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Time to change a market-beating portfolio
I'm more cautious in today's politically volatile environment, so raising some cash makes sense. I might miss a big rally, but I prefer to protect my healthy gains.
By Timothy Middleton
Im in the nail-biting mode.
The model portfolio of exchange-traded funds that I introduced nearly a year ago enjoyed a decent third quarter, sneaking up 3.4% and continuing to beat both its index and the stock market.
The portfolio has benefited from being fully invested and strongly tilted toward equities, with 75% of my imaginary assets there. Now Im worried. The presidential election is too close to call. Im raising some cash and growing cautious.
Specifically, Im cutting my most successful position in half and eliminating two others, in the process boosting my cash reserve, currently nil, to 10% of assets. Im willing to risk some underperformance. Market corrections can be horrible things, and any upset to the precarious political balance now could ignite one.
The net effect of my changes will be to draw down equities by nearly 8%, to 67% of total assets, reducing the fixed-income component to 23%, and establishing the cash reserve. I want to hedge the gains Ive already accumulated, which have taken the portfolio up 5.1% this year, and 9.8% since it was launched.
By the numbers
Heres how the portfolio looked after the close of trading Oct. 6, when I ran all these numbers:
| Model ETF portfolio | | ETF | Value | % of portfolio | | Equities | | 75% | | S&P 500 Spider (SPY, news, msgs) | $27,967 | 26% | | iShares DJ Select Dividend (DVY, news, msgs) | $20,234 | 18% | | iShares MSCI Japan (EWJ, news, msgs) | $8,667 | 8% | | iShares MSCI EMU (EZU, news, msgs) | $8,576 | 8% | | iShares Russell 2000 (IWM, news, msgs) | $6,492 | 6% | | Nasdaq 100 (QQQ, news, msgs) | $6,231 | 6% | | iShares MSCI EAFA (EFA, news, msgs) | $4,622 | 4% | | Fixed income | | 25% | | iShares Lehman Aggregate Bond (AGG, news, msgs) | $9,996 | 9% | | iShares Cohen & Steers Realty (ICF, news, msgs) | $10,614 | 10% | | iShares Trust TIPS (TIP, news, msgs) | $6,183 | 6% | | Cash | $228 | 0% | | Total | $109,810 | 100% |
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Note: Numbers are rounded.
Source: MSN Money Portfolio Manager
Heres how these securities have been faring:
| How my ETF picks have performed | | Security | 3 mos. | YTD | Security | 3 mos. | YTD | | S&P 500 Spider (SPY, news, msgs) | 2.86 | 4.17 | Nasdaq 100 (QQQ, news, msgs) | 1.72 | 0.53 | | iShares DJ Select Dividend (DVY, news, msgs) | 7.73 | 11.75 | iShares MSCI EAFA (EFA, news, msgs) | 3.43 | 5.6 | | iShares MSCI Japan (EWJ, news, msgs) | -0.1 | 3.94 | iShares Lehman Aggregate Bond (AGG, news, msgs) | 1.71 | 2.17 | | iShares MSCI EMU (EZU, news, msgs) | 3.56 | 4.49 | iShares Cohen & Steers Realty (ICF, news, msgs) | 10.37 | 19.03 | | iShares Russell 2000 (IWM, news, msgs) | 3.67 | 7.25 | iShares Trust TIPS (TIP, news, msgs) | 1.33 | 4.44 |
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Note: As of 10/06/2004
Source: Morningstar
I created this portfolio using exchange-traded funds rather than mutual funds because they're more economical. The total expense ratio of my portfolio, including assumed transaction costs of $20 on each trade, is 28 basis points (0.28%). A similar portfolio of mutual funds could cost at least twice as much.
I also use ETFs because they're pure index vehicles, eliminating manager -- and management -- risk. I dont need to worry that the person at the helm will be hit by a bus, nor that the management company will cut secret deals with favored investors at my expense, as happened in the mutual fund scandals.
