ValidFi News and Articles

Investing with Styles Can Pay off

2010-07-07T10:22:00.001-07:00

Portfolio construction consists of the following steps

Decide personal risk profile which determines the target allocation in risk assets.
Decide asset allocation method: strategic or tactical or both (strategic does not change target asset allocations while tactical can alter allocations more actively)
Decide target allocation for each asset in a strategic asset allocation
Periodically rebalancing portfolios

For a portfolio using strategic asset allocation, with long term target allocation being fixed (and only changed when major events such as approaching to retirement and children college education spending, for example), one can further enhance a portfolio return and reduce the risk by rebalancing and fund selection in an asset class. It is reported that adopting proper timing and way to rebalance a portfolio can improve return and reduce risk (see Daryanani opportunitstic rebalancing article). In this article, we focus on fund selection.

In most retirement or well designed portfolios, it is a popular practice to have funds with various style exposures. In a stock/equity asset, a fund style is defined as value style (growth/blend/value) and size style (large/mid/small cap). The Morningstar 9 boxes of styles are essentially the combinations of the 3 value and 3 size styles. In a fixed income asset, a fund style is a combination of credit risk (junk/investment grade) and interest rate risk (short/intermediate/long) for corporate bonds or a just interest rate risk for treasury bonds. In an actively managed portfolio, it is a well recognized and widely practiced method to select funds based on style rotation to improve a portfolio alpha or return. For example, in an article published in Journal of Asset Management (May, 2007), B. Arshanapalli , L. Switzer and K. Panju concluded that active multi-style rotation strategies can be devised to outperform the best performing buy-and-hold portfolio.

MyPlanIQ maintains an index fund based plan or an ETF based plan using candidate funds based on those in a lazy portfolio proposed by Fund Advice Paul Merriman and maintained by MarketWatch.com (called Fund Advice Ultimate Buy and Hold Portfolio) (see here for the independently tracked portfolio on MyPlanIQ.com). The candidate funds and the original allocation are as follows

Index	ETF	Allocation
Vanguard Interm-Tm Trs (VFITX)	iShares 3-7 Year Treasury (IEI)	20%
Vanguard Short-Tm Trs(VFISX)	iShares 3-7 Year Treasury (SHY)	12%
Vanguard Intl Val (VTRIX)	iShares MSCI EAFE Value Index (EFV)	12%
Vanguard Dev Mkts (VDMIX)	iShares MSCI EAFE Index (EFA)	12%
Vanguard Inflation-Prot (VIPSX)	iShares TIPS Bond (TIP)	8%
Vanguard Small-Cap Idx (NAESX)	iShares Russell 2000 Index (IWM)	6%
Vanguard Small-Cap Val (VISVX)	iShares Russell 2000 Value Index (IWN)	6%
Vanguard Value Idx (VIVAX)	iShares Russell 3000 Value Index (IWW)	6%
Vanguard 500 Index (VFINX)	SPDR S&P 500 (SPY)	6%
Vanguard Emerging Mkt (VEIEX)	iSharess Emerging Market Stock (EEM)	6%
Vanguard REIT Idx (VGSIX)	iShares Dow Jones REIT Index (IYR)	6%

The funds cover five asset classes: U.S. Equity, International Equity, Emerging Mkt Equity, U.S. REIT and Fixed Income. They have various style exposures for U.S. stock market (equity), International Stocks and Fixed income.

MyPlanIQ Strategic Asset Allocation (SAA) selects funds with the best risk adjusted returns for each asset class when rebalancing. The following table compares the Strategic Asset Allocation (SAA) moderate portfolios in both index fund and ETF plans as well as the original portfolio (both MyPlanIQ SAA moderate portfolios have 40% allocation in fixed income). We also include the strategic asset allocation moderate portfolio in MyPlanIQ Five Core Asset ETF Plan that consists one fund for each asset class.

As of 7/2/2010

Portfolio	1 Yr Return	3 Yr Return	5 Yr Return	Since 12/2000
FundAdvice SAA Moderate Index Funds	17%	-1.0%	5.1%	7.4%
FundAdvice SAA Moderate ETF	16.7%	-2.2%	4.8%	7%
FundAdvice Buy and Hold Index Funds	14.5%	-2.4%	4.1%	5.7%
Five Core SAA Moderate	16.9%	-3.4%	3.93%	5.6%

From the above table, we can observe:

Diversified into styles improves return (FundAdvice Buy and Hold vs. Five Core SAA Moderate).
Style rotation adds 1.3-1.7% returns over buy and hold (SAA Moderate ETF or Index Funds vs. FundAdvice Buy and Hold).

The above observations are consistent across thousands of plans MyPlanIQ maintains. We should also point out that better fund/style selection does not alter the overall portfolio risk allocation, which is a major advantage over an actively managed tactical asset allocation portfolio.

At the moment, for U.S. stocks, MyPlanIQ SAA favors small cap (IWM), small cap value (IWN). For fixed income, it favors Inflation-protected treasury (TIP).

ETF Selection in CNBC Diversified Global Core Model Portfolio

2010-06-20T22:49:00.001-07:00

CNBC reporter Bob Pisani asked three ETF experts--Matt Hougan from IndexUniverse, Tom Lydon from ETF Trends, and Jim Lowell -- to assemble several different Model ETF Portfolios. They came up with six Model ETF Portfolios, all reflecting different sentiments on the direction of stocks and the global economy.This plan is based on the ETFs in their Diversified Global Core portfolio. The portfolios went live on May 19, 2010.
In this article, we discuss the ETFs selected for this portfolio and how they are compared against a standard five core asset portfolio.
The following funds in the original CNBC Diversified Global Core portfolio cover five major asset classes tilted to some narrower themes:

US Equity: iShares Russell 3000 (IWV) for U.S. large cap.
Foreign Equity: Vanguard FTSE All-World ex-US ETF (VEU) for developed country stocks
Emerging Market: SPDR S&P China (GXC) for Chinese stocks
Commodities: PowerShares DB Commodity Idx Trking Fund (DBC) for broad base commodities
Fixed Income: Vanguard Total Bond Market (BND) for broad base U.S. bonds, iShares iBoxx $ Invest Grade Corp Bond (LQD) for U.S. investment grade corporate bonds and SPDR Lehman Intl Treasury Bond (BWX) for international bonds
Alternative: PowerShares DB G10 Currency Harvest (DBV) for carry trade based currency trading to hedge against U.S. dollar depreciation.

Looking closely at the ETFs, one can make the following observations:

US Equity: a specific focus on large cap instead of a broad base index fund such as Vanguard Total Stock Market (VTI).
Emerging Market: focus on China instead of broad base emerging market stock index fund such as Vanguard Emerging Market Index (VWO) or EEM.
Fixed Income: in addition to Total Bond Market Index (BND), it has specific focus on long term corporate investment grade bond index (LQD). Moreover, allocating in International Treasury Bond (BWX) is a hedge against U.S. dollar depreciation.
Alternative: PowerShares DB G10 Currency Harvest (DBV) is a carry trade based ETF that takes long positions in the three currencies with highest interest rates and short positions in the three with lowest interest rates. In general, carry trade does well in good economic periods but could perform poorly in a sudden economic and market slump, as evidenced in 2008. Notice also the average daily trading volume of DBV is less 150,000, making it a less desirable key asset holding.

Based on the candidate funds mentioned above, we created a plan that generates both Strategic and Tactical Asset Allocation model portfolios. The following is a comparison between the CNBC core portfolio and the model portfolios using SAA (Strategic Asset Allocation) or TAA (Tactical Asset Allocation) since the beginning of 2008.

	2008	2009	2010	1 Year	Inception
CNBC Global Diversified Core Portfolio	-28.6	28.6	-2.15	16.16	-4.25
Strategic Asset Allocation Growth	-31.2	30.38	-3.14	11.42	-5.57
Tactical Asset Allocation Growth	1.83	12.12	-2.85	11.59	4.29

Compared with the CNBC Portfolio, currently, the Tactical Asset Allocation Growth model portfolio has 30% in LQD, 43% in IWV and 27% in BND. It is quite defensive as this portfolio’s target allocation in risky assets is 80%.
The portfolio's narrower focus makes it less a 'core' portfolio but more like an 'active' portfolio. Moreover, we believe that using carry trade based currency DBV, though serves the purpose of hedging against US dollar depreciation, is not necessary. For example, both commodities and international bonds have negative correlation with US dollar value.
In our opinion, average investors are better served with a portfolio of major assets with enough liquidity. MyPlanIQ has created a Five Core Asset Index Funds Commodity ETF plan that has the following funds:

US Equity: Vanguard Total Stock Market ETF (VTI)
Foreign Equity: Vanguard FTSE All-world ex-US ETF (VEU)
Emerging Market Equity: Vanguard Emerging Market Index (VWO)
Commodity: PowerShares Commodities Index (DBC)
US Fixed Income: Vanguard Total Bond Market Index (BND)

The following is a comparison between the Tactical Asset Allocation (TAA) growth model portfolios for both CNBC and the above Five Core Asset plan (for comparison purpose, we also include the original CNBC Core portfolio).

	2008	2009	2010	1 Year	Inception
CNBC Global Diversified Core Portfolio	-28.6	28.6	-2.15	16.16	-4.25
CNBC Tactical Asset Allocation Growth	1.83	12.12	-2.85	11.59	4.29
Five Core Asset Tactical Asset Allocation Growth	-3.7	24.88	-1.8	18.52	6.97

Even though the above comparison is limited to the short history of portfolios due to some ETFs' short history, one could still see that the Five Core Asset TAA portfolio outperforms the corresponding CNBC TAA one. This is consistent with what we demonstrated in the previous article: just using five or six most liquid assets in a portfolio based on the tactical asset allocation strategy enables one to achieve very respectable returns.
In conclusion, CNBC Diversified Global Core ETF portfolio indeed has a diverse coverage on key assets. Investors could still simplify and be better served with just broad base index funds for major assets.

Usable, Understandable For 401K Asset Allocation

2010-06-11T16:49:00.001-07:00

For many, achieving good investment returns is an arcane art for the gifted few. An exclusive club of magicians weave their spells and works their magic with new members appearing from time to time. It's our place to cross their palms with silver to get the benefit of their potions.

In a previous article building a simple portfolio was discussed. This moves this art towards a science that is open to all, because the SIB Portfolio allows us to create a benchmark based on asset allocation. This can be used to compare against other plans and give some measure of the funds available.

Five asset classes are chosen based on well proven academic research and practical proof:

US Equity
Developed Market Equity
Emerging Market Equity
Real Estate Investment Trust (REITs)
Fixed Income

The claim of asset allocation is that over 90% of the returns are derived from the asset classes and not the selection of the funds themselves. So that if you select the funds that represent the right asset classes from your 401K, you will get better returns than chasing after the highest performing funds from the last 1, 2, or 3 years.

To demonstrate the point, MyPlanIQ created a series of portfolios derived from asset allocation strategies, risk profile and Vanguard index funds for each of the five asset classes.

Table 1 shows the funds available for the SIB portfolios. The mix of the funds will be driven by the risk profile of the individual and the asset strategy selected.

Asset Class	Symbol	Vanguard Name
US Equity	VTSMX	Total Stock Market Index
Developed Market Equity	VGTSX	Total Intl Stock Index
Emerging Market Equity	VEIEX	Emerging Market Stock Index
Real Estate	VGSIX	REIT Index
Fixed Income	VBMFX	Total Bond Market Index

Nothing complex, just a simple portfolio derived from funds that are easy to understand and can serve as a simple benchmark against which more complex (and expensive) portfolios can be measured.

