and what it is you need the portfolio to do. If you want to reframe this to say it is difficult and that the majority of people will not "beat the market" whatever his precise and undefined (in the interview) meaning then I absolutely agree; most people will not beat the market. I would go on to say that many people will be done in by emotions, poor decisions and other behavioral issues.

The bigger picture goal needs to be having enough money when you need it. I have stated countless times that the idea of trying to beat the market for a quarter or a year is less important than the long term result. If you have enough money when you need it (assuming you are not incredibly wealthy to start with) that will be far more important than whether you beat the market when you were 50 years old.

A little lighter; the group that owns the Red Sox (along with NESN, Fenway Park and an auto racing team) is trying to buy the Liverpool Football Club which is in the Premier League. Maybe they will go public and I can buy 8 shares as a nod to Carl Yastrzemski.

Finally a big nod to Roy Halladay for his no hitter yesterday against the Reds. This is was big on several levels; it was the first post season game of his career, his second no hitter of the season and the second no hitter is post season history. The play by play announcer for TBS had one of the best one-liners I have ever heard from an announcer. After the fifth inning he said "hey, you might want to call your friends."
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It's The End Of The World And Farrell Knows It

If you thought Paul Farrell was a pessimist before then after reading this article from him you will look back on the others and view those as the musings of a cock-eyed optimist drinking Kudlow Kool-Aid.

In his most recent he takes inspiration from Taleb's trust (almost) no one idea and lays out a scenario for the Fed to fail no later than 2020 under the weight of layers of corruption and conflicts that leads to class warfare and riots over food and water. If it is not clear his is talking about the US.

First things first the Fed as we know it (or think we know it) is the third central bank the US has had so the Fed failing one way or another would not be unprecedented and the reasons Farrell cites are close to the reasons why the first two shut down (per my limited understanding).

A modern failure of the Fed would certainly be disruptive in a meaningful way but as a practical matter would probably look more like a restructuring of some sort. The country would continue to have a central bank. During such a disruption I would expect just about every foreign market to panic down with the US market as a restructuring of the US central bank would reasonably scare the hell out of a lot of people.

In the article Farrell cites quotes from various people that were very wrong about the financial crisis including “Emerging markets are the global investors’ safe haven" from Worth (magazine?). Again were there to be a central bank failure I would expect most world markets to panic down right along with the US as in 2008. A realistic expectation for global diversification should not include completely missing a panic like 2008 or the crash of 1987.

I believe I set a reasonable goal for global investing before the crisis and have mentioned it many times since. In seeking out countries that offer the best chance of diversification I think you need countries that have different fundamental attributes than the US--they should also be relatively healthy and give some reasonable hope of doing well. In that light a realistic hope is that some countries with different attributes might turn down at a different time than the US, recover quicker, go down less or any combo of the three and there were many countries that did exactly this through the recent/current financial crisis.

The three that I wrote about most often in that context were Brazil, Chile and Norway. We know that the S&P 500 peaked in October 2007. Brazil and Norway peaked in May 2008; they generally kept going up for eight months past the US peak. Chile peaked about the same time as the US but only went down about 30% at its worst compared to 55% for the S&P 500. Chile is now about 40% above its old peak, Brazil is about 20% above its old peak while Norway is down a little less than 20% from its peak and the SPX is down around 26% from its peak.

There are many other examples of course but these are the ones I wrote about the most. In the face of another panic that might come about due to some fundamental shock, real or perceived, something similar will happen again in terms of other markets. Looking over the course of the last decade, as I have mentioned dozens of times, the US along with several other "important" markets were down for the decade while plenty of markets were up plenty--as I have said those countries went on without us and this effect would happen again. That is not to say it will necessarily be same ones, that is for you to sort out for yourself but it will happen.

There will always be an argument like the one Farrell is making and it will always be compelling to you on some level but the most extreme outcomes are incredibly rare although markets often brace for the absolute worst.

The picture is from the website of a company I was researching yesterday. I got a kick out of all those people standing in the bucket of the uber front loader.
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Diversified At 15 Holdings?

