8/14/08

A Lazy Model ETF Portfolio Underweighting US

Mohamed El-Erian, who managed Harvard University's investments and is now at PIMCO, has been in the news recently recommending long term investors to underweight US securities. He suggests the following asset allocation:

US Stocks 15%
Developed ex-US stocks 15%
Emerging Stocks 12%
US Bonds 5%
International Bonds 9%
Real Estate 6%
Commodities 11%
Inflation Protected Bonds 5%
Infrastructure 5%
Private Equity 7%
Cash for Special Opportunities 8%

You can read more about it here.

I started a model ETF portfolio inspired by El-Erian's suggested asset allocation. The asset allocation is as follows:

US Stocks (VTI) 15%
Other Developed Market Stocks (VEU) 15%
Emerging Markets Stocks (VWO) 12%
Frontier Markets Stocks (FRN) 1%
US Bonds (BND) 5%
International Bonds (BWX) 9%
Real Estate (RWO) 8%
Commodities (RJI) 10%
Infrastructure (IGF) 5%
US Inflation Linked Bonds (IPE) 7.5%
International Inflation Linked Bonds (WIP) 7.5%
Cash 5%

The portfolio's average expense ratio is 0.33%.

Overall, the target allocation is:

Stocks (including Infrastructure and REITs) 56%
Bonds 29%
Commodities 10%
Cash 5%

The portfolio is moderately risky in its allocation, and is intended for a long investing time horizon.

RJI was chosen over the more popular DBC for commodities because it has the same expense ratio, offers exposure to a greater variety of commodities, and does not make distributions. RJI is an ETN; it matures in late October 2022. At that time, it will be replaced in the portfolio with a similar vehicle.

RWO was chosen over VNQ, because, while more expensive, it offers global real estate exposure (foreign holdings account for more than half of its portfolio). The idea behind the portfolio is that the rest of the world will outperform the US in the future. FRN was chosen in the same spirit, to add a little boost from nascent growth in places like Nigeria and Poland.

BND was chosen over the more popular AGG because it performs the same way, but with a smaller expense ratio. Same goes for IPE over TIP.

The sizable allocations in inflation linked bonds may be question begging. Many contend (correctly, in my opinion) that inflation is much higher than is reflected in government figures. Investing in TIPs thus potentially results in losing to inflation. However, it's better than keeping the allocation in cash, at least in time of low interest rates (if in the future regular bond rates become substantially higher than those of TIPs, the portfolio's target weightings may be changed to compensate). Also, TIPs can provide portfolio stability in tough times. Consider how TIPs performed vs the S&P 500 over the past year (not including monthly distributions):



In the chart above, S&P 500 is in green.


How the Portfolio Will Be Tracked

The portfolio will be tracked in the spreadsheet below. For viewing ease, it will also be available here.



The portfolio starts out with $10,000. It will be updated once a month, here, on the first Saturday or Sunday of every month that follows a trading day (e.g., if the first Saturday of the month falls on the 1st, the portfolio will be updated on the 8th or 9th).

No holding will ever be sold, unless it tracks its underlying index incorrectly or there is something wrong with the index (e.g., it diverges significantly from other comparable indexes). The portfolio will be rebalanced monthly with an additional investment of $500. Any dividends received will be reinvested along with the $500 each month. For sake of ease, dividends will be tracked by the ex-date rather than the pay date. As dividends are part of the portfolio's gain, they will not be added to the cost basis. For sake of ease, taxes will not be factored in the portfolio's performance.

Cash will not earn interest.

There are brokers that have commission free trading (Zecco, for example). There are other brokers that allow fractional share buying (Sharebuilder, SogoTrade, for example). For sake of ease, it will be assumed that the portfolio is in a brokerage account that has both these features, fractional share buying and no commissions.

Starting purchase prices were determined at market close on Wednesday, August 13, 2008. Purchase prices for future $500 monthly investments will be determined as of market close on the first trading Friday of each month.

The portfolio's performance will be compared with that of the S&P 500. A hypothetical $10,000 was invested in SPY on Wednesday, August 13, 2008. Monthly investments of $500 will be made under the same rules and assumptions as those outlined for the portfolio above. The spreadsheet will track the S&P's returns.

Disclaimer: This is for demonstration and entertainment purposes only and should not be considered investment advice.

Disclosure: At the time of posting, I do not hold any positions in the securities discussed above.