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Introducing The ETF Monkey 2016 Model Portfolio

Summary For the past couple of weeks, I have been reading extensively through the 2016 investment outlooks of top-quality research firms. In this article, I will present six themes that I gleaned from my research. Ultimately, I will assign weightings and present The ETF Monkey 2016 Model Portfolio. In future articles, I will develop ETF-based portfolios based on this model, from three major providers. First of all, I would like to begin with a word of thanks to my 366 followers, and 88 real-time followers. When I started my work here on Seeking Alpha using the pseudonym ETF Monkey, I had a total of 59 followers from my previous work and, I believe, only five or six real-time followers. I am deeply grateful to each and every one of you! This past July 1, I presented The ETF Monkey Vanguard Core Portfolio . The portfolio features what I call “beautiful simplicity,” demonstrating that one can build a low-cost, greatly diversified portfolio with as few as three ETFs. Like many other authors here on Seeking Alpha, I would now like to offer my thoughts on a model portfolio for 2016. I have spent a fair amount of time over the past couple of weeks reviewing various 2016 outlooks from a variety of quality sources; including PIMCO , BlackRock (NYSE: BLK ), Wells Fargo (NYSE: WFC ), Vanguard , Bank of America Merrill Lynch (NYSE: BAC ), Goldman Sachs (NYSE: GS ), Deloitte , and AAII . Needless to say, there is a great deal of divergent thought represented in these outlooks. And, certainly, I was not able to carefully read every last word of every outlook. What I focused on, though, was looking for common themes ; ideas that ran through more than one outlook. From that research, I have developed The ETF Monkey Model 2016 Portfolio . In this article, I will feature the main themes that struck me, as well as outline what I believe to be a model asset allocation for the year ahead. But I am also going to go a step further. I will follow up this “theoretical” work in future articles by selecting what I believe to be the best ETFs to use to actually construct this portfolio. I will do so for three different major providers: Vanguard, Fidelity (featuring iShares funds), and Charles Schwab (NYSE: SCHW ). The idea will be that investors who use these three providers can select commission-free ETFs both to build and subsequently rebalance their portfolios, all without incurring excess trading costs. Finally, using closing prices on December 31, 2015, I will both build and track each version moving forward to get some idea of comparative performance. I will also track all of them against the performance of The ETF Monkey Vanguard Core Portfolio. As readers may surmise, I have a two-fold goal from this exercise: To attempt to determine how much of a difference selecting ETFs from different providers makes if one starts from the same basic place. For example, in some cases, one provider may offer a better expense ratio for a certain component or asset class. How much difference does this make over time? To attempt to determine if this “ideal” 2016 portfolio is able to outperform the rather basic ETF Monkey Vanguard Core Portfolio, built very simply using three core Vanguard ETFs and using the weighting derived from the Vanguard Target Retirement 2035 Fund ; designed for an investor approximately 20 years from retirement. Let’s begin by taking an overall look at the big picture. The Big Picture As they say, “a picture is worth a thousand words.” With that in mind, I am going to open this section, called “The Big Picture,” by very literally presenting three big pictures. Here’s the first one, from PIMCO’s 2016 outlook, featuring 10-Year return estimates across several asset classes: (click to enlarge) Take a quick look across those projections, particularly the asset classes highlighted in red. You will see each of those show up in some fashion in the themes I will develop as the article progresses. Here is our second big picture. This one is from BlackRock’s 2016 Outlook. (click to enlarge) Similar to the first picture, look at the boxes and arrows, and what they indicate. You may already be able to discern some common themes simply by comparing these two graphics. Finally, using the S&P 500 index to represent the U.S. stocks and various Vanguard ETFs as proxies for other averages, have a look at how various markets have performed over the most recent two-year period. In the graph below, the Vanguard FTSE Developed Markets ETF ( VEA) represents developed markets as an overall group, the Vanguard FTSE Emerging Markets ETF ( VWO) represents emerging markets, and the Vanguard FTSE Europe ETF ( VGK) represents Europe specifically. ^GSPC data by YCharts With that overview, we now come to six investment themes gleaned from my research, which I believe will benefit investors in 2016. Theme #1: The “New Neutral” Some investors may recognize the phrase “new neutral” as being from PIMCO, and you would be correct. Here is a brief quote concerning its overall expectations: At the center of our New Neutral thesis is the belief that even as central banks raise rates, they will do so slowly and prudently… We don’t foresee an inflation problem… Low interest rates and moderate inflation together support a muted but prolonged business cycle, and we believe this combination helps to sustain current asset valuations. We would argue that the tailwind from ever-lower