Andy Hagans'  Instablog

Those who believe in the virtues of passive indexing will generally pooh-pooh the idea that one can beat the market. But the truth is, a small percentage of people do beat the market over the long term. Putting aside the statistical flukes (retail investors who get lucky), you can still observe a group of people who have managed to beat the market over a long period of time, with a very large amount of money. Besides Warren Buffett, several Ivy League endowment managers have consistently beat the market by a large margin, with billions of dollars at stake. Of course, this is made possible partly because many investing instruments are available to larger institutional investors that retail investors cannot access. But according to these managers, the trick for individual investors isn’t active trading: it’s better asset allocation. Here’s how you can build your own “Ivy League endowment fund” using ETFs.

Mebane Faber: It’s the Beta, Stupid!

Mebane Faber is the author of The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets. In an interview with Hard Assets Investor, Mr. Faber explains that individual investors won’t be able to replicate the alpha that endowment managers achieve, simply because they won’t have access to the same opportunities (e.g., hedge funds). According to Mr. Faber, investors should instead take a cue from the allocation formula traditionally utilized by by endowment fund managers. He believes that by allocating less to equities, individuals can reduce their beta–volatility&... thus achieve higher returns in the long run.

[Without hedge funds, you're left with] five asset classes: U.S. stocks, foreign stocks, real estate, bonds and commodities. There are a lot of caveats, but the allocation that endowments have historically made to these is approximately 20% in each… And you can do that using major indexes for each asset class, each of which is investable with an ETF: S&P 500 (U.S. equities), MSCI EAFE (foreign equities), NAREIT (real estate), 10-year Treasuries (bonds) and S&P GSCI (commodities).

According to the article, that model portfolio has a 0.8 correlation to the endowment portfolios, so you’re basically getting their beta but not their alpha. Such a portfolio would be less susceptible to the wild market swings we’ve seen in the past few years, indeed.

The Tiger Woods of Endowment Management: David Swensen

Yale’s Money Guru Shares Wisdom with Masses at NPR.org details the model portfolio recommended by Yale’s endowment manager, David Swensen. (Incidentally, the portfolio also got a mention in the recent bestseller, I Will Teach You to Be Rich.) Why is Mr. Swensen’s recommendation so appealing? Well, for starters, he’s beat the market by a wide margin over a long period of time. (The article, written in 2006, refers to an average 16 percent annual return over 21 years.) He’s also considered the top university endowment manager in the world. For individual investors, he recommends the following model portfolio. Note that his portfolio allocation implies that by going light on equities, but having significant bond and real estate holdings, you can get strong returns with less overall risk than you can with a stock-heavy allocation.

Swensen’s Model Portfolio (Using Vanguard ETFs):

• Domestic Equity (30 percent): Vanguard Total Stock Market Index Fund (VTSMX)
• Emerging Market Equity (5 percent): Vanguard Total International Stock Index Fund (VGTSX)
• Foreign Developed Equity (15 percent): Vanguard Emerging Markets Stock Index Fund (VEIEX)
• Real Estate Investment Trusts (20 percent): Vanguard REIT Index Fund (VGSIX)
• U.S. Treasury Notes and Bonds (15 percent): Vanguard Treasury Funds (VFISX, VFITX, VUSTX)
• U.S. Treasury Inflation-Protection Securities, or TIPS (15 percent): Vanguard Inflation-Protected Securities Fund (VIPSX)

If you look around, you can find other endowment-style model portfolios geared towards individual investors, but some themes are consistent: passive indexing, intelligent asset allocation, and an eye on minimizing costs. Once again, ETFs prove to be an efficient tool to implement a proven investment strategy.

Further Reading on Endowment Portfolio Allocation

If you’re interested in reading more about “endowment style” portfolios, I recommend you read the following articles:

• NPR: Yale’s Money Guru Shares Wisdom with Masses
• Hard Assets Investor: How To Invest Like A Top Endowment
• Amazon.com: The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets (book)

Disclosure: At the date of publishing, the author does not own shares of any ETF mentioned in this article.

Obama administration officials have today announced that students at a New York City high school were sickened by the same strain of swine flu that has killed people in Mexico, adding to fears in the U.S. after cases in Texas, California, and Kansas. There are now 20 confirmed cases of the deadly flu in five states. Meanwhile, the World Health Organization yesterday declared the outbreak of the virus “a public health emergency of international concern”. No, you’re not being morbid if you’re wondering: how will this affect the markets this week?

