Tag Archives: modern

An Aggressive Portfolio For Investors Using Modern Portfolio Theory

Summary The aggressive allocation strategy incorporates a mere 15% of the portfolio to bonds. The portfolio also contains 8% to utilities and 25% to equity REITs which are sensitive to movements in interest rates. This kind of portfolio is designed for an investor that can bear substantial risk and is willing to have the portfolio rebalanced at regular intervals. I’ve selected a combination of the Schwab and Vanguard funds that I find attractive. Several are in my portfolio. Facing expectations for an increase in domestic short-term rates, portfolio strategy has been on my mind. Frequent readers will know that I cover mREITs a great deal and invest a material portion of my portfolio in the mREITs that I consider most attractive. In this piece, I want to talk about a strategy that I think would be very reasonable for the rest of the portfolio. Before we get into the allocations, I want to stress that this is designed as an aggressive portfolio and for many investors, this portfolio would simply be too risky. I have a long-time horizon, and aggressive allocations make sense for me. Each investor should carefully consider their circumstances. The Strategy I feel that a portfolio like this would be most useful under MPT (Modern Portfolio Theory). The portfolio would be designed with the expectation of frequently rebalancing positions. That can be a problem for investors that are holding their positions across several accounts or don’t have free trading on the securities. Several of these ETFs will qualify for free trading through either Schwab or Vanguard but not both. I’d love to see each of those brokerages bring out additional funds to make it possible for an investor to select funds from only one brokerage for this strategy. It might be possible through Vanguard, but I’m more familiar with Schwab’s international options. Tax Exempt For the purpose of this article, I’m assuming the accounts are retirement accounts that are tax exempt. Some investors may figure that this would be a problem because the employer sponsored 401k is unlikely to have all of these options, but I’ve personally had success with rolling former employer 401k accounts into IRA accounts. The heavy weight for domestic equity REITs would be fairly strange for an investor facing higher income taxes on the position. Asset Allocation That domestic total allocation of 65% could be treated as a home country bias and there may be some arguments for moving that combined position down to 60% of the total portfolio so that international positions and bonds can be increased. For now, I’m going to go with 65% in the combination of domestic equity and domestic equity REITs. Many investors may think 40% into traditional equity with 25% into equity REITs is incredibly heavy on equity REITs, but I see the lack of corporate taxation as a huge and durable advantage for providing superior growth. Domestic Equity The first 40% gets broken up between three funds: I’ve used the Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) over the Vanguard Total Stock Market ETF (NYSEARCA: VTI ) on the basis of a .01% lower expense ratio. This is fairly small, but I’m long both ETFs in different accounts. I’m also using the Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) and love the defensive allocations. In this case, I opted to use the broad market ETF because I’m combining it with the Vanguard Consumer Staples ETF (NYSEARCA: VDC ) and the Vanguard Utilities ETF (NYSEARCA: VPU ) to make the combined domestic equity position significantly more defensive. Equity REITs This is fairly simple. Investors could use the Vanguard REIT Index ETF (NYSEARCA: VNQ ) or the Schwab U.S. REIT ETF (NYSEARCA: SCHH ). For investors seeking higher dividend payouts, the easy answer is VNQ. Since I have a very long time until the retirement and the portfolios are very similar, I’ve been adding more to my SCHH holdings since it has free trading a lower expense ratio. International As I noted at the start of the article, I’m more familiar with Schwab’s international options than with Vanguard’s. The Schwab International Equity ETF (NYSEARCA: SCHF ) gets only 5% of the portfolio and matches the Schwab Emerging Markets ETF (NYSEARCA: SCHE ). The heaviest weight goes to the Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ) because I want the international equity allocations to favor smaller companies on the assumption that they will earn more of their revenues from the international market. I don’t have much use for overweighting multinational companies that happen to have their headquarters in a different country. Therefore, I prefer the smaller companies in this space. Bonds I went with a mix of the Schwab U.S. Aggregate Bond ETF to get very high credit quality (including treasuries) and fairly moderate duration and the Vanguard Long-Term Corporate Bond Index ETF (NASDAQ: VCLT ) for a higher yield. The long duration on high credit quality corporate issues allows the fund to still exhibit a negative correlation with the S&P 500 while offering significantly stronger yields than treasury securities of the same long maturity. One Problem Using a portfolio like this would be ideal for an aggressive investor that is ready to put a rebalancing plan in place. Some of the brokerages will offer options to create an automatic portfolio and will allow users to influence the allocations. When I tested out Schwab’s feature for it, I was disappointed to find that some of my favorite Schwab funds were not included in the options. Of course, Schwab also does not have an equivalent option to VDC or VPU in its group of funds with extremely low expense ratios. If it rolls out an option that would allow automatic rebalancing across the account with my favorite ETFs included, I would be very interested in trying it. I wouldn’t want to incorporate my mREIT positions into that part of the portfolio, but I would feel comfortable designing a weighting system for the rest of my portfolio that would be automatically rebalanced. One of the funds I was disappointed to see excluded from the system was SCHH. Since this kind of rebalancing system would be problematic outside of tax-exempt accounts, I would really want to be able to run a heavy equity REIT allocation. Conclusion I’d love to see brokers continue to develop their portfolio management tools so that it is simple for investors to set up a portfolio like this. They would need to be careful about handling things such as rebalancing and allow investors to set a goal like to rebalance individual positions when the bid-ask spread is only one cent.

