Casey Smith is President of Wiser Wealth Management, Marietta, GA-based fee-only fiduciary wealth management firm offering asset management, tax preparation, estate planning and financial planning services. Wiser’s unique investing techniques have earned Casey speaking engagements at top ETF conferences around the world.
Seeking Alpha's Jonathan Liss recently spoke with Mr. Smith to find out how he planned to position clients in 2011 in light of his understanding of how a range of macro-economic trends were likely to unfold in the coming year:
Seeking Alpha (SA): Despite predictions of a dip in equities amid slow global growth in 2010, stocks were clearly the better choice than bonds in 2010, especially in Q4 where bonds sold off almost across the board whereas stock returns remained robust. How are you planning to position clients in 2011 in terms of an equities/bond mix?
Casey Smith (CS): The economy is showing signs of improvement; corporate earnings have been better than expected. Some analysts are talking about double-digit gains in equities for 2011, but there is still considerable downside risk as well. Our government is spending $1.60 of each $1 received in tax revenue, unemployment remains high, several European countries are still on the brink of default and the tax breaks to help individual/small business owners are only good for two years.
That being said, we do not focus our portfolios on short-term events but rather on five-year allocations based on our assessment of long-term healthy asset classes. We seek a maximum gain for a given amount of risk across our risk-based models.
This past summer we reduced our bond duration in anticipation of an improving economy and greater risk in long-term bonds, however we did not change our fixed income vs. equity allocation. There certainly is a case for moving some bond allocations into companies that continue to increase their dividends. Vanguard’s Dividend Appreciation ETF (VIG) is a great example of what we would consider for a reallocation into equities in some of our models as we begin 2011. WisdomTree has dividend weighted ETFs that would be a consideration as well.
SA: Name one ETF investment that worked out particularly well in 2010 and one that was a bust.
CS: Despite all the calls for Emerging Market Bonds to fold in 2010, the JPM EMBI Global Index posted a double-digit gain for the year. A repeat performance will depend on how well inflation is handled (or not handled) in those countries.
Other individual equity sectors did well, but to invest in fixed income that produced a double-digit gain with a high yield, while also held in U.S. Dollars, iShares Emerging Market Bond ETF (EMB) – which tracks the index above - deserves recognition. Gold was also a good investment in 2010. iShares Gold Trust (IAU) gained 26% in 2010. With more uncertainty on the horizon, gold stands to benefit in 2011 as well, though it also has the potential to be the largest bubble since Holland’s tulip and bulb bubble burst in 1637.
In my opinion, the worst investment in 2010 was cash. The national average for FDIC insured accounts is 0.17% APY. Inflation will be just above 1%, yet individual investors either remain in cash or keep pouring large percentages of their investment portfolios into bonds, at high prices. The stock market has a long-term rate of return of 10% (the “Little Book of Common Sense Investing” puts the number at 10.2%), yet individual investors and some professionals are more motivated by fear rather than long-term results and indisputable data. Cash should be used for an emergency reserve fund and not as a long-term retirement investment. Investor behavior will continue to unnecessarily erode portfolio returns in 2011 and into the future.
SA: Which of these funds did you actually hold in client accounts? Were there any specific investments that failed to perform as you expected? How do you generally arrive at your investing decisions?
CS: We hold iShares JP Morgan USD Emerging Market Bond ETF (EMB) in all our accounts and gold through iPath Dow Jones-UBS Commodity Index Total Return ETN (DJP). Cash is held in our portfolios, up to 7%, where we have regular withdrawals.
We manage five index models. We track the actual indexes then seek out the best ETFs to fill those assignments. Model reviews usually take place during the summer months as that is our slow period, however sometimes events will force changes sooner, such as reviewing treasury allocations in portfolios.
In 2010 our models performed as expected. We are constantly looking at risk/reward within the portfolios. Our conservative model is always a concern because the clients are very risk averse and we are constantly looking for new ideas on how to benefit from a rising stock market, yet still protecting the portfolio from wild swings. The portfolio survived 2008 very well, but we also have to keep up with cost of living increases. The more aggressive models are easier to manage, as the portfolio with a longer-term time horizon will benefit from riskier asset classes.
SA: Are we likely to see a continued sell-off in fixed income ETFs into 2011? Where can income investors turn for safety while still getting a reasonable yield?
CS: A sell-off in treasury bonds is likely for 2011 however there could be support for treasuries if Europe continues to worsen or if we have a “surprise” here in the U.S. With so many analysts calling for a large gain in equities in 2011, it makes me a little cautious to abandon bonds. How often are all the analysts right? Investors contributing monthly to their 401ks and IRAs get the benefit of dollar cost averaging which will allow them to benefit from buying bonds at lower prices. Those no longer contributing to their retirement can look to dividend paying companies through ETFs to help protect principal while still maintaining yield. As I mentioned earlier, Vanguard’s Dividend Appreciation ETF (VIG) is a great choice.
