Portfolio 3 Updated December 2019

Portfolio three is 12 years old.  The beneficiary contributed $6500 and the trustee $13,000 for a total of $19,500.  The current value is $25,768 for a gain of $6,168 or 31%, which is 3.8% / year when adjusted for the timing of cash flows.  See the details here or go to the link on the right.

This portfolio recently changed from a stock portfolio to an ETF portfolio, like Portfolio 2.  We sold off the stocks and purchased ETF’s, including 52% in equities,  10% in gold, 28% bonds, and 10% cash (currently yielding 1.7%).

ETF Portfolios and Fall 2019 Selections

We have two ETF portfolios because it is difficult for these beneficiaries to hold individual stocks because of their professions.  We moved Portfolio 2 to ETF’s several years ago and just sold the individual stocks in Portfolio 3 so that we can invest for Fall 2019 in “ETF mode”.

Portfolio two has the following ETF’s:

  • VTI – the Vanguard all US market ETF
  • VEU – the Vanguard all non-US market ETF
  • HEFA – the “hedged” non-US market (so that it is not exposed to changes in currency rates)
  • IAU – the ETF that tracks the price of gold
  • Cash – the remaining dollars (40%) are in the Vanguard money market (VMMXX), which currently returns 2% / year

The decision for Fall 2019 is whether to keep this high cash allocation or to increase the allocation for equities.

Option One – keep current allocation

Option Two – add a bond ETF.  Bond ETF’s go up when interest rates go down (as they have been doing).  We could put $5000 in BND (Total bond market ETF)

Option Three – add $5000 to VWO which is the Emerging Markets ETF (broad) from Vanguard

Option Four – add an additional $5000 to VTI, which is the US stock market ETF

Options Two – Four can all be done since there is $17,367 in cash.

Portfolio Three:

Portfolio Three has $24,561 in cash.  We need to set up ETF’s for this portfolio and can broadly follow the same model as portfolio two.

Base model:

  • VTI – US market -30% of investment
  • VEU / HEFA – 15% each (non US markets, with half hedged) for a total of 30%
  • IAU – optional, could be 10%
  • Cash or BND – could be 30%

These percentages could be changed as needed.

NYT Article on Emerging Market Bond Mutual Funds

Recently I wrote about ETF’s for international bond funds that are denominated in local (non US Dollar) currencies.  The NYT in their Sunday edition had a mutual fund report (they still segregate mutual funds from ETF’s, even though they are generally substitutes for one another) that discussed a similar tactic called “Emerging-Market Bonds Quench a Yield Thirst“.  This article is focused on emerging markets (like Brazil and China and the Asian countries) rather than the developed markets that those ETF’s target.

The article approaches foreign bonds as a way to achieve a higher yield (interest income) since US interest rates are minuscule.

With the measly yields now offered on presumably safer bonds, like United States Treasuries, savers are seeking more appealing sources of income.  And in the first quarter this year, the average emerging-bond fund tracked by Morningstar returned 7 percent, versus 0.3 percent for the Barclays Capital US Aggregate Bond Index.

The article gets more sophisticated but this is a “classic” case of confusing risk and return.  The return on emerging market debt SHOULD be substantially higher than for less-risky debt, assuming that US debt is actually less risky.

The relative risk of emerging markets compared with developed markets has changed… The average debt level of emerging market countries like Brazil and China is far lower than that of developed ones like the United States and Japan… emerging economies have continued to surge even as much of the developed world keeps struggling with the aftermath of the 2008 financial crisis.

That’s true.  If you ignore the complexities of legal systems and whether or not a country like Brazil or China would default if it was in their best interests to do so, by statistics alone they are superior to the developed world.  Having a modern legal system and being tied to the West didn’t save Greek debt holders from having to take a 75% loss on principal, after all.

The article goes on to describe two key differences – bonds issued in US dollars (“dollar bonds”) and those that invest in bonds denominated in local currencies.  In the previous article on foreign ETF’s I covered Germany, Canada and Australia – those countries would not offer bonds denominated in anything but their local currencies (Euro for now, Canadian dollar, and Australian dollar) but for emerging countries often the debt is denominated in some other currency which makes it more palatable to investors, particularly non-local investors.

If you denominate an emerging market bond in US dollars, then that has the same effect as “hedging” your bond portfolio against fluctuation in the local currency against the dollar, which is a frequent practice for many mutual funds because investors wanted purely the higher yield (and theoretical increase in risk of principal loss that come with this) and didn’t want to also add in the “currency risk” of fluctuations against the US dollar.

