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Revisiting Our Diversified ETF Portfolio

I think it’s time that we revisited our Diversified ETF Portfolio that I published on May 31, 2011.  It’s been fourteen months, and we should see how well we have done.

This posting will prove that I am not a professional investment advisor, because I am willing to document how my investment picks lost money.

Fourteen months ago, I constructed a portfolio of eight ETFs to demonstrate that we could create a diversified portfolio using only a small number of ETFs.  You can read that post here.

To recap, here are the components of that portfolio:

Category ETF
Symbol
ETF Name Portfolio
Percent
———————————- ———– ————————————————– ———–
Domestic Stocks VTI Vanguard Total US Stock Mkt. 13%
Foreign Developed Mkt. VEA Vanguard MSCI Euro Pacific 5%
Foreign Emerging Mkt. VWO Vanguard MSCI Emerg. Mkt. 7%
Gold/Silver Bullion IAU iShares Gold Trust 20%
Gold/Silver Miners GDX Market Vectors Gold Miners 5%
Commodities GCC GreenHaven Equal-Weight Commodity 15%
Real Estate VNQ Vanguard MSCI U.S. REIT 25%
Bonds BSV Vanguard Short-Term US Bond Mix 10%
——-
Total 100%
.

To chart the portfolio’s performance, I used a handy program called EzBacktest, that you can find at http://ezbacktest.blogspot.com.  I really like this tool, and its free.

Here is the portfolio performance from May 31, 2011 through August 10, 2012.
ETF Portfolio Performance
The blue area shows the portfolio’s value and the red line is the S&P 500.  These are the statistics provided by EzBacktest:

Avg. Dividend Yield:   1.55%
Annualized Return:    -0.5%
14-Month Return:       -0.6%
Under-performed the S&P 500 by 5.1%

If we had invested $10,000, our portfolio would now be worth $9,940.  We lost $60, whereas investing everything in the S&P 500 would have given us a profit of about $430.

To illustrate which ETFs were the worst performers, here is a relative performance chart provided by StockCharts.com.
Portfolio Components Performance

As you can see, the worst performers were GDX (gold miners), GCC (commodities), VWO (foreign emerging markets), and VEA (foreign developed markets).  The best performer was VNQ (real estate investment trusts).  VTI (total stock market) was just marginally better than the S&P 500.

The problem with a diversified portfolio, is that you have exposure to bad sectors as well as good sectors.  Over these fourteen months, the bad sectors were horrible, and the good sectors were mediocre.

So, the question to ask is “What do we do now?”  I still like the component ETFs of the portfolio.  So, assuming that we still want to be diversified, I will merely adjust the percentages.

I think we had a little too much exposure to gold, so I will reduce the percentages of IAU and GDX.  I would also like more exposure to US equities, so I will increase the percentage of VTI.

The foreign markets (developed and emerging) did horribly over the past year, and they may not do very well for the next year, but I still want exposure to them.  I expect Bonds to stay about the same for another year, and then decrease in value, but I will keep some exposure to them.

Commodities didn’t do well, but I expect that to change over the next year, so I will keep some exposure to them.

Here is my Rebalanced Diversified ETF Portfoio:

Category ETF
Symbol
ETF Name Portfolio
Percent
———————————- ———– ————————————————– ———–
Domestic Stocks VTI Vanguard Total US Stock Mkt. 17%
Foreign Developed Mkt. VEA Vanguard MSCI Euro Pacific 5%
Foreign Emerging Mkt. VWO Vanguard MSCI Emerg. Mkt. 8%
Gold/Silver Bullion IAU iShares Gold Trust 16%
Gold/Silver Miners GDX Market Vectors Gold Miners 4%
Commodities GCC GreenHaven Equal-Weight Commodity 15%
Real Estate VNQ Vanguard MSCI U.S. REIT 25%
Bonds BSV Vanguard Short-Term US Bond Mix 10%
——-
Total 100%
.

Let’s see if I am still willing to post the portfolio performance next year.

