Monthly Archives: October 2016

Performance Tracking October 2016

performance_20161031

For calculation methodology see earlier post

Passive Portfolio

Benchmark SPY declined by 1.73% in October while AGG also declined 0.82%. In fact, the rise in interest rates probably precipitated the decline in equities. My passive portfolio sans PMs declined by 1.26%, slightly better than benchmarks. Including PMs, the decline was 1.76% slightly worse. Putting the majority of my fixed income in stable value funds continue to pay off. Indeed, I’m contemplating moving out of the total bond fund entirely. I’ll likely do that as part of my annual review and rebalance. Otherwise, not change in target allocation.

Active Portfolio

The active portfolio had a very poor month, losing 5.57%. PM stocks, muni closed end funds and my company stock all had significant losses. For PMs, the miners were weaker than the physical, indication another leg down. The COT is still quite negative despite the $80 drop. I expect another leg down, possibly into January. The losses in my company stock is likely tied with the annual RSU vesting cycle, assume many sold portions to pay taxes or even entirely. I’ll also be looking to sell but at a more opportune time. Closed end muni funds had a very good run this year and the pay out is probably not sustainable in this low rate environment. This is not unexpected. However, I’m a long term holder and 5.5% fed/state tax free yield is equivalent to almost 10% tax free yield to me. If Hilary gets elected, I expect muni’s to get a bid since taxes will likely go up.

My DGI portfolio at -0.71% performed better than the market. In October, short puts in Nike were exercised. They were intended as a long term hold. Short puts in United Technologies expired worthless.

Plan and Forecast

The year end rally has so far been elusive. I continue to expect a correction of 10-15% but not much more into Q1. Per my long term model, by the middle of next year we’d be rip roaring upwards. I know it’s difficult to envision given the current political climate but those are the scenarios where big money is made.

Beyond 60/40

60/40 or 60% equities and 40% bonds has long been the standard benchmark to which portfolio performances are measured against. One typical low-cost implementation uses the total stock market (VTI/VTSMX/VTSAX) and the total bond market (AGG/BND/VBMFX/VBTLX) funds. Other acceptable variations include substituting the total stock market can be substituted with an S&P 500 index fund (SPY/VOO/VFINX/VFIAX) with little impact on the total returns. Indeed I use SPY/AGG as the benchmark in my monthly performance tracking. Another variation is to use intermediate treasuries (IEI/IEF/VGIT/VSIGX) for the bond allocation due to better credit and a more negative correlation with equities during crisis. Weightings other than 60/40, such as 70/30, 50/50 introduce different risk-return trade-offs but derive returns from the same sources. These portfolios constitute the standard “boiler-plate” recommendations to most investors, along with some kind of “glide path” of equity percentage reduction with age. These are eminently reasonable recommendations and for many people, they serve the purpose. However, as I have come to emphasize risk control and view return on a risk-adjusted rather than absolute basis, I became more and more drawn to alternative assets.

Portfolio Theory

The Modern Portfolio Theory (MPT) revolutionized our understanding of portfolio construction. One of its key teachings is the advantage of holding low or negatively correlated portfolio components – simply put, we are told to select such asset classes that also have high enough expected returns. Unfortunately, MPT is ex post, i.e., backward looking based on past returns and correlations. It’s for good reason that the warning “past return does not guarantee future results” is dotted around financial ads like the surgeon genera’s warning on cigarette packs. Future returns are notoriously difficult to forecast; in contrast, cross asset correlations, while still time varying, are more stable and predictable. More recent portfolio construction methods: risk-parity, maximum diversification, and minimum variance (reference) rely on correlations and other risk factors rather than future returns (the expected portfolio returns are still calculated from the expected future returns of each asset but the allocations are not). It is beyond the scope of this blog post to discuss the intricacies of these approaches other than saying they affirmed the MPT teaching of selecting asset classes that have low/negative cross-correlations. In my view, the most significant impact of these work is negating the notion that the recommended portfolios (typically containing a significant amount of alternative assets) as based on past performance data mining. As long as we believe the alternative assets will have low/negative correlations to the mainstream equity/bonds in 60/40 in the future, they have a place in our portfolios.

Global Asset Composition

The global investible universe is much greater than publicly traded US equities and bonds. The chart below provides a comprehensive picture (as of 2013) where global investible assets total $101 billion. US ex-REIT equities only account for 18% of the global total, roughly equal to the share of international developed (13.7%) and emerging markets (4%) combined. The share of US IG bonds is 15.2%, considerably less than international development market bonds (22.4%), while EM bonds make up 2.7%. These 4 asset classes (US/ex-US equities/bonds) are 76% (77.2% including public REITs) of the global investible universe. One key take-away is that ex-US is really important if you want to gain exposure to a more diverse set of economic drivers, although ex-US bonds give me pause given their negative interest rates.

