Monthly Archives: July 2017

Portfolio Review July 2017

This is my second portfolio review on the verge of the one year anniversary of this blog. The inaugural edition can be found here. Some background can be found here and here.

Overview

First of all, I want to update the table in the Financial Independence Progress Report.

The portfolio is well on its way to achieving the moderately aggressive goal of “Financial Security” by the end of this year. This milestone is defined as having 20X in the “Total Invested”; where X is, with some padding, the projected post-retirement annual spend. I’d still have a mortgage balance but 20X is such that even if I were to lose my job we would still be able to survive. There would be some painful belt-tightening but at least we wouldn’t end up in the street. YTD, the portfolio has already matched last year in percentage gains (10.87%) as calculated by the simple Dietz method. It’s currently positioned to take advantage of accelerating gains, especially in technology stocks.

“Total Invested” in the table includes the “Total Portfolio” as tracked in this blog as well as the 529 accounts for my daughters and the cash value of a small pension from my wife’s previous employer. “Total Portfolio” is about 90% of “Total Invested”. Networth is defined as “Total Invested” + home equity. We don’t own any investment real estate. I also find it too cumbersome to track the worth of miscellaneous items. The two pie charts below break down the location of various assets.

We’ve always maximized contributions to tax-advantaged vehicles for as long as I can remember. Since my wife is a SAHM these days, current contributions are for my 401K, HSA, and two backdoor Roth IRAs. The backdoor Roth is one reason we kept my wife’s 401K with the previous employer, besides the outstanding stable value fund and other low-fee index vehicles there. Taxable is just shy of half of “Total Invested”, to be drawn upon in early retirement. In a typical year, our taxable contribution outweighs the tax-advantaged kind by some margin, but it does vary since a large part of my pay is incentive-based. Unfortunately I already know 2017 will be leaner than any of the 3 previous years — that I’m still confident about hitting the year end goal is testament to the strength of this market.

Portfolio Strategy Diversification and Asset Allocation

There are two ways to cut across the total portfolio, the first is by different strategies, whether active or passive. Passive stands at just over 40%, active at 56% and the emergency fund (EF) occupies 4%. During the past year, I moved a portion of EF into active accounts due to higher confidence about my position with my employer. The EF is equivalent to about 10 months of current expenses, including potential outlay for medical insurance if I were to be laid off. Total portfolio returns are calculated with cash drag from the EF. The total portfolio and its subcomponents are compared against the benchmark 60/40 SPY/AGG each month.

Before going into each of the passive and active strategies, there is another, more conventional way to look at the overall asset allocation. By that measure I’m at 56% equities, 24% fixed income, 12% precious metal (PM) bullion and miner (miners are not counted towards general equities), 6% cash (includes EF and undeployed cash in active accounts), and finally 2% other that includes cryptocurrencies and options (marked to market). It is difficult to gauge the risk level of this portfolio using conventional stock/bond metrics. 56% equity is very conservative for my age; 24% fixed income + 6% cash is in-line with main stream recommendations. But the fact is I’m already close to the far end of my risk scale since there are assets that are, shall we say, quite volatile. I’m currently underweight PM, 12% with partial hedge vs. 15% target. In addition, I may take on additional option positions. These changes should be completed by the end of August.

Passive Accounts

Passive accounts is where I use Vanguard or equivalent index funds for the equities including REITs. The discussion in May is still current. Target allocation is 55% equities, 30% fixed income (stable value funds only) and 15% PM (mostly bullion). At the start of each year, I conduct a review and set the asset allocation for the rest of the year. Mid-year changes are allowed as long as they are part of the yearly plan. Changes are usually in 5-point steps and there is a maximum swing of 15 percentage points from equities to fixed income. I’m already at the most aggressive stance in my passive accounts and cannot take on any further risks.

Within equities I take a mild slice and dice approach. US is slightly tilted to small and international moderately tilted to EM. The split between US/international is 50/50, and there is a dash of REITs since I don’t have any in my active accounts.

Active Accounts

The active accounts are purely discretionary. They are currently allocated at like this: PMs, 11% actual vs. 14% target; fixed income CEFs, 22% target and actual; growth stocks, 14% actual vs. 15% target; DGI stocks, 45% target and actual; other, 4% actual and target; and cash, 3.5% actual vs. 0% target. Among these categories, I expect the “other” which is cryptocurrencies and options to drift away from the target and I’d be quite alright with that.