For SAA, the assets were first split into fixed income and risky assets. This split was dictated by the risk profile (fixed income 20% growth, 40% moderate, 60% conservative). Then allocation of risky assets is made equally and there is periodic rebalancing to ensure that the portfolio remains with the correct ratios.

For TAA, the assets were also split into fixed income and risky assets based on the risk profile. However, the allocation of the assets will vary based on economic conditions. In essence, when one asset class is not performing well (for example, emerging markets in a time of financial uncertainty), there will be a shift to other asset classes.

Historical simulations were run for six portfolios:

Table 2 shows the performance of the SIB portfolios based on the risk profile and asset allocation strategy

Strategic Asset Allocation	1Yr AR	1Yr Sharpe	3Yr AR	3Yr Sharpe	5Yr AR	5Yr Sharpe
Five Core Asset Index Funds Strategic Asset Allocation Growth	43%	233%	1%	-0%	9%	31%
Five Core Asset Index Funds Strategic Asset Allocation Moderate	33%	236%	3%	8%	8%	38%
Five Core Asset Index Funds Strategic Asset Allocation Conservative	25%	275%	4%	24%	7%	52%

Tactical Asset Allocation	1Yr AR	1Yr Sharpe	3Yr AR	3Yr Sharpe	5Yr AR	5Yr Sharpe
Five Core Asset Index Funds Tactical Asset Allocation Growth	38%	224%	13%	85%	18%	120%
Five Core Asset Index Funds Tactical Asset Allocation Moderate	30%	241%	11%	97%	15%	127%
Five Core Asset Index Funds Tactical Asset Allocation Conservative	22%	267%	9%	112%	11%	140%

The first thing of note is that the simple portfolios perform very well - demonstrating that asset allocation is key to success. The second thing of note is that tactical asset allocation consistently gives better performance in the long run.

When applying this to a 401K plan, you may have limited choices of funds in each category so that you may not be able to achieve the best of all possible performance - but even with sub-optimal funds, by picking the right asset classes, you should be able to improve your returns.

When I checked my own 401K plan, for which I did what most people did - pick a few funds at random and hope - I have achieved a five year return of 5.19%. If I had used TAA applied to the plan funds I would have seen a return of 10.74% -- remember that an additional 6% a year over a decade will double your retirement money.

Key takeaways:

Improving your returns is not that difficult - you can understand it and drive it - even with limited choices in your plan, you can do better without having to spend hours learning some secret art - compare your current results with what the SIB portfolios achieved.
TAA has consistently outperformed SAA. More on TAA. More on SAA.
Superior fund selection will return 1-2% extra - for free. More on SIB fund selection.

In future articles, we will start comparing specific 401K plans against the SIB portfolio and derive a league table of best and worst of breed.

labels:investment,ETF, 401K

Symbols: VTSMX , VGTSX, VEIEX, VGSIX, VBMFX,

David Swensen's Six Asset Investment Plan

2010-06-07T17:58:00.001-07:00

David Swensen, the Yale Endowment Manager, proposed this one size fit in all model portfolio for individual investors. The major difference between this portfolio and other conventional portfolios is that it emphasizes international equities (including emerging market equities) as well as real estate investment. Compared with various diversified portfolios, an interesting asset class missing is the commodities, which has been considered to be an excellent anti-inflation diversifier. This is complemented with its emphasis on the inflation-protected treasury bonds. In the model portfolio constructed, we assume annual rebalance although Swensen actually pointed out that in Yale's institutional portfolio, they rebalanced daily, which, by his estimate, gave about 1-2% of excessive returns vs. annual rebalancing.

Compared with the Simpler Is Better (SIB) portfolios we discussed in the previous article, Swensen excluded commodities while putting emphasis on using fixed income for the purposes of inflation protection and portfolio hedging. Since commodities ETFs and index funds are still problematic (see this article), Swensen's six assets are the most investable assets.

Note: it has been confusing whether Swensen advocated using long term treasury bonds or just an average duration treasury bonds. In his book Unconventional Success: A Fundamental Approach to Personal Investment, he wrote "The purity of noncallable, long-term, default-free Treasury bonds provides the most powerful diversification to investor portfolios". Based on this sentence, it has been interpreted that he meant to use the long term treasury bond. However, recently, a reader posted a reply from David Swensen on this question in morningstar.com that indicates the average duration of treasury bonds.

The portfolio consists of the following:

30% in Vanguard Total Stock Market Index (VTSMX or Vanguard ETF VTI)
20% in Vanguard REIT Index (VGSIX or Vanguard ETF VNQ)
20% in Vanguard Total International Stock (VGTSX) or (15% in VGTSX or Vanguard ETF VEU and 5% in VEIEX or Vanguard ETF VWO)
15% in Vanguard Inflation Protected Securities (VIPSX or iShares Tip TIP)
15% in Vanguard Long Term Treasury Index (VUSTX or iShares TLT or Vanguard ETF EDV)

We have constructed both index fund based and ETF based plans using the above funds. Model portfolios using MyPlanIQ Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA) are generated. The following compares the Swensen's portfolio with SAA moderate and TAA moderate model portfolios. Since the ETF based plan has shorter history, we present here the index fund based portfolios.

SAA moderate model portfolio differs from Swensen's portfolio in both its target allocation and rebalancing frequency. SAA moderate is equally weighted among risky assets US Equity, International and Emerging Market Equity. It rebalances monthly whenever an asset weight deviates 20% from the target weight. The Swensen's rebalances annually. This, along with the proper selection between VIPSX and VUSTX in the fixed income portion, contributes to the outperformance over the Swensen's portfolio.

TAA has the best performance as it used asset momentum to rotate out of risky equity assets and avoided big loss in 2008 and early 2009. The following table shows its performance from 12/31/2000 to 6/7/2010.

	2001	2002	2003	2004	2005	2006	2007	2008	2009	2010	1 Yr	3 Yr	5 Yr	Inception
Annualized Return (%)	3.31	8.28	24.48	13.65	12.99	15.49	19	-4.49	18.69	-1.66	16.56	7.72	11.2	11.32
Sharpe Ratio (%)	19.32	116.15	353.29	136.95	139.2	126.87	123.7	-72.15	147.98	-10.34	107.23	55.36	84.95	103.24

In conclusion, David Swensen's six assets are the most investable core assets with which main stream asset allocation strategies can be used to achieve reasonable investment results.

Selecting Candidate ETFs for Effective Portfolio Construction

2010-06-01T10:18:00.000-07:00

Selecting the right funds in a portfolio strategy is critical for both self-directed investors and administrators of retirement plans such as 401(k) and IRAs. Working with too few funds limits diversification benefits and limits opportunities. On the other hand, too many funds can be confusing and misleading. Getting the right mix is especially important in a retirement plan as participants have a wide range of differing requirements and demands that will drive their financial planning. For ETF investors, the ever increasing number of ETFs (the latest tally is $782 billion asset in 810 funds) only exacerbates this problem.

MyPlanIQ has developed guidelines for providing the optimal investment choices for an ETF based plan or a portfolio. The following are the key criteria to consider when making such choices.

Diversification

Candidate funds should cover major asset classes at least. We consider the following the major classes.

US Equity
Developed Country Equity (ex. US)
Emerging Market Equity
Real Estate Investment Trusts (REITs, most US)
Commodities
Fixed Income

For global investors, we add Foreign Fixed Income as another major asset. Minor assets and styles are also possible candidates if strategies employed handle them effectively. We do not advocate going down to sector or industry levels since their volatile and concentrated nature defeats the diversification purpose

Fund Qualities

Since most ETFs are index funds, the following should be used to select an ETF.

Liquidity: The minimum requirement should be at least 250K daily average volume in last 3 months – exclude ETFs with low trading volume. The other major factor to consider is the total net asset an ETF is held. In general, we would prefer at least $1 billion asset for a major ETF.
Tracking error: how closely it tracks its stated index benchmark. Price/Nav discount/premium and bid-ask spreads are two important factors to consider here. In general, for two ETFs that have the same stated index benchmark, the one has tracks the benchmark more closely should be picked.
Fee: all things equal, low expense fee is a key advantage for a long term portfolio. Vanguard ETFs and index funds have set high standard/bars for other ETFs to measure up to.
Return: again, all things equal, return is another factor to use to distinguish ETFs.

Portfolio Building

In addition, it is critical to see how these selected funds work with each other. For example, consider the following two choices: US Equity, Emerging Market Equity and Fixed Income vs. US Equity, Developed Country Equity and Fixed Income. How would these asset classes work together? How would the actual funds behave when putting them together? MyPlanIQ uses a proprietary method to perform historical simulation to evaluate portfolio effectiveness.

Let’s try to select candidate ETFs for a simple core portfolio that consists of 6 key major assets mentioned above. We will build two funds – the one we think is the best and compare it with the most popular in each asset class.

US Equity: there are plenty choices here. The first comes to mind is the Wilshire 5000 Total Return index. Claymore launched an ETF (WFVK) to track this index in March 2010. However, since this is a fairly new ETF, its trading volume is light and thus is excluded. The other venerable index would be Vanguard Total Stock Market Index ETF (VTI). Its average daily trading volume in the past 3 months is more than 2 million shares. Another choice is the oldest and most popular S&P 500 ETF: SPDR SP 500 (SPY). This is the most liquid ETF and it has the least bid-ask spread. It has more than 200 million shares change hands daily. SPY, however, is a large cap index, not a broad base index. We prefer VTI over SPY.

Developed Market Equity: MSCI EAFE index (EFA) and Vanguard FTSE All-World ex-US ETF (VEU) are the two candidates. Vanguard Total World Stock (VT) is a one for all equity ETF that covers all of three equity asset classes (U.S. Developed and Emerging Markets). We prefer VEU over EFA, considering the low expense Vanguard charges for VEU.

Emerging Market Equity: iShares MSCI Emerging Market Index (EEM) and Vanguard Emerging Market Equity (VWO) are the two candidates. Matt Hougan from IndexUniverse and others have written several articles discussing both ETFs. Again, Vanguard VWO is clearly a winner after taking cost into account.

Real Estate Investment Truse (REITs): Dow Jones U.S. Real Estate Investment Trusts (IYR) is the most popular while iShares Cohen & Steer Realty Majors (ICF) is more concentrated on major REITs. Vanguard REIT Index ETF (VNQ) has the lowest expense, wide diversification and high trading volume. VNQ is clearly the choice here.

Commodities: Powershares DB Commodity Index ETF (DBC) and iShares S&P GSCI Commodity Index (GSG) are the two main choices. It is interesting to see that DBC has higher expense (1.3%) than GSG (0.75%) while GSG is more concentrated on energy commodities (74% vs. 55%). In general, DBC is more balanced though GSG has wider exposure among many commodities. This article has some more detailed writeup on the comparison between the two ETFs. DBC, though not as diversified as GSG, is more balanced in major commodities. We prefer DBC.

Fixed Income: for a broad base fixed income exposure, iShares Barclays (Lehman) Aggregate Bond (AGG ) and Vanguard Total Bond Market (BND) are the clear two candidates. With its lower expense cost (0.11%), BND is better than AGG (0.2% expense). This article compares the two ETFs in more detail.

MyPlanIQ has created two plans for the core portfolios. The candidate funds for Six Core Asset ETFs Most Popular are chosen based on their popularity (history and liquidity). The candidate funds for the other plan Six Core Asset ETFs are chosen based on more detailed criteria outlined above. The following table shows the selections of the two plans:

	Six Core Asset ETFs	Six Core Asset ETFs Most Popular
US Equity	VTI	SPY
Developed Market Equity	VEU	EFA
Emerging Market Equity	VWO	EEM
REITs	VNQ	IYR
Commodities	DBC	DBC
Fixed Income	BND	AGG

The following table shows the performance of model portfolios: one Strategic Asset Allocation (SAA) Moderate and one Tactical Asset Allocation (TAA) Moderate portfolio are chosen for each plan.

