In last five years or so, Exchange Traded Funds (ETFs) have grown in numbers and it asset values. In my view, ETF is another form of investing vehicle available (among many others) to investing or trading community. The major attraction for ETF has been low cost expenses and fees in comparison to mutual funds and ability in trade during market hours. Like any other investing vehicles, I believe ETFs are good vehicles depending upon how/why an individual investor uses in its portfolio. The simplicity with which you can buy and sell an ETF makes it even more difficult to understand how it is structured, what are its constituents, etc., So before you buy an ETF you much understand why you want to buy it and what role it plays in your portfolio. Broad market exposure and access to alternative assets are two important roles ETF can play in your portfolios.

• Broad Exposure: ETFs are very good investment vehicle for hedging against broad market performance, broad industry sector, broader country exposure, or any particular asset class. When investing in ETF, investors need to make sure that it represents its intended objective. Many ETFs just invest in few bunch of stocks and expect only those small number of stocks to provide broader exposure. In my viewpoint, ETFs for broad exposure should consist of more than 250 or 300 stocks.

• Access to Alternative Assets: This is one the significant benefits depending upon how the ETF is constructed. E.g. ETFs based funds for leverages, currencies, commodities, futures, etc are being made available. However, I believe that such ETFs are high risk opportunities. I am not advocating the use of such assets, but merely pointing the fact that such asset classes were not available earlier. Whichever theme one chooses, I believe the asset in ETFs should be basket of stocks or businesses dealing in those particular domains.

ETFs can play these two roles successfully if investors are investing for long haul and understand their structure.

• Time Horizon: Investment in ETFs should be for long haul. The time horizon should be in the order 10 years, 15 years, or even more. The true benefit of investing ETF is derived when investing for long term. One of the methods to invest in ETF is dollar cost averaging over a period of time. There is a school of thought that investors should buy when an ETF is below intrinsic value or relative PE is less than one. In my view for individual investor, it is next to impossible or futile to go into this exercise. Keep it simple, and hence buy and/or continue to add when it is below 200 day and 365 day moving average.

• ETF Structure: Understand what an ETF consists of, e.g. common stocks, futures, options, leverages, etc. Many ETFs are closed end funds with high expenses, many provide dividends that include return of capital, many provide short term gains distributions (tax implications), many consist of only 30 or 40 stocks based on capitalization, etc. In addition, investors need to more careful for ETF focusing on emerging markets. Many funds just invest in ADR/GDR/ADS, which is locally available in US and still charge high fees, many only have less than 100 stocks, etc.

Strategically, ETFs can provide a means to strengthen investors portfolio and help in asset allocation. At this point in time, I believe ETFs are the best investment vehicles to get exposure to a broader emerging markets. Investors do not need to worry about identifying countries or individual companies in emerging countries. They not only provide individual investors a means to invest, but also a mechanism to buy and sell easily during trading hours.

What role does ETF play your portfolio?

This article was first published on The DIV-Net on October 16, 2009.

Last week, I presented an update on the monthly progress of my dividend portfolio. In this post, I am discussing the quarterly risk analysis. My objective here to make sure I am continuing to following my risk management process.

1. Maintain pre-determined asset class allocation;
2. Maintain pre-determined diversification (any sector should not exceed 10%); and
3. Dividends from a single stock should not exceed 5% of total dividends.

My dividend portfolio holdings can be referenced in My Portfolio menu at top of this page.

Maintaining Asset Allocation

Chart 1 shows the asset class allocation along with my maximum target limits. In general, I am continuing to meet (or much closer) to my pre-defined target levels. During 3Q09, I did not make any contribution to the emerging markets index funds such as VWO and EPI. This was because I believe they rose too quickly to my comfort level. I am still tad lower than my maximum limit for emerging markets.

Dividend Portfolio : 3Q09 Asset Allocation

Maintaining Diversification

For industry sectors, I have a pre-defined maximum limit of 10% for each sector. Chart 2 shows that I have higher exposure (relative to my limit) in financial derivates and consumer sector. Energy sector is almost equal to my max limit.

• Financial derivatives is a sector including dividend CEFs and REITs and hence it has higher percentage. Since this includes two sub sectors, I am comfortable with this exposure.
• The consumer sector allocation increased significantly because of my recent purchases. I took the opportunity of lower valuations and initiated position within the same quarter. This resulted in higher allocation. My future purchases will likely to be limited in this sector.

For morningstar style classification, I do not have any pre-defined allocation limits. Chart 2 also shows that my portfolio is concentrated around large cap stocks (more so on value and growth). Intuitively that seems to be correct because majority of the dividend-growth stocks are stable and mature companies. I add two mid cap dividend growth stocks in last few months. I will continue to look for small cap dividend growth stocks. Another option is to invests in a broad small cap index ETF.

