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Defend your portfolio with ETFs
I think the economy may weaken, and the political situation looks tricky at best. So, Im adjusting my exchange-traded fund portfolio to keep myself safe.
By Timothy Middleton
New Fed Chairman Ben Bernanke can be just as difficult to understand as his predecessor, Alan Greenspan. A recession could be coming, he said in a speech last week, or then again, maybe not. Therefore, the Federal Reserve will stop raising interest rates, or maybe it wont.
Left to guess, I am betting on a weaker, rather than a stronger, economy. For this and other reasons, I am going to tilt my model portfolio of exchange-traded funds just a bit more toward defensiveness in the second quarter.
I began becoming more cautious at the end of last years fourth quarter, and that paid off, as my model gained 5.8% in the three months ended March 22. The domestic stock market eked out only a 3.3% advance in the same period, as represented by S&P Depositary Receipts (SPY, news, msgs), the ETF that mirrors the S&P 500 index.
The Morningstar moderate-asset-allocation category, the mutual fund type most similar in design to my model portfolio, gained only an average of 2.9% in the first period. Since the portfolio was launched in November 2003, it has delivered a total return of 33.1%, which is a 13% annual rate. The moderate allocation group has advanced 22%, an annual rate of 8.9%.
Related news and commentary on MSN Money
A missed opportunity
I could have done better still had I not made my usual assortment of errors. Three months ago, I cut back on the small-capitalization stocks represented by iShares Russell 2000 Index (IWM, news, msgs), and it shot up 9.1% in the first quarter, far more than any other domestic stock holding.
I placed a bet on the Japanese market with iShares MSCI Japan Index (EWJ, news, msgs), and while it edged out the S&P 500 with a gain of 4.4%, it badly lagged the 10.3% advance of iShares MSCI EAFE Index (EFA, news, msgs), the broad measure of foreign stocks. (MSCI EAFE stands for Morgan Stanley Capital International Europe, Australia, Far East.)
My overarching theme -- that foreign equities will outperform domestic ones -- was primarily responsible for my success, as all foreign-stock categories beat their domestic equivalents, paced by the 12% advance in the first quarter of iShares MSCI Emerging Markets Index (EEM, news, msgs).
Also, my decision to hold nearly half of my income-oriented investments as cash was a winner, as that asset classs 1% return in the first quarter was much better than either of my bond holdings, which were flat.
My next step is going to be to raise some more cash by cutting diversified domestic stocks to their minimum level of 30% of total assets. I see a lot of risks ahead, and the possibility of recession is only one.
The White House is weakened, increasing the odds of higher taxes at home and greater mischief overseas in places like Iran. Nativism is rising, as evidenced by welshing on the Dubai Ports deal. Thats an ill omen for trade, which is the lynchpin of our economic growth, as well as everybody elses.
Heres how the portfolio finished the first quarter and how it will enter the second:
| Middletons ETF portfolio, first quarter 2006 | | Exchange-traded fund | 1st quarter return | Share of holdings, quarter start | Share of holdings, quarter end | | Equities | | 71.7% | 67.3% | | iShares Goldman Sachs Natural Resources (IGE, news, msgs) | 3.2% | 10.6% | 10.6% | | iShares MSCI EAFE Index (EFA, news, msgs) | 10.3% | 15.3% | 15.3% | | iShares Russell 2000 Index (IWM, news, msgs) | 9.1% | 13% | 10.5% | | Nasdaq-100 Trust (QQQQ, news, msgs) | -0.5% | 11.9% | 10% | | S&P Depositary Receipts (SPY, news, msgs) | 3.3% | 9.5% | 9.5% | | iShares MSCI Emerging Markets Index (EEM, news, msgs) | 12% | 6.4% | 6.4% | | iShares MSCI Japan Index (EWJ, news, msgs) | 4.4% | 5% | 5% | | Fixed income | | 28.1% | 32.7% | | iShares Lehman Aggregate Bond Fund (AGG, news, msgs) | -0.2% | 4.7% | 4.7% | | iShares Cohen & Steers Realty Majors Index Fund (ICF, news, msgs) | 13.7% | 6.3% | 6.3% | | Sallie Mae CPI-Linked Notes (OSM, news, msgs) | 0.12% | 4.7% | 4.7% | | Cash | 1% | $15,638* | $22,670** | | Totals | N/A | $125,748 | $133,097 |
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Notes: Data as of 03/22/2006. Totals do not add up due to rounding.
