Gold ETFs

There was a comment on some old post of mine from Seeking Alpha where the reader questioned the gold in the vault for the SPDR Gold Trust (GLD). He said something like if you want your gold, will it be there and I think he was implying the same for the other physical gold ETFs. We own GLD for our clients.

This line of thinking is far from original, this has been a matter of doubt for a while with some people. I'm not sure what the origin for this is and I suppose it doesn't really matter the origin, there are people who do not believe there is the proper amount of gold in the respective vaults.

Chances are there is no convincing someone who believes the vaults are deficient that the correct amount is there. This is very simple however. Do you believe the gold is in there? I think this is a straight forward yes or no question. It is for me, I believe it is in there without hesitation. You either think it is there or you don't. If you don't then you clearly should not even consider owning the fund. There is no need to take on this type of worry in your portfolio. I have zero doubt the correct amount is there and so we own the fund.

People seem to get very worked up about this which is ok I guess other than it seems like wasted negative energy. Perhaps there is something similar with my opinion about Chinese reverse mergers. While I certainly don't think all of them are frauds the potential goes up in this realm and I simply don't want to take on that type of worry/risk. Simple avoidance without negative energy. This makes investing and life in general much easier.
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Confirmation Bias, Again

Jeff Saut quoted a couple of investment luminaries this week including one I know personally. From Ken Fisher in 1989 was;

Here’s the paradox: the odds are overwhelming I will end up richer by aiming for a good return rather than a brilliant return – and sleep better en route.

And from Benjamin Graham;

The essence of investment management is the management of RISKS, not the management of RETURNS. Well-managed portfolios start with this precept.

From John Serapere I would add;

75-50

I don't remember hearing that when I worked at Fisher (for a few months in 2002) but long time readers will know that the above, even if worded differently, are cornerstones to my approach. The 75-50 refers to a portfolio strategy that targets 75% of the upside of the market and only 50% of the downside (do the math, it works).

In terms of people who read my site or others like it, many of you are do-it-yourselfers but may not necessarily be expert stock pickers (and you don't have to be). The idea of going along for the ride during the up phases of the cycle and then being devoted to learning and understanding what causes large declines and seeking to take defensive action fairly early in the decline to avoid the full brunt of down a lot as I call it is not only valid, but I would say easier and places even less emphasis on stock picking which seems to be something many prefer not to do.

Another aspect to avoiding the full brunt of down a lot is it places less importance in being specifically correct while the market is going up. Generally speaking, I still believe that global equities (so choosing some countries correctly, and correctly avoiding some others) combined with a proper savings rate can get the job done for people with realistic ideas about spending. So if well selected countries can return 8-10% annually over the long term, that will include the booms, busts and everything in between. So just going long and holding on no matter what could work. For people, though, who do not want to see their portfolio cut half every so often who can take defensive action and either outperform by knowing when to get back in or can get to the same long term result with a much smoother ride even if they get back in "late."

After a big move up people tend to discount the value of smoothing out the ride but I am telling you first hand (because people really do forget) there is panic at the bottom. If anyone is ever going to do the wrong thing it will be after the market, and by extension their portfolio, has cut half. For many people, avoiding the panic that goes with being down 50% could be a life/portfolio saver.

Yesterday after we parted ways with Pep (pictured with me at the ATM) we went to the town of Roslyn which is where the show Northern Exposure was filmed. This was one of my two all time favorite shows (the other being the shockingly profane Deadwood). The town is very much as it was when the show was in production. We got a bunch of pictures, needless to say. Dr. Fleischman's office looks the same from the outside but is a gift shop inside. The guy who works there moved to Roslyn from New Jersey eight years ago because of his love of the show. I thought I was a fan until I heard that story. As a bit of hindsight bias, of course there was someone who rearranged his life for the love of the show.

We also got into Seattle and did some walking around. We hit Cafe Ladro at 801 Pine Street and they made a hell of a mocha.
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Lost Decades?

Cam Hui had a post up exploring the current state of affairs in Europe as he ponders the ingredients for a lost decade.

I would submit that if there are seeds for a lost decade then what it would actually be is a second lost decade. Over the last ten years the DAX is up 20%, Spain is up a little less, the CAC in France is down a hair more than 20% and the Netherlands are down about 35%. While we're at the FTSE 100 is up single digits.

Things not like about Europe include that the continent does not offer much diversification compared to other parts of the world, the demographics are lousy, the fundamentals stink in most places and threaten the one place that may not stink (Germany). Maybe Poland, Slovakia, Estonia and Turkey (if it every really gets in they way it wants) can help turn the fortunes around but there are far better foreign destinations to choose from.

For this you need to look at the country indexes not the ETFs which have all done better because the US dollar has gone down against the Euro.

That is Mount Rainier on our way to take Pep to the U-W training facility in Eatonville. I took that one with my phone. Thank you for all the suggestions on yesterday's post.
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Pep

As I mentioned a few days ago, we are headed up to Seattle today with Pep pictured to the left. Pep is a very hyper dog who has been returned four times for being too hyper. He is not suited to be someone's pet but his hyperactivity and ball focused behavior makes it very possible he can be trained as a working dog of one kind or another like search and rescue.

As some of you may know, my wife works full time in dog rescue for United Animal Friends, mostly things related to regular adoptions and she also does email communication, social media and is on the board. With a lot of phone calls and emails she got Pep accepted into a training program at the University of Washington--I don't know if accepted is most precise term but you get the idea.

Kind of a neat thing, all the stuff in the "travel bag" that Joellyn bought for Pep was covered by a Petsmart gift card from a Random Roger reader so a big thank you for that.

This was why I asked for input about coffee houses in Seattle. After we drop Pep off we are going to hang out for a couple of days. I'd still welcome any coffee house suggestions.
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Sunday Morning Coffee

Barron's Electronic Trader column this week linked to a very neat resource that appears to be called Subject Browser but the URL is http://stocks.overthefalls.com/. Whatever the name, when the page loads you can put in a ticker symbol in the search box at the top of the page and it will load the symbol into the various websites located in the left hand sidebar. Once it loads it provides for instant toggling and the links in each window are functional.

This allows, for example, looking at the Key Statistics from Yahoo and the chart from whatever your favorite chart site is (I'm assuming Yahoo charts is no one's favorite). I did have a couple of quirks with it. One that several of the links to the left could not load, this could have something to do with my satellite based ISP (our only choice for now). The other quirk was that after a few minutes the page refreshed on its own to the Seeking Alpha page for whatever symbol was plugged in. I'm not sure if that was something I did or not but if anyone knows please leave a comment. Still this made a great first impression. I think this sort of thing might exist elsewhere but the combination of the clean interface and tabbed like loading of all the sites made it very comfortable to use.

Short post today as my hectic schedule continues until the end of the month. I've had fire department stuff Friday, yesterday and this morning I am headed out to proctor make up pack tests (three miles, 45 lbs with a 45 minute time limit--actually we get an extra 45 seconds for being above 5000 feet) for what I hope will be at least five people.

















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The Big Picture for the Week of March 27, 2011

Seeking Alpha sent me some interview questions that I am working on over the weekend and should be published mid week sometime. The following is a preview with one question and answer.

SA: Where would you plot U.S. equities as an asset class on the risk curve right now?

RN: I think I would frame my answer a little differently versus the question. The fundamentals in the US are not good and I cannot envision how the Fed’s targeting of asset prices and equity markets won’t end up causing more pain but right here right now, for whatever reason, these things don’t matter to the market. It is important to realize that the market seems inclined to go higher for some period of time and as malignant as the environment might be, the right trade is more long than not with some sort of defensive trigger point in place if there ever turns out to be a consequence for what the Fed has been doing. In theory, there could be no consequence but planning for consequence is very important.

Yesterday and today is the Prescott Basin Ops Drill which is an annual inter-agency training that apparently is very unique. I am told that this drill is a national model and that the level of cooperation we have here is rare.

This year I participated with the planning group which started back in November with monthly meetings. Amusingly it reminds me of something from college; I organized the Greek Week Volleyball tournament one year which required work and planning with a bunch of people from outside our house.
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Success Requires Flexibility

Yesterday I stumbled across a series of articles that I think all tie into the need for flexibility in portfolio construction and cycle navigation along with the need to understand that all aspects of this business evolve. Sometimes evolution is slow but sometimes it is rapid and awareness of this can be a crucial determinant of success in pursuing the ultimate goal; having enough money when you need it.

