Category Archives: Portfolio Construction

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!

The Arithmetic of Prudence, Part 3

Part 2 of this series dealt with the asymmetry of marginal utility and that prudence often requires maximizing the probability of reaching a minimum objective rather than maximizing the expected portfolio value. This is especially true when one or more of the following applies:

  • The time horizon is short, e.g. < 10 years.
  • The investor is a prodigious saver; i.e., less reliant on returns to reach goals.
  • The portfolio is in distribution.

The table below summarizes my portfolio recommendation depending on the life stage of the investor.

The demarcation between early and late accumulation, early and late distribution are 10 years to and from the retirement date, respectively. Other authors have referred to the decade before and after retirement as the retirement red zone. Michael Kites recommends a “bond tent” from 10 years before to 15 years after retirement. It has a more elongated taper but based on the same principles.

The recommendation is for principles only. There isn’t specific allocation recommendation due to the enormous variation in individual risk tolerances. 70% stocks/30% bonds may be ultra conservative to one and a roller-coaster ride to another. However, the relative measures of risk ought to hold for the same investor at different stages of his investing life. I also believe in the soundness of some popular advices: greater allocation to equities during early accumulation and the use of annuities (SPIAs) for baseline income during late distribution.

As laid out in Part 2 of this series I advocate sacrificing some growth for reduced volatility in late accumulation and early distribution. The need to do so is recognized by mainstream writers but I find their typical advice of increasing the fixed income allocation too simplistic. I have written about the alternative asset classes in Beyond 60/40. In my own portfolio I continue to explore cost-effective ways to incorporate these assets consistent with modern portfolio construction methods such as risk parity, minimum correlation and maximum diversification but tailored to an individual investor with a desire to reduce trading frequency.

We live in an age where competition in the financial services industry has given the individual investor access to an unprecedented array of products at reasonable costs. Of course, not all of them make sense and the onus is upon us to separate the wheat from the chaff. But quite often I see in the PF blogosphere and forums an avoidance on principle. In some there is a suspicion to all things from the financial services industry, a suspicion no doubt born out of experience with its dodgy business practices. In others, it feels like a fundamentalist fervor against anything not a 3-fund portfolio. Whatever the reason, the majority of the DIYers continue clinging to 60-year old portfolio construction methods. I have never tried to convert anybody but have always read forum (e.g. Bogleheads) exchanges about alternative assets (typically gold) and portfolio construction (slice-and-dice, factors) with interest — when emotions are high and arguments are well-thought it makes a great spectator sport!

In the table I had the same recommendation for both late accumulation and early distribution. For obvious reasons my mental efforts have been directed to late accumulation. After the retirement threshold I can see greater emphasis on income generation: increasing allocation to CEFs, higher yielding stocks, more aggressive option writing, and less emphasis on speculative assets. The asset categories will remain the same but the percentage will differ. I expect tax considerations to play a larger role than return-volatility trade-offs.

Speaking of the distribution phase, two recent opus (both are deserving of this word) contributed significantly to our understanding: a series by EarlyRetirementNow and the work by none other than the great Bill Sharpe. Bill Sharpe also called decumulation “the nastiest, hardest problem in Finance”. It is indeed difficult, if not insoluble, if the requirements are:

  • The only allowed assets are equities and bonds.
  • The allocation is static or follow a simple age-dependent formula.
  • The withdrawal rate is anywhere close to 4%.

As they say, 2 out of 3 ain’t bad. Variable withdrawal strategies can help, but critics will say they’re market-timing in disguise: in effect, if not on purpose. PortfolioCharts has repeatedly shown the benefits of gold in increasing the safe and perpetual withdrawal rates, but gold haters will continue to hate. I suppose that leaves getting more money/requiring less as the fool-proof way of ensuring success. But try to tell that to a 23-yr old ER-aspirant!

So far as my own plan is concerned, none of the three bullets apply. But since I’m far from the Epicurean ideal, I’ll be working for another 10-12 years yet!

Investing Philosophy

I’ve been meaning to update the my portfolio post which is linked under the “portfolio” navigation tab, but I’m in the process of deploying cash as part of the on-going correction. So I figure I’ll write a separate post about my investing philosophy.