	1 Year Annualized Return	1 Year Sharpe Ratio	3 Year Annualized Return	3 Year Sharpe Ratio	5 Year Annualized Return	5 Year Sharpe Ratio
Six Core SAA Moderate	17%	116%	2%	5%	7%	32%
Six Core Most Popular SAA Moderate	13%	88%	-2%	-15%	5%	17%
Six Core TAA Moderate	18%	116%	12%	82%	16%	102%
Six Core Most Popular TAA Moderate	17%	99%	10%	64%	13%	89%

From the above table, one could clearly see that the selection of candidate funds for constructing a portfolio plays an important role in portfolio returns. The 2-3% difference of annualized returns in the past 5 years between the two corresponding portfolios is striking. It clearly shows that it pays to put more efforts in selecting funds.

The impressive performance of Six Core Asset ETFs supports the maxim ‘simpler is better’.

ETFs for 401K Portfolio Building

2010-05-20T15:55:00.001-07:00

ETFs have become increasingly popular in taxable or self-directed IRA portfolios. A flurry of introducing commission free ETFs will only accelerate ETF. There is another less visible but significant move to make ETFs a staple in traditional company sponsored retirement plans such as the 2.7 trillion 401(k) sector.

iShares (recently acquired by BlackRock) established iShares401k.com to promote ETFs within the 401(k) industry. Two vendors AdvisorETF401k and Ascensus have signed up to provide iShares ETFs for 401(k) plans.

It is interesting to note that Ascensus provides an aggregate ETF trading platform for participants. Based on a document on the Ascensue web site, "All trades submitted for the day for each ETF on the Ascensus platform will receive the same average share price. The average share price is calculated based on the market price received for actual shares traded plus the fees noted below. This method allows for automation of trades, which minimizes trading costs, and enables participants to own whole and fractional shares of ETFs." That certainly makes ETF trading more like traditional mutual fund end of day settlement.

Sungard provides an ETF 401(k) platform also allows late day processing for ETFs: i.e. ETFs trades are treated as mutual funds and they are settled using market close prices at 4pm EST. This restriction/feature is arguable but certainly makes ETFs more like long term portfolio building elements instead of intra-day trading vehicles. The other salient feature for Sungard's solution is that it allows participants to hole fractional ETF shares, much like mutual funds. This is very important for small accounts, which are typical in retirement 401(k) accounts.

Interested readers are referred to MyPlanIQ's iShares ETFs plan to see how these ETFs could be used in constructing a portfolio. There are a total of 187 iShares ETFs that cover major asset classes including US Equity (various Russell 1000, 2000, 3000 ETFs including IWF, IWB, IWD, IWZ, IWV, IWW, IWP, IWS, IWO, IWM, IWN, IWC, IWR and S&P large/mid and small cap ETFs), Foreign Equity (EFA, SCZ, ACWX), Emerging Market Equity (EEM), Real Estate (IYR and various foreign REITs such as IFGL) and US Fixed Income (AGG and many well known bond funds such as TLT, IEF, SHY, TIP, MBS, MUB, LQD, CFT, CSJ, HYG) and foreign bonds (EMB, IGOV). As in Vanguard's ETFs, the only major asset class missing is commodities. That, however, is a major asset class not covered by traditional mutual funds in most 401(k) plans anyway.

Another noticeable ETF 401(k) provider is ShareBuilder401K whose goal is low cost. It is sponsored jointly by ING Direct and ShareBuilder, a discount brokerage. Costco recently launched a Costco ShareBuilder 401k plan that has become popular among small businesses. The ShareBuilder401K consists of 15 ETFs. One noticeable major asset missing is Real Estate Investment Trusts (REITs). It would also be improved with more coverage on asset classes such as fixed income and foreign bonds. MyPlanIQ has constructed a plan to help participants in ShareBuilder401K in portfolio building. Both iShares ETFs plan and ShareBuilder 401K Plan have shown that it is possible to achieve very reasonable performance if proper portfolio strategies such as the Strategic Asset Allocation and Tactical Asset Allocation strategies provided by MyPlanIQ are used.

In an effective retirement plan using mutual funds or separately managed accounts, the key factors to select candidate funds in a plan are low cost, quality of funds and quality of diversification. With ETFs, low cost is a standout factor but it still varies from one ETF to another. The uality of funds include how close those ETFs track their intended benchmarks (so called tracking errors), liquidity and bid-ask spread (trading friction). The quality of diversification or coverage is about how many major and minor asset classes are covered by the candidate funds, as discussed above. A follow up article will give more detail on how to construct and rate a good ETF plan.

Tom Lydon has written several good articles on ETFs in 401(k) such as this and this. In addition, IndexUniverse.com has done excellent coverage on this topic such as this article.

Commission-free ETFs Enable Portfolio Building Using Asset Allocation Strategies

2010-05-13T22:38:00.001-07:00

The latest Vanguard announcement on offering all the company's 46 ETF trades commission free marks a new era for ETFs. In our opinion, with trading costs removed, ETFs are now a viable alternative to index and actively managed mutual funds in portfolio building and asset allocation.
Three brokerage firms, Vanguard, Fidelity and Schwab, have announced commission-free ETFs. Let's first compare them in the following table:

Asset Classes	Sub Asset Classes	Vanguard	Fidelity	Schwab
US Equity	Large Cap	MGC, MGK, MGV, VTI,VTV, VUG, VXF,VV,VIG, VYM	IWD, IVV, IWB, IWV, IVW, IWF,IVE	SCHB, SCHX, SCHG, SCHV
US Equity	Mid Cap	VO, VOT, VOE	IJJ, IJH, IJK
US Equity	Small Cap	VB, VBK, VBR	IJS, IWN, IJR, IWM, IJT, IWO	SCHA
Foreign Equity		VT, VEU, VSS,VEA,VGK,VPL	EFA, ACWI, SCZ	SCHF, SCHC
Emerging Mkt Equity		VWO	EEM	SCHE
REIT		VNQ
US Fixed Income	Treasury Government	VGSH, VGIT, VGLT, EDV, VMBS	TIP, MUB
US Fixed Income	Corporate	VCSH, VCIT, VCLT	LQD
US Fixed Income	General	BSV, BIV, BLV, BND	AGG
Intl Fixed Income		N/A	EMB
Sectors		VPU, VOX, VAW, VGT, VIS, VHT, VFH, VDE, VDC, VCR

From the table, one could see that Vanguard commission free ETFs covers most of major and minor asset classes. Schwab, on the other hand, offers limited coverage. Schwab's ETFs have relatively short history but, given Schwab's reputable mutual funds, one would expect these ETFs would offer competitive performance compared with iShares and Vanguard's ETFs. Among all of the offerings, asset class foreign bonds and commodities are noticeably missing. From diversification point of view, we would like to see those asset classes are covered.
The significance of commission free ETFs should not be understated: periodically rebalancing of a portfolio using strategic asset allocation is now free and at will, no more redemption and round trip charge (though we are not advocating frequent trading), no more lockup period and various fund classes (remember those class A, B, C, D, Y, Z shares?).
Commission free ETFs make very good instruments for constructing a portfolio using a good tactical asset allocation strategy. Remember academic research keeps reminding people of the trading cost? It is gone. Now, one could build an ETF based portfolio using some of best tactical asset allocation strategies. For example, on MyPlanIQ.com, it offers a Vanguard ETFs plan that has several model portfolios based on Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA). The following table shows the comparable performance among VBINX (Vanguard Balance Fund Index, a 60% stock and 40% bond portfolio), SAA moderate portfolio and TAA moderate portfolio.
The following illustrates the performance comparison among TAA, SAA and VBINX.

The performance comparison is as follows:

	1 yr AR	1 yr Sharpe	3 Yr AR	3 YR Sharpe	5 YR AR	5 YR Sharpe
Vanguard ETF TAA (P_16707)	27%	1.8	11.6%	0.74	15.6%	1.01
Vanguard ETF SAA (P_15214)	30%	2.06	5%	0.2	10%	0.46
Vanguard Balance Fund Index (VBINX)	18.1%	1.7	-1.75%	-0.15	3.4%	0.11

Commission free ETFs are not free of problems. The major remaining issue is the trade friction or so called bid and ask spread: with an index mutual fund, one has no such a problem. This problem is exacerbated by low volumes for some ETFs. Care should be still given for those ETFs. We expect, however, the growing volume and popularity of ETFs will eventually make these problems less serious.

We applaud the recent industry moves and are looking forward to more such moves to make them completely free. We believe this represents a significant step forward to further level play fields between retail investors and professional investors.

Introducing a New Service: MyPlanIQ for ETFs, Mutual Funds, 401(k), Variable Annuities, VULs Investments

2010-05-05T15:49:00.000-07:00

Dear ValidFi Users,

As a registered and active ValidFi user, you have given us valuable suggestions and questions in the past. We appreciate your interests and help. We are pleased to announce the first relase of MyPlanIQ -- http://www.myplaniq.com/. Your ValiDfi username and login has been transferred to MyPlanIQ and you are welcome to log in at any time.

We learned from ValidFi users that there is a need for easy to use portfolio creation tailored to a wide range of investments: self directed brokerage accounts using ETFs or mutual funds, 401(k), 529, Variable Annuity portfolios, Variable Universal Life (VUL) portfolios.

MyPlanIQ solves the problem by building a portfolio driven by advanced strategy, your risk profile, and mapped only to what your plan makes available.

At the moment, MyPlanIQ supports two major strategies: Strategic and Tactical Asset Allocation. The Tactical Asset Allocation strategy is a variation of ValidFi's Goldman Sachs Global Tactical Asset Allocation strategy that has been popular among ValidFi's users. If you are looking for a corresponding plan in MyPlanIQ.com for such a portfolio, we suggest you look at plan Diversified Major Asset ETFs Goldman Sachs Global Tactical Asset Allocation.

As time goes, we plan to support more strategies including Guru Asset Allocation Clones.

As in ValidFi, MyPlanIQ monitors the portfolios daily and will send you rebalancing email alert if there is a rebalancing event monthly.

MyPlanIQ is subscription based. The plan costs $9.95 a month (or $99.5 a year). We believe low cost is one of the key advantages for us to deliver values.

The default setting is free while working with data that is delayed one quarter. As an active Validfi user, you can register for active data and will receive an extended six month trial period.

Thank you for your continuous interests and support.

ValidFi staff

Smart Money Reduces Stock Allocation

2010-04-04T16:52:00.001-07:00

With the hope of economic recovery, investors have pushed stock markets to new highs. S&P 500 (SPY) has risen 5.7% year to date and reaches the highest point in the past 18 months. iShares Russell 2000 (IWM) has risen even more: 9.6% year to date. The latest labor market news released on Friday would certainly add fuel to the fire.

However, using John Hussman's phrases, the market climate of stock markets has been in a state of strenuous overvaluation, overbought conditions, overbullish sentiment, and hostile yield pressures. In addition to such a heightened overbought state of stock markets, investors should also stay vigilant on the upcoming mortgage reset tidal and the inter play of under currents of sovereign debt markets, inflation pressures and geopolitical forces. ValidFi's Smart Money indicator, an asset allocation analysis of asset allocation mutual funds managed by top managers, is designed to extract real time asset allocation trends between equities and bonds for these smart money managers. As of last Friday March 29, 2010, this indicator signaled that these managers have dramatically reduced stock market exposure recently.