Whether the mutual funds invest in “dollar bonds” or bonds denominated in local currency will impact the potential returns of the fund as well as the riskiness of the assets in the fund (likelihood of default).  Per the article many of the funds operate a “mix” of these strategies, which may mitigate some risk (dollar bonds may be issued by more solvent issuers and also don’t have currency risk) but likely leaves some yield “on the table” from local issuers willing to pay a higher rate in local currency as well as the potential gain or loss on fluctuations from the local currency vs. the US dollar.

In the US, corporations mostly go to the public corporate bond market for funding, whereas in emerging countries companies often go to local banks (and Europe is somewhere in the middle).  Since so many companies in the US rely on markets for debt funding, the overall market is (relatively) liquid and large in size, and as a result there are many metrics to track and there is a long history of data to review.  In developing countries, the corporate markets aren’t very deep, and those that do issue debt rather than going to banks often issue it in “dollar” bonds instead of local currencies.  Per the article:

Local-currency corporates exist in Brazil, but the market isn’t very deep… in a less mature market, he might stick with dollar issues.

Compared to the total universe of mutual funds and ETF’s, the portion that is tied to

  • emerging market debt
  • has bonds denominated in local currencies and / or “dollar” bonds
  • has a liquid enough market to make sense
Is still very low compared to the vast universe of mutual funds and ETF’s that cater to US based debt obligations.  However, this is a growing market as investors
  • Shy away from the pitifully low yields offered from US entities
  • Realize that the credit quality of the US (recently downgraded) and many states (such as Illinois, which is in dire financial straits) is not what it used to be
  • Realize that the US dollar has been in a long term decline over many decades against many major currencies and by being substantially invested in US dollar denominated assets they are in effect losing return when compared against foreign based assets (even though it doesn’t show up directly in the US dollar based financial statements)
I am still researching these areas for my personal investing and learning more about 1) the markets 2) how the mutual funds and ETF’s are structured 3) how currency risk is managed or not managed (hedged) within each of the financial instruments 4) the types of instruments that each fund is holding and the benchmark that it uses to determine success.  Specific mutual fund companies that offer these funds include JP Morgan, Barclays, Power Shares, iShares, and others.
Another item to note is whether the financial instrument is an ETF or a mutual fund.  ETF’s generally (but not always) avoid capital gains and losses being pushed to you annually and you can defer them until the instrument is bought or sold on an exchange, which is generally more tax efficient.  You can learn more about the particular instrument that you are considering buying by looking to see their pattern of historical distributions and whether or not they have paid capital gains.
Cross posted at LITGM

Researching Foreign Bond Funds (ETF’s)

Recently I have been evaluating my total portfolio in terms of US dollar exposure.  Traditional (primitive) metrics of portfolio evaluation picked concepts like

  1. Splitting your portfolio between cash / bonds / stocks / real estate
  2. Splitting your stock portion between US and foreign stocks
  3. Breaking down your stock exposure into industry sectors like technology, finance, consumer products, etc…
  4. Adding a category for commodities, generally broken down between the precious metals (particularly gold, which had a huge run up) and everything else (oil, grains, metals, etc….)
  5. Reviewing your investments in terms of yield whether it is measured in interest return (bonds, REITS) or dividends (stocks)
  6. Categorizing your investments by “tax efficiency”, which favors municipal bonds (which are exempt from Federal and often state taxes) and currently dividends (taxed at a 15% rate) but punishes normal interest which is taxed as ordinary income
  7. Splitting your personal portfolio into “retirement” funds which generally are invested without paying taxes, grow (hopefully) over the years with reinvested dividends and interest, but are taxed when you retire and start taking withdrawals, from “non-retirement” funds which are subject to current taxation on dividends and interest but whose “basis” or original investment value have already been taxed.  A third category is Roth investment vehicles which are taxed now but the gain or loss above the current value is not taxed when you take out funds upon retirement

These concepts are all useful ways to review how your money is being allocated across all these sectors of investing.  There is no “one” right way to allocate your portfolio or to even assess how your portfolio is currently deployed.

On the topic of bonds, to me they traditionally represented 1) primarily a vehicle to earn interest, with the rate of interest dependent upon the riskiness of the bond 2) a (relatively) secure means of investing meaning that you expect to get your principal back (i.e. if you invest $50,000 at 2% which unfortunately would be a great rate now you pretty much are focusing on earning $1000 / year in interest and ultimately getting back your $50,000 when the bond matures).