The first article comes from the CFA Institute and questions the college endowment model like the ones made famous at Harvard and Yale. The article pointed out 1990 to 2007 as being unique because the equity market went up nine fold. In that time there was a proliferation of "new" investment vehicles like hedge funds, sovereign wealth funds and as already mentioned we learned a lot about the endowment models of Yale and Harvard.

The article posits the need for more of a top down approach going forward with less focus on the "investment silo" that has made Harvard and Yale so successful. The idea being that a nine fold rise lifted a lot of other boats and that if a nine fold rise will not occur again in such a short time then the approach needs to change to, in the author's view, more top down which is a nice bit of confirmation bias to what I have been doing.

There was an interesting bit about diversification in this article that on the one hand it works except when you need it like in 2008. On the other hand all it really does is make sure you are not too concentrated in the worst performing asset class so in that context it worked in 2008. You can draw whatever you want from that but I thought it was an interesting framing of the debate.

In reading these types of analyses one thing that always seems to be missing is the acknowledgment that cash can be an asset class and a tactical tool. If you somehow knew that stocks would drop 50% and could only choose between owning stocks and cash yielding zero wouldn't you switch to cash? So while in the real world we cannot know that the market will cut in half we can understand when conditions are more favorable for equities and when they are less favorable and act accordingly. While pensions and endowments may have constrictions on how much cash they can hold you as an individual or as an RIA have no such constrictions which is an advantage you have; you can use cash as a tactical tool.

Cash didn't drop 50% from October 2007 to March 2009.

Also is this from All About Alpha asking, perhaps half jokingly, if a meaningful allocation to gold could have mitigated the return issues that so many pensions have. AAA talks about the small slice that gold has in the S&P GSCI Index that many pensions apparently benchmark to for their commodity allocations. The allocation to a broad commodity index seeks a diversification from equities but a broad index still is sensitive to economic cyclicality but the reasons for owning gold are different. In a way owning gold is simpler because it represents the fear trade. In a way it is more complicated because the emotions behind fear are complicated. Whatever your take between the two gold by itself is still different than an index dominated by crude oil.

The final article that I think is related is about ETFs being the next bubble. The actual article is so illogical that I am not going to address it other than to say not every ETF will be right for every investor and some ETFs will not be right for the vast majority of investors but there is a negative sentiment toward the product that exists and this article is just another example.

You as an individual or RIA are not constrained by mandates devised by bureaucrats that must take in political considerations. Assuming you are willing to spend the time you can go anywhere in any proportion you want. While 15% in gold is way too much for my liking and no endowment or pension would get anywhere close to 15% you can (just an example and allocation like that would be extremely volatile). The AAA article mentions part of the problem for pensions was the so called lost decade of the 2000s for large caps stocks in the US and the Western European markets along with Japan that dominate most foreign benchmarks.

Again, you have the flexibility to avoid those segments. Obviously this is what I've been doing and what I have been writing about for a very long time but the notion of your having more flexibility is a different way to frame this and I think promotes how important it is toward the ultimate goal of having enough money when you need it. Owning Brazil for example, was far less important in the 1990s than it was in the 2000s. The necessary exposures changed dramatically from the one decade to the next which is exactly what I have in mind in talking about evolution.

This flexibility and evolution can include ETFs or not but for most of us, at least a little ETF exposure will probably make sense. Certainly it does for the way we try to help our firm's clients.
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Thursday Tidbits

A bunch of stuff today.

Bill Miller was on with Erin Burnett yesterday for an hour. Toward the end of the show Erin asked what his biggest regret was and he said his biggest regret "was certainly getting the financial crisis wrong, we had very robust strategies for virtually every kind of market disruption from inverted yield curves to the crash on 1987 and that was a case where we just didn't get the difference between a liquidity driven crisis like 1987 and a collateral driven crisis like 2008."

I've picked on him before. What robust strategies could he have had for the inverted yield curve? He was grossly overweight financials (and apparently still is) at the worst time including GSEs that almost went to zero. I had a very un-robust strategy for inverted yield curves, I reduced exposure and blogged about it incessantly.

Since 2000 there have been two market calamities and he fared worse than the SPX during the most recent calamity and went down almost as much as the SPX during the first calamity (you need to look at Morningstar which captures the dividends). Despite his lagging the SPX in 2010 I have little doubt that if the next ten years is good for domestic markets he will do very well but why should anyone expect him to ever see the next calamity. When I hear him speak, I now have no idea if he knows what he is talking about. It would be reasonable to conclude he did not understand what he owned with the GSEs--what else doesn't he understand? Bespoke has a little more about him and his fund.

If his strategies were somehow robust, then they were too robust and missed the forest for the trees. You can have success keeping things very simple. I strive for simplicity.

Next up is possibly the second worst article I've ever read at Seeking Alpha (I would say the worst but I remember saying that before about another article but don't remember what that article was). The other day I made a comment about not confusing being smart with a bull market. The article in question talks about the author having made a portfolio recommendation three years ago to an eighty something year old that was 30% in gold, 30% in silver and most of the rest of it in other commodity related items. He said it was "an illustration" to show this person what a bad job his advisor was doing.

The result was fantastic in nominal terms. The author pointed out that "it still outperformed any standard asset allocation recommended by professionals, with a relatively low level of risk." This is the grossest example of failure to understand the risk taken I've ever read. It is embedded with so many fallacies and biases that at first I thought it was a joke (and if it is a joke then the joke is clearly on me). But it is a great example for the extreme nature of the portfolio of how important the concept of risk adjusted returns are and why it is important to educate yourself on this if you have not already done so.

Deutsche Bank rolled out the following ETNs;

* PowerShares DB German Bund Futures ETN (NYSEArca: BUNL)
* PowerShares DB 3x German Bund Futures ETN (NYSEArca: BUNT)
* PowerShares DB Italian Treasury Bond Futures ETN (NYSEArca: ITLY)
* PowerShares DB 3x Italian Treasury Bond Futures ETN (NYSEArca: ITLT)
* PowerShares DB Japanese Govt Bond Futures ETN (NYSEArca: JGBL)
* PowerShares DB 3x Japanese Govt Bond Futures ETN (NYSEArca: JGBT)

I think this is an important listing not for what the funds cover but because it breaks the ice on foreign sovereign products that go to the individual country level. To be clear these track futures prices and it looks as though there will be no interest payments. Again, I view this as an ice-breaker.

Global X filed for yet more ETFs. One would be called Global X Global Auto ETF and the other would be the Global X Farming ETF. I looked at the site for the index provider for the Farming fund but did not find the underlying index, if you find it please leave a link. The Auto ETF is from a different provider and I did not look them up.

The farming fund of course holds a lot of conceptual appeal to me. The new CROP fund from IndexIQ makes a good first impression but there is nothing to say that fund must be the way in for all times, we'll see what the Global X fund looks like if it ever lists. Generally I believe the demand for better food is a one way trade but I am not saying that would be the case with the stocks. In the face of another meltdown I have no expectation that farms would offer a place to hide even with a great demand story. Any allocation I might implement for clients would be small.

The auto ETF is something of an enigma. About the only business worse than autos is airlines yet it is clear that the number of cars purchased in countries where a middle class is ascending is going to skyrocket. I have zero doubt about this yet I think the businesses stink. Maybe "stink" will turn out to be wrong about smaller companies located in and serving these markets but I am pretty sure that if it happens, it will be without me.
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Exploring Bubbles

Later this morning I am due to be interviewed by the WSJ about "scarcity" as an investment theme which I think means water and ag-related equities. As an amusing coincidence Robert Shiller is calling out farmland as the next bubble. Pragmatic Capitalist Cullen Roche has more detail on Shiller and he is sort of in agreement, he is focused more on commodities as a bubble in the making. The two are related but not precisely the same.

Farmland is not a bubble and I am quite certain it will not become a bubble.

Bubbles are all encompassing events that take many things down with them. For example the US housing market turned out to be a bubble taking down many world stock markets, many world fixed income markets and many world GDPs. As the bubble was inflating there were astounding statistics about equity extraction, a proliferation of mortgage products requiring no money down, an abundance of house flipping television shows and anecdotally a couple of people I know actually thought it was impossible to lose money in real estate.

