By Joseph Hogue, CFA
Part one of the series looked at the core portion of the portfolio, U.S. Sector Investments, as a way to diversify risks and add stability to the overall portfolio. The article also described investments in Master Limited Partnerships and Real Estate as an income generator while allowing the individual investor to participate in asset classes normally requiring large cash investments and more intensive management.
The goal of the series is to describe a long-term strategy that includes diversification in asset types and economic drivers while providing for growth and income suitable to the investor's time horizon and risk tolerance.
While individual investors need to assess their own needs in terms of risk and return requirements, there is some overlap in portfolio construction. The investments and percentage allocations below will not be suitable for all investors but can be used as a start to constructing your own portfolio.
The portfolio described in the series should be a portion of your total investable assets, not the entire nest egg. While some of the components may satisfy the need for different asset classes, i.e. real estate and alternative assets, you will still need an allocation in bonds. Investment in emerging market bonds are described as part of the EM portion in the article, but these investments behave similarly to stock investments and do not satisfy the need for fixed income investments in your portfolio. Investors should always incorporate some form of cash holdings, whether through treasuries or money-market funds, to satisfy short-term needs.
Hedge Funds (5%)
Exchange Traded Funds provide a particularly appealing opportunity to the average investor seeking exposure to hedge fund strategies. ETFs representing traditional investing strategies can help investors gain exposure to many securities with one purchase, but most are fairly easily replicable through direct stock purchases. Hedge fund ETFs replicate the extremely complicated world of arbitrage and hedging, something the majority of investors would have a hard time doing on a daily basis. Many of the exchange traded funds trade on a rules-based strategy and do not have risk exposure to a particular manager.
The IQ Hedge Multi-Strategy Tracker (QAI) attempts to replicate the risk-adjusted returns of hedge funds using an aggregation of styles including: long/short equity, global macro, market neutral, event-driven, and fixed-income arbitrage. The fund has returned 1.5% in the past year, tracking the performance of the S&P500 (SPY) closely but with much lower volatility. The fund does not actually invest in hedge funds but tracks a rules-based index. This allows it to provide a hedge fund strategy but includes no manager-specific risk. The fund holds a broad range of asset classes with bonds comprising a little over half (51.3%) of the fund. The fund's expense ratio is .75% but also charges .38% in other fees for a total operating expense of 1.13%. Maximum drawdown, a measure of risk by which hedge funds are typically measured, is the largest decline between two periods. The max drawdown for the QAI since inception was -7.9% versus a drawdown of the S&P500 of -36.1% for the same period. The fund pays a dividend yield of 1.34%.
Emerging Markets (35%)
Fueling this strong consumer and domestic growth is a surge in capital inflows from developed market investors. The exceptionally low yield in developed market bonds and accommodative monetary policies is driving investors to emerging markets in a search for returns. With explicit promises by the Federal Reserve to keep rates low through 2014 and similar needs to keep rates low in the rest of the developed world, foreign direct investment and growth in the emerging world should continue into the next few years. Not only do emerging markets provide for long-term growth and income, but they can also help protect investors against the loss of purchasing power from the long-term trend in dollar weakness.
The iShares S&P Latin America 40 (ILF) is the most heavily-traded ETF for Latin America exposure with about two million shares traded daily. Despite its claim of providing exposure across Latin America, it is heavily concentrated in the stocks of two countries: Brazil (54.2%) and Mexico (26.9%) with marginal exposure to Chile (11.0%), Peru (4.8%), and Colombia (2.3). For this reason, I would generally recommend combining it with another fund or a selection of the country-specific funds covering the region. The fund currently pays a 2.9% dividend yield.
The Global X FTSE Andean 40 (AND) has been created to take advantage of the integrated markets. The Andean fund holds the 40 most liquid equities in Chile, Colombia, and Peru and charges an expense ratio of 0.72%. The fund tracks the new MILA exchange closely with country weights of Chile (51.0%), Colombia (33.4%), and Peru (15.5%). Sector exposure also mimics the integrated exchange, though with some tracking risk, with: materials (26.4%), financials (24.3%), consumer goods (12.6%), utilities (12.4%), energy (12.0%), and industrials (10.2%). Based on the most recent dividend the fund pays an annualized 1.5% dividend yield.
