Wacky Theory Time

For the last few days we've been looking at some of the building blocks of what portfolio construction has been and asking whether or not individual investors need to make changes to how they do things. I also think there are practical applications, at least conversationally, for investment advisors as well.

In that light it might be worth putting forth a wacky-ish theory as a basis for making the conversation a little more interesting. Another motivation for this post is an article from Invest With An Edge that asks Is Modern Portfolio Out Of Date. My general take on MPT is that the assumptions that it relies on work except for the times that they don't, if you take my meaning.

For the concept I will lay out I make a couple of assumptions that you are welcome to disagree with but you can't have a wacky theory without a couple of assumptions. The first assumption is that because of very low interest rates most of the bond market is unattractive and because of the extent to which the crisis is not over fundamentally the risk reward in the high yield market is not so hot. The next assumption is that many investors, including advisors, don't like to pick stocks preferring funds of some sort. Assumption number three is that the broadest of the broad indexes will not offer great results as they are heaviest in the fundamentally least attractive segments of the market.

I made a comment in passing that a tiny allocation to equities, as mentioned by Felix Salmon, is probably not the way to go but that someone ratcheting down to a 50% allocation to equities from 70% might be a reasonable reaction to the previous decade but still the bond market is not very attractive (you're buying high, prices may or may not go down but buying high is buying high).

The chart compares the Index IQ Multi Strategy Tracker ETF (QAI) and the IndexIQ Macro Tracker (MCRO) against the iShares TIP ETF (TIP) and the S&P 500. TIP is a client holding.

When QAI and MCRO came out I was very skeptical but save for the last month they have delivered as advertised, IMO. QAI appears to have rolled over very recently due to exposure in EFA and EEM while MCRO had 32% in emerging market ETFs as of 3/31/10. For the returns for QAI and MCRO you see on the chart you can add 80 or 90 basis points for dividends paid by the funds in December.

In addition to the 5-6% that TIP went up it paid a little over 3% in dividends in the trailing 12 months but that means nothing going forward.

With short term bond yields so low the results of QAI, MCRO and TIP offer real competition for bond exposure. Hopefully it is obvious that there are many other products out there that could fill the role. But so the first part of the wacky theory is putting half the portfolio in things like QAI, MCRO and TIP because so much of the bond market is priced so highly and the fundamentals for so many segments stink.

The second half of the wacky theory is to put the other half of the portfolio into countries that no one talks about or at least don't talk about very often. This could be via country ETFs or thematic ETFs. Research could include South America, Antipodes, much of Asia (not Japan), Scandinavia, Israel, maybe Egypt and Canada. In addition to the most of the large cap country funds, IndexIQ (I do not get paid by them and they do not advertise on my site) has a few small cap country funds with more on the way.

Regarding thematic funds, obviously you need to be on board with the theme but things like wind, smart grid, nuclear--whatever--there are plenty of choices and more on the way. With this sort of approach there would need to be great care taken to watch for sector imbalances and any other type of imbalance. A lopsided portfolio no matter what it owns will come home to roost at some point.

The overall wacky theory addresses what I believe is a lousy environment for bonds and the possibility that broad based indexing will continue to come up short for a while longer. You can decide, and comment, whether these things are addressed well or not or whether they even need addressing.

For the 1+1=11 Brigade this post was theoretical, I'm not doing this, I don't own QAI or MCRO. These posts are about extreme ideas as a means of exploring moderate portfolio tweaks. For example I've written a lot of posts about absolute return funds and strategies but we own one fund in this space with only a 2-3% target allocation.