Ditto the tech bubble. Since that was more of a stock market-centric event I would add that there were dozens of publicly traded, unprofitable internet stocks with little to no revenue with market capitalizations well north of $100 billion.

A few years ago I was on CNBC and asked whether solar stocks were a bubble. I think I was on to discuss this because of a couple of bearish of articles I wrote about solar for theStreet.com but either way it most certainly was not a bubble. At the time the total market cap of the Market Vectors Solar ETF (KWT) was less than $100 billion. Here I am talking about the sum of all the market caps of the stocks in the fund not the AUM in the fund. So the comparison was dozens of unprofitable companies each with market caps above $100 billion versus an entire industry worth less than $100 billion. The market cap of KWT now is only about $40 billion (I didn't realize it had dropped that much and stayed down until I just looked for this post).

The SPDR Gold Trust (GLD) which we own for clients is by far the largest exchange traded commodity product in the US at $55 billion and I am quite certain it is by far the largest exchange traded commodity product in the world. I am fairly certain (but did not look up every ETP) that iShares Silver is the second largest at $12 billion. PowerShares DB Commodity Index Tracking Fund (DBC) is a relatively big one at $6 billion. The The iPath Dow Jones-UBS Commodity Index Total Return ETN (DJP) used to be a very popular one and it has $3 billion AUM.

I would be surprised if all of these added up to $100 billion but there is no way they all add up to $150 billion. As for related equities , the materials sector currently comprises 3.62% of the S&P 500 and 10.99% of the EAFE Index which are both a long way from the 20% level that becomes a flashing yellow light for reducing exposure.

As for farmland the numbers for the bubble case are a little more plausible. According to this from Thomas Hoenig, 1/6 of US jobs and US economic activity are farm related (these numbers surprise me) and the value of of all US farmland is up a lot to now $2 trillion dollars. In doing some Googling I found a couple of estimates for the total value of all US real estate to be $20 trillion but I have a low confidence in that number.

If farmland goes down a lot in value it would be for one of two reasons as best as I can tell; one would be that food prices would drop which would be a net positive for most of the economy or due to serious distortions with interest rates making the business of farming difficult/impossible/money losing but higher rates would be bad for the entire real estate market and the entire economy for that matter and very unlikely to originate in the farming industry--so farmland hurt by the economy not farmland hurting the economy.

I would also think that a decline in commodities would have several economic benefits and that it would not be a decline in commodity prices that would hurt economic activity, more like a downturn in economic activity hurting commodity prices.

This is not to say that both farmland and commodities are not manias that will see huge price declines because anything can drop a lot in price. Not everything that drops a lot in price is a bubble. Bubbles truly hurt many people and take many things down with them. The question of whether solar was a bubble a few years ago was a popular one at the time. The industry then went supernova (whether because of it own fundamentals or the bigger economic picture) and no one cared. When the real bubble surfaced, solar as a bubble was thoroughly disregarded.

This post is neither bullish or bearish so much as an exploration of a misused term. If you are worried about commodities and/or farmland imploding then make sure you don't own so much that a massive decline could do you in. If gold somehow went to $400 in the next week I promise you there would be tales of people being wiped out for being 100% in gold on margin.

There are obvious fundamental tailwinds for commodities and farm-related investments ranging from modernization to lack of supply but there are always fundamental tailwinds for these things. A large price decline is far less of a problem than being wildly over exposed when the bottom does fall out.

On an unrelated note some of you may recall I like to watch college lacrosse, among many other sports. This season one of the big advertisers for ESPNU's coverage is Select Sector SPDRs which is very funny as my wife tells me I am the only person watching.
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ETFs Jump In It

If you didn't hear, Index IQ is coming out with a global small cap agribusiness ETF that will have ticker CROP. It is supposed to start trading today.

About all I could glean for now about the make up of the fund is that it will hold stocks from a lot of different countries, no stock will exceed 10% (subject to rebalancing) and 30% of the fund will be in crop production and farming. We'll see what that means perhaps as soon as later today but this could be about a close as we get to a farmland ETF.

There are all kinds of plantation stocks trading in Asian markets and a couple where the plantations are in Asia but the stocks list in London. These are not easy to trade and if the fund captures that then this stands to be meaningful and also have the potential to look much different than Market Vectors Agribusiness (MOO) that we own for clients.

Emerging Global filed last week to dramatically increase its India offerings with sector funds that correspond to the ten big SPX sectors. They already have India covered with infrastructure and small cap. India has become a tougher market to own, fundamentally. A few years ago it seemed like anything India went up, this was also the case with Chinese stocks. As is often the case the theme has evolved and success requires being more selective.

Long story short I want no part of financials or telecom in India. The other sectors are all at least maybes. Any broad large funds will have exposure to those two sectors, the EG Shares India Small Cap Fund (SCIN) doesn't seem to have any telecom but does have some financials in it. The consumer space is very promising from the top down but buying that fund would depend on what was in it. I think utilities is kind of a sector for the future as there are things like hydroelectricity but the electricity infrastructure seems fairly primitive for now. The industrial and materials sectors will obviously capture the infrastructure needed as well the actual infrastructure fund.

At some point I expect we'll add India across the board as we had it quite a few years ago and it would be nice to have choice at the sector level as individual stocks from India are a little tougher to access.

WisdomTree now has an Asian bond ETF and it avoids Japan which is a plus. I wrote about it for theStreet.com. WisdomTree has a Latin American bond ETF in the works which could also be very interesting unless it is 40% Mexico or something.

Yesterday I stumbled across a Brazilian hydroelectric company called AES Tiete (AESAY). I don't know much about it yet but where there is at least one in Brazil, India and a couple in China I'm thinking there are several others around the world--maybe enough for an ETF? Alternative energy is a volatile space but I think it makes more sense to consider when the alternative energy comes from the utility than when it is dependent on the end user retrofitting their home.

Maybe we can add this to the list of ETF ideas we've compiled over the years which includes toll road, air and sea ports, cement companies and publicly traded exchanges.
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Monday Twofer

Yesterday I read an article at Seeking Alpha where the author revisited his analysis of a large cap industrial stock that he wrote about favorably last October. Since mid October the stock is up 31% versus about 9% for the S&P 500. The stock in question is one I own for clients (the name is not important for this post) and so obviously I am favorably disposed.

The author reasonably notes his having been correct before and lays out why he believes the name still has bright prospects ahead. As noted above the market is up 9% in the last six months which should at the very least should make us wonder about the notion of confusing being smart with a bull market. The history of this stock has been to go up more than the market but also to go down more than the market. While this is at least a little counter factual my hunch is that having been involved with this name for seven or eight years that had the market been down 9% in the last six months that this stock would have been down more.

This does not make the author wrong or make it a bad stock but from the top down, during a bull market (or if you prefer, during this ongoing sucker's rally) most healthy companies go up and this company is healthy. There is plenty of need/demand for this company's stuff and it is very profitable. Generically speaking this type of stock should go up in a rising market and that is generally what this one does.

This is about understanding what type of stock this company has. It is cyclical and typically performs as mentioned above, contrasted maybe with some sort of stock that could be thought of as being in its own world.

Next up is the following comment left on another post I read at Seeking Alpha (not my post);

If I had to guess, you don't actually don't invest at all and you're just ETF holding charlatan like much of the academic community. There is no independent opinion in this article at all.

So aside from the harshness of it I think there are a couple of behavioral issues here to mention. I think there is a fair bit of ego exhibited along the lines of only pure stock pickers are real investors. There are all sorts of reasons why not everyone picks stocks. There are issues of time available, account size, analytical skill, volatility tolerances and so on. While some do look down on the use of funds (exchange traded or otherwise), just as using nothing but ETFs doesn't makes sense (no single wrapper can possibly be the best for all exposures at all times) so too does using only individual stocks for every single exposure in a diversified portfolio not make sense.

As investment products proliferate and evolve some will turn out to be useless or even dangerous but there are also plenty that will be very useful in terms of addressing some of the issues above like time available and so on and to not make use of what is available seems silly to me.