In times like these, it’s good to look at comparable situations in the recent past, which this article from the Daily Telegraph does:

During the panic about Asian bird flu in 2005 and 2006, airline, hotel groups, insurers, and oil companies stocks fell heavily, while shares in drug, healthcare, and cleaning product businesses soared.

“I think there will be little bit of a lift for pharmaceuticals, but this may not follow through unless the situation gets out of hand,” said Paul Kavanagh of stockbroker Killik & Co.

To be clear, at this point, there’s a lot of uncertainty around the swine flu situation. Uncertainty however has proven to be a big market mover in the past year. Further, even the slightest new information about such a potentially explosive issue could have a significant effect on the markets. Here are some possibilities in the short term.

Sectors That Could Be Hit Hard

• Transportation sector: Travel advisories and recommendations to stay home won’t help transportation stocks; ETFs like IYT.
• Energy: Fewer people flying and traveling in general could cause weaker overall demand for energy and crude oil funds; ETFs like USO.
• Equities in general: As we’ve seen in the past six months, a little bit of uncertainty can go a long way towards causing equities to tank; ETFs that index equities such as SPY and VTI.

Sectors That Could Get a Lift

• Pharma and Healthcare sectors: In anticipation of demand for vaccines and health services, shares of pharmaceutical and healthcare companies could appreciate; ETFs like IRY and IHE.
• Gold and Commodities: In the last year precious metal ETFs have been popular buys on days when panic seemed to set in; ETFs like GLD and SLV.
• Treasuries: Similarly, a flight to safety away from equities could make for inflows in bond funds thought to be very secure; ETFs like IEF and TIP.

Again, these are just some of the possible short-term effects we could see resulting from the swine flu epidemic news. The swine flu coverage will be in the media simultaneously with other economic announcements, so it’s anyone’s guess where things will end up. Further, it’s worth remembering that at this point, even the authorities have limited information on and predictive power over the swine flu situation; as the situation changes and becomes more or less clear, the markets will continue to absorb the information. Either way, it will be interesting to see the movement this week.

Disclosure: At the date of publishing, the author currently owns shares of ETFs mentioned in this article: TIP and VTI.

On paper, the hedge fund industry is one ripe for a challenge from the ETF industry. Hedge funds have high manager risk, and were previously out of reach for many investors due to high minimum investment requirements and exorbitant fees. Enter the hedge fund ETF.

The First Ever Hedge Fund ETF: QAI

The IQ Hedge Multi-Strategy Tracker (QAI) began trading last month as the first ever hedge fund ETF. Of course, it’s not the first time someone has used ETFs to mimic hedge funds. Many people have utilized ETFs to build their own hedge funds, so to speak. Though, this strategy requires active research and management, and wouldn’t necessary track the publicly available hedge fund activity, which QAI does.

QAI is also unique in that it doesn’t try to execute a particular hedge fund strategy, but rather tries to to replicate the returns of the IQ Hedge Multi-Strategy Index, which tracks the entire hedge fund universe. Essentially, it buys the entire hedge fund market, which includes long/short equity hedge funds, global macro hedge funds, market neutral hedge funds, event-driven hedge funds, fixed income arbitrage hedge funds, and emerging markets hedge funds. It doesn’t invest in hedge funds directly, but instead in other instruments which can allow it to mimic their returns.

Advantages of Hedge Fund ETFs over Actual Hedge Funds

The hedge fund ETF is an intriguing product, because, assuming it can actually mimic hedge fund returns and behavior, it holds many advantages over an actual hedge fund:

• Fees: Compare .75% (hedge fund ETF) vs. “2 and 20″ (which effectively could range from 2% to 10+% in any given year!).
• Manager Risk: Compare tracking an index (hedge fund ETF) vs. trusting a particular hedge fund manager to meet or exceed his peers (and not giving your money to Bernie Madoff).
• Minimums: Compare investing any amount (hedge fund ETF) vs. investing the fund-minimum in a hedge fund (only available to very high net worth individuals in most cases).
• Withdrawal/Redemption/Transaction Fees: Compare the ability to trade any time you want and pay only a broker transaction fee ($7 at Scottrade for instance) vs. paying redemption feeds and possibly facing other restrictions with a hedge fund.
• Transparency: Compare virtually total transparency (hedge fund ETF) vs. the opacity of a hedge fund.
• Regulation: Compare a very clear regulatory environment (hedge fund ETF) vs. the little federal oversight over hedge funds.

Of course, we’ll need time to determine how useful hedge fund ETFs really are. But we have plenty of historical hedge fund data to compare them against; so the next 12-24 months should paint a clearer picture.

Disclosure: At the date of publishing, the author currently does not own any shares of the specific stocks mentioned.