Below is a list of the basic tenets that I try to follow:

  • Long biased
  • Globally diversified
  • Minimize taxes and expenses
  • Diversify sources of return
  • Strategy diversification
  • Market timing according to cycles of years of duration or longer
  • Use options to generate income and smooth the ride

The first three bullet points are in the “main stream”. As a rule, I don’t have a regular “cash” allocation in either passive or active strategies. Instead, there is a separate emergency fund component in the total portfolio. I’m also far more comfortable being long than short. In the passive accounts at least, I maintain a 50/50 US/international split in equities, although the composition such as large/small US equity or international developed/EM can be fluid. To the third point, I maximize tax deferred contributions every year, including back-door Roth. All assets in the passive accounts are tax-advantaged with the exception of physical PM bullions. In the active accounts, the taxable fixed income CEFs are in tax advantaged as are about half of PM miners and bullion funds. Expenses are minimized by using best-of-breed funds for each asset and doing everything myself. In passive accounts, that means Vanguard index funds/ETFs or equivalent. For individual stocks, I use InteractiveBrokers where the commission is usually under 1 basis point, and partially covered by the interest from security-lending. My expense ratio for holding stocks is at least one order of magnitude less than that of the lowest cost index funds.

The fourth point “diversify sources of return” motivates me to look beyond the traditional stocks and bonds. It’s the reason I have a significant allocation to leveraged fixed-income CEFs (target 24% of active). Taxable multi-sector CEFs have equity like returns and volatilities but are no more than 40% correlated to equities (e.g. VTI, correlation is period dependent, cf. Leveraged muni CEFs provide tax-free income and even lower correlation to equities (same comment as before). In contrast, sub-sectors within equities are correlated to whole at 90% or above. In the context of mean variance optimization, assets with reasonable returns AND low correlations are extremely valuable in portfolio construction. This is contrary to the Bill Bernstein view that one should take risks in equities and fixed income is for safety — a view that unsurprisingly leads to equity dominated portfolios and equity dominated risk profiles. Note that when the fixed income allocation is viewed across my entire portfolio, the risk profile is a “bar-bell”: stable value funds in passive and leveraged CEFs in active. Diversification is also a reason behind my overall 15% allocation to PMs which I discussed here. The blog post by Charlie Biello is highly recommended — I think of it every time I read a straw man attack on gold along the lines of: gold is thought of useful as an inflation-hedge, data shows it is not; therefore gold is useless. Another often-heard objection is based on the inclusion of gold’s return data just 1975 when gold ownership was again legal despite data from PortfolioCharts shows gold’s ability to lower volatility from multiple starting and ending dates. From a portfolio construction perspective, the only requirement for the inclusion of gold is the low correlation to other assets. I haven’t seen any evidence or prediction that this correlation is going to change in the future.

The fifth point “strategy diversification” speaks to my adoption of both passive and active approaches. The passive/active debate is all the rage in financial media today. Passive is clearly winning and the shift is far from over. Lower fees is undoubtedly beneficial to the investing public. However in so far as the democratization of investing makes it easier to invest and funnels more capital to assets, their valuation must rise thus suppressing future returns. A recent post from the always-insightful PhilosophicalEconomics discussed from a similar perspective. As passive grows in dominance, another danger is the synchronization of investor’s emotional response to market declines. This is a major reason I employ both passive and active strategies so as to be able to hedge from within the active accounts when the time comes. I also try to avoid the most obvious pit falls in active, i.e. high fees, lack of diversification, to at least give myself a shot at beating my benchmark.

The sixth point “market timing” is perhaps the most controversial. My reasons were laid out this post. The primary objective is to avoid large draw downs in preparation for early retirement within 10-12 years. If my portfolio should suffer a 30% draw down, there would be a significant impact on the quality of retirement or alternatively the retirement date. I haven’t been able to find a static asset allocation that provides adequate protection while simultaneously provide a high return – that pretty much captures the main dilemma facing all investors. A more diverse allocation can reduce the size of the hedges necessary but no static allocation can ever be truly “all weather”. I believe the solution is market timing but only at the right intervals. The tools I rely on are a specific equity pricing model and technical analysis. A second objective of market timing is to enhance returns. I have been say since last November that we’re entering a blow-off phase in the stock market; the view reinforces my long bias and allows me to increase my equity exposure from a baseline of <50% overall. My current projection for the market top is S&P 3000+ sometime around Q4’18 to Q1’19. I also see PMs in a bull market which gives me license to go above a baseline allocation of 10% gold bullion to include silver and mining equities that are leveraged to gold. My current view is that PMs will top after equities, probably later in 2019. Gold should be over $3500 and has a good shot at $5000/oz.