On a slightly more macro note there are countless ways to have success with investing and no one person can be good at all of them. That which is right for you will probably not be right for other people. Investors have success buying on strength while others buy on weakness, ditto selling strength or weakness. There is trading versus investing, momentum versus buy and hold, top down versus bottom up and stock picking versus using funds. Any of it can work and any of it can fail. Figuring out what is best for you is a key building block to long term investing success.

Lastly I need some help unrelated to investing. We are going to Seattle soon for a couple of days for something dog rescue-related (more details to follow) and we want to hit up a couple of the coffee houses up there that are not Starbucks. We know about Stumptown from Portland but would welcome any input, we are staying downtown. We are trying to avoid getting back and someone saying "you went to Seattle and didn't go to....?" Any help would be much appreciated.
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Sunday Morning Coffee

A couple of quotes from Barron's

Kevin Holt manager of the Van Kampen Comstock Fund (ACSTX);

In an environment where people panic, and they overact based on what they see on a day-to-day basis, our competitive advantage at the end of the day is patience, in a world and market that's very impatient.

Assuming you are more interested in investing versus trading, the ability to zoom out a little and think about the big picture is crucial when the real goal is to have enough money when you need it. No single holding can be the best at all times in all markets.

And this from Dylan Grice at Societe Generale who "...penned a piece entitled 'Buy Japan, and prepare to buy with both hands. 'Grice pointed out that there were still plenty of risks, but Japan 'is beginning to look cheap.' "

Cheap stocks don't have to go up and from the top down Japan has a debt load that is 225% of GDP and a serious demographic problem. Speculating that something will have a quick pop can be valid idea of course but I think you're on unstable ground when you do that type of trade in a market where the fundamentals stink as I believe is the case with Japan.
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The Big Picture for the Week of March 20, 2011

Joe Dear CIO from CALPERS was on the network during the week defending the decision to keep the pension's 7.75% return target after averaging only 4.5% over the last ten years. He said that if they were using a typical 60/40 asset allocation based in the US that 7.75% would not be attainable but since they will move away from that and since they will find managers that can add alpha he believes that 7.75 is an attainable objective over the long term. He also noted that 7.75% is still below the median target for pension plans in the US.

What could possibly go wrong with a plan that relies on generating alpha and an assumption that returns will improve by 72% on an annualized basis? Actually I think there are all sorts of learning opportunities here and despite the absurd risks embedded I think these are very useful comments.

First there are political issues that are essentially immutable but need to be understood. If they lower the targeted return then that increases the shortfall. I believe I heard that the pension was only funded at 60% but after last year it had improved to being 70% funded (if you know different numbers please leave a comment). Whatever the actual stats, the process of calculating the funding includes assumed future returns so a lowering of the assumed return increases the shortfall which creates political problems (yes, this is bad).

The other sort of political point is that Dear cannot go on CNBC and say "yeah, we're going to stick with 7.75% but really we'd be lucky to get 5% so obviously our numbers will be way off and a lot of current pensioners and people looking to retire soon are going to get hurt when we blow up, which by my calculation, using a realistic return assumption, will be in 2017 or 2018." Something like that and they would set the state on fire.

Dear's comment about 7.75% being less than the median target for other pensions is a complete throwaway. If the fund does blow up, the fact that their assumption might have been less will be no solace to anyone getting wiped out by this and if a failure were to result in legal or civil proceeding I can't imagine that would have any impact on the outcome.

Things start to get more interesting in his acknowledgment that a 60/40 US based portfolio offers little chance of getting the job done. Obviously this is a nice bit of confirmation bias as I have been saying the same thing since before this blog started. In making this argument my focus is on long term fundamentals, about seeking investment destinations where authorities are not taking desperate measures to keep things going, where debt statistics aren't obviously lousy, demographics don't stink and maybe the country is becoming more relevant in the world economic order.

Often this line of thinking will draw comments on Seeking Alpha pointing how Germany did over the last few months or some equally short term time frame with something that contradicts my thesis. This has been my thesis for a long time and over the longer term it has been playing out, but over the short term anything can happen regardless of fundamentals so, with a nod to Karl Popper, the market action for six months or a year does not invalidate the thesis. Of course the thesis could turn out to be wrong but it is not the market action of a single year by itself that would make it wrong.

Dear is not an idiot, unless he is an idiot for being subject to the politics embedded in working for a public pension, and if he thinks there is a better chance of achieving the desired return outside of the basic 60/40 US based framework then we might want to heed that. We probably don't have access to the real estate exposure they do (although I don't want that exposure anyway) or the hedge funds they do but we can easily access foreign markets and this is getting progressively easier as time goes on.

The other point to hit on is the assumption of alpha and the need for alpha in order for the numbers to work. A few weeks ago I paraphrased Felix Salmon who noted that whatever the the stock market does in your investing lifetime, you will probably lag behind it a little bit. This pertains to both individuals and professionals. I would add this does not have to be universally true as some professionals and some individuals will outperform the market over the long term which is encouraging but if this is true then it must also be true that some other professionals and individuals will badly underperform the market. Our way of trying to add value is to try to avoid the full brunt of down a lot and try to be correct on some fairly big, long term macro themes but if I somehow knew that the market would go up 10% every single year and that I would be up 9% every year I would make that work just fine in my own financial plan.

The above is obviously about being a diligent, or even aggressive saver. If you save properly and can be somewhere close, performance wise, to a normal, long term market result your plan should work assuming prudent spending decisions. The advantage you have over any pension is that you have a better chance of making the number you ultimately have work. If you think you need $1 million and you end up with $875,000 you can make that work because, well, you have to. If the pension has 1 million benefit recipients then they must pay those 1 million people and must pay them a certain amount--until it goes bust.

If a pension is underfunded then the managers and anyone else involved with running the fund obviously want to improve the liability situation. The potential failure in the case needing alpha just for the math to work is truly a dilemma that no one should want personally. If you're 50 have $400,000 saved, live a $100,000 life style that you don't want to give up then you have a real problem. Whether or not you've admitted it to yourself or not, something is going to have to give. Personally, I am very motivated to avoid that situation.

The picture; a year and half ago I posted a picture of a hazmat ATV from the NYFD when was back there for a CNBC thing. I pondered whether Walker Fire should have these for fire. It turns out fire ATVs exist. It is a six-wheeler that has been modified to be a little longer than normal with 160 gallon capacity. I am very surprised to see a hose-reel on there as they weigh a ton. The neighboring FD has an ATV that they use but I do not believe it has water or pumping capability, I believe it is just for transport. I'm not about to suggest one of these unless someone donates a Ranger big enough to build our own but it is pretty neat to look at.
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The World Owes Us Nothing

As many of us are enjoying the best two days of the year, those being the first two days of the main draw of the NCAA Basketball Tournament, I wanted to talk about a Facebook post that got my attention for multiple reasons. This person spun the apparent fact that his business is not where he would like it to be in terms of number of customers/clients because most of the people where he lives are "conservative far right" and don't see the need for his service (which is not in the least a political field of word).

His service is not scalable and must occur in person so this "conservative far right" is his potential client base unless he moves. Let me say I have no idea if he is any good at what he does nor do I know whether anyone needs the service he provides but obviously he does know the extent to which his service is needed.

From where I sit his success or failure will hinge on his ability to relate his service to the lives of the people who must be his customers if he is to have customers. It is not the political ideology of his potential customers that is preventing his success it is that he has not figured out how to effectively relate his service to his potential audience. I'm not sure how he can ever have success if he continues to blame other people. I can't imagine this is an original sentiment but individuals are the greatest determinants of or impediments to their own success.

We have all encountered this attitude before in our lives but I am not sure how prevalent it is (hopefully not too prevalent). The idea that something will be handed to you when you have your own business is fatally flawed and there nothing preventing anyone from getting their expenses down.

Embedded in this, unfortunately is so called class warfare. My self employed friend has some very specific ideas about the wealthy and what they are doing to the poor which is what he considers himself. On this issue I try to just stay on my own mat but I know that some people who think of themselves as being poor are very resentful of the wealthy and use wealth gap data to support their argument. I'm not sure what these people are looking for. My friend wants a more prosperous business but resents people who already have some measure of the prosperity he appears to seek. I don't have much sense of where the wealthy are coming from as they don't seem to talk about this much (why would they?).

