The Evolution of the Chinese Ecnomy

By now you've probably read the NY Times article by David Leonhardt titled Can the Chinese Become Big Spenders? It is a very lengthy piece that among other things seems to chronicle what seems like a peculiarly rapid evolution of the Chinese economy.

Here's a good quote to start with;

To continue growing rapidly, China needs to make the next transition, from sweatshop economy to innovation economy. This transition is the one that has often proved difficult elsewhere. Once a country has turned itself into an export factory, it cannot keep growing by repeating the exercise. It can’t move a worker from an inefficient farm to a modern factory more than once. It cannot even retain its industrial might forever.

China makes a lot of stuff the world (including the US in a big way) needs or wants. Cheap labor has been one facet of the China story and prosperity is leading to higher wages which contributes to the improved living conditions. At some point the cheap labor may not be that cheap anymore and this sort of manufacturing will move to other countries like Vietnam.

The article cites various stats about the lack of innovation, mostly technologically oriented, in China compared to the US (think piracy of intellectual property) although there was no mention of Huawei (at least I don't think so, it was a long article). It is not clear to me that innovation is quite the linchpin the article makes out, at least not yet as it seems like China can really sell efficiency for many years to come. Of course at some point there is no more efficiency to be had and so something, maybe innovation, must come next.

China now spends about 50 percent of its gross domestic product on a broad category economists call investment — roads, bridges, trains, ports, technology, factories and office buildings.

The investment in infrastructure is a huge theme in many markets around the world. This is part of the process of an ascending middle class in many countries (keep in mind "middle class" will be different that the US version of the term) that I, and many others, have been writing about for years. There are ETFs galore to invest in to capture this space (talking more broadly than just China), many domestic stocks that are beneficiaries of this theme or foreign stocks that are building the infrastructure or servicing it. Globally this theme has a long way to go in terms of time. I think the article is implying a shorter shelf life for this in China than I think is actually the case. As roads connecting the more modern east with the rural west are built, dramatically reducing travel times, manufacturing can move to the west where it will be cheaper for a while thus bringing the potential for middle class life to the rural part of the countries as opposed to people migrating out of the rural areas seeking an improved quality of life.

China’s gradualist approach to economic policy has been a big part of its success. The country avoided the turmoil that some of Eastern Europe experienced when it switched almost overnight to a market system.

If turmoil has been avoided I think it would be because China has much deeper pockets than any of the Eastern European countries. The article gives plenty of attention to the overcapacity issues and these loom as real threats but it seems China understands that there is a threat from this, less clear is if they understand the magnitude and whether things they are doing to cool of certain parts of the economy will be effective.

The government holds down the price of coal, oil and other natural resources, hurting interior provinces that produce these resources to the benefit of coastal exporters that use them. Beijing also sets a ceiling on interest rates, which harms households trying to build a nest egg and helps capital-intensive businesses that borrow to expand.

The above paragraph highlights some of the complexities that go with investing in China. Investing in China has never not been complex and complex isn't going to go away soon. My thoughts on how to invest in China have focused on parts of the economy where money must be spent, is obviously going to be spent while trying to avoid parts of the market that seem to be right in the line of fire of overcapacity and speculation. This translates, to my way of thinking anyway, to materials, energy, things consumers must use, things that consumers want to use while avoiding banks and insurance companies. I have also avoided tech names as well but don't feel they are must avoid as I do with financials.

In client accounts I first owned an oil stock, then a phone stock but now only have very light exposure via a couple of ETFs with the expectation of adding consumer exposure later one way or another. I remain convinced that toll road stocks are a great way in fundamentally but for now the liquidity is not sufficient to buy anywhere close to across the board.
Read more!

Sunday Morning Coffee

This week's Barron's featured a three article Retirement Special Report. One of the articles was on long term care insurance, one was on an idea for a new type of TIPS and the third offered ideas about where to capture yield.

Many people seem to be skeptical about all forms of insurance as am I and health care costs are extremely controversial for all sorts of reasons but these are issues that most of us do have to grapple with (if you have millions in the bank you can cope financially with a $500,000 illness).

Bruce Krasting recently noted that his insurance premium was going up 25% at an annualized rate from a little over $1600 per month which is obviously a very big dollar amount these days although some folks do have a higher premium. The Barron's article notes the costs of long term care policies going up and also because of the dynamics of the industry that some companies are getting out of the business.

Long term care is tricky because it is a type of insurance you may never need but according to the article only 2/3 of seniors will need long term care at some point in their lives. Personally I am motivated to be one of the other third and hope a combination of lucky genetics (my parents are 84 and 79 and have not needed this) and a lot of vigorous exercise will do the trick. We have no control over our genes (yet?) but we can commit to exercising regularly and while I'm at it eliminating soda from our diets.

The article did not talk about health insurance but this also looms as problematic as evidenced by Bruce's premium increase from what already seems like an astronomical number. One possible solution for people working on their own is to try to get into a group plan with some organization where they have an affiliation. For me, I think I could get insurance through my fraternity and I know I could get it via the fire department (more likely an association of many fire departments or firefighters). This can't work for everyone but it can solve the problem for some folks.

The article about a new type of TIPS was an idea about what seemed to me to be reverse zero coupon bonds where the payout has an inflation component. Essentially you would by this product, the author called it an amortizing TIP, at face value, it would pay out an interest rate that adjusted for inflation and do so in a way that the principal exhausted after 30 years. The government is going to issue the debt so this would be about making the wrapper, based on the arguments in the article, a little more useful for investors (read the article for the logic).

As long as people realize there is no principal coming back at maturity it seems like a cheaper and more liquid annuity of sorts and seems potentially useful for being part of the solution as it removes some of the variables of executing a retirement plan and creates some predictability (per the author). There was no discussion as to whether the numbers involved could work from the government's standpoint but I though the idea was interesting and is a reminder that there can and will be innovative ideas (hopefully more that are not government related) to help with some of the retirement problems that appear to be lurking just around the corner.

The third article on capturing yield certainly covered most of the bases in terms of what is available but didn't delve enough into what can go wrong with each segment. The key takeaway should be that in a zero percent world something that yields 6% has risks. Having risks is not a bad thing per se but too many people do not understand the risks they are taking and end up with too much exposure to something that then blows up. A little exposure to something that blows up should not damage your financial plan but a lot of exposure might.

I stumbled across the pictured fire truck while doing a little work at the fire station. That is one beefy brush truck I have to say, but the open air seating (so to speak) makes it more for grass fires (our fuels are trees and brush) where you pump and roll which I have never seen in a brush truck because of how quickly they run out of water. Still pretty neat looking though.
Read more!

The Big Picture for the Week of November 28, 2010

Pragmatic Capitalism reposted a list of ten reasons why US banks are better to buy than European banks which was originated at Credit Suisse. You should click through to read the list. The logic of the list might be completely correct drawing the correct conclusion; US banks may indeed be better to buy than European banks.

That said, they could both stink and be undeserving of your investment dollars. If you have been reading this site for a while you know that this has been my opinion for a long time now; they both stink and that one group might collectively stink less is not much of a hook for me.

The notion of sovereign contagion should be plausible from Asia 12 years ago and what has happened thus far in Europe. Of course there might not be any further dominoes to fall which leaves banks that operate in markets facing declining real estate prices, over indebted consumers, lousy demographics and weak (at best) growth prospects. From where I sit it doesn't look much different for the US banks in terms of where we are right now and what appears to lie ahead fundamentally, even if there are many trading opportunities along the way.

I was able to find three financial sector ETFs that exclude the US and Europe (if there are others please leave a comment as it would be easy to overlook something given how many funds there are). There is the iShares Far East Financial Fund (FEFN) which is 59% Japan. There is the iShares Emerging Markets Financial Fund (EMFN) which is promising but has 28% in Chinese financials which I want no part of for reasons I have said many times before. There is also the EG Shares Emerging Markets Financials Titans ETF (EFN) which is 40% in China. A fourth possibility requires going a little narrower with the Global X Brazil Financial Sector ETF (BRAF). I am not a fan of Brazilian financials and have no exposure but I think they have better prospects than Chinese financials.

For several years already and going into the future, in my opinion alpha can be generated in this sector by simply avoiding domestic and European banks and I also do not want Japanese or Chinese financials.

A perfectly valid way to build financial sector exposure, although I prefer individual stocks here, is to capture it via country funds. I've disclosed many times being partial to banks from Canada, Chile and Australia. The respective country funds have plenty of financial exposure but if, for example, you are going to buy iShares Australia (EWA) you need to know a little bit about BHP Billiton (BHP) which is the largest holding in the fund. A few clients own EWA as do I. There are plenty of of other country funds that are very heavy in financials like iShares Singapore (EWS) and the Global X Nordic 30 (GXF) which are 50% and 28% in financials respectively and there are more still.

