By Tim Middleton
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Mutual Funds
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An ETF strategy that's beating the market
Exposure to bonds, overseas markets and real estate kept my model portfolio in the black even as stocks turned sour. Still, it's time to make a couple of adjustments.
By Timothy Middleton
As miserable as the first quarter was, diversified investors finished ahead. Moreover, its likely that regardless whether stocks recover from their malaise, spreading your money around will continue to drive positive total returns in the uncertain months to come.
While the Dow Jones Industrial Average ($INDU) has sagged 0.8% as of March 29, plenty of other asset classes have more than compensated. Foreign stocks were solidly positive, as were bonds and real estate.
The model portfolio of exchange-traded funds that I introduced in November finished the first quarter ahead 1.7%. It would have done better still if I hadnt blundered in the selection of the wrong security to stand in for dividend-paying stocks. Its a mistake Ill correct this month.
The models performance was almost entirely due to its 25% weighting in fixed-income securities. Bonds rallied in the quarter as terrorism concerns caused people to turn to safe investments.
The model also was launched just in time to catch results from December, a month in which stocks did extremely well, aside from the Nasdaq 100 Index Tracking Stock (QQQ, news, msgs), which was already beginning a swoon that has taken it down 1.7% by March 29.
Im using that four-month period as a guide to make portfolio changes now. There are only two, because I believe the first-quarter turbulence will prove fleeting as the domestic and global economies improve. The first is to correct my mistake on dividends, and the second is to further diversify the portfolios foreign-stock holdings.
An international shift
As I opined when I set up the portfolio, I was more willing to invest in Europe than in Japan, both because its interest rates had more room to come down and because its politics were more stable.
Since then, Ive decided Japans central bank is taking steps that can sustain higher equity prices, although I dont expect them to repeat the stunning 38% gain returned last year by the average Japan mutual fund.
Yes, weve had a fantastic rally, but the valuations are still very good, says Curtis Freeze, manager of Japan Smaller Companies Fund (JSCFX). The Nikkei Index reached a 25-year low at the 8,000 level one year ago, and while it has rebounded to 11,500, it remains far below the 20,000 level, where it stood only four years ago.
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My model portfolio consists of exchanged-traded index funds because they're pure asset-allocation portfolios (and they also happen to be more immune to most of the hanky panky disclosed in recent mutual fund scandals). My allocation is 75% stocks and 25% fixed income, and that will remain unchanged over the next three months, which is how often I make adjustments. Domestic equities are 55% of the total and foreign stocks 20%.
Finding dividend yields
In November, I allocated 18% of the portfolio to Diamonds Trust (DIA, news, msgs), using the Dow Jones Industrials tracking index as a proxy for dividend-paying stocks. I believed then, and still do, that dividend-paying stocks are well suited to the current market, where large established companies are doing better than smaller, more problematic firms.
But the Dow is yielding 1.4%, about the same as the S&P 500 ($INX). A better dividend play among exchange-traded funds is iShares Dow Jones Select Dividend Index (DVY, news, msgs), which is yielding north of 2%. Its top holdings, Altria Group (MO, news, msgs), Honeywell International (HON, news, msgs) and PNC Financial Services (PNC, news, msgs), yield 5%, 2.3% and 3.6%, respectively, compared with 1.9% at Diamonds' Procter & Gamble (PG, news, msgs), 1.6% at United Technologies (UTX, news, msgs) and 0.7% at IBM (IBM, news, msgs).
Since Nov. 25, when the portfolio was launched, Select Dividend has advanced more than 7%, compared with the 6.5% gain of the Diamonds. (I didnt consider Select Dividend in November because it had been launched only a few weeks earlier, and I wasnt aware of it.)
So with today's close, Ill swap the portfolios holding of Diamonds for Select Dividend. Ill add to that purchase the $911 in dividends the portfolio has earned since its launch.
Betting on Japan
At the same time, Ill sell one-half of the portfolios holdings of iShares MSCI-EMU (EZU, news, msgs), which tracks European stocks, and buy a corresponding amount of iShares MSCI-Japan (EWJ, news, msgs).
Despite last years run-up, the Nikkei is actually a little cheaper than the S&P 500, which is a first in my career, says Mark Headley, manager of Matthews Japan Fund (MJFOX). Typical price-to-earnings ratios are 15 or 20, he says, although the economic outlook is better than it has been in more than a decade.
Corporate restructuring, which Japans hidebound Ministry of Finance has resisted, is beginning to occur, Headley says. Bank of Japan appears to have won a bureaucratic fight with the ministry and also is flooding capital markets with liquidity to combat deflation.
If this current trend remains intact, you have the worlds second-largest market looking like it could get back on its feet, Headley says.
BOJ also has been buying dollars to defend the yen -- nearly $100 billion in the year's first two months, half the total it spent last year -- and as deflation is conquered, that spending could abate, allowing the greenback to depreciate and giving U.S. investors a currency-translation bonus.
Fixed-income strategy will remain intact
Japan is the worlds largest purchaser of U.S. Treasury bonds, and, to the degree it cuts back its buying, those bonds will fall. So in the portfolios fixed-income element, I am not adjusting the interest-rate hedge I installed in November, a 6% commitment to very short bonds to reduce the duration of the core 10% holding in the iShares Lehman Aggregate Bond Fund (AGG, news, msgs).
Im also not altering my allocation on the fixed-income side to a real estate fund, which began the period with 9% of assets and finishes with nearly 10%, due to its outperformance. With high-quality bonds yielding 5% or less, income investors need all the extra performance they can find and still feel comfortable with.
So the portfolio stands this way:
| Model ETF portfolio | | Equity | Value ($) | % change | % of portfolio | | Spiders (SPY, news, msgs) | 27,467 | 6.7 | 25.8 | | Diamonds Trust (DIA, news, msgs) | 18,942 | 6.5 | 17.8 | | iShares MSCI-EMU (EZU, news, msgs) | 16,096 | 8.9 | 15.1 | | iShares Lehman Aggregate Bond (AGG, news, msgs) | 10,175 | 2.3 | 9.5 | | iShares Cohen & Steers Realty Majors (ICF, news, msgs) | 10,095 | 12.5 | 9.5 | | iShares Russell 2000 (IWM, news, msgs) | 6,387 | 7.2 | 6.0 | | iShares Lehman 1-3 Year Treasury (SHY, news, msgs) | 5,970 | 1.1 | 5.6 | | Nasdaq 100 Tracking Stock (QQQ, news, msgs) | 6,093 | 1.9 | 5.7 | | iShares MSCI EAFE (EFA, news, msgs) | 4,489 | 12.1 | 4.2 | | Cash | 911 | | 0.8 | | Total | 106,626 | 6.7 | 100 | | Vanguard Balanced Index (VBINX, news, msgs) | NA | 3.2 | NA |
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Note: 11/25/2003-03/29/2004. Dividends not reinvested.
Source: MSN Money Portfolio Manager
The 6.7% total return since inception handily beats most market benchmarks with significantly less risk. Most investors look at stocks as red meat and bonds as creamed spinach, forgetting how well they go together.
(Returns of the model portfolio include transactions costs, which are fixed at $20 per ETF trade. The portfolio was begun with $100,000, of which $180 was spent establishing the initial positions. Dividends aren't reinvested. The portfolios blended annual expense ratio is 0.28%. It's designed for a tax-sheltered account, such as an IRA or 401(k), and current taxes aren't taken into account.)
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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