Introducing My ETF Portfolio

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John Crossman submits:

My partner and I decided to set up a small business in 2008 which would help people invest. We grandly decided to call it Independent Research Partners and in keeping with our Asian roots, we called our product "Fund King". The name was inspired by and sounds similar, in Mandarin, to our company name in Chinese.

Our original concept was to help Taiwanese investors navigate through the maze of nearly three thousand mutual funds that are licensed for sale here. While Morningstar does have a fledgling presence here, no one is really looking at the investment universe as a whole. As a result, clients are confused and their investment results have been less than stellar of late (actually since about 2005).

And what do the clients want? Having worked with Taiwanese customers extensively for many years, we were already well aware of their main criteria: "Make me money!" OK, perhaps a bit blunt but then again, isn't that why people invest? Our experience over the last 18 months has convinced us that the criteria remains unchanged.


So why ETFs? After getting the Taiwan Fund System set up, a number of our clients asked us if we could apply our "System" to other markets. Since our System was designed to work on international mutual funds, it was not a very big step to substitute ETFs.

A system, you say? Yes, but we think our take on it is a little different from your average turbo charged quant product. We wanted a system that would work for a wide variety of investors, all of whom have different long term investment goals.

How do we approach things? In a fairly standard manner, with a few twists. We divide the investment process into two parts: Asset Selection and Asset Investment.

Asset Selection - In this first part, we define an "asset universe". To make this more concrete, I will share my asset universe at the end of this post and track it on a weekly basis. The idea behind the "asset universe" is to pick assets that I would like to own under a variety of investment conditions. Sometimes, Gold is hot...at other times, it might be China or European stocks or Government bonds. The key thing is to pick assets that YOU feel comfortable with.

Comfort level is as important as investment case because we are trying to reduce the emotional component of investing to the lowest possible level. To demonstrate, when I first set up my ETF Portfolio (35 ETFs) in early 2008, I included [[EWP]] and [[XHB]], Spain and Home Builders respectively. At the time, I thought that these two asset classes had been clobbered and would bounce strongly at some point in the future. I was right of course but when the System flashed a switch into them, I hesitated.

More importantly, I made the same mistake twice. In each case, I ignored the system at first, panicked and bought after the ETFs had risen and then, after the system recommended a switch into more promising assets, I hung on for too long hoping to get back to even. By picking assets that were "marginal" for me, I managed to defeat the system that we had spent so much time building. The hit to my pride was much bigger than the monetary hit, fortunately.

So, I went back and took out the assets that others had suggested were a good idea or that I had added to make my portfolio more "balanced". US Microcaps are a good example. Is there anything wrong with them? No. Will they outperform at some point over the next two or three years? I am pretty sure they will. But when IWC's number comes up, will I hesitate and second guess? Hmmm...Let's make room for something I am more comfortable with.

Asset Investment - Now that we have a universe we are comfortable with, how do we go about investing in it? Rather than follow the traditional method of spreading our money as thinly as possible and rebalancing on a regular basis, we wondered what would happen if we periodically ranked and selected the most promising 15% of our universe and invested only in those. Rebalancing would not be a top slicing issue but rather we would switch out of one position when another asset class started to look more promising on a subsequent reranking. There are literally thousands of ways to approach this so we chose a very simple Relative Strength method and applied it in a manner likely to rank our assets on a medium term (3-6 month) investment horizon.

The goal is to buy a promising asset, hold it as long as it looks better than the alternatives and switch into something more promising when the opportunity arises. After all, isn't that what investing is supposed to be about? The trick is to systematize those decisions so that we don't need to reinvent the wheel each time and we do not get sideswiped by emotional considerations.

What about hedging and risk budgets and efficient investing frontiers? These were all high end concepts that I had dealt with when designing and repairing quant funds in a previous incarnation. While the theory and math behind them are impressive, I noticed two problems with these complex investment systems: they lagged on the upside and they failed to provide the amount of asset protection promised on the downside. My conclusion? By trying so hard to reduce risk, these funds failed to perform in line with my expectations (as well as my clients at the time).

Rather than always seeking to eliminate risk, why not accept that investment is risky (substitute "volatile", if you prefer) and proceed accordingly. As such, while our system is crude, one can characterize it as a risk-on, risk-off investment signal. When risk appetite is high, asset classes like emerging market equities will dominate the top of the rankings. When global risk appetite is low, government bonds and cash-like asset classes will float to the top as risky assets rank lower.

Is the system ever wrong?

Actually the System is designed with failure in mind. As an asset class gains momentum it moves up the rankings until it reaches our predefined threshold (top three out of 20 in the case of this example portfolio). When it crosses that point, an existing asset class falls below the threshold. That is the signal to switch horses.

How does that help you when one is wrong? Because one is reranking the assets on a periodic basis (say, once a week), the Fund King System is constantly checking one's assets against each other. If a certain asset class starts to lose momentum, it will lose its top ranking and be replaced by a more promising asset. Does this happen instantly? No. What if all the risky assets are showing weak relative strength? Then the money market assets will move to the top rankings. So, the System can be wrong, but it is unlikely to remain wrong for long and its ranking mechanism is designed to provide self correcting feedback to the system.

The bottom line - does it make money?

In our experience, the two part system can produce solid long term results. What do we define as long term? 5 years. What is making money? More than 100% over that period which translates into a compounded return in the high teens annually. Do all of our portfolios produce these results? No, and in our experience, the primary reason for failure is tied directly to the asset selection part of the process. It seems that no system, no matter how good you might think it to be, can improve performance significantly if the underlying assets are crummy.

But, I think a better answer may be to track my ETF portfolio through this blog. That way, you can watch over my shoulder as the Fund King System reacts to the changing financial market conditions. There is always a bull market somewhere and when there isn't, we can always hide in cash.

Portfolio Universe

Developed Markets

  • [[SPY]] - US Equity Market
  • [[FEZ]] - European Equity Market
  • [[EWH]] - Hong Kong Equity Market
  • [[EWY]] - Korean Equity Market
  • [[EWT]] - Taiwan Equity Market

Sectors

  • [[IXC]] - Global Energy Sector
  • [[IXG]] - Global Financial Sector
  • [[XPH]] - Pharmaceutical Sector

Emerging Markets

  • [[EWZ]] - Brazilian Equity Market
  • [[RSX]] - Russian Equity Market
  • [[EPI]] - Indian Equity Market
  • [[FXI]] - Chinese Equity Market
  • [[EWW]] - Mexican Equity Market
  • [[TUR]] - Turkish Equity Market

Fixed Income

  • [[TLT]] - 20+ Year US Treasuries

Currencies

  • [[FXY]] - Japanese Yen
  • [[FXE]] - European Euro
  • [[FXA]] - Australian Dollar

Commodities

  • [[DBA]] - Agricultural Futures
  • [[GLD]] - Gold

As a demonstration, I plan to update this "story of an ETF portfolio" on a weekly basis. In order to add some comment points for readers, I plan to add observations about why certain ETFs are ranking higher than others. If you have suggestions, comments or criticisms, please chime in.

For next week, I will also start to delve into why I chose the ETFs that I did.

Disclosure: I am long the top three ETFs in the rankings which are [[TUR]], [[EWH]], and [[EPI]].

See also Handling China With Care: ETF Pullback Choices on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: EWH , EWT , EWY , FEZ , SPY

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