Efficient Market Hypothesis And Random Walk Theory: Buy ‘David Swensen’s Portfolio’

Summary The author recommends using “David Swensen’s portfolio” as a key component of the Core Portfolio. Recommendation for the Satellite Portfolio will be covered in a separate article. Recommendation is in line with the implications of Efficient Market Hypothesis (EMH) and Random Walk Hypothesis (RWH). EMH and RWH imply that it’s impossible to consistently beat the market and suggest the utilization of passive investment approach. Recommended Portfolio Allocation The main goal of this series of articles is to introduce new stock investors to academic theories and help them develop their own approach to stock investing. Knowing academic theories and their implications should help investors gain confidence in their chosen path. That confidence is key in ensuring that investors consistently execute their chosen investment strategy. As we will discuss in the next articles, consistency is one of the main friends of stock investors. I will be suggesting an approach to stock investing that will be based on findings of Nobel laureates and market practitioners. With each article, we will be moving one step closer to developing an investment approach/portfolio that individual investors will be comfortable holding on to through thick and thin. We will start with David Swensen, CIO of Yale endowment since 1985, where he manages over $20 billion (as of Q3 2014, endowment assets were $23.9 billion). Over the decade (through 2009), the endowment realized an average annual return of 11.8 percent. It is an impressive performance given that this period covers the financial crisis of 2008. David’s consistent track record sparked debates if the new college building should be named after him. He is believed to be the alumni who contributed the most to the school through his management of the Yale endowment portfolio. David is credited with inventing the Yale Model (an application of modern portfolio theory that we will discuss in the next article). David Swensen suggests that individual investors should limit their portfolio to a handful, well-selected ETFs that will provide diversification across major asset classes (e.g. stock, real estate, and bonds) and geographies (i.e. developed and emerging countries) at a low-cost and tax-efficient manner. His recommendation is very much in line with the approach suggested by John Bogle (founder of Vanguard). David lays out the proposed allocation across asset classes as following: Asset Class Allocation Domestic Equity 30% Foreign Developed Equity 15% Emerging Market Equity 5% Real Estate 20% U.S. Treasury Bonds 15% U.S. Treasury Inflation Protected Securities 15% Source: David Swensen Strategy’s Strengths and Limitations MarketWatch developed a list of funds that closely resembles exposures that David Swensen proposed. The list of funds and its historical performance is presented in the table below. As you can see from the table, the proposed allocation has underperformed the S&P 500. As of 11/14/15 Fund Allocation 1-Year Return 3-Year Return 5-Year Return 10-Year Return Total Stock Market VTSMX 30% 0.62% 15.89% 13.05% 7.45% Foreign Developed VTMGX 15% -2.85% 7.67% 3.98% 3.73% Emerging Market VEIEX 5% -16.37% -3.49% -3.85% 4.44% Real Estate VGSIX 20% 0.36% 10.45% 11.04% 7.05% Long-term Bonds VUSTX 15% 2.99% 0.92% 6.82% 6.66% TIPS VIPSX 15% -2.17% -2.64% 1.98% 3.85% S&P 500 1.29% 16.18% 13.40% 7.31% Source: David Swensen, MarketWatch Main drivers of the underperformance are allocations to foreign developed markets, long-term bonds, TIPS and emerging markets. It’s not much of a surprise to see fixed-income instruments (i.e. long-term bonds and TIPS) underperform stocks (due to equity risk premium) over the long term. Analyzing the shorter period (up to 3-5 years), one can think of many reasons for the outperformance of US stocks vs. foreign developed and EM stocks. For long-term investors, arguments of mean reversion should make them comfortable holding on to diversified portfolio over the long term. As such, investors should not discard the model portfolio proposed by Swensen just yet. As mentioned, the list of carefully selected ETFs (must be low-cost and tax-efficient) should form the base of your portfolio. We will refer to this portion of the suggested portfolio approach as “Core Portfolio”. We will discuss the second portion of the proposed portfolio “Satellite Portfolio” in the future articles and share the rational for having such a satellite portfolio that might utilize a non-passive approach. Suffice it to say that EMH and RWH should provide enough confidence to individual investors to stick with the Core Portfolio allocations as long as the investors keep in mind that over the long run stocks provide positive real return. Actual Portfolio Allocations and ETFs Given the tax efficiency of ETFs, the author finds it more appropriate to use ETFs instead of mutual funds for the Core Portfolio. The actual list of ETFs and corresponding allocations is presented below: Asset Class ETFs Allocation Domestic Equity VTI 30% Foreign Developed Equity VEA 15% Emerging Market Equity VWO 5% Real Estate VNQ 20% Long-Term Treasuries TLT 15% TIPS TIP 15% There are a number of reasons for this recommendation: 1. The actual allocation to various asset classes is in line with David Swensen’s proposed allocations. Theoretical underpinning for passive investing is presented in the last section of this article. 