How I Really Invest My Money

December 06, 2007

You raise some good points about my portfolio, Jim, although I (surprise, surprise) disagree with many of them.

First, a mea culpa: My initial post put the expense ratio of my low-cost portfolio at 13.4 basis points, which was incorrect. I had accidentally listed the expense ratio for the iPath DJ-AIG Commodity ETN at 70 basis points instead of the correct 75. Switch those figures and my blended ER rises to 0.1365% ... still pretty cheap! (My post has since been corrected.)

Second, I specifically said that this low-cost portfolio was not my real portfolio. For starters, I hold and have held a few individual stocks (horrors!). I own BioMarin (NDAQ: BMRN) and have for years; for those of you who don't know, I got my start as a biotech analyst for an actively managed mutual fund, and I'm tremendously interested in that sector. I also own an Indian bank, HDFC (NYSE: HDB), which I bought after visiting that country in December 2005. And, of course, I own 1 share each of DJP and ERO as part of my private letter request experiment.

Third, on the commodities front, I actively manage my exposure to the various commodity indexes depending on the status of contango/backwardation. So while the oil-light DJ-AIG index was attractive through early summer while oil was in contango, the GSCI has been the place to be since then as backwardation has taken hold in the oil markets. The DJ-AIG also has a large weight in natural gas, which has been stuck in contango, making the DJ-AIG/GSCI switch a no-brainer. As I've said before, I don't think blind indexing works in the commodities market, because the indexes aren't as good and the term structure of the market introduces variables like contango that can be easily exploited. I listed DJP in the low-cost portfolio because I launched this portfolio in June, when DJP was the right play—so I kept it there for consistency. I won't ping-pong back and forth between various funds in my real portfolio, but will adjust when large changes in the structure of the markets occur.

Fourth, I don't own REITs either, for the same reason as you: I've got plenty of real estate exposure in my house. I included them because a lot of people include them as part of target-date-style portfolios.

Fifth, your tilt toward small/value doesn't seem smart right now. I'm not smart enough to understand why small-caps and value stocks have outperformed over the past 50 years, so I just steer clear of the whole tilting matter (I've read the arguments, but none of them clinch it for me). But as a critique of your portfolio, now strikes me as specifically the wrong time for a small/value tilt. My guess is that small/value does well when risks aren't being punished—when default rates are low and the spread between investment-grade bonds and junk debt is narrowing, as it did in a major way from 2001-2005/6. But with the economy on the rocks and valuations compressed after a seven-year run of small/value outperformance, I'd guess that the risks inherent in this asset class may show up soon. In fact, they already have over the last six months.

Sixth, and most importantly, recent developments in the ETF market have me thinking of a lot more asset classes than I have in the past. Here are some of the market segments and funds that I think are very, very interesting, and that I'm continuing to monitor and evaluate.

  • 1) Small Cap International: While I steer clear of tilting in the U.S. markets, the idea of international small-cap exposure makes sense. I believe that correlations between large-cap stocks are tightening worldwide, and will continue to tighten; conversely, I think that small-cap international will retain some diversification benefit, as those companies are tied more closely to the fate of local economies. There are a number of ETFs to choose from in this space, including the WisdomTree International Small Cap Dividend Fund (DLS) and the SPDR S&P International Small Cap ETF (GWX).

  • 2) China: I'm convinced by the long-term China boom, and as I've said before, I think global indexes are underweight China thanks to the hegemony of free-float adjustments. As Randall commented on your last blog, it's a matter of when and not if China becomes a major economic superpower. For China exposure, the SPDR S&P China ETF (GXC) seems to offer the most diversification, although arguments can be made for the focused large-cap exposure of FXI as well.

(I'm less convinced about the broader BRICs—Russia seems unstable and a bit one-dimensional, India's infrastructure is poor and Brazil I just don't know much about.)

  • 3) Japan: I'm pretty sure I have enough Japan exposure in my portfolio, but given its proximity to China and the way valuations have come in, I've recently heard some convincing arguments from very smart people for increasing your exposure to Japan. This is not something I'm likely to do, but I find it interesting enough to mention here.

  • 4) Bond Diversification: The introduction of the new bond ETFs is interesting to me: international Treasuries, TIPS, high yield. I'm not sure how this all fits into my portfolio, as I haven't studied enough. But I plan to look into it in 2008.
  • 5) Thematic Asset Classes: I can't help but be intrigued by some of these thematic ETFs. The Claymore Timber ETF (CUT) deserves study as an asset class previously unavailable to retail investors like me. I'm also intrigued by the arguments for the water ETFs (FWT, PHO, PIQ, etc.). I see too much hype in alternative energy, but energy efficiency and the PowerShares Cleantech Portfolio (PZD) make sense to me. And I've always liked that carry-trade ETF, the PowerShares DB G10 Currency Harvest Fund (DBV). Nuclear power (NCR)? Agribusiness (MOO)? There are a lot of good ideas out there.
  • 6) Coming Down The Pike: That doesn't even touch on what might launch in 2008. A 130/30 fund or a market-neutral portfolio or even a hedge fund replication product could be interesting. The All-World NETS ETF from Northern Trust is a winner. And as the data accumulates on the various fundamental/dividend/etc. ETFs, it'll be time to look at those again.

There we have it. I tend to re-evaluate my portfolios in a significant way in late January/early February, once the craziness of the holiday season settles down. We'll see what happens. Generally speaking, though, I like to keep it simple, and the core of my portfolio will remain the same: broadly diversified, low-cost exposure to the global equity markets.

In the meantime, I'll keep monitoring the low-cost portfolio for what it is: a measure of the lowest-cost way the average investor can gain exposure to a broadly diversified portfolio of assets. To me, it's a testament to the entire ETF industry that you can achieve solid exposure for 13.65 basis points per year in annual expense. And I hope that number continues to come down in the future.

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