Tuesday, June 19, 2007

New portfolio composition

Ever since quitting my job and becoming a full time dad I’ve be re-thinking about my portfolio and how to maximize its performance for several reasons. First, I needed to move my company 401k to a solo 401k at Fidelity. Second, I needed to deploy the funds resulting from exercising company stock options. Last but not least, I have felt a lack of discipline in carrying out specific plans, whether its stock selection, stop-loss taking or adherence to a certain time frame. To address all three items, I decided to redefine objectives of various parts of my portfolio and put them in writing.

Before proceeding further let me say that I have learnt a lot from these two blogs: World Beta by Mebane Faber, a hedge fund manager, and Moomin Valley by mOOm, an economist and trader. Rather than highlighting any specific posts, I make the recommendations site-wide because of their consistent quality.

Beyond Passive Allocation: all about Alpha and Beta
In the capital asset pricing model (CAPM: primer), portfolio return is driven by two factors: alpha and beta. They are respectively, the intercept and slope of the linear regression of the portfolio return versus some benchmark. Beta is seen as a measure of the risk undertaken and alpha the extra return derived from the money manager’s skill. [I described alpha and beta for my own portfolio at the end of 2006.]

Without going into too much details, I’ll simply state that I believe that “positive alpha” (the ability of managers to beat the market) exists. One good example is the so-called “activist” hedge fund that takes a substantial position in an undervalued company and then lifts the stock price by forcing through certain management/strategy changes. In this way, said hedge fund capitalizes on a certain market inefficiency.

Current cutting edge thinking on portfolio construction is to combine both beta and alpha approaches. The beta portion of the portfolio would just be the passive asset allocation/index investing method that, e.g. Vanguard is all about. The alpha segment is considerably more complicated since there are so many different active management styles (long/short, global macro, distressed debt, event driven, etc.). Ideally, different strategies are uncorrelated with each other and the best managers in each can be found. This is essentially how those billion dollar endowment funds outperform the market year after year. While we individual investors rarely have access to the best money managers, the point is that there are other levels of diversification above just covering all the asset classes in a passive fashion.

Finally, mOOm at moominvalley also uses two other terms “passive alpha” and “active alpha”, the former describes where he takes a position in publicly traded asset managers and the latter his own efforts in trading and stock picking.

Allocation Pyramid

The pyramid chart illustrates my current target portfolio composition. At the foundation is the passively invested/asset allocated portion. Most of the money is in retirement accounts. It is currently 50% of the total portfolio and I vow not to tweak the allocation except at the annual rebalance. I have included some alternative asset managers and hedged mutual funds here. I consider this the beta and passive alpha portion of my portfolio.

The middle trench consists of some income producing assets that includes CANROYs, oil tankers and other high dividend funds/stocks. I joking call this my “income on steroids” group. This trench also includes my PM and other commodity/resource stocks (obviously there are overlaps with the CANROYs). Finally, there is a less well defined “others” section that houses things like the aerospace and defense ETF (ITA). Most of the money in this section sits at Scottrade and TDAmeritrde where I do most of the intraday research.

The top of the pyramid is a new section devoted to short term trading based on models I have been developing. The models have given excellent results in back-testing, but the whole thing is still a learning process as I confront my own psychology weaknesses. Currently it takes up less than 5% of my total portfolio but I hope to increase it if results warrant. The money now sits with Zecco despite the problems I’ve had (review part 1, 2, 3). Both top segments are in the “active alpha” category. Since I employ very different stock selection and trading strategies they should move quite independent from each other.

Time frames and reliance on TA
In the pyramid diagram I labeled the progression in the reliance on technical analysis as the time frame (intended holding period) shortens. My short term trading is momentum based and generally has holding periods of days. On the other hand, the passive accounts are for buy-and-hold with annual rebalancing. The trench in the middle lies in between the extremes. The “income on steroids” group, PM and resource stocks I’m quite happy about holding long term (i.e. years), while others I may look at weekly charts for good entry and exit points so that the holding period may be months. Naturally, as reliance on TA wanes, reliance on fundamental and big-picture analysis waxes.

New asset allocation in the passive accounts
My old asset allocation plan was approximately 30% domestic equities/30% foreign equities/10% PM and resource/30% bonds. The new plan is shown in the table below.

Major changes include:

  • Bonds are reduced to 20% from 30% for a number of reasons. The primary one being that I feel we can take on a little more risk in our portfolios. I try to keep the duration short, but have added some floating rate, loan participation funds. I also have some closed-end municipal bond funds in a taxable account. Their leverage amplifies volatility which also justifies a lower bond weighting.
  • I reduced my domestic equity exposure to 20% from 30%; however, some of the alternate asset classes invest primarily in the US. My wife’s company’s stock has been performing well and I maintained a position in her 401k account. It’s not a large position so I didn’t bother classifying it into one of the other four classes. The top six lines in the table represent positions in my wife's 401k account. Other than the company stock, they are like sub-accounts at an insurance company but the fees are decent.
  • The international equity exposure is now 24%, down from 30%, although I increased exposure to commodities with should benefit from a robust world economy and especially the emerging markets.
  • Previously, I didn’t have a position in REITs which turned out to be an excellent investment class last year. Now I have a 5% exposure despite the weak technical outlook of this sector. I chose to implement it with the international REIT index ETF (RWX) which I feel have better long term prospects.
  • The biggest change is the addition of what I call "alternative" that falls into the “passive alpha” category. PSP is an ETF of listed private equity companies; HSGFX is a fully hedged mutual fund managed by John Hussman; lastly, TFSMX is a market neutral fund with an excellent history of risk-adjusted-returns. HSGFX did well in the latest bear market but only provided bond like returns since 2003. I believe it will continue to provide low, positive returns if the bull market continues, which is another justification to lower the exposure to bonds.

In future posts, I’ll discuss the other two segments in greater detail.