Permanent Link to this post: http://richardkinnaird.com/blog/revisiting-our-diversified-etf-portfolio/

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Sunday, August 12th, 2012 Stocks Comments Off on Revisiting Our Diversified ETF Portfolio

A Diversified Portfolio of ETFs

Several weeks ago, I posted an article titled Asset Classes For Portfolio Diversification.  In that article, I presented a chart showing how I categorize investments to determine how well-diversified my portfolio is.

Today I decided to create a sample diversified portfolio using only Exchange Traded Funds (ETFs).  I wanted to use the fewest number of ETFs possible to achieve diversification.  I used ETFs because each ETF invests in many stocks, bonds, options or futures contracts, so that each ETF has its risk spread over many investments.

DISCLAIMER:  I am not recommending that you buy any of these ETFs.  I chose real ETFs to demonstrate how an investor could construct a diversified portfolio and to calculate how that specific portfolio would have performed.  As I discussed in the previous article on diversification, everyone will have their own desired percentages for each investment category.  Any specific example portfolio, such as this one, will not be suitable for everyone.

Although I will discuss why I chose each ETF, and may give alternative choices, the particular ETFs may not be suitable for you.  One website that you can use to select ETFs in various categories is the ETFdb Category Tool.

The Example Portfolio

Category ETF
Symbol
ETF Name Portfolio
Percent
———————————- ———– ————————————————– ———–

Domestic Stocks

VTI

Vanguard Total US Stock Mkt.

13%

Foreign Developed Mkt.

VEA

Vanguard MSCI Euro Pacific

5%

Foreign Emerging Mkt.

VWO

Vanguard MSCI Emerg. Mkt.

7%

Gold/Silver Bullion

IAU

iShares Gold Trust

20%

Gold/Silver Miners

GDX

Market Vectors Gold Miners

5%

Commodities

GCC

GreenHaven Equal-Weight Commodity

15%

Real Estate

VNQ

Vanguard MSCI U.S. REIT

25%

Bonds

BSV

Vanguard Short-Term US Bond Mix

10%
——-

Total

100%

Using these ETFs our Asset Diversification Chart looks like this:

ETF Portfolio Diversification

Notice that there is nothing allocated for Cash.  Any portfolio should have an allocation for Cash, but since that doesn’t affect the performance (measured in dollars) I have left Cash out of the portfolio.

There is also no allocation for Currencies or Other.  That is on purpose.  It’s hard to measure the performance of “Other” investments, and I don’t think most people should fool around with Currencies.

Portfolio Performance

I used a “backtest” tool to see how this portfolio would have performed. [Update: A better backtest tool is the free program EzBacktest, that you can find at http://ezbacktest.blogspot.com.]

Over the past two years, this portfolio would have had a total return of 59.1% compared with 50.1% for the S&P500.  The compound annual growth (CAGR) of this portfolio would have been 26.1% per year compared with 22.5% for the S&P500.

The following chart shows the performance.  The portfolio is in green and the S&P500 is in blue.  $100K invested two years ago would grow to $159,100 vs. $150,100 for the S&P500.  This is 6% better than the S&P500.

ETF Portfolio 2-Yr. Performance

It should be noted that this two-year period is after the crash of September, 2008 to March, 2009.  The following chart shows the performance from February 1, 2008 through May 27, 2011.

ETF Portfolio 2.5-Yr. Performance

Including the crash, the portfolio would have had a total return of 21.9% vs. only 2.6% for the S&P500.  The portfolio’s CAGR would have been 6.1% per year vs. 0.8% for the S&P500.

About the Specific ETFs

In choosing the ETFs for this portfolio, I tried to use Vanguard products, because Vanguard usually has lower management fees than other companies.  If you are a Schwab investor, you can invest in Schwab ETFs with low fees and no sales commissions.  Other brokers have commission-free arrangements with some of the ETFs.

Three of the ETFs weren’t my first choice for the portfolio.  I would have preferred to use GDXJ, the “junior miners” (small cap.) ETF instead of GDX, but GDXJ hasn’t been around long enough to demonstrate performance.