I don't think this actually requires any less work however. The Market Vectors Egypt ETF (EGPT) is 46% financials. Egypt has some good things going for it to be sure but would you buy the fund not knowing anything about the Egyptian banking or financial system? Hopefully your answer would be no.

Additionally, in using country funds, heed must be paid to the cumulative exposure to all the sectors. You may not have a problem with being 30% financials (way too much for me) but you should know that, or some other number, is your weighting.

The picture is the Astoria, OR branch of Bank of America, at least it was 16 months ago.
Read more!

Save More, Spend Less

Jonathan Hoenig has a wonderful post up about his oft mentioned grandmother who recently passed away at age 106. In the article Jonathan mentions a bit of wisdom that is similar to something Nassim Taleb has said. Taleb has talked about people learning everything they need about finance from their grandmother in terms of saving a lot of money and avoiding debt (both sides of the transaction).

Specifically he writes;

The most often-repeated financial advice she gave me was also the simplest: Save your money. Long before Suze Orman and Dave Ramsey made fortunes selling books about living beneath your means, this old lady, like many children of immigrants who survived the Depression, understood the importance of frugality and delayed gratification. As a child, she’d reward me for good behavior with a few coins while asking how much of it I intended to put away. “If you get a dollar, save a quarter,” she’d implore. That discipline stuck with me at an early age.

Market participants seem to be questioning the viability of markets and investing more than any time I can remember. It should be obvious that a big part of the solution can come from our own behaviors, independent of market volatility, of spending and saving. Reducing the monthly nut means the portfolio has to do less work and a larger savings pile means a greater margin for error along the way.

As a very obvious example a $15,000 monthly income funding a $10,000 lifestyle where $4000 goes to taxes and $1000 into savings leaves very little room for the unexpected. These people would not make it one month in the face of job loss. The same income funding a $3000-$4000 lifestyle will have a much easier time enduring the unexpected.

I realize some folks do their best under financial pressure, but if that is not you (it certainly is not me) I would look to behaviors of spending and saving instead of hoping the market bails you out by going up a lot. Too many people rely on this form of denial.
Read more!

Happy Thanksgiving!

Always a good day for football, once (or twice) a year food and a little introspection on what you are thankful for. Me, I'm thankful for a ridiculously long list of things.
Read more!

Hedging Evolves?

IndexUniverse reported that NasdaqOMX has recently created five indexes that could be very interesting should someone license them for exchange trade products. The idea is that the indexes track correlations between a stock and an ETF or two ETFs. The interest here is that correlations going up can be a proxy for defensive action in a portfolio which could have been part of a defensive solution (with a couple of the new indexes) during the meltdown.

The indexes as follows;

Nasdaq OMX Alpha AAPL vs. SPY Index (NAVSPY)
Nasdaq OMX Alpha GLD vs. SPY Index (GVSPY)
Nasdaq OMX Alpha TLT vs. SPY Index (TVSPY)
Nasdaq OMX Alpha C vs. XLF Index (CVXLF)
Nasdaq OMX Alpha EEM vs. SPY Index (EVSPY)

To be clear the symbols are for indexes not investable products.

It seems unlikely that the AAPL v SPY index or the Citigroup v XLF offer much in the way of defensive protection. Changes in the relationship of either stock to a related equity index (fund) would seem to be more about goings on with the individual stock than the broad market. It is possible that at times C v XLF could be a proxy for a pairs trade; during a broad uptrend where C declines the correlation could go down but that seems like a stretch.

The other three could play into a defensive strategy maybe as is, inverse or leveraged. According to ETF Replay the correlation between EEM and SPY drifted lower to 0.72 into the Lehman weekend and then popped up to 0.95 in just a couple of months which could have worked out to a 31% pop (give or take) in an ETP tracking this relationship. From July 2008 the correlation between TLT and SPY, again according to ETF Replay, went from negative 0.39 on July 15 2008 to negative 0.72 on October 7, 2008 before going up to negative 0.16 on June 11, 2009 and then going back down to negative 0.78 on June 28, 2010. The moves in the correlation between GLD and SPY have been even bigger.

The moves above are big enough to matter even in the small portfolio weightings I prefer but they would require monitoring different things than with using a "plain vanilla" inverse index fund.

I was thrilled with how inverse funds helped during the meltdown but we also used a couple of absolute return funds, one of which did very well and while the other did not do as well it did not blow up like some funds did. Despite my feeling constructive about the past result I cannot rule out luck's role in making the meltdown the type of perfect storm where an inverse fund really smoothed out the ride and so must allow for the possibility that the next big decline could look different in such a way where an inverse fund somehow does less heavy lifting.

Investing evolves, investment products evolve and so too should strategies evolve. Mega cap indexing worked great in the 1980s and 1990s and it stunk in the 2000s. There are all sorts of things that used to be very important that now mean almost nothing in terms of being market moving; when was the last time you thought about book to bill ratios? Things do change, hopefully for the better, and I think these indexes offer some great potential for people looking to take defensive action in the face of down a lot.

If these ever do become successful ETPs I could see the product line expanding to pit regions against each other or country funds against broader indexes or maybe commodities against various things.

Today is day three of three of the Maui Invitational so the last of the pictures from last year's tourney which I was lucky enough to go to.

Not sure if I need to disclose this but my blog posts recently started running on the Nasdaq site. I don't get paid in any way for this and my contacts there are marketing people not the people behind the above indexes.
Read more!

What About Poland?

The Streetwise Professor put up a useful post about possible or probable shale gas in Poland that could be the third largest deposit in Europe behind Russia and Norway. Poland is in relatively good shape in terms of stats and still has its own currency but if the shale is viable it would improve the outlook of the country considerably.

Poland as a country is on decent footing and this stands to improve their footing even more so, this is reason for me to try to learn a little more for inclusion in the portfolio down the road and if I were to add it, how I might go about it. To be clear this is simply a look around to see what's what.

One way in would be broadly with one of the two (that I know of) ETFs; Market Vectors Poland (PLND) and the iShares Poland (EPOL). Both funds are very similar in terms of sector weightings (each more than 40% in financials) and individual holdings--there is single stock risk with a couple of banks that each have large weights in both funds but this is less of an issue with PLND. Going broad is valid as the shale working out would make Poland, as a country, a more attractive investment destination.

Given that this story is about a new supply of natural gas it also makes sense to consider a Polish energy company. One of the larger ones in the two ETFs is Polski Koncern Naftowy Orlen, or Orlen for short which has an ADR with ticker PSKNY. I found conflicting data on how much it trades but either way it is very thin but with patient limit orders I think $10,000-$20,000 worth of shares could get executed for anyone so interested. A quick, and I do mean quick, glance at the website had several references to shale so presumably the company is involved one way or another.

Assuming for a moment that Orlen is involved then buying the stock is buying into something that stands to benefit in a meaningful way if this plays out or get hurt if it does not play out. This contrasts to someone like Conoco Philips (COP) which has about a $92 billion market cap and is very involved in Poland. If I am reading COP's most recent earnings report correctly the shale in Poland would be part of "Emerging Businesses" which collectively lost $20 million. Obviously they are involved because they believe in the project but this is one of what must be many of these and while the company could benefit from the Poland shale it will never be a proxy for the Poland shale.

The point here was just an example of process. The story is interesting, there are a couple of ways to access and I spent a few minutes poking around as a starting point. If it wasn't clear I found Orlen by looking under the hood of the two ETFs. At this point I have no idea if Poland will make its way into the portfolio and at this point all I know about Orlen is that it exists and looks to me like a real company; I tend to be a little stricter than "I'll buy it because it exists."
Read more!

ETF Strategies or Strategic ETFs?

As we try to line up our ducks for the Superbowl of Indexing conference for the panel I am moderating that I mentioned the other day titled Where Are We Now? ETF Industry Review, one of the panelists made an interesting comment that ties into a comment left by a reader on the above linked post.

The thread is along the lines of rules based or strategy based ETFs doing the work instead of the end user doing the work and given this, is this the direction that the end user market actually wants to go in.

If that is unclear, here is an example with a strategy for which there is no fund. Certain market participants take heed of the action between the Australian dollar and the Swiss franc expressed as AUDCHF (this is not made up). When AUDCHF goes up, so the Aussie going up at the Swissi's expense, it is perceived as a risk on environment and when AUDCHF is headed lower it is risk off. Anyone so interested could play this with ETFs going long one and short the other or vice versa. A fund provider could create an ETF that plays these two currencies against each other based on some sort of rules based criteria or an end user could simply do this directly using the corresponding ETFs and assuming they had a margin account to accommodate short sales.