The following two charts clearly illustrate such a trend:

The first chart, ValidFi Smart Money Indicator, shows that the top asset allocation managers reduced US equity exposure from recent high 78% on 3/12/2010 to 58% on 4/1/2010, a 20% reduction. This is very significant as S&P 500 ETF SPY rose from 115.46 to a new high 117.8 during the same period. The second chart, ValidFi Pro Money Indicator, which measures the aggregate average US equity exposure among 900 plus moderate allocation mutual funds, shows that the pro money allocation managers also reduced their stock market exposure, although on a much smaller scale. It is also interesting to point out that both types of managers now allocate roughly the same capital to stocks.

Though any indicator could suffer from false signals, which is not a surprise statistically, ValidFi's smart money indicator has been proven to be a reliable signal (again, statistically): a model portfolio that is based on the same asset allocation analysis technique to derive its asset allocations among an array of major assets including US Equities (SPY), International Equities (EFA), Emerging Market Stocks (EEM), REIT (IYR), Commodities (DBC, GLD), US Bonds (AGG etc.) has delivered annualized return 11% since 7/30/2001 to 4/1/2010.

If smart money managers and pro fund managers have been cautious, a prudent investor at this moment should at least rebalance portfolios so that the elevated risky asset exposures (equities and REITs, for example) could be reduced and get back to a risk level you are more comfortable with. It pays to take some money off the table to reduce risk.

Smart Money Asset Allocation Review

2010-01-24T12:36:00.001-08:00

Recent market volatility marked the first serious drop since November last year. It is timely to review how smart investors have prepared and reacted to such a change. The following analysis is based on ValidFi's real time asset allocation analysis tool for mutual funds.

First, let's take a look at several best performing moderate asset allocation funds in the last 3 years.

The following are beta (asset exposure) changes of the stock market (using Vanguard Total Stock Market Index VTSMX as the proxy) for moderate allocation funds Janus Balance (JABAX), FPA Crescent (FPACX), Waddell & Reed Asset Strategy (WYASX) and Ivy Asset Strategy (WASYX). Notice also the beta reduction does not mean the manager actually makes a physical asset reduction in his portfolio. It could mean that his portfolio has been positioned defensively (such as more heavily in defensive sectors such as consumer staples). Same is true for beta increase also.

Taking into account S&P 500 index (SPY)'s 2% year to date drop, one could see that all of these funds have reduced their exposure to equity somewhat. Notice further that other than FPACX, the other three funds reduced their exposure right at the beginning of year. Such a move apparently reveals the year end asset rebalancing. It seems to be very prudent and timely to make such reductions (or a rebalancing act). Also, notice both Waddell & Reed and Ivy made drastic reductions on days 1/14 and 1/15.
On the other hand, if we look at funds with under exposure going to the new year, such as Vanguard Wellesley Income (VWINX) and GMO Benchmark-Free Allocation (GBMFX), these funds actually increased their equity exposures during this correction period:

Currently, ValidFi's Guru Asset Allocation Clone with Diversified Bonds portfolio has the following asset mix: 25% short term bond allocation (SHY and CSJ), 7.41% high yield bond (HYG or JNK) and the rest is in stocks (SPY, EFA, EEM), REIT (IYR or ICF) and gold GLD.

All in all, from the above, we could infer that smart money managers do not expect a drastic stock market melt down (at least at this moment) while they are making timely move to adjust their asset exposure to the right mix. One should definitely reduce equity exposure if he/she has over exposure to this asset. On the other hand, for those whose equity exposure has been under the target allocation, it might be prudent to gradually increase the allocation.

International Stock Investing: Diversified Timing on Country ETFs

2009-12-20T17:46:00.001-08:00

In our previous article, we alluded that in a diversified portfolio, putting a long term timing indicator such as 10 month simple moving average on risky assets such as stocks, commodities could effectively reduce risk (i.e. big loss) while improving return. Investors are in a heightened state of anxiety these days as equity markets are consistently at a level where some analysts find them over valued (such as John Hussman's recent analysis or Robert Shiller's Cyclically Adjusted 10 Year PE ratio (Price to Earnings Ratio). Using a long term timing indicator to safe guard these portions of a portfolio is an effective way to do so.

In the international stock asset, investors could utilize today's diverse array of country ETFs to get an exposure. The following is the list of country ETFs used in this strategy:

The Netherlands (EWN)
Germany (EWG)
France (EWQ)
Switzerland (EWL)
Italy (EWI)
United Kingdom (EWU)
Belgium (EWK)
Austria (EWO)
Singapore (EWS)
Hong Kong (EWH)
Japan (EWJ)
Canada (EWC)
South Africa (EZA)

The portfolio has equally weighted amount on each country ETF. A 10 month Simple Moving Average (SMA) is used for each ETF. The strategy checks the SMA indicators at the end of each week and does the necessary transactions. Furthermore, the portfolio is rebalanced every year.

The following table illustrates the performance of this portfolio from 5/18/2009 to 12/18/2009.

	Last 5 Years	Last 3 Years	Last 1 Years	Up To Date	2004	2005	2006	2007	2008	2009
Annualized Return(%)	11.749	7.969	20.542	13.414	19.892	9.477	21.57	11.594	-6.249	20.541
Sharpe Ratio(%)	70.258	43.454	109.953	84.593	186.162	69.757	134.478	47.291	-195.092	108.191
Standard Deviation(%)	14.011	15.175	18.597	13.697	10.319	10.475	13.589	18.123	3.679	18.9
Draw Down(%)	16.916	16.916	9.694	16.916	3.938	7.902	15.169	10.354	6.529	9.694

This portfolio compares favorably with the unguarded EFA which has the following performance (2004 is a full year data) while Up To Date being from 5/18/2004 to 12/18/2009.

	Last 5 Years	Last 3 Years	Last 1 Years	Up To Date	2004	2005	2006	2007	2008	2009
AR(%)	3.33	-7.032	28.904	6.21	18.93	13.322	25.806	9.951	-42.126	24.844
Sharpe Ratio(%)	5.051	-24.366	89.625	16.4	123.536	103.547	162.686	44.417	-92.86	79.664
Standard Deviation(%)	28.199	34.513	32.145	26.7	14.541	11.664	14.933	18.337	47.084	32.209
Draw Down(%)	61.761	61.761	30.238	61.761	9.806	7.192	15.755	11.576	54.496	30.238

Users could modify this portfolio to allow addition of recently introduced country ETFs such as emerging or new country ETFs including EWZ (Brazil), FXI (China), INP (India, an ETN or INDY, an ETF). RSX (Russia), TUR (Turkey), THD (Thailand), South Korea (EWY), PLND (Poland) and VNM (Vietnam), or even regional ETFs such as EPP (pacific), AFK (Africa), GAF (Africa and Middle East), VGK or IEV (Europe). Moreover, users could change the country weights. It is very encouraging to see that there are some many country ETFs available for investors to get a diversified exposure. Certainly cautions should be taken for those with very little liquidity.

John Hussman Commentary on 12/14/2009: Decidedly Speculative

2009-12-14T12:01:00.001-08:00

John Hussman's weekly comment on 12/14/2009: Any virtue of stocks here is decidedly speculative. Stocks are overvalued to a level from which uninspiring returns have always followed. That fact is true regardless of whether or not the economy is in a sustainable recovery. More detailed here. Hussman has been negative since September this year. Recently, however, he has adopted a slight speculative stance on US stock market through call option exposure. Based on his commentary and our estimate here, the stock exposure beta of Hussman Strategic Growth Fund HSGFX is less than 10%. The following are some key points from his above commentary.

S&P historical return: Using Barsky-Delong model, to achieve annual real return of 4.2%, the S&P would need to be at 810. Or putting it the other way, Hussman stated that "the conclusion is not that stocks must decline immediately, but rather, that long-term total returns for the S&P 500 are likely to be less than 4.2% after inflation." "Alternatively, on the assumption that future growth rates match what we've observed over the past two decades and indeed over most of the past century, an expected long-term total return of 10% for the S&P 500 (what investors generally carry in their heads as the 'typical'long-term return on stocks) would currently be consistent with an index level of 672".
'Second wave' concerns begin to appear: Hussman has been warning that the second wave of housing credit crunching (the mortgage reset) is approaching the peak at this moment. He quoted Meredith Whitney's interview on CNBC which was very negative on the outlook of 2010: "which is so disturbing on so many levels to have so many Americans be kicked out of the financial system, and the consequence both political and economic of that is a real issue you can't get around. It's never happened before in this country or in the modern economy. The biggest trend in 2010 will be seeing who gets kicked out of the banking system."

So the question is whether the banks could withstand the upcoming credit loss, even with their newly raised equity from public markets this year. Furthermore, with the bailout in effect, how much the banks could shift the loss to the government, i.e. tax payers. Based on the 'stealth stimulus' theory reported by Wall Street Journal, consumers are foreclosing homes and freeing their cash flow to 'stimulate' the economy. Thus consumers -> banks -> taxpayers flow will do a 'stealth' wealth redistribution with 'banks' being intact!

Any way you put it, we are definitely at a situation with many potential landmines. The best approach at this moment is to rebalance your portfolio's asset allocation back to a risk level you could tolerate (remember 2008?) and then stick to the strategies/plans you have chosen.

Core Satellite Portfolios: A Sound and Proven Method to Achieve Reasonable Return with Managed Risk

2009-12-08T12:22:00.001-08:00

The concept of core satellite portfolio construction has been adopted for several years by many investment and wealth managers. The EDHEC has collected several papers detailing this concept. ValidFi has maintained a so called Simple Core Satellite Portoflios strategy to show case this concept. In this article, we will discuss the effectiveness of combining simple timing and passive allocation to achieve better risk adjusted returns.

The key idea behind the core satellite portfolios is that, while the traditional passive (buy and hold) strategic asset allocation is suited for long term investment, the short term or intermediate term risk is too much for an ordinary investor to bear with. A portfolio with over 20% peak to trough drawdown (i.e. loss) is probably the maximum for many investors. On the other hand, an actively managed portfolio, while reducing short term risks, could suffer from a stream of short term loss. For example, a moving average based equity portfolio buys into the stock market when the stock market index such as S&P 500 index SPY rises above its 200 days moving average and sells out of the market when the index drops below the 200 days moving average. This strategy works well to protect capital during severe market downturns such as 2008's but it could suffer from loss when markets whip saw in a side way fashion. Furthermore, it could forgo a significant portion of profits when markets rise from depressed low levels. The following table illustrates correlations between the two strategies:

	Early Bull	Late Bull	Bear	Side Way
Passive Buy and Hold	Good	Good	Bad	OK
Moving Average Timing	Miss	Good	Good	Bad

Apparently, these two strategies complement to each other in various market or economic cycles. Furthermore, both strategies have exhibited good long term average returns. Combining these two strategies in a portfolio should be able to maintain the long term return while reducing the risk or smoothing out the return curve.

We employed ValidFi's portfolio tool to construct core satellite portfolios based on the above two strategies. The following are three such portfolios that ValidFi now lively monitors.

	Buy and Hold Equity	Fixed Income (Total Bond Market Index)	200 Days Simple Moving Average Equity (Satellite)
75% Stocks and 25% Bonds Buy and Hold	75%	25%	0%
30% Stocks and 40% Bonds and 30% Satellite Timing Equity	30%	40%	30%
25% Stocks and 25% Bonds and 50% Satellite Timing Equity	25%	25%	50%

The first two columns combined represent the core part of a portfolio and the last column represents the satellite (actively managed) part of a portfolio. For the stock investment, Vanguard 500 index VFINX (ETF equivalent SPY) is used and for the fixed income part, Vanguard Totoal Bond Market Index VBMFX (ETF equivalent AGG) is used.