policy rates… is largely past us. Moreover, current valuations… are likely to constrain potential returns going forward. Therefore investors must adjust to a world where returns on asset classes and the paradigm for constructing optimal portfolios over the next five years are unlikely to resemble those of the last five or even 30 years. Echoing similar sentiments, BlackRock’s 2016 Outlook offers the following: The wave of central bank liquidity looks to have crested. Monetary policy may take a back seat to other cycles for the first time since the financial crisis. Finally, this from Vanguard’s 2016 Investment Outlook: The U.S. Federal Reserve is likely to pursue a “dovish tightening” cycle that removes some of the unprecedented accommodation exercised due to the “exigent circumstances” of the global financial crisis. In our view, there is a high likelihood of an extended pause in interest rates at, say, 1%, that opens the door for balance-sheet normalization and leaves the inflation-adjusted federal funds rate negative through 2017. Essentially, this theme posits a period of muted results as we move forward. At the same time, while the tailwind provided by the current interest rate environment is almost surely behind us, the Fed is expected to move slowly with respect to raising interest rates, allowing some maintenance of current asset valuations. Theme #2: Better Opportunities May Exist Outside the U.S. Our second theme takes note of the historically high valuations currently reflected in the U.S. market, and the fact that one may find better returns in 2016 by being willing to look beyond the shores of the United States. For this section, we will think very broadly in terms of the entire international segment, both with respect to developed and emerging markets. I will feature two specific targets in later sections. The BlackRock 2016 Outlook features this theme extremely succinctly: Valuations appear to have leapt ahead of the business cycle in many markets, especially in the U.S. We have essentially been borrowing returns from the future. PIMCO’s outlook appears to agree with this thesis, as explained here: In developed markets, to name a few examples, we believe global equities outside of the U.S. offer better forward return potential than those within. Across credit sectors we see superior opportunities in European financial and U.S. housing sectors. With respect to government debt, we generally find inflation-linked securities more attractive than their nominal counterparts. Finally, from Vanguard: The growth outlook for developed markets, on the other hand, remains modest, but steady. As a result, the developed economies of the United States and Europe should contribute their highest relative percentage to global growth in nearly two decades. Based on this theme, I will include a relatively modest allocation for domestic (U.S.) equities and what may be considered to be a somewhat aggressive allocation in developed international markets in my model portfolio for 2016. Theme #3: Consider Europe The BlackRock 2016 Outlook specifically features Europe as a candidate for consideration. It writes: For example, we suggest building exposure to cheaper developed markets where monetary policy is unambiguously expansionary and valuations are more forgiving, such as in Europe and Japan. This is backed up by a helpful table comparing the valuation levels of U.S. securities against their European counterparts, both in various sectors as well as overall. (click to enlarge) PIMCO also features this in its outlook, noting many of the same characteristics. Looking around the globe, European equities appear attractive over the secular horizon. In addition to the broader developments discussed, the trend toward increased dividend payout and a higher equity risk premium provide a good backdrop for superior returns. European equities offer high levels of earnings yields and valuations are lower relative to history. In its Q4 Global Economic Outlook , after frankly discussing the challenges Europe faces from the slowing Chinese economy, Deloitte offers the following observation: Despite this very volatile, challenging environment, the Eurozone has continued its recovery. In fact, this may be seen as evidence that the recovery can now weather external shocks. In this way, the Eurozone has left the “stall-speed-phase” of the recovery behind, in which it was highly vulnerable to external turbulences. Finally, with regard to the related outlook for monetary policy in Europe, Vanguard notes: Elsewhere, further monetary stimulus is highly likely. The European Central Bank and Bank of Japan are both likely to pursue additional quantitative easing and, as we noted in our 2015 outlook, are unlikely to raise rates this decade. Based on this theme, in addition to my overall allocation in developed international markets, I will include a small additional allocation dedicated specifically to Europe in my model portfolio for 2016. Theme #4: A Measured Gamble on Emerging Markets This particular item may be the most high-risk, high-reward venture within the portfolio. The picture in emerging markets is far from clear. In my research, I found comments ranging from great concern to cautious optimism. Clearly, the impact from China may be acutely felt in these economies, so could the effects of the Fed increasing interest rates in the U.S. Perhaps, the clearest example of a positive comment I saw comes from PIMCO. It acknowledges the risks but, at the