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"All About Market Timing"
by Leslie Masonson
Mutual Funds
Recent articles:
• Build a portfolio that repels fraud, 11/18/2003
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| | Mutual Funds
A nimble, cheap and safe ETF portfolio
They're easier to trade than mutual funds, less risky than stocks, and more impervious to fraud than either, making them perfect for the flexible portion of your portfolio.
By Timothy Middleton
It's easy to see why the allure of exchange-traded funds is growing these days.
More scandal rained down on mutual funds in the past week, with a second official at Strong Funds accused of improper trading, the House passing a sweeping measure to regulate the industry more tightly and Massachusetts regulators issuing subpoenas to five fund families operating there, citing issues that at least need to be examined.
Central to the scandal has been a practice usually described as market timing. Actually, as hordes of legitimate market timers have reminded me in e-mails, it should be called rapid trading, because it isn't an investment strategy so much as a 24-hour fraud.
Market timing is a legitimate investment approach, the words describing a host of strategies. Leslie Masonson explains five of them in a new book, "All About Market Timing" (McGraw-Hill, 2003).
My philosophy to time the market is to use equities only, and to be in and out at the appropriate time, he says. The election-cycle strategy, for instance, is based on owning stocks in the years before and during a presidential election, and being 100% in cash the two years in between.
My personal notion of market timing is much different. It's more akin to traditional sector rotation, aiming to avoid groups headed for a fall in favor of those with brighter prospects. I recommend using the approach in what I call the flexible, as opposed to core, portion of ones portfolio.
Why ETFs are a good bet
I described my core strategy last week. It addressed the 40% of assets you almost never trade. The other 60% is the flexible portion, and these securities can be traded as often as you wish.
Mutual funds can be used in both the core and flexible portions, but exchange-traded funds are particularly suited to the flexible slots. They have lower costs than mutual funds and can be bought and sold whenever you want at their then-current value. In contrast, mutual funds are priced just once a day, and many funds impose an extra fee on shares redeemed within 90 days.
Perhaps most important these days, exchange-traded funds have natural immunity to the scandals sweeping through mutual funds. Thats not to say criminals wont find a way to abuse them, but they dont lend themselves to the varieties of abuse currently on display.
There are more than 100 exchange-traded funds, all of them indexed to some published measure, from the S&P 500 ($INX) to biotechnology stocks. One of their many appeals is that you can use them to implement strategies that would be clumsy with mutual funds.
Putting ETFs to work for you
For example, an investment newsletter named Fidelity Monitor, published in Rocklin, Calif., recommends a sector-allocation strategy that surged 34.7% in the year's first 10 months, compared with the S&Ps 21.2% advance.
It uses Fidelity Select funds, which means either you must be a Fidelity customer or be willing to pay transaction fees at other brokers. Exchange-traded funds, however, can be traded in any brokerage account, including those inside many 401(k) plans.
Here is how I would substitute ETFs for the newsletters current recommendations.
| Equity sector portfolio allocation | | Fidelity Select fund | % of portfolio | ETF equivalent | | Energy (FSENX) | 12% | Oil Services Holders (OIH, news, msgs) | | Developing Communications (FSDCX) | 21% | iShares Dow Jones U.S. Telecommunications (IYZ, news, msgs) | | Biotechnology (FBIOX) | 18% | iShares Nasdaq Biotechnology (IBB, news, msgs) | | Software & Computers (FSCSX) | 18% | iShares Goldman Sachs Software (IGV, news, msgs) | | Technology (FSPTX) | 16% | iShares Goldman Sachs Technology (IGM, news, msgs) | | Computers (FDCPX) | 15% | SPDR Technology (XLK, news, msgs) |
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Sources: Fidelity Monitor, MSN Money
In this example, iShares Goldman Sachs Technology Index Fund (IGM, news, msgs) substitutes for Fidelity Select Technology (FSPTX) because their holdings are similar, and SPDR Technology (XLK, news, msgs) subs for Fidelity Select Computers (FDCPX) because the Spider is top-heavy with computer names.
Fidelity Monitor uses a proprietary quantitative methodology to choose funds it holds for an average of one to two years. But any sector allocation strategy can employ ETFs.