Here I think a small dose of Ayn Rand might fit in with some self-motivation to do for ourselves, to create our own opportunities, so to speak, to figure out and then build our own happiness. In conjunction with that sort of big picture vagueness are the usual practical things I talk about all the time which includes living below your means and saving as much as you can.

If more people spent time working on their own problems we'd have fewer problems. To whit babyboomers haven't saved any money for retirement (intentional hyperbole) and there seems to be some real doubt about the viability of the program (I expect zero payout when my time comes). If you have saved properly then you are more likely dealing with an inconvenience if social security plays out as a worst case scenario not a financial deathblow.

I'll finish this part of the post with a quote I've used before from our friend Bill here in Walker that I think pertains; you can figure it out now or you can figure it out later but if you can figure it out now your life will be much easier.

The first full day of the tournament was awesome including San Diego State's fist win in the tourney. They beat Northern Colorado despite a very impressive outing by UNC's Devon Beitzel. He was UNC's best player and he stepped up big time in that game; very impressive.
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A Real Analogy

Yesterday was the last day of my Pumps and Hydraulics class at the Wildfire Academy and we spent it in the field making sure everyone in the class knew how to set up a pump from scratch, operate it properly and do basic troubleshooting.

We partnered up in groups of two. My partner and I first set up a dry pump just to go through the process. There were also two pumps that would actually deliver water so each pairing would do a turn with the dry pump and then the actual wet pump.

By the time it came to our turn on the wet pump the class instructors had begun to start sabotaging the process in various ways which has very practical value in that during a wildfire all sorts of things go wrong. I was told by the instructor of my entry level class eight years ago to expect chaos on a fire so something not going right with the pump would fall well within the bounds of a white swan event on a fire.

In putting the entire assembly together there are certain connections that should be hand tight and other connections that need to be tightened with a "spanner" wrench. Tightening something with a spanner wrench requires, ahem, having a spanner wrench. Pump kits have a spanner wrench in them but the instructor took ours at some point (I think this was before we started).

The picture is of my radio harness. Aside from holding the radio there are all sorts of things that can go in the pouch (zippered across the top) like earplugs, some sort of energy bar and so on. Along the front there are pockets for various thing that I keep with me like a pocket knife and to the far left pointed to by the white pen is, you guessed it; my own spanner wrench.

There are two things here, one is that we were going to be around hoses, water and pumps all day so it seemed like a pretty good bet that at some point something would need to be tightened and then later loosened and slightly bigger picture when fighting a wildfire last thing you want is to need something and not have it; something to eat, a couple of band-aids, a couple of kleenex, some TP squares, a second pair of socks and a few other things that you can plan out to minimize bulk and weight.

Also relevant here is the concept of situational awareness. The instructor pulled the hard suction line out of the water source (hard rubber hose that connects the pump and the water source, the pump sucks that water and discharges it through the regular fire hose) which I heard him do and so I simply put back into the water (for anyone who knows this stuff it had a foot valve so I did not need to re-prime the pump). Coming into the day it never occurred to me the instructors would do this (they also jacked up the spark plug) yet I was prepared anyway. Out of 18 students I was the only one with a spanner wrench and maybe one of four with a pocket knife.

I can see all sorts of parallels to investing here. I did not expect the instructors to sabotage us--no one expected Japan to have an earthquake so big that it would move the island. As this has unfolded, the S&P 500 has dropped 3.6% since last Friday's close. In the face of that event some stocks have done ok for various reasons. Long time holding Caterpillar (CAT) is up very slightly. Recent portfolio addition Market Vectors Coal (KOL) is up 2% since Friday's close.

This, I guess, is an argument for diversification. I had not thought about this type of external shock in terms of portfolio construction but in having my full radio harness, so to speak, I feel that the volatility of the portfolio has been muted a little and hopefully that will continue to work if this continues to be a market event.

I've talked before about holdings bringing specific attributes to the portfolio or having purposes within the portfolio which is similar to the various tools at a firefighter's disposal. The broader a portfolio is constructed the fewer specific tools you have. The broadest funds make for very blunt tools. For accounts that are big enough, specialized tools seems by far the better way to go.
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Odds and Ends

A couple of weeks ago I mentioned the interview in Barron's with the guy from Muddy Waters research, he is one a prominent basher of the Chinese reverse mergers, in particular China Media Express Holdings (CCME). I mentioned this as part of my ongoing belief that Chinese reverse mergers are best left alone. One reader called me an "unwitting voice for shorts" on that post.

You may have heard that Deloitte & Touche resigned as CCME's auditors. Neither Yahoo Finance nor Google Finance show trading for the last couple of days (I am guessing it is halted but since I have no position and have left it alone it doesn't matter to me) but this is clearly bad news for the company and anyone long the stock. Obviously I am vindicated, right!? No, as the post in question was a reminder to just leave these alone, not get short. The potential reward available from these companies can be had in plenty of market niches without taking the risk unfolding with CCME and I believe exists with other reverse mergers.

Market Vectors came out with a me too Colombia ETF with ticker symbol COLX. One difference maker is that it owns several companies primarily traded in Canada but "derive" much of their revenue in Colombia. As the fund is just getting out of the blocks it is too early to know whether the Canadians will make it more attractive or less than the Global Colombia ETF (GXG). Another point of differentiation is that COLX only allows for 8% positions where as GXG currently has three stocks greater than 13% each.

A comment about Japan; this seems to be scaring the hell out of people. I've seen in a couple of places that the quake moved the island over a few feet which I did not know was possible (did you?). Obviously the situation is still unfolding and we don't know how long this will be market moving but in terms of market impact this is an external shock that could easily have economic implications. This part of it is not unprecedented. This might cause the SPX to breach its 200 DMA (or trigger some other indicator you care about) or not. The prudent course of action is to stick to whatever strategy you laid out for yourself ahead of time and then stick to it (I would be shocked if anyone has continued to read this blog for any length of time and not created some strategy for defensive action).

The above paragraph should not be confused with stay in no matter what but more of a stick to your own discipline no matter what and those two are not the same thing.

Long story short I have a buddy who is a Major League Umpire and the umpires have put up a charity auction website that is running until March 20, I hope you will check it out.

Well March is here, the conference tournaments were generally outstanding and of course the NCAA Tournament started last night much to the glee of many people. Last night's games were a testament to just how dreadful Clark Kellog is as a commentator (I avoided him all season). They should have Bill Raftery and Verne Lundquist in the "A" slot, how do they not realize this?
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Opportunity

I am in the middle of a three day stint of learning all I can about the Mark 3 portable pump, there is more to learn than you'd think.

This is happening at the Arizona Wildfire Academy which is a big deal and brings people in from all over. I had lunch yesterday with one of the other firefighters from our outfit and the chief from a district up near Flagstaff that serves 3000 residents and has 49 paid firefighters which is huge for a "small" department.

The nature of things in our department right now is that as assistant chief I have a much larger role in operational decision mking than the previous six fire seasons that I had the same role. I was lucky enough to get the chief we were having lunch with to open up about all sorts of things relevant to the issues that our department is dealing with, they went through the same things back in the 1990s.

I had a ton of homework for the class (despite the simplicity of the picture there are a lot of math formulas involved) so no normal blog post just an observation about seizing an admittedly small moment.
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Prioritizing Stock Selection

Michael Santoli's column this week focused more on ETFs than usual. He talked about stock picking not having been rewarded in the last few years due in part, he says, to "the dominance of macro, rather than company-specific factors, in driving returns."

He went on to support his argument with stats about the number of funds in various categories (large cap, mid cap and small cap) that have lagged their respective benchmarks over the last three years. He says this creates a desire to just use index ETFs to merely capture the exposure.

Actually I think this is a flawed argument. Most mutual funds have to be close to fully invested often having limits to how much cash they can raise. This is a similar dilemma as exists at full service brokerage firms where brokers place assets with outside managers. In both cases the mandate is invest this money (there will be exceptions here and there) so this means the money has to be invested. The managers in question must assume that the asset allocation decision has been made and for all the manager knows money in their fund could be part of an asset allocation where they have the only 10% targeted to equities. That a bunch of funds lagged their benchmarks during an anomalous period is at best incomplete information.

His macro conclusion could be correct, I just don't think the mutual fund results are much of an indicator.