Lastly I use options to enhance returns. More opportunities are provided by directly owning individual stocks than an index as the parts will move more than the whole. I’m a premium seller since it’s known that realized volatilities are lower than implied volatilities. I predominantly sell margin/cash secured OTM puts on stocks I’d like to own while use technical analysis for entry points. From time to time, I also use options for leveraged longs as discussed here.

So there you go, these are the seven tenets that guide my investing decisions. People attach an almost religious fervor to their chosen investment approach, so I’m not out to convert anyone. It is a human condition that no amount of back testing or modeling can predict the actual returns which will only be known at the end of our investing lives by which time it’s too late to change. I have made peace with my path and will accept anything that comes my way.

Portfolio Changes 2017

A new year is always a time for reflection and planning for the future. This is especially true for one’s investments. My investment policy statement (IPS) allows for a once-a-year plan review and gradual changes in my passive allocation. Those changes don’t have to be implemented right away and can subject to a range of dates or pre-conditions. The important thing is to keep a record of them and hold myself accountable.

2016 Results

I was quite happy with the portfolio level gains in 2016: 10.87%. It was calculated with the Simple Dietz method which meant contributions were properly accounted for. One of my pet peeves for many personal finance blogs is the co-mingling of contributions and investment returns. Another widely used formula is (end value – start value – contributions)/start value. It’s generally fine except when the contribution is large. The simple Dietz method adds half of the contribution to the denominator to approximate the time-weighted return. The 10.87% figure was calculated on an annual basis, more accurate would be to chain link monthly figures. Unfortunately the official record for this blog was only started in August. I’ll have much more data to work with in the future.

AllocateStartly had a summary of various allocation strategies for 2016. The Golden Butterfly portfolio which I drew inspirations from was the top dog at 10.79%, while the benchmark 60/40 portfolio returned 7.71%. So it doesn’t seem I have much to complain about. Though in all fairness I took on more risk — I have silver/miners in my PM sector, my equities are higher and cash position lower. Conversely, the equity slice-and-dice to include international hurt my returns. The timing of the start of this blog was unfortunate as July was the high watermark in terms of percentage gains. I gave back more than 3 points in the 2nd half of the year while the S&P was going gang-busters, so the results from August look rather poor. I’m an unabashed market timer, so that’s definitely something to improve on.

A New X

I have no plans to disclose actual dollar amounts — I hope it doesn’t detract from the ideas discussed here. At times I have spoken about the portfolio value in terms of X, where X is my non-inflation-adjusted, no-mortgage, target annual pre-tax retirement income. More recently, after some thought about desired life-style and future medical expenses, I’ve decided to increase X by about 10%. I don’t foresee any further changes to this figure.

Current investible assets stand at 17X after a contribution of 1.3X and a gain of 1.6X in 2016. I define “financial independence” as 25X plus a paid-for primary residence. There is still 4.5X left on the mortgage. Being naturally conservative I’ll probably keep working until reaching 30-35X. This amount will also include any future financial support for my daughters. There’s definitely some margin of safety in X, such that I call investible assets at 20X “financial independence lite” even without paying off the mortgage. It’s tantalizingly close, with luck may even be reached in 2017.

Passive Allocation

My guiding assumptions for the next couple of years are based on an equity pricing model I have been following. So the plan is to increase the equity allocation slightly after a drop in the market in the first quarter.

I’ll maintain the 50/50 split between US and international and increase the overall equity allocation by 5% which comes out of TBM. No changes in PMs.

Active Portfolio

The active and overall portfolios don’t follow a set allocation, although I do check it for risk management purposes. The overall equity allocation may grow to 55% by the end of 2017 from 50%. I expect the DGI portfolio that is heavy in consumer staples to under perform the broader market but don’t plan to make any major changes. Additions to the DGI will likely be old tech (MSFT, QCOM, CSCO), or a high-growth, low payout name like V. I plan to add more to growth stocks, currently at 7% of the active portfolio, and bring it up to 10%.

Option writing was a reasonably successful endeavor last year but my activity tapered off as job responsibilities increased. It’s still something I plan to continue this year, although I don’t have a target in mind. It is reassuring to know that if I ever lose my job I can generate some income this way. I do plan to use more synthetic equities (buy call, sell put) as a means to increase leverage. More details will follow when I open such positions.