Dividend Portfolio : 3Q09 Diversification

Criteria of Maximum Dividend per Stock

My objective here is to make sure that dividends from any given company do not exceed 5% limit. This limit allows me to reduce the impact of dividend cuts on passive cash flow. The chart shows that O (~7%), AOD (~14%) exceeds my pre-defined limit. I will not be making any changes any of the individual positions. I do not expect to see dividend cut in O. My capital allocation to AOD is very low and even if the dividend is cut in half, my yield will still be more than 5% and dividend contribution be still above 5% of total dividends cash flow. However, I will not be making any future purchases. Therefore, my allocation will automatically come down.

Dividend Tree : 3Q09 Max Dividend Criteria

The quarterly update shows what action I took during 3Q09.  I hope with this approach to risk-based allocation, I will reduce my risk to dividend cash flow and continue to maintain potential for capital appreciation.

As the stock markets continue to recover (assuming it has not done yet), the talk of inflation is coming back in the news. Our government has pumped in so much of printed money in the system that there is a concern that US economy will experience inflationary times. There is no denying that inflation will take away chunk of our real returns from overall investing returns.

Many of the well known economists and investors (including Warren Buffett) have expressed concerns about inflation. Among all the experts and pundits, I believe, David Swensen gave a very pragmatic and down to earth response to this question in an interview on WealthTrack. According to Swensen, he does not know what will happen. He cannot predict it. There will be inflation if the recent pumping of money supports the economy and growth returns to US economy. If there is no growth, then there will be deflation of dollar value. His message was to address these issues with proper diversification and asset allocation. As individual investors what can we do to (or rather how can we) blunt the effect of inflation or deflation. Following are five aspects one can look into to manage their asset diversification.

• First, include Treasury Inflation Protected Securities (TIPS) in your portfolio. As an example, one can consider simple US Treasury based bond fund like iShares Barclays TIPs (TIP) to offset this risk. It also has low operating expenses of 0.2%.
• Second, include gold commodity as an asset in your portfolio. I believe one should hold physical gold in some form (like coins, bars, jeweler, etc). There is no point in holding those gold derivatives which can easily be manipulated. Furthermore, most of the world currencies are now completely detached from gold standard. So I would really question the notion that gold remains an inflation hedge. I tend to believe gold is an excellent hedge against any short to intermediate term crisis like currency issues, sovereignty issues, etc. It is important not to go crazy and binge on gold, but maintain an asset allocation that you are comfortable with.
• Third, include dividend paying stocks in your portfolio for companies that are doing business in commodities. These companies are able to increase prices of their products as price of raw commodities increase. Examples of such companies are ADM, EEP, KMP, BP, XOM, CLX, MCD, utilities, etc. These types of companies are less susceptible to inflationary environment.
• Fourth, include dividend paying stocks of US based or developed country multinational companies that derive significant chunk of their earnings from emerging markets. As inflation erodes dollar value, currencies from other countries can provide the fill up to their earnings.
• Fifth, include emerging market ETFs (stocks or bonds) in your portfolio. It is important to look for ETFs that are based on individual markets, denominated in local currency, and essentially captures a wider market base. The simple way to start your allocation using VWO or EEM, which are broad based. After that look for individual country ETFs. In my opinion, all those ETFs and funds that hold dollar denominated ADR and ADS does not provide hedge against the dollar inflation/deflation.

The message here is that maintaining a diversified asset allocation should be simple and easy to understand. What’s the point in investing in those confusing derivatives and linked to futures (commodity or currency) which are difficult to understand.

What is approach to this issue? How do you plan to address it in your portfolio?

This article was first published at The DIV-Net on October 1, 2009.

Let me open today’s post with a question. How do we decide what is an effective asset allocation for us?

As individual investors we all know that we need to maintain a diversified asset allocation in our portfolios. We are also aware of different types of asset class and investment vehicles. Unfortunately, for most of us individual investors (note: individual investors) that’s where we hit dead end on asset allocation discussions. We really do not know how to engineer a portfolio that has optimum asset allocation for our risk profile.

Theoretically, asset allocation is a risk management methodology driven by relationship between expected return and risk. Can we use this classical approach of asset allocation to dividend investing? It can be argued that the inclusion of dividends in ‘expected return’ captures the dividends, and hence, it can be applied. My viewpoint is, these asset allocation methodologies are driven by expected return on capital. We dividend investors know that in short (3 to 5 years) to intermediate (5 to 8 years) term the dividends have a small contribution to the total return. The significant contribution of dividends starts to accelerate after 10 to 12 years. In addition, the dividend investors would find that asset allocation becomes very challenging, particular with reference to foreign (developed and emerging) asset classes.

