A 'Group of 2' Portfolio to Reduce Risks and Enhance Returns

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 |  Includes: FXI, SPY, VWO
by: Hao Jin, CFA

The U.S. stock markets closed lower yesterday, despite the death of Osama bin Laden. Mounting U.S. government debts, a record level of federal deficits and slowing U.S. growth leave investors wondering how to position themselves. One of the options is to look at emerging markets. However, these markets are very volatile. A group of Two (G2) portfolio, which mixes iShares FTSE China 25 Index Fund (NYSEARCA:FXI) and SPDR S&P 500 (NYSEARCA:SPY), may be a solution to increase your return.

Here are four reasons to add FXI to your equity portfolio:

1. Stronger Fundamentals

The table below from iShares.com shows that FXI has lower P/E and lower Price/Book ratios than the U.S. Dow Jones index fund (NYSEARCA:IYY).

Fundamentals & Risk

FXI

Dow Jones U.S. Index

Price to Earnings Ratio

16.4

20.3

Price to Book Ratio

2.3

3.7

Beta vs S&P 500

0.5

1.0

Standard Dev. (3 year)

32%

22%

Click to enlarge

Due to valid date difference, each website might have different P/E data. For example, in CNBC.com, FXI's P/E is 9.4 and SPY's P/E is 14. In Yahoo Finance, FXI's P/E is 11 and SPY's P/E is 14. Either way, FXI is much cheaper than U.S. market from the P/E point of view.

2. Higher Growth Rate

As for economic growth, developing counties are expected to grow at two to three times the rate of the United States. For China, the growth rate is even higher. The Gross Domestic Product (GDP) in China expanded 9.70 percent in the first quarter of 2011 over the same quarter last year.

3. Protect Yourself From U.S. Dollar Depreciation

Last week the Fed's decision to keep interest rates at historically low levels added to a likelihood in declines of the U.S.dollar against other currencies. As long as the Fed is printing money, buying booming emerging markets is an easy bet.

4. Diversity

Asset allocation can be more than just the split between stocks and bonds. If you are mixing asset classes with different countries, such as U.S. and Chinese stocks, then it would reduce risk and smooth returns. The following chart shows the last five years of returns for FXI (in green), SPY (in red) and G2 (in blue, with 60% SPY and 40% FXI). FXI had a wild run, which most conservative investors can't tolerant. But the G2 portfolio smoothed out volatility, yet enhanced return.

Click to enlarge
(Click to enlarge)

Conclusion

The dollar is near its 2008 lows, and oil is near its 2008 highs. The "2011 is 2008 all over again" theme has exploded recently. Any economy that saves and invests and works hard always wins out in the future over countries that consume, borrow and spend, according to Jim Rogers.

With a potential housing bubble, inflation fears, tightening monetary policy and widespread protests, China has its own problems. However, by adding Chinese stocks into your equity portfolio, you could enhance your return while reducing the risk. You might choose broader emerging markets such as Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO) if you concerns about country specified risks. After all, diversification is the only free lunch in investing.

Disclosure: I am long FXI, SPY.