The fundamental issue is that some advocates are arguing which idea is better rather than focus on the execution of the idea. The “better mousetrap” approach assumes that Adam Smith’s invisible hand will somehow make investors better by merely changing their investment strategies. It ignores that investors continues to have the same underlying mind-set and self-control (or lack thereof) which lead to unsatisfactory results under the previous strategy.

If we assume the personal finance is the business of managing your own money, one could recite the saying often made in business: give me a grade B idea and grade A execution over a grade A idea and grade B execution any day. The prime example of this saying is Apple which has no special technology over its rivals but arguably executes it strategy more effectively.

I always find it dangerous to support an idea rather than to focus on execution of the idea.  I use both strategies and I would credit the success and attribute the failures of both strategies in my personal investing to the same factor- I either did or did not execute the strategies properly. I did not become a better investor over-night by becoming adopting one strategy over another.

Having said that, a properly executed passive investing is a more contextually appropriate strategy for investors with minimum time/knowledge and relatively modest assets to invest (for those exploring passive investing, try Canadian Couch Potato as an excellent start). But the “mutual fund-itis” which is increasingly present in the passive investing produce range (fee creep, passive funds which are not really passive, too many choice) means that investors face the same execution issues as active investing.

As the name implies, a barbell investing strategy is weighed at both ends with extremes of asset allocation with a thin to non-existent middle. One of the underlying beliefs of a barbell investing strategy, as with any asset allocation strategy, is to even out volatility. Philosophically, some argue, if we live in a world of volatility, we can no longer gauge risk accurately. How do you know if something is a moderate risk where a regime stands one day and falls the next-  do you listen to the risk management “experts” who look great backtesting but are equally inept predicting the future as you or I?

The barbell strategy’s underlying philosophy is that the market will do poorly or will do well. But it will probably avoid a cushy sideways movement for long periods of time. To this end, it takes extreme positions. If you are a fixed income investor, a barbell asset allocation involves investing in short-term government issued bonds on one end and long term, high yield corporate bonds on the other end. If the corporate bonds do not pay out, the investor still has the government bonds to rely upon.

If an investor is allocating between cash, fixed income and equities, a barbell investing strategy would recommend a large holding in conservative fixed income positions (short term, highly rated government bonds) and then a small holdings in extremely high risk/high reward equities with some experts recommending purchasing options and/or extremely leveraged positions (think triple-leveraged ETF’s as an example). Thus, on the thin wedge of the portfolio, the risk/reward proposition is relatively quite high but with a large buffer to mitigate against the entire portfolio suffering.

It is, admittedly, a strategy not fit for all. It requires real fortitude on the riskier end of the allocation. It is also a strategy that assumes the world/market will be an unpredictable place and the only outcomes are no risk/high risk. However, it does give some real food for thought when high-net worth advisors are pushing this strategy; it may indicate the new normal in the future is, by nature, an unpredictable and rocky place.

Before the credit crisis some economists told us to spend given that we had entered a golden age devoid of recessions. Now economists are urging economic policies that encourage spending when many households are trying to de-leverage; this strategy may give a short-term spike to the economy (and save some political jobs) but its like asking a poker player to go all in one more time with $100 left. Odds are this player will end up with nothing.

If we were all rational investors we would behave like well-run corporations- unemotional decision making based on the bottom line. While some economists are telling us to spend again, what are these same profit-making institutions doing? Refinancing debt at cheaper interest rates and hoarding money until one sees an economic trend one way or another. It is not very sexy and not enriching m & a starved i-bankers but that’s exactly the point.

On a societal level, this may not be a good thing in the short-term but expecting an economic recovery to occur so quickly defiles how economies work.  Sitting on cash in the short-term may be frustrating to economists but it may be a far more prudent course of action to shore up household balance sheets than jumping from investing trend to investing trend.

Makes one wonder if we should be following the advice of an economist who may make a decent salary or following the actions of well-run corporations that make millions and billions in profit?

The alternative to shifting a portfolio from equity to bonds is to shift from pure appreciation play equities (think tech stocks, gold and mining stocks) to blue chip dividend paying funds.  In the absence of any contextual factors, would a dividend yielding stock outperform bonds?

Let’s exclude government issued bonds (i.e. treasuries) from the equation given their yield is so low and concentrate on the favor of the year, the corporate bonds (whether high yield or, um, not high yield) versus dividend stocks.