Applying the example to any fund in existence that might be of interest to you; would you rather build it yourself or have a fund company build it for you? There is no wrong answer unless the market votes with its dollars and no money goes into the strategic funds and they end up closing. But that is the issue, does the marketplace want these or would most end users prefer to do it themselves.

The way the conference panels go (very quickly without getting to even half the things planned for) I think this one will fall through the cracks but it is a great talking point about the future direction of the ETF industry. My preference leans toward doing it myself but not exclusively. The core of our portfolio is a combo of very simple products each with very specific attributes blended in such a way as to hopefully deliver a predictable result--most importantly the volatility of the portfolio versus the market being predictability sought after.

Simple products above means narrow products. An individual stock might be a good pick or a bad pick but most high yielders stay high yielders, many volatile holdings are volatile most of the time, most low beta holdings are low beta most of the time; Cameco (if we owned it) would likely always be a proxy for volatile, materials exposure and if some aspect of that changed then the name could become a sell.

The Rydex Managed Futures Fund (RYMFX) is an example where we had good luck during the meltdown with a product where the work was done for us although the result of the fund was precise and consistent; low beta, low correlation exposure in a market that was puking down.

The bigger idea is avoiding blunt instruments and the broader the investment product the more blunt it will be. A portfolio full of blunt instruments has been exactly the wrong way to position for many years now and I believe will continue to be wrong for years to come. As I tend to not be an all or none person some products where the work is done for you are ok but I prefer to do it myself.

The Maui Invitational starts today one hour before the close.
Read more!

Sunday Morning Coffee

A bit of a catchall post.

First up is a reiteration about why domestic banks are still best to be avoided. We heard earlier this week about another round of stress tests for 19 banks. On top of that is the issue of put backs which Barron's goes into in tremendous depth this weekend. Basically the banks could be on the hook for mortgages gone bad where things like poor lending standards can be shown to be the cause. The way I read the article the burden for this is not all that difficult--not to say this is a lay up but bankers are already conceding there will be some put backs.

This is exactly the sort of thing I had in mind several years ago when I first started talking about more shoes to drop for the banks. Was this the biggest financial crisis in 80 years? Well then there will be fallout for a long time and getting in front of it with your portfolio is very unnecessary.

The interview in Barron's this week was with Donald Coxe about all things commodities. Coxe prefers equities of commodity producers over the actual commodities believing that returns in the stocks is superior.

It makes sense to qualify Coxe's comments a little. I don't think the two (the stocks and the actual commodities) should be thought of as an either/or where each one delivers the same effect to a diversified portfolio. I would say that each offers different attributes. According to ETF Replay the Energy Sector SPDR (XLE) has correlation of 0.91 with SPY. Over the last two years the correlation has ranged from 0.83 to 0.95. The SPDR Gold Trust (GLD), which we own for clients, currently correlates at 0.44 having ranged from -0.33 to 0.67. While that is not exactly an apples to apples it does make the point. Commodity stocks are stocks and should be expected to correlate somewhat closely to a broad equity index even if there might be a fundamental case for them to outperform a broad equity index.

In an environment where stocks are dropping a lot I would expect commodity stocks to drop right in line with the market or maybe more depending on the event due to their cyclicality. This is not a knock on the stocks as I have been overweight the materials sector for longer than this blog has existed but to repeat they offer different attributes and there is room for both in a diversified portfolio.

Lastly is an article written by Matt Hougan from IndexUniverse that showed up on Barry Ritholtz' site. Matt set out to debunk recent commentaries warning that ETFs could collapse, are threats to market stability and are impeding the function of capital markets. Matt quickly dispatches the first two and notes that the third one is a little more complicated in terms of price discovery and market efficiency. Matt made a couple of points that I would frame a little differently.

Matt says that indexed assets represent a small fraction of the stock market's value making the idea that they, ETFs, are the tail wagging the dog simply incorrect. While I agree that the tail wagging the dog is not a real problem it is not nothing either. Matt didn't say the size of "fraction" but it is bigger than he thinks in that there are shares that exist that are held in accounts that will never come into play in the market. We have several stocks in the portfolio that have been there for years that are unlikely to ever leave (not impossible they get sold but improbable). The more useful number here would be ETF volume versus average volume. If you look at that you will see where occasionally where ETF volume is very important.

As a dramatic (and easy) example take a look the new Global X Norway ETF (NORW) on the first day that the fund started. NORW opened for business on November 11. The second largest holding in the fund at 14,900 shares is DNB Nor (DNBHF) which is a bank stock. The ordinary shares average 1600 shares per day but the day before the fund listed it traded 31,200 shares. I imagine that whoever Global X bought the shares from had to buy them from someone else creating a double print of sorts. I could be wrong about how the fund was created but if I am looking at this correctly it creates the chance of being briefly disruptive but not permanently disruptive.

Further on Matt notes that "ETFs reject single-stock analysis as the best approach to investing." This implies that no stock analysis needs to be done and I think this is less than ideal. There are a lot of funds that have meaningful concentration issues. Back to NORW which has an 18% weighting in client holding Statoil (STO). I think STO is a great stock but anyone buying NORW might want to take a moment to understand the production dynamics in the North Sea and what Statoil has been doing to mitigate this issue--the management doesn't really let grass grow which means the company changes and these changes need to be kept up with. Additionally the stock occasionally has periods of extreme volatility. It would be very easy to only look at a one year chart and not see some of the past volatility. To use an example I have used before; the iShares US Telecom ETF (IWZ) allocates 15% to AT&T and 11% to Verizon. Are you really going to buy that fund but do zero work to understand those two stocks? I know some people will not do any work but I think that is a big mistake.

Did you see any of that football game between Illinois and Northwestern at Wrigley Field? Very neat.
Read more!

The Big Picture for the Week of November 21, 2010

As a follow up to yesterday's post deconstructing a Dollar Proof portfolio from Morningstar I thought it might be interesting to explore the Dollar Proof concept going sector by sector as not every equity sector is so easy to add foreign exposure but many are. In going sector by sector the context is the ten big sectors that comprise the S&P 500 and one other point before starting is that while there are ETFs for each sector I think a portfolio that includes individual stocks is a better way to go.

Technology is a difficult sector for me as I believe the sector is still broken from ten years ago. There are plenty of tech stocks that have done well of course but almost all of the most "important" domestic tech stocks are a long way below where they were ten years ago. I'm not thrilled with the broad foreign tech ETFs like IPK from SPDR and AXIT from iShares are each very heavy in Japan. I don't mind broad domestic exposure in this sector but I think Taiwan would be a good place to look for dollar proofing. There is the iShares ETF with ticker EWT, the IndexIQ Taiwan Small Cap TWON which is not quite as heavy in tech stocks as EWT and there are several stocks easily traded in the US most of which have very high yields.

I am quite comfortable with the financial sector for the simple reason that from the top down the sector warned very early on of trouble (its weight in the SPX and the inversion of the yield curve several years ago) and it has been quite clear to me that domestic banks and European banks are best avoided for now--this might be the case for years to come. I've been equally vocal about avoiding Chinese banks as well.

We have had good luck with bank stocks from Chile, Australia and Canada. The banks from Norway, Singapore, Malaysia and Israel also seem to be on relatively firm ground in terms of how the businesses were run before the crisis and I believe can do well going forward. I also think there is utility in the publicly traded exchanges including foreigns. We also own an index provider.

Anyone interested in Singaporean banks could use iShares Singapore (EWS) as a proxy as the fund is 50% financials and while I am not wild about Brazilian banks there is an ETF for that; GlobalX Brazil Financial Sector ETF (BRAF). More so than most of the other sectors, maybe more so than all the sectors, I think individual stocks are the way to go for financials. The ETFs seem to have too much exposure to the "wrong" places. Of course I could be missing a fund but my belief about stocks might make this difficult in terms of overcoming biases to implement in such a way as to bypass the worst or most vulnerable banking systems.

Energy might be the easiest sector to add foreign exposure because just about every country has a big oil company. Even Hungary has its Exxon with MOL Magyar Olaj (MGYOY). To be clear I don't have any interest in the name but it is accessible for anyone who is interested. In addition to plenty of individual stocks from all sorts of countries there are plenty of ETFs that are broad within the sector and also very specialized--we recently added a coal industry ETF. Work still needs to be done to properly research names and segments within the sector but finding choices is very easy.

Health care seems like an easy one for dollar proofing but I might give it a Lee Corso "not so fast, my friend." I think it is easy but getting there requires a willingness to go beyond the big pharma stocks. If you agree with that statement then it rules out the broad sector ETFs or more correctly means not relying solely on those ETFs. Above a certain account size we use a domestic big pharma, a Swiss big pharma, a Danish specialty company and a foreign generic company.