In this context, I looked at David Swensen’s work with Yale Endowment Fund (source). This is an institutional fund, therefore, may not have a direct bearing on individual investors. I am including it in this discussion to highlight how the fund’s asset allocation is managed by using ‘expected real return’ and ‘standard deviation of the returns’. The table below shows the different asset classes with expected real return and standard deviations.

In this table, we can see that every asset class has its own expected return and its corresponding standard deviation. In general, I was quite surprised by the single digit expected real return and higher percentage of standard deviations (in 20s). The expected real return excludes inflation, but still it appears to be quite different than the generally purported value of approximately 10% (domestic equity) and 10+% (foreign equity).

The interesting point in this asset allocation methodology is the use of concept of expected return. Keeping with this methodology, as a dividend investor, I have recently started doing following:

• Looking at my asset allocation from the viewpoint of risk-to-dividend (referenced in Dividend Tree Holdings)
• Use of ‘expected dividend return/growth’ instead of expected return (will discuss in future posts).

In the earlier post, I discussed that risk management should include asset allocation and quality of investments. I also mentioned criteria’s that I use for my dividend portfolio. The four criteria I use are:

1. Maintain diversified asset allocation;
2. Continuity of the stock to meet my buying objective;
3. Companies’ ability to consistently grow dividends; and
4. Dividends from a single stock should not exceed 5% of total dividends.

Today in this post I am using above criteria’s to analyze (and action taken) my dividend portfolio. My dividend portfolio holdings can be referenced in “My Holding” menu at top of this page.

Maintaining diversified asset allocation

I look at asset allocation in three different ways viz. (i) asset class; (ii) industry sectors; and (iii) morningstar style classification. For each type of analysis, I have a pre-defined target levels. At this point in time, these are just an arbitrary numbers which I believe is good for risk profile. I do not have any reasoning why those numbers.

• For asset class, in general, I am continuing to meet (or much closer) to my pre-defined targets levels. Emerging market is one asset class for which I do not have any exposure. This is one area in which I need to do more work.

• For industry sectors, I have a pre-defined maximum limit of 10% for each sector. The chart shows that I higher exposure (relative to my limit) in financial derivates (i.e CEFs), healthcare, and real estate. The health care exposure is limited to JNJ and PFE. At this point in time, both are good quality stocks. So I intend to continue holding it with no further capital allocation. Financial derivates is a sector, where I will reduce my exposure.

• The chart for morningstar style classification shows that my dividend portfolio is concentrated around large cap value and growth stocks. Intuitively that seems to be correct because majority of the dividend-growth stocks are stable and mature companies. I may perhaps need to add mid cap stocks. I will be looking into this.

Continuity of the stock to meet my buying objective

Qualitatively, except AOD and IGD, all of the positions that I have in my dividend portfolio continue to meet my buying objective.

• Based on this criterion; AOD (shifting concentration from international to US-Based), and IGD (return of capital) are two stocks which are in probation.

Companies’ ability to consistently grow dividends

All the stocks continue to meet this criterion except GE, IIA, IGD, and PID.

• PID is an index ETF which continues to meet my buying objective. Therefore, I intend to continue to holding PID even though it is not growing the dividends.

• Based on this criterion alone; GE (no increase), IIA (managed distribution, no increase), IGD (return of capital based distribution) are three stocks which are in probation.

Individual stock dividend less than 5% of total dividends

The chart shows that GE (~10%) and AOD (~20%) exceeds my pre-defined limit by significant amount. I will need to scale back my exposure to ensure that dividend cuts do not affect my passive cash flow.

Action taken:

My asset allocation showed that I had excessive exposure to financial derivates (IGD, IIA, AOD) and I had higher exposure to risk-to-dividend (ADO, GE). I made following changes:

• I reduced my holding in GE by selling partial positions. My dividends from GE are now only 5.5%.
• I have put IGD in the sell block. IGD is an example from my high yield chasing days when I was still learning different aspects of distributions such as income, qualified dividends, ROC, short gain, long gains etc. I do not believe it is a good quality investment because majority of the distribution consist of return of capital. Selling IGD will also help in reducing my exposure to fund based investments. I am evaluating when to sell.
• I am continuing with IIA a real estate based income CEF. It continues to meet my buying objective and maintains stable dividend annually.
• My concern with AOD is the CEF has transformed from 65%+ international allocation to 65%+ US-based allocation. I am no longer getting international exposure with AOD (which was my buying objective). However, my current capital allocation for AOD is 6.2% which I expect to reduce further with more stock purchases in this quarter. Additionally, my existing YOC is in excess of 20%. Assuming dividend reduction by 10 to 15%, even then my YOC will be well above 5% and it will reduce my single stock dividend to approx 10% or even less. With this background, I intend to continue holding AOD. I will be looking into changing my objective to hold this stock.
  
  

I hope with this approach to risk-based allocation, I will reduce my risk to dividend cash flow and continue to maintain potential for capital appreciation.