In a previous post I spoke of structuring the portfolio to take advantage of both asset bubbles and the supposedly “normal” markets. Given the very nature of bubbles the portion devoted to them needs to be small. Right now that function is taken up by the “other” category which is a combination of cryptocurrencies and directional option combos on tech stocks. My posts on cryptocurrencies can be found here. They are known for extreme volatility. For example, the daily volatility of bitcoin is over 4%, or about 4 times that of gold. Other coins such as Ethereum are even more volatile. So to make the volatilities equal the cryptocurrency position needs to be less than a quarter of the gold position, assume zero correlation. Although I have been writing more about cryptocurrencies lately, larger return potential ought to lie in the developing tech bubble, most likely with AI as the major meme. My chosen vehicles here are option combos that offer high leverage. Similar option strategies were discussed here. Besides cryptocurrencies and tech stocks, I also expect PMs develop into a full-fledged bubble but maturing after the tech stocks.

The rest of the active accounts is geared towards a “normal” if growth-biased market with the same broad categories as passive: PMs, fixed income, and stocks but with more risk. For example, miners, i.e. GDX/GDXJ are a large part of PMs, and they are leveraged to gold price by a factor of 3-4. Fixed income consisted of all leveraged CEFs, which are diametrically opposed to the stable value funds in risk. One major portfolio shuffle this year was to reduce the muni allocation, as it was one source of the major hit last November, increasing taxable CEF allocation in tax-advantaged accounts and move all DGI stocks into taxable accounts. The taxable CEFs have had outstanding performance YTD. This too will one day pass I’m sure, but for now the CEFs are the most reliable performer I have.

At a combined 60% of the active accounts, the actively picked stocks are the largest segment in my portfolio. Performance of the DGI stocks have been tracked since blog inception and I found them rather disappointing to tell you the truth. After the portfolio shuffle, the growth stocks are also being tracked and so far the combined performance just about matches that of SPY. That underscores again how difficult it is to beat the index. I have given myself all the advantages of low cost (one time transaction fee much less than 1 basis point), long holding period, balance between diversification and concentration (~30 stocks total). Of course, there is still the issue of positive skew to contend with. The main advantages I can really see for active stock picking are:

  • More opportunities to sell options
  • The blended dividend rate of the DGI and growth stocks are currently under 1.6%, lower than that of SPY or VTI, so there is some tax savings.
  • It potentially allows me to be more nimble when the market peaks.

The last point is purely hypothetical for now. At any rate, I don’t expect any appreciable out-performance over the index. Below is the sector weight vs. that of S&P. This is something I monitor only, the market weight is not being viewed as a target. If anything, I’m interested in avoiding the under-performing sectors such as energy. Even though the energy sector may have reached a short-term bottom, I’m not optimistic about the secular trend, at least as far as the most vanilla holdings that I have: Exxon and Chevron.

So that’s it, a comprehensive view of the current portfolio. It feels like the major pieces are all in place. With luck, we’ll have the wind behind us for the next 12 months and I’m stoked to see how far it can go.

Some Rambling Thoughts on Investing Philosophy

I’ve previously written a blog post about the key tenets of my investing philosophy that were more about the actual practice. In contrast this post is a collection of more fundamental views.

On the human condition in investing and its axiom

First of all, the human condition as it pertains to investing is that we can never be sure of future returns. The typical investing time horizon and the nature of returns is such that we have one life to live and the return will only be known at the end by which time it’s too late to change anything. Given the stage of my life, I’m obsessed with maximizing retirement date certainty. I spend much time thinking about two approaches to taming the (downside) volatility without compromising return potential: asset class diversification and market timing done correctly.

“Buy low sell high” is the only axiom of investing, everything else is derived from, therefore subordinate to, it. There are heuristics or rules of thumb that are derived from experience. But no matter how much experience it’s based on, or how authoritative a figure it comes from, a heuristic can never over-rule the axiom. For example, I invest in PMs and cryptocurrencies with the goal to “buy low sell high” even though they don’t conform to someone’s notion of productive assets. The word speculate as opposed to invest is used to describe, often derogatorily, such activities by some. To me, the word speculate carries no negative connotation. As a matter of fact, I believe successful speculation requires above-average understanding of human psychology and macroeconomics, as well as superior mental discipline. So no, I don’t mind being called a “speculator” at all.

On diversification, market timing and bubbles

The benefits of diversification with uncorrelated assets is mathematically derivable. It does not derive its validity from backtesting, although backtesting confirms it works. I consider that a first level corollary to the axiom of investing. There aren’t that many of those either — “costs matter” is another. Early literature of “Modern” Portfolio Theory which was developed in the 50’s focused on the two-asset universe of stocks and bonds. For a long time they were the only options available to individual investors; however, in this day and age, it’s sad to see how much of the investing public is still operating with this now self-imposed limitation. I’ve grown used to the resistance to alternative assets displayed on forums like Bogleheads and MMM. These days I click on threads about gold and cryptocurrency with the anticipation of a spectator at a UFC event. I’m usually not disappointed.

