Answers To Advisor Questions About Broadly Diversified Portfolios Using Modern Portfolio Theory

Tuesday, February 05, 2013 22:30
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Answers To Advisor Questions About Broadly Diversified Portfolios Using Modern Portfolio Theory

 

At a webinar two weeks ago, I spoke about bond investing in a period where rates were widely expected to rise. While the session went beyond an hour, we did not have time to answer all the questions from attendees. Here below are my answers to all the questions.

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Editor's note: Craig Israeslen, is an expert on asset allocation, index investing, and Modren Portfolio Theory. He blogs regularly on A4A and has partnered with Advisor Products to provide advisors using his 7Twelve Portfolio research with client communications.  
 
Any difference between bond mutual funds vs. individual bonds in your analysis?
Good question. No, my analysis of bonds is only at the bond mutual fund level (or in some cases bond index level).
 
Do you want the commodity fund to be long only?
Yes, that is my preference. The loss potential when short positions go bad is not worth the risk in a strategic approach such as 7Twelve.
 
What would cause you to change any of the asset classes in his model, i.e. remove one or add another?
The one asset class that is “fluid” is the Cash position. If an investor already has a large cash position (say, the equivalent of one year of living expenses) I would have no problem with the “Cash” asset class being used by a different asset class, such as ultra-short term bonds (just an example).
 
Do you have any suggestions on the number of active managers in each asset class?
That is an interesting question—which implies that multiple mutual funds might be used in the 12 asset classes. I don’t approach it that way (I use one ticker per asset class). However, use of several funds within each asset class is a reasonable idea. One concern would be the issue of redundancy in the holdings among the various funds being used, particularly if active managers are being utilized. Another concern would be the possible increase in the aggregate expense ratio of the overall portfolio if adding funds with higher expense ratios. 
 
Aren't you ignoring the likelihood that TIPS, foreign bonds, and cash might be correlated to the weak US bond performance.
Using monthly returns, over the past 10 years the international bond ETF that I use in the “Passive” 7Twelve model has had a 55% correlation to aggregate US bonds.  TIPS has had a 71% correlation to US bonds, and cash has had a 2% correlation to US bonds. 
 
Over the past 3 years international bonds have had a 24% correlation to US bonds, TIPS have had a 56% correlation to US bonds, and cash has had an 11% correlation to US bonds.
 
I certainly agree that US fixed income players (US bonds, US TIPS, and US cash) all are affected by some common forces, but they haven’t (as yet) demonstrated correlation anywhere close to the correlations observed among US large, mid, and small cap equity.
 
You showed returns for 7 7Twelve portfolios.  Have you looked at after-tax returns?  I'm curious if the Passive, or Tax Efficient strategies, may have had better after-tax returns than the others.
I have not measured exact after tax returns for the various 7Twelve models, but I have calculated the “tax efficiency” of the various models (shown below). The lower the number, the better.
 
 
Active 7Twelve
Passive 7Twelve
Vanguard7Twelve
T. Rowe Price7Twelve
Fidelity
7Twelve
Tax Efficient 7Twelve
DFA 7Twelve
 
3-Year Tax Efficiency
(2010-2012)
 
0.82
0.65
0.70
0.76
0.71
0.49
0.81
 
Why the same 8.3 % in cash?  Is that a drag on the overall return under any timeframe?
Over the past 5 years (2008-2012), the 12 asset 7Twelve model with an 8.33% allocation to each asset (including cash) had a 3.42% annualized return (compared to 1.69% for the S&P 500). Without cash in the model (meaning there were 11 asset classes each with 9.09% allocation) the 5 year annualized return was 3.49%. During periods of dramatic volatility cash is a helpful stabilizer even if it isn’t producing much a return. 
 
Over the past 15 years, the 12 asset model (with cash) had a 7.95% annualized return, and without cash (11 asset model) the 15-year annualized return was 8.34%. I’m not convinced the 40 or so basis points is worth not having the liquid buffer that cash provides.
 
Where does gold/precious metal fit in?
Gold and other metals (precious and industrial) will be represented in the fund utilized in the Commodities allocation. Presently, the commodities ETF that I use has 8% in gold, 2% in silver, 4.2% in aluminum, 4.2% in zinc, and 4.2% in copper.
 
Is there a software program that you recommend for this?  Money Guide Pro does not include all these asset classes.
I use a fairly large Excel sheet that I’ve built. I’m not very familiar with other software such as Money Guide Pro.
 
In a specific asset category, i.e., large cap, do you segment between value, core & growth?
In the US small cap equity category I favor a distinct value tilt. 
 
In a 60/40 model in an active portfolio, the cash allocation would be 10%?
The allocation for all 12 asset classes is 8.33% -- including cash. However, see question #7 above.
 
Do you prefer hedged or unhedged non-us bonds?
Unhedged is my preference.
 
Are you going to the Index Universe conference?
No, but I will be speaking at the Inside Indexing Conference in Boston on April 22-23.
 
Are you using AGG as the bond security?
I’m using BND, but BSV is also an option for those who want to shorten duration.
 
Where do you put REITs? and preferred stocks?
One of the 12 asset categories in the 7Twelve model is Real Estate, thus REIT’s are represented there. The 7Twelve model does not have a specific asset category that isolates preferred stocks.
 
Is there a material difference between the effect of rising rates on bond returns (say over a ten year period) depending on the starting coupon rate?
Not that I am aware of. But I have not specifically studied that question. It’s a very good question and I’ll look into it.
 
How much of a small and value tilt are included in these portfolios?
I employ a distinct value tilt in US small cap equity. There are two non-US equity categories: developed non-US equity and emerging non-US equity. The fund I use in the emerging non-US equity category has about a 12% allocation to midcaps and 0.5% allocation to small caps. 

 

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