However, the general perception that the bond world is “safe” doesn’t jibe with events that have occurred over the last decade or so.  These events include:

  • The massive budget deficits being run by the major world democratic powers in the US and Europe both at the Federal and regional / local levels, which are unsustainable as we found out in Greece and are likely to find out in many other places to come
  • The decline of over 30% in the US dollar against other currencies over the last few years, caused by many factors but primarily our low interest rates and a semi-deliberate policy of devaluation
  • My personal local exposure to government entities in Illinois at the state and local level (Illinois has the worst state credit rating in the US, and Cook county and the city of Chicago are famously corrupt) which leads me to expect the worst from the municipal bond market

These factors caused me to begin researching foreign bond funds.  My goal was to find foreign bond funds that are

  1. From countries with a reasonable prospect of being stable and paid back (i.e. not Greece or countries with no track record)
  2. Denominated in a currency that is not US dollar based that is likely to be around in the future (i.e. Canadian or Australian dollar, the Asian currencies, etc…)
  3. Put into a fund that doesn‘t HEDGE vs the US dollar – many overseas bond funds hedge against the US dollar so although you get foreign investment exposure in terms of returns and risks, you still are based on the US dollars gains and losses over time.  This is new because until recently most of the funds I can find tended to hedge currency exposure
  4. Have a low cost of ownership; preferably as an ETF which doesn’t (generally) incur capital gains and losses on a given year; these changes are “baked” into the share price which fluctuates over time and then you can choose when and how to incur the gain or loss by selling shares rather than being forced to book the gains or losses each year depending on fund activity

I briefly considered buying individual foreign bonds but this required a lot more work and understanding than I was prepared to do.  This may be something I’d consider in the future but since I don’t want to be consumed in research and exposed to unknown IRS forms and risks (since we do our own taxes and direct our own investment) for now I was looking at something less complex.

While it may seem that a lot of individuals are thinking the same things as me (the above thoughts are pretty obvious) sometimes you have to “wait around” for the industry to come to the same conclusions.  I bought the first dividend-focused ETF (DVY) when it came out and was waiting for a while to find it (and I heard about an early cash-back credit card and was an early adopter of this, as well).

PIMCO recently seemed to have what I was looking for when they released three new ETF’s.  The ETF’s are for Australia, Canada and Germany.  Here is a link to the PIMCO web site describing these three investment opportunities.

 PIMCO recently introduced three country index exchange traded funds (ETFs) focused on enabling investors to capitalize on the investment opportunities in Australia, Canada and Germany. PIMCO believes these three countries have balance sheets and debt dynamics that are well positioned in the global economy, considering the potential for slower growth and ongoing deleveraging, and offer important diversification of currency exposures for U.S. investors.

This description from their web site has what I am looking for:

  • Countries whose debt load appears sustainable or well managed
  • Non US currency exposure THAT IS NOT HEDGED
  • In ETF form to limit annual capital gains and losses but allow you as the investor to choose the time for “harvesting” your gains and losses
  • A reasonable level of total expenses, which are incredibly important for interest bearing instruments at a time of low interest rates (they are 0.5% for the Australian bond fund, which is still on the high end for me)
  • A reasonable level of asset size is desired so that the ETF doesn’t behave erratically or face the possibility of closure (sometimes ETF’s are closed and money is given back to investors).  It helps that PIMCO is huge and if they are likely to move into a sector like foreign bond ETF’s they wouldn’t seem likely to just shut down a fund if it grows more slowly than anticipated
  • Australia in particular offers yield (investment return) much higher than US bonds; they currently are above 4% when you’d be lucky to get 2% in US equivalent Federal debt right now.  This of course is factored into the currency level vs. dollar (it is high now) so in some “grand equilibrium” scheme they may or may not be in balance; but in the short to medium term it is fair to say that Australian debt “yields” more than US equivalent debt

In my investing I generally try not to anticipate specific events but rather to have a broader and more diversified spread on investments.  From a currency side, you have the Australian dollar, the Canadian dollar, and the Euro.  The Australian and Canadian dollars have had a huge run-up against the US dollar, which would make someone “chasing return” salivate, and the Euro faces downward pressure for many reasons most notably the PIIGS (Portugal, Italy, Ireland, Greece and Spain) and their expanding financial difficulties and deficits.  However, the game ahead is very long, and anyone that can reliably predict the trend of currencies against the US dollar wouldn’t be writing a blog like this or even commenting on it, they’d be in a giant private jet flying to their giant private island because that is an exceedingly difficult or possibly impossible thing to do.  And even if the Euro goes kaput, a German focused fund would convert into the new German currency, which would be predicted to be among the best currencies of the broken-up Europe.

I will look at these three funds in detail and likely buy ETF’s in them which will 1) be in the bond class 2) hold a reasonable prospect of continued repayment 3) provide non US dollar diversity.

Cross posted at LITGM