Recessions, Corrections and Bears (Oh My)

1. The probability of a US recession in 2008 continues to rise with Intrade putting the probability at 47%. Goldman puts those odds at between 40-45%.Meanwhile Former Secretary of the Treasury (and former Harvard President) Larry Summers thinks a recession is 'likely':
2. But, usually we don't know about a recession until after it is over:
3. The US market entered correction territory (10% downturn) for the first time since11/02-3/03:
4. The Shanghai stock market officially entered a bear market (20% downturn):
   

In such a market environment, having lower volatility assets in your portfolio is incredibly valuable. We continue to be optimistic about the growth story of some of our key stocks and about the fundamental value of an Endowment style asset allocation model.

Hat Tips: Bespoke, Ticker Sense

Currency Harvest ETF Looks Promising

The Powershares G10 Currency Harvest Fund (DBV - PDF Fact Sheet) has steadily gathered assets and has performed very well so far this year with a YTD return of 13.22%.


Here's the definition of what the fund does from the PowerShares website:

The Index is comprised of currency futures contracts on certain G10 currencies and is designed to exploit the trend that currencies associated with relatively high interest rates, on average, tend to rise in value relative to currencies associated with relatively low interest rates. The G10 currency universe from which the index selects currently includes U.S. Dollars, Euros, Japanese Yen, Canadian Dollars, Swiss Francs, British Pounds, Australian Dollars, New Zealand Dollars, Norwegian Krone and Swedish Krona.

The current portfolio is long the Aussie Dollar, New Zealand Dollar and British Pound and short the Japanese Yen, Swedish Krona and Swiss Franc:
Throughout the year, the weightings of each commodity component in the Index will naturally change based on changes in the underlying futures prices. The Fund's underlying holdings are rebalanced to the Index's base weights.

What I find particularly attractive about the index performance is that it has performed very well in tough years for the stock market and it only has one negative year on its record:


We are continually evaluating new ETF offerings, and this is another example of a fund that appears to offer good currency exposure for buy and hold investors with limited tolerance for volatility.

BHP Billiton: A Great Commodity Play

BHP is the world's largest diversified resource company and is dual listed on the London and Australian stock exchanges. Its roots date back to the 1800's but it has existed as BHP Billiton since 2001 following the merger of BHP with Billiton. The company maintains its headquarters in Melbourne, Australia. BHP explores for, mines or produces the following commodities: Petroleum, Aluminum, Base Metals (silver, zinc, lead, uranium etc.), Carbon Steel Materials, Diamonds, Energy Coal and Stainless Steel Materials.

The company has benefited greatly in recent years from rising commodity prices and will in all likelihood continue to do so in the future. While I do like some of BHP's rivals, namely Anglo-American (AAUK) and Rio Tinto (RTP), I think BHP is the best of the bunch. The company has fatter margins than its rivals and trades at a forward PE of 15 even after its dramatic rise over the last 5 years, when it has been up 488%. While I prefer using commodity futures to get direct commodity exposure, a company like BHP can get similar exposure with some idiosyncratic risk.
BHP is up over 72% this year, RTP is up 45% and AAUK us up over 32%. It has been a hot sector, which makes me a little bit nervous. But, I still think rising demand for commodities from China, India and elsewhere make the sector a good value even at these prices.

Emerging Market ETF Options

Vanguard's Emerging Markets ETF (VWO) is beatings its iShares rival (EEM) by 3.18% YTD. Vanguard's VWO is up 23.87% on the year, the MSCI EM Index is up 22.31% and EEM is up 20.89%. Since both funds supposedly track the same index -- the MSCI Emerging Markets Free index -- the high tracking error is bad news for both companies, but is particularly bad for iShares as investors typically are more accomodative if the tracking error leaves them ahead. The Vanguard fund has one other advantage, its expense ratio is 0.30% vs. 0.75% for the iShares fund. But, in spite of these apparent advantages the iShares fund is still 9.5 times larger than the Vanguard fund, proving once again that it is notoriously hard for ETF providers to make up ground on the market leader. We were early adopters of the iShares EEM ETF but are currently looking at VWO as a viable alternative.

The source of the difference may well be the allocation of each ETF to each emerging market country. If you look at the Vanguard fund you will notice that it has slightly more exposure to India, Russia, Brazil, Taiwan and South Korea and less exposure to Mexico, South Africa and China.


While I don't think that the VWO outperformance will necessarily persist, its low expense ratio is attractive. The iShares fund has to beat Vanguard's VWO by 45 basis points a year in order to overcome the difference. That alone may be a good reason for the switch. Since we usually supplement our MSCI EM exposure with country specific ETF's the specific country allocations become less important and the need to obtain cheap beta more important.