2. The approach utilizes low-cost and tax-efficient ETFs. Typically, Vanguard ETFs are on the low end of fees. Also, ETFs are more tax-efficient than the mutual fund structure. A word of caution before you start implementing the recommendation – I’m not a tax advisor, and therefore, I strongly suggest you consult your tax advisor for any tax-related matters. Also, I would like to mention that this article is just the first one in the series. In the next articles, we will continue exploring the stock market theories and how they impact the way I invest. Next stop will be Harry Markowitz’s Modern Portfolio Theory and the need to diversify across a broad spectrum of asset classes. This article will be followed by Noisy Market Hypothesis, which should lift the spirits of investors who would like to “beat the market”. Appendix: Theory Dr. Eugene Fama, a Nobel Laureate, is thought of as the Father of Efficient Market Hypothesis (EMH). EMH suggests that current asset prices fully reflect all currently available information. To put it simply, stock prices should react only to news; and as you know, news is random in its nature. Due to this randomness, EMH implies that consistently outperforming the market on a risk-adjusted basis is impossible. In other words, don’t put your money into an individual “hot” stock or entrust to an active asset manager. Talking about randomness, one cannot skip mentioning the Random Walk Hypothesis (RWH), which traces back to Louis Bachelier. RWH argues that stock prices are random: chances that a professional analyst identifies a winning stock is similar to a flip of the coin. In a 1965 article, “Random Walks in Stock Market Prices”, Dr. Fama draws the parallels between EMH and RWH. As already mentioned, EMH and RWH imply that stock investors would be better off investing in passive index funds or mimicking such fund investments. On average, active investing (e.g. intentionally investing a higher portion of the portfolio in a specific stock or sector) is expected to yield similar risk-adjusted returns as passive investments. Some behavioral economists (note: we will cover behavioral finance and its implications in the future articles) would even argue that active investing should result in inferior returns, as emotions of investors will make them buy hot stocks just before these stocks peak and throw the towel just before the market bottoms. Industry practitioners, such as John Bogle of Vanguard, would further argue that investing is a zero-sum game: few basis points of alpha that one active manager generates come at the expense of another active manager. Furthermore, a typical individual investor who entrusted his/her funds to an active manager would come out short after receiving an average market return, less management fees and tax bill. Typical high turnover of active asset management mandates leads to higher transactions costs (e.g. bid-ask spread) and higher tax bill (i.e. short-term gains are taxed at a higher rate than long-term capital gains and dividends). All of the above suggests that low-cost, tax-efficient ETFs are optimal investment instruments for the Core Portfolio. References/Bibliography George A. Akerlof and Robert J. Shiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism , Princeton University Press, 2009 John Bogle on Investing: The First 50 Years , McGraw-Hill, 2000 Colin Read, The Efficient Market Hypothesists: Bachelier, Samuelson, Fama, Ross, Tobin and Shiller , Palgrave Macmillan, 2012 David Swensen, Unconventional Success: A Fundamental Approach to Personal Investment, Free Press, 2005 Next article: M odern Portfolio Theory: Introduce Alternatives To Your Portfolio

Kayne Anderson MLP Investment Company – A Value Play With A 12% Yield

Summary The fund claims to invest at least 85% of total assets in energy-related master limited partnerships. It currently pays a dividend in the 12% range. The fund as a consistent track record of 11 years. If you recently sold the Kayne Anderson MLP Investment Company ( KYN), I wouldn’t blame you. It seems like the thing to do at this point. The MLP space has been beat up, bloodied, and stomped into the dirt. Overall, the oil & gas storage and transportation sector has fallen more than 30% in the past 12 months. The situation looks ugly and may get worse. So, why put any money into this space? Well, let’s see what it has to offer. Fund Strategy KYN seeks high total returns by investing in energy-related master limited partnerships (MLPs) and their affiliates and in other companies that operate assets used in the gathering, transporting, processing, storing, refining, distributing, and mining of marketing natural gas, natural gas liquids, crude oil, refined petroleum products