This is the 16th piece in our Positioning for 2012 series. Readers can find the entire Positioning For 2012 series here.
Casey Smith is President of Wiser Wealth Management, a Marietta, Georgia-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. When not running Wiser Wealth, Casey doubles as a pilot for an Atlanta-based commercial airline.
Seeking Alpha's Jonathan Liss recently spoke with Casey to find out how he planned to position clients 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?
Casey Smith (CS): Wiser Wealth Management is a fiduciary fee only wealth management firm. Our investment philosophy is to maintain a diversified portfolio, keep costs low and always invest for the long-term.
As portfolio managers, we believe that long-term investing should focus on the use of index funds (Index mutual funds, ETFs or ETNs) as the only vehicles for investing. Very few active managers have beaten their assigned index over long periods of time. This also means that we will not attempt to time the market, make emotional short-term portfolio decisions or place large bets on any single sector or asset class. We seek to invest in long-term healthy asset classes.
Diversification is key to any portfolio. Our portfolios tend to have exposure to fourteen global asset classes. We choose these assets classes based on the historical long-term risk of holding these investments as well as what we call common sense future expectations. Through the use of index funds, we generally have portfolios that hold more than 3,200 stocks and over 6,000 bonds, thus we virtually eliminate company risk and focus on asset class and market risk.
Keeping average portfolio costs below 50bps also increases the client’s rate of return, compared to costs associated with active managers and expensive brokerage houses.
SA: To better understand your process, which are the 14 asset classes you split portfolios into? How do you decide what allocation to give to each?
CS: We currently have client models exposed to the following indexes: US large cap dividend focused, the S&P 500, S&P 400, S&P 600, Developed Europe large cap equity, Developed Europe equity with a dividend focus, Developed Europe small cap equity, Emerging Markets equity, Emerging Markets equity with a dividend focus, Frontier markets, US commodities, the US Aggregate Float Adjusted bond index, Treasury Inflation Protected Bonds, International Treasury Bonds held in local currency, US High Yield Bonds, US Preferred Stock, 1-5 year US Treasuries, Short maturity corporate bonds and cash.
We manage five models ranging from conservative to aggressive. Many of our clients fall into an income growth model. This particular model has 30% exposure to world equity markets and a total portfolio cost of 0.33%.
We focus on asset class risk when building a portfolio. Using the income growth model as an example, we have assigned a risk number of 6 to the portfolio, meaning that we want the average long-term standard deviation of this portfolio to be no greater than 6. We select from the assets classes mentioned above based on long-term standard deviations while also taking into account future realistic expectations. For example, long-term bonds would not have the same outlook as the results from the last 10 years. We want a portfolio yield of 3.5%. This is obtainable only by having a value tilt to the equity portion while keeping bond duration short to reduce the threat of rising interest rates into the future. We look to keep our client annual withdrawals to be no greater than 3-4.5% of the portfolio value. This will keep them from withdrawing principal, unless of course they plan a principal drawn down as part of their investment policy/retirement plan.
SA: Name one investment that exceeded your expectations in 2011, and one you had high hopes for that didn't pan out. Do you see any particular investment surprising investors over the next year?
CS: Treasury Inflation Protected Securities (TIPS) are guaranteed by the US Government and help investors keep up with inflation. The principal of TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. We did not think that inflation was going to be a real threat to US investors in 2011, however my team certainly wanted to still be invested in TIPS as a long term healthy asset class. Our ETF choice for TIPS is Pimco’s 1-5 Year TIPS Index (STPZ). The fund currently yields 3% and has returned 5% in 2011. With the S&P 500 posting a lesser yield and 2011 total return, TIPS are a bit of a surprise winner.
In 2010 we believed that the dollar would continue to fall versus world currencies for the foreseeable future, and we wanted to take advantage of this. Certain advertisers would have you believe that owning gold would be a good hedge, but historically, gold does not have a negative correlation with a falling dollar. Another option was to use a currency fund, but in doing so our investors would not actually own any currency - just future contracts, which have added risks. So we elected to use iShares S&P/Citigroup International Treasury ETF (IGOV). This ETF invests in foreign treasury bonds in their local currency. This allows our investors to own a real asset, receive a dividend of just over 3% and have a near 95% negative correlation to the US Dollar. We started the year off very well; however the European Debt crisis brought down the euro, which has a good representation within the fund. The year to date return for IGOV is 0.03%, less than our expectations.