Asset Allocation with Commodities and TIPs

In a post from June 8th about Bill Gross I discussed the importance of commodity and TIPS exposure in a portfolio. Today's market provided a brilliant example of why commodities and TIPS work as diversifiers. In a day where most equity indexes were down over 1% two ETF's performed quite well: the Powershares DB Commodity Index (DBC) and iShares TIPS (TIP).

1. iShares TIPS (TIP) +0.79%
2. Powershares DB Commodity (DBC) +0.68%
   
3. Dow -1.09%
4. NASD -1.15%
5. S&P 500 -1.41%

Clean Energy and Water

Two ETF offerings from PowerShares -- PBW and PHO -- have been core parts of the commodity allocation of our portfolios over the past 12 months and have performed very well.

We started buying the Powershares WilderHill Clean Energy ETF (PBW) around this time last year when the fund was trading in the 17's. At the time the fund had retreated almost 40% from its high on the year. It is up 28% so far YTD and we continue to feel that it is still well positioned to take advantage of investor interest in clean energy technology. It has accumulated roughly $900 million of investor money.

We started buying the Powershares Water Resources ETF (PHO) in 2006 as well, accumulating when PHO was trading under $19. The fund is up almost 16% YTD and has accumulated $1.54 billion of assets.

We still like PHO but we are currently analyzing a new Powershares ETF called the Global Water Portfolio (PIO). The fund just launched and only has $47.79MM of assets but due to its global slant it may be more attractive in the long run than PHO. The two ETF's are actually very similar and share 13 of the same holdings, which is about a third of each fund. (Shared holdings are highlighted, click to enlarge.)

The main advantage of PIO is that it offers broader international exposure. It has holding in Japan, the UK, Singapore, Canada, China, Austria, Germany, France and Finland as seen below:
I wouldn't be surprised that if PIO attracts enough assets it will show up in our portfolios sometime later this year. We have also looked at the Claymore Global Water ETF (CGW) and the First Trust ISE Water Index ETF (FIW).

How much Australia Exposure do you have?

In the chart below I graphed the performance of 4 prominent Asian stock market indexes -- Japan, Malaysia, Hong Kong, Singapore -- and Australia over a 5 year period. If I had taken a survey to see if investors thought that the Asian countries or Australia was a better market to invest in over the past 5 years, I would bet that most retail investors would put their money on Asia. Here is the list from worst to best:

1. US - S&P 500 - 5.7% CAGR
   
2. Japan - DJ Japan - 11.91% CAGR
3. Malaysia - DJ Malaysia - 14.7% CAGR
   
4. China - DJ Hong Kong - 15.8%
5. Singapore - DJ Singapore - 19.2% CAGR
   
6. Australia - DJ Australia - 23.3% CAGR
   

So what is the lesson here? Well, for starters proper asset allocation hopefully gave each of you exposure to these and other emerging markets in your portfolio. If you didn't have adequate exposure to this area your returns have probably lagged over the past 5 years. Today with companies like iShares offering more and more invidual country ETF's you can get more precise exposure to countries that are well positioned for growth over the next 5-10 years. Even though Australia (EWA), Singapore (EWS) and Malaysia (EWM) have all been hot for some time I believe that all three will continue to benefit from the explosive growth of China and India. The downside of course is the volatility.

A Word of Caution: Country-specific ETF's are not for the faint of heart. Expect some sort of major emerging markets pullback in 2007 along the lines of that which we experienced in the summer of 2006. That pullback very well may be a good time to start developing a longer term emerging markets position.

Eugene Fama on the Keys of Investing

Eugene Fama, the ultimate random walker, has a video on the Dimensional Fund Advisors website in which he gives advice to investors. I encourage you to view the video in its entirety here. Here is a quote of the most important advice:

"The evidence is quite clear. If you do any systematic analysis of investment performance what you find is people basically get return for risk and then from that you subtract fees and expenses. It is the costs that basically determine deferentials in portfolio performance. Active managers charge more so they tend to do worse. But, that doesn't mean people will stop doing it. Especially MBA students, all the ones that want to be portfolio managers want to be active managers naturally since if they're lucky and they win they end up rich. And that is very, very attractive to them so lots of students in my class even end up being active portfolio managers. I don't know where they learn how to do it though. The evidence is also clear that what does matter in portfolio strategies is asset allocation. The choice of stocks versus bonds and within stocks a tilt toward value and a tilt towards small. Now those are basically the decisions you face, plus international diversification is another aspect of it."

I agree with Eugene in large part, though I'm sure most Hedge Fund managers would watch this video and laugh all the way to the bank. I was a little bit disturbed by the fact that international diversification seems like such an afterthought to Gene as I feel it is such a pivotal part of portfolio construction. I also personally feel that utilizing other asset classes -- such as REITS and commodities -- can be very valuable in portfolio construction particularly as a means to dampen volatility and drive returns during prolonged market downturns. It would be interesting to ask Gene his opinion on that question in person. It might be a while before I get that opportunity . . .

