Investment strategy of the SmallTrades ETF Portfolio

February 14, 2014

An index ETF is designed to capture the investment returns from a financial market.  The SmallTrades ETF Portfolio (“Portfolio”) uses index ETFs to invest in several financial markets.  The goal of the Portfolio is to earn returns at a faster rate than possible by investing in risk-free bonds or the broad market of U.S. stocks, thereby ensuring that the accumulation of returns outpaces the inflation of prices in the American economy.  Success is measured by the following benchmark indices:

Investment strategy

The Portfolio is a high-risk, high-return investment in ETFs that duplicate well-established market indices for global stocks, U.S. bonds, U.S. real estate investment trusts, and gold bullion.  Twenty five percent of the portfolio’s market value is allocated to each index.  The ETFs generate at least 99% of the portfolio’s value and any remaining value is stored in a money market fund.  The ETFs will be held indefinitely except when faced with the advantage of replacing one with a more suitable ETF for the same index.

Table of holdings

ETF trading symbol Market Allocation
 AGG   U.S. bonds 25%
 GLD   Gold bullion 12.5%
 SGOL     Gold bullion 12.5%
 VNQ     U.S. real estate investment trusts 25%
 VT  Global stocks 25%

Expected return

Unfortunately there is no 50-100 year history of ETF performance that enables the forecast of an expected return.  To compensate for this limitation, two models were used to test the allocation plan shown in the table of holdings.  In one model of the 15-year recovery from the 1997 Asian Financial Crisis, the allocation plan outperformed the U.S. stock market.  In the other model of the 5-year recovery from the 2008 Global Financial Crisis, the allocation plan underperformed the U.S. stock market.  Among both time periods, the lowest return of the model portfolio was 8.5%.

  • MARKETS portfolio of financial-market returns from 1997 to 2011: The global-stocks market was simulated by a mixture of 75% U.S. large capitalization stocks and 25% emerging markets stocks.  Trading and management fees were excluded from the model.  The annualized return of the portfolio was 8.5% in comparison to the 5.7% annualized return of U.S. large capitalization stocks.
  • ETF portfolio of historical prices from 2008-2013: Trading fees, but not management fees, were included in the calculations (– management fees are charged in the primary market before ETFs are listed in the stock market).  The annualized return of the portfolio was 10.9% in comparison to the 17.8% annualized return of SPY, an ETF that tracks the Standard & Poor’s 500 Total Return.

Risk management

The holding period will be at least 5 years.  Fluctuation in market prices is the main risk of investing in index ETFs.  The likelihood of incurring a loss from a declining market decreases as the length of the holding period increases (– e.g., the risk of loss from stocks and bonds declines by 50% as the length of the holding period increases from 1 to 5 years; and, the risk declines by 80% when the holding period is extended to 10 years (1)).

The Portfolio will be rebalanced as needed to maintain the allocation plan within an acceptable limit of 28% error.  The Portfolio is concentrated in 4 markets and losses may occur when one or several markets decline.  The 25% allocation plan assigns equal weightings to each financial market in order to smooth the effect of market declines.  After accounting for trading fees, the strategy of rebalancing a large allocation error is more cost-effective than using a rebalancing schedule.

The Portfolio holdings are investable, have established reputations, charge low management fees, and are safely structured.  Although there’s no guarantee that the index ETFs will sustain their historical performance, the stock market, bond market, and real estate market ETFs provide diversified investments in underlying assets.  The risk of investing in these ETFs is lower than the risk of investing in an underlying asset.  Gold bullion ETFs are non-diversified investments in the volatile gold market.  Gold bullion is theoretically susceptible to physical damage by theft or fire.  This risk is diminished by investing in two funds, GLD and SGOL, that store the bullion in separate vaults located in London and Lucerne.

The investor’s tax burden can be reduced by holding these index ETFs in a tax-deferred retirement account.