For 2012, we could see emerging market index’s showing us big returns in portfolios if there is some debt reconciliation within the Eurozone. Our emerging market ETFs are Vanguard Emerging Markets ETF (VWO) (-15% - all numbers are for FY2011), WisdomTree Emerging Markets Equity Income ETF (DEM) (-9%), WisdomTree Emerging Markets SmallCap Dividend ETF (DGS) (-19%) and Guggenheim Frontier Markets ETF (FRN) (-22%). This year WisdomeTree’s dividend weighted funds certainly outpaced the core index holdings. Currently the MSCI Emerging Market Index has a trailing PE that sits near a 5 year low relative to the trailing P/E for the S&P 500. This historically has been a buy signal. Our clients’ continue to dollar cost average into these ETFs throughout the year, making the sell-off this year not as bad as advertised for new investments.
SA: To which index or fund - if any - do you benchmark your performance? Has this changed recently, and if so, why?
CS: On client reports we compare all portfolios to the S&P 500. This is partly because that is an index that clients compare us to, rightly, or not. The S&P 500 gets reported to them on all major news sources, thus they are most familiar with it. We believe that we should be comparing our models to a risk-adjusted index such as Standard and Poor’s Target Risk Indexes or the Dow Jones equivalent. We are periodically doing this internally but have not added this measure to client reports. Reporting both the S&P 500 and the appropriate target risk indexes is being considered.
SA: Do you believe gold is a genuine hedge in uncertain markets? If so, how much exposure to it or other precious metals do you have? If not, where are you turning for potential downside diversification?
CS: We have been looking for what Gold is correlated with. We are reading in many places that it is both a commodity and a currency. We see advertisements that it is the best inflation hedge and that every investor must own it. In reality Gold is a lot like antique furniture. It pays no dividends, making it only worth what you can find a buyer for. We found low historical correlation with inflation and the US Dollar, however it is almost perfectly correlated with fear.
Our gold allocation comes within our preferred commodity ETN, iPath Dow Jones-AIG Commodity Index Total Return (DJP). I believe that it is about 5% of our allocation to DJP, which itself ranges from 3 – 5% of our total portfolios.
We have also noticed that during times of global stress gold has recently been selling off. This has been seen in the last few months but also after Japan’s natural disaster. The thinking here is that countries will need to sell gold to raise real currency to repair infrastructure or pay bills.
If you were depending on gold as an “end of the world” trade, owning it outright would be better than through an ETF. Historically hard liquor, cigarettes and guns become the new currency, as we saw during the fall of the USSR. We do not provide guidance here, just an observation.
Our clients take a long term look at portfolio performance. With a focus on living on your yield plus 3%, short term market risk is not as threatening. For clients approaching or in retirement, 10% of their account is kept in CDs, Short term corporates via PIMCO Enhanced Short Maturity Strategy ETF (MINT) or cash to fund their immediate financial needs. Longer-term downside diversification is currently being handled by US Treasuries through Vanguard Total Bond Market ETF (BND) and iShares Barclays 1-3 Year Treasury Bond ETF (SHY). We also look to dividends to help increase portfolio yield and decrease overall downside portfolio risk.
SA: Will fear of Eurozone contagion continue to drive the market’s direction, and how are you protecting client assets from potential fallout there?
CS: Europe is another example of how intertwined the global economy is. While Greece does not affect the US directly, it having a negative effect on France and Germany does. Now we have to consider the viability of Italy and Spain. For the first two quarters of 2012 we see this as the largest obstacle to US markets having a positive start. It is hard to imagine the Eurozone breaking up, but that probability is a growing risk. If the countries do stick it out for the greater economic good, local control of finances will have to be diminished. Either option is difficult to implement and will have market implications worldwide.
We still believe that Europe will be a long-term healthy asset class. It will be a more attractive investment, as the deleveraging process is gradually completed. We have not changed our foreign allocation with our models. As we rebalance, we are purchasing more of Europe at these lower prices. Our more conservative models are using WisdomTree DEFA ETF (DWM), a focus of dividend paying companies within Europe, the Far East and Australia. Year to date DWM is down 10% versus the standard in European investing iShares MSCI EAFE Index ETF (EFA) which is down 13%.
SA: We are coming up on an election year. Will this be good or bad for markets? Are you positioning for different potential outcomes?
CS: We are standing at a crossroads. We can go the narrow path and rebuild on our country’s long history of innovation and hard work, or we can get on the highway of seeking entitlements and protesting every hard working American who has benefited from capitalism. The latter is much easier.
The ability of the US to recover from hardships has not been because of our government's actions but because of the will of the American people. I have covered the world and of all the developed nations, the US has the hardest working and most creative population. We have a winner’s “can do” mentality. However our newer generations are not always willing to put forth the effort. Instead we see protest for entitlements that they somehow feel that they are obligated to receive. This is our biggest long-term threat as it changes how we think about business and capitalism.
