Portfolio Balancing, Part Two

Even if you have 20 or 50 million dollars and several homes and other physical assets, a 1929-32 or 2000-2003 bear market could have reduced your investments to a solitary million, or worse, if you were leveraged and had mortgages and other debt as well. I personally know of one casualty of this magnitude, but there are stories everywhere about other people like the one person I knew.

My own awakening three to four years ago was realizing that low versus high volatility funds, or income versus capital gains funds, were a better way to diversifiy than simple bond versus stock portfolios which the marketers trumpet.  There are a lot of income funds which are run more or less like hedge funds. In this sense Dodge & Cox's Balanced Fund (DODBX, since 1931) is an income fund, and so is Vanguard/Wellington's Wellesley fund (VWINX). Both feature bonds of variable duration (maturity)and stocks paying high dividends or with superior growth. Since 1988 Wellesley Income Fund has returned 7.3% and Dodge & Cox Balanced has returned 10.6% annually. Berwyn Income Fund (BERIX)is another slighly more complicated balanced income fund which I like. Hussman Growth Fund is variably hedged in mid caps, but it also captures the short term interest rate on top of its hedge record. HSGFX returned over 13% per year from 2000 to today.

The other low volatility income fund development is in bond funds themselves. There are a lot of bond categories other than Treasuries and high-grade corporates: high yield (junk) bonds, foreign developed country sovereign bonds, foreign emerging market bonds, quasi-bond convertibles, and high yield municipals, among others. As in any other area of investment, there are people who are experts and who win consistently. Many of these categories trade more in line with equities but in a less volatile manner. Some of my favorites are Loomis-Sayles Bond Fund (LSBRX or LSBDX), Hussman Total Return Fund (HSTRX), and Vanguard hi-yield municipal bond fund (VWAHX or VWALX). These are funds with excellent long term management and performance in these challenging but rewarding areas. Pimco's Asset Fund (PAAIX or PASDX) is another income allocation fund much like a hedge fund and advised by Robert Arnott, but it has several layers of cost as it is a fund containing other Pimco funds.

To traditional investors these low voaltility income funds may sound exotic or risky--they did to me--but these funds have been around and have proved themselves over several decades. And they have very low cost structures compared to hedge funds which they emulate. They have returned 9-12% annually over the past 18 years with low price volatility or downside price loss. Funds of this type, including Wellesley, Dodge & Cox Balanced,
Hussman Growth and some of the others have become 70% of my overall retirement portfolio.

But we also need some exposure to volatility for long term capital growth and inflation protection. For that 30% of my total portfolio, I have divided it into six sectors which can be hot at different times: small caps, mid caps, globals, health, resource, and volatile incomes, about 5% of total portfolio in each.

In the small caps sector I have a new strategic Vanguard fund, VSTCX, paired with Perritt Micro-Caps, PRCGX. In the mid caps sector I really like Fairholme Fund, FAIRX. In the global sector I have my all-time favorite, First Eagle Global, SGENX or FESGX. In the health sector, I like mainly Vanguard Health Care VGHCX and a much smaller piece in Fidelity BioTech, FBIOX. In the resource sector Vanguard Energy and Vanguard Precious Metals, VGENX and VGPMX, and a few individual stocks. In the volatile income sector Vanguard REIT, VGSIX, and the Vanguard Utility ETF, VPU, or their mutual fund version, VUIAX work. All of these have excellent returns and do not all go up or down together.

I ran a simulated study of six low volatility and six high volatility stocks first from September 1, 2000 to March 11,2003 and then from March 11, 2003 to June 9, 2006. 70% of the portfolio is made up of equal amounts of the six low volatlity funds, and 30% is made up of equal amounts of the high volatility stocks. I added the annual total returns for each of the two major categories. Then I multiplied the categories by 0.7 (low volatility) or 0.3 (high volatility) and summed these. From 2000-2003 the total annualized return for the whole portfolio was 7.05% of which 0.7 times the 5.24 annualized total return was 5.24% from the low volatility funds. The six high volatility funds added 1.82% in total returns(6.05% times 0.3) for a grand total of 7.05% annualized total return during the worst bear market in a generation. Even though the SPX dropped 49% (-21.7% annualized) from its 2000 high to the March 11,2003 low, the simulated 70/30 portfolio gained 7% annualized.