Copyright © 2013 Douglas R. Knight

References

1.           James B. Cloonan, A lifetime strategy for investing.  American Association of Individual Investors, Chicago, 201


Modified holdings, January 2014

February 5, 2014

The Vanguard Total World Stock ETF (VT) replaces the Vanguard FTSE Emerging Markets ETF (VWO) in the SmallTrades ETF Portfolio.  The revised portfolio will be rebalanced as needed to correct a 28% error in asset allocation. 

Rationale

The investment performance of VWO is declining due to unfavorable conditions in the emerging markets.  Political turmoil and fragile economies in several regions of the emerging markets account for declining global productivity (1,2,3).  The impact on financial markets is shown by a slight downtrend in emerging markets stock indices compared to an upsurge in developed markets stock indices (chart 1, ref 4).

chart 1.  Line graphs represent 3 series of cumulative returns from an investment of $1 (USD) in 2003.  The cumulative returns of the All-World Markets, Developed Markets, and Emerging Markets were computed from the total annual returns of the FTSE Global Equity Index Series.   The All-World Markets were comprised of Developed Markets (approximately 75% weighting) and Emerging Markets (approximately 25% weighting).  Frontier Markets were excluded.

chart 1. Line graphs represent 3 series of cumulative returns from an investment of $1 (USD) in 2003. The cumulative returns of the All-World Markets, Developed Markets, and Emerging Markets were computed from the total annual returns of the FTSE Global Equity Index Series. The All-World Markets were comprised of Developed Markets (approximately 75% weighting) and Emerging Markets (approximately 25% weighting). Frontier Markets were excluded.

The investment strategy of VWO is to track the FTSE Emerging Markets index while VT seeks to track the FTSE All-World Markets index.  Chart 2 (below) is similar to Chart 1 in showing that VWO’s market prices are gradually declining while VT’s prices are steadily climbing.

chart 2

chart 2

The replacement of VWO by VT in the SmallTrades ETF Portfolio will satisfy the risk-management strategy of diversification.  The revised Portfolio might outperform the benchmark S&P 500 total return index under favorable market conditions in years to come.  Here are several lines of supportive evidence:

1)      A hybrid stocks index of U.S. large-capitalization stocks (75% weighting) and emerging market stocks (25% weighting) yielded an annualized return of 6.1% compared to an 5.7% annualized return from the benchmark U.S. large-capitalization stocks.  The time period was 1997-2011.

2)      A model portfolio of the hybrid stocks, U.S. bonds, U.S. REITs, and precious metals indices yielded an annualized return of 8.5% compared to the benchmark 5.7% return.   Equal amounts were invested in every index at the beginning of the 1997-2011 holding period.

3)      VT tracks the FTSE Global All-Cap index.

4)      Charts 3 and 4 ( below) summarize the 5 year performance of the revised SmallTrades ETF Portfolio as determined by an updated ETFportfolioDESIGNER2.  The best rebalancing strategy is to correct a 28% “rebalance signal”.

chart 3

chart 3

chart 4

chart 4

Portfolio Mechanics

The SmallTrades ETF Portfolio is modified by substituting VT for VWO without changing the original allocation plan.  Twenty five percent of the portfolio’s market value is allocated to four asset classes represented by VT, VNQ, AGG, and the combined GLD-SGOL holdings –[comment: GLD and SGOL are operationally equivalent except that they store gold bullion in different vaults located in London and Zurich.  The split vaults help protect from physical damage and theft in one vault]–.  The Portfolio will be rebalanced when any asset class deviates outside the 72-128% range of expected market values.

References

1.           Emerging markets, Locus of extremity.  Developing economies struggle to cope with a new world. The Economist.  2/1/2014

2.           Paul Wiseman and Joshua Freed.  Markets staggered by global concerns. Associated Press. 1/25/2014.

3.           Emerging economies; When giants slow down. The Economist  7/27/2013.

4.           FTSE Factsheet.  12/31/2013.


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