In a head to head comparison, the yields are as follows:

Average corporate bond yield as of August 31, 2010: 3.8% (source: Bloomberg)
Dividend yield of the S & P 500 for 2009: 2.0% (it sat at 1.85% as of last Friday)
Dividend yield of the S&P High Yield Dividend Aristocrats Index (50 top dividend yielding stocks traded on the S & P 500): 3.7% (ETF’s which track this index lose some yield due to tracking errors; see this fund which tracks the high yield dividend aristocrats for example)

The nominal return of corporate bonds then is greater than the dividend yield of the S & P 500 or the high yield dividend aristocrats. However, the story does not end there.

You have to factor in the effect of taxes on return. Interest income is taxed at a federal marginal tax rate in the U.S. starting at 25% for anyone making over $33,951 to 35% for anyone making over $372,951 (I excluded the tax rate for anyone making under $33,951 and have forgone state and municipal taxes from this equation for simplicity’s sake). The dividend tax rate in the U.S. is 15% for a qualified dividends (for now; no one knows what is happening after 2010 when the 2003 tax cuts expire).

In Canada, interest income is also taxed at the federal marginal tax rate from 15% up to income of $40,790 to 29% for income over $127,061 (again, excluding the provincial taxes which, in some provinces, pushes the top marginal tax rate into the 40′s%). The federal portion of the eligible dividend tax rate does not exceed 15.88%.

The tax difference between interest from corporate bonds and dividends from stock is most profoundly felt as you move up the income tax bracket. The higher yield of corporate bonds over dividend stocks is, in some circumstances, only on a pre-tax basis.  In fact, under the current tax system, there is a strong argument that the higher your tax bracket, the more tax advantageous it is to be weighted towards dividend yield stocks over corporate bonds all things being equaled.

The tax disincentive of corporate bond is mitigated to a large extent by purchasing these products in tax deferred accounts. However, this fails to consider the other part of the equation- dividend yield stocks have consistently outperformed non-dividend yielding stocks. It is the possibility of lost appreciation, especially for an investor who has a long investing horizon, which makes opting too heavily for corporate bond in lieu of dividends problematic.

Having said all of that, investing is not an either or proposition. A shrewd investor should have both corporate bonds and dividend stocks in their portfolio.  For most investors, it becomes a question of portfolio weighting of the two products. If nothing else, this post should at least draw one’s attention again on the effect of taxes on returns. Good luck.

(some of you may have noticed that the look and feel of the blog has changed. This is temporary. My WordPress template crashed last week. A new format will installed soon.)

With such relative success, how then do these institutions and managers manage their money?

The following is the asset allocation of each of the 3 (current as of October 2010):

Harvard: 46% equity, 8% fixed income, 16% absolute return (read hedge funds), 28% real assets (real estate commodities and real return/inflation protected bonds), 2% cash

Yale: 26% equity, 4% fixed income, 28% real assets, 42% absolute return, 0% cash

Asset allocations among endowment/institutional investors can be a little more aggressive than the average investor because they need to constantly pay out the beneficiaries of the plan. The additional risk taken to achieve this return is mitigated somewhat by steady contributions. Even if the fund or assets under management has a bad year, they have some comfort in knowing money will still be coming in the door. Thus, read the above with a grain of salt.

Regardless, what is interesting to note is how small an exposure the managers of these funds have to fixed income (read this piece by Bill Gross on government bonds to understand why; yes, one of the most respected fixed income mangers in the United States calls government debt a ponzi scheme). Harvard and Yale have between them a 1% asset allocation to high-yield bonds.

Institutional investors are not always right. One wonders if a 42% exposure to hedge funds and private equity is a little too risky for many Yale alumni.  Investing decisions should not also be made on a sample size of two (albeit over $25 billion of assets under management). But it is interesting to note while the average investor is in fixed income, with a recent rush into high-yield bonds, the institutional investors have stayed away.

Their capital preservation strategy instead is focused on hard assets. Real estate is, to many, a surprising focus but, on this scale, it is typically commercial or industrial real estate. Safety in hard assets may be a comment on a preference on cap rates of assets people and businesses need over the solvency of governments.

Certainly food for thought and a different way of looking at capital preservation than simply a flight into fixed income.

The best and worst thing to happen to the investing public is the internet. It was provided us with research and information we otherwise would have great difficulty obtaining but it has given us collective ADD and a sense we should all become day-traders to be successful investors.

