Beating the Market with ETFs and Tactical Asset Allocation

Transcription

1 Beating the Market with ETFs and Tactical Asset Allocation Marvin Appel, M.D., Ph.D. CEO, Appel Asset Management Corp. Great Neck, NY

2 Beating the Market--outline Navigating the market: A simple way to optimize risk and reward Take the easy way out: The only portfolio you will ever need for long term investing Where the money is: Relative strength as a tactical asset allocation tool. Conclusion Some new ETFs that look promising.

3 A Simple Way to Measure Risk

4 Mar-99 Apr-99 May-99 Jun-99 Jul-99 Aug-99 Sep-99 Oct-99 Nov-99 Jan-00 Feb-00 Mar-00 Dec-99 Growth of $100 3/10/99-3/10/2000 Nasdaq 100 Tracking Stock (QQQQ) First Eagle Global (SGENX)

5 Nasdaq 100 Tracking Stock (QQQQ) First Eagle Global (SGENX) Mar-99 Sep-99 Mar-00 Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Growth of $100 3/10/99-2/27/2007

6 on Jan. 14, % drawdown Dow Jones Industrial Average on Oct. 9, x100 x

7 ishares MSCI Emerging Market Index Fund (EEM) April 2003-May 2006 July-Aug % drawdown March-April % drawdown October % drawdown May-June % drawdown April-May % drawdown

8 S&P 500 Index and worst drawdowns (overall gain 14%/year) 8% drawdown ishares MSCI Emerging Market Index Fund (EEM) April 2003-May 2006 (overall gain 40%/year) 7% drawdown 5% drawdown 8% drawdown 6% drawdown Feb.-March % drawdown 9% drawdown x10 x1090 July-Aug % drawdown April-May % drawdown March-April % drawdown October % drawdown May-June % drawdown

9 Different areas of the stock market

10 Market capitalization Value of all a company s shares = market capitalization. Large-cap = $10 billion and over Small-cap = $2 billion and under As a general rule, compared to small-caps, largecap stocks have tended to be safer slightly less profitable Better when the U.S. dollar is weaker (large-caps have more of their earnings from sales abroad)

11 Value versus growth stocks Value stocks appear to be good bargains based on the current situation of the company. Growth stocks appear expensive based on the current situation but the price is potentially justified by the future situation. As a general rule, compared to growth stocks value stocks have tended to Pay higher dividends Be less risky Gain less during strong market climates Hold up better during weak market climates

12 Value and growth stocks (cont.) Industries more likely to have value stocks Financials Large oil companies Utilities Industries more likely to have growth stocks Technology Healthcare Consumer discretionary (homebuilding, media, entertainment)

13 Value Large-cap Large-cap value Small-cap Small-cap value Growth Large-cap growth Small-cap growth

14 Diversification: Improve safety by not putting all your eggs in one basket.

15 A properly diversified portfolio should have a better balance between risk and reward than any of its individual components Real estate (REIT's) Small cap value S&P 500 Diversified April, 2004: REIT's lose 14% : REIT's fall, S&P 500 pulls portfolio higher. 2002: Portfolio loses less than any of its separate components. Feb-97 Aug-97 Feb-98 Aug-98 Feb-99 Aug-99 Feb-00 Aug-00 Feb-01 Aug-01 Feb-02 Aug-02 Feb-03 Aug-03 Feb-04 Aug-04 Feb-05

16 REITs and Small-cap Value have not always been more profitable than the S&P % 60.00% 50.00% 40.00% REIT fund average Russell 2000 Value Index S&P 500 Index Fund Diversified equity mix 30.00% 20.00% 10.00% 0.00% % % Dec-86 Mar-87 Jun-87 Sep-87 Dec-87 Mar-88 Jun-88 Sep-88 Dec-88 Mar-89 Jun-89 Sep-89 Dec-89 Mar-90 Jun-90 Sep-90 Dec-90

17 Diversification in action: The One-decision portfolio Cash 60% of income half (30% of total portfolio) Income half of portfolio Stock half of portfolio S&P % of stock half (20% of total portfolio) Bonds 40% of income half (20% of total portfolio) Small cap value 20% of stock half (10% of total portfolio) REITs 40% of stock half (20% of total portfolio)

18 Compounded annual gains for the components of the one-decision portfolio % 14% 12% 10% 9.0% 14.3% 11.5% 12.7% 10.3% 11.9% 8% 6% 6.4% 4% 2% 0% US Bonds T-bills Russell 2000 Value S&P 500 REITs onedecision portfolio onedecision, no cash

19 Drawdowns of the one-decision portfolio and its components 0% -5% US Bonds T-bills -1% Russell 2000 Value S&P 500 REITs onedecision portfolio onedecision, no cash -10% -15% -20% -25% -9% -21% -11% -16% -30% -35% -40% -33% -45% -45%