This next election could have implications on the stock market. The current President has had 3 years of on the job training with no prior real leadership experience, going up against one of two Republican presidential hopefuls that have decades of real business experience. This has to be good for US businesses, employees and investors. I do not think that there is much needed to start business growth at this time other than a good “we're behind you” speech from a President that actually understands how to run a business, versus protesting them.
There are individual sectors that would benefit from a changing of the guard at the White House. However being diversification-focused indexers, we are not as concerned about these sectors as we are about overall market performance. A Democrat vs. a Republican White House does not drive our model allocations but is fun to talk about.
SA: Are U.S. stocks cheap on the whole right now, or are current valuations misleading in a market environment where fundamentals can significantly worsen very quickly?
CS: A 10-year treasury bond currently yields 1.91%. The iShares S&P 500 Index ETF (IVV) yields 1.95%. An ETF with a dividend focus such as iShares High Dividend Equity ETF (HDV) yields 4%. These are compelling cases for new stock investments with 10-year time horizons.
That being said, a bad headline out of Europe can cost a US equity investment easily 3% to the downside in just a few hours or days. Investors with new money should be dollar cost averaging their way into the market while taking the approach that no matter what happens, they're in it for the long haul. Pulling money out because they “feel like the market is going to drop” is poor behavior that if they repeat over and over at the wrong time will simply make them broke. Fear is not an investment strategy. If they cannot handle the market's ups and downs, then they should allocate more to short term bonds or take the low yields on CDs. At no point should anyone consider an annuity product.
SA: Is the housing market in U.S. still an issue or not so much anymore? Will prices continue to fall? Do you have exposure to either REITs or residential real estate in client portfolios?
CS: Real estate is local. Specific private real estate investments can be made in local markets that would make sense, however nationally, we see flat to declining prices, mostly due to the high employment rate and those that are underemployed or jobless having to face foreclosure.
We currently do not have exposure to REITs within our models. We still do not see this as a long-term healthy asset class. Going forward we may consider Vanguard REIT Index ETF (VNQ), but currently have no plans to add it to our models.
SA: Where do you see Treasury yields in 12 months? Are Treasuries worth buying at current (low) yields? For clients requiring income, where have you been turning in this low yield environment?
CS: The direction of Treasuries seems to depend on what happens in Europe or the next crisis. In twelve months we could easily see similar yields to today. Investors are certainly not buying treasuries for the yield, but for safety of principal.
There is a reason why a high yield bond has its yield. They’re not handing out free money. Rather than chasing yield we have been focusing our conservative and Income portfolios on dividend paying stocks. This is a great way to increase yield while maintaining overall portfolio risk. Adding iShares High Dividend ETF (HDV, yield 4%), PowerShares’ S&P Low Volatility ETF (SPLV, yield 3.3%) or State Street’s SPDR Dividend ETF (SDY, yield 3.2%) can boost yield compared to the S&P 500 and historically has lower comparative volatility. Investors looking for US small and mid cap dividends should also consider WisdomTree MidCap Dividend ETF (DON) and WisdomTree SmallCap Dividend ETF (DES).
SA: Have you changed your allocation to muni bonds in client accounts? Do you view them as riskier than they have been in the past given state and local budget challenges?
CS: Three years ago we invested directly into muni bonds for clients. They were the “just like” treasury trades with low or no tax implications. As the insurers to the munis went out of business it became apparent that these investments were certainly not “risk free.” We certainly view them as riskier and certainly would prefer them within an index fund rather than individually.
We currently are not using munis within our models. The benefit of using them at this time does not outweigh the opportunities that we see in other healthier asset classes.
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?
CS: Investor behavior is the most important ingredient to a successful portfolio. Selling when fearful at the bottom of a cycle and buying when greedy at the top is not a sound investment strategy, yet everyone from individual to institutional investors participate in this capital destroying behavior. We hear buy and hold is dead. I always respond to this question with buy and hold what? Individual stocks? Gold? The S&P 500?
Buy and hold investing is certainly not dead; you just have to apply it differently than what finance textbooks set it up for in the past. Holding bonds, large, mid, and small cap stocks with a little international stock mixed in creates a good core, but there are more global asset classes to consider. Your choices are emerging market stocks and bonds, perhaps frontier markets, international bonds, real estate, commodities and, while not exactly an asset class, equity dividends. You allocate within these asset classes to achieve a clearly defined risk objective. Retired investors are looking for the maximum gain for the least amount of risk, while young investors are looking for a maximum gain for a given amount of risk.
For 10 plus years of investing, the risk/reward of the last ten years points to a moderate or moderately conservative allocation. Our moderate risk portfolio breaks down into the categories below:
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Disclosure: Casey Smith's clients hold positions in STPZ, IGOV, VWO, DEM, DGS, FRN, DJP, MINT, BND, SHY, DWM, EFA, HDV, and SPLV.