As more and more of my friends and family embark on investment adventures, whether because they’ve been consistently saving money from their first grown-up job or need to figure out what to do with unwieldy Roth IRAs or 401ks near retirement, I have been getting a few requests a month for advice on what to do.
Unfortunately, there is no ‘one size fits all’ portfolio plan. There isn’t even an age filter for different portfolios. A 23-year-old I help is saving for a down payment and wants as little risk as possible with fixed income, while a 56-year-old is looking to actively manage an IRA in almost all stocks.
So after hours and hours of pondering their unique portfolio challenges while holding my breath under water at the pool or playing with my cats, I’ve come up with four distinct risk levels and paired them with the portfolio strategies that could serve each best.
Risk Level 1: Fixed Income
This approach is pretty boring. My girlfriend and I used it to save for a down payment, which my sister (aka the mysterious 23-year-old friend above) is also doing. Short of a default, you rarely see any sort of permanent capital loss with fixed income.
Fixed income investing is simply loaning money to some other entity. We like to focus on municipalities and high yield corporate debt. Right now everything else you can find domestically is overpriced after a 30-year bull market.
Luckily, we don’t have to actually do the legwork of analyzing municipalities or distressed corporations – we’ll leave that to the professionals.
How ETFs and CEFs work
ETFs or Exchange Traded Funds and CEFs or Closed-Ends Funds (which is a subset of ETFs) are the vehicles we will use to invest in fixed income. They are a pool of money typically invested passively with criteria set at inception though sometimes invested actively by a manger. They trade on an exchange like a stock would – with ETFs new shares are generated for every purchase and the new cash is then invested; with CEFs there is a finite amount of shares and buyers must bid them away from sellers.
This fact helps us find our niche. Because there are no new shares created, buyers will sometimes bid more than the value of the assets in the fund (this is called the Net Asset value or NAV) and sellers will sometimes ask less than the NAV. This creates either a discount or premium to the NAV. We will target closed-ends funds that trade at a discount.
If we manage to find a CEF that holds a basket of muni bonds that yield 4% at a discount, we gain two advantages. First, if the NAV is $10 and the market price is $9, the potential gain as the market price reverts to the mean of $10 is 11%, which is more than almost any fixed income instrument you can find short of investing in Venezuelan bonds. Secondly, we will target munis that are tax shielded which means you don’t have to pay a tax on the distributions. So if you are in the 25% tax rate bucket, a 4% yield is the equivalent of a 5.33% after-tax yield in a different instrument.
Because you will find generally the same performance in any CEF that holds Munis, we will focus on the discount and the expense ratio. We are looking to keep the expense ratio below 1%.
To look for Munis, I used the Closed-End Fund Center’s screener. I set the screen to look only for CEFs trading at a discount and classified as: FIXED INCOME – TAX-EXEMPT, with an expense ratio of 1% or less. Here is the result sorted by Premium/Discount:
The market return column takes into account a reversion to the mean price and the distribution yield (which is in the last column). The top two funds by distribution yield also have the highest expense ratio so there is definitely a trade-off. Patient investors could likely refresh this screen monthly and only invest when the market return, adjusting for the expense ratio, is above a chosen benchmark such as 10% or 8%. Otherwise, picking several funds at discounts with satisfactory yields and low expense ratios should be sufficient.
When straying from munis, my two favorite alternative fixed income investments are so-called ‘junk bonds’ and emerging market debt.
Junk bonds are the debt of distressed corporations. Because there is some element of uncertainty regarding the solvency of these corporations, the yield is much higher. To mitigate this risk, high yield ETFs will typically employ a manager and analyst to gauge the credit of the bonds and then use diversification to not allow one company’s collapse to have a material impact on the fund. In the portfolios I manage we hold the Blackrock Corp High Yield fund (HYT). HYT’s current distribution yield is 7.94%, its adjusted expense ratio is 0.97%, it manages just over $2B and it currently holds 100 bonds.
Emerging market debt allows us to gain exposure to debt that is less correlated to the US bond market bubble and has much stronger returns. For this we will go with the simple Vanguard option of the Vanguard Emerging Markets Government Bond ETF (VWOB).
Risk Level 2: Global Asset Allocation
If you fell asleep reading the subhead for risk level one, number two may be for you. I can make this one sound extra sexy by calling it tactical global asset allocation. This is the method that I talk about in my soon to be published book.
Asset allocation involves finding uncorrelated asset classes and diversifying among them. The theory is that when one asset goes down or sideways for an extended period the others will pick up the slack and lower volatility.
Though this strategy likely won’t result in amazing returns very often, it will allow you to set it and forget it until you rebalance your portfolio each year. You’ll have confidence knowing that you won’t have to worry about losing half or more of your portfolio or seeing a decade of less than inflation returns.
