This is the second piece in our Positioning for 2012 series. Readers can find the entire Positioning For 2012 series here.
Lowell Herr runs the ITA Wealth Management website, with a focus on asset allocation, index investing, and a passive to semi-passive approach to portfolio management. The site tracks 20 different portfolios catering to a range of investors needs, tastes and circumstances. A former physics teacher, Herr's strong mathematical foundation is apparent in unique approach to portfolio construction.
Seeking Alpha's Jonathan Liss recently spoke with Lowell to find out how he planned to position portfolios in 2012 in light of his understanding of how a range of macro-economic and geopolitical trends were likely to unfold in the coming year.
Seeking Alpha (SA): How would you generally describe your investing style/philosophy?
Lowell Herr (LH): I’m a “mosaic” investor and here is what I mean by that term. The core of the portfolio is constructed around non-managed index ETFs with a few highly selected stocks sprinkled in from time to time. I tend toward passive investing, but will use technical indicators when a portfolio is not outperforming the benchmark. In addition, I skew portfolios toward value rather than growth and I allocate a greater percentage to mid- and small-cap asset classes when compared to a broad market index such as the VTSMX.
My investment style has been greatly influenced by William Bernstein, Richard Ferri, William Sharpe, Eugene Fama, Kenneth French, Larry Swedroe, Charles Ellis, Roger Gibson, and Burton Malkiel.
SA: Within equities, are there any particular sectors or themes you are currently overweight or underweight? If so, why?
LH: Although I generally don’t invest in sectors other than REITs, I track sectors to see if there are buying opportunity. For example, I use a “Delta Factor” calculation as a probability indicator to find sectors that provide the greatest opportunity for growth over the next six to twelve months. As shown below, financials (VFH) is currently that sector.
The reason for downplaying sectors is that asset classes cover all sectors, but sectors will not incorporate all asset classes.
SA: Which asset classes are you overweight? Which are you underweight? Why?
LH: As mentioned above, I overweight value and the smaller cap asset classes. The screen shot below is an example of a typical Strategic Asset Allocation (SAA) plan. The following SAA plan has been in place for eleven years with only minor changes. International REITs was added a few years ago.
In many portfolios I’m beginning to eliminate “core” asset classes as they are highly correlated with the broad U.S. Equities market and I’m looking for ETF investments with a lower correlation to the broad market.
click to enlarge
SA: To which index or fund – if any – do you benchmark your performance? Has this changed recently, and if so, why?
LH: For a basic benchmark, I use Vanguard’s Total Stock Market Index Fund, the VTSMX. In addition, VFINX and VGTSX benchmarks are built into a customized portfolio tracking spreadsheet known as the TLH Spreadsheet.
While I rely on the VTSMX as a primary benchmark, it is incomplete or inappropriate for most portfolios. For example, portfolios that hold bonds, emerging markets, commodities, and REITs are not well served with a benchmark that is keyed to the U.S. Equities market. For that reason, I developed the ITA Index, a customizable benchmark that is built into the TLH Spreadsheet. The ITA Index tells the investor how well their portfolio is performing with respect to the Strategic Asset Allocation plan.
SA: Why not benchmark to a ‘balanced or target-date mutual fund’ to allow investors to see the value you are adding vs. traditional mutual fund solutions to the strategic asset allocation needs of investors? What is the benefit of constructing your own benchmark?
LH: A balanced benchmark fund will not necessarily match my asset allocation mix, whereas the ITA Index benchmark will fit each plan. If I allocate 16% to bonds, the ITA Index tracks the portfolio as if 16% were invested in bonds. Once more, while I use the VTSMX as one benchmark, I also have the ITA Index as a customized benchmark that is designed to fit each specific portfolio. Different portfolios have different Strategic Asset Allocation (SAA) plans and the ITA Index benchmark is set up to adjust for each SAA plan.
SA: What attention, if any, do you pay to portfolio risk and how do you measure it?
LH: Risk or portfolio uncertainty, as I prefer to call it, receives a lot of attention as portfolio return and risk are highly correlated. While many portfolio managers use mean-variance or standard deviation to measure portfolio volatility, that method penalizes the money manager for volatility to the upside as well as the downside. Investors revel in volatility to the upside and anguish over downside movement so a different measurement is required.
Within the TLH Spreadsheet I’ve developed a way to calculate the Sortino Ratio. This is a semi-variance calculation where the upside volatility is ignored and the portfolio manager is only punished for downside variations or uncertainty.
While the Sortino Ratio, in order to generate a positive value, requires the Internal Rate of Return of the portfolio to exceed a Desired Target Return™, I’ve developed an even higher standard of measuring portfolio uncertainty. The Retirement Ratio, to generate a positive value, must outperform either the DTR or withdrawal rate plus inflation – whichever is the larger value.
