Litman / Gregory Find Value in Junk

During the past few months, managers at Litman/Gregory Asset Management have been tweaking their index-only fund portfolios.

In particular, the Bay Area-based adviser and money manager has been building positions in high-yield bonds and emerging market stocks, hoping to capitalize on temporary inefficiencies in the market.

"The market is generally efficient. But there are times when prices get out of whack with fundamentals. In the case of high-yield bonds, they sold off dramatically in the fall of 2008," said Alice Lowenstein, the firm's director of managed portfolios. "When an asset class is really beaten down, our process assesses whether it's overdone."

Litman/Gregory manages about $2 billion in assets for outside advisers. It also runs another $2 billion in private accounts and through its Masters' Select family of mutual funds. Besides offering actively managed portfolios, the firm also creates model portfolios that are index-based. The portfolios are generally built using a mix of exchange-traded funds as well as index mutual funds.

Recent Index-Based Portfolio Moves

Litman/Gregory started raising positions in junk bond funds last October by 3-5%, depending on risk levels. In late November 2008 and mid-February 2009, they added to those positions. Both times, the firm's managers used proceeds from the sale of U.S. equities to bump up allocations in bonds to a high point of 15% in the most aggressive portfolios.

"In most of the scenarios we can envision right now over the next three-to-five years, high-yield bonds as an asset class look more attractive than even equities," said Lowenstein. "Of course, conditions can change very quickly in these types of conditions. But we continue to own high-yield bonds and believe their significant yields can offer a short-term cushion if the market falls."

With junk, the firm's 10-member analyst team builds scenarios to test the impact of factors such as how rising default rates and interest rates can impact yield spreads as well as longer-term performance.

"We don't try to predict any particular outcome. We simply try to build models of what we might see happen," said Lowenstein. "Baked into those scenarios are macroeconomic trends that could impact valuations and earnings growth for stocks, for example."

The firm's managers in May also shifted some stock assets into emerging markets, bumping those allocations to between 3-7%, says Lowenstein. Such a tactical move was funded by taking assets from a combination of U.S. and developed international stock fund positions.

Lowenstein says that those kinds of tactical moves only come when analysts see "fat pitches" coming investors' way. "Unlike baseball, you don't have to swing if it isn't a great pitch," she said. "So we don't unless our confidence level is pretty high."

A model index-based portfolio with a neutral target allocation of 60% stocks and 40% bonds (which Litman/Gregory calls its balanced strategy), currently is taking the following tilt:

Littman/Gregory Balanced Model Portfolio
Asset Class	Fund	Ticker	Weight
Investment-Grade Bonds	iShares Barclays Aggregate Bond Index	AGG	42.5%
Junk Bonds	Various mutual funds	N/A	12%
Large-Cap U.S. Equities	iShares S&P 500 iShares S&P 100	IVV OEF	27.5%
Small-Cap U.S. Equities	iShares Russell 2000	IWM	2%
International Developed Equities	Vanguard FTSE All-World ex-US ET	VEU	11%
Emerging Markets	Vanguard Emerging Markets ETF	VWO	5%

With 54.5% of the portfolio in bonds, it might seem that the portfolio is nearly 15% overweight fixed income. But that's true only when junk and investment-grade bonds are grouped together. Studies have shown that junk as a group is more correlated to equities than most other types of bonds.

"In this case, we're not allocating our fixed-income assets [in investment-grade] to a more risky asset class [in junk bonds]. Instead, we took some of our holdings in equities to fund bigger positions in high-yield," said Lowenstein.

Tactical Asset Allocation Strategy

Last year, asset class valuations and scenarios for potential longer-term returns were shaken dramatically by the market's huge fall, she adds.

"Starting from mid-September of 2008 when the financial crisis really grew in scope, we made about five tactical changes through year's end. But that's very unusual," said Lowenstein. "Normally, we wouldn't see that much activity in a whole year."

According to Litman/Gregory's calculations, its index-based 60/40 model portfolio has outperformed its benchmark by a significant amount over time. Since the portfolio's inception on Jan. 1, 2002, it had returned an average annualized 3.12% through April. That compares with its benchmark's total return of 2.14%.

The firm uses a benchmark for its 60/40 model portfolio consisting of:

• The Vanguard Total Bond Market Index Fund (VBMSX), 40%

• The Vanguard 500 Index (VFINX), 40%

• The iShares Russell 2000 Index (IWM), 8%

• The Vanguard Total International Stock Index Fund (VGTSX), 12%

"We primarily employ ETFs in our index-based portfolios," said Lowenstein. "But our benchmarks use a combination of index mutual funds and ETFs."

Either way, she says Litman/Gregory stresses low-priced and well-managed vehicles of both types. "We recommend that advisers take a common-sense approach in applying factors such as account sizes, trading costs and investment strategies when choosing between ETFs and index mutual funds in individual portfolios," said Lowenstein.

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

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