same time, offers some possible reasons for optimism: Turning to emerging markets (EM), we believe that on average these sectors should outperform comparable developed market sectors over the secular horizon, but are likely to do so with higher volatility and other risks that must be considered. As in the developed markets, lower yields have been a tremendous supporter of performance for EM assets following the financial crisis. However, in the past few years, emerging markets have gone through numerous challenges that have led to generally disappointing performance. Lower growth, lower commodity prices, weak exports and a strong U.S. dollar recently have been serious headwinds. The silver lining of the recent challenges, however, is that EM assets generally offer more favorable starting valuations. EM growth, which is expected to be higher than in developed markets, also helps valuations appear attractive. Add in the higher level of investments and productivity enhancements, and we have a favorable backdrop for attractive secular returns from emerging markets. Bank of America/Merrill Lynch offers this somewhat positive view: Start of emerging markets recovery – For the first time since 2010, average annual growth in emerging markets should begin rising to 4.3 percent in 2016 from 4.0 percent in 2015. Excluding China, growth should pick up to 3.1 percent in 2016 from 2.6 percent in 2015. About three-quarters of emerging market economies could show signs of recovery by the middle of 2016, whereas Brazil could contract further to -3.5 percent as it struggles to climb out of recession. Investment likely will become the key driver of the emerging market recovery. Asset price returns of roughly 2.7 percent for external sovereign debt, 2.5 to 3.5 percent for emerging market corporate debt, and 1.0 percent for local currency debt are expected in 2016. In contrast, Vanguard cautions: Most significantly, the high-growth “goldilocks” era enjoyed by many emerging markets over the past 15 years is over. Indeed, we anticipate “sustained fragility” for global trade and manufacturing, given China’s ongoing rebalancing and until structural, business-model adjustment occurs across emerging markets. We do not anticipate a Chinese recession in the near term, but China’s investment slowdown represents the greatest downside risk. Finally, BlackRock summarizes their view of emerging markets this way: Investor sentiment is near record lows, according to the latest BofA Merrill Lynch Global Fund Manager Survey, which we view as a good contrarian indicator. Assets also are generally cheap… The same is true for companies that derive a large part of their revenues from the emerging world including China. They have severely underperformed in the past year… and now offer selected value. We are nibbling at EM assets, but not enough to fill our overall underweights. I have been watching this segment closely for some time. Given the weak pricing of this asset class, which can be graphed as being basically flat since 2009, this is going to be the biggest gamble in my model portfolio for 2016. I am going to assign it a relatively aggressive weighting of 7.5%. Theme #5: Consider TIPS As A Preferred Alternative To Bonds This theme actually caught me by surprise as I went through my research. With the prospects for inflation remaining low, TIPS have fallen somewhat out of favor of late. Interestingly, this is commented on favorably in BlackRock’s outlook: Among government bonds, only Treasury Inflation Protected Securities (TIPS) have gotten cheaper. Ten-year TIPS are effectively pricing in an average annual inflation rate of just 1.25% measured in personal consumption expenditures (PCE) terms, well below the Fed’s 2% target. Even 30-year inflation expectations have been dragged down by the oil price slump, pricing in annual PCE inflation of 1.45%. Can inflation really stay so low for so long? This sets a low bar for TIPS to outperform nominal bonds. PIMCO appears to agree with this view. Here are its comments: For the core government bond anchor in a multi-asset portfolio, we like U.S. TIPS (Treasury Inflation-Protected Securities). Not only are they an asset carrying only one risk, real rate risk (unlike nominal government bonds that carry both real rate and inflation risks), but we also view them as attractively valued relative to nominal bonds. The large amount of slack in the global economy over the past few years as well as the recent commodity price correction have resulted not only in a drop in inflation expectations (and fears of possible deflation until recently), but also in a near complete removal of inflation risk premium from the markets. Under these conditions, we think TIPS are an attractive choice for the core fixed income component of a multi-asset portfolio. Based on this theme, my allocation to TIPS will actually exceed my generic allocation to bonds in my model portfolio for 2016. In addition, my allocation to bonds will be right on the middle of the market, in terms of duration. I hope to balance the amount of income provided with overall downside risk. Theme #6: Include Some Exposure To REITs A truly diversified portfolio includes exposure to both multiple geographies as well as multiple asset classes. This can include some form of exposure to real assets . In the graphic from PIMCO featured towards the outset of this article, you will notice that, in addition to TIPS, the greatest forecasted returns over the next 10 years were featured