Merrill Lynch is Bearish on the Economy

I wrote a few weeks back about Alan Greenspan's recession prediction. Well it seems that Alan isn't the only one predicting a recession these days. Merrill Lynch issued a research report last week that came to the same conclusion. You can read the report here. They are urging Bernanke to cut interest rates this year to avert a recession.

The bottom line of all this is that it is becoming increasingly likely that a decline in home prices could lead to a recessionary environment. Therefore, following the leading housing indicators will be very important this year. As an investor facing these economic predictions remember that there is no replacement for a disciplined multiple asset class investment strategy. Don't let predictions scare you into changing your portfolio allocations. Not even Alan Greenspan and Merrill Lynch can see the future.

Is Real Estate a Good Investment?

I've had a lot of people ask me whether or not residential real estate is a smart investment. Of course the question is usually couched liked this: "I only invest in real estate because it is the best investment, don't you agree?" Because I'd rather not ruffle too many feathers I usually just respond "it depends." The bottom line is that we just experienced a decade long real estate boom. No one wants to listen to anyone say that residential real estate should just be a home, not a retirement plan and certainly not the place to keep your entire nest egg. Three years from now I suspect this will be an easier conversation.

Instead of giving you my own long winded thesis on home ownership I will just refer you to a couple of charts and a great article from David Crook. Mr. Crook (great name eh?) is the Editor of the Wall Street Journal Weekend Edition and is the author of a great book entitled "The Wall Street Journal Complete Real-Estate Investing Guidebook." He's a smart guy, I just wish more people would listen to what he has to say. You can and should read the article in its entirety here. To whet your appetite check out this graph from the article.


I always say why present a case with words when you can accomplish much more with numbers. Well below you will find two graphs. Click each one to enlarge.

This first graph shows the annualized rate of return to stocks and real estate over 5 years from 2001-2006.

This second graph shows the annualized rate of return of stocks and real estate over thirty years from 1976-2006.
Remember, investing is about strategic asset allocation, rebalancing and time invested. The last time I checked most assets move in cycles. Over the past decade real estate has boomed, which tells me that real estate returns should revert to their longer term average over the next cycle. However since you live in your home it is hard to "rebalance" it as a part of your overall portfolio and perhaps even harder to make unemotional financial decisions about it. Therefore real estate should be a part of your investment strategy/retirement plan, but it probably shouldn't be your entire investment strategy/retirement plan. Remember diversification across asset classes works because we simply can't predict which asset class will outperform over the next 5-10 year period. If we knew that then we would sell all of our other investments and buy that one asset and hold it for 5-10 years.

I would love to hear comments or suggestions.

An ETF Primer

For those of you who stay up to date on the financial markets I'm sure you have watched with wonder as ETF's have gone from obscure investment product to a position of relative prominence in the industry. For those of you not in the know perhaps a quick brush-up is in order.

An ETF, or an Exchange Traded Fund, has the following features:

1. ETF's are listed on an exchange and thus trade like a stock (High Liquidity)
   
2. When you buy one ETF you get access to a basket of securities (Diversification)
3. An ETF typically tracks an index or an intellidex, and as such it is not actively managed (well at least not yet . . .).
4. ETF's are tax efficient and have very low fees.

While this is by no means an exhaustive list of the traits of ETF's it should be enough for many of you to realize how advantageous these instruments can be for the average investor. In fact many of the top pro's (like Yale's David Swenson) in the industry are now recommending ETF portfolios to the average investor.

For years mutual funds were the standard way to get diversification in a portfolio. When you buy a mutual fund you pay a front end load to get in and then an annual management fee around every single year. The idea is you pay a smart money manager to manage your investments, benefit from being diversified and hopefully get better returns as a result.

One problem; mutual fund returns after expenses underperform the market. In all my reading I have yet to find an economics article in a peer-reviewed journal that has been able to convince me that mutual fund managers are able to "Add Alpha."

The solution: if you can lower your fees, create more tax efficiency and access markets that were previously inaccessible to the average investor, and do all of this using ETF's, it seems like a no-brainer. Unfortunately that isn't the end of the story.

ETF's have trading costs and can suffer from tracking error. They are not great for every investor. They are perhaps best for lump sum investors with a buy and hold philosophy rather than for those making systematic contributions or who actively trade.

I suggest you brush up on the basics using the following resources and we'll pick this up again next week. Feel free to fire off any comments/questions.

• Read the good news about taxes and the balanced view on taxes.

• Read about how well ETF's do at tracking their indexes.

• Read about how ETFs give access to new markets.