Also, I might have replaced VTI with SCHG and SCHA, two newer Schwab ETFs.  SCHG is large-cap growth, and SCHA is small-cap growth.  Because VTI is classified as a “large-cap blend,” the allocation chart doesn’t show any small cap stocks.  It’s OK for all the foreign stocks to be large-cap, but I would have preferred for about half of the domestic stocks to be small-to-mid-cap.  Schwab also has an equivalent ETF to VWO (SCHE, emerging markets).

In Commodities, the most obvious choices would probably have been DBC or RJI.  However, since I was only going to choose one ETF for this category, I chose GCC, because it has more exposure to Agriculture and less exposure to Energy than the other two ETFs.

Which ETFs Performed the Best?

Over the past two years, the best-performing ETF was VNQ the Real Estate Investment Trust ETF.  Its total return was 106%.  The second-best performers were a tie between VTI (total stock market) and IAU (gold) at 55%.  The worst performers were BSV (bonds 0.8%) and GDX (gold miners 1.6%).

Conclusion

It isn’t difficult to construct a diversified portfolio using eight to ten ETFs.  In the example portfolio, if your total investment was $10,000 then you would still have at least $500 in each ETF.

Our example beat the S&P500, which is usually used as a benchmark for investment performance.  Making 6% more than the benchmark over a two-year period may not seem very impressive, but a 6% beat is not bad.

Also, the example portfolio was slightly less volatile than the S&P500.  Over two years, its volatility was 16.1% vs. 16.6% for the S&P500.  However, in the second timeframe, which included the crash, the portfolio volatility was 21.4% vs. 28.8% for the S&P500.

These eight ETFs may not perform as well in the future, so this is not a recommendation.  In fact, the only one of these ETFs that I own is IAU.  Also, the allocation percentages of my personal portfolio are not the same as the percentages of this example portfolio, so even I am not putting money into this particular portfolio.

[Update: See how this portfolio performed during the first fourteen months after this article was posted.]

Permanent Link to this post: http://richardkinnaird.com/blog/a-diversified-portfolio-of-etfs/

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Sunday, May 29th, 2011 Stocks Comments Off on A Diversified Portfolio of ETFs

Asset Classes For Portfolio Diversification

“Don’t put all your eggs in one basket,” is a traditional idiom that warns us not to risk everything on a single venture.  If you divide your eggs into two baskets, and one basket is dropped, you have still preserved half your eggs.  Applied to investing, this strategy is referred to as diversification.

Many years ago, when I was in the financial planning business, “diversification” was interpreted to mean, “Divide your investments between US stocks and US bonds and make sure the stocks cover all the market sectors.”  Today, even the average investor can be much more sophisticated in portfolio diversification.  Using Exchange Traded Funds (ETFs), any investor can diversify much more broadly than was possible in the old days.

For example, you shouldn’t limit yourself to only US stocks and bonds.  It is very easy to invest in foreign stocks and bonds using ETFs.  Going back to our egg-harvesting example, international diversification is analogous to, “Even if you have your eggs divided into two baskets, don’t let the same person carry both baskets.”  This way if one person (country) stumbles, you have another person carrying some of your eggs.

How to Diversify

The diagram below illustrates how I approach asset diversification.  It may be a little complicated for some people, but it illustrates my view of the investment universe.

Asset Diversification

As you move from left to right in the diagram, each box represents a filter or a categorization for the asset to the left.  For example, both Stocks and Bonds are first divided into either Domestic or Foreign.

To be more accurate, I should have called “Stocks” “Equities” because further to the right I divide them into Stocks, Funds/ETFs or Options.

For each Domestic Stock, I categorize it by my goal for that stock.  My goals are either Growth, Income or High Risk/Reward.  Both Growth and Income Stocks are intended to be held long-term, while High Risk/Reward Stocks probably can’t be held for very long because they are volatile and were purchased with the hope of a good short-term gain while being watched carefully.

