Tuesday, October 1, 2013

Money Honey's Portfolio

Well, we had seen the 7/12 portfolio, Rob Arnott's portfolio as well as James Picerno's GMI in my last post about asset allocation.

Taking a page from them, while referencing other sources and using my accumulated knowledge until now, I'm come up with a slight variation of their recommendations.

But first, let's look at what were essential parts in all their portfolios:
  1. US stocks
  2. Developed Foreign stocks
  3. REITs
  4. TIPS
  5. US bonds
  6. Foreign bonds
  7. Commodities
Now, these 7 asset classes were part of all their portfolios. That accounts for 58% of the 7/12, 70% of Arnott's and 54% of the GMI's portfolio.

So now we have the stragglers.

Emerging Markets stocks and Cash were both recommended by the 7/12 and the GMI.

Emerging Market bonds and High Yield bonds were both recommended by Arnott and the GMI.

7/12 recommends natural resources equities.

Arnott recommends US government long term bonds.

GMI recommends Foreign Corporate Bonds and Foreign TIPS.

So now, after looking at all of this, I've decided to take of course the recommendations that have 2 overlaps, as well some tweaking, so this is what I've got.

  1. US stocks
  2. Developed Foreign stocks
  3. Emerging Market stocks
  4. REITs
  5. High Yield bonds
  6. Foreign Corporate bonds
  7. Developed Foreign bonds
  8. Emerging Markets bonds
  9. US bonds
  10. TIPS
  11. Commodities
Now, that's over 11 different classes, and I actually do think that they provide a very nice range of asset classes with unique characters. The stocks are related as a broad asset class, but different in region and thus risk. That is the same for bonds segment too.

So it's basically equal weighted stocks, equal weighted bonds, REITs, HY bonds, TIPS and commodities.

However, now to even more tweaking. The reason why I have to tweak it is because of 2 reasons. Firstly, I do not live in the US, so that shakes things up a little. Secondly, the products available to me are also vastly different due to my geography.

So, now let's take a look at what I've come up with for myself, a Singaporean investor

  1. US stocks
  2. Developed Foreign stocks
  3. Emerging Market stocks
  4. REITs
  5. Global High Yield bonds
  6. Global Corporate bonds
  7. Global TIPS
  8. US bonds
  9. Developed Foreign bonds
  10. Emerging Market bonds
  11. Commodities
Point to note, I did leave out Cash because being Asian, I will never ever be 100% fully invested in the market at any point of time. I will keep a sturdy amount of reserves to provide safety, as well as emergency dry powder ammunition in case an amazing bargain opportunity arises.

So, 1-3 covers nicely the global equity segment, but it is equal weighted instead of market cap weighted. This of course doesn't do much to US stocks and EAFE stocks since they are almost 50/50 in MSCI world. However, in MSCI ACWI, EM stocks account for less than 20% of the allocation. After watching a few videos based from Arnott's research firm, I've quite done away with the market cap weighting. Equal weighting is a natural form of rebalancing as well. Therefore, my main equity segment will have a nice 33% split across the US, developed markets ex US and the emerging markets.

*I am considering using dividend stocks in these regions as replacements for the broad market index

8-10 actually mirrors my thinking that I have used in equities, and have applied this over to the bond segment of my portfolio. Given that all regions and areas of the world are under somewhat different economic situations, interest rates can vary, which also varies the yield. Again, this equal weighting helps increase yield when it comes to rebalancing.

5 and 6 are relatively tricky. Aren't high yield bonds essential corporate bonds as well? That's a true enough statement, but not all corporate bonds are high yield bonds! Basically, the main distinction between the 2 groups here comes down to it's investment grade rating. For global corporate bonds, I am looking for bonds equal to are exceeding the BBB minimum to be considered investment grade. For global high yield bonds I'm willing to go down to as much as a B, but preferably in the BB range. From my eyeballing estimation, the yield benefit jump from BB to B is not worth the default risk. 

These 2 segments will help the bond segment of my portfolio by boosting yield, while the stronger non-corporate bonds provide a good baseline

However, given that the trend is towards increasing interest rates looking far ahead into the future, I will strictly avoid long term bonds (10+ years). Even looking at interest rate risk in the market, durations above 5 years makes my stomach churn a little, especially when their current yields are less than durations, which is the case in most of the non-corporate bonds.

4 is REITs, and you all know that I love REITs. I've written a whole post pretty much just only talking about REITs. It's a nice blend of giving equity-like returns, while providing fixed-income-like cash flows. Since it a plus two ways, there is also a big negative ways, which is that drawdowns are higher than equity.

6 is global TIPS. The reason for not splitting between US TIPS and foreign TIPS are two fold. Firstly, I do not live in the US and transact with USD, secondly the lack of product availability. Global TIPS allow me to insure that at least part of my portfolio will definitely keep up if there is high inflation in the future, but can also nicely add to the bond baseline that I mentioned above.

11 is finally commodities. I am not really a big fan of commodities, and many articles that I have read do not recommend it. However, given that is recommended by all 3 portfolios, it is rather had to make a quantitative case against the use of commodities. Plus, it is always used for diversification purposes, which I suppose is one of the aims of the portfolio that I hope to achieve.

Technically, 4, 6 and 11 can form another group, which are essentially alternatives which main function is to provide a hedge against inflation. These 3 asset classes should be able to keep up with prices on a real term, negating the effects of inflation.

So bonds provide a nice base case on relatively constant and low yields. The corporate bonds adds a little cherry on top while systematically going up and down the base case. Stocks trend above both of these lines, erratically going up and down on it's whims and fancies. And lastly, the inflation hedge silently tracks in the background, following the positive and negative effects of inflation in sidestep.

What this creates (hopefully) is a smoother yield curve which is able to tolerate a variety of economic scenarios with less volatility than an singular asset class, but still trends upwards and generates returns above the rate of inflation.

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