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After tough quarter, ETF portfolio needs a tune-up
Fed action and the dollar's rise combined to give my selection of ETFs a one-two punch, and the first negative quarter so far. Though it could have been worse, it's time to adjust.
By Timothy Middleton
A hawkish Fed and a stronger dollar helped push my portfolio of exchange-traded funds into the red for the quarter, the first negative performance period since I launched the model portfolio 16 months ago.
Rising U.S. interest rates have finally crashed headlong into global securities markets, with the harsh impact aggravated by fears of inflation. When the Federal Reserve announced a "measured" increase in its overnight lending rate from 2.5% to 2.75%, on March 22, it hinted rising consumer prices might force a half-percentage-point hike the next time it meets to set the rate, on May 3.
That result is that nine of the 10 holdings in my model lost money in the quarter. The cumulative decline in the portfolio's value was 1.7% in the quarter, as of March 23, when I closed the books.
That decline was, fortunately, less than the market's swoon of 2.8%, as represented by S&P Depositary Receipts (SPY, news, msgs), the ETF that tracks the S&P 500 Index ($INX). It was also less than the 2.3% slippage of Vanguard Balanced Index Fund (VBINX), a stock-and-bond portfolio I compare the model against.
Many stock investors are feeling the sting of the Fed's vigilance. "The fundamental problem is that (Federal Reserve Chairman Alan) Greenspan has indicated we're going to neutral, and neutral on the Fed funds rate will be close to 4% by year end," notes Jim Swanson, chief investment strategist for MFS Investment Management. "Why would you buy a 10-year Treasury at 4.2%, when a money market fund could get you 4% by year end? The market was not anticipating this."
Nor was I, so my model wasn't defensive enough. It shed $2,052 in principal to finish the period with a value of $113,946. It has thus gained 13.9% since beginning with $100,000 on Nov. 28, 2003. In the same 16 months, Vanguard Balanced Index Fund was ahead 7.9% and the Spider index 12.5%. The model's performance includes trading expenses of $10 per transaction.
The portfolio would have done much worse if I hadn't shifted 5% of its assets into iShares Goldman Sachs Natural Resource (IGE, news, msgs) at the end of last year. It surged 10.3% in the quarter, offsetting many of the other declines.
More about ETFs on MSN Money
Crude oil prices are approaching $60 a barrel, and demand for gasoline typically climbs in the second quarter, so I expect energy stocks to continue to perform well. I'm boosting my position in this fund to 7.5% of assets.
I'm trimming other positions to fund this and other changes I'm making, including raising the portfolio's cash reserve to nearly 20% of assets.
Here's how the portfolio's holdings performed in the first quarter.
| ETF portfolio | | Security | %/assets | YTD | | | | | Equities | | | | S&P Spider (SPY, news, msgs) | 19.6 | - 2.8 | | iShares DJ Select Dividend (DVY, news, msgs) | 18.0 | - 2.8 | | iShares MSCI - EMU (EZU, news, msgs) | 8.5 | - 0.7 | | iShares MSCI - EAFE (EFA, news, msgs) | 7.1 | - 0.6 | | iShares Russell 2000 (IWM, news, msgs) | 5.9 | - 5.6 | | Nasdaq 100 Trust Series I (QQQQ, news, msgs) | 5.4 | - 9.2 | | iShares Goldman Sachs Natural Resources (IGE, news, msgs) | 5.6 | + 10.3 | | iShares MSCI Emerg Mkts Index (EEM, news, msgs) | 5.1 | - 0.8 | | | | | Fixed income | | | | iShares Lehman Agg (AGG, news, msgs) | 19.9 | - 1.0 | | Templeton Global Income (GIM, news, msgs) | 4.5 | - 10.1 |
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Note: As of 3/23/2005.
Source: MSN Money, Morningstar Inc.
My most spectacular failure in the period was Templeton Global Income (GIF), a closed-end bond fund I bought at the end of last year because there are no ETFs indexed to foreign bonds. The U.S. dollar's rally in the first quarter tilted investor demand away from foreign debt. The fund's share price tumbled 10.1%, partly because its discount to net asset value, trivial three months ago, widened to 7.6%.