However, if you read a recent interview with billionaire T. Boone Pickens, his traditional investing horizon is 5 years (it is now 2 years for him because he’s 82 years old). 5 years is, arguably, even a short period of time for an investor with a 15-20 year plus investing horizon, remembering Pickens made his reputation as a corporate raider (now known as private equity post Gordon Gekko) and hedge fund manager- occupations not exactly known for patience.

If you looked at the interval of time between recessions in the U.S. since the end of WW II, the results are (in years rounded up), 3, 4, 3, 2, 9, 3, 5, 1, 8, 10, 6. In other words, even a minimum of 5 year hold period in a product or investing strategy would have outlasted or equaled 7 of 11 economic cycles of one recession to another since WWII. By jumping in and out under 5 years, an investor risks missing the run-up in a recovery or investing at the start of a down-turn.

(as a side note, note how much larger the last 3 numbers are to the first 8- the 9 year figure notwithstanding. It tends to show how historically anomalous the period of 1982-2007 was and how “normal” a recession should be in the natural economic cycle of any nation. In other words, hyperbole of a possible 2nd recession tends to ignore historical realities)

The exception, as Pickens referred to, is if you have a short investing horizon a minimal 5 year period may be too long.

The long and the short of it is that it is not so much that a strategy is misguided but a poor investor does not give any strategy or product enough time to come to fruition. It is analogous to, short of a disaster, cutting a first date short halfway through dinner and deciding he/she is not worthy of a second date. How you know with such a small sample size?

Investing horizons also becomes a great litmus test for the quality of an investment advisor. If he/she cannot stick to a prudent strategy or product they recommended to you for 5 or more years, it may show they are merely salespeople churning through your portfolio for commission.

Part of problem is that we are impatient investors. The other problem is that we are dabblers as people. Just as many resolve to attend the gym/eat healthier/be better people on the turning of each calendar year, a large group of us also make half-attempts towards these goals and then give up due to resistance, hard work, unrealistic goals etc. As Napoleon Hill, author of Think & Grow Rich, wrote: “Spasmodic or occasional effort to apply the rule will be of no value to you. To get results, you must apply all the rules  until their application becomes a fixed habit to you.”

The issue becomes then, as well intentioned as someone may be towards self-improvement, how do we stick to it?  One method I have used recently is an accountability partner.

Very simply, pick someone who has the same drive and determination to reach a goal as you; their goal may be different or the same. Write down the goal(s) and how you intent to achieve this goal. For example, your goal could be to reduce your personal debt by an additional $5,000 in the next 12 months; in order to achieve this goal, you will have to make an additional $96.15 payment towards week towards paying down debt. The key though is to pick a reasonable goal. If you are unemployed, it would make little sense to agree to a goal to reduce debt by $5,000; perhaps a more realistic goal in this context would be to make 3 calls/meetings a day to find a job.

At an allotted time each week/month (or whatever interval is appropriate), have one of you call the other and report on your progress. Here’s the key- you have to be honest and your accountability partner cannot take your missing the goal with indifference. Just like a good coach, they have to make you feel uncomfortable and, quite frankly, bad that you missed your goal. Since your partner has a goal in mind too, there’s a certain embarrassment factor if your partner is well on their way to the goal while you are not.

To raise the stakes slightly, pick either a positive reinforcement reward or negative reinforcement punishment if you fail to meet your goal at the end of the period you set out. A positive reinforcement goal is you get something if you reach your goal. For example, you can take yourself and your significant other to a nice dinner if you meet your goal. A negative reinforcement is something is taken away or you are forced to do something you despise if you fail to reach the goal. For example, you have to engage in public speaking, a fear for most people, if you fail to meet your goal.

Sound like a lot of hard work and a lot of pain? That is exactly the point. It is hard to reach the next point in any aspects of life without some discomfort.

The goal is to pick a partner who will hold you accountable and to put an honest effort on the goal. One wonders if investment advisors could become accountability partners in order to prove that they provide value.

Good luck.

Using a very small sample size of the stock market recovery in the Swedish OMX exchange in the 12 months after the dot com bust, the researchers attempted to look at factors such as price to book ratio, price to earnings ratios, enterprise value/EBIT, debt levels and dividend yields and applied these financial ratios and factors to the study group to determine if tracking any one ratio would give an investor insight into which stocks would out-perform the market in the preliminary stages of a recovery.

