My ETF Portfolio: Chapter 7, Reviewing the Universe

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 |  Includes: DBA, EPI, EWH, EWT, EWW, EWY, EWZ, FEZ, FXA, FXE, FXI, FXY, GLD, IXC, IXG, RSX, SPY, TLT, TUR, XPH
by: John Crossman

Current RankingThis week is a good time to review what we have in the 20 ETF Universe and start to plan for changes that we might want to make at the three month mark coming up in three weeks.

First, a quick review of the performance of the portfolio: We are currently holding 250 shares of IXC (Global Energy), 550 shares of EWT (Taiwan MSCI), and 160 shares of EWW (Mexico Investible) plus $659.85 in cash. So far we have racked up $87.45 in commissions and $1,450.50 in short term capital losses. The portfolio was up 2.1% last week so we are still underwater in week 9 with a total loss of 1.86%. We started with $30k on November 15th and at Friday’s close, we are looking at $29,441.95.

As you can see from the ranking (to your right), there is no need for any switches this week.

Changing the Universe of Assets

When I laid out the rules, I concentrated on the weekly ranking and trading. I did not specifically mention parameters for the quarterly review (although I have hinted at them in a few posts).

So let’s correct that now: I plan to review the universe of 20 ETFs once a quarter and change no more than two of the ETFs. The limit of 10% change is arbitrary but I choose to constrain myself so that I am compelled to think a bit harder and hopefully make better choices.

Before we get into the meat of it, let’s review the basic structure of the system.

Separate Asset Selection From Trading

The system is a two step process: Selecting our asset universe and ranking the universe. Each part is equally important and the goal is to remove as much emotion as possible from the investment process on the premise that emotions can and will damage long term returns.

We have determined that it is more important to squeeze emotion out of the actual buying and selling of investments than it is to eliminate it from the selection of assets to be considered.

If one thinks about it in terms of the brain, we want to be able to use all of our brain to find our ideas: both sides of the “modern” prefrontal cortex and the “ancient” limbic system. Since we are picking a basket of potential investments and not trading them yet, the fight or flight message center in the limbic system should not be overly stimulated. And, since we are working mostly from a fundamental top down analytical point of view, pattern recognition (another limbic system specialty which is great for hunting wooly mammoths but can lead you astray in financial markets) should be kept at bay.

So, in effect, we can accept that part of the evaluation process does involve emotions, if only just to get to the point of “feeling confident about an investment thesis.” Trying to completely eliminate emotion from the asset selection portion of the process runs the risk of ending up with a total black box investment solution. The problem with a black box is that it tends to blow up in one’s face when the model of the markets and the actual markets diverge too greatly.

Removing Emotion From Trading

When it comes to the actual buying and selling of the ETFs, we want to shackle the limbic system with hard and fast rules. The goal is to filter out the noise and excitement of daily (and intraday) moves so that we are not rushing to the keyboards on every new datapoint or new pattern in the numbers. In our case, we use a simple momentum system to rank assets for momentum. That momentum can and will change so we will only invest in the top three assets at any one time and review the ranking on a weekly basis to keep our money deployed in the most promising ideas.

Just as important, however, we do not want to allow the ranking part of the process overly influence the asset selection and review process.

Portfolio Universe Review

Developed Markets

  • SPY - US Equity Market
  • FEZ - European Equity Market
  • EWH - Hong Kong Equity Market
  • EWY - Korean Equity Market
  • EWT - Taiwan Equity Market

Sectors

  • IXC - Global Energy Sector
  • IXG - Global Financial Sector
  • XPH - Pharmaceutical Sector

Emerging Markets

  • EWZ - Brazilian Equity Market
  • RSX - Russian Equity Market
  • EPI - Indian Equity Market
  • FXI - Chinese Equity Market
  • EWW - Mexican Equity Market
  • TUR - Turkish Equity Market

Fixed Income

  • TLT - 20+ Year US Treasuries

Currencies

  • FXY - Japanese Yen
  • FXE - European Euro
  • FXA - Australian Dollar

Commodities

  • DBA - Agricultural Futures
  • GLD - Gold

The first thing to look at is whether we are overly concentrated in one area or another. In the case of my ETF portfolio, there is a definite bias towards Emerging Market Equities and Asia. That reflects my interests, analysis and yes, my underlying beliefs. Therefore we could consider replacing RSX (Russia), the weakest of the BRICs, and perhaps we do not need to have both Taiwan (NYSEARCA:EWT) and Korea (NYSEARCA:EWY) in the universe.

The second thing to look at would be assets that don’t bring much to the table. SPY and FEZ are pretty broad based indices and given the outlook for the developed economies over the next three to five years, it might make more sense to replace these with individual sectors that might display more momentum. I would probably replace SPY first as the universe is already very US focused and we want to have something in place if “Old Europe” we to take off (something I am not anticipating).

The third thing I will be looking for is some balance. The most obvious hole in the universe is the fixed income portion which is represented by only one asset, TLT. I will have to do some serious research on this area as it is my weak spot. Since I already have US governments covered, I will see what I can find in the corporate and emerging market areas.

Now that we have identified some ideas, it is time to do some research and start weighing up the pros and cons over my investment horizon which is 3 to 5 years. We will tackle some of the proposed changes in the next chapter so that we can finalize our thinking and be ready to implement the changes before week 12 rolls around.

Disclosure: I am long EWT, EWW, IXC.