If a Domestic Stock can’t provide me with Growth, Income or the prospect of a short-term gain, I shouldn’t own it.

Foreign Stocks are first classified as Developed Markets or Emerging Markets before assigning each Stock to a Sector.

Second in importance, after the investment goal for a Stock, is the business Sector it falls into.  Most often, you see sectors categorized in a couple of ways:

Morningstar Sectors S&P 500 Sectors
Business Services
Consumer Goods Consumer Staples
Consumer Services Consumer Discretionary
Media
Energy Energy
Financial Services Financials
Health Care Health Care
Industrial Materials Materials
Hardware Industrials
Software Information Technology
Telecommunications Telecom Services
Utilities Utilities

These categories are too granular for me.  I divide stocks up into eight categories:

My Sectors

  • Technology
  • Consumer
  • Health
  • Energy
  • Financials
  • Industrials
  • Utilities/Telecom
  • Commodities

I group Consumer Staples, Consumer Discretionary, Consumer Goods, Consumer Services and Media all together into “Consumer.”

I also group Telecommunications Services (e.g. AT&T, Verizon) and Utilities (e.g. Con Edison, Duke Power) into one category.  The rationale here is that they are both semi-regulated services for the consumer that bill monthly and usually pay dividends.

There is one obvious overlap/redundancy in the diagram.  One of the Stock Sectors is “Commodities” and one of the major asset types on the left is also “Commodities.”  Following the Commodities major type all the way to the right shows that one of the three ways to invest in Commodities is Producer Stocks.  These Producer Stocks also fall into one of two Stock Sectors: Commodities or Energy.  The reason I have this in two places is because many stock ETFs are diversified across Sectors including Commodities and Energy, so I have Sectors for this.  Other Individual Stocks or specialty ETFs are exclusively Commodities, so they go into Commodities Producer Stocks or Commodities ETFs.

Both Foreign and Domestic Stocks are classified as either Large Cap or Small Cap.  After you have allocated a portion of your portfolio to Domestic/Foreign, Goal/Market, Sector and Capitalization, you can put that money into either Individual Stocks, Mutual Funds or ETFs.  For Domestic Stocks, I also consider Options.

The diagram shows a similar treatment for classifying the other investment types.

I have a separate major asset type for Gold & Silver.  In a previous post I explained why I don’t consider Gold to be a Commodity; it should be thought of as the Universal Foreign Currency.  However, I only put fiat (paper money) foreign currencies into their own major asset type — Currencies.

Gold could be a major type all by itself, and Silver could be under Commodities, but Gold and Silver are enough alike and track together well enough to lump them together.

Why Bother?

So, why do I bother with this taxonomy of assets?  Two reasons:  1) If you already have an investment portfolio, you can see what percentage of it fits into each box.  This will reveal holes in your coverage which you can decide to ignore or fix.  2) If you are planning a portfolio from the top down, you can allocate percentages to each box according to your individual needs, goals and philosophies.

Although I am not as rigorous as the diagram might indicate, I do try to keep track of the percentage of my portfolio I have allocated to each box.  If I think I’m too heavy or too light in a category, I will fix it.

For many investors, this level of analysis will be overkill.  There are so many category possibilities that you may not have enough money to allocate to all, or even most, categories.  That’s perfectly OK.  In fact, even if you do have enough assets, you may choose to put nothing into one or more categories.  For example, contrary to conventional wisdom, I have almost nothing in Bonds of any type.  I have very little in the Currencies box or the Other box.  When I was an entrepreneur, all my assets were in the Other box.

How Much Should Be Allocated to Each Box?

This is the fundamental question, and, unfortunately, one answer does not apply to everyone.  In fact, even if every investor agreed with my taxonomy and had lots of money to invest, each investor would probably have a different allocation.