The findings came down to three factors which they stressed should not be read together:

1. 12 month trailing performance. The worst the stock performed prior to the market hitting bottom, the more likely it would outperform the market during the recovery period.
2. High dividend yield stocks. Stocks that paid high dividend yields during the downturn tend to out-perform the market during the recovery.
3. Price to earnings ratio. Low p/e stocks tend to do better in recoveries but is a factor with less weight than the other two.

The sample size and study group are far too small to draw any definitive conclusions but the above does make sense. Given that poor performing stocks, which one assumes have lower p/e ratios than their peers with healthier balance sheets, tend to a longer ways to go to recover than stocks that went sideways during the downturn. Thus, when the recovery starts, the relative and absolute bounce is greater than their industry peers.

As for dividends, the paper did not address what a “high” dividend yield was or how high was too high. But, similarly, their findings do make sense. A dividend yielding stock that can maintain its dividend during downturns shows the market that it has its house fundamentally in order and, assuming that investors are more cautious in the embryonic stages of a recovery, there may be an initial overweight towards safer dividend paying stock when cash goes back into equities.

Applied against the run-up since March, what are we to make of all of this? Certainly, low p/e stocks in financial services and oil/gas have made a recovery, returning most of the paper losses for those who hung on. The dividend paying stalwarts of the market also seemed to have held on and done quite well since March.

But, with the S & P 500 p/e ratio at approximately 18, have we already peaked on the stock market recovery?  The stocks that under-performed may have already risen if the S & P p/e is approaching 20 and there may not too much more upside. Contextually, historical p/e is in the mid-teens and a p/e at 20 has never been sustainable for long periods of time.  Predicating the future is a mug’s game but food for thought.

The entire paper on stock market research is certainly very interesting and quite an accomplishment for an undergrad paper.

Gold, unlike silver or copper, has no industrial usage. In fact, other than for purely cosmetic purposes,  it has no utility which could at least justify an inherent floor price of the commodity. Having said that, gold is the closet thing to a universal currency. If you were in the Republic of Benin, you would most likely get room and board with physical gold; I am not as sure if you tried to pay with USD you would have the same success (especially lately). Obviously, there is also a huge market for gold in the jewellery industry and it is a highly desired luxury for most cultures.

However, it is the concept that gold is a universal currency that makes it, in some respects, better than a money market fund as an investment. When paper currencies that the developing world recognize as the standard falters (i.e. the USD), the markets rush to gold since its underlying value is not dependent on policy decisions of governments or their relative solvency.  As confidence wanes in paper currencies, governments typically resort to printing more of it which only accerlerates gold’s demand since you now have inflationary pressures on paper currency as well and gold is a good hedge against inflation (see below).

The end result is that, in bad times, gold serves as an able substitute for cash. As Jeremy Siegel found, a $1 invested in gold in 1802 would yield $32. 84 in 2006. It serves to protect the value of the $1 invested which, if kept in cash would be worth considerably less than $1.00 due to inflation. But as Siegel also points out that is all gold is: a good protection against inflation.  But, the opportunity costs of investing in gold long-term in lieu of other investment classes is enormous.

Like everything else in investing, gold has its time and place. I would not dismiss the fact it has no utility as a reason not to invest in it. Whether most of us like it or not, I call gold the irrationality hedge. The more irrational the markets get, the better gold is a hedge against such irrationality. The extreme example being times of war. What are governments doing in war? Most are stock-piling or stealing gold from where-ever they can get it.

Does this defy some well-reasoned argument why anyone would want to invest in a commodity that really does nothing other than look pretty? Of course it does but is the market that rational? I suspect the last 9-12 months is a walking argument that the market is not rational.

However, when such irrationality ends (and it always does), one should move out of gold. It is, and should be used, as nothing more than a short-term cash substitute and a hedge against inflation.

The argument that anyone should have substantial portions of their portfolio in gold defies any type of long-term prudent portfolio management. If the world is so bad that gold prices are astronomical, does the size of your portfolio really matter compared to, say, imminent threat of physical harm to one’s self and their family? Investing vast percentages of your net worth in gold long-term due to impending economic armageddon misses the practical point that a net worth calculation probably doesn’t matter anymore when your primary need is survival and self-preservation.

At the end of the day, substitute cash for gold. You would only hold cash/gold in your portfolio in the short-term and during times of uncertainity. Holding a large portion of it or holding it in the medium and long term will generally not serve a prudent long-term investor well.

