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Long only, value, bonds, portfolio strategy
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Summary

  • Small Cap and Mid Cap stocks are the backbone of an aggressive portfolio. Both classes can be value and growth opportunities.
  • Pharmaceutical and Healthcare equities are non-cyclical and fare well throughout the business cycle. They have also outperformed the market in the previous year.
  • Commodities are volatile but can serve as tactical add-ons to the portfolio. Investors may enhance returns by allocating more or less weight to this asset class.
  • Natural gas may be a long-term play, while precious metals are generally a good hedge against inflation.
  • Determining preferences and staying loyal to them is key for choosing appropriate weights for portfolio construction.

Sometimes investors want to play aggressively in pursuit of higher equilibrium returns. Typically, asset classes picked for these ventures are small cap stocks, cyclical equities, commodities (even futures and options on those), and others. Popular strategies include weight-shifting for market sectors within a portfolio, tactical allocation, timing, etc. I have analyzed long-term strategies involving six asset classes that encompass 15 ETFs (decent amount for a partial elimination of non-market risk). The following illustration shows classes and their proportions within an optimal long-only portfolio:

(click to enlarge)

Here are some findings in connection with the portfolio composition:

  • 70% of funds are allocated to some type of equities, while the rest are shared by ETFs focused on commodities and alternative strategies
  • Diversified stocks (Small and Mid Cap) make up almost a third of the portfolio, while 40% is allocated for health-concentrated equities
  • Commodities play an important part in expected returns and are given a considerable space within the portfolio

ETFs by Asset Class

As done previously, I have decided to group ETFs by class for readers' convenience.

Small Cap Stocks ETFs

This class of assets is famous for highest returns in the long run (low-to-mid teens for the past decade). Since market returns are generally equilibrium, these stocks come along with higher levels of risk (both market and non-market, i.e. firm risks). Small caps are expected to deliver returns in the form of capital appreciation, since any free cash flows (if they exist at all in this class) are reinvested at high ROE. Data in the model has shown that small caps tend to outperform other asset classes, although marginal returns come at increasing levels of risk.

ProShares Ultra SmallCap600 (NYSEARCA:SAA)

This ETF is both a very profitable and an extremely volatile asset. Since its inception, it has shown a weighted average return of 23.5% and a standard deviation of 48.5%. It is small in size ($32+ M) and pays no dividend. Started in 2007, it has rallied 55%+ above its IPO price after an initial drop of ~85% during 2008. It has increased ten-fold since then. The beta is high, standing at 2.4.

Rydex S&P SmallCap 600 Pure Value ETF (NYSEARCA:RZV)

This fund invests primarily in equities considered to be undervalued to their fundamentals. Hence, the fund has a P/E ratio of less than 10X. Historically, the strategy has proven to be profitable as the fund has demonstrated a weighted average return of 17.5%. However, the risk has been high, too: the standard deviation of returns is around 27%. Compared to its aforementioned peer, the fund lost much less in the same crisis period: around 75%. As a consequence, it has increased "only" five-fold since the market trough. The fund's beta is 1.87 and it pays a small dividend of 0.64% of the current price.

Mid Cap Stocks ETFs

An often overlooked asset class, Mid Caps, offers a compelling mix of growth and value. Less risky than Small Caps, these stocks have shown slightly lower returns in combination with a level of dividends, which are usually uncommon in the world of small equities. I have mixed some value and growth ETFs that have worked along this strategy.

Rydex S&P MidCap 400 Pure Growth (NYSEARCA:RFG)

This is a sizable fund ($838M+) trading at ~12X P/E with a beta of 1.2 and a dividend yield of 0.64%. Historically, it has shown returns of 16.2% on average at a market risk of 27%. During the worst-of-the-worst, it lost less that 50% of its value and then rallied approximately 4X from the historical minimum. During 2013, it has delivered a return of ~26%, slightly below the market.