Using the same approach and funds, from March 11,2003 to June 9, 2006 the low voalitilty funds contributed 7.44% annualized to the return (10.62 times 0.7) while the high volatility funds contributed 8.91% (30% of 29.7) for a grand total of 16.35% per year for the portfolio. SPX gained 15.28% during the same period.

For the whole period from September 1, 2001 to last Friday, the low voaltility funds returned 9.21 times 0.7 or 6.45% to the total, and the high volatility funds returned 19.91% times 0.3 or 5.67%. The total annualized return for the portfolio was 12.12% per year. The Vanguard Institutional class S&P 500 fund (VIIIX) with very low cost and with all dividends reinvested had a total annual return of -1.49% per year from September 1, 2000 to last Friday. 12% annualized returns for ten years takes $10,000 to $33,000, and by taking profits and rebalancing you would not have needed ANY market timing with this type of portfolio, even with the worst bear market in decades raging during the first half of the study.

Obviously I did not have this whole 70/30 portfolio at the time, and no one did. Husssman didn't even begin operations until 2000. I did own some of these funds, particularly the inflation sensitive metals, energy and real estate funds due to my Kondratieff bias beginning in 1999. I also had Dodge & Cox. The others are ones I discovered  while looking for low volatility gainers. But as my studies evolved over the past few years I have come to own all but one of them now and will add the one I don't have. (In my own account I have given Hussman Growth HSGFX a double weighting to the other low volatility income funds.) The point of the study is to demonstrate that low volatility income funds with good managements can reduce the volatility of a high beta capital gains portfolio, such as my 30% portion. Even the high volatility funds tend to have consistent gains but gains are of course much lower or absent during a severe bear market when the income funds are pulling the portfolio cart.

The fund keys are MANAGEMENT, CONSISTENCY, and LOW VOLATILITY. Two internet websites which have been of great help to me in finding such funds are  http://www.fasttrack.net and http://moneycentral.msn.com/investor/research/fundwelcome.asp?Funds=1
FastTrack also has a splendid program which they sell, or sell the data for, but their free total return charts at their site are fabulous. FastTrack also will let you use their program and data for a month for free with no credit card disclosure. MSN also has a good free chart program one can download.

The two FastTrack charts below show the entire investment period, 2000-2006, one with the low volatilty funds, the other with the high volatility funds. For the study I made separate charts for each period, but these two will suffice to give you the flavor of the results as well as of the FastTrack program I am evaluating on their free trial.

Getting back to the fund study, I have mentioned in an earlier article that many of these funds have substantial foreign holdings, so despite the fact that I have only 5% in globals, the overseas markets are well represented overall. Many US funds now routinely contain world stocks in both general funds and in sector funds. The fact of the matter is that foreign and niche stock sectors, like the  30% of my portfolio, are much more volatile than seasoned large caps and US bonds. They tend to outperform greatly for 2-5 years and then lie dead for ages. They have been hot for five or six years now, so they may be due for a rest. This fits with my concept, which I have presented here at the blog, of an interlude in the Kondratieff Wave inflationary bull market. The important thing is to think long term but use intermediate term changes to adjust long term investments and trading. Gold and commodities may have peaked and the dollar and US bonds may have bottomed for a while, as I have previously suggested. We don't need to go overboard and dump or change all investments, but we can adjust them and take profits in extended niches and markets, which I have done. In fact I have made very few changes except to take profits in the metals, energy, and international sectors as a rebalancing exercise.

In this fund study I left out of consideration gold bullion coins and bars and silver which are held separately as a long term asset, like my home and other personal assets. They are a part of the larger picture but not immediately relevant to retirement investment planning.

Regard all of this series, and this whole site, as my diary of investment and my technical approaches to analysis. I am not and do not want to be an investment advisor, and am merely telling you what I am thinking and doing, for what it's worth. Do your own homework and due diligence.