The following table shows the characteristics of the portfolios from a period 6/30/1988 to 12/7/2009.

	Last 1 Years	Last 3 Years	Last 5 Years	Since 6/30/1988
Annualized Return 75% Stocks and 25% Bonds Buy and Hold	24.3%	-1.98%	2.42%	8.2%
Annualized Return 30% Stocks and 40% Bonds and 30% Satellite Timing Equity	19%	4.3%	5.7%	8.9%
Annualized Return 25% Stocks and 25% Bonds and 50% Satellite Timing Equity	20.3%	5.4%	6.7%	9.5%
Max. Drawdown 75% Stocks and 25% Bonds Buy and Hold	20.8%	42.4%	42.4%	42.4%
Max. Drawdown 30% Stocks and 40% Bonds and 30% Satellite Timing Equity	8.75%	17.7%	17.7%	17.7%
Max. Drawdown 25% Stocks and 25% Bonds and 50% Satellite Timing Equity	7.2%	16.3%	16.3%	16.3%

It is evident that core satellite portfolios not only enhanced returns (from 0.7% to 1.3% annually) but also reduced the maximum drawdown (risk) dramatically. The buy and hold portfolio had gut wrenching 42% maximum drawdown which, we suspect, very few investors had stomachs to tolerate.

The above is a simple example to utilize ValidFi's portfolio platform to construct, study and monitor composite portfolios. For investors who desire to have more diversification over various assets and strategies, such a platform could be handy.

A Well Balanced Wealth Management Investment Strategy

2009-11-29T12:16:00.001-08:00

Inflation and deflation are the two most important factors for a well designed wealth management investment strategy. Inflation destroys the long term purchasing power while deflation reduces the effectiveness of the capitalism's basic profit machine. A well designed long term strategy thus needs to have a well balanced hedge in both economic cycles. Harry Browne's permanent portfolio is designed over various major asset classes to tackle this problem. A more actively managed strategy is Doug Roberts' Follow the Fed Strategy. In this article, we will discuss this well balanced strategy ValidFi maintains in some detail.

This strategy is simply based on the fed monetary policy to follow the Fed. Research shows that big caps behave better than small caps when money is tight while small caps outperform big caps when money is easy. Similar relationship is also found in gold and Treasury bonds. Gold is doing better than Treasury bonds when the Fed's money policy is easy, and vice versa. Switching between large and small stocks, gold and Treasury bonds depends on the Fed's monetary policy.

To lower the risk still further, simple intermediate government notes are added to the portfolio. Thus this strategy allocates assets equally among large/small stocks, gold/Treasury bonds and intermediate government notes.

1. Determine whether money is tight or easy

The indicator we use is T-bill -12 month value minus Inflation - 12 month value, as described in the Barrons' articles. If the former is larger than the latter, then Fed's money policy is tight.
The T-bill - 12m is the trailing 12 - month compound return using the last twelve monthly T - bill's values.
Similarly the Inflation -12m measures the trailing 12-month compound return using the last 12- month inflation values. Inflation is calculated as the change in CPI index between this month and last month divided by last month's CPI index.
We can also compare the above indicator value with the 64-day simple moving average value of the indicator. If the former is larger than the latter, then the Fed's tight, and vice versa.

2. Portfolios
A conservative model portfolio would be simply allocating 1/3 each to large/small cap equity, gold/long term treasury and intermediate treasury notes.

If money is tight, the portfolio is composed of:
- 33.33% in large stocks
- 33.33% in Treasury bonds
- 33.33% in intermediate treasury notes
If money is easy, the portfolio is made up of:
- 33.33% in small stocks
- 33.33% in gold
- 33.33% in intermediate treasury notes

3. Switching frequency
The strategy adjusts portfolios every month according to the money status.

If short-term T-bill rate remains higher/lower than inflation, no adjustment is made to the portfolio because money remains tight/easy.
Similarly, if the indicator value stays above/below 0, or it's higher/lower than the 64-day simple moving average value of the indicator, no adjustment needs to be done to the portfolio.
However, if the money status changes, for example, money is tight right now while it was easy last time, investors must adjust the portfolio accordingly. In this case, portfolios should be switched to the other type so that investors can achieve higher returns while remaining lower risks.

We have found that using the 64-day simple moving average performs much better than simply basing on whether the indicator's value is positive or negative.

The following table compares the performance between the conservative portfolio and the permanent portfolio (PRPFX) from 1/1/1997 to 11/27/2009.

	Last 1 Years	Last 3 Years	Last 5 Years	Since 1/1/97 to 11/27/09
Roberts Portfolio Annualized Return	22.3%	7.4%	9.4%	9.9%
PRPFX Annualized Return	28.7%	7.3%	8.5%	8.46%
Roberts Portfolio Sharpe Ratio	1.7	0.5	0.68	0.77
PRPFX Sharpe Ratio	1.66	0.41	0.54	0.65

Doug Roberts' strategy is one of those well balanced long term strategies adopted by wealth managers to preserve capital and purchasing power while achieving reasonable growth. At the moment, the strategy decides that "money is easy" (which is obviously true) and invests in both small cap and gold.

Low Risk yet Reasonable Return Strategies Using Long Term Stock Market Timing Indicators

2009-11-22T19:19:00.001-08:00

What? Are you Madoff? These days, anything related to 'low risk' or 'steady' returns generates skepticism. It is very understandable and perfectly reasonable for investors to have such a feeling, given what have happened in the financial industries.

However, if an investor does follow sound and safe investment principles consistently and disciplinarily, yes, Virginia, there is a hope! In the following, we will show how one could achieve a 10% return in the past 9 years by simply incorporating Buffett or Shiller long term stock market timing indicators in your investing.
The idea is simply that, when the stock market is significantly undervalued, one should fully invest in the stock market; when the stock market is significantly overvalued, one should sell the stocks and fully invest in bonds using some fixed income strategies. The proxy to invest in stock market is Wilshire 500 total return index while the strategies for fixed income investment are Alpha Dynamics for Multi Sector Bonds. This strategy evaluates 32 multi-sector bond mutual funds every quarter based on their trailing one year's Alphas and then select top 3 three funds for next quarter investment. The quarterly rebalancing frequency allows investors to avoid the short term redemption fee charged by brokerages or fund companies. It switches to Cash (13 week treasury bill) when none of the funds has positive 1 year alpha.

The following table illustrates the performances for the two portfolios from 12/31/2000 to 11/20/2009.

	Annualized Return	Standard Deviation	Maximum Drawdown
Buffett Indicator based Bond as Cash	12.73%	1.21	11%
Shiller Indicator based Bond As Cash	10.38%	11.1%	20%
Wilshire 5000 Total Return	-0.58%	22.2%	56.6%

A portfolio with much longer history (from 12/31/1990 to 11/20/2009) using Shiller's metric and alpha based high yield bond fund quarterly switch strategy shows a similar result (9.75% annualized return).

The above are just some of examples to show that if one is patient enough and avoids the hype in a long term period, he/she will be rewarded with low risk reasonable returns.

John Hussman's Peak PE Ratio as a Long Term Stock Market Indicator

2009-11-15T18:42:00.001-08:00

John Hussman, manager of Hussman Strategy Growth Fund (HSGFX) proposed price to peak 10 year average earnings as a long term stock market valuation gauge. Compared with the normal one year price to earning ratio, Price to Peak Earnings would eliminate short term noise. This is similar to Shiller's Cyclically Adjusted Price Earning ratio (CAPE10) and Warren Buffett's stock market GNP/GDP metric. In his weekly commentary on Dec 5, 2005, titled as 'Earnings Revert to the Mean, Stocks Will Struggle', he proposed a simplistic method: "buy when Price to Peak Earnings is lower than 15 and sell when it exceeds 19.5". John Hussman has been using this as the valuation yardstick to manage the Hussman Strategic Growth Fund HSGFX.
It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to the Warren Buffett's stock market GNP/GDP metric and Shiller's CAPE, the following strategy characterizes the stock market valuation into the following five categories based on the ratio of the current Peak PEs to the long term average Peak PEs:

Significantly Overvalued (SO): such as if the ratio >= 150%
Modestly Overvalued (MO): such as if 117% <= ratio < 150%
Fairly Valued (FV): such as if 83% <= ratio < 117%
Modestly Undervalued (MU): such as if 67% <= ratio < 83%
Significantly Undervalued (SU): such as if ratio < 67%

These five categories are determined by four valuation parameters (such as 150%, 117%, 83% and 67% in the above). At each rebalancing (adjusting) period (such as weekly or monthly), the strategy decides at what region the US stock market valuation is and then does the following rebalancing:

SO: 0% in stock, 100% in cash.
MO: 25% in stock, 75% in cash.
FV: 50% in stock, 50% in cash
MU: 75% in stock, 25% in cash
SU: 100% in stock, 0% in cash

The stock market exposure is through buying Wilshire 5000 total return index (^DWC) or it could be set by users. Users could adjust the valuation parameters to get an effect like only buying at significantly undervalued (SU) level and selling at significantly overvalued (SO) level. Some of model portfolios of this strategy are:

SO: >=150%, MO: [117%, 150%), FV: [83%, 117%), MU: [67%, 83%), SU: <67%
SO: >=150%, MO, FV, MU: [67%, 150%), SU: <67%

A model portfolio called P Hussman Peak PE Market Timing Strategy Buy 15 Sell 19.5 Weekly is also maintained to live monitor the strategy suggested in 'Earnings Revert to the Mean, Stocks Will Struggle'.
The following table compares the performance of the three long term stock market indicators. All of the portfolios are based on 'buy at significantly undervalued and sell at significantly overvalued' strategy.

	12/31/1970 to 11/13/2009
Buffet GNP Metric Annualized Return	9.74%
Shiller CAPE10 Annualized Return	6.9%
Hussman Peak PE Annualized Return	8.02%
Wiilshire 5000 Total Return Annualized Return	6.9%
Buffet GNP Metric Sharpe Ratio	0.53
Shiller CAPE10 Sharpe Ratio	0.25
Hussman Peak PE Sharpe Ratio	0.33
Wilshire 5000 Total Return Sharpe Ratio	0.15

All of the strategies have achieved better returns and much higher Sharpe ratios compared with Wilshire 5000 total return index.

On Friday 11/13/2009, Both Buffett and Hussman metrics indicated the market was fairly valued: Buffet Total Stock Market Valuation to GNP ratio was 78.6% while Hussman's Peak PE10 to the long term Peak PE10 average was 1.04 (current peak PE 10 was 12.4 and the long term average was 11.9). Shiller CAPE10 to its long term average indicates the market was 22% overvalued. It should be noted that John Hussman has been very cautious recently, pointing out the uniqueness of the current economic situation. Interested readers should read his latest weekly commentary here.