ETFs also are traded like stocks, on an exchange throughout the day, so I dont need to worry about redemption fees or rules against frequent trading, which most mutual funds impose. Of course, my trading isnt exactly frantic; usually one or two roundtrips every three months.
A moderate risk appetite
The portfolio is designed for a person with a moderate appetite for risk, and Im quite content with its basic direction. It's heavily overweight conservative, dividend-paying domestic stocks, as represented by iShares Dow Jones Select Dividend, and foreign stocks, and both have outperformed the S&P 500.
iShares Cohen & Steers Realty Majors has been particularly successful, up more than 10% in the third quarter and nearly 20% overall. I consider real estate investment trusts to be income vehicles and so include this fund among my bond holdings.
These high-yielding trusts add plenty of juice to income, but they're also volatile. This fund plunged 14.9% in April, which was the worst month for property stocks in more than two decades. Since then, REITs have gotten relatively expensive, trading at an average of 13 times cash flow, up from their historical average of 11.5 times.
To ice this cake, Cohen & Steers, the funds manager and the foremost REIT investor, went public in August, and its shares have since surged 23%, to $16. By selling equity to the public, these savvy managers signaled to me a peak in their market. So Im cutting my stake in this fund by half, to 5% of assets.
I'm also eliminating the portfolios stake in iShares MSCI Japan. The table above doesnt show the real damage this fund has done to my results. It's down 7.5% since I added it at the end of the first quarter. I'm increasingly less inclined to make regional bets.
Backing off bonds
Also, Im selling iShares TIP Bond Fund. I added it at the end of the second quarter to extend the portfolios duration, or interest rate risk, as I explained at the time. Now I think the bond rally has gotten a bit ahead of itself, so I want to reduce duration.
My cash proceeds from these sales will be about $20,100. To them, Ill add the $228 I have built up in dividends over the last three months, which will be more than enough to pay trading costs for my transactions.
I'll allocate $11,000 to my cash reserve. The balance I will use to buy iShares Lehman 1-3 Year Treasury. This is the fund I swapped out of to buy iShares TIP Bond Fund three months ago, and Im glad I did. Since then, it has advanced only 0.36%, compared with iShares TIP Bond Fund's gain of 1.33%. But iShares Lehman 1-3 Year Treasury has a duration of 1.6 years, compared with 5.1 for iShares TIP Bond Fund.
Just as I saw bonds being oversold three months ago, theyre overbought now. The yield on the 10-year Treasury, 4.25%, is about where it was when the Federal Reserve began hiking interest rates earlier this year. That 10-year rate is likely to lurch up in coming months, reducing bond prices commensurately.
My core bond holding, iShares Lehman Aggregate Bond, has a duration of 4.6 years, meaning its principal value would decline 4.6% if interest rates were to rise one percentage point. By combining it with iShares Lehman 1-3 Year, I cut my overall duration to about three years, thus reducing interest-rate risk by one-third.
Another risk factor
By taking these steps, I introduce yet another risk, however -- the risk that my brief career as a market-beater will come to an end. The model portfolio is benchmarked to Vanguard Balanced Index Fund (VBINX), and beat that measure by 74 basis points in the last three months, or 28%, and by 103 basis points, or 26%, so far this year.
The portfolio beat the S&P 500 Spider by 51 basis points, or 18%, in the quarter, and 89 points (21%) for the year to date.
I'll squander that lead if some really good news arrives on the scene in the next couple of months and prompts a market rally. Stocks have been sidewinding so long that any move up could be explosive. My opportunity cost will be measured by how well iShares Russell 2000 and Nasdaq 100 perform in the fourth quarter. If I were bolder, I'd split the cash between them.
But if the news is bad, my cash cushion will lessen the pain. And this political year is a real pain.
If youre keeping track of this portfolio, it began on Nov. 25, 2003, with $100,000. The value at the end of 2003 was $104,521. The value at the end of the second quarter was $106,235.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Vanguard Balanced Index, iShares MSCI Japan Index.
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