I can see that situation worsening before May, so I'm taking my losses and selling out this position.
Domestic stocks did far worse than foreign equities in the period, and that hurt because they are my largest concentration, with nearly 55% of assets. So I am cutting my allocation to the S&P Spiders to 10% of assets. Balanced against the increase in the resources fund, the effect is to trim domestic equities to about 47% of assets.
I'm also shrinking iShares Lehman Aggregate Bond (AGG, news, msgs) to 10% of assets, my minimum fixed-income allocation. As Swanson points out, cash yields are heading toward the same level this fund yielded last year.
The effect of all these trades will be to increase cash to 18.1% of assets, from 0.4%, or $512 now, which represents dividends earned in the quarter. Dividends are not automatically reinvested in the model.
Last year the euro zone was the engine that drove the broader MSCI EAFE Index of big-cap foreign stocks, but this year that leadership has headed east. So I'm selling the entire stake in iShares MSCI European Monetary Union (EZU, news, msgs) and investing the proceeds in iShares MSCI EAFE (EFA, news, msgs), which captures all non-U.S. developed markets.
I'm also adding a bit of the cash I'm raising to boost this position to 20% of assets. Japan and Europe are growing more slowly than the United States, but successful companies abroad are only beginning to introduce the kind of productivity improvements that drove the domestic market higher in the 1990s.
I'm going to hold my position in iShares MSCI Emerging Market Index (EEM, news, msgs). (In our database, this security is mislabeled Emerging Markets Income. We are working with our data supplier to correct the error.)
I continually monitor other investment classes, notably real estate, which contributed significantly to the portfolio's outperformance last year. I eliminated it this year expecting a correction, and it has come. IShares Cohen & Steers Realty Majors (ICF, news, msgs) was down 8.1% in the first period.
Now real estate investment trusts, which the Cohen & Steers fund owns, are priced much closer to fair value. I'm concerned, however, that rising interest rates will continue to spook real estate investors, so I'm not restoring this fund to the portfolio yet.
(Returns of these benchmarks do not include any transaction charges. The model does recognize them, however, because an investor would.)
Here's how the portfolio looked in the first quarter, and how it will be rejiggered for the second.
| Revamped ETF portfolio | | Security | First Quarter | | Second Quarter | | | #/shares | %/assets | #/shares | %/assets | | Equities | | 75.2 | | 71.6 | | S&P Spider (SPY, news, msgs) | 191 | 19.6 | 97 | 10.0 | | iShares DJ Select Dividend (DVY, news, msgs) | 344 | 18.0 | 344 | 18.0 | | iShares MSCI - EMU (EZU, news, msgs) | 134 | 8.5 | 0 | 0 | | iShares MSCI - EAFE (EFA, news, msgs) | 51 | 7.1 | 143 | 20.0 | | iShares Russell 2000 (IWM, news, msgs) | 55 | 5.9 | 55 | 5.9 | | Nasdaq 100 Trust Series I (QQQQ, news, msgs) | 170 | 5.4 | 170 | 5.4 | | iShares Goldman Sachs Natural Resources (IGE, news, msgs) | 44 | 5.6 | 59 | 7.5 | | iShares MSCI Emerg Mkts Index (EEM, news, msgs) | 29 | 5.1 | 29 | 5.1 | | | | | | | Fixed income | | 24.8 | | 28.1 | | iShares Lehman Agg (AGG, news, msgs) | 225 | 19.9 | 113 | 10.0 | | Templeton Global Income (GIM, news, msgs) | 591 | 4.5 | 0 | 0 | | Cash | $512 | 0.4 | $20,654 | 18.1 |
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Note: As of March 23 market close. Columns may not total, due to rounding.
Source: MSN Money
This portfolio was created in the wake of the mutual-fund scandals over market timing and late trading. Exchange-traded funds are used because they are much less vulnerable to such abuse.
My personal portfolio is very similar to this one in its weightings, but I invest largely in mutual funds rather than ETFs.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Vanguard Balanced Index Fund.
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