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Fine-tuning a winning ETF portfolio for '05
Thanks in part to dividend-paying stocks, overseas investments and REITs, my portfolio is beating the market. Here's how I'll tweak it for the new year.
By Timothy Middleton
The model portfolio of exchange-traded funds I launched a year ago is finishing 2004 with a gain of 11%, handily beating its benchmark of stocks and bonds, as well as the market itself.
My biggest winners have been dividend-paying domestic stocks; foreign equities -- particularly in the euro zone -- and real estate investment trusts (REITs). Entering the new year, I'm making only minor tweaks to the model, although I'm raising its risk profile modestly because I think 2005 will be kind to stocks and not unkind to bonds.
Some experts agree. "We believe the stock market will post surprisingly positive returns for a third consecutive year," says Brian Belski, market strategist for Piper Jaffray.
Adds Craig Callahan, chief investment officer of Icon Funds, "Our analysis still indicates that the broad market is undervalued by about 12%."
Corporations certainly don't think prices are too high: Mergers and acquisitions is up about 30% this year, Callahan notes, after rising 24% last year.
Here's how the model looks now, and how it'll look after I make adjustments the day this column appears.
| Model ETF portfolio | | Security | YTD perf. (%) | Current allocation (%) | Revised allocation (%) | | Equities | | 67 | 75 | | S&P 500 Spider (SPY, news, msgs) | 9.7 | 25 | 20 | | iShares DJ Sel Dividend (DVY, news, msgs) | 17.7 | 18 | 18 | | iShares MSCI-EMU (EZU, news, msgs) | 18.4 | 8 | 8 | | iShares Russell 2000 (IWM, news, msgs) | 17.5 | 6 | 6 | | Nasdaq 100 (QQQQ, news, msgs) | 9.0 | 6 | 6 | | iShares MSCI EAFE (EFA, news, msgs) | 16.4 | 4 | 7 | | iShares Goldman Sachs Natural Resources (IGE, news, msgs) | 23.5 | 0 | 5 | | iShares MSCI Emerging Markets Index Fund (EEM, news, msgs) | 21.9 | 0 | 5 | | Fixed income | | 22 | 25 | | iShares Lehman US Agg Bd (AGG, news, msgs) | 3.9 | 9 | 20 | | iShares Lehman 1-3 Year Treasury (SHY, news, msgs) | 0.7 | 8 | 0 | | iShares Cohen & Steers (ICF, news, msgs) | 35.1 | 5 | 0 | | Templeton Global Income (GIM, news, msgs) | 5.4 | 0 | 5 | | Cash | | 10 | 0 |
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Notes: Not all figures total, due to rounding. Data as of Dec. 22, 2004. The value of the portfolio on Dec. 23 was $115,998. It began the year with assets of $104,521.
Source: MSN Money
To parse these changes:
I want to put a bit more money to work overseas, both because the economic recovery is global and because I expect the dollar to continue to weaken. Says Richard Hoey, Dreyfus Funds' chief investment strategist, "We believe that there are reasonably good odds of an orderly downtrend in the dollar, at least in the near term."
Looking overseas
So I'm taking some of the portfolio's 10% in cash and boosting my stake in iShares MSCI EAFE Index (EFA, news, msgs). I'm also establishing a 5% stake in iShares MSCI Emerging Markets Index Fund (EEM, news, msgs). This fund went on a tear in the fourth quarter, surging nearly 18% to scurry ahead 21.9% this year.
Related news and commentary on MSN Money
Domestically, I'm cutting the portfolio's allocation to S&P 500 Spider (SPY, news, msgs) to 20% of assets, from 25%, and putting that money into iShares Goldman Sachs Natural Resources Index Fund (IGE, news, msgs). In doing so, I'm contradicting an opinion I offered in October that energy was a better short than a long. I was more right than wrong: Since then, while the market has surged 8%, the Spider Energy Sector (XLE, news, msgs) and iShares Energy Sector Index (IYE, news, msgs) are flat.
But now I'm judging that to have been a refreshing pause, and like Ralph Waldo Emerson, I will not let consistency become a hobgoblin. I'm adding energy because I think oil prices are ratcheting up permanently, in part because China's consumption is increasing.
I'll add a natural resources rather than a pure energy fund, because China is also gobbling up other commodities. The iShares Goldman Sachs Natural Resources fund also offers exposure to gold, a hedge against unforeseen calamities. It has 61% of its assets in oil, 15% in oil services, 13% in metals and mining, 7% in forest products and the balance in gas and basic materials.
The sum of these changes takes equities to 75% of assets, from 67%, and tilts them more heavily abroad. Domestic equities remain 55% of total assets, but foreign equities rise to 20%, from 12%.
Behaving orderly
On the income side, I'm eliminating my duration hedge in very short bonds because the Federal Reserve is managing to cut inflation expectations at the same time it's raising interest rates. Eliminating the short-duration fund increases my exposure to interest rates, but also my expected return. Lower inflation expectations equal lower long-term interest rates.
I'm also eliminating real estate. It was 10% of the model's assets for most of 2004, and performed spectacularly, with iShares Cohen & Steers (ICF, news, msgs) soaring 35.1% this year. But I cut my stake to 5% at the end of the third quarter, viewing the group as overvalued.
It went up instead, gaining 17.9% in the last three months, but that only makes it riskier.
I also think foreign bonds will deliver excellent returns in 2005, so I'm adding a fund to exploit those markets. It is Templeton Global Income (GIM, news, msgs).
This is a closed-end, rather than exchange-traded, fund. I'm employing it only because there are no ETFs covering this marketplace. Closed-ends trade like stocks, as ETFs do, so utilizing them doesn't affect the architecture of the model. But it does alter it from a purely indexed portfolio. The Templeton fund is actively managed.
The sum of these changes is to increase the portfolio's standard deviation, or price volatility, to 15.4% from its current level of about 12%. All of the funds I'm boosting (except the Lehman aggregate) or introducing have higher standard deviations than the ones I'm eliminating or cutting back.
As I wrote in early December, risk is better avoided these days than embraced. The model's standard deviation is now roughly the same as the market, but substantially below that of the market's riskiest categories, such as Nasdaq.
The Nasdaq 100 Index (QQQQ, news, msgs) has a standard deviation of 26.3%.
Toward the top of the pile
Happily, the model is heading toward year end nicely ahead of the S&P 500, with S&P Spiders, a clone of the benchmark, up 9.7%. The Dow Jones Industrial Average has managed to eke out a gain of less than 4%.
But because the model always holds a significant bond weighting, I measure it against Vanguard Balanced Index (VBINX), which is ahead 9.1%.
Looked at another way, the model's performance has been better than that of 96% of mutual funds with the same or lower standard deviation, according to the Morningstar database. Using the higher standard deviation I'm adopting for 2005, it would've beaten 90% of such mutual funds.
The goal in creating the model was to use ETFs to achieve superior performance without the risk of scandal that plagued the mutual fund industry in 2003. So far it's succeeding.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Vanguard Balanced Index.
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