I’m an avowed market-timer, one that’s primarily interested in cycles of years duration or longer. The combination of market-timing and freedom to speculate allows me to take advantage of asset bubbles. The mainstream views bubbles as unavoidable evils of the free market, and the ability to hold through them with clenched teeth and unwavering asset allocation the ultimate financial virtue. I’d like to offer a different point of view. We know that bubbles appear with some regularity: PMs in early 80’s, Japanese stock and RE in early 90’s, dot com bubble of 2000, the housing bubble of ’07; and depending on who you ask on-going and near future: bond, cryptocurrency, Nasdaq and PMs. Given the length (build up, blow-off, collapse) and magnitude of these bubbles there is a possible variant perception: that the bubbles are the main acts, and the supposedly normal markets merely a chorus in the background on this financial stage of ours. According this view, a portion of our portfolio should be expressly directed towards taking advantage of bubbles, while the rest under the traditional asset allocation geared towards the “normal” market that are the plateau from which the bubble peaks rise. It takes great skill to ride a bubble due to the great emotion and hype invariably accompany each and that no two bubbles are alike. But successfully negotiating even just one could set one up for life, or at the minimum build a significant base from which compounding with a traditional allocation will ensure a comfortable retirement. For additional thoughts on riding asset bubbles see here.

On passive vs. active

Hardly a week goes by without encountering an article on the active to passive transition. I personally use them both for strategy diversification. Index funds are a great invention: for someone not inclined to put in the time and effort there is no better investment vehicle. In all likelihood the trend of active funds to passive will continue, especially in a bull market where hedging degrades performance. I believe that in so far as passive investing puts more money in the pockets of the public, more capital may be attracted into equities than would otherwise, further perpetuating equity bubbles. I also believe it’s possible for passive to become too big: market orders can be market distorting when passive is the only game in town.

I could probably go all indexing in the equity portion of my portfolio — my goal for actively picked stocks is to match the return of SPY anyway. One reason for staying with individual stocks is that it affords greater opportunities to write options, at the least when the goal is to have them expire OTM. Another reason is that even though I’m a lousy stock picker now, there’s always a chance that I’ll improve, and I’d like some incentives for doing so. Somewhere inside there is a voice reminding me too much of even a good thing can be problematic. Nothing has manifested yet but I have been thinking about how index funds may distort the market and how vulnerable they can be:

  • Index funds take money away from high shareholder yield (dividend + buyback) companies to distribute among the entire index, assuming the majority re-invests distributions. This will create a disincentive for shareholder yield.
  • Suppose a hedge fund builds up a large position in an index member. It can use artificial trades to increase the price before dumping it to index funds.
  • It behooves to ask, in the example above, how a hedge fund could build up a large position in the first place. Index funds won’t be selling unless there is wide panic. But to generate wide panic just to load up on a stock may be too much to ask, although there may be specific external events in certain sectors that can create opportunities. Other possibilities include an index member acquiring a non-index member by issuing stock, or a particularly large buy-back that creates forced buy/sell conditions for the index funds can be taken advantage of. The most likely scenario remains when there is deterioration in the fundamentals of an index member, and a hedge fund can dump its existing position or simply go short after artificially elevating the price.
  • The issue of stock-based acquisition requires further scrutiny. Recall that was a game CSCO played masterfully during the dot com era when using its high P/E stocks to buy low P/E companies provided an instantaneous boost to its numbers. Will we see them again (a large cross-border deal should do the trick) when index funds gladly foot the bill?
  • Lastly, there is a danger of net capital flows out of index funds as baby-boomers retire.

Let’s be clear: these are not things that are happening now but what could happen when index funds become dominant. Various people has put the line at 90%. Personally I see it as a question of when, not if. That’s why I intend to maintain an active component lest getting swept away when the tide comes back in.

So there you go, some disjointed ramblings that should give better context to my investment decisions. I hope you find them somewhat thought-provoking.

On Bubbles

Charlie Bilello from Pension Partners pointed out that the CAPE is now over 30. His piece is balanced and well written as always but it won’t prevent others from using the data to once again proclaim that the market is expensive and that we’re in a bubble, etc. So far so good and I might even agree. But if the implication is that there is impending doom then I have to beg to differ.

Many writers, the eminent Larry Swedroe among them, have argued that the historical context of the P/E ratio has evolved. I find no reason to doubt them, so let’s take the shorter term relative movement as an indication of multiple expansion or contraction. In 1921-29, the CAPE ratio went from 5 to 30, for a gain of 6X. In 1982-2000, the CAPE ratio went from about 7 to 44, another 6X. The CAPE low of 2009 was about 12.5. Now I’m not about to forecast a CAPE of 75 (although within the realm of possibility, cf. Japan 1990), but surely an increase of mere 2.5X can’t be the end of this bubble if it can be called such? If this is indeed the coming-home-to-roost of all the QE by all the central banks since the great financial crisis then we will have much, much further to go. To say otherwise is to say “this time is different”.