A Sample Portfolio with ETFs
I go a little more in depth in the book, but here I will just create a simple portfolio with some domestic and international allocations and choose one low fee ETF for each.
- 5% – Cash
- 5% – Blackrock Corp High Yield fund (HYT)
- 5% – Vanguard Emerging Markets Government Bond ETF (VWOB)
- 10% – Central Fund of Canada (CEF) (Gold & Silver)
- 5% – United States Commodity Index (USCI)
- 5% – Adams Natural Resources Fund (PEO)
- 10% – Vanguard REIT ETF (VNQ)
- 10% – iShares Global REIT (REET)
- 10% – PowerShares Dividend Achievers (PFM)
- 10% – Cambria Value & Momentum (GMOM)
- 10% – Cambria Shareholder Yield (SYLD)
- 15% – Cambria Global Value (GVAL)
Risk Level 3: All in Stocks
Now we get to a legitimately exciting investing strategy. Depending on when you start and when you stop, stocks can return anywhere between 5% annually and 15% annually for decades. This is what fuels millionaire retirements and the jealousy of jocks who made fun of you in high school for knowing what EBITDA meant.
Some Passive Opportunities
My favorite passive opportunities for stocks are in the portfolio above. I will outline each of them a little more here.
- PowerShares Dividend Achievers (PFM) – Holds shares of only companies that have increased their dividends for 25 straight years. This allows for a modest yield, a value component and the consistency of a business that has had the strength to raise prices and increase its dividend for 25 straight years.
- Cambria Value & Momentum (GMOM) – Has a universe of thousands of assets in which it can invest. Only invests in those that are in an uptrend and undervalued. Can also go to cash to hedge against overvalued markets.
- Cambria Shareholder Yield (SYLD) – Sorts all domestic stocks by the amount of money they return to shareholders through buying back shares, paying dividends or paying down debt and buys the top 100.
- Cambria Global Value (GVAL) – Chooses the top 25% most undervalued countries in a 45 country universe and invests in the most undervalued companies with market caps over $200mm.
Some Active Opportunities
My girlfriend is currently employing the strategy I will recount here, so my future happiness may depend on its success. For most people, individual stock selection will not be a long-term winning endeavor, but there are a few ways to make it work:
- Don’t invest all your savings in individual stocks unless you’re going to work full time choosing them. Invest the majority of your portfolio with the methods we’ve talked about and then pick some stocks to fill it out.
- Buy what you know. If you work in marketing don’t buy a biotech company with fortunes that will rise or fall based on one drug for some disease that 19 people have.
- Pay attention to value. You may know LinkedIn’s business inside and out but paying 100x earning for it is just setting yourself up for failure.
- Use professional resources. I’m not a big fan of most brokers and most research from Wall St. – too many conflicts of interest. However, I love Morningstar’s rating system and there are several newsletters to which I will subscribe for life (which ones they are is for a different article). Seek out professional sources you trust and take their advice.
Risk Level 4: Trading
This is the stuff Michael Lewis writes about and your cousin’s grandfather-in-law works with all day to afford his seven yachts. If you get good at trading, you can generate great returns fast, but it’s unlikely that will happen, so here are some things more likely to help you succeed.
Creating a Base Portfolio
The first thing I did when I decided to start trading was build a base portfolio. >60% of my portfolio is in solid, dividend paying businesses with great managers. I will either beat the index or closely lag it with these stocks, but I will very likely not have a permanent capital loss in them. This will make my total returns more consistent and provide equity in any margin calls.
Some Other Trading Tips
- Sell covered calls. Calls are an option to buy a stock at strike price before a certain date. The calls have an intrinsic value which is the difference between the market price and the strike price, as well as an implied volatility which is the value given to the chance that the market price will rise. When you have owned an investment for a while and are willing to sell it, you can sell a call at that strike price and take in the premium for implied volatility. In the best-case scenario, you don’t have to sell your shares and you keep the premium. Worst case you keep the premium and sell the stock where you were already confident selling it.
- Sell naked puts. Puts are the opposite of calls – the stockholder gets the option to sell a stock at a strike price. When you find a strong stock you are willing to own at a certain price you can sell a put. Best case you don’t have to buy the stock and keep the premium. Worst case you get the premium and buy a stock at a price you were ok with.
- Buy deep in the money calls. Deep in the money calls are calls with a strike price below the current price. Because the market price is above the strike price, the value of the options is mostly intrinsic value. The price of the options moves more in line with the stock. The advantage in this strategy is the inherent leverage: if a stock you think will go up in the next six months is trading for $10/share and you think it will jump to $15 you may be able to buy a call option with an $8 strike for $3. If the price moves up 50% to $15, your call option could move up in value to around $8 which would be a 167% return.
- Use margin. Margin is simply using a loan to buy stocks. In my account, I focus on the base portfolio for margin and try to find consistent, strong growers to purchase.