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| | Mutual Funds
ETF portfolio still trouncing market
With most of the damage done to bonds, it's time to take off an interest-rate hedge. Keep an eye on small-cap and technology stocks.
By Timothy Middleton
The second quarter was turbulent but ultimately allowed stocks and some fixed-income investments to rise, albeit moderately.
The economic recovery is building strength and spreading to other markets; most foreign bourses have performed on a par with the United States in recent months. In the case of the model investment portfolio I first recommended in November and updated at the end of the first period, that means Im making only a single change at midyear.
The change will remove the interest-rate hedge I put on my fixed-income portfolio from the outset. As I wrote recently, I think most of the damage to bonds at this point in the economic cycle has already been done. Bond investors can be a touch less cautious than they were.
I'm not making any changes in my mix of equity funds, but I'm watching with great interest developments in two areas I have underweighted, small-cap and technology stocks. Both enjoyed sizable rallies in the second quarter. Three months from now, when next I tinker with this portfolio, I may cut back my large-cap or foreign weighting to boost one or both of these areas.
Running the numbers
In the first six months of the year, as of June 22, my model delivered total returns of 1.9%, beating the 1.5% return of its benchmark, the Vanguard Balanced Index Fund (VBINX). Since inception last November, the portfolio has returned 6.2%, half again as much as the benchmarks 4% gain.
This portfolio consists of exchange-traded index funds, designed for an investor with a moderate appetite for risk. It usually holds at least a quarter of assets in fixed-income securities, which is the current weighting. At least a third of its assets are allocated to equities; the present mix is relatively aggressive because my outlook for equities is positive.
Heres how the portfolio looks now:
| Model ETF portfolio at quarter's end | | ETF | Value | % of portfolio | | Equities | | 76% | | Spiders (SPY, news, msgs) | $27,731 | 26% | | iShares DJ Select Dividend (DVY, news, msgs) | $19,020 | 18% | | iShares MSCI Japan (EWJ, news, msgs) | $8,944 | 8% | | iShares MSCI EMU (EZU, news, msgs) | $8,221 | 8% | | iShares Russel 2000 (IWM, news, msgs) | $6,235 | 6% | | Nasdaq 100 (QQQ, news, msgs) | $6,191 | 6% | | iShares MSCI EAFA (EFA, news, msgs) | $4,514 | 4% | | Fixed income | | 24% | | iShares Lehman Aggregate Bond (AGG, news, msgs) | $9,799 | 9% | | iShares Cohen & Steers Realty (ICF, news, msgs) | $9,534 | 9% | | iShares 1-3 Treasury Bond (SHY, news, msgs) | $5,864 | 6% | | Cash | $183 | 0% | | | | | Total | $106,235 | 100% |
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11/25/2003 to 6/21/2004. Columns may not total due to rounding. Portfolio began with a value of $100,000.
Source: MSN Money Portfolio Manager
Domestic equities: Roughly 25% of my core portfolio is devoted to large-capitalization stocks, represented by Spiders (SPY, news, msgs), the S&P 500 index. This year I have supplemented that with a roughly 18% commitment to other large caps. My small-cap, represented by the iShares Russell 2000 (IWM, news, msgs), and technology allocations, represent by the Nasdaq 100 Index Tracking Stock (QQQ, news, msgs), are only a combined 12%, my minimum for each category, because the current market favors big stocks.
So far, this allocation is largely paying off. This year, the Spiders ETF has advanced 2.6%, while iShares Dow Jones Select Dividend Index Fund (DVY, news, msgs) has gone up 3.4%. Small caps and technology did miserably until very recently.
Their recent surge has caught my eye, but not fully convinced me its time to increase their weight in the mix. Ill postpone any possible changes along those lines until three months from now.
Looking overseas
Foreign equities: My core foreign position is iShares MSCI EAFE (EFA, news, msgs), the MSCI foreign stock benchmark, which has advanced 2.8% this year, roughly on a par with domestic stocks. I have also taken, and continue to hold, positions in Japan through iShares MSCI Japan (EWJ, news, msgs) and Europe through iShares MSCI EMU (EZU, news, msgs).
Although these funds have lagged iShares MSCI EAFE at various points in the last six months, they behaved very nicely in the second quarter, with the Japan ETF up 3.1% and the European ETF ahead 4.3%. So Ill continue to stick with the mix of three funds, but events in coming months could draw me toward more emerging markets exposure, which iShares MSCI EAFE has.
(There is also an emerging markets exchange-traded fund, iShares MSCI Emerging Markets (EEM, news, msgs). It has had a terrible year, down 5.7%, but Ill be watching it.)
Taking off the hedge
Fixed income: The sole change Im making to the model is to sell iShares 1-3 Treasury Bond Fund (SHY, news, msgs). I purchased it originally to reduce the duration, or interest-rate risk, of my core position in iShares Lehman Aggregate Bond (AGG, news, msgs). That strategy worked: iShares Lehman Aggregate has declined 0.9% since the portfolio's inception, whereas iShares 1-3 Treasury is up 0.5%.
Now, however, I think the worst of the carnage is over at this stage of recovery. So Im willing to extend the portfolios duration, which I will do with iShares Trust TIPS (TIP, news, msgs). These Treasury bonds are also inflation-protected, and this fund is up 0.6% this year.
Meanwhile, Im leaving in place my allocation of iShares Cohen & Steers Realty Majors (ICF, news, msgs), a real estate fund. It took a beating in the second quarter, falling 5.8%, but remains solidly ahead 4.6% this year and 8.9% since the portfolios inception.
Here is how the portfolio will look after the changes are made:
| Revised model ETF portfolio | | ETF | Value | % of portfolio | | Equities | | 76% | | Spiders (SPY, news, msgs) | $27,731 | 26% | | iShares DJ Select Dividend (DVY, news, msgs) | $19,020 | 18% | | iShares MSCI Japan (EWJ, news, msgs) | $8,944 | 8% | | iShares MSCI EMU (EZU, news, msgs) | $8,221 | 8% | | iShares Russel 2000 (IWM, news, msgs) | $6,235 | 6% | | Nasdaq 100 (QQQ, news, msgs) | $6,191 | 6% | | iShares MSCI EAFA (EFA, news, msgs) | $4,514 | 4% | | Fixed income | | 24% | | iShares Lehman Aggregate Bond (AGG, news, msgs) | $9,799 | 9% | | iShares Cohen & Steers Realty (ICF, news, msgs) | $9,534 | 9% | | iShares Trust TIPS (TIP, news, msgs) | $6,047 | 6% | | Cash | $0.00 | 0% | | | | | Total | $106,235 | 100% |
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In the seventh months since the portfolio was created, the outperformance of equities has tilted my original 75/25 split between the asset classes to 76/24. When that gets closer to 80/20, Ill rebalance by selling equity funds and buying the iShares Lehman Aggregate Bond Fund.
(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 owned the following securities mentioned in this article: iShares MSCI Japan (EWJ).
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