WisdomTree MidCap Earnings Fund (NYSEARCA:EZM)

This midsized fund ($500M+) invests in medium-sized publicly-traded companies that have shown positive earnings in the last four quarters (casual rebalancing occurs at the end of each calendar year). It has a slightly higher beta than its peer (1.23) but offers a significantly higher dividend yield of 0.97%. Since its inception on 2007, it has delivered weighted average annual returns of circa 15% at the same risk as its above mentioned peer. During the crisis, it lost more than 50% of value, but also recovered more than its rival in the following years. In 2013, it has actually shown an alpha of ~4% to S&P 500.

Pharmaceuticals & Healthcare

The reasons why I included this class of stocks is that, first of all, I never mentioned it in my previous articles on dividends and/or equities in general and, secondly, that constituent companies are considered to be non-cyclical. I have chosen a number of these to differentiate among various stage businesses. To save readers' time, I have constructed a table with key metrics for the selected funds:

(click to enlarge)

Readers should notice two facts: p&h companies have outperformed the market in 2013 and they have historically been more balanced in terms of risk/return (i.e. compare weighted average returns to standard deviations) than both small and mid-caps in general.

Commodities & Precious Metals

In contrast with equities, commodities and metals cannot be easily valued by average investors. These classes are highly volatile and trade within a specific price channel excluding the possibility of long-term capital appreciation. In other words, these are tactical asset classes where investors can earn extra return (loss) during a short medium-term trend. And, while precious metals such as silver and gold are generally accepted as inflation hedges, commodities like oil and gas are pure betting. Commodities make up a significant part of the presented above portfolio. The list of the selected securities is presented below:

(click to enlarge)

Readers should notice that metals lost significantly during the last year, while having posted a decent weighted average return over the last decade. The ETFs do not pay dividends. As a side note, natural gas ETFs within the list have shown negative covariance with most asset classes. However, this phenomenon is due to the long-term depreciation in spot prices rather than a rule of thumb. Investors should be aware of that and, if they take a long-term approach, should expose a part of their portfolios to natural gas assets.

Alternatives

This asset class is considered to be uncorrelated with the markets in general. Although in recent years correlations have been on the rise, especially during market downturns, investors like to get exposed to alternative investments to some extent. The major reason is that some segments of this class (e.g. private equity, venture capital, etc.) have shown high equilibrium returns over the past decade. I have included a fund I think should be considered by readers for further analysis and/or exposure.

Claymore Beacon Spin-Off (NYSEARCA:CSD)

The ETF follows returns of an equity index called the Beacon Spin-off Index. The Index is comprised of 40 stocks of companies that have been spun off in the past 30 months. Although there are no restrictions to capitalization, companies included in the Index are usually small to mid-cap with equity values under $10 billion. It should be noted that the ETF has a net expense ratio of 0.65% which is considerably high for an ETF.

Turning to financials, the fund has a market cap of almost $773M and trades with a beta of 1.02. It offers a dividend yield of 0.19% and has returned 18.5% on average since inception (end of 2006). During 2013, it returned approximately 50%; during the crisis of 2008-2009, it lost almost 70% of its all-time high value. The standard deviation is rather high at 36.3%.

Other Portfolios

Besides the portfolio that I think is optimal, there are other options available. Readers may choose according to a number of metrics: diversification ratio, dividend yield, expected return, risk, beta, etc. They can also choose simply a plain vanilla portfolio, which is the one that has capital allocated to each asset equally (first column).

(click to enlarge)

Note that past performance may not necessarily indicate future returns (at least if you believe the market is semi-strong efficient at minimum). Nevertheless, the most viable option in terms of risk/return is the 5% to 15% Long-Only portfolio, which is presented in the beginning. The risk-minimized options are highly undesirable given miserable expected returns and risk/reward ratios. However, this is understandable because the assets selected for the portfolio are not meant to be for risk-averse investors. The summary chart is given below:

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Readers are welcome to substitute selected funds with their own preferences. I believe that I have laid down a solid framework for a fairly diversified portfolio customized for risk-seeking investors.

Source: Choose These Or Similar ETFs If You Embrace Risk