Follow the Smart Money Asset Allocation

2009-11-06T15:37:00.001-08:00

It is well recognized that asset allocation is perhaps the most important determining factor for investment return and risk. Tracking professional money managers' asset allocations in a timely fashion is thus of great interests. Moreover, being able to track timely smart pros moves is even better.
Various techniques have been used for this purpose. One of widely followed methods is to track mutual funds monthly money flows. This approach could only give us monthly information, which is not exactly very timely in a fast changing market. A more serious problem with this is that it only could tell us how the investors move money among various assets such as equities, fixed incomes and commodities. It does not really reveal what allocations mutual fund managers are making. Furthermore, this would not give us any information how 'smart' managers are doing.
Some other similar approaches are mostly focused on sentiments. For example, Hulbert Financial Digest has been tracking investment newsletters' bullish/bearish sentiments on equity and gold. Investment newsletters represent a small fraction of the investment opinions. Other well known sentiment indicators include Investors Intelligence's bullish/bearish poll as well as AAII (American Association of Individual Investors) bullish/bearish poll. These indicators offer insights into certain types of investors. They are mostly used as contrarian indicators.
ValidFi recently introduced Pro Money (Asset Allocation) Indicator and Smart Money (Asset Allocation) Indicator. Both indicators track moderate allocation funds' asset exposures US equities and US aggregate bonds. The technique behind these indicators is to derive timely quantitative asset exposures by directly analyzing a fund's beta exposures for various assets such as US equities and fixed income. The Pro Money Indicator is based on the aggregate asset exposure from majority of US moderate allocation mutual funds (481 funds total). The Smart Money indicator is based on the average exposure among a selected list of top funds. These top funds are selected based on their past risk adjusted returns as well as their consistent performance during market downturns. The indicators are updated weekly.
Using Pro Money and Smart Money Indicators, we create weekly adjusting portfolios separately. The asset allocations of US equities and US bonds (using Vanguard Total Stock Market Index Fund VTSMX and Vanguard Total Bond Index Fund VBMFX as proxies) are derived based on the indicators' allocations. The following table compares these two portfolios and Vanguard Balanced Index Fund VBINX.

	2008	2009	1/1/2008 to 11/5/2009 (Annualized Return)
Smart Money Return	-8.2%	6.48%	-1.23%
Pro Money Return	-19.12%	15.73%	-3.56%
VBINX Return	-22%	14.9%	-5.6%
Smart Money Sharpe	-0.82	0.56	0.7
Pro Money Sharpe	-0.93	0.97	0.8
VBINX Sharpe	-1.05	1	-0.5

From the table, one could see that Pro Money is closely matched to VBINX. This is not surprising as Pro Money is tracking the majority of US balanced funds asset allocation. Arguably, the above table only shows a short history. The model portfolios of strategy Guru Asset Allocation Clone have longer history. This strategy uses the same technique to arrive at asset allocation decisions. The risk and return of model portfolios like this show the effectiveness of this technique.
So what are the current Pro and Smart Money allocations? From the following two charts, one could see that the Pro US equity allocation has steadily risen since April until late September. The Smart Money US equity allocation is somewhat interesting: with a steep rise since July (recall Dow Theory, along with other indicators, gave buy signals during that time), it had a large reduction in early September but immediately increased to around 75%. Also pay special attention to the last week's (10/26-10/30) allocation changes: instead of reducing the equity allocation along with the general market correction (during the week, VTSMX dropped 5.6%), the Pro actually slightly increased the equity allocation while Smart Money decreased its equity exposure 9% (from 78.4% to 69.2%)! Call it stubborn bullishness!

ValidFi Pro Money Equity Allocation

ValidFi Smart Money Equity Allocation

Robert Shiller's Cyclically Adjusted Price Earning Ratio as a Long Term Timing Indicator

2009-10-25T10:02:00.001-07:00

(Correction: this article is corrected version from the previous one published on 10/23/2009. In the previous artilce, we used nominal PE10 instead of real PE 10, that resulted in higher PE10 ratio, which is incorrect).
Yale Professor Robert Shiller has devised and maintained a so called "Cyclically Adjusted Price Earning Ratio" (CAPE10) as an alternative to the popular PE ratio to value the US stock market. CAPE10 is defined as the ratio of price to the average of last 10 year trailing S&P 500 annual earnings. In his now famous book titled as "Irrational Exuberance", Shiller popularized this ratio as a long term stock market valuation metric. As it stands on last Friday October 30, 2009, the current CAPE10 is 18.88 while the long term average CAPE10 (since year 1881) is 16.38. This implies that the current US stock market is 16% over valued.

It is interesting to examine how effective using such a metric as a long term stock market timing indicator. Similar to the Warren Buffett's stock market metric, ValidFi implements and maintains a live strategy called Shiller Cyclically Adjusted PE 10 Stock Market Timing Strategy. One of its model portfolios buys stocks only when this ratio is deemed to be significantly under valued (the current CAPE10 is 33% lower than the long term CAPE10 average) and goes into cash when such as ratio signals significant over valued (if the current CAPE10 is 50% higher than its long term average). The stock market exposure is through buying Wilshire 5000 total return index (^DWC).

From 12/31/1970 to 11/2/2009, the weekly adjusted portfolio achieves 6.8% annualized return and standard deviation 11.9% compared with Wilshire 5000 total return's annualized return 6.77% and standard deviation 19.5%. Such a portfolio was in cash from 5/12/1995 all the way to 2/20/2009! See the following chart:

It is hard to believe that an average investor would have such patience to stay out of the stock market for such a long time, especially during the bull markets. However, a prudent investor would utilize such an indicator to carefully manage the risk during over valued periods.

Some readers might ask that since Shiller's indicator is a long term indicator, what strategies one could use during the long time periods when it is out of stock market. We will have follow up articles on how to combine such a long term indicator and some safe strategies to achieve safe and more reasonable returns.

Interested readers could find the up to date information of both Shiller and Buffett indicators on ValidFi's 360 Degree Market View page.

Halloween Indicators Issue Buy Signals: Now What?

2009-10-17T16:45:00.001-07:00

Mark Hulbert recently published a story on marketwatch.com: Hybrid Halloween Indicators. The original Halloween indicator (or sometimes called "sell in May and go away") has been studied extensively. In his story, Hulbert mentioned a research paper published in 2002 in his article. The paper found that most stock markets around the globe indeed exhibited such abnormality: "sell in early May and buy in late October" could achieve excessive risk adjusted return.
The improved strategy proposed by Sy Harding (detailed description could be found here and here) issued a buy signal on Friday Oct. 16, 2009. This strategy uses MACD to further pinpoint the buy/sell dates around April and October time frames. It is pertinent to compare such a strategy with the original strategy as well as with the buy and hold strategy at this time.
The "original" strategy dictates that one sell on April 26th and buy on October 16th. The following table compared the performance of the three strategies from 7/1/1971 to 10/16/2009. All of them use Wilshire 5000 total return index as the proxy to the stock market investment and use 13 week treasury bill as the cash when they are out of the stock market.

	Since 1971	Last 5 Years	Last 3 Years	Last 1 Year
AR (%) Original	7.769	2.544	-1.938	-7.138
AR (%) Improved	8.236	2.696	1.364	3.777
AR (%) Wilshire 5000	6.733	0.693	-6.55	17.488
Sharpe (%) Original	28.915	3.211	-15.331	-20.388
Sharpe (%) Improved	38.481	5.097	-1.172	14.826
Sharpe (%) Wilshire 5000	16.064	-5.257	-27.383	45.033
Max. Drawdown (%) Original	35.107	35.107	35.107	32.114
Max. Drawdown (%) Improved	33.073	33.073	33.073	27.306
Max. Drawdown (%) Wilshire 5000	56.645	56.645	56.645	32.13

From the table, one could see that the "improved" strategy does the best in terms of overall return and risk. Overall, one could clearly see that both "original" and "improved" strategies have outperformed the buy and hold strategy.

From the above graph, we could see that the "improved" strategy waited till the end of 2008 to get into the stock market, thus sidestepping some loss that the "original" strategy incurred during the October to December time frame. Unfortunately, both of them suffered a great deal from the March steep decline. This is a clear reminder that such strategies are not fool proof and they are still subject to stock market's big swing.
Given the steep run-up of the stock market so far, a favorable seasonality backdrop should be treated just as a backdrop: one should not blindly follow the strategy alone but instead, taking such a statistical evidence into consideration during your portfolio management such as portfolio rebalancing.

Even In Slow Boring Fixed Income Investing, Hot Hands Are Still Hot

2009-10-11T17:39:00.001-07:00

Momentum effect, i.e. a phenomenon that past 'hot' funds or assets will continue to be 'hot' in a certain future period, has been widely recognized as a market inefficiency, both by practitioners and academic researchers. Momentum based strategies have been proposed in equity (stocks), commodities and asset allocation investing (see our previous article for more information).

Less well known is that momentum effect exists even in boring and slowly moving fixed income (bonds) markets. In a recent research paper titled 'Hot Hands' in Bond Funds by Derwall, Jeroen and Huij, Joop, it is shown that investing based on past performance momentum in bond funds could earn statistically significant returns. In practice, FundX's Janet Brown has a long running investment newsletter on a technique called 'Upgrading'. One of its model portfolios is based on selecting bond funds based on a momentum score. Utilizing such a method, FundX now manages a mutual fund FundX Flexible Income (INCMX).

ValidFi maintains various types of bond fund momentum based strategies. One model portfolio selects a bond fund monthly or quarterly among a list of funds whose managers have won Morningstar's fixed income manager of the year award since 7//30/2000. In the past 9 years, both monthly and quarterly based portfolios have achieved more than 10% annualized return. The following table compares the two portfolios performance (from 7/30/2000 to 10/10/2009):

	Up To Date	Last 5 Years	Last 3 Years	Last 1 Years
AR(%) (monthly portfolio)	11.46	9.806	10.462	23.226
AR(%) (quarterly portfolio)	10.926	9.828	10.499	20.67
Sharpe Ratio(%) (monthly portfolio)	206.991	159.332	175.41	478.605
Sharpe Ratio(%) (quarterly portfolio)	191.389	157.406	172.05	399.162
Standard Deviation(%) (monthly portfolio)	4.681	4.925	5.054	4.827
Standard Deviation(%) (quarterly portfolio)	4.784	4.784	5.174	5.147
Max. Draw Down(%) (monthly portfolio)	7.437	5.4	5.4	3.419
Max. Draw Down(%) (quarterly portfolio)	7.437	7.437	5.4	3.419

Compared with one of the best bond funds, Pimco's Total Return Fund PTTRX (managed by Bill Gross who won Morningstar's manager of the year award in 1998, 2000 and 2007), both monthly and quarterly adjusted portfolios outperform it. The following chart shows the comparison between PTTRX and the quarterly adjusted portfolio.

At the moment, both portfolios pick Loomis Sayles Bond Instl (LSBDX) as their investment.

In addition to actively managed bond mutual fund momentum, the index bond ETFs or mutual funds also exhibit good momentum. We will have more follow up articles to detail these investing strategies.

PIMCO's Global Multi-Asset Fund PGMAX Reduced Equity Exposure Recently

2009-10-05T18:34:00.000-07:00

Recent Barron's article: seeking safe returns in a perilous world revealed PIMCO's newly introduced global multi-asset fund PGMAX and their asset allocation guidelines: based on risk factor allocation instead of traditional asset pigeonholes.

It is interesting to see that ValidFi's Realtime Asset Allocation tool revealed that PGMAX recently reduced its equity exposure (click to enlarge the chart):

Gurus' Asset Allocation in the Recent Market Whipsaw

2009-10-05T12:57:00.001-07:00

Entering October, one saw the markets trembled a little bit. It's time to review several well known asset allocators' positions.
Top performing asset allocation fund Leuthold Core Investment LCORX (19.4% YTD return up to 10/2/2009) made a noticeable reduction in its equity exposure: from almost 100% to 71%. That is quite significant, even if one takes the recent market drop into consideration. See the following chart:

The other top performing fund Janus Balanced (JABAX) (17.1% YTD return up to 10/2/2009) has been steady after some equity reduction at the end of September: its equity exposure has been around 50%. See the following chart:

Waddell & Reed Asset Strategy Y (WYASX) (17% YTD return up to 10/2/2009) has increased its international equity exposure significantly since early September:

The above is derived from ValidFi's innovative Realtime Asset Allocation (RAA) analysis tool. The actual percentage of allocation might not be that accurate. However, the tool is doing a reasonable job to identify the allocation trend and its change. For the equity exposures mentioned above, we would like to clarify that they represent an estimated Beta correlation with the equity index (represented by Vanguard Total Stock Market Index VTSMX). It does not represent the actual asset allocation but instead represents how close the asset (equity) portion is related to the stock market index VTSMX. For example, a fund could have a 100% Beta on the equity portion but its actual equity allocation is 70%, that would mean that this fund's equity portion's beta is 1.4 (100%/70%).