The Market Vectors Indonesia (IDX) invests in companies domiciled in Indonesia or that accrue at least 50% of their revenue from the country. The fund's two largest sector holdings are in financial services (26.3%) and basic materials (22.8%). The fund currently pays a 1.5% dividend yield.
iShares MSCI Malaysia (EWM) is a broad-based representation of the performance of companies in the Malaysian market. The fund holds 44 stocks concentrated in financial services (29.5%), industrials (20.8%), consumer goods (20.6%), and telecommunications (9.5%). The fund has fallen by 9.3% over the last 12 months and currently trades for 15.0 times trailing earnings. The fund currently pays a 4.1% dividend yield.
Pacific Investment Management Company (PIMCO) analyst Brigitte Posch makes the case in a recent note for emerging market high-yield corporate bonds in 2012. There is a strong case for emerging market debt, even those issued with sub-investment grade ratings. Most investors are still too uncomfortable to invest in emerging market corporate debt, so a good alternative is EM sovereign debt. Unlike the sovereign debt crisis in Europe, most emerging market countries have reasonable debt and deficit ratios.
The PowerShares Emerging Markets Sovereign Debt Fund (PCY) is an exchange-traded fund that invests in the dollar-denominated bonds of emerging market countries. The fund pays a dividend yield of 5.5% and has outperformed the S&P500 by 8.2% over the past year. The relatively strong fiscal accounts in emerging markets means that these bonds are fairly safe compared to historic standards. The WisdomTree Emerging Markets Local Debt (ELD) is an exchange-traded fund that invests in the local currency-denominated bonds of emerging market countries. The fund pays a dividend yield of 5.1% but has lost 1.9% over the last year due to falling currencies in the emerging world. The dollar-denominated bonds may continue to outperform as global economic worries pressure emerging currencies, but the local currency bond fund should outperform over the longer-term as the EM currencies rebound and appreciate relative to the dollar.
Investors may want to balance these choices in the emerging market space with a broader fund like the iShares MSCI Emerging Market Fund (EEM). The fund holds 836 companies across all sectors but with an overweight in financials, energy, materials, and information technology. China, Brazil, South Korea, and Taiwan make up 58.2% of holdings with exposure around the globe. The expense ratio is 0.67% with a dividend yield of 1.92%.
Portfolio Return and Volatility versus the S&P500
The chart below shows the daily returns for the portfolio since October 2004 versus the S&P500. The percentages recommended for each group were equally divided among investment options within the group. Many of the funds are fairly new so the portfolio percentage for each group was reallocated each time a fund's data dropped off. Subsequently, actual performance may differ if data were available for all funds for the entire period. Past performance is not necessarily an indicator of future performance.
(Click chart to enlarge)
The portfolio returned an annualized 8.9% over the period compared with a 4.7% annualized return in the S&P500. Volatility for the portfolio is slightly higher at 24.5% versus 22.5% for the index but the Sharpe Ratio, a measure of risk-adjusted returns, is higher at .36 versus .21 for the index. This means that investors in the portfolio are being well rewarded for the additional risk. Additionally, the portfolio currently pays a dividend of 2.8% versus a yield of 1.9% for the index.
While the investments described in part one of the series were added as a source of stability and income, the investments above add relatively more growth with incremental risk to the portfolio. Notice that even in the emerging market 'growth' investments, selections were made that provided some current income just as there is some growth potential in the 'income' investments. Use of funds gives the investor the ability to diversify holdings over hundreds of companies and eliminate non-systematic risk.
Beyond the selection of specific investments, other decisions must be made to form a rational strategy. Decisions like asset allocation and rebalancing can be just as important as investment selection and will be covered in future articles. Featured in a previous article, "Two Proven Investment Strategies that Work, and One to Avoid," the core-satellite and cash-secured put strategies both offer opportunities in portfolio construction.