Cam Hui from Humble Student of the Market posted a recap and link to an article from the Global & Mail by Avner Mandelman that made the case for a diversified portfolio only having 15-20 holdings. The number is not particularly shocking but I thought it might be interesting to deconstruct that number to see if it is practical for do-it-yourselfers and to see what it might look like broadly speaking.

The idea with a small number, although not how it was stated in the article, is to "put all your eggs in one basket and then watch the basket very closely." This can be an effective use of time because it is easier to keep tabs on 15 or 20 holdings than 50. The article cites research from Meir Statman that concludes there are diminishing returns from diversification passed 16 holdings.

So if one builds a portfolio at the sector level and uses the S&P 500 as a benchmark then I suppose there could be as few as ten holdings--there are ten big sectors in the SPX. If one simply buys each Sector SPDR in proportion with the SPX then all that has been done is to recreate the benchmark expensively but that is the starting point for construction of a portfolio; here is the index what are you going to do differently?

So without worrying about specific proportion versus the index (which quickly becomes a compliance issue) one can look at each sector and decide whether they are better off with the SPX components from that sector, this is what the Sector SPDRs own, or some other ETF (for this part of the post lets just focus on ETFs). For example, instead of the Utility Sector SPDR (XLU) someone might feel that the SPDR Global Infrastructure ETF (GII) which is about 85% utilities without much overlap with XLU or maybe the SPDR International Utilities ETF (IPU) would be better.

Each sector could be studied to assess where value might be added versus the Sector SPDR. I would note that value could be solely seeking outperformance or looking for a risk adjusted result. The example above with utilities covers the fund-ground that one could explore; plain vanilla with XLU, plain foreign with IPU and a niche or theme with GII.

The idea of adding themes in this way is very important. Infrastructure lends itself to being proxies for several sectors including industrials and utilities--the EG Shares China Infrastructure ETF (CHXX) could be a proxy for real estate (not a way I would want to go but as an example). I read something yesterday about Steel ETFs which could be proxies for the materials sector, there are of course other examples. Some country funds are so heavy in one sector that they too can be proxies for sectors; iShares Singapore at 50% in financials and client holding iShares Peru (EPU) being 65% materials as examples.

Using only one ETF per sector may not be such a great idea at least not with all ten. Whereas utilities, materials and telecom are all between 3-4% of the benchmark I think just one holding for those is just fine, assuming some weight close to the benchmark. The other seven sectors range in weight from 10.3% to 18.7% of the index. Using two holdings for each of those seven and one holding for the small three and that adds up to 17 holdings which is close enough to the 16 the Statmat cited.

For the sectors where an investor might try to get it done with two holdings there could be a core and explore sort of thing. Energy as an example some portion could go into something like the Energy Sector SPDR (XLE) with the explore perhaps targeting volatility like the Jefferies Wildcatter ETF (WCAT) or targeting yield like one of of the many MLP ETPs.

Hopefully it is obvious that anywhere above we could instead be talking about individual stocks although I would not want 9% each in two tech stocks which is what it would take to equalweight the sector. As far as where I stand on 15-20 holdings, while there is no right or wrong I prefer more than that. There are many countries, themes and attributes I try to embed into a portfolio and it would be difficult to do in just 17 holdings. While it is certainly possible that holding number 24 or 37 offers less utility than holding number 12 that does not mean that holdings 24 and 37 are useless either.

On a sort of related note last night we watched IRT Deadliest Roads which aired Sunday night on the History Channel. It is about some of the drivers from Ice Road Truckers trying to drive on roads that look a lot like the one pictured above that i thought were from Bolivia but now I am not so sure. Each of the truckers was hauling a load of cement up to the JP construction site where they are building a hydroelectric plant. I am pretty sure that JP is Jindal Steel and Power which you can find under the hood of several India focused ETFs including the EG Shares India Infrastructure ETF (INXX). It is interesting that the show is about India infrastructure.
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