Monday, February 20, 2006

Asset allocation basics: Part IV Tweaking the asset mix

Laudatory as I was about Merriman’s website, I was not suggesting his asset allocation (AA) plans were perfect. In this post we’ll take a closer look at the missing or omitted sectors from his plans. This exercise will also serve to elucidate some of my macro views as well as my reasons for differing from Merriman’s basic equities/bonds framework. A list of AA plans is included at the end but no endorsement is to be inferred. Any agreements naturally bolster my arguments, while any differences should be seen as opening up new areas for investigation. Here as anywhere else in this blog, the aim is to help my readers making financial decisions for themselves.


Income trusts in general can be thought of as straddling both stocks and bonds. They may be considered ultra long maturity fixed income plays that also reflect the value of the underlying assets. REITs have been on fire in the past five years, along with the inflation of the housing bubble. Along with price appreciation comes the erosion of value, however; and I’m quite concerned with the deflation of the housing bubble which I firmly believe is underway. In this environment, all real estate related securities faces a severe headwind. Although there may be apartment/commercial/nursing home/forestry REITs that are more price resistant, it’s difficult to gain specific exposure to them in a cost effective way. The days of indiscriminate buying of REITs are over. For this reason, I’m not inclined to include them in my AA plan.

Several ETFs of REITs (VNQ, IYR, and RWR) exist and would be my preferred investment vehicle for general exposure if I choose to do so. More information on REITs can be found here.


“Commodity” is a wide-ranging term encompassing hydrocarbon fuels (oil, gas, coal), metals (precious and base), soft goods (grains, sugar), etc. They are described by three major indices: the Commodity Research Bureau (CRB) index, the DJ/AIG commodity index and the Goldman Sachs Commodity indices. All have shown tremendous appreciation since1999.

If you have been following my other articles, you would have known that I’m heavily over weighted in precious metals (PMs) and the energy complex. One attraction of PMs is their lack of correlation to either general equities or bonds according to this study by the highly regarded Ibbotson Associates. I have yet to write a big picture overview for the PM sector, but I urge readers to visit the PM related sites I have linked to in the side bar.

Anyone had to fill up gas in the last two years would understand my preoccupation with the energy sector. I subscribe to the “peak oil” theory which basically states that the world’s reserve of cheap oil has already/is going to run out. Again, this is a topic deserving of at least several posts of its own, and I won’t go into much details here.

Jim Rogers was the best selling author of Adventure Capitalist and Investment Biker. He was also partner to Soros in the legendary Quantum fund. "Rogers also offers practical advice and information for beginners, including the best resources, how to read the commodities reports in the newspaper or on television, the various ways to open an account, information on index funds (such as Rogers' own index fund that he started in 1998), mechanisms, terminology, and other vital details people must know before investing. Clearly written and entertaining." -- Amazon review

There are two ways to gain exposure to commodities: buy the commodities themselves, or buy stocks in the commodity producing (including exploration) companies. In the first category, the Pimco commodity real return strategy fund (PCRDX and family) and the newly launched Deutsch Bank commodity index ETF (DBC) are two convenient ways for participating in the general commodity bull market. Both funds use futures and options to replicate the performance of a commodity index (DJ/AIG commodity index for PCRDX and DB liquid commodity index for DBC). For PMs specifically, there are two index ETFs (GLD and IAU for gold), and two closed-end funds (CEF, the Central Canada Fund, for both gold and silver; and GGN for gold and natural resources) that offer convenient ways to take an interest in physical bullion. Buying the actual commodity eschews individual company risks and may offer short term trading opportunities when there is temporary backwardation in the futures market (short term trading is contrary to the concept of asset allocation but I included it for here completeness). Stocks in the commodity producing (or exploration) companies are more volatile, usually carry some political and management risk, but also offer a healthy leverage to the commodity as they come to be more and more valued on their secure reserves. They suit my risk appetite very well as you may have gathered from my portfolio. [Just to be pedantic: I’m not worried that the rise in the FED funds rate will affect the DCF valuation of these companies. Due to the surplus capacity and rising middle class in India and China, the composite inflation rate (e.g., CPI), which determines the FED funds rate over the long run, is sure to be below the rate of inflation in commodity prices.]

I have spill the most ink in this section because in my view its lack of representation is the biggest weakness in Merriman’s portfolios.My own target allocation is 30% general domestic equities, 30% general international equities, 10% commodities and 30% bonds. Without my over weighting in commodities in the actively managed portfolio the number would probably be at around 20%.

Municipal bonds

For individuals in high tax brackets and whose bond allocation are in taxable accounts, municipal bonds offer superior return as the income is tax free at the federal and state level. There are closed-end funds that offer very respectable yields (5-6% at this writing). A great site to do research on them is

International bonds/foreign currencies

The US$ has been trending downward since 2000, although the decline was interrupted since the beginning of 2005, I’m of the opinion that it will resume as soon as the market anticipate a halt to the current FED raising cycle. The reasons for its decline and rebound, and the possible resumption of decline again justify a post of their own, but for the task at hand, diversification alone should be reason enough to look at fixed income instruments denominated in other currencies.

"Posterity may remember The Dollar Crisis as a seminal book in the field of 21st century economics. Indeed, rarely has a book offered such a grim yet, well argued view of the current economic situation facing the world."-- Steven Irvine, FinanceAsia "Duncan writes like a man who’s already seen tomorrow." -- James Grant, Grant’s Interest Rate Observer

I currently own OIBAX (yes, it has a front load) in my AA accounts.Some no load alternatives are PSAFX (has ~15% PM), BEGBX, PFBDX, PEMDX, LSGLX, etc. I’m still exploring closed-end funds in this area. On the currency side, Everbank offers foreign currency CD’s (single currency CD’s with a minimum of $10k, index CD’s from 20k) that are worth looking into.

Tax considerations

I’m not an expert on taxes and I have been applying asset allocation to each of our individual 401(k)s and other accounts, mostly out of legacy reasons. The accepted wisdom (here and here) though, calls for putting securities with high dividend/distribution rates in tax advantaged accounts. Put it another way, the bonds should be in the retirement accounts and the stocks in taxable accounts to take advantage of tax deferral in one and long term capital gains rate in the other. (Note dissenting view here.)

A short list of asset allocation plans found around the web
Paul Merriman’s model portfolios using Schwab, Vanguard, Fidelity, T. Rowe Price funds and ETFs. No REITs or commodities.
Index Fund Advisor’s portfolios using DFA funds. Has REITs, no commodities.
An ETF based asset allocation plan, part of a very well written guide to investing. Has REITs, doesn’t have commodities and otherwise not (quite) enamored with sector ETFs. Tries to cover the entire domestic stock and bond markets.
What do you know? A fellow fan of both Paul Merriman and Jim Rogers! An AA plan using mutual funds.
A similar plan to the one above, using mostly ETFs.
Random Roger (Roger Nusbaum, a money manager with a great blog) discusses a model portfolio from Agile Investors that includes commodities, energy MLPs, and heavily tilted towards Japan.
Tim Middleton from MSN Money regularly writes about his model ETF portfolio. No REITs, includes IGE.
A portfolio using Vanguard funds that’s very similar to the ones from Index Fund Advisors.
A portfolio that tries to cover all bases using mutual funds.

Now that the asset mix has been decided, the next step is to choose the best available securities that represent each asset class which we’ll address in the next post.

< Part III Part V>