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Kenneth Smith has been spending a lot of time lately trying to make sure that market volatility doesn't send investors into a tailspin.

As a result, the chief investment officer at Seattle-based Empirical Wealth Management says that the high net worth and institutional clients he works with aren't ready to panic yet.

But he credits such realistic expectations not only to this year's educational push. Smith explains that he has been sounding a similar theme when markets were running strong from 2003 through late last year. The difference, he says, was not to chase short-term performance of soaring asset classes.

Now, conditions are different. But the veteran advisor and portfolio manager says keeping a level head and remaining unemotional in seemingly bearish times is as important as ever. Through good times and bad, he and his co-managers at Empirical emphasize that they've stuck to the same process of monitoring asset class correlations and global market capitalization trends.

And with most segments of equities pummeled this year, Smith believes that investors who've been disciplined about rebalancing their portfolios according to a long-term asset allocation plan can find plenty of good buying opportunities right now.

"The valuations right now in some areas of the market are very reasonable," said Smith. "Earnings could drop and valuations could change. But we're encouraging our long-term oriented clients, especially the younger ones, to use these current market conditions to raise their stock allocations back to proper levels."

Carpe Diem

In fact, Smith says he has been scrambling to come up with extra money to put into stock funds for the portfolios of his daughters.

"Even for investors with shorter investment horizons, conditions right now offer a good buying opportunity in stocks," he said. "We're not telling older investors closer to retirement to go overboard and load up on stock funds. But unless their circumstances and goals have changed, we think it's a good time for people to rebalance portfolios at attractive valuations."

The firm's average allocation for his 500-plus clients is around 60% equities right now, says Smith. He prefers exchange-traded funds and passively managed portfolios from Dimensional Fund Advisors. A typical investor at Empirical might have 35% to U.S. large-cap funds. That's down from about 45% a few years ago.

In large-blend categories, Smith likes the Vanguard Large Cap ETF (NYSE: VV). He also tilts to the DFA U.S. Large Cap Value Fund (DFLVX).

The advisor targets another 20% to U.S. small-cap funds, which is relatively consistent with allocations of past years. That's divided across micro-caps, small-cap blend funds and small-cap value funds. Smith uses the iShares Russell Microcap Index (NYSE: IWC) and the Vanguard Small Cap Value ETF (NYSE: VBR) to fill those shoes. Smith also likes to include the Vanguard Small Cap ETF (NYSE: VB) and the DFA U.S. Small Cap Fund (DFSTX).

Some 25% of client stock assets now go into developed international markets. "In 2003, it started at around 16% and gradually has been bumped up," said Smith.

He uses four different funds in those areas. One of these is the Vanguard Europe Pacific ETF (NYSE: VEA) for large-blend international markets. The advisement firm mixes that with the DFA International Value Fund (DFIVX). For exposure to smaller foreign stocks, it's implementing in portfolios the DFA International Small Company Fund (DFISX) and the DFA International Small Cap Value Fund (DISVX).

In emerging markets, Smith will add about 10% of a typical client's stock assets into the DFA Emerging Markets Core Equity Fund (DFCEX). He also likes the Vanguard Emerging Markets Stock ETF (NYSE: VWO) for some portfolios.

"In early 2005, we started bumping up emerging markets allocations from around 4%," said Smith. "But emerging markets got up to about 12% of world markets based on capitalization levels at the beginning of this year. The year before it was close to 7%."

He added: "We'll be evaluating that asset class again at year-end to see if it needs more adjusting based on global capitalization rates, correlations and valuations."

Smith is also putting his clients into the Northern Global Rest Estate Index Fund (NGREX). On average, client portfolios will have about 5% of its stock assets in that fund, according to Smith.

"It's just a straight index mutual fund," he added. "It came out about two years ago and was the first passively managed index fund that provided exposure to global REITs. It holds both U.S. and international real estate companies."

Finally on the equity side, Smith puts about 5% of an average client's assets into the iShares S&P GSCI Commodity-Indexed Trust (NYSE: GSG). "We like the exchange-traded notes in the commodities area," he said. "But until there's a ruling that changes the tax structure of commodities ETNs, we're sticking to the ETFs. And we also don't want to take on the credit risks with ETNs right now."

Rebalancing Rather Than Pooling

Empirical is rebalancing client assets into both stocks and commodities now. "But we're not big fans of buying into big pools of gold or metals. We don't focus on any one sector—we want exposure to a broad range of commodities," said Smith.

And the GSG's index weights commodities based on global production, he adds, "which is the most straightforward and pure weighting methodology among commodities ETFs and ETNs."

Empirical rebalances portfolios based on a banding system. If an asset class shifts anywhere from 10% to 25% off its target allocation, then Smith and his team will consider making changes. Each asset class and fund is given different bands within a portfolio, he says.

"We're not market timers. But we review valuations for every asset class. So we do make adjustments, but it's not based on macroeconomics. It's based on changing correlations and valuations of different asset classes over longer periods of time," said Smith.

For bonds, Empirical focuses on constructing portfolios that are as non-correlated to stocks with as little risk as possible. "We keep it very simple using shorter-term durations and very high-quality funds," said Smith.

Empirical has four basic ETFs it includes in client portfolios. Those include the iShares Lehman 1-3 Year Treasury Bond Index (NYSE: SHY) and the iShares 3-7 Year Treasury Bond Index (NYSE: IEI). The other two are the iShares 1-3 Year Credit Bond Index (NYSE: CSJ) and the iShares TIPS Bond Index (NYSE: TIP).

The firm's investment policy committee has just changed allocations within fixed-income because of narrowing spreads between TIPs and nominal Treasuries, says Smith.

It's now allocating about 30% into TIP, up from 20% a month ago. Targets for the other three are: SHY (20%); IEI (15%) and CSJ (35%).

"We want the average duration of portfolios to be around five years or less. If you have a greater number of longer-termed bonds in a portfolio, correlations with stocks go up. And the longer the maturity of bonds, the greater the interest rate risks. So we find that five years or less poses the best risk-reward profile," said Smith.

-- This article was submitted by IndexUniverse.com's Murray Coleman.

Source: Good Times, Bad Times, Same Strategy Required