As to the bigger point about stock picking, being a top down investor I am inclined to mostly agree but I would probably always think that--I don't think the term stock picker's market holds much water. The top down line of thinking is very easy to understand; the most important decision is whether to be in the market at all. Forgetting taxes and commission drag for a moment, if you knew the broad market was going to cut in half, the best thing to do would be to sell out and wait for the decline instead of trying to find the few stocks that would somehow go up.

In the real world we do have taxes and commissions and we can't know that the market will cut in half but we can heed warnings from the market about elevated risks versus other points in the cycle and practically speaking we can reduce net long exposure one way or another.

Basic top down theory would say that picking countries, sectors and themes would be less important than being in the market or not but more important than stock picking. If you only made one active decision in 2008 and it was to avoid financials you fared much better than the S&P 500.

Stock picking being least important is far from unimportant. The first thing that comes to mind here is dividends. While dividends are not the most important thing in a year like 2009 when the market goes up twenty-something percent, they are very important most of the time. Here the conversation could include sustainability or growth but either way I am a big believer in adding some basis point versus the benchmark, this matters during most of a typical cycle, and this is done at the stock picking level--it is very difficult to get a 3% yield in a portfolio using ETFs and still being properly diversified.

Also every segment where you might be inclined to use an individual stock instead of a fund of some sort will have some names that are "right" and some that are "wrong" and sorting this out correctly more often than not will also be a big, long term difference maker. As one example, over the last five years Hewlett Packard is up 22% which looks like a fantastic result given the 1.7% increase of the S&P 500 until you realize that in the same time Apple (AAPL) is up 444%.

It is also easier to increase or decrease portfolio volatility with individual stocks. While this is not as important as being in or out of the market I do believe it to be quite important and again it is about stock picking.

Today, tomorrow and Wednesday I will be taking a class at the Arizona Wildfire Academy which I am looking forward to. It has been a few years since I took a class so it should be fun. Fortunately the college campus where it is held has wifi and my phone should keep me in touch as well.
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Sunday Morning Coffee

Barron's had a lengthy article about currency ETFs, fundamental reasons to consider having more exposure to non-dollar denominated assets, how the dollar is becoming less relevant in the world economic order and that cash, like equities and fixed income, is an asset class that could be useful to diversify into foreign.

This is somewhat amusing to me as I've been saying these things for years and obviously I was far from the first to make these observations. I've covered this ground many times so without repeating the entire thread I believe the loss of dollar hegemony will not be a disastrous train wreck but more of what we have seen; the dollar today is less important than it was five years ago. Many transactions between other countries that used to be conducted in US dollars are now being done directly. The fundamentals backing the US dollar have certainly changed which makes the dollar less attractive by some magnitude. You can decide for yourself what the magnitude is but I think it will be far more gradual of a thing because despite the state of the USD and economy the US is still a very wealthy country (wealth gaps notwithstanding) and many countries rely on us to buy stuff from them and while consumption and income numbers may still tweak at the margin we are still buying a lot of stuff.

Even though this is not apocalyptic I do believe in investing extensively in foreign denominated assets. For the most part we own foreign stocks and short dated foreign sovereign debt. In the past we've done more with currency ETFs and could use them again.

The Barron's interview had a lot of comments from Ray Dalio on this topic. One snippet from him;

I believe that sometime in the next 18 months, we will probably have a seismic shift, very similar to the Bretton Woods breakup in 1971, in which linked monetary policies and linked exchange-rate policies come undone. The pain of holding them together is going to be terrible, and that's going to create the seismic shift.

He generally prefers currency from creditor countries (as opposed to debtor nations) and emerging market currencies.

The currency article is quite clear that this doesn't have to be about becoming an active currency trader looking to scalp a few pips every hour. I think for people not so concerned about being very right about a single currency the two WisdomTree basket ETFs can work. One owns emerging market currencies and has symbol CEW (I own a few shares of that one) and the other owns currencies from commodity based economies and has ticker CCX. Obviously there is a little overlap between the two.

What I think these can do is offer protection against a dollar erosion which for many investors can be the solution. While I have used single currency ETFs for clients before it is important to understand this type of trade requires more in the way of analysis as some sort of change in the story in the Canadian dollar would obviously have a much larger impact on FXC than CCX. This is not to say that single currency ETFs are a bad idea but there is a different type of work load involved.
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The Big Picture for the Week of March 13, 2011

IndexUniverse posted an interview with a portfolio manager who only uses country funds to build client portfolios. On one hand it was an interesting interview but on the other hand I'm not quite sure what to make of it. First let me say that anyone can have success with any strategy so this is not meant to be critical of this one approach so much as figure out what we might be able to learn.

I place a lot of emphasis on country selection and also country avoidance so I am on board with this part of it; country selection for outperformance and effective diversification. For a little background I've mentioned quite a few times how important both country selection and sector selection (more like sector avoidance) were over the last ten years but that going forward I don't think sector selection will be as important as country selection. What made sector selection so important was that two sectors grew too big (tech to 30% of the SPX and then more recently financials to greater than 20%); a sector greater than 20% is like a yellow flashing light and above 30% is like a tsunami siren. My hunch is that it will be a while before another sector gets that large after happening twice so close together but if it happens; then that sector will be an underweight.

On the flip side I do think country selection will again be very important in this decade. I've referred to Bespoke Investment Group's data dozens of times that show many markets around the world having normal or better than normal decades during the 2000s as the SPX was falling 24% on a price basis.

In the IU article the portfolio manager has a process for winnowing down the list of possible countries with one of the screens being that there is an ETF for that country. Here the strategy is a little lost as in the name of not taking single stock risk they only use ETFs. I would suggest using whatever you think is the best proxy not defaulting to the country fund. Back in 2007 I was on a panel at an ETF conference and one of my co-panelists asked me why I prefer Volvo (VOLVY) to the iShares Sweden (EWD)--this anecdote is a repeat. I've been favorably disposed to Sweden as an investment destination for years and we still own Volvo.

The reason to prefer Volvo over EWD is that the ETF has always been heavy in Ericsson (ERIC) which is a company I want no part of. Deciding you don't want a stock takes a lot less time than selecting one to buy. Volvo has generally outperformed the ETF at every turn but I would note that Volvo went down more than EWD during the crisis which strikes me as normal for a heavy industrial stock. While I have not crunched the numbers I believe the outperfomance is primarily attributable to the large weighting of ERIC in the ETF.

This has also been true with our position in Vale (VALE) versus iShares Brazil (EWZ). Obviously not every stock pick will outperform the corresponding country fund and in several instances that isn't necessarily the objective but some of the country funds are heavily weighted in stinkers, EWD with ERIC, and this is reason enough to seek another way in and, zooming out a little bit, circles back to the idea that it makes no sense that any single wrapper can be the best way in to all exposures at all times.

One thing not addressed in the article is whether narrower country funds can be used. For example there are small cap funds for Taiwan, Australia, Korea and Canada from IndexIQ, EG Shares has a small cap fund and infrastructure fund for India and plenty of providers have a small cap Japan fund. Another provider, maybe Global X, filed for a bunch more small cap country funds. Obviously Global X has sector funds for China and Brazil, what about them?

In previous posts I've mentioned looking at getting back into South Africa. There is one stock I like but the volume might be a little light. In thinking about ETFs there is of course the iShares South Africa (EZA) but perhaps the First Trust Platinum ETF (PLTM) would be better, that fund is 33% South Africa, or one of the miners directly? Even if the one stock I am most interested in doesn't have enough volume there are other names with the necessary volume that are also very solid companies. This sort of sifting process makes much more sense than limiting to one type of wrapper but maybe you see it differently? Perhaps he would say that if a country fund is too heavy in a stinker stock he would avoid the fund but does that mean he would then have to avoid a country that otherwise screened well? I tend to think the country exposure is more important than the wrapper.

ETFs clearly democratize this sort of thing and using a lot of ETFs is certainly valid but exclusive use is far less valid.
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The ETF Select List Is Here ! And It Stinks!

Schwab published an ETF Select List of what it describes as the best fund choices for 50 categories. While there is a little utility, for the most part it is worthless.