20 Risk-adjusted performance US Bonds T-bills Russell 2000 Value S&P 500 REITs onedecision portfolio onedecision, no cash

21 Implementing the one-decision portfolio Vanguard portfolio 20% S&P 500 Index fund (VFINX) 10% Small-cap value index fund (VISVX) 20% REITs (VGSIX) 20% U.S. investment grade bonds (VBMFX) 30% cash (Vanguard Prime Money Market or NJ Tax-exempt money market if tax bracket is above 30%) ETF/Fund portfolio 20% S&P 500 Index ETF (SPY) 10% ishares S&P 600 Value Index ETF (IJS) 20% ishares Cohen & Steers Realty Majors (ICF) 20% U.S. investment grade bonds (AGG) 30% Highland Floating Rate (XLFAX only through discount brokerage with no load)

22 Trend-Following Strategies Attempt to recognize new long-term trends after they have begun (but early enough to be able to profit) Can outperform a broadlybased benchmark when a strong trend is in force. Can trail a broadly-based benchmark when the prevailing trend is in the process of changing or when there is no major trend.

23 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Russell 1000 Value (large cap value) Russell 1000 Growth (large cap growth) Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Russell 1000 Value / Russell 1000 Growth Rising means value stronger than growth. Falling means growth stronger than value. Sept July 2006 Trend favored value.

24 Sep-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-02 Dec-06 Mar-07 Jun Russell 1000 Value (large-cap value) Russell 1000 Growth (large-cap growth) Half value / half growth

25 MSCI Emerging Markets Index MSCI Europe Index : Emerging markets stronger Rising = Em. Mkts stronger Falling = Europe stronger : Europe stronger : Emerging markets stronger Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05

26 Example: Selecting Which Part of the World in which to Invest ishares MSCI Emerging Market ETF (EEM) ishares MSCI Japan (EWJ) ishares S&P Europe 350 ETF (IEV) On the last day of each quarter, select the single one of the three ETFs above that gained the most. Hold that for the upcoming quarter.

27 Mar-88 Mar-89 Mar-90 Mar-91 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Emerging Mkts Europe Japan Active strategy average Source:

28 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul EEM MSCI Em. Mkt IEV MSCI Europe EWJ MSCI Japan Emerging markets: index and ETF Europe: index and ETF Japan: index and ETF

29 Hypothetical Growth of $10, Using Russell 1000 Value, Russell 1000 Growth Russell 2000 Value, Russell 2000 Growth Top 2 styles each quarter Top style each quarter Average of four styles Mar-79 Mar-81 Mar-83 Mar-85 Mar-87 Mar-89 Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07

30 Implementing the U.S. Equity Style Allocation Model ishares Russell 1000 Value ETF (IWD) ishares Russell 1000 Growth ETF (IWF) ishares Russell 2000 Value ETF (IWN) ishares Russell 2000 Growth ETF (IWO) Advanced strategy Use ishares S&P 500 Growth ETF (IVW) and S&P 600 Growth ETF (IJT) instead of IWF and IWO.

31 Current model recommendations for the first quarter of 2008 Among U.S. equity investment styles, small and large cap growth are selected (IJT and IVW) Among foreign markets, emerging markets are selected (EEM)

32 New ETFs That Can Work for You. Future investment results cannot be guaranteed.

33 Pros and cons of new ETFs New asset classes (commodities and currencies). More international exposure. Higher dividend income (Wisdom Tree, ishares DVY and PFF) New indexing methodologies might perform better than float weighting in certain investment climates Equal weighting (Rydex) Fundamental weighting (Wisdom Tree) Specialized funds (PHO) Lower liquidity Higher expenses than original ETFs Unproven methods of index construction. Little real-time trading experience. Less transparency (proprietary indexes such as Claymore, Power Shares)

34 Promising New ETFs Exchange-traded Notes (ETNs) for commodity and currency exposure Investment income Equities with high dividend yields High-yield bond ETFs: PFF and HYG Tax-free bonds

35 ipath Exchange-Traded Notes (ETNs) These track investments that you otherwise could not buy or short directly. ETNs track a variety of commodity indexes and foreign currencies. Unlike ETFs, ETNs do not represent proportional ownership of a portfolio. Rather, ETNs are derivatives with Barclays as the counter-party. For now, ETNs enjoy better tax treatment if held for more than a year. Commodity ETNs have an expense ratio of 0.45%.

36 Example DJ AIG Commodity Index Total Return Goal is to match the return of an unleveraged investment in the underlying future including interest on cash collateral. 9% 8% 34% Energy Agriculture 16% 33% Industrial metals Precious metals Livestock

37 DJP has closely tracked its benchmark ipath ETN (DJP, left scale) DJ-AIG Commodity Index plus interest less 0.75%/yr (right scale) /8/2006 8/8/ /8/ /8/2006 2/8/2