For example, let’s look at a traditional (old-fashioned) allocation strategy.  The following is copied from a Schwab newsletter I recently received.  They gave an example of three different portfolios:

Conservative Moderate Aggressive
15% Large Cap 35% Large Cap 50% Large Cap
0% Small Cap 10% Small Cap 20% Small Cap
5% Foreign Stocks 15% Foreign Stocks 25% Foreign Stocks
50% Fixed Income 35% Fixed Income 0% Fixed Income
30% Cash 5% Cash 5% Cash

Large Cap and Small Cap both refer to US Stocks.  Fixed Income usually means Bonds.  For Foreign Stocks, Schwab recommends for all three portfolios:  65% Foreign Large Cap, 15% Foreign Small Cap and 20% Emerging Markets.

As you can see, this is a much simpler diversification strategy than I have for myself.  It is easier to explain and (more importantly) to sell.  I can see the logic in their strategy, and I suspect that most investors are not even this diversified.  At my age, they would recommend that I have the Conservative portfolio, which I most certainly do not have.

Their portfolios completely ignore Gold & Silver, Commodities, Real Estate and Currencies.  I can understand this because the only Real Estate most people have is their home; Currencies are difficult to trade; and Gold is for paranoid nut jobs (Just kidding. I’m putting words into Charles Schwab’s mouth).  But even in Schwab’s simplified model, it takes three portfolios to meet everyone’s needs.

If I go into too much detail on how to allocate investment assets, I might cross the line into giving investment advice, which I am not qualified to do.  That being said, I think when it comes to stocks, I like to have between 60/40 and 40/60 allocated to Domestic/Foreign.  The same could be said for Developed/Emerging in the Foreign Stock category.

When it comes to Gold, even Jim Cramer recommends 10% to 20% of your assets in Gold, and I agree with him.

When it comes to Real Estate, I don’t include my home in my portfolio.  I realize that for many people, their home is their largest investment, but I choose to put as little money into my home as I comfortably can.  In fact, a case can be made for renting, but that could be the subject of another blog posting.  I do think that some of your assets should be in Real Estate, even if it’s your home.

I am also a fan of Commodities, especially Agricultural Commodities.  We are entering into a period of global food shortages, and I think this is a good investment category.

When it comes to Currencies, most people should probably not put too much money into this category.

Cash is probably the most important category, because it is the first box a beginning investor should fill.  If you don’t have enough Cash saved to cover at least four months of bare-bones expenses, you probably shouldn’t have any other investments.

I think I’ve rambled on long enough on this subject.  Maybe later I’ll have a few thoughts on some other aspects of my diagram.

Permanent Link to this post: http://richardkinnaird.com/blog/asset-classes-for-portfolio-diversification/

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Sunday, March 6th, 2011 Gold, Stocks 1 Comment

10-, 20- and 30-Year Stock Returns

I found a blog post with three interesting charts.  The first chart shows the 10-year return of owning the S&P 500 stocks and reinvesting dividends.  The second and third charts repeat this for 20-year and 30-year periods.

Over the last ten years, your annualized return would be a loss (-1.86%).  Over the last twenty years, your annualized return would be +6.38%.

This is the link to that blog post.

Permanent Link to this post: http://richardkinnaird.com/blog/10-20-and-30-year-stock-returns/

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Tuesday, November 30th, 2010 Stocks Comments Off on 10-, 20- and 30-Year Stock Returns

Smackdown: Stocks vs. Gold vs. Housing

In a previous post, we examined the performance of single-family Home values relative to Stocks and various Commodities.  What about a direct comparison of the investment performance of Stocks, Gold and Housing?

The chart below examines the performance of these investments over the last twenty years.  The Stocks (S&P 500) graph does not include reinvesting dividends.  The red line plots Stocks (the S&P 500 index).  The pink line plots residential Housing (the Case-Schiller index).  The gold line plots Gold, and the black line plots a “Balanced Portfolio” consisting of one-third each of Stocks, Gold and single-family Housing.  If I had included reinvesting dividends, Stocks would have performed better.
Investment Performance
As you can see, both Stocks and Gold would have increased about 350%.  Housing would have increased about 200%.  The Balanced Portfolio did pretty well (at 300%) and was less volatile.