One theme that I think could be added at some point is medical tourism which would be foreign exposure but I would need direct access as the pinksheet volume in these names is too thin. I personally would stay away from Chinese pharma as it seems like the odds for something going wrong are quite high--also many of them are reverse mergers which raises other problems.

For anyone not interested in going really narrow with the healthcare sector I don't think the domestic ETFs are a bad hold. I think there is also longer term opportunity in this space with medical devices which is mostly domestic but there are a few foreign stocks here as well. One thing to consider here is that many of the individual stocks in the space have very good dividends which might be difficult to capture in a broad ETF.

I'll address staples and discretionary together because some of the funds lump them together. For staples we have food, tobacco and alcohol for their very high dividends which again may not be captured in an ETF. For discretionary we use one ETF and Nike which aside from what I think is a great product line also captures foreign aspirational volume--note this makes Nike a beneficiary of not a proxy for. I can see increasing the foreign exposure here via an ETF. There is one from EG Shares and two from GlobalX. I'm not sure what I would add in or when but I think there is long term value in capturing the consumer in countries where a middle class is ascending.

Industrials are also an easy sector to add foreign exposure but I would stay away from broad funds like SPDR International Industrials (IPN) or iShares International Industrial (AXID) because they are heavy in Japan and Europe. There are plenty of themes in this sector like water and infrastructure which lend themselves to foreign and defense which I would go domestic and there are ETFs for these. There are other themes like solar and wind--each of these has their share of headwinds these days but the funds exist. I think a mix of ETFs and stocks is best here; we have Caterpillar and Swedish company and for people willing to use individual stocks there are names from many countries to choose from.

Obviously the materials sector has plenty of individual stocks and thematic ETFs; miners of various metals and resources, chemical companies and food related. Stocks or ETFs, I think either can work and the access is very easy. This sector should be no problem for someone who cares about dollar proofing given the abundant choice.

Utilities are another easy one, especially for anyone willing to use individual stocks and do some looking. There are many ADRs from all sorts of countries to choose from and some ETFs. The funds are not terribly precise but decent yield can be had from the funds which doesn't happen often.

If energy is not the easiest sector to add foreign exposure then telecom is. Just about every country has a big phone company--even Morocco is accessible through this sector. We use one foreign stock with a very high yield and a domestic ETF with a decent yield. Obviously this sector is a great source of yield for a portfolio.

In general, the narrower you are willing to go the easier it will be to avoid some lousy markets and groups of stocks. With several sectors I believe using individual stocks will make for a better risk adjusted result but of course there will be a lot more work involved. I would not rely exclusively on any type of product be it ETFs or illiquid pink sheet stocks but those two along with NYSE or regular Nasdaq ADRs should get the job done. Another reason to consider individual names is that some segments are not covered by ETFs with some examples being toll roads, fisheries and cement companies although looking under the hood of ETFs at some of the smaller holdings can be a good starting point for research for any segment or sector.
Read more!

Morningstar's Anti Dollar ETF Portfolio

Maybe the people at Morningstar are starting to listen to me and trying to offer some actual insightful ETF content (I am quite certain I don't actually show up on their radar) as they offered up something they called the Dollar Proof ETF Portfolio. The portfolio contained ten ETFs covering equities, bonds, commodities and currency.

The Dollar Proof Portfolio gets off to a peculiar start with a 20% weighting to the Vanguard Total Stock Market (VTI) which is a domestic large cap fund. In terms of constructing a diversified portfolio using broad based funds then VTI makes sense but where dollar-proofing is the goal the logic is lost on me. Someone might say that the multinationals in the fund do business overseas and offer some insulation. A multinational might benefit from a weak dollar but it is not a proxy for foreign anything. To repeat from I don't know how many past posts; beneficiary of is not the same thing as proxy for.

The Dollar Proof Portfolio also has large weightings in Vanguard FTSE All World ex-US VEU, Vanguard FTSE All World ex-US Small Cap (VSS), SPDR Barclays Intl Inflation Protected (WIP), SPDR Barclays Intl Treasury Bond (BWX) and PowerShares Dollar Down ETF (UDN) totaling 59% of the portfolio.

The issue with these funds is that they all have big exposure to the euro; in order listed above 31%, 25%, 27%, 37% and 57%. There are also liberal doses to the UK and Japan. The issue with the euro is that for all the reasons listed in the Morningstar article, the euro is up a very similar creek as the greenback so a portfolio that bets heavily on the euro is hoping that as bad as the dollar might be the euro is not quite as bad. Between the dollar and the euro I am not sure which one is worse and I am certainly not willing to bet client money that the euro will win the ugly contest. I think this point is crucial and thus invalidates the portfolio even if the commentary to support it makes some good points.

Also included in the portfolio are small exposures to gold which I agree with, a position in the new WisdomTree Emerging Market Local Debt Fund (ELD) which I also agree with and the iShares DJ US Oil & Gas Exploration & Production ETF (IEO) which in a way makes sense but in a way not. A weak dollar helps energy companies but I would think it would make more sense to own foreign energy companies than domestic ones and IEO is a domestic fund.

In thinking about a better way to go about this I would suggest going much narrower with the equity exposure such that the euro is either minimized or avoided altogether. While I think individual stocks should be included here, funds covering countries in Latin America (there is one regional fund from iShares and another on the way from GlobalX), the Scandies, Antipodes, Asia although I would avoid Japan and China funds that are heavy in financials, Israel, Canada and although we are not in there now I would add Africa in a small dose to this list.

Another way to access this idea that I did not see mentioned in the original post could be via one of the currencies pegged to the US dollar. The idea here is that a debasement in the US dollar makes a peg more difficult to maintain. This has been evident, for example, with a hot inflation rate in Hong Kong along with real estate appreciation.

The idea behind the Dollar Proof Portfolio is sound but the way they go about it relies on instruments that are simply too blunt. The idea is sophisticated but most of the funds suggested are not. ETFs offer all sorts of access and specialization to implement many sophisticated ideas. If you want to build a portfolio around a very specific idea it only makes sense put as much thought into how to implement toward the concept as you do coming up with the concept.

Some clients own BWX and WIP.
Read more!

Your Input Needed For ETF Conference Panel

On December 6th I am moderating a panel at the Super Bowl of Indexing called Where Are We Now? ETF Industry Review. The panelists as of now are Deborah Fuhr from Blackrock, Scott Burns from Morningstar, Joanne Hill from ProShares and Mariana Bush from Wells Fargo.

My idea on how to frame the panel is that they are the industry and we, the audience, me and you if you comment with a question, are the end users of the products. What sorts of things do you want to know about in terms of new product innovation, how people are reacting to relatively new products, different ways to analyze the funds, what needs to change completely, what is working very well, what about fixed income, what about the flash crash, what about the Kauffman report what about whatever else you would want to ask industry bigwigs.

I've solicited input along these lines quite a few times in the past and it yields some good questions so hopefully you can contribute this time as well. Thank you.
Read more!

Wednesday Roundup

I concluded yesterday's post with a joke about repeating that post today by replacing municipal bonds with European stocks. Well I guess it turns out not to be just a joke as things in Ireland appear to be deteriorating quickly creating a visible path for a bailout in Portugal with possibility of bailouts needed in Spain, Italy and even France (assumes several dominoes).

For more on this you can read Bruce Krasting and Credit Writedowns. Being informed is very important, I mentioned this the other day, but more so than being up on current events is being correctly positioned. Long time readers are probably bored with my repeated admonitions on avoiding big Western Europe but the region at best has been an underweight for years which has been my position and for now I see no path for changing.

To sort of repeat from past posts; Europe probably needs to take desperate measures to help some of its members. How much portfolio exposure do you want to a region that is on the verge of desperate steps? This also applies to the US.

Next I wanted to touch on client holding Caterpillar's (CAT) taking over Bucyrus (BUCY). CAT CEO Douglas Oberhelman was in several places talking about the desire to get more involved with mining equipment because of what they perceive as a longer term trend of increasing demand caused by the build up and out of infrastructure as more countries see a middle class of sorts ascend.

This is a theme I have been writing about for a long time and have been investing in for a long time as well. The point I have tried to convey with this theme is that it is going to play out, it already has been playing out, the money is going to be spent and many countries will see improved quality of life for many people with the proper context that the middle class in these places will not be the same as middle class in the US.

This creates a tailwind for any stocks involved which is a positive but it has to be understood that no stock theme will go straight up. CAT is doing this deal based on an expectation that will play out over many years. If over the next 12 months all equity markets are down then so too will CAT be down. Buying BUCY is an investment made with an eye to future, not the next quarter.