The rest of the asset classes are usually referred to as “alternatives”, the access to which is getting easier as asset managers try to increase AUM. However, care is definitely warranted.

global_aa_20161016

Source

Princeton Endowment Model

Among major university endowments Yale and Harvard’s draw the most attention. The former, due to the legend of its long term CIO David Swensen

, and the latter due to its sheer size (~$30+ billion). Yet unbeknown to many, Princeton amassed one of the best records in recent years. Looking at the allocation of its “policy portfolio”, the thing that immediately jumps out is the low “straight” equity allocation of only 26% consisting of 10% each of domestic and emerging and 6% of international. Within this slice, the overweight of EM is noteworthy. Private equity and independent return (i.e. absolute return) each takes up another quarter. Lastly, real assets take up 19% and fixed income only 5%. Princeton’s 2014-15 financial report is worth a read as it goes over sources of over-performance (it helps to be a $22 billion endowment to have access to some great managers) as well as the evolution of its policy portfolio since 1996. Its approach is very active – the policy portfolio appears to be constantly tweaked and it uses outside active managers for each of its allocation slices. The approach has obviously worked out for them as the rolling 10 year returns have been nothing short of amazing. Though as the equity bull aged the out-performance has declined to “only” 3% a year from a stratospheric 7-10% a year. So what are the key take-aways for a retail investor who has no chance of accessing the same managers that Princeton has access to? First of all, good active managers do out-perform. Secondly, it behooves us to consider alternatives that are not correlated to the classical 60/40 but also has equity-like returns.

princeton_aa_20161016
princeton_returns_20161016

Source

Asset Correlations

Before factor investing was all the rage, there was “tilting” to small and value based on the Fama-French 3-factor model. I think of tilting as a qualitative and low cost way of getting exposure to those factors. One of the best known example is the Merriman buy-and-hold portfolios. Though from a portfolio construction point of view, most equity sub-classes are very tightly correlated to each other. The correlations are 0.9 and above amongst VTI (total), SPY (large blend), VB (small blend), VBR (small value) and VXUS (international). They’re >0.8 with VWO (emerging) and >0.7 with VNQ (REITs).

equity_corr_20161016

Source

On the other hand, correlations among various components of the bond market are all over the place. Treasuries of various maturities are negatively correlated with equities, as are treasuries dominated AGG (total bond). Interestingly so is MBS (mortgage backed securities). Munis (MUB) are uncorrelated; while HYG (high yield) is quite equity-like.

fi_corr_20161016

Source

Examples

As written before, gold is the foremost asset that has essentially zero correlation to both equities and bonds. It has been a major part in both my active and passive portfolios. There may be additional candidates within the fixed income space according to the correlation matrix above. Typically, I would replace equities with the alternatives resulting in a portfolio with much lower traditional equity percentage than most age based formula would recommend. While equities have a high expected return, this approach will likely raise risk-adjusted returns.

There are some readily accessible examples of portfolios than goes beyond the traditional 60/40. Meb Farber has been writing on this topic for a long time. Paul Novell from Investing for a living has been writing nice follow-ups to Farber with additional performance data. Below are various portfolios that he tracked. By many metrics, the 60/40 is in the bottom half of the list.

Source

Performance Tracking September 2016

performance_20160930

For calculation methodology see earlier post

I caught an error in the DGI return calculation for August and corrected it here. August returns of passive/active/overall were not impacted.

Passive Portfolio

Continue to outperform vs. essentially flat for the benchmark. PMs proved an additional source of return this month contrary to last. Within the traditional equity slice_and_dice, both international and emerging outperformed. Lackluster results from $AGG continue to justify putting most of fixed income in stable value. There were no portfolio changes other than regular HSA and 401K contributions.

Active Portfolio

There are more activities to report here. The DGI portfolio had another weak month. Declines in the likes of Wells Fargo and Nike were insufficiently offset by advances in old tech. I took the opportunity to add to Wells, Nike and Exxon. I also sold puts in Nike and United Technology. These transactions capture the core of what I try to do in my DGI portfolio: add to names I’ve picked out on weakness. With dozens of candidates sufficient weakness occurs much more frequently than in an index.

I closed out profitable trading positions in Credit Suisse ($CS) and Fibria Celulose ($FBR, a Brazilian pulp maker). Both were small positions entered in July when market volatility was low and I couldn’t find any decent option selling opportunities. CS was a bet that the fall-out from Deutsche would be limited and I was able to close just before the latest flare-up. FBR as on the thesis that the conclusion of Rio Olympics would weaken the Real (true). The amount of profit wasn’t much higher than a typical successful option trade by design and I’m not particularly eager to do similar trades again.

One losing position was Novo Nordisk ($NVO) options. It was sized incorrectly (too large a position as I was trying something fancy) from the beginning. About the only good thing I can say about that trade was that I cut loss correctly. NVO continued to drop after my exit but that wasn’t consequential to whether the exit was good or not. Other sources of losses in the active portfolio included my company stock which is my single largest position (other than funds). It has done very well over the years and I have a plan to reduce. Additional losses were from my big chunk of muni closed-end funds.

Plan and Forecast

Unlike the prevailing pessimism I see a likely year-end rally followed by a correction in Q1’17. I can afford to engage in this kind of speculation since there’s little I can do to act on that opinion. My forecast model is calling for a normal level of market exposure. I’m staying close to fully invested and my “tracking error” will be mainly driven by sector allocation and stock selection.