Here is the same data adjusted for inflation (using the CPI):
Investment Performance Adjusted For Inflation
I chose the last twenty years because this is about as long as many people hold investments before retirement.  These charts assume that you invested a lump sum of money in 1990.  The performance of an investment really does depend upon when you invest your money.  That’s why financial planners recommend that you invest monthly to “dollar cost average” the money you invest.

What if you had a time machine and could go back in time to invest a lump sum of money?  What would you invest in?  Which investment is best depends upon how far back in time you travel.  The chart below shows the best investment depending upon which year you invested your money.
Lump Sum Investment Required in Specific Year
This chart shows how much money you would have had to invest in order to have $100,000 in 2010.  If you only traveled back to 2006, you would have had to invest more than $100K in Housing or Stocks to have $100K today.  You need to travel back in time to a year where the graph dips lower so that less money is required for investment.  The lower a line dips, the better the time to invest.

If you traveled back to 1990, you could have put your money in either Stocks or Gold (a little under $30K ) to grow to $100K in 2010.  The first chart also shows this equivalence.

In 1999, you wouldn’t want to invest in Stocks, because that was a peak in the market and you would need to invest $125K to end up with only $100K.  1997 to 2003 would have been a great time to invest in Gold.

At no time was single-family Housing the best place to invest (the lowest line).  In fact, there were only twelve years that Housing wasn’t the worst place to invest.  Remember, this is a “buy low” chart; it tells you when you can buy lowest.

The Case-Schiller home price index averages twenty large cities.  There are certainly some cities where home prices have performed better.  There are also some stocks that have performed better than the S&P 500 index.

Just because the house you live in has under-performed as an investment, doesn’t mean that all real estate is a bad investment.  Many people have had good success investing in income-producing property such as apartment buildings, office buildings, etc.  Income producing property has a more rational valuation method than does single-family housing.  Just as the value of stocks is roughly based on the earnings of the stock’s company, income-producing property is roughly valued on the annual rent it produces.  There is a “price-to-earnings ratio” for stocks and a “gross rent multiplier” for income property.  Buying income property is a business decision, buying the house you live in is usually an emotional decision.

So what is the bottom line of the previous charts?  I think one conclusion is “You shouldn’t have most of your assets tied up in the house you live in.”  Also worth noting is that for the last nineteen years, Gold has been the best investment.  For ten of those nineteen years, Stocks were the worst place to invest a lump sum.

The Balanced Portfolio is one-third each Stocks, Gold and Housing.  Some financial advisors suggest that you have ten percent of your portfolio in Gold.  Is ten percent enough to diversify a portfolio?

Let’s see how four different diversified portfolios performed over the last twenty years.  The chart below shows our Balanced Portfolio in black.  A portfolio with only ten percent Gold and forty-five percent each Stocks and Housing is shown in gold.  A portfolio with ten percent Stocks and forty-five percent each in Gold and Housing is shown in red.  And a portfolio with ten percent Housing and forty-five percent each in Gold and Stocks is shown in pink.
Four Diversified Portfolios
It’s obvious that the worst performance is the portfolio that only has only ten percent in Stocks, the red line.

The portfolio that is only ten percent Gold performs best until 2008 when both Stocks and Housing are in decline and Gold starts to take off.

The portfolio that is only ten percent Housing performs second best until 2009 when it takes off and is the best performer.

This chart indicates that the most important part of your portfolio is Stocks.  If at least one-third of your portfolio is in Stocks, you would have done OK.  The two portfolios that had forty-five percent in Stocks (gold and pink lines) generally did the best.

So what kinds of stocks are best?  And what about bonds?  Maybe we will discuss those topics in another post.

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Friday, November 19th, 2010 Gold, Real Estate, Stocks 1 Comment

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I am not a registered financial advisor. I only offer opinions, and sometimes these opinions veer off at weird angles from conventional wisdom (That's probably why you are here). My advice is, "Don't take my advice." Read my sidelong glances at economic issues and form your own conclusions.

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