SA: In which sectors do you expect strength in 2011 and beyond? Where do you expect particular weakness? What factors are key in coming to your investment thesis?
CS: Looking at the large amount of cash that the S&P 500 companies are sitting on, technology should be a great investment as companies begin to reinvest in their businesses. The Consumer Discretionary and Materials sectors should be good investments as well. Just the perception of a healthy economy here in the U.S. would help consumers open up their wallets to increase spending, increasing sales and making the case for companies to hire.
In full disclosure, we do not follow individual sectors, as we do not invest through sector rotation but rather core asset classes. These three sectors seem to have a strong thesis for someone looking for sector plays.
SA: Are you not currently long any sector ETFs in client portfolios?
CS: No, we do not invest in individual sectors. Some may consider commodities as a sector but we look at it as an asset class. Sector rotation falls into active management. ETFs are great for active management or passive. We are passive investors continuously looking for long-term healthy asset classes.
SA: What are your expectations for commodities, the dollar and precious metals in 2011 and beyond? Will we finally start to see some real inflation in the coming year?
CS: If we do have a serious inflation issue, I do not see it happening until the latter part of 2011 or even 2012. We made inflation-related moves during the financial crisis with the understanding that the U.S. would recover and that purchasing TIPS and commodities would pay off in the long term. However, QE2 is proof that deflation is more of a concern today than inflation.
The dollar will continue to fall in 2011 as the U.S. Government does not seem concerned about supporting it. A falling dollar is a form of economic stimulus. Also, the fall of the dollar may not seem as bad if the Euro keeps falling at a faster rate. We do not use currency funds as a tool at Wiser Wealth but will invest in other countries as part of a currency and inflation hedge. For example, Asian equities lost 1.9% in 2010, but if you held the index in U.S. currency, you would have gained almost 10%. This is because of the fall of the US Dollar vs. the Yuan.
Precious metals will continue to be the headline story in 2011, specifically gold. Who is buying gold? We know that the Chinese are purchasing it but we also know that your maid and car mechanic are also buying due to every other commercial on radio and TV telling them that it is the only safe asset in which to invest. You can now sell your gold at kiosks at malls all over the country. Tupperware parties are so ‘90s; gold parties are now the craze!
Do you remember how during the tech bubble everyone was creating businesses ending in .com, day trading was king and the PE ratio was deemed old fashioned since there were no real earnings? Gold is now headed down that path. I cannot predict when, but history tells us a straight line up does not go on into infinity. Despite its recent price climb, gold does not pass our long-term healthy asset class test. Nevertheless it is represented in our commodity holding, iPath Dow Jones-UBS Commodity Index Total Return ETN (DJP), with gold making up 10% of the performance of the index. An ETN actually holds nothing and is basically a promissory note, which takes away the tax issue of precious metal holdings.
SA: The tax advantages of ETNs over ETFs in the commodity space are fairly clear. How about the risk of contango in futures-based products like DJP. Is that a concern at all?
CS: You have to be aware of contango and the negative effect it can have on performance, but despite this risk, DJP has been tracking its index well. We chose DJP because of its diversification with the commodity asset class. We also do not want the negative tax implications of commodity ETFs passed on to our clients, thus we feel that DJP is still the best diversified option in the ETP space. If an investor expressed a desire to hold a specific commodity such as precious metals, we would suggest the ETF approach in actually holding the physical asset.
SA: Let's move on to some specific issues that will affect equity returns in 2011 and beyond. In November the Fed implemented another round of QE. Will we get a third round of fiscal stimulus in 2011? Which sectors/asset classes do you think are ideal to play the Fed's actions?
CS: The Federal Reserve is out of its normal “tricks” to stimulate the economy. QE2 has gotten a lot of press, mostly bad at first and now somewhat indifferent due to the worst-case scenarios of QE2 not panning out. Some are calling for a third round to help prevent deflation; I am personally indifferent in regards to portfolio management terms.
We have a long-term focus and 10 to 20 from now, QE2 will once again just be a boat reference. QE2 is essentially the creation of inflation. The government is looking for an inflation rate of 2%. This simply means that “stuff” should get a little more expensive and debt will be easier to obtain.
A diversified commodities ETN like DJP would be a good play on inflation, manufactured or not. A third round of Quantitative Easing simply means that deflation is still a concern and inflation investments might still be a bargain.
SA: How does the incoming Republican House majority affect the economic outlook for the next two years? Is gridlock ultimately good or bad for equity returns?