Somewhere I picked up a saying, “you cannot manage what you do not measure.” While portfolio planning is fundamental to successful investing, so is benchmarking, rebalancing, and accurate measurement of portfolio uncertainty.
SA: 2010-2011 saw a notable rush for the exits from equities and equity vehicles. Is this a cyclical, or secular shift? What would it take to bring them back?
LH: Since I am a long-term investor, I don’t pay too much attention to market gyrations. In a few specialized portfolios I apply some technical analysis as described in more detail on my blog.
SA: How frequently do you rebalance client portfolios? Is this tied into markets at all (i.e. do you use allocation bands?), or do you rebalance at specific time intervals regardless of market gyrations?
LH: I use a 20% to 25% allocation band for most portfolios. In an 18-year study running from 1989 through 2007, I found that the best performance comes when one uses somewhere between a 30% and 35% allocation band. I lowered that so asset classes would not become overweighted. All this is built into the TLH Spreadsheet so it is quite easy to monitor.
SA: Moving on to some themes that are likely to weigh heavily on the market in 2012, will the crisis in the Eurozone continue to drive the market’s direction, and how are you protecting client assets from potential fallout there?
LH: I continue to hold developed international markets (EFA or VEU) and emerging markets (EEM or VWO) in most portfolios. As mentioned before, I will use a few technical indicators if a portfolio lags its benchmark. Currently, I am not fully invested in VEU and VWO in all portfolios.
SA: What do you mean exactly by "not fully invested in VEU and VWO"?
LH: Assume a full position in developed international markets (VEU) is 15%. Right now I do not hold a full 15% position in several portfolios due to technical signals. I’m waiting for the price of the ETF to move above a particular Exponential Moving Average (EMA) before I will take a full position. The same holds true for emerging markets (VWO) and international REITs (RWX).
SA: International equities proved volatile for both developed and developing markets over the past 2 years. Do you see a clear winner going forward?
LH: I’ve been decreasing the allocation percentage in developed international markets (VEU) and increasing the percentage in emerging markets (VWO). Obviously, I think the advantage will go to emerging markets, at least over the next few years.
One individual country I include in emerging markets is Indonesia. Two ETF options for playing Indonesia are iShares MSCI Indonesia Investable Market Index ETF (EIDO) and Market Vectors Indonesia Index ETF (IDX).
SA: Why Indonesia specifically? Which of those two ETFs is your preferred investment vehicle?
LH: EIDO is my preference as IDX has come off a great four-year run. Even so, my indicators show a “Hold” for both ETFs. I added Indonesia about a year ago and expect to hold on for another four or five years as it has a young population with a government that is showing increased stability. This is definitely a higher risk investment and not for everyone. I hold it in just a few portfolios.
SA: So then where are the real growth stories overseas right now?
LH: My preference is to stick with broad based ETFs rather than specialize. However, I do maintain a database of emerging market ETFs and I look at the “Delta Factor” for a wide array of individual countries to see if there are significant opportunities. One possibility is Italy (EWI), but as everyone knows, they have special problems so I’ll wait to see what happens in that country. One can make a probability argument for picking up a few blocks of EWI and EWP.
SA: How much exposure to emerging markets do you have both in terms of stocks and bonds?
LH: Target percentages for emerging markets are running from 10% to 25%, depending on the portfolio. For the higher percentages I am allocating 20% to emerging markets (VWO) and 5% to emerging market bonds (EMB).
SA: What is the ideal asset allocation for someone with a long-term horizon (greater than a decade) and no need to touch their investments? Can investors continue to rely on stocks after the ‘lost decade’ we just experienced?
LH: To answer this question, I need to know the age of the investor and whether or not they will have social security and/or pension income in retirement. If the investor can expect sufficient income in retirement from a pension and SS, then they can take a greater risk with their portfolio.
For this argument, assume one is 50, self-employed, and will need to retire on social security and portfolio returns. In this situation, I am inclined to move toward a 50% bonds, and 50% equity portfolio. The other option is to tilt the portfolio toward dividend oriented ETFs and dividend stocks so one can reduce the percentage in bonds.
SA: So no allocation to Commodities at present time?
LH: Actually, I am allocating between 4% and 10% to commodities for most portfolios. This percentage is included in the 50% equity allocation.
SA: Which dividend ETFs are currently making their way into your client portfolios right now and why those funds specifically?
LH: Two that I favor are iShares Dow Jones Select Dividend Index ETF (DVY) and iShares Dow Jones EPAC Select Dividend Index ETF (IDV). DVY has a yield around 3.9% and IDV is generating nearly 4.7%. Both ETFs fall in the value side of the investing spectrum and that fits my overall investing philosophy. Both ETFs have been kind to my portfolios over the last few years.
Disclosure: Lowell Herr is long VNQ, VFH, VEU, VWO, EFA, EMB and EIDO