The list seems to be targeted at an Investing 101 or maybe Investing 102 audience. Most of the equity categories are broad and so in choosing the best funds for each broad category many of the funds are from Schwab and bunch more from Vanguard. I'm not critical of the fact that so many Schwab funds are the best pick. I heard an interview on CNBC about this earlier in the week and one purpose here is best choices for Schwab customers. The expense ratios of Schwab's funds are very competitive and there is no commission to trade them at Schwab. In that light where each ETF provider has, for example, a total market funds and the correlation between all of them will be 99 or 100 then why not go with cheapest possible choice?

While the above is true it would seem to rule out things like RAFI, WisdomTree, Revenue Shares and probably a couple of other providers who may have built better mousetraps.

The sector sections is truly pitiful. Nine of the ten sectors are the Select Sector SPDRs, the only one that isn't is telecom because there isn't a true Sector SPDR for telecom (the SPDR Telecom ETF is brand new, seems to own names not in the SPX and is not cap weighted). For Telecom they have iShares US Telecom (IYZ). Somehow, the methodology ignores a lot of fund families where sectors are concerned.

What about PowerShares? The PowerShares Dynamic Energy Sector ETF (PXI) has outperformed XLE since inception, for one year, for two years and for three years. PXI has an expense ration of 0.65% versus 0.20% for XLE. So yes XLE is cheaper and while making a decision based solely on past results is not a great idea, PowerShares probably does deserve a seat at the table.

The other thing that is lost here with sector funds is foreign sectors which appear to get no consideration as a category (meaning they might as well not exist) not to mention niche funds that can serve as proxies for sectors. Domestic sector funds can look very different from foreign sectors funds and this becomes very important in portfolio construction.

The easiest example here is probably the materials sector. What has been the allure of the sector over the last five years or so? I think one big driver has been mining stocks. The Materials Sector SPDR (XLB) is more about chemical stocks than mining companies. Dupont (DD) and Dow Chemical (DOW) add up to 22% of the fund and there are many other chemical names in the fund. Freeport Mcmoran (FCX) and Newmont (NEM) combine for 20% of the fund, but they appear to be the extent of the mining exposure. There are also a lot of metals producers and depending on the particulars these could be price takers not price makers which would matter to me.

A fund like iShares Global Materials (MXI) on the other hand has 56% in mining and it is the miners that dominate the top ten. Some clients own MXI. As another example the EG Shares Emerging Metals and Mining ETF (EMT) appears to have about 70% in mining companies (if you include coal companies). Relative to being the same sector I think the differences in performance are enough to matter but this could be in the eye of the beholder.

The country fund section only had two countries; Japan and China. Long time readers will know the importance I place on country selection and by only having two countries Schwab is simply ignoring this segment.

The exchange traded product space has vast possibilities for portfolio construction (preferably in conjunction with other products) but the select list doesn't begin to take take advantage of what is out there.
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Is Savings Rate More Important Than Returns?

On Monday I spoke at a pretty large gathering of 401k investors at a company whose plan we manage. During that seminar there was one question that brought me back to a point I've made once or twice before but that is crucial to understanding the importance of portfolio returns.

The importance of saving money comes up here often and although I don't bring it up often enough, for many people the manner in which they save will be more important than investment results (here the assumption is that investment results are not super human or freakishly bad).

This can matter on several different levels, you figure out for yourself whether it pertains to you or not. One way this is relevant is for people just starting out. I'll use the example of a Health Savings Account because if you have one, you've probably not had it very long. A few years ago when they first became available I believe the maximum contribution was $5000, now it is $6150. In year one if you deposited the full $5000 and had a very good year how much would you have made on the $5000? I think a real good year (not super human) might be $1000 which is obviously 20%.

At the start of the second year if you put in another $5000 the account goes from $6000 to $11,000 which is an increase of 83%--obviously not an investment gain but after the second deposit the account is much larger than the investment result and I would say the discipline to make that second deposit is more important than the investment result. If the investment result in the second year was again 20% or $2200 I would say that would still be less important than the third deposit which by now might able to be $6150 (this has been the max for three years now I believe). You can carry this out as far as you want and decide at what point you think the return is more important than the deposit but it would probably be after quite a few years as getting 20% repeatedly would drift into super human.

Someone who is 50-60 years old probably has something specific in mind about when they want to retire or what their retirement will look like (or at least an aspiration of what it will look like). If this is you, how much money do you have right now? How many more years of accumulation to you plan to have? How much per year can you save while you are still accumulating?

If you planning on 12 more years of accumulation and can put away $20,000 per year (this presumes you are at your peak earnings which we know is not the case for everyone) then we are talking about $240,000. In this example where does $240,000 stand? For some 50 year olds it will be a lot of money and for some it will be very little. If we take a middling number and say the total nest egg today is $200,000 with a 65% equity allocation and over the next 12 years that $130,000 doubles (not a super human result) and the fixed income portion goes up 40% then the $200,000 becomes $358,000. Add in the $240,000 saved and the portfolio is up to $598,000.

I realize the math is overly simple but this is not a blueprint, just an example. It is probably a push as to whether the savings is more important in this example but it is at least equally important as the withdrawal rate from $598,000 is much larger than $358,000 whether we are talking about the 4% rule or something else. I would also note from this example though that $200,000 was accumulated up to whatever age we are talking which was a period of decades compared to turning up the savings and socking away $240,000 in what the end user hopes is his last 12 years of accumulating.

A final point on this regard is that if the last ten years has taught you that you don't have a tolerance for normal stock market volatility then you might only have 40-50% in equities (maybe less?) which means less overall long term price appreciation which places a greater emphasis on savings or as I've worded it before if you want less stock market exposure, no problem, just plan on saving more money.

As a follow up to yesterday's post about dividends a reader at Seeking Alpha left the following comment;

"Even a portfolio with a market equaling yield of 2-ish percent would only need modest gains to meet a reasonable withdrawal rate."

Does this mean that you sell some of the portfolio?

Once the selling starts, when does it stop?

Doesn't selling off assets increase the risk that the client might "outlive their money"?

My reply;

There are countless studies from different sources that draw the same conclusion about a 4% withdrawal rate having a 90-95% success rate (that is not outliving your money).

From where I sit a combination of price appreciation, stock dividends and bond interest over a long period of time works if the account holder can stick to 4%. There will of course be down years but the number crunching behind the 4% rule takes that into account. There is no guarantee but the numbers can work.

The picture is from the green sand beach on the Big Island. The sand is actually green, kind of pea soup colored.
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Man Can't Live On Dividends Alone

One Seeking Alpha contributor I read is David Van Knapp who writes about dividend investing in the context of drawing income for retirement. David had a post yesterday that among other things asked for input about how RIAs approach dividends thinking that they are often ignored by advisors. I don't think that is true but either way below is the conversation David and I had in the comments of his post;

Me: I don't think RIA's ignore dividends in the manner you frame. In building a diversified portfolio there are likely to be quite a few companies with solid track records of dividend growth along with companies that pay no dividends.

FWIW, I target a yield for the overall portfolio, 3% is a good number for us. We own enough different names (usually 30-40) that dividends are hitting the account all the time--the month of May is a big month as a couple our foreign stocks are annual pays and pay that month--such that there is very rarely any need to sell something for the client to take their distribution.

Even a portfolio with a market equaling yield of 2-ish percent would only need modest gains to meet a reasonable withdrawal rate. In describing what we do it is not a story about dividend growth it is about diversification which INCLUDES dividend growers.

Please don't take this as a commercial but in terms of what RIAs do I would tweak the way you frame it as being the way to think of it.

David: Roger, Thanks for your comment. Your "FWIW" is invaluable. You do target an overall portfolio yield! You do recognize the trade-off of yield dollars for withdrawal dollars! That's great.

I think I know your answer to this, but I'll ask it anyway: Do you classify dividend stocks as a separate category of investment? If not a separate asset class, then at least as a separate category of stocks? If neither, then how do you target the 3% yield...or is that just a natural byproduct of the way you select investments? I guess another way of asking the same question would be, how do you "target" the 3% return? To me, "target" implies proactive strategies/actions to achieve it.

Me: Part of the process for me in building the portfolio is selecting what I think are the best exposures for each sector, country and theme. Some sectors, countries and themes lend themselves to being dividend centric and some not.