The takeaway from the above is that we are in a period of uncertainty. In such a period, it is crucial to be consistent with strategies you are using and position your portfolio accordingly.

Time to Rebalance Your Portfolios

2009-09-29T13:21:00.001-07:00

Portfolio rebalancing is perhaps the only 'free' lunch once you have set a strategic portfolio allocation based on your risk profile. Numerous articles have been published to study the pros and cons of portfolio rebalancing. The key factors behind portfolio rebalancing are:

Risk and return control: when certain assets have appreciated too much, you would like to "take some money off the table" by selling portions of assets to bring back to your preset allocation targets. When certain assets have gone down too much, you would like to "buy cheap" so that you could take the "on sale" opportunity.
Psychological feeling: when your portfolio allocation is out of balance, the over weight or under weight will give you uneasy feeling. Such a feeling is best described as the urge to do something in behavioral finance. Investors so often want to do something about their investment and most of time, they venture into markets without a clear guideline on their portfolio allocation. By the time they realize, their portfolio is out of whack and very often, they also lose money. Portfolio rebalancing with target allocations fixed is a sensible safe guideline to curb such "random" behavior.

As stock and other assets have appreciated so much recently (see the following table), the uneasy feeling on a looming correction is on everyone's mind. Now that we are approaching the end of third quarter, it is time to have a checkup on your portfolios.

Major Asset Performance

as of 9/25/2009, sorted by 13 weeks performance

Description	Symbol	1 Week	4 Weeks	13 Weeks	26 Weeks	52 Weeks
US Equity REITs	VNQ	-5.38%	3.39%	33.72%	71.82%	-29.51%
International REITs	RWX	-3.54%	3.64%	22.04%	58.26%	-11.72%
Emerging Market Stks	VWO	-1.94%	6.28%	18.57%	56.09%	10.61%
International Developed Stks	EFA	-2.43%	2.22%	18.04%	45.45%	-6.10%
Frontier Market Stks	FRN	-1.31%	5.61%	17.89%	60.39%	-5.25%
US Stocks	VTI	-2.40%	1.79%	15.16%	30.68%	-11.42%
US High Yield Bonds	JNK	0.84%	5.94%	13.83%	38.80%	10.95%
Emerging Mkt Bonds	PCY	0.04%	3.72%	13.43%	26.74%	22.77%
International Treasury Bonds	BWX	0.05%	2.95%	6.49%	13.47%	10.91%
Municipal Bonds	MUB	0.47%	2.58%	5.93%	7.20%	10.80%
US Credit Bonds	CFT	1.06%	1.62%	5.54%	15.49%	16.50%
Gold	GLD	-1.69%	3.33%	5.10%	6.96%	11.96%
Total US Bonds	BND	0.46%	0.81%	2.29%	4.33%	7.13%
Intermediate Treasuries	IEF	1.10%	0.93%	1.89%	-2.87%	6.96%
Mortgage Back Bonds	MBB	0.31%	0.62%	1.57%	2.06%	7.93%
Treasury Bills	SHV	-0.02%	-0.01%	-0.03%	0.07%	0.60%
Commodities	GSG	-2.24%	-5.34%	-2.92%	12.76%	-47.54%

The most popular rebalancing method is to periodically rebalance monthly, quarterly or annually rebalancing. For people who would like to be more active, opportunistic rebalancing strategy proposed by Gobind Daryanani from TD Ameritrade Institutional has shown to be effective if proper parameters are chosen. The opportunistic rebalancing method examines a portfolio periodically (such as biweekly). For those assets whose allocations are out of certain preset threshold (such as 20% more or less than the target percentage), these assets are rebalanced back to their target allocation percentages. For example, an asset with 30% target allocation would be rebalanced back to its 30% target if its allocation is over 36% or under 24%. The following table compares the performances of three methods: no rebalancing, annual rebalancing, quarter rebalancing and opportunistic rebalancing (monthly check and 20% band) on a Roger Gibson Five Asset Portfolio.

Annualized Return	Last 5 Years	Last 3 Years	Last 1 Year	Since 12/31/1997
Opportunistic Rebalancing Monthly 20% Band	3.39%	-3.35%	-15.67%	5.61%
Roger Gibson Annual Rebalancing	2.37%	-4.4%	-17.6%	5.41%
Roger Gibson Quarterly Rebalancing	3.09%	-3.7%	-16.15%	5.31%
Roger Gibson Monthly Rebalancing	2.35%	-4.65%	-17.84%	4.92%
Roger Gibson No Rebalancing	1.69%	-5.85%	-18.77%	4.17%

It should be noted that there are various parameters to be set for the opportunistic rebalancing method. Some of them are not as good as even a periodical rebalancing. However, rebalancing in some way definitely helps to improve your portfolio performance. Interested readers could further compare the risk (standard deviation and maximum drawdown) for these portfolios (and their various settings) from here.
It is also interesting to apply timing techniques to portfolio rebalancing. In our previous article we showed that applying timing to a diversified portfolio could reduce risk and enhance return. Using this in a portfolio rebalancing manner deserves a separate serious study.

Buffett Stock Market Indicator: Simple Yet Effective

2009-09-19T12:05:00.001-07:00

In his 2001 Fortune magazine article, Warren Buffett used the ratio of the market value of all US publically traded securities to Gross National Product (GNP) as a yardstick to measure the stock market valuation. He stated that

"The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment".

He further went on to say

"If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%--as it did in 1999 and a part of 2000--you are playing with fire".

Such a simple yet elegant metric (we call it Buffett Stock Market Indicator) could be implemented in several ways. At the moment, ValidFi maintains a strategy called Warren Buffett Total Stock Market Value to GNP Ratio Strategy. This strategy characterizes the stock market valuation into the following five categories:

Significantly Overvalued (SO): such as if the ratio >= 115%.
Modestly Overvalued (MO): such as if 90% <= ratio < 115%.
Fairly Valued (FV): such as if 75% <= ratio < 90%.
Modestly Undervalued (MU): such as if 50% <= ratio < 75%.
Significantly Undervalued (SU): such as if ratio < 50%

These five categories are determined by four valuation parameters (such as 115%, 90%, 75% and 50% in the above). At each rebalancing (adjusting) period (such as weekly or monthly), the strategy decides at what category the US stock market valuation is and then does the following rebalancing:

SO: 0% in stock, 100% in cash.
MO: 25% in stock, 75% in cash.
FV: 50% in stock, 50% in cash.
MU: 75% in stock, 25% in cash.
SU: 100% in stock, 0% in cash.

The stock market exposure is through buying Wilshire 5000 total return index (^DWC) or it could be set by users. Users could adjust the valuation parameters to get an effect such as only buying at significantly undervalued (SU) level and selling at significantly overvalued (SO) level. Some of model portfolios of this strategy are:

SO: >=115%, MO: [90%, 115%), FV: [75%, 90%), MU: [50%, 75%), SU: <50%.
SO: >=115%, MO, FV, MU: [50%, 115%), SU: <50%.

The total US stock market valuation is based on Wilshire 5000 index while the GNP is based on Federal Reserve's quarterly released number. From 12/31/1980 to 9/18/2009, the weekly adjusted portfolio achieves 8.648% annualized return and standard deviation 12.2% compared with Wilshire 5000 total return's annualized return 7.4% and standard deviation 17.5%.

It is even more amazing if an investor opted to invest only when the market was significantly undervalued and went to cash when the market became significantly overvalued. Such a strategy would keep an investor in cash from 2/27/1998 to 3/6/2009: avoiding the last two bubbles altogether! The following figure shows the transactions:

Such a portfolio achieves annualized return 9.71% with standard deviation 11.4% from 12/31/1980 to 9/18/2009. There are only 3 transactions during this whole 29+ year period.

On last Friday (9/18/2009), the Buffett Indicator stood at 77.5%, valuing the US stock market as Fairly Valued if one uses the 5 categories above.

Along with Buffett Indicator, ValidFi recently introduced various financial, economic and sentiment indicators. Interested readers could find up to date information of these indicators on ValidFi's 360 Degree Market View page.

Market Timing Strategies Based on Financial and Sentiment Indicators

2009-09-16T00:03:00.001-07:00

Market timing strategies have been controversial: academics published many studies in this subject and most of them concluded that it is useless to pursue market timing. On the other hand, practitioners have been using this for many years (explicitly or implicitly). In a paper published by Neuhier and Schlusche in Feb. 2009, titled as Data Snooping and Market-Timing Rule Performance, the study examined stock market timing strategies based on various combinations of financial and sentiment indicators. The paper's conclusion is mostly negative on those strategies based on historical simulation during the period from 1981 to 2007. With the recent market upheavals, it is interesting to revisit these strategies by including the period since 2007 to now.

The basic idea behind these strategies is to remain invested in the stock market when expected returns are high and switch to cash investments when the market is expected to underperform. Investors long securities but temporarily exit the market and switch to holding cash in bad times based on certain timing indicators. By avoiding exposure to stock market during the weakest months and being long during the rest of the time, one would hope to reduce risk and achieve a reasonable return. The key to measure the performance of these strategies should include the risk factors such as maximum drawdown (measured as the maximum from a peak to a following trough percentage), standard deviation and Sharpe ratio (the so called risk adjusted return).

ValidFi recently released various stock market timing strategies based on the description from the paper. These strategies and their model portfolios are now lively monitored on validfi.com. These strategies employ the following indicators:

Financial indicators
- Earning to price: essentially this is the S&P 500 PE ratio.
- Dividend yield: this indicator is tracking S&P 500 companies' aggregate dividend yields in the past 12 months.
- Dividend payout ratio: S&P 500 dividend payout ratio.
- Bond to equity: the relative bond yield and earning yield relationship. The so called Fed model is one version of this.
Interest rate indicators
- Long term interest rate: based on long term Treasury bond yield. This indicator is sensitive to long term inflation expectation.
- Short term interest rate: based on short term Treasury bill yield.
- Maturity spread: the difference between long term and short term bond yields.
- Credit spread: the difference between high yield (junk) bond and the investment grade corporate bond yield. The bigger the spread, the higher investors' risk appetite is.
- Expected inflation: difference between nominal and real interest rate.
Sentiment indicators
- CBOE equity put/call ratio: the short term total equity put volume over the short term total equity call volume.
- CBOE S&P 500 implied volatility VIX: the implied volatility of short term option contracts on S&P 500 index. This indicator is also called 'fear factor'.

In these strategies, several threshold values of the indicators are considered. They are either a historical value, such as the moving average or a certain percentile or a fixed number. Other parameters include delay days (number of days waited to take an equity position after a switching signal) and waiting days (minimum number of days to keep a position after switching). The model portfolios have various parameter settings. In general, we find using SMA30 or SMA120 (30 or 120 days Simple Moving Average) are the most natural ways to set the parameters even though they might not be the best parameters.

The following table illustrates the performance of these strategies with the best parameter settings. From the table, one could see that financial indicator long term interest rate, interest rate indicator credit spread and the sentiment indicator put/call ratio have the best Sharpe ratios in the period monitored. The long term interest rate, being sensitive to the economic condition, surprisingly has an excellent predictive effect since 1963. On the other hand, the expected inflation based strategy has quite a bit under performance. We believe it might be due to the inaccurate estimate methodology used.

