In this article, I set out to address a much-desired portfolio management problem: what to do with overvalued securities? For my own part, I manage a small portfolio through my investment company. The portfolio consists entirely of ETFs that track various index funds, which I manage passively and trade only when each position drifts from its desired weight. (More on that later, and in future articles.)
Now, on to the issue at hand. An analysis of my portfolio as of the market close on February 27, 2012, indicates that about 98% of all tax lots held (out of a total of 116) are currently trading at a gain (since the portfolio was established in October 2010). These tax lots are part of positions in 7 separate types of asset classes (more on that later). Further, on an unrealized basis, if the portfolio was completely liquidated I would realize a capital gain of almost 8% after commissions. While this is good news, there's one constituent of the portfolio that has me especially worried: long-term U.S. treasury bonds, which I invest in through TLT. This particular holding's best and worst tax lots are listed below:
As everybody knows, treasuries (and TLT) are up huge over the past year. I saw that 27.9% reached 32% at various points last year. If I had to guess the obvious, I'd bet that in several more years when the Fed increases interest rates again that treasuries will creep all the way back down to a more proper valuation and the huge gain shown above will vanish. I have no guesses when this will eventually happen, as I don't do predictions, but I do know that it will happen in the next year or two. The figures above also indicate that (at least since late 2011) treasuries have risen about as high as they're going to go. Fear of the wide fluctuations in equity prices has created a superficially-high "safe haven" in U.S. treasuries, which cannot keep rising indefinitely.
Now, based on my own portfolio strategy the solution to the overvalued TLT issue is simple: just keep doing what you're doing. Namely, maintaining a portfolio of index ETFs and only trading when the weights are out of balance. Assuming that the ETFs in all of the other asset classes I own (VTI for domestic equities, VEA for foreign developed market equities, VWO for emerging market equities, VNQ for real estate, DBC for commodities, and TIP for inflation-protected bonds) keep rising as they have, I plan on selling TLT all the way back down to where it was on 03/02/2011. Over the years I have found that this grouping of securities has provided a well-balanced, diversified, and sometimes uncorrelated investment portfolio. Which, if you subscribe to the index theory of investment, is the perfect cure for volatile markets and overpriced asset classes.
Finally, by my estimations, if TLT hypothetically made the same per-share dividend payments for the past 12 months (total of approximately $3.89/share) at the 03/02/2011 closing price of $90.95, its yield would be about 4.2%. Not too shabby, and much better than the current 3.3% yield. Additionally, by late July of this year, all of the lots currently at a 20% or more gain will be long-term. Which anyone else could have jumped-on by purchasing treasuries right before they took off. Personally, I think I'm well-prepared for the inevitable drop that's coming.
In the meantime, I'll just keep shuffling TLT, TIP, VTI, VNQ, VWO, VEA, and DBC around to keep them balanced. Generally there has been at least one gainer amongst them when the rest have a bad day.