as coming from REITs. I was happy to see this, as I include a measured weighting in REITs in my personal portfolio. What makes REITs intriguing to me is that they represent an asset class that is sort of partway between stocks and bonds. Their unique tax structure requires that they pay out at least 90% of their earnings in the form of dividends, making them in some ways similar to a bond. At the same time, a well-run REIT can also benefit from capital gains, as the value of the properties they hold can increase over time, making them in some ways similar to a stock. Based on this theme, in addition to my overall allocation for bonds and TIPS, I will include a modest additional allocation dedicated specifically to REITs in my model portfolio for 2016. Putting It All Together: The ETF Monkey 2016 Model Portfolio Based on everything that preceded it, here are the official asset allocations for The ETF Monkey 2016 Model Portfolio: Asset Class Weighting (%) Comments Domestic Stocks (General) 30.00 See Theme #2. Domestic Stocks (High Dividend) 5.00 I am going to include one ETF providing minor targeted exposure to high-yield securities, to help generate income for the portfolio. Overall, this brings my domestic stock allocation to 35%. Foreign Stocks – Developed 20.00 See Theme #2. Foreign Stocks – Emerging 7.50 See Theme #4. Foreign Stocks – Europe 5.00 See Theme #3. TIPS 15.00 See Theme #5. Bonds 10.00 REITS 7.50 See Theme #6. TOTAL 100.00 As I mentioned in the outset, look for further articles to follow. In these, I will reveal my choices for the specific ETFs with which to build this portfolio, from three different providers; Vanguard, Fidelity (with iShares funds), and Charles Schwab. Until then, I thank you for reading, and wish you… Happy Investing! Authors Note: If you like my work, I would be deeply indebted, and highly grateful, if you could be sure to follow me here on Seeking Alpha, as well as feature my work to friends, colleagues and/or relatives who may be interested in the subject matter. Other than the time you invest to read, there is no other cost for the work that I do. Your support will enable me to continue my efforts.

The Dynamics Of Liquidity And Investing

I’ve been getting questions recently about liquidity , specifically in the context of exchange traded funds ( ETFs ). Liquidity is a hot topic in financial markets these days, so let’s spend a little time going over it. First, we’ll explore what we mean by “liquidity” and then we’ll explain what it means when it comes to ETFs. Defining liquidity When I think about liquidity, I think about a transaction: I am able to buy or sell something at a known price. The more liquid an investment, the easier it is to buy and sell without affecting the asset’s price. More fully, liquidity has three main components: price, time and size. If an asset is liquid, I can trade it quickly, and I can trade a large amount of it, without moving its price. In reality, most investments involve trade-offs between these three components. Want to trade quickly? You may not be able to trade a large amount, or you may impact the price you are going to receive. Want to trade a large amount? Do it slowly, or be prepared to impact prices. A general rule of thumb for liquidity for most investments is that you can get two of the three attributes, but not all three at once. If we consider liquid assets, a large cap stock is a good example. Unless you are trading a significant number of shares, you can generally trade fairly quickly at a price that is close to what you see on the exchange. A home, on the other hand, is relatively illiquid; you can get an estimate on its price, but until a buyer signs on the dotted line and you have a check in hand, it’s unclear what you’ll actually get when selling your home. And it will generally take you a while to sell your home, no matter what its size. Liquidity and ETFs When it comes to a security like an ETF, I can see that it’s trading at a certain price, and I can generally buy or sell that ETF at a price that’s pretty close to the quoted price. I can generally trade fairly quickly, as long as my trade is not large compared to the security’s volume. A large ETF trade is in some ways similar to a large equity trade; I need to trade over time or risk impacting the price. Let’s take it a step further and look at bond ETFs. If you want to go out and buy a bond, you can’t just buy it on the open market via an exchange. Instead you would buy it over the counter, in a negotiated transaction with a broker. The price you would trade at is often unclear, and it can be difficult to trade a large amount, or trade quickly. In fact, some investors may find that individual bonds don’t have any of the three aforementioned features of liquidity. With a bond ETF, which is a basket of bonds traded on an exchange, you have much more price transparency. You can actually see the price at which a bond ETF is trading and have a sense of the price of a trade and how many shares might be available to trade at that price. As the bond ETF trades on an exchange, you can generally trade it with the same speed as an individual stock. The liquidity rule of thumb still applies to bond ETFs; it can be difficult to trade in large size, quickly and without impacting price, but overall, exchange trading liquidity can be greater than liquidity in underlying markets . And that is an improvement that all investors can benefit from. This post originally appeared on the BlackRock Blog.

