Geoff Considine

All-ETF Portfolios vs. Strategic Mix of Stocks

Dear John (yes, this is a 'dear John' letter):

In the spirit of productive debate, why don't you email me (or simply post) a very diversified ETF portolio to start with that meets your criteria. If my supposition is correct, I will be able to find a variety of individual stocks that will improve the risk/return profile of this portfolio. Granted, such a test will be anecdotal but lets give it a shot. You will have the chance to demonstrate what you feel to be a 'best in breed' ETF portfolio. for simplicity, lets make it one with at least three years of historical data.

To make this work, I would ask that you refrain from pejorative name calling and the like. I believe that the other readers anc contributors to Seeking Alpha might feel the same.

All-ETF Portfolios vs. Strategic Mix of Stocks

To John Doe:

Apparently you have just not read my paper. I specifically state and have reiterated that the article is designed to show one thing: how individual equities can have better diversification properties than a fund that is already asymptotically close to its maximum diversification.

As an aside, I will note that you are apparently the only person who has read this who felt that it is "intellectually dishonest" or in any way misleading. I write articles on topics that I find interesting. QPP is intended to help investors and their advisors make better allocation decisions and we get regular feedback that it is doing just that.

Of course you are correct that I want people to buy our software--that is the nature of business.

All-ETF Portfolios vs. Strategic Mix of Stocks

Oh--one other thought. A company like EXC is NOT the an ideal way to get exposure to commodities. Utilities such as EXC provide some exposure to commodities but their fundamental exposure is the spark spread in commodities. The spark spread is the difference between the cost of generating electricity and the price at which you can sell it. The spark spread is widely traded in commodities markets and has its own long-term dynamics. I am personally rather bullish on having long-term exposure to the spark spread. That said, utilities also do have exposure to the direction of energy commodities, but you invest in utilities because you want exposure to the spark spread and commodities. For a direct commodity play, it is better to look elsewhere.

All-ETF Portfolios vs. Strategic Mix of Stocks

To John Doe:

I would like to address several of John's points. The essence of portfolio theory is not to invest in different asset classes because they are different. To the contrary, it is about correlation. Utilities, for example, have low correlation to the S&P500 and thus are very useful in exploiting 'portfolio effects'. My articles emphasize exploiting portfolio effects--correlations-... than simply thinking that you can diversify by buying 'different' asset classes. It is unwise to think of 'stocks' as an asset class and to thereby constrain your thinking.

Mean - variance optimization is not all of portfolio theory. In fact, the pitfalls of mean-variance optimization are well known. I would suggest that you have a look at The Intelligent Asset Allocator in which Bernstein identifies many problems with applying that concept in raw form. As Bernstein shows, if you run a mean variance optimizer over the recent past, you can always find some portfolios that dramatically outperform on a risk-adjusted basis. In recent years, commodities have been outperformers. I understand that.

This article is written to focus in a single issue--the portfolio was not intended as a suggested portfolio. I feel that this is clear in the text.

As an aside, and if it matters to you, I have worked as a quantitative analyst for more than seven years--with a focus on portfolio risk management. I am not a professional journalist.

Nothing that I said is designed in any way as a judgement on any asset class. It is an example. I have no beef with commodities as an asset class and they have dramatically outperformed as an asset class in recent years.

The simple point of this article is that combining individual stocks can provide a level of diversification that is not entirely available buy buying funds. This is a direct consequence of the statistics and how volatility scales with the number of portfolio components. This is a complex idea and very new for many people. I suggest reading A Random Walk Down Wall St for intro to this idea.

All-ETF Portfolios vs. Strategic Mix of Stocks

Reply to XTF:

I am afraid that you have missed the point here. This is not a data mining exercise--this effect shows up commonly and is a natural consequence of portfolio theory. You can find this effect with many possible combinations of portfolio assets because of the non-linear diversification benefit and the number of holdings in a portfolio increases. If you have the time to read other articles you have written, you will find that our portfolio tools are remarkable resistant to 'over fitting' to historical data and this is well documented.

Further, you will note that I specifically stated that this sample portfolio is not ideal or suggested--it is just there for purposes of illustration--as I said, this effect will show up in almost any portfolio.

All-ETF Portfolios vs. Strategic Mix of Stocks

By the way, this title was added by an SA Editor--not my title.

Asset Allocation: Finding Your Risk Level

Hi Neil:

You are, of course, perfectly correct that you can substantially increase portfolio survivability if you have a plan to reduce your income draw if your portfolio declines. QPP actually has this capability--there is a tool to reduce your draw when your portfolio declines. Alternatively, you can plan for the worst case by using a flat draw (inflation adjusted) that represents your lowest required income and see how that improves things. In real applications, you are likely to run QPP once a year to see how things are doing. You can plan based on a single draw but if your portfolio is down, survival rates will suggest lowing your draw for a while. I do not expect people to try to model their real behavior--although that could be interesting. The goal of QPP is to provide people with fairly simple but realistic tools. The estimate of an ideal risk level for "John" helps him to determine how aggressive to be to maximize his portfolio survival. Real life will intercede and complicate things, but I feel that the final model portfolio is a much better approximation of where John's portfolio should be than the oiriginal model portfolio.

I am loathe to overcomplicate the tools because many investors see the tools that I have as too complex already:)

thanks for the comment.