We've owned VALE and STO each for about six years (subject to shaving down and adding back in). In that time VALE is up 500%--for this name I don't really care about the dividend, I view the name as a great way to own Brazil, materials and volatility for the long term.

STO is up about 95% so the annually paid 4-5% dividend has been a much more important component to why we want the name.

In buying tech stocks, although several now have very good yields, it is not the primary consideration but it would be more important with utilities and telecom.

Energy and financials are examples where we want a mix of high yielders and what we hope will be fast growers.

Hope that makes sense.

David: It does make sense, Roger, and thanks for engaging in this discussion, you are about the only "pro" to share your thoughts. Let me rephrase what you said and see if I have it right. You look for the "best" exposures by sector, country, and theme. I take it that by "best" you mean the best prospects for capital gains in some cases, and total return in other cases. In the latter, dividends would play more of a role in your selection process. That's your selection process in a nutshell?

If so (and correct me if I am wrong), then the yield of the resulting portfolio sort of happens as a byproduct of the securities you select. Forgive me, I am having trouble correlating the "targeting" of 3% yield with a selection process that does not emphasize yield. Not trying to argue, I just want to understand.

When the time comes for your clients to live off their portfolios, I take it that the proportion of yield dollars as compared to withdrawal dollars is developed on a case-by-case basis? What's the maximum "safe" withdrawal rate that you recommend? Do you have clients that exceed that? What do you think of the Vanguard hybrid model described in the article?

Me: "Best" is a function of several things in terms of where we are in the cycle, trends emerging in each part of the market, or something becoming more attractive--we recently added Ecopetrol for many clients.

As far as targeting a yield. The portfolio was originally built in 2003, it had a certain yield. Along the way as changes have been made the yield goes up or down a little with each change made. If I wanted to have a noticeable change up in the portfolio's yield for some reason I could (examples only) swap SU for YPF and IYW for MXIM and add quite a few basis points to the yield. The few purchases we made early in 2009 would have had less regard for yield because the market had cut in half and some sort of snap back was plausible. Really this has become a matter of spreadsheet work.

As for living off portfolios I blog about "whatever you got 4% (more realistically 1% per quarter)" without worrying about increasing it for inflation because if the portfolio is growing then you'd be taking 1% (or less) of a bigger pie every quarter. I would note that my role is portfolio manager and I have little to no client contact in this regard, my colleagues do that.

David: I do exactly the same thing: 1% per quarter. I know I make it sound sometimes as if I take dividends directly and spend them, but actually I mentally run them through my "cistern" to compute total spending allowance. What we are both using is model #2 from the Vanguard article. I like the method, because it does not mindlessly increase for inflation when your assets are contracting. Allowance decreases are at the margin and easy to tolerate. In actual execution, the dividend dollars make up most of the "withdrawal." I am not at the point yet where dividend dollars totally fund what we need for our retirement budget, although that goal is getting closer and closer as the dividends keep going up.
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Ok, But The Math Doesn't Work

A year or two ago I reconnected with a friend from highschool on Facebook. He has turned out to be extremely liberal in his political thinking and regularly posts links and status updates consistent with his beliefs. He has been very pro-union in some of his posts and has been keenly interested in the goings on in Wisconsin these days despite living in another state. He feels very strongly about his beliefs to the point I would say of being entrenched.

This week's John Mauldin post devoted some space to the various entitlement issues and the notion of congress figuring out how to cut $61 billion in expenses versus a $1.6 trillion problem. As I read this and thought about my friend's posts I had a moment of clarity or perhaps better stated as a moment of simplicity which is that for so many of the country's problems the math doesn't work.

All of the reasons that someone might be pro-union might be 100% correct but the math doesn't work. Cutting $61 billion is expenses might be a win of some sort but in the full context of the problem does not itself represent any progress toward a solution. The retirement savings quandary that now exists (referring to the ridiculously low average savings that people have) can be thought of in one way as not understanding the math needed to make it work.

To the union issue, that there is not enough money for workers to get everything they have previously bargained for, that return assumptions are way too high and that the unions have dirty hands (as well as management) in the failures that have occurred would, I believe, be a conversation that my friend could not hear. If union leaders negotiated some sort of dollar figure 15 years ago (making up an example) that has proven out to be wildly unsustainable what should happen? I am not intending to make a political argument here. I can't say that a union doesn't deserve something they successfully negotiated for but if the math doesn't work then that means the math doesn't work.

In simplistic terms the math appears to be breaking down with all sorts of different things which makes debating these things along political or ideological lines futile. An analogy that is related to our fire department; for several years the community has been having a heated debate about whether or not to become a fire district (an entity with taxing authority) or remain donation based. One bone of contention is how much of a tax would be imposed. Related to the potential tax is what sort of service the community wants. On bit of advice that has been pretty consistent along these lines has been not to ask what service is wanted but how much people want to pay. We can have everything but the more service (really I mean paid personnel and new equipment) the more we will all pay. It is quite simple in that regard.

Well, we can have all the medicare, social security and union benefits we want. It's just that the more we want the more we will have to pay. I'm not arguing for more taxes from a belief standpoint, simply pointing out that there is a deficiency that exists. We either pay more or we get less. To the extent this holds water for you it argues all the more for staying on your own mat (self sufficiency). For me this means saving a lot, living below my means and having a job that I want to keep well past typical retirement age. For you, self sufficient could mean something completely different but either way we cannot rely on other people to get the math right, we need make sure that if nothing else our own math works.
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Sunday Morning Coffee

Just a few odds and ends this morning as I've got an incredibly busy week coming.

First up is from a profile in Barron's of a fund called the Goldman Sachs Technology Tollkeeper (GITAX). Here is a quote from one of the managers.

"We would rather own the tollkeeper than the bridge builder," says portfolio-manager Scott Kolar, 38. "Even if traffic doesn't grow, it can raise the price. That allows it to grow year after year without deploying more capital."

This line of thinking applies to actual toll road companies. This is a niche I've been interested in for several years now but unfortunately the space is too thinly traded for us to do any across the board activity. I own one of the Chinese toll road companies for a couple of clients and in one of my IRAs. These stocks are very capable of going down but the ones I've looked at seem to have steady businesses.

As far as the fund itself it is an actively managed fund with a very narrow mandate. This type of fund can work in a narrow based portfolio. GITAX will always be a proxy for some specific niche in the tech sector as opposed to a broadly managed fund which might be heavy in tech today but six months from now might own no tech, having loaded up on something else creating an unintended lopsided bet in a portfolio. To be clear I am not recommending the fund just pointing it out as an example of something I've talked about before.

Barron's also had an interview with Carson Block from Muddy Waters Research. If the name is unfamiliar he has made a name for himself calling shenanigans on a few Chinese companies that are reverse mergers. One example is a company called China Media Express Holdings (CCME). The company has an installed base of TV monitors installed on city buses and sells advertising on those monitors. Read the article but essentially not too many people in China know the company or have seen the monitors on the buses. Oops.

The story with many of these companies sounds great but these are much dicier than regular Chinese companies. You may think regular Chinese companies are unreasonably dicey, some folks do, I am not that worried, but I am telling you the reverse mergers are dicier still.

Lastly James Altucher had a post on his blog about living longer that was a long list of dos and don'ts with some interesting things that I had not thought of before. Included in the list was don't drink soda which I've mentioned occasionally for years now. It was a long post, well worth reading, but I would say the focus was preventative. Things like stress, poor diet and bad habits cause all sorts of problems for people and so James explored ways to minimize or eliminate these things from our lives. He gave an interesting example that captures the essence of column; if you knew you were going to die on December 15, 2020 in Springfield, IL you'd probably make sure you weren't in Springfield on December 15, 2020.

I am very big on reducing or eliminating stress. We've structured our life to avoid several different types of stress. Not having to deal with daily commuter traffic removes a lot of stress and more related to the topic of this web site living well below your means reduces many types of financial stress. You don't have to worry about large debt payments when you don't have debt. You don't have to worry about a large mortgage payment if you don't have a large mortgage and so on.

I would add a couple of things to James' to do list. One would be to get involved volunteering for something. This can give much more meaning to life and ideally would be a stress reliever from other things in your life (like your 9-5). The other thing would be to get a dog or two; they are great companions and sources for both humor and stress relief.
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