Lastly a reader at Seeking Alpha asked the following question;

I'd be interested in more of your thoughts on "time allocation" vs asset allocation
- do you think this type of self induced bias exists in investors? and shouldn't that be a factor in which vehicle they chose to use to invest?

how would you recommend a person allocate their time to be balancing the exploration of new ideas while capitalizing on areas of interest and knowledge?

The starting point has to be self awareness of limitations in terms of time and ability to understand the subject. This may be easier said than done but is crucial to enhancing long term success however you define it. Another building block here is the various fallacies and other behavioral issues that we all have. This is why in the past I have written about and tried expand on points made by Nassim Taleb. Dealing with our money is a deeply psychological thing as it hits many fears that people have. This has lead me to try to avoid situations where client fears could be heightened in such a way that would cause them to panic.

Obviously I think every aspect of investing and capital markets is fascinating, I love the work for the prospect of always learning new things, but not everyone feels that way. I have very few friends with any interest in capital markets let alone an all-encompassing vocation. I write often the narrowness of a portfolio being mostly about time available to spend. For many people inclination is a component of time available and the two would go a long way to determining a reasonable product mix. Maybe I am wrong but someone who is inclined to seek out stock market blog content probably has the inclination to build a portfolio with some narrow funds and a couple of individual stocks.

Whether that is correct or not the simple answer to this reader's line of questioning is introspection on many aspects of your makeup.
Read more!

Muni Bond ETFs In Trouble, No Kidding

One crucial aspect of having at least mediocre long term results with investing is taking heed from very obvious observations. Catching the obvious observations makes every other aspect of the task of investing much easier.

One very obvious observation that I have been repeating over and over is that it makes no sense to have expected that the worst financial crisis in 80 year was going to wrap up in 12-18 months. I have said repeatedly that there will be more shoes to drop. The latest news in Ireland is probably developing into another shoe--it is certainly market moving.

So it is with the state of the states, municipal bonds and muni bond ETFs. There was a quick segment on CNBC yesterday with Herb Greenberg talking about the S&P National AMT-Free Municipal Bond Fund (MUB) which has been selling off of late. It is down 5.5% since peaking on August 25th which compares to a drop of 2.46% for the iShares Barclays 7-10 Year Treasury Bond Fund (IEF) which appears to be the closest treasury ETF in terms of maturity. These moves would not be a big deal for equities but bonds are a different story. The "distribution yield" for MUB is currently 3.36%. Extrapolating the September 1st dividend, anyone buying at the high might have been expecting a yield of 3.59% so they are down about 200 basis points beyond what they hoped to yield. The math in this process is simple math but still makes the point and obviously there is no par value for an ETF to return to and future payouts could be smaller depending on market conditions.

The states generally have a lot of problems in terms of having budget deficits, pension shortfalls and declining tax revenues (including sales, income and property) and these problems are not brand new and at this point should not be shocking to anyone. Given the telegraphing of this I have been saying for a couple of years now that avoiding exposure to this problem and however big it actually becomes seems like an obvious thing to do.

At times, recently, there have been pundits making the case for muni bonds for various reasons but it seems to me that these arguments rely on the market and system working the same as it always has like that the ratings are accurate and that there would be enough insurance should any AAA paper default. Whether you remember this or not, 15 years ago the notion of Fannie or Freddie failing was unthinkable. Four years ago how many people were using the argument of there never having been a national price drop for real estate (which I don't think was actually true) to explain why real estate prices would not drop nationally this time?

Marc Ostwalt was quoted yesterday as saying 40 of the 50 states are technically bankrupt. It doesn't really matter if that number is accurate when you take a step back and think about the big picture. Repeated from above 48 states have budget deficits (the last time I looked), many states have serious pension problems waiting for them and the typical (tax) revenue sources are producing less revenue.

Objectively speaking, how does this space make sense? For tomorrow's post, I will repeat the above but replace "muni bonds" with "Big Western Europe." (humor attempt)

We are now in the middle of 24 hours of live college hoops on ESPN. Not too shabby.
Read more!

Barron's Cover Story On ETFs = Snoozer

In an admittedly nerdy way I was pretty excited when I saw the title of the this weeks Barron's cover story; ETFs Everywhere. It didn't take long for excitement to turn into disappointment as it was nothing more than a soft news piece written on an elementary level. At this point in the timeline of ETFs I would expect even Money Magazine to move the discussion a little further along and from Barron's I would expect actual incite insight (made a typo that a reader pointed out) on an number of salient points.

There were two different one-liners that offer a starting point for a useful discussion (not followed through on in the article) that we might be able to expand on here a little bit.

The first one was ETFs are a great democratizing force which is a point I have made many times and believe in wholeheartedly. A hedge fund has access to all sorts of foreign destinations and complex strategies. These used to be off limits to retail investors but now are obviously quite accessible to anyone inclined to spend the time.

I think the utility depends on the individual. My preference is to work ETFs into the portfolio where I think they are the best tool for a particular space. This boils to to weighing the alternative choices and picking the best.

As a follow up from yesterday they can also be a time saver for some people. Whereas everyone has a limit to how many stocks they can follow an ETF can obviously serve as a proxy for a sector, country or theme with less work than needed for any individual stocks for a given sector, country or theme. I would caution however (repeat concept) a little bit of research needs to be done on stocks with very large weightings in any ETFs you buy. And of course there must be ongoing study for any narrow ETFs used. Are you going to buy a water ETF and then not follow the industry at all?

The one-liner I liked was "Financial advisors who once picked stocks for clients and later selected mutual funds have morphed into asset allocators, and ETFs are an easy and low-cost way to get diversification." Jeremy Grantham talked about the importance of asset allocation over stock picking. This is the core of top down analysis which notes that being in the market or not accounts for about 70% of the eventual return and decisions about sectors and countries account for another 20% of the eventual return leaving stock selection as the least important final 10%. These numbers are fairly consistent across numerous studies.

While I believe heed needs to be paid to all three components (in-or-out, country/sector, stock selection) ETFs do offer the chance for success with only the first two which tying in the above contributes to the extent to which ETFs are a democratizing force.
Read more!

Sunday Morning Coffee

As a follow up to yesterday's post I wanted to address a comment left at Seeking Alpha on a recent post on country selection and ETFs.

I get really frustrated when I see blended offerings like "emerging market infrastructure" that span geography and sectors. Let the portfolio managers handle investment blends - just give us the unadulterated building blocks.

I answered by asking why he doesn't use individual stocks to which he replied;

1. Reach - accessing markets like New Zealand, Philippines, etc.
2. Bandwidth - I'm a one man shop, how can I effectively analyze stocks across 70 odd countries - covering all sectors and market caps?

It is not crystal clear whether this person works in the industry or not but either way one element of how you construct your portfolio is the time available to research and monitor; this applies to people who work in the industry and do-it-yourselfers. The spectrum here ranges from someone like mark Mobius who probably has an army of analysts so time can be spent weighing the merits of the various Sri Lankan grocery stores (presumes there are publicly traded grocery stores in Sri Lanka) to someone with literally no time/inclination and so would rather hire the task out. None of these are bad or good, they just are.

The reader's first comment makes it seem like he does prefer to make some very narrow decisions but in his second comment acknowledges the limits of his time. I think the reader is missing something, based on the comment thread anyway, which is that he takes the idea of introducing individual stocks to an extreme conclusion of watching 70 markets (not sure where that number comes, maybe it is the actual number of countries with stock markets?) but of course it does not have to be that extreme.

As the comments quoted above reference countries we might be safe in assuming that the reader is comfortable making country decisions...but not 70 markets worth. It does not take a lot of work to rule a country out. As a personal example I have no interest in owning Italy. It is an easily accessible country with the iShares Italy (EWI) and many individual stocks. I've never been a fan of the country but this could change at some point of course. Between reading the Wall Street Journal and FT every day and taking in an hour of CNBC Europe every morning I am at least remotely in touch. That is close enough so that if I hear/read something might cause me to change my mind about Italy I can then devote more time to research into whether I want that country in the portfolio and if I do get to that point, then figuring what I think is the best way in.

The above about Italy also pertains to other European countries we don't own and if you substitute CNBC Asia for CNBC Europe then it pertains to the places in Asia we don't own. General current events and the TV commentary is enough to keep tabs on many places I don't want to own for now and requires minimal effort.

We own about a dozen foreign countries and I keep close tabs (so more effort than described above) on several more countries, maybe another dozen or so, but whatever the number it is nowhere near 70. I think the current events/CNBC description makes for an efficient use of time. For countries I care more about I would layer in Bloomberg, Seeking Alpha and news feeds.