Closed End Funds

My current asset allocation has about 35% in fixed income/cash, which is about age – 10. Within the passive portion, 40% is fixed income (FI), split between stable value (SV) funds and the total bond market (TBM) 35/5. The interest rate is about 2% for the SV funds in my 401K and an outstanding 3+% in my wife’s 401K. They compare favorable to current bond yields such that I’m considering getting out of TBM altogether. Views on my approach to FI in my passive accounts may vary from mainstream to conservative.

The opposite is true in my active accounts where I use leveraged closed end funds (CEFs) for the FI allocation. In open-end mutual funds, investors transact with the mutual fund company. In closed-end funds, investors buy or sell fund shares with other investors on an exchange. CEFs operate just like an ETF except usually they’re actively managed. ETFs have a fund sponsor who can create/destroy fund units in response to demand so that fund price tracks closely its net asset value (NAV). In contrast, CEFs can have market values that deviate substantially from NAV. Such discount/premium is a key evaluation criterion for CEFs.

One outstanding feature of many CEFs is their high current yield. For example, I own PCI, PDI and PTY in my tax-advantaged accounts. PCI/PDI are multi-sector funds, whereas PTY is a corporate bond fund. All are managed by Pimco. Yields in the trailing 12 months were 12-14%. Double digit yields were made possible by employing leverage, typically around 40% (achieved by issuing lower-yielding preferred shares). Leverage works both ways so you can say my overall approach to FI is a “bar-bell” in terms of risk. CEF management fees are on par with (the more expensive) active mutual funds but obviously the after-fees return is the primary consideration. Pimco funds are known to employ derivatives to hedge interest rate risk which makes them particularly valuable in this environment.

In my taxable account, I also own leveraged muni CEFs, PCQ and PCK, both CA muni funds managed by Pimco (yes I think they are the best in this business). They’re yielding 5.5-6% which is close to double digit pre-tax yields depending on your tax bracket. They dropped quite a bit post election since certain anticipated tax changes will make them less attractive. I’m less worried about these tax changes than the longer term fiscal situation in California. For now they are medium term (~2 years) holds. I will not add to them, but rather will seek opportunities to sell especially if I can create more space in my tax-advantaged accounts.

The backdrop of any FI discussion is of course the direction of interest rates. I believe rates have in fact bottomed. Not all is lost for FI though. Hedging with interest rate derivatives is one approach. For now, MBS (mortgage backed securities) should do quite well as pre-payments stop. Floating rate loans should do quite well, too. In fact, I’ve already picked out a CEF in the latter category for my watch list.

There is far more diversity in FI as I pointed out in Beyond 60/40. A recent post from Newfound Research did an excellent job decomposing risk factors in various FI instruments:

Most individual investors have an FI allocation heavy in treasuries and investment grade corporates which is a lot of rate exposure (see LQD and TLT in the graph). I find it ill-advised giving my outlook on rates. At any rate, individual investors tend not to pay much attention to FI, since they tend to be overweighted in equities anyway. Readers of this blog though should not be surprised by where I stand. I don’t think a TBM index fund works nearly as well as its equity counterpart. One reason being the index is weighted by issuance. That there are non-economic, state actors with heavy footprints is another. Not to mention it doesn’t cover SV funds, CDs, and bank loans if one considers all the FI options available.

Supplementing DGI for Retirement Income

A common criticism for DGI for retirement income is that it requires a higher portfolio value due to current low yields, thus over-saving and longer working years. That is a valid point. The canonical approach for retirement income generation is to withdraw a fixed percentage, e.g. 4% from a $1M portfolio for an initial annual income of $40K. The S&P 500 yields just over 2% today. A 4% yielding portfolio will force one into high yielding but low growth sectors such as utilities, telecoms, and REITs, etc. This naturally increases portfolio risk.

My solution is: supplementing a well-rounded, high quality DGI portfolio with high-yielding CEFs. Let’s do some quick math. Assuming the DGI portfolio yields 2.5% and has a 7% annual growth rate. We can also construct a CEF portfolio with 8% yield and assume no principle growth. Then the combination of $727K in the DGI portfolio and $273K in CEFs will generate $40K initially. The weighted portfolio growth will be 0.727 x 7% > 5%, more than enough to overcome inflation. All of the assumed numbers are quite conservative and can easily be constructed from securities available today.

Readers interested in investing in CEFs should do their due diligence. Two resources I find tremendously helpful are CEFConnect and the MorningStar discussion forum.