Few weeks ago, I posted an article earlier which discussed why emerging markets (e.g. BRIC) cannot be clubbed together. There are so many significant differences that it makes sense to look at it individually. Most likely it will also provide maximum possible return for our invested dollars. While China continues to receive most attention in the press, I believe its India that provides a much better option for small individual investors. Following are three reasons I believe India has relatively more fundamental strength than other countries.

• Inward Consumption Based Growth: India’s economy is consumption oriented when compared to other emerging markets. India’s export contributes less than 15% to its $1.2T GDP. The IT outsourcing services and back office has garnered most of the business media coverage; however, these industries have less than 8% contribution to the GDP and employ less than 5 million people. This is an indicator of growth by internal production and consumption. It is less reliant on exports. Quite contrarily, these technology services perform better in recession, because it is all about optimizing operational cost. In addition, its reserve bank (a.ka. central bank) has very conservative monetary policy, which is why we did not see failure of the banks (or banking system) during the current financial melt down. There were no widespread bank bailouts.

• Transparency: It has democratic governance which on many occasions slows down the decision making progress, but provides better transparency (relative to Russia and China). As of today, its currency is freely convertible for trading goods and services, but there are certain restrictions for international asset acquisition. However, it has a pragmatic roadmap to allow its currency to fully float with market dynamics. It has demonstrated international policy of non-confrontation which, to certain extent, immunes its economy from international squabbles.

• Government Stimulus Driven Growth is Less: The Indian market has rebounded in line with other emerging markets like China or Brazil. While it remains to be seen whether it can be sustained, the indicators suggests it may not hit similar level of bottoms again. A recent article showed rebound of earnings for companies in its SENSEX index. The key in this rebound is; not much is being supported by government driven expenditure or public infrastructure projects. In fact, it continues to stumble on its infrastructure.

Finally, India can boast that its government is run by a bunch of prominent economists (with political and public support). The architect of Indian economic reforms, who laid down the path for reforms 18 years ago, is now at its helm as a prime minister. It is always good to have a non-political leader who is not only an economist, but someone who knows how to execute it in the complex state like India. Therefore, I continue to believe that on long 10+ year time horizons my dollars are “relatively” safer in India markets than any other emerging markets. I do not expect to be a smooth ride. There will be time period when markets will crash, but it will eventually come out stronger.

Having said that, I believe, individual investors should use ETF based investment vehicles for India (or any other emerging markets) which invest in array of companies and have less fees and commissions. Keeping with this thought process, I use Wisdom Tree India based ETF, EPI. You may read more about my reasons for selecting EPI for this objective.

As individual investors, we are always careful of what we invest in and what investing vehicle we use. We try to filter the business media noise or recommendations from analyst or fund house marketing data. In last few years, we have been told that the simple and easiest way to invest in new growing emerging markets is use emerging market ETFs and/or funds. There are so many different funds with so many different themes that we should understand whether we are really getting what we are looking for. Following are few examples as observations on structures of ETFs.

Example 1: VWO and EEM are funds based on MSCI emerging market select index which is market capitalization based index. It includes 18 to 20 emerging economies where stocks can be bought free of any restrictions.

• VWO has 60% of assets invested in 130 stocks (all in native countries), while EEM’s 60% assets are in only 42 corporations (approximately 29 in ADR/GDRs).
• VWO is invested in 784 stocks with expense ratio of 0.24%, while EEM is invested in only 342 securities with expense ratio of 0.72%.
• If both are based on same index, why are these funds so different? EEM goes the easy route of investing in ADRs/GDRs, less number of corporations, and still has three times the expenses?

Example 2: BIK is fund for BRIC markets. BIK is invested in only 40 companies distributed in four countries. Of which 54% of its assets are in only 10 companies. The fund still has an expense ratio of 0.4%. Emerging economies has combined GDP of about USD 10trillion or more, and this fund picks only 40 companies to represent this. Does that make sense?

Example 3: BKF is market capitalization based index fund designed to follow MSCI’s BRIC Index. It is designed to focus only on four BRIC countries.

• BKF is invested 176 corporations out of which 34 are in the form of ADR/GDR.
• Approximately 60% of its assets are invested in only 23 corporations. With such a high concentrated position in only four countries and 23 corporations, I do not understand the rationale for expense ratio of 0.72%.

Example 4: Four funds IIF, IFN, PIN, INP, and EPI have somewhat similar objective to track performance of Indian Corporations. Each has a different method on how they execute it.

• Funds expenses are IIF (1.40%), IFN (1.18%), INP (0.89%), EPI (0.88%), and PIN (0.78%).
• Funds IIF, INP, and PIN have more than 50% investments in top 10, IFN is close of 50%. The fund with highest expenses, i.e. IIF, has approx. 62% invested in top 10. Fund EPI has 46% invested in top 10, with almost 17% allocation to just one corporation.
• After such a high fees and varied executions methods, these funds could find only seven specific corporations (in 4 funds or more), four corporations (in 2 or more), only 10 corporations (in one fund only). To put this into perspective, on India’s Bombay Stock Exchange, there were 7500 listed equities (in 2006), 7706 equities (in 2007), 7821 equities (in 2008), and 7784 equities (in 2009). The exchange’s index, known as SENSEX, itself has 30 companies on its roll. In short, with all the expertise these funds have, they could only find 21 companies of which more than 10 are common occurrences.

A general observation here is we need to really understand what we are buying. These examples show that every fund is not what we think they are.

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.