The same can apply to how you stay current on themes. Current events reading can keep you in touch with more time devoted to "important" themes. As an example I have no interest in solar for reasons I've written about many times before but stay remotely in contact with current events (there was an article in this weeks Barron's that was about a five minute read). Compare that to coal (maybe not a theme but close enough) which I follow much more closely, seek out content to read and spent time determining what I think is the best way in for clients.

Where individual stocks are concerned I know Jim Cramer says one hour per week per stock. I have no idea how much time I spend per week on each stock. I do my best to catch any news or commentary on what we hold but obviously I do not find everything published everywhere. I know people spend more time on each stock and some other people spend less time on each stock. There is no right answer and no matter how much study you do you can still get caught off guard with something along the lines of whatever happened to Upjohn in India way back when or what happened to DGW recently (didn't own either one).

Part of getting caught off guard, and it will happen occasionally, is how you react. Recently we had a name drop 5% one day and then another 5% the next day. It is a foreign stock and the news was about possible gains made by competitors. New found success by a competitor is not a deathblow for a company; maybe lottery ticket biotechs are an exception. By virtue of my understanding of the company and the industry (I concede plenty of folks know it far better than I) I was able to buy opportunistically for an account we've been implementing. The stock in question took back the 10% over the next two days and is now higher still.

I believe I follow the names close enough to understand what most things mean but as stated many times before I know I will get some picks wrong for whatever reason. The combination of right and wrong has delivered the type of result I seek over the entire cycle. I am of course describing an aspect of staying on my own mat. You might be reading this site to help define the parameters of your mat (take little bits of process from many places and create your own process).

The above is pretty much how I do things. I start reading about 90 minutes before the open and read through most of the stock market day with half an eye on CNBC in case there is something I need to hear. If there is trading to be done that takes priority over reading but usually can get to the reading later in the day as most of what I need prints early in the day. When I get back from the gym there is a little more reading but probably less than in the morning and this is also when I usually write. The weekends are a lot of reading with sports on.

I offer this up as a compare and contrast and also as a template of sorts. The original reader acknowledges the limits of his time, we all have limits. We can all only get done what we can get done but as mentioned above there are ways to leverage your time efficiently and multitask. One stray item in passing can be the thing that leads you to something important but you won't hit every single positive thing out there. While working smarter might evoke an image of Dogbert and Pointy Haired Boss there is something to it and if the reader above can't leverage his time differently then yeah shouldn't use stocks but maybe you can.
Read more!

The Big Picture for the Week of November 14, 2010

By now you've probably seen at least some of the Jeremy Grantham interview on CNBC. Credit Writedowns posted the entire video and it is worth watching. Here is the written transcript as well. There are a couple of things I wanted to hone in on and explore.

About 2/3 of the way through he says;

So, if someone put a gun to my head and said, "I've got to buy stocks. What should I buy?" I'd say, "Buy two units of the Coca-Colas. They're the cheapest group in— in the equity world. Buttress it with a fairly large dose of emerging markets. They're a little overpriced. But, they've got potential. And— a lot more cash than normal for opportunities should the bubble blow up.

He says he isn't specifically recommending Coca Cola (or Johnson & Johnson which is a client holding and a name he has mentioned elsewhere) but he likes this sort of blue chip dividend stock. His comments on emerging markets are a little contradictory in that he lays out a case for the move to continue for a while and he makes the comment above as well but he also notes that they have already started to sell and are now at a modest underweight. The reason for this is that the stocks are no longer cheap and GMO is a strict value shop.

If you stick with a strict value strategy of some sort then you need to always stick with it but you can do this and still believe a theme has legs even if it is not "cheap." If one wanted to take Grantham's advice literally there are of course ways to do it with individual stocks, ETFs or a combo of both.

In thinking about blue chips in the context he means he obviously named KO and in past posts he's mentioned JNJ. To that we could probably add some other staples stocks like tobacco companies and consumer product makers as individual stocks. Finding a half dozen names like this, mature, low beta dividend payers to build one (out of three per Grantham) tranche of the portfolio would not be difficult.

Of course instead of a handful of names like the above this portion could possibly go into something like the SPDR S&P Dividend ETF (SDY) or the iShares DJ Select Dividend Fund (DVY) which a couple of clients own. The trailing yields are 3.26% and 3.73% respectively. An important point of understanding is that these funds have gone through some serious upheaval as a result of the financial crisis. DVY used to be more than 40% financials and now is just 12% in that sector and while I am not certain how much of SDY used to be in financials (I've never held that one for clients) I believe the number was similar and now that fund has 10.5% in financials. Both funds now are heaviest in utilities followed by staples. Where there was upheaval in the past, there could be in the future.

As I think about picking between a handful of blue chips and one of the dividend funds while being true to Grantham's idea I believe I'd rather pick a few stocks. In the context I think we are working under it seems like five or six stocks would result in fewer moving parts than the variables that might impact a dividend ETF. Again the idea is staying true to what Grantham appears to be talking about.

Grantham refers frequently to the other tranche as emerging markets which is a term I think has lost meaning. In picking countries I think the euro should be avoided (one exception would be Finland) along with Japan with a minimal weighting (if any) to the UK. From there countries need to be selected by merit with an understanding of the volatility characteristics of any countries selected.

For this tranche I think picking ETFs is much easier to do in terms of capturing the effect that Grantham is talking about. This can be done with country funds, thematic funds (which includes sector funds) or a combo of the two. There are now dozens of country and regional funds, plenty of theme funds with the desired country exposure and of course sector funds for Brazil and China and we should expect more specialized funds to come out of the pipeline.

While the funds certainly make for easy access I do not think they allow for shortcuts in the analytical process. Anyone buying the iShares South Africa ETF (EZA), for example, needs to understand the dynamics of the country, both past and current, and should have at least an inkling of what is going on at MTN Group which weighs in at 11% of the fund and Sasol (SSL) at 9.5% of the fund.

If you agree with my belief that proper study includes at least a little time spent on the largest holdings then you might be willing to consider individual stocks instead of just ETFs. The chart captures an index in blue versus a component of that index in red. Over a long period of time the stock has outperformed but you can tell from the chart that over shorter periods both the index and the equity track closely together without a whole lot of volatility except during the meltdown.

I stumbled across the stock in some random article, then saw it is a midsize component in the ETF for its country. It is a real company with an English website and annual report with a long track record of profitability. Three percent allocated to this stock may or may not work out as a good hold but it won't wipe anyone out--the key being proper allocation, a favorable disposition toward the country, belief in the company's numbers, at least a decent understanding of what goes on day to day at the company and a reasonable basis to expect that the company will continue to execute.

If you spend the time I promise you that you will find interesting companies, that serve as fine proxies for their country with a better yield than you would get buying the country fund.

The third tranche of Grantham's answer was holding cash for future opportunities. The gripe that people have with cash is the low yield. Yes yields are low but if you can train yourself to think of cash as a tool at your disposal then the low yields should be less of a mental obstacle.

As a much shorter point, early in the interview Grantham makes the case for top down management essentially saying that once you get things like countries and themes correct, the stock chosen should be far less important of a decision. Far less important, yes, but not totally unimportant. In buying a big Canadian bank or a big Australian bank, for example, the vast majority of the time it probably doesn't matter which one you choose. The correlation is usually very tight and they all seem to take turns being the "best."

However in going broader and saying you just want one country where maybe the choices are more limited, then the work picking a stock can be more difficult--there are fewer stocks for Hungary than Canada for example-- and so here the argument for a stock becomes far less compelling.
Read more!

One Way To Analyze ETF Portfolios

There are a lot of blog posts out there that offer suggestions for ETF portfolios. The suggested portfolios are either useful or not but I thought it would be useful to spend a little time on one possible way to analyze a portfolio, not so you can go implement this but so that you might think a little differently in terms of how to assess a portfolio that you put together for yourself.

I picked ten ETFs at random and input them into a spreadsheet with a simplistic weighting to explore what the sector make up might yield from something very random. The ten ETFs as follows;

iShares Chile (ECH)
iShares New Zealand (ENZL)
iShares Indonesia (EIDO)
Market Vectors Egypt (EGPT)
EG Shares Emerging Market Consumer (ECON)
iShares Emerging Market Infrastructure (EMIF)
Global X Nordic 30 (GXF)
Global X Norway 30 (NORW)
Market Vectors Small Cap India (SCIF)
Index IQ Small Cap Taiwan (TWON)

Obviously this would be a narrow based portfolio seeking specific effects and obviously it bypasses the euro, Japan and the US. It also missed countries I like including Canada and Australia.

As random as it is (I only changed one fund from the original ten) the sector weights are not insane but not ideal which is ok (explanation to follow). A point I make often is that it is very easy with funds to end up grossly overweight certain sectors, most typically financial stocks. As a crazy example a portfolio consisting of only iShares Singapore, EGPT above and Market Vectors Poland would have about a 45% weight to financials which would be a gross overweight (versus the sector weightings in the S&P 500).