CS: Having a group in Congress that will look to businesses as part of a solution to the economic recovery will benefit investors and “Main Street” moving forward. The President has over-promised and under-delivered on the economy, thus I think there will be compromises made and gridlock will be avoided on the economic front.
Whether Congress can reduce the budget deficit is the biggest issue. Unfortunately I believe that gridlock will be an issue here. In good economic times gridlock may be okay, but in 2011 and for the next five to ten years we need to fix the spending problem and have clear leadership in the direction that we take our economic policies. We need less political risk here at home. This process has begun and in 2011 I think we will see more pro-business policies.
SA: How about the situation in the EU. Have you lightened up on European stock/bond exposure in client portfolios as a result of continuing contagion there? Are there any bright spots you'd focus on in terms of European equity allocation?
CS: Europe certainly has some issues but there are still healthy companies there. The problem is more political, meaning the socialism model is proving to be flawed. Government setting wages and benefits versus a free market and budget deficits that are out of control will make the U.S. economic recovery look very easy. The euro currency experiment is being pushed to its limits and in less civilized times may have started wars! Key policy makers in Europe say that the euro is the only way into the future, only time will tell.
That being said, removing Europe from your portfolio would be an overreaction. When everyone is exiting an asset class, the individual investor should refrain from timing any market and keep purchasing at the lower prices. This makes iShares MSCI EAFE ETF (EFA) a viable core holding as well as a fund like the WisdomTree DEFA ETF (DWM) that focuses on dividend paying companies in Europe. If dollar cost averaging cannot be done, then rebalancing the portfolio will help in purchasing Europe at lower prices.
SA: What weighting are you currently giving Europe equities in client portfolios?
CS: Europe gets 3–15% of a portfolio depending on risk tolerance. Obviously a conservation of principal portfolio is 3% and an aggressive portfolio is 15%.
SA: Same question but for U.S. states like California and Illinois. Will a government bailout ultimately be necessary to backstop state debt as defaults pile up? Are muni bond funds something you're avoiding going into 2011, or do their significant tax benefits still outweigh the possible downside of one or more states defaulting?
CS: This is a great question. With the tax efficiency of ETFs, we have been able to virtually eliminate our muni holdings from our accounts for most of our clients. There is certainly still a benefit to the tax-free income, however munis as a whole no longer fall into our category of a long-term healthy asset class.
You could make the case for holding individual municipal bonds, but muni ETFs could bring some undesired risk because of states like California. I cannot speculate on if and how these governments could get bailed out. I would hope for taxpayers across the country that those states would make tough financial choices in order to get their budgets back in shape and spare other Americans from the cost of bad choices and in some cases corrupt government.
SA: The U.S. housing market seems to be in the midst of another prolonged leg down. How are you playing this via ETFs? Is the commercial real estate market a better bet going forward? How much weight are you giving to REIT funds in client portfolios?
CS: We removed REITs from our portfolios in February 2007. There were several reasons for this, with the number one reason being that we did not see the asset class as a whole benefiting us over the next five years. For clients who qualified, we invested what we would have allocated to REITS into private equity that was purchasing land near the South Carolina coast at deeply depressed prices using no leverage (i.e. cash purchases only). As these investments wind down we are once again looking at REIT ETFs.
We have noticed that the private equity funds have not recovered as well as REITs. This appears to contribute to the REITs’ ability to raise capital through stock offerings where private equity is having a hard time selling to new investors. This makes REIT ETFs more attractive.
In the past we have used iShares Cohen and Steers Real Estate Majors ETF (ICF) but we now have many more choices in the REIT ETF market. The FTSE NAREIT index ETFs offered by iShares will allow us to diversify into REITs around the globe, if we so choose. Commercial real estate seems more stable going forward, especially now that the retail sector has calmed down. Some of the largest REITs in the commercial indexes are retail property managers. We would cap REITS at 5% in most portfolios.
SA: Finally, one of the great economic stories of our time is the emergence of China and, to a lesser extent, India as global economic powerhouses. How much weight do you recommend for emerging market ETFs in both stock and bond ETF allocations?
CS: We currently use Vanguard Emerging Markets ETF (VWO) for our emerging market exposure - our allocation here is 3%-10% depending on risk tolerance. Our emerging market bond exposure is through iShares JPMorgan USD Emerging Markets Bond ETF (EMB), which makes up 5%-8% of our portfolios. Both have proven to be great investments in 2010. Emerging market bond ETFs will face an uphill battle in 2011 due to inflation, but the balance sheets of emerging market countries generally look more appealing than those of developed countries. The risk is higher but we believe that there is still a long-term bullish outlook on this asset class.
Disclosure: We currently hold EMB, VIG, DJP, EFA, DWM and VWO in client accounts.