I have been saying on this blog since last November that we’re entering a generational bull market. Currently the model is seeing a consolidation low in July, flat in August, but a truly maniacal phase for 12-18 months thereafter.

Speaking of bubbles, the Collaborative Fund recently published The Reasonable Formation of Unreasonable Things. Here are a couple of gems:

The majority of your lifetime investment returns will be determined by decisions that take place during a small minority of the time.

Bubbles are not anomalies or mistakes. They are an unavoidable feature of markets where investors with different goals compete on the same field. they would occur even if everyone was a financial saint.

It’s a hallmark of thought-provocativeness that the readers may draw different conclusions from the ones the author intended. It reads to me that one of the article’s main purpose was to warn long-term investors of the dangers of irrational pricing during bubbles. Pointing out the difference in goals and time frames was a beautiful rebuttal to EMH which sometimes is used to justify “buy at any price”. But to me the greater take away was the importance of the bubbles — rational, inevitable, and the driver of long term returns that those smooth, monotonically uptrending curves from a fantasy land called Excel would have you overlook.

Two recent articles by Jason Zweig (here and here), speaks to the difficulty of riding a bubble: specifically, a money manager Samuel Lee and his experience with Ethereum. Except in this case, the final chapter, or more than likely the second act, has not yet been written. Jason Zweig is too good a writer and has too much understanding to express an opinion other than saying it’s really hard. So here I would like to give myself some pointers that I hope to follow:

  • Participate — showing up is half the battle, especially when others are calling it a bubble.
  • Don’t be greedy. Position size control is paramount. Set a volatility limit as well as a position limit.
  • Do not envy those in earlier with a lower cost basis, nor those in later with a larger position.
  • Take profits, often. It’s impossible to catch the exact bottom or top. Play with the house’s money.
  • Do not take positions to justify a point.
  • The majority of the portfolio should be in an allocation that one would have in the absence of bubbles.

The last point is an import one for me. My speculative positions are benchmarked against cash, not the 60/40 much less 100% stocks. Why would it be otherwise if the bubble is expected to be short lived? Taking profits, even partially, forces one to re-evaluate the whole position.

We live in interesting times. I see three bubbles in progress or developing that require very different treatments. In cryptocurrencies, I have taken a position and am simply content to sell a little bit as prices rise. In PMs I have a 15% baseline allocation but trade around the cycles. Exposure can be increased by being in silver, miners, 3x ETFs and options while maintaining the same nominal allocation. In stocks and Nadaq in particular, I’m willing to increase the overall allocation along with highly leveraged option positions. These are in contrast to their neutral allocations of 0%, 15% and 45% (for all equities), respectively.

The next year or two should be very interesting.

Performance Tracking June 2017

For calculation methodology see this post. Tracking growth stocks and fixed income CEFs started in April’17.

For June my total portfolio returned 0.9% exceeding both SPY at 0.64% and 60/40 at 0.38%. YTD the total portfolio is at 8.3% vs. 9.18% for SPY and 6.43% in 60/40. In terms of stock picking, growth stocks lagged this month as can be expected from the headwind faced by leading tech stocks. The DGI stocks were strong in part because of the realization of dividend payment (cash basis on when they were paid, shifting about 0.3% from last month). When the growth and DGI stocks were taken as a whole, they slightly exceeded SPY for the past three months which was better than expectations. CEFs continue to be a highlight of the portfolio as previously mentioned. Cryptocurrencies were a positive driver despite entering a correction since BTC reached $3000.

AllocateSmartly is now tracking 37 different tactical and static allocations. In June, 0.90% would have placed my portfolio at third overall, albeit a distant third. YTD 8.3% would have been 11th out of 37. The active accounts’ YTD gain of 10.29% would have been 2nd overall.

Going forward I see a difficult summer ahead with continued consolidation in erstwhile leading stocks. Gold may finally find a bottom in July. I have been hedging my miners using DUST and I’m finally looking to buy more gold coins for my passive accounts. To be discussed further in an upcoming market commentary.

Pimco Taxable CEFs YTD

Someone posted a summary of Pimco taxable CEF YTD results to the MorningStar CEF discussion board, which I reproduce below.

The numbers speak for themselves. Of these I own PDI, PCI, and PFN, and I used to own PTY. In addition to taxable multi-strategy, I also own muni and bank loan CEFs. Together CEFs currently make up 22% of my active accounts. They’re one end of my bar-bell strategy in fixed income — the other end being stable value funds in passive accounts.

It is true they use leverage and have high fees relative to bond index funds. But they also offer liquidity and after-fees performance not normally seen in public investment vehicles, with the exception of perhaps BDCs and mortgage REITs. I’ve owned CEFs for well over 10 years. During this time, I have looked at P2P lending, real estate crowd sourcing, and other private vehicles and never found a reason to bite.

Note: This is not investment advice, do you own DD!