An ETF Primer

Via Robert Sinche at Amherst Pierpont Securities: Every once in a while a topic, usually the media coverage of a topic, creates a burr in my saddle, as they say. While that has taken place less frequently as I age, the coverage of the ETF market, and particularly the High Yield ETF market, has now reached that level. To be sure, the detailed operation of the ETF market is complicated and I have benefitted significantly from a dialogue with my former colleague and BlackRock Chief FI Investment Strategist Jeff Rosenberg. What I present below, however, are my views and may or may not represent his views. So, there seems to be the view that the creation of ETFs have brought capital into various market segments and, somehow, have added to risk and volatility in those markets. High yield bond ETFs currently are the target of many. But to argue that somehow the money that flowed into ETFs is now creating forced selling and excessive volatility reflects what I think is a lack of understanding on how ETF construction takes place . To be sure, the process IS very complicated and I can understand the misconceptions, and hopefully this note may add some information to the discussion. Jeff forwarded a 2012 paper (pdf attached) by Downing and Lyuee, and for those who want to go through the detailed analysis feel free to do so. What I am more interested in is their excellent discussion of the ETF creation process on pages 3-4. The key quote from the paper is below. As I understand the issue, the selling of ETFs generally only leads to the selling of the underlying assets when there is an arbitrage opportunity for the APs (see below) to buy the ETF and sell the underlying if the price of the ETF falls too far below the NAV of the underlying securities. But it also can work the opposite way – if the underlying securities get too cheap relative to the ETF price, the APs can buy the underlying securities and sell the ETF in the market. It is in this context that ETFs could trade huge volumes at prices set in the open market between buyers and sellers without having to transact ANY underlying securities. In other words, transactions in the underlying securities will take place because of arbitrage opportunities, not simply because investors are selling the ETF . In this context, it does seem to me that ETFs can increase market liquidity and price discovery, not exacerbate the situation in illiquid underlying markets. This is actually different than the open-end MF market – if investors sell their positions in open-end funds the fund company must liquidate underlying securities (unless they already were holding cash positions,), a much bigger problem for the underlying market. Comments/feedback/correction appreciated. Exchange-traded funds (ETFs) are investment vehicles that combine the key features of traditional mutual funds and individual stocks. The typical ETF structure is much like a mutual fund in that shares in the fund represent claims on a portfolio of securities. Typically the ETF portfolio is constructed to track a publicly available index such as the S&P 500. Like stocks, shares in an ETF can be bought or sold (long or short) on an exchange throughout the trading day. This is in contrast to mutual funds, where transactions in shares of the fund occur directly with the fund company at the close of each business day. The pricing mechanism of ETFs relies on the so-called “creation/redemption” process. If an ETF is trading at a price that is higher than the sum of its constituents’ prices, i.e. trading at a premium, the Authorized Participants (APs), which are usually market makers, can purchase the underlying securities and exchange them for shares in the ETF with the ETF manager, and immediately sell the ETF shares on the exchange for a quick profit. This creation mechanism ensures that any premium in ETF pricing is arbitraged away by the APs. The redemption process, which eliminates discounts in ETF pricing, works in the reverse direction. The composition of the basket of securities eligible for creation/redemption is published daily by the ETF manager. In practice, ETF managers may not require that the basket of securities to be exchanged for ETF shares perfectly match the published holdings given the liquidity constraints imposed by the underlying market (i.e., not every bond is trading everyday). The manager may decide to accept a basket where some securities are substituted by similar securities if the substitution would not increase tracking error. One common misconception is that ETFs are “forced sellers” of bonds when markets decline. The rationale behind this view is that, as markets fall and investors sell ETF shares, the ETF portfolio manager will be required to sell securities to fund redemptions. This dynamic does in fact occur with traditional open end mutual funds. While open end mutual funds typically carry a cash reserve to help facilitate redemptions, this reserve may be quickly exhausted during periods of larger outflows, resulting in a sale of securities by the mutual fund portfolio manager. In contrast, ETF investors sell shares of their ETFs on exchange. Whether or not an ETF share redemption ultimately occurs will be driven by the relationship between the exchange market price of the ETF and the actionable value of the underlying redemption basket. If it is economically attractive to exchange shares for bonds, APs will likely seek to do so. At the extreme, if bond markets are impaired, ETF investors may still be able to liquidate their shares on exchange, albeit at a market price that could differ appreciably from the NAV and the ETF’s index (both of which may lag given the limited trading activity in the OTC bond market). In this sense, ETFs do have an additional liquidity venue the exchange which may actually serve to reduce the amount of trading activity in the OTC bond market relative to a traditional open end bond mutual fund. Critics often cite the appearance of anomalous premiums or discounts during periods of market volatility as evidence of dysfunctional behavior in the ETF. However, such behavior often reflects elements of price discovery given the gap in liquidity between the ETF and the underlying bond market [Tucker and Laipply (2012)].