The correction in the PM sector has a 50/50 chance of being completed – yes, I’m aware of the (lack of) information content in this statement. I’ve completed whatever tweaking on the periphery which mostly consisted of keeping the same dollar exposure but increasing leverage to gold price. Now I sit and wait.

The Enigma that is Gold

Gold is by far the most controversial investment, always eliciting strong feelings on both sides. One of Warren Buffett’s most often repeated missives on gold is: “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” (source). Now I consider Warren Buffett the foremost capital allocator of our time and deserves deep admiration. I also think under the folksy, cherry-coke-drinking persona is one of the shrewdest businessman alive. He plays the part of a benevolent capitalist to the hilt to curry favor with the government for the lightest regulation and oversight possible – skillfully, legally, and to the benefit of $BRK shareholders. As for those who would substitute Buffett’s professed thought on gold for their own, they should at least be aware of what he did with silver (Google Buffett and silver). Remember: everything he says about gold should apply to silver – with the exception of having to dig a bigger hole.

There are plenty of straw-man arguments against gold. They typically go like this: people buy gold for inflation protection (false premise but since when has that stopped a good argument?), but gold did poorly last time inflation was high, therefore gold wasn’t really an inflation hedge, therefore you shouldn’t buy gold. For real insight into what gold is and is not read this instead. Author Charlie Bielello did a great job dissecting whether gold is currency/commodity/inflation hedge/safe haven based on annual return data from 1972. The conclusion is that gold does not fit into any of these categories. In other words, gold is unique and in a class of its own. I’m totally fine with that – to me there are only two valid reasons for owning gold: 1) as a portfolio diversifier; 2) because it’s in a (long-term) uptrend (well, there is a third reason but I don’t really want to conjure up the image of Mr. T).

Portfolio Diversifier

The Permanent Portfolio (PP) – equal weight of Stocks/long term treasuries/gold/cash – was introduced by Harry Brown as a portfolio that works in all economic conditions: prosperity, deflation, recession and inflation. It’s had a huge influence on me and there will be no shortage of future posts on both the PP and portfolio construction in general. For now I’ll simply point out the main difference between the PP and the traditional stock/bond portfolio: gold. If we look at the correlations between these assets:

pp_correlation_20161001

Source

The 1-3 year treasury ETF $SHY is being used as a cash proxy and as expected has minimal volatility. Gold, or $GLD as a proxy, has low correlation (by low I generally want to see < 0.3) with both stocks and long term treasuries thus providing a diversification benefit. In general, asset returns are volatile and difficult to forecast, but volatilities and correlations are more stable. The exact amount of diversification benefit depends on realized returns for each asset, but its existence a mathematical fact not a function of back-testing.

That said we can’t eat mathematical derivations, unlike actual returns. Countless hours have been spent (wasted?) on arguing about gold’s position in one’s portfolio. My own view is that even if the long term return of gold is only keeping up with inflation, I would still keep a position but at a proportion much less than 25%, perhaps about 10%. I see prosperity as the more dominant economic condition based on my previously stated view that KNOWLEDGE, which is at the core of human progress, is still being expanded, disseminated and leveraged for growth, and it’s hard to see that trend reversing. One way to express that view is through the Golden Butterfly portfolio proposed by Tyler at the excellent site PortfolioCharts.com. The Golden Butterfly is composed of 20% large cap blend stocks, 20% small cap value stocks, 20% long term treasuries, 20% short term treasuries, and 20% gold. So about twice equity as other assets and some slice-and-dice to boot. My own passive portfolio is not too dissimilar: a different slice-and-dice in the equity portion; if you count REIT as real assets then that’s 20% of the portfolio including 15% PM; the fixed income portion takes advantage of stable value funds. In broad strokes, both can be described as 40% equity/40% fixed income/20% real assets.

The Current Multi-Year Trend in Gold

As disclosed in the first post on this site, I currently have a 16% allocation to PMs overall. That figure includes silver as well as mining company shares, both are highly leveraged to gold prices.

gld_gdx_correlation_20161001

Source

In particular, the unhedged gold miner index HUI/$GDX is leveraged about 4:1 to gold. 40% of my PM allocation is in mining stocks, in essence expressing a directional view that the bottom has been put in Dec’15. Could I be wrong? Sure, I reckon there’s a 25% chance that we’ll see a lower low from here, but the longer term trend should be up so the consequences of being wrong are not as severe. Some corroborating evidence for the bottom being in can be seen in this article. My current target price for gold this cycle is about $3500-5000 per oz.

My opinion on gold is based on my (admittedly limited) understanding of monetary history, but it is my own understanding nonetheless. It’s a fact that there are gold advocates who hold world views that some may find unsavory. Perhaps that’s why debates about gold as an investment option are often so heated and emotional. Personally I’m tired of a binary view of the world where there are only two camps of people and sharing a single trait or view with one camp automatically pigeonholes you into that camp with all other traits and views. I’ll leave it at that. Lastly it should be clear by now that I intend to time gold, albeit in a multi-year time frame. For my views on market timing please refer to Guilty as Charged.