*Cash was 12.4% of my holdings at the quarters start.
**Cash was 17% at the quarters end.
Sources: MSN Money, Morningstar
Taking these groups in the order in which they appear on this table:
Natural resources: Energy, which accounts for more than 80% of the Goldman Sachs Natural Resources Index, has taken a breather as last years hurricane disasters were followed by an unusually mild winter. Long term, though, I think this group will outperform the market, so Im sticking with it.
Foreign stocks: My overweighting of this group grows out of my conviction the dollar will weaken, giving me currency profits, while at the same time other developed nations are earlier in the economic cycle than we are, with more room for profits to grow.
Small-cap domestic stocks: As I argued in my March 14 column The best bonds to buy right now, the market is punishing risk these days, and small stocks are riskier than large ones. This group defied me in the first quarter. But if the economy weakens, it will suffer.
Nasdaq stocks: These are risky, too, and they actually declined marginally in the first period. I am trimming them for the second time in as many calendar quarters to bring the sum of small-cap, Nasdaq and large-cap domestic stocks to 30%.
S&P 500: The underperformance of this group relative to my other holdings has taken it down to 9.5% of total assets. I consider 10% to be a minimal holding of these stocks, but 0.5% of my portfolio is only $665, and the commission paid to buy such a tiny amount of this ETF, $10, is out of proportion to any possible benefit.
Emerging markets: Arguably the riskiest assets in the equity universe, stocks of companies in developing markets have been surging upwards for three years. But I expect theres still plenty of room for countries like China and India, especially, to contribute big gains at least until a global recession looms, which is not the case right now.
Japan: I have established a terrible record of making regional bets over the past two-plus years, and I probably ought to sell this Japan fund and put the money into the EAFE index, of which Japan is only one part, albeit the largest part. But I persist in believing Japan is only now beginning to deliver the kind of earnings growth that can fuel a big market rally, so Im sticking with it.
On the income side of the portfolio
Bonds: The Lehman Brothers US Aggregate Bond Index was little changed in the first quarter, and Im not expecting much out of it in the second. But the moment the market decides the Fed has stopped raising interest rates, this index -- and fund -- could pop. So, Im hanging around.
Real estate: iShares Cohen & Steers Realty Majors Index Fund (ICF, news, msgs) invests in real-estate investment trusts, which are stock-like, but I consider this fund strictly an income investment. It pays a quarterly dividend currently equal to a 3.8% annual yield. This funds sizzling performance -- up an average of more than 30% a year in each of the last three, according to Morningstar -- cant be sustained much longer, but my allocation is modest and a correction wouldnt hurt badly.
Inflation-protected notes: This investment was barely positive in the first quarter, but I own it strictly as a hedge against inflation. Im not particularly worried about inflation at the moment, but I could be wrong. The hedge seems prudent.
Cash: Like financial-management software in general, ours at MSN Money doesnt treat cash as an investment, but it is. My assumption of a 1% return on my cash horde in the first quarter is based on widely available annual rates at online banks and brokerages of more than 4% on money market accounts.
Considering that cash is completely safe, the fact that it is also outperforming bonds makes it irresistible. I am raising my allocation to 17%, from little more than 12%.
This is the most cash this portfolio has ever held. But since the Fed is continuing to raise interest rates, cash is becoming more and more valuable month by month. I am also raising cash in my personal portfolio. I regard it as the most attractive investment in the marketplace at the moment.
Also, I am instituting stop-loss orders on all my ETFs at 15% below their prices on March 22, when I closed the books on the first quarter. Since I cant change the portfolio more often than once every three months, I need some protection in case something truly dreadful, such as a dirty-bomb terrorist attack, occurs in the interim.
One of the advantages ETFs have over mutual funds is that their stock-like characteristics make it possible to attach stop-loss orders to them.
Off-year elections are coming this fall, and as they approach, I expect the air to become particularly foul -- and markets correspondingly jittery. So between now and then, Im apt to become ever more cautious.
Americans dont expect much from our politicians, and we mostly get what we expect.
At the time of publication Timothy Middleton didnt own any securities mentioned in this article.
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