Asset Allocation and ETFs

by: Roger Nusbaum

Cam Hui from the Humble Student Of The Markets blog had a post recapping David Rosenberg's proposed asset allocation. The allocation as written by Rosenberg;

The name of the game is to focus attention on strategies that:

* Deliver income (including dividend growth, hybrid funds and corporate bonds since company balance sheets are in fine shape);
* Minimize volatility and emphasize on capital preservation in a secular bear market (true long-short “hedge fund” portfolios), and;
* Commodities (precious metals as a “buffer” in a financially unstable world; and industrial commodities to take advantage of (i) the secular growth dynamics in Asia, and (ii) repeated rounds of currency depreciation inevitably lead to trade protectionism and “security of supply” constraints, which tend to benefit basic materials.

I did not see any specific percentages so perhaps each of the three should be targeted at 33% of the portfolio. Finding ETFs that generally fit the bill should not be that difficult.

Looking at "income" first, dividend growth limits the choices some. A lot of the dividend ETFs simply target the fattest yields. The SPDR S&P Dividend ETF (NYSEARCA:SDY) targets companies that have raised their dividend for at least 25 years in a row. Since its inception it has soundly outperformed the iShares Dividend Select ETF (NYSEARCA:DVY) but that outperformance started in late 2008. SDY is heaviest in utilities at 23% followed by staples at 16% and materials at 10%. Perhaps the drubbing in financials in the last couple of years explains the low (compared to other dividend funds) 10% weight.

One form of hybrid security is preferred stocks. There are a couple of ETFs out there in this space including the iShares S&P US Preferred Stock Index Fund (NYSEARCA:PFF) and the PowerShares Preferred Portfolio (NYSEARCA:PGX). Both funds are very heavy in financial stocks -- 88% and 83%, respectively. That would make me uncomfortable.

Obviously just about every ETF provider has corporate bond funds. I'll mention the new Claymore BulletShares series again and mention that it would make sense for anyone interested in this type of allocation to look for a fund with relatively little financial sector exposure. I recently mentioned that one of the providers (I believe PowerShares) filed for sector bond funds. I'd much rather own bonds from the industrial sector (we own some UPS bonds for some clients) or the healthcare sector (we own some Eli Lilly (NYSE:LLY) bonds for some clients) than load up on bonds from the financial sector.

For long short exposure there are several funds from IndexIQ, the iShares Diversified Alternatives Trust (NYSEARCA:ALT) and the ELEMENTS Linked to the S&P Commodity Trends Indicator Total Return (NYSEARCA:LSC) along with quite a few traditional mutual funds including the merger arbitrage funds mentioned the other day.

There are all sorts of funds to access commodities for both methods: owning the underlying or equities in the respective spaces. A less volatile broad based fund has been the Greenhaven Continuous Commodity Index Fund (NYSEARCA:GCC). It is less volatile because it equal weights the commodities in the index so it has less exposure to crude oil than most other broad funds like the PowerShares DB Commodity Tracking Index (NYSEARCA:DBC). Obviously there are many choices for narrower exposures to ag, base metals, energy and so on. I'll mention that iPath is sort of replacing most of its commodity ETNs with funds that are five basis points cheaper and callable by the issuer (remember ETNs are debt obligations).

There are also countless equity funds to choose from like from the big boys like iShares and SPDR and the upstarts like EG Shares, Market Vectors and GlobalX.

So finding funds to choose from is not difficult obviously a proper study needs to be done, I just chose funds semi randomly. There are now over 1000 ETPs and as this is just a blog post and not a client proposal I did not do an in depth study.

That disclaimed it makes sense to understand where this is vulnerable. The concern with the income stuff was alluded to above with the big exposure to financial stocks with the preferreds and the bonds. One other fund to look at is the iShares Barclays Credit Bond Fund (CFT) which is 42% industrial companies. SDY's exposure to financials is quite reasonable.

The issue with long short is that funds that you and I would have access to have no guarantee of "working" in the future. We have had good luck with the Rydex Managed Futures Fund (MUTF:RYMFX) during the worst of the decline but there is no reliable way to know, beyond faith in the methodology, that it will work again. This does not mean they should be avoided just, repeat point coming, that these are not infallible and too much exposure to one fund could really come back to bite.

Among other attributes, commodities are cyclical. Many commodities have struggled lately perhaps over perceptions of a less robust recovery than some were expecting or maybe another reason. If you buy into the cyclicality of this space then they could go down more before, again, being an inflation hedge of some sort or otherwise storing value.

From a slightly bigger perspective one thing that sometimes gets lost in conversations about asset allocations is that occasionally they need to be changed tactically. The easiest example is my underweighting equities when the S&P 500 goes below its 200 DMA but there are other example as well. The combo of positive data and negative data leads me to think things will be slow for quite a while and if that turns out to be correct then having a lot of commodity exposure will be a bad idea.

Additionally, commodities (often) and commodity stocks (almost always) add volatility to a portfolio as opposed to most utilities stocks that you would expect to reduce volatility. In accounts where we use an ETF for mining stock exposure we use the iShares Global Materials ETF (NYSEARCA:MXI). From its peak in May 2008 it dropped 63% at its worst compared to 50% for the SPX. From the recent peak in April MXI is down 20% versus 12% for the broader market. If this trend continues then a very large exposure (not that Rosenberg is suggesting that) could be very problematic.