or coal. Basically, companies that store and/or transport petroleum products. Top 10 Holdings as of 9/30/15 Enterprise Products Partners L.P. (NYSE: EPD ) 13.7% Energy Transfer Partners, L.P. (NYSE: ETP ) 12.0% Williams Partners L.P. (NYSE: WPZ ) 8.2% Kinder Morgan, Inc. (NYSE: KMI ) 7.4% Plains All American Pipeline, L.P. (NYSE: PAA ) 6.2% ONEOK Partners, L.P. (NYSE: OKS ) 4.9% MarkWest Energy Partners, L.P. (NYSE: MWE ) 4.7% Buckeye Partners, L.P. (NYSE: BPL ) 4.0% DCP Midstream Partners, LP (NYSE: DPM ) 3.9% Western Gas Partners, LP (NYSE: WES ) 3.9% Portfolio as of 9/30/15 Data taken from the fund’s website Value Proposition These companies, along with their massive infrastructure investments carry the life blood of this country. They have created a complex web of pipelines and storage facilities that reach every corner of the continental United States. These companies deliver about 26.6 trillion cubic feet of natural gas annually throughout the U.S. so we can keep our lights on, keep our homes warm, and power our industries. Also, much of the crude oil and refined products consumed must be moved and stored throughout the country. Pipelines have become the most cost-efficient way to move these products. Producers of oil and gas as well as customers of these products are equally dependent on the infrastructure investments made by the oil & gas storage and transportation sector companies. In other words, these infrastructure companies are a vital and an integral component of our modern society. Also, consider this. Further investments in our oil & gas storage and transportation infrastructure are continually needed to provide conduits for new oil & gas production and refined products. These new materials and products would be stranded without expansion of the infrastructure. Because of this fact, there is literally tens of billions of dollars’ worth of backlog for new infrastructure projects. Therefore, companies that operate in this space are not likely to be going out of business anytime soon. KYN allows you to invest in many of the companies easily and without the hassle of the dreaded K-1. And right now, there is a sale going on in the MLP sector. KYN is now selling at 50% of its price from November 2014. I think with so many choices out there in the MLP space, it makes sense to let someone else do the picking and save yourself the headache that goes with the K-1s. Risks However, investing in KYN is not for the timid. It is a Closed Ended Investment Company or CEF. If you are not familiar with these, it would be best if you did some research before investing in them. See CEF Connect for further research. This type of fund often uses leverage to enhance its returns. In the case of KYN, its leverage is about 32%. With that, you will notice that these types of funds typical exhibit more volatility than the overall market. It can be as high as twice the S&P 500’s typical volatility. Outlook So, where is KYN headed? In my opinion, we haven’t seen the bottom yet. But that doesn’t mean you shouldn’t have this stock on your radar. Today’s dog is tomorrow’s champion. Keep an eye on stocks like EPD, ETP, and KMI. These are the top three holdings in KYN. All but KMI appear to forming a bottoming pattern. Watch for the momentum indicators to begin to turn higher. This should indicate the bottom is in. Then, it’s time to start scaling in. Build a position over a few months. Be patient and let it come in. Here’s a recent chart of EPD showing its price consolidating around the $25 area. Also, it shows the RSI indicator in an up-trend. These are signs that the stock is bottoming and a trend reversal should soon follow. (click to enlarge) Chart Courtesy of stockcharts.com Why Invest? If you are looking for a good value play that will pay you to wait, KYN may be what you looking for. At the moment, this stock is paying a dividend in the 12% neighborhood. It also has a good record of increasing dividends. According to one source, Dividend Stocks , KYN’s 5-year dividend growth rate is over 9%. And according to Kayne Anderson’s fact sheet , funds invested at inception, i.e., September 2004, would have doubled by September 2015. That works out to be about 6.75% annual return. Not too bad when you also consider the increasing dividend stream you would have had during that time. There was only a slight decrease in dividends during the 2009-2010 period. Of course, it all depends on what your goals are. Are you looking for a steady stream of dependable dividends? I believe that KYN has proved it can do that. Conclusion One final thought I will throw in for free! KYN is not for everybody, but think about this. Money on the sidelines, for all practical purposes, is not earning anything in this low interest rate environment. That goes for all of us small-time retail investors as well as the large hedge funds and institutional investors. Stocks in the MLP space will not fall forever. Sooner or later, they will be noticed by the value hunters. Money will then flow to where there is value. And I believe the value of the MLP space is getting very compelling.