Table 1: The Best Performance Portfolio of Each Market Timing Strategy
(From start date to 9/9/2009)

	Timing on S&P 500 Index	Timing	Timing	Buy and Hold S&P 500 Index (dividend is not reinvested)	Buy and Hold	Buy and Hold
Indicator	Parameters	AR	Sharpe	Start Date	AR	Sharpe
Long Term Interest Rate	SMA30, 5, 5	9.58%	0.481	4/1/1987	5.78%	0.148
Short Term Interest Rate	SMA30,1,1	4.82%	0.081	1/1/1963	6.16%	0.142
Maturity Spread	SMA30, 5, 5	3.37%	-0.041	1/1/1963	6.16%	0.142
Earning to Price	SMA30, 1, 1	6.27%	0.271	1/1/1990	5.60%	0.158
Dividend Yield	SMA30, 1, 1	3.26%	0.053	1/1/1990	5.60%	0.158
Bond to Equity	SMA30, 1, 1	6.54%	0.253	1/1/1990	5.60%	0.158
Dividend Payout Ratio	SMA120, 5, 5	6.57%	0.307	1/1/1990	5.60%	0.158
Credit Spread	SMA30, 1, 1	8.53%	0.404	1/1/1997	2.66%	0.019
VIX	SMA30, 5, 5	4.17%	0.137	1/1/1991	6.29%	0.201
Expected Inflation	SMA30, 1, 1	1.72%	0.004	1/1/2003	2.44%	0.035
Put/Call Ratio	SMA30, 5, 5	7.54%	0.377	1/1/2004	-1.28%	-0.137
Learning	256, 256	5.85%	0.237	1/1/1990	5.60%	0.158
Voting	0.6, 1 month	4.22%	0.107	1/1/1990	5.60%	0.158

In addition to the live strategies mentioned above, ValidFi also maintains a 360 degree market view page to monitor various indicators and most asset classes trends.

This article only serves as an introduction to the above strategies. We will have more follow up articles to discuss individual strategies in more detail.

Recent Gurus' Asset Allocations

2009-09-08T11:13:00.000-07:00

With summer fading away, we now suddenly find ourselves in September, one of the worst months for the stock market. It is thus a good time to check up your portfolio and make necessary adjustments if it is necessary.

In the previous article, we introduced ValidFi's Guru Asset Allocation Watch and strategies. The Guru Asset Allocation Clone strategy applies ValidFi's proprietary algorithm to detect a mutual fund's asset exposure and utilizes the derived information to make necessary asset allocation decision for each month. The risk adjusted performance of the strategy is fairly impressive for the past ten years. Readers could examine one of its model portfolios for more information.

The portfolio recently made a noticeable asset allocation change on August 31st. 2009. The following table compares its August and September allocations (notice that the funds used to represent the asset classes could be replaced by ETFs such as SPY, EFA, IYR, TIP, CIU or CFT, BWX, EEM, HYG or JNK and BND or AGG).

Asset	August Allocation	September Allocation
VBMFX	0.00%	0.00%
VFISX	20.47%	0.00%
VWEHX	0.56%	2.31%
VEIEX	3.50%	5.08%
TGBAX	10.25%	0.00%
VFICX	15.09%	46.52%
VIPSX	10.80%	27.98%
VGSIX	0.03%	0.06%
GLD	0.00%	0.00%
VGTSX	2.96%	1.96%
VFINX	36.34%	16.08%
Stock Exposure	42.83%	23.18%

From the above table, the most noticeable changes are:

Total stock exposure: reduced from 42.83% to 23.18%
Fixed income allocation: big increase to Investment Grade Corporate Bond (VFICX) and Inflation Protected Treasury Bond (VIPSX)

The September allocation is very defensive.

Let us further examine the recent allocation moves for several top performing allocation funds.
The following picture illustrates Vanguard Wellesley Income Fund (VWINX). We could see the fund made noticeable reduction in equity exposure during August.

The other top allocation fund, GMO Benchmark-Free Allocation GBMFX has the following allocation trend:

Again, the fund made equity reduction during the August time frame.

Readers are encouraged to take advantage of the ValidFi's Real Time Asset Allocation tool to find out asset allocation trends of your favorite funds. It is free but requires a registration during its Beta testing period.
To summarize, several great asset allocation investors have made a very defensive move. Even if you don't want to change your asset allocation right now, it pays to keep an eye on this.

Benefiting from Simple Hedging Techniques (Part II)

2009-09-02T15:01:00.000-07:00

In the previous article, we discuss a simple hedging technique. In this part, we will discuss more effective ways to hedge.
A natural way to improve hedging technique is to use timing indicators as the guide to hedge or unhedge. Moving averages are one of the simplest and effective indicators. Using moving averages, one could start to short the chosen index ETF when the indicator gives a sell signal and then buy back the ETF when the indicator gives a buy signal. ValidFi's Momentum Hedge is a very good example to show that by using such a simple technique, one could achieve a reasonably good return while reducing the risk dramatically. In this strategy, a portfolio based on Sector Rotation Fidelity Select Funds strategy is used as the long portion of the portfolio while short position on SPY is taken based on whether SPY price is lower than the 130 days EMA (Exponential Moving Average) or 200 days SMA (Simple Moving Average). The following is the comparison of the long only portfolio and the hedged portfolio using 130 days EMA up to 9/1/2009.

		Last 1 Year (%)	Last 3 Year (%)	Last 5 Year(%)	Since 12/31/1993 (%)
Annual Return	Long Only	-11.83	-0.51	11.62	16.01
Annual Return	Hedged	27.6	8.6	15.4	13.8
Sharpe Ratio	Long Only	-32.3	-7.6	35.69	55.07
Sharpe Ratio	Hedged	120.5	32.1	62.7	51.3
Standard Deviation	Long Only	37.2	29	27	24.7
Standard Deviation	Hedged	22.7	21.3	21.4	22.1
Maximum Drawdown	Long Only	34.9	47.5	47.5	51.1
Maximum Drawdown	Hedged	13.9	20	20.4	49.6

Notice that maximum drawdown for the hedged portfolio improved in the last 1, 3 and 5 years but it has a huge 49.6% maximum drawdown since the inception date. This occurred during 2000-2001 period. This offers a cautious tale to hedge against a momentum driven portfolio: there might be still a period of time where some mismatched performances between the long and the short portions of the portfolio could be way too high to be tolerated.
Yet another way to hedge is to always short so called weak assets (or sectors) with a corresponding or a lesser amount. When shorting with equal amount as the long portion's, this is often called zero cost hedge as in theory (and for large institutions), the brokers would use the borrowed amount from the short sale to offset the long amount used. In ValidFi's Global Tactical Asset Allocation Momentum strategy, based on the original paper suggested, 100% short amount is used to short the worst performing three assets based on their past price performance while in the meantime keeping a long portfolio on the best performing three assets. For example, at the moment, the long part of the portfolio consists of VUSTX, GLD, VWEHX and the short part of the portfolio consists of VGSIX, VIMSX and VGTSX. Notice in this portfolio, we use index funds as the shorted indexes. In practice, one should substitute the above using ETFs equivalent. That would translate into long TLT, GLD, HYG and short IYR, MDY and EFA. The result is a mixed bag as one could see from here.
It should be noted that aside from the hedging, one could always perform tactical asset allocation (such as reducing or increasing the risky asset exposure) to avoid taking short positions. It is a simpler solution. The main reason to hedge instead of reducing the risky asset exposure by selling has to be that one believes the long portfolio could outperform the shorted index(es) during the possible market downturn. If this does not hold or it is hard to justify such an out performance, reducing or liquidating the positions is a better choice. The pros and cons should be weighed carefully.
One notable mutual fund which performs long and hedging is Hussman Strategy Growth Fund (HSGFX) managed by John Hussman. For anyone who is interested in the hedging techniques and Dr. Hussman's view point on current economic and market conditions, his weekly comments offer wealth of educational and prescient information.
In conclusions, some simple hedging techniques could go a long way to protect your capital while enhancing returns. In the current economic conditions, it is worthwhile to pay attention to them.

Benefiting from Simple Hedging Techniques (Part I)

2009-08-28T21:31:00.000-07:00

On August 28, 2009, seekingalpha.com. Amid the euphoria on possible economic recovery, most major stock and debt markets have risen in an almost nonstop fashion since June of this year. This presents a heightened anxiety among many prudent investors: will there be another leg down if the rosy picture about the economics turns out to be premature? Read more ...

Commodity ETF Strategies: Now and Later

2009-08-24T17:15:00.000-07:00

On August 24, 2009, SeekingAlpha.com. Managed futures has been long recognized to be an excellent portfolio diversifier.

However, long only commodity investment is not good enough. For example, in this 2008-2009 period, commodity ETFs such as DBC, GSG based on broad based commodity indexes and most of ETFs based on narrow commodity industry indexes such as DBA, DBE, DBB did not do well. Read more ...

Follow the Gurus in Asset Allocation

2009-08-17T16:22:00.000-07:00

On August 17, 2009, SeekingAlpha.com. Studies have shown that asset allocation is the most important determinant factor in a mutual fund's performance: according to a study by Gary Brinson, Randolph Hood and Gilbert Beebower, asset allocation strategies are responsible for over 90% of variations in portfolio performance. Read more ...

Value and Momentum Strategies for Asset Allocation and Stock Investment

2009-08-03T17:09:00.000-07:00

On August 03, 2009, SeekingAlpha.com. In this article, we will discuss value and momentum strategy styles in some detail. Read more ...

Diversify Asset Classes and Investment Strategies

2009-07-28T19:06:00.000-07:00

On July 28, 2009, SeekingAlpha.com. The 2008 markets taught us a valuable lesson that just merely holding once considered 'diversified' assets in a portfolio is not sufficient or, at best is very difficult, to reduce the systemic risk: during the 2008 market stress, almost all of assets (other than the US Treasuries and cash) were suddenly correlated and declined simultaneously. Read more ...

ValidFi Beta Announcement

2009-07-01T18:00:00.000-07:00

On July 1, 2009. ValidFi today launches beta testing version of an innovative web site www.validfi.com and services for investors. ValidFi.com's missions are to provide

* comprehensive knowledge base for financial planning and investment strategies published by books, magazines and academic papers. ValidFi also provides proprietary strategies. Through live monitoring and historical performance data of strategies provided by ValidFi.com, investors are able to navigate through tumultuous market conditions and noisy hearsay with clear, objective and up to date information.
* Guru asset allocation investment strategies to follow great investors on their Beta exposure (asset allocation) and Alpha (security selection) through FundAlpha and FundBeta Clones.
* precise guidelines and easy to use tools to allow users to evaluate and construct suitable portfolios with diverse time tested strategies in a wide risk spectrum.
* fund analysis based on strategy centric information such as effective beta and style gains to gain better insights into mutual funds, ETFs, closed end funds.
* an easy to use platform for users to monitor and study strategies and research their effects in a portfolio. Advanced portfolio construction and management tools are offered.

LTI Systems, Inc., the creator of ValidFi.com, was founded by seasoned high tech entrepreneurs in Silicon Valley, California. The founders have strong business, finance and technology experience through their successful entrepreneur careers in several software, semiconductor and computer electronics companies. Investors themselves, over the time, the founders realized that there is much need of a platform and knowledge base to reference, monitor and study financial strategies suggested by vast publications, media and academic research. Moreover, easy to use quantitative tools are developed for better utilizing strategies in portfolio construction and for better understanding the risk and performance of financial products such as mutual funds.

contact information:
email: support@validfi.com
phone: 510-279-3131