Thus, in an industry pushing more and more product, how many ETFs is too many ETFs in your portfolio?

Let’s look at the “why” question first. Why are you investing in an ETF based portfolio? Primarily, an ETF portfolio allows the investor low cost, diversification and an ability to re-balance from time to time. The question of “what” or “how many” should always be answered by referring back to the answers to the question why.

I am going to answer the “what” and “how many” without specifics to a product. Product is product. The primacy of strategy should always be top of mind rather than on product. More practically, Canadian Capitalist does a superior job commenting on ETF product and reference should be made to his blog.

Instead, my post addresses whether you may be committing mutual fund-itis by buying too many ETFs by analyzing each asset class.

CASH

An ideal ETF portfolio should not be a fully invested portfolio. After all, one of the reasons why you build an ETF portfolio is to re-balance periodically to capitalize on market weaknesses and to prevent a drift away from diversification. Always keep cash around to utilize this advantage fully (good advice no matter what your investing strategy). How much? This is subject to some debate. I like keeping 5-10% of my portfolio  in normal times and between 10-15% in volatile markets.

FIXED INCOME

One could achieve significant fix income diversity by 3 fixed income ETFs although 2 is probably a better number. If you want full coverage without too much duplication, consider: (i) a government bond ETF (short term for greater predictability); (iii) corporate bond ETF; and (iii) real return (aka TIPS) ETF for inflation protection.

If you opt for two fixed income ETFs, and assuming you want some margin of safety, consider looking at a short-term government ETF and real return ETF. If you want to be more aggressive, then substitute the government ETF with a laddered corporate bond ETF (bond laddering is a fixed income strategy where one purchases bonds that mature at regularly internals- for example, a portion of the portfolio matures every year) and a real return ETF.

What about preferred shares ETFs? As a hybrid debt-equity instrument, it can be classified as fixed income given it pays set distributions. However, preferred shares are typically issued by financials and utilities which constitute large portions of mature equity indexes. Thus, if a financial or utility hits a rough patch, it could adversely impact your equity and fixed income holdings if you hold both preferred share ETFs and a board based equity ETF. Since one of the advantages of an ideal ETF portfolio is diversification, it is arguable that loading up on preferred shares ETFs is defeating this purpose if there is a large equity holding in a ETF portfolio.

EQUITY

The portion of equity in your portfolio depends on your risk tolerance and investing horizon. The larger your risk tolerance and the longer your horizon, the larger portion of your portfolio should be in equities (typically, the formula is 120- your age should be your holdings in equities but a safer formula is 100- your age).

Depending on where you live, you may want to consider 3-4 EFTs: (i) and (ii) 2 ETF’s tracking the major North American equity index (typically S&P 500) and a major European/Asian equity index (typically the MSCI EAFE Index); (iii) an ETF tracking a LARGE emerging market index (as opposed to country specific); (iv) Canadians like purchasing ETFs tracking the TSX (which is really a financials, energy, materials index) OR, if you do not like the TSX, an ETF tracking a mid-cap or small-cap index (if you have the stomach for it).

It is in this portion of a ETF portfolio that mutual fund-itis usually occurs. People buy dividend paying ETFs, BRIC ETFs, ETF’s tracking specific countries or industries (I am still giggling about the ETF that tracks airline stock; might as well buy a distressed debt ETF to hedge against your loss now). Since dividend-paying stocks constitute large portions of large equity indexes and stocks issued in BRIC countries may also constitute holdings an in emerging market indexes, duplication is occurring and, again, the goal of diversification is being defeated. Having said that…

FUN MONEY

ETF investing can arguable be boring: it is quite passive and you aren’t rooting for one company in general, you are rooting for the indexes. Thus, if one has a long investing horizon and wants some excitement, one could take 2-5% of their portfolio and basically take a risk on something high-risk, high reward ETF (bio-tech, wind power etc.) keeping in mind: (i) the ETF could lose a lot of its value; and (ii) fun money should be kept a very small portion of your portfolio.

In summary, one should consider:

1. Cash
2. 2-3 Fixed Income ETF’s
3. 3-4 equity ETF’s
4. Fun money ETF (if you can handle the downside risk).

But the key is that each of the ETFs are tracking broad based indexes rather than narrow indexes.

Anyone have any thoughts on how much is too much in ETF investing?