Flexible investing strategies
My strategy for flexible investing is to over- and underweight asset categories. For example, I am bearish on bonds because of the inevitability of higher interest rates. I think the recent outperformance of small-cap stocks is going to end and dividend-paying stocks and other big caps are going to assert leadership.
Using ETFs, I would implement these ideas in the 60% of the portfolio I describe as flexible in this manner:
| Moderate flex-portfolio allocation | | Fund | Comment | % allocated of flex port | % allocated of total port | | Diamonds Trust (DIA, news, msgs) | Overweight dividend-paying stocks | 30% | 18% | | iShares MSCI EMU Index (EZU, news, msgs) | Hedge dollar decline with exposure to euro | 25% | 15% | | S&P 500 Depositary Receipts (SPY, news, msgs) | Overweight big-cap stocks | 20% | 12% | | iShares Cohen & Steers Realty Majors (ICF, news, msgs) | Diversify income, moderate stock risk | 15% | 9% | | iShares Lehman 1-3 Year Treasury (SHY, news, msgs) | Reduce bond duration | 10% | 6% |
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Diamonds Trust (DIA, news, msgs) represents the Dow Jones Industrial Average ($INDU), which is a little stodgier than the S&P 500 and doesnt play a role in what I call the core portfolio. I am using the flex portfolio to tilt the total portfolio away from the riskiest stocks and toward the steadiest.
Because bonds look so unattractive, I am adding real estate to the income portfolio, and adding a short-term bond fund to bring down the duration, or interest-rate risk, of my core intermediate-term high-quality bonds.
When the flex and core portions are combined, the total portfolio looks like this:
| Total moderate portfolio allocation | | ETF | Allocation | ETF | Allocation | | Equities: | 75% | Fixed income: | 25% | | S&P 500 Depositary Receipts (SPY, news, msgs) | 26% | iShares Lehman Aggregate Bond (AGG, news, msgs) | 10% | | Diamonds (DIA, news, msgs) | 18% | iShares Cohen & Steers Realty Majors (ICF, news, msgs) | 9% | | iShares MSCI EMU Index (EZU, news, msgs) | 15% | iShares Lehman 1-3 Year Treasury (SHY, news, msgs) | 6% | | iShares Russell 2000 (IWM, news, msgs) | 6% | | | | Nasdaq 100 Tracking Stock (QQQ, news, msgs) | 6% | | | | iShares MSCI EAFE Index (EFA, news, msgs) | 4% | | |
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For someone with a moderate appetite for risk, this provides equity exposure tilted toward big caps and foreign stocks, with stocks denominated in euros significantly overweighted to exploit a weaker U.S. dollar.
The income exposure includes real estate, currently yielding more than 5%, as well as bonds. The iShares Lehman 1-3 Year Treasury (SHY, news, msgs) has a duration of 1.68 years, compared with the 4.64 year duration of the core Lehman Aggregate holding. The effect is to produce a blended duration of 3.53 years for the portfolios bond holdings, which produces 24% less exposure to interest-rate risk.
That is, a one-percentage-point increase in interest rates would knock 4.64% off the value of the Lehman Aggregate, but only 3.53% off this bond portfolio. I expect the interest payments on the bond funds to exceed this amount, meaning the risk to principal is negligible.
Added advantages
Whats more, by using ETFs, I have brought annual expenses on the portfolio down to less than 25 cents on each $100 invested, at least 50% less than a mix of the cheapest index mutual funds would cost.
To this must be added trading commissions, but at $30 per round trip and no more than five trades in two years (turnover of 0% in the core portfolio and 50% in the flex), that's $75 a year, or less than 8 cents per $100 in a $100,000 account, still economical.
Recommending ETFs doesnt mean Im turning my back on mutual funds; they are the largest component of my personal portfolio because, in general, I prefer active management to indexing.
But I am taking steps to reduce my risk to scandal. One of my funds, PBGH Clipper Focus (PBFOX), was sideswiped when its distributor, PBHG, was implicated in the scandal. I have since been doing due diligence on the fund and will report what Ive learned next week.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: PBHG Clipper Focus.
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