The total sector weightings of the ten funds weighted simplistically (per compliance I need to be vague on this point) worked out as follows;

Tech 5.7% versus 19.3% for the SPX
Financials 16.8% versus 15.6% for SPX
Energy 10.1% versus 11.4% for SPX
Health Care 2.1% versus 11.1% for SPX
Consumer (staples plus discretionary) 21.4% versus 21.2% for SPX
Industrials 15.4% versus 10.6% for SPX
Materials 11.5% versus 3.6% for SPX
Utilities 7% versus 3.4% for SPX
Telecom 6.1% versus 3.0% for SPX

Maybe you think the sector weightings are insane. The tech and health care underweights are extreme in my opinion and the materials overweight would be a little rough as well but you might disagree which is fine. What I think is clear is that as a starting point it would be easy to tweak this in any direction someone wanted to go. One tech sector fund and one health sector fund added to take the count up to 12 funds would increase the weight in those sectors obviously and it would shave a few percentage points off the materials exposure.

Obviously any interest in changing countries, like a swap out Indonesia for the Philippines for whatever reason would be easy to do with a swap of funds and in that example would increase the financial weighting some but not be wildly disruptive in terms of needing to move everything around.

The important takeaway is that the sector analysis is simple spreadsheet work done by going to the sites of the fund providers and putting the numbers into excel. The same thing can be done with countries if the sought after fund mix includes more theme funds than country funds. The provider sites also usually have information on market cap and maybe volatility as well (depends on the provider). There are other sources for this information too including Morningstar but the work is simple; plug it in and hit the sum button.

Zooming out a little; however a portfolio is constructed, obviously I prefer many more holdings and use of individual stocks, it is important to keep tabs on the stats of your portfolio. Doing so should also help reduce the extent to which you might get blindsided by some sort of event.

Hopefully it is obvious that the mix above is hypothetical and would do very badly in some sort of risk-off dollar rally situation and of the funds listed we only use two of them anywhere, EMIF and ECH.
Read more!

Kauffman Poo-Poos ETFs, Everyone Else Says Their Wrong

First, Happy Veterans Day.

If you follow the ETF industry then you know about the recent report from the Kauffman Foundation that took all sorts of shots at ETFs that were then debunked by IndexUniverse here and here and also by ETF Trends. If you rely on ETFs for any meaningful portion of your portfolio then you need keep tabs on this sort of thing.

You may recall a similar story a couple of months ago when Andrew Bogan wrote an article that got a lot of attention about whether an ETF could implode under the weight of too large a short interest. Like the Kaufmann report many well regarded ETF bloggers quickly pointed out the inaccuracies of that post too.

There is a more useful path for most of us to take here. ETFs are a revolutionary investment product (I may have called them evolutionary before so I guess I am upgrading my opinion). People are right to be on the lookout for potential serious problems and so various folks are exploring the issue and apparently getting some facts wrong as they do but again the ongoing study can be productive.

However ETFs are investment products and every so often investment products go bad one way or another and no one should think ETFs are immune to this possibility. Note that I say possibility because I have no expectation or fear of some sort of fatal flaw that truly destroys the wealth of ETF investors. Just because I have no expectation of such a malfunction does not mean one can't happen. This is extremely, extremely improbable but the idea that it is impossible is incorrect.

Were there to some sort of catastrophe it would not be in every single fund but I would think more like some sort of unpredictable event affecting one of the most frequently traded funds as a sort of one-off. Again, I have no expectation of such a thing.

Obviously I am a big believer in ETFs, use them liberally in my practice and will continue to do so but if your account is large enough where individual stocks mixed in with funds would not create an unreasonable commission drag then you should use some individual stocks.

In the context of building a narrow based portfolio in weighing between an ETF or a common stock, there are plenty of stocks that correlate quite closely with the indexes they are a part; of course this is an easier connection to make with a stock that is a large component of a fund. I made a reference to this the other day noting that Cameco (CCJ) is by far the largest holding in the new Global X Uranium Fund (URA) at about 20% and the stock and fund are very likely to always have a high correlation. The Global X Lithium Fund (LIT) likely has a similar situation with SQM. Anyone interested on both themes could, with proper diligence, could just as easily buy the stock for one of the themes and the fund for the other. Note this is just an example I don't own either stock or either fund personally or for clients.

Additionally I would again bring up the point that ETF don't always pay much in the way of dividends. It is difficult to build a narrow based portfolio with ETFs and get much yield. The point being that no product can meet all needs. However you build your portfolio it seems obvious that for some segments ETFs would be the best way to go but for some other segments individual stocks should be the best way to go. Aside from having a better constructed portfolio you should also avoid the full brunt of some sort of ETF mishap that turns out to be worse than the Flash Crash should it ever happen.

As for the picture, apparently Kauffman is Ewing Kauffman former owner of the Kansas City Royals.
Read more!

Norway (ETF) On The Way Today!

GlobalX is cranking up the new product machine to pump out the FTSE Norway 30 ETF which will have ticker symbol NORW. Long time readers will know I place a high value on Norway as an investment destination and I think a country fund for Norway is overdue.

I will be doing a writeup about it for theStreet.com so without frontrunning that I will say that it is heaviest by far in the energy sector which should not be a surprise to anyone but also offers access to a country through a fund that is not heavy in financial stocks. That may seem a bit redundant but many country funds out there are very heavy in financials which is not bad by itself but if you buy ten country funds and they are all 50% financials you are not well diversified at the sector level. No word yet on whether any of the Norwegian fisheries are in the new fund.

In order not to frontrun the article I'll write on NORW I'll make a bigger picture point in this post. A couple of days ago I was asked to share a couple of observations with one of the news services about the most popular new ETFs from 2010--most popular in terms of assets in the funds.

The list of funds provided by the news service generally had a theme to them of normal domestic equity investing doesn't work anymore. I say this based on the various metals fund listed along with country funds and an emerging market debt fund and the Norway fund plays right into the idea.

Obviously I've been beating this drum for a long time. When I first started writing about these types of destinations the idea was better diversification than Europe because they have different fundamental attributes than the US. Different attributes, IMO, makes for better diversification. The way things have evolved it turns out that many of these countries had better fundamentals coming into the crisis and have done a better job recovering from the way the crisis played out in global stock markets.

The attractiveness these various normal domestic equity investing doesn't work anymore-funds is easy to understand and the performance has garnered investor demand and the fund providers are meeting that demand with supply in the form of countries, very specialized mining company funds and so on.

The behaviors exhibited have all happened before, like with solar stocks 30 years ago and internet stocks ten years ago. I do not conclude the same outcome here but it is worth understanding that the creation of many investment products often leads to supply overwhelming demand resulting in lower prices. Arguing over whether this can happen with these types of funds, countries and metals is less productive than making sure that some sort large decline does not do your portfolio in.

The best way to do this is to own countries will all sorts of different attributes. At various points countries like Hungary, Latvia and Iceland have had their turns as the best performing markets. I realize these countries aren't easily accessible but the point is easy to grasp. Who knows how long it will be before these three make sense again (might already be there with Latvia) but these are times that favor surplus (or close to surplus) countries. At some point will be a time that favors deficit countries that are more in their own world.

Hopefully it is clear I would not suggest holding on to something like Hungary all the way down, this is more about recognizing that too much of anything makes for risky portfolio construction.

Statoil (pictured, not mentioned) is a client and personal holding.
Read more!

Forest For The Trees Moment

Short post as I have to head to Phoenix for a meeting.

I found an article at Seeking Alpha titled Three ETFs to Play Amazon While Remaining Diversified. In the article the author notes three ETFs that are apparently heavy in Amazon. I'm all for diversification but if you want to capture something going on at a particular company why the hell wouldn't you just buy the stock?

The idea of doing enough research to conclude you want in on the action and then going with an ETF in its place seems beyond upside down to me. ETFs are useful for all sorts of exposures and strategies but not as proxies for a stock that comprises some portion of a fund.
Read more!

Small Trade

We executed a trade the other day in larger accounts that does not increase our net long exposure but should increase the volatility of the portfolio a little allowing a little more participation should there be more upside to this rally.

Several years ago I changed around our exposure to the energy sector by selling a couple of of individual stocks in the sector and replacing them with the WisdomTree International Energy ETF (DKA). Swapping stocks for an large cap ETF should reduce the volatility of the portfolio and that was the case back when we did this trade. One way to get in front of a meaningful downturn (as opposed to a fast panic) is to reduce volatility, subsequently swapping from a large cap ETF into common stocks or a narrower ETF should add some volatility back into the portfolio.

We have done several trades in the last couple of years to increase equity exposure and volatility so the one from last week is simply the latest. We sold a portion of DKA and replaced it with the Market Vectors Coal ETF (KOL); again as dollar for dollar swap (subject to rounding) the idea with this trade is to add a little volatility.

Once the decision to add coal was made I decided I wanted to use an ETF because the two that are out there each cover a lot of ground including China and energy is a sector in China I am comfortable with. KOL trades more volume than the PowerShares equivalent plus the PowerShares fund has about 11% in uranium stocks which is not bad but I can see adding uranium one way or another as a separate holding at some point in the future.

A couple of nuggets about coal that you probably know about are that congress is expected to be more lenient toward coal companies which would benefit some of the stocks in the fund and something like 70% of China's electricity comes from coal which should benefit another portion of the fund and as mentioned the other day (and many other times) the ascendancy of the middle class will mean more energy consumption and this, in my opinion will be a steadier force in China's economy and so hopefully in the Chinese capital markets.

There are two big picture drivers behind wanting to add a little volatility. One is that after three years the S&P 500 is still 20% below its peak and there is plenty of skepticism toward the US market (I am plenty skeptical). While it is reasonable to expect negative consequences from quantitative easing I doubt we will see them in the immediate future based on what we know now about the plan for targeting assets and the wealth effect.
Read more!

Sunday Morning Coffee

Barron's had all sorts of interesting things to talk about this week.

First was an interview with Scott Minerd from Guggenheim Partners. He had some interesting comments on asset allocation.

He said that 10-20% of a portfolio should go into art and collectibles. I thought this was astounding. I have no doubt that data can be found to support his opinion but anecdotally it seems like I always hear about these things not doing well-- other than the Honus Wagner T-206 or some painting that was bought five years ago for $12 million being sold for $30 million. I've got one of the Tim Flannery surf board cards--anyone out there who will bid me $0.17 (humor attempt)?

Seriously, part of the decision to get into collectibles and art as investments has to include willingness and ability to sit on very illiquid assets and understand that conditions can change. If you want to buy a piece of art or some other collectible I would do so because you love the item and not because you expect some rate of return.

Minerd also averred for 10-20% in commodities where he would overweight metals presumably over softs, agriculture and energy. He would then split the rest between equities and fixed income with 10% of equities in emerging markets. He said that US equities are "exceptionally cheap." US equities might be exceptionally cheap but the fundamentals to cause higher prices are not there, certainly not compared to many foreign destinations. The Fed's explicit targeting of asset prices creates a weak an unnatural foundation.

The mutual fund article looked at the Aston River Road Dividend All Cap Value Fund (ARDEX). Early in the article Barron's notes that "The fund yields 2.27%, far more than any but the longest-term Treasury securities." What? The 2.27% is corroborated by Morningstar. The trailing yield on the SPDR S&P 500 ETF (SPY) of 1.96% so I'm not sure why they are all worked up about an extra 31 basis points in yield.

In my confusion over this I went to the company's web site to see if maybe it is a dividend growth fund meaning that they look for stocks with good prospects of growing their dividends which is a valid strategy but not necessarily a high yielding one. The description as follows; The Aston/River Road Dividend All Cap Value Fund invests in a diversified, multi-cap portfolio of income producing equity securities with yields that management believes will exceed the Russell 3000 Value Index.

The fund itself has done quite well. It has outperformed its benchmarks pretty consistently and went down a lot less than the market during the meltdown but I don't see how this is a high yielding fund, or even a dividend fund. BigCharts.com has the yield of this fund as being quite low for most of the last five years getting above 3% for a while when the market was at its lows in 2009. It might be a good fund but if you need yield, contrary to what Barron's said, there are plenty of funds that yield more than 2.27%.

Lastly was an article titled China's Sure Bet about that country's shift from buying nothing but US treasuries to buying now a mix of treasuries and hard assets or companies in the materials sector all in the interest of building out the industrial base of the country. It was a great read and reiterated several important points that I have been trying to make for a while.

First is that the build up and out of the infrastructure that provides a middle class lifestyle of sorts for more people is going to happen even if the economy and stock market ebb and flow. This means that one productive way to invest in China is in companies that are up and down this process which can include energy companies, cement companies, infrastructure builders or companies that provide the actual service to the end users (toll road stocks as an example for that last one).

It also reiterates the extent to which despite all the attention that banks (and to a lesser extent reverse mergers that list on American exchanges) receive the manner in which China is spending its money tells you there are plenty of other places in the country to look. I do not know if there will ever be a problem for the Chinese banks and real estate companies but if you've done some reading it seems obvious that it is these segments that are most at risk for some sort of mistake which is why I avoid the sector in China

Lastly the article gives a sense of how much China is driving the global economy. Maybe instead of not fighting the Fed we should focus on not fighting the Chinese Sovereign Wealth Fund (or other pools of capital).
Read more!

The Big Picture for the Week of November 7, 2010

James Picerno explored an idea put forth by research at MSCI Barra about what role global benchmarks should play in portfolio construction by money managers and the extent to which more and more US based managers are going global. This is of interest here because going more into foreign equity exposure has been one of the primary threads on this site.

A building block for the conclusion of the research was the extent to which US stocks comprise less of the world's total market cap; down to 40% from 50% ten years ago. As an active manager the nitty gritty of indexing is obviously not as important as any of the active decisions that might get made. One way to look at the US' market cap going from 50% to 40% during a ten year stretch where the US was down is that foreign outperformed during that time period. While I haven't looked under the hood of the research it is reasonable to conclude that foreign grew in the world's market cap at the expense of the US given that, again, the US was down for the period in question.

Part of the goal of active management of course would have been to look forward and see that foreign might be poised to outperform. From the point I started this phase of my career, early in the last decade, this seemed like a very obvious conclusion to draw; that is that specific foreign markets would outperform the US.

From an evolution standpoint, since inception in late 2001 the iShares MSCI EAFE Index Fund (EFA) is up 49% versus a 9.4% gain for the S&P 500 so EFA was the better hold. However almost all of that advantage occurred in the earlier part of the decade before the financial crisis. In the last five years EFA is up 5.4% versus a gain of 0.47% for the S&P 500--the 5.4% is overstated because the euro is up 20% versus the greenback in that five years and EFA obviously translates into dollars. Before you say that all correlations went to 1.00 I would point out that in the last five years Brazil and Chile are each up about 140%, Israel is up 70%, Shanghai is up 200% (despite being down 50% from its peak), Malaysia up 60% and so on.

James quotes the research as follows; "our research suggests that global equity mandates, together with dedicated emerging market mandates and small cap mandates, may be emerging as the 'new classic' structure for implementing equity allocation." Conceptually this is fine but I am not a fan of being overly rigid with these things, obviously as an individual you don't have to be overly rigid and if you are an advisor then you may or may not have flexibility with this sort of thing. We do have flexibility for the reason that if it makes more sense to simply avoid some segment of the capital market than to pick the thing that can go up while everything else is going down then that is what we'll do.

James opines that "a possible equity mix might be constructed with a 50% weight in a global equity fund with the remaining 50% allocated in regional, industry and/or style funds." Above a certain account size I am not a fan broad based like ACWI and VT which are specifically mentioned elsewhere in the article but from the standpoint of staying on your own mat this can be a suitable way to go.

From 30,000 feet I obviously agree with the article but I think the conclusion was obvious years ago. I do not really believe that most of the investment management industry is only now getting around to discovering foreign investing and doing so only with the broadest funds. Whether that is true or not hopefully my years of advocating narrower exposure has resonated with you and you are doing the research, making the decisions and taking advantage of the resources available.

On a related note I am seeing more and more articles on investing in Argentina. The country has a lousy history, was much more globally relevant many years ago, does have some positive attributes looking forward and a little recent political uncertainty mixed in. Per BNY Mellon ADR site I count 24 ADRs available between the NYSE and five letter stocks. The benchmark Merval Index has historically been more volatile than the US market. As a microcosm, during the last five years it fell a little more than the US during the meltdown and is up much much more than the US since the low.

Now, as markets are going up all sorts of favorable attention is being paid and it makes you feel like you've missed something but on the next meaningful downturn I would assume it will go down much more and any commentary will make you feel like you are crazy for ever having even thought about buying in. You can sort out whether Argentina specifically makes sense for you but the volatility characteristics of the country are not unique and do have a place in a diversified portfolio. While not a new destination, there was a closed end fund many years ago that appears to be gone now, it might be new to you and there will be other new destinations too.

As much as I like Chile, in theory if everyone buys in it won't go up anymore. While that is a ridiculous comment it makes the point mentioned above which is the themes and destinations do evolve and sometimes the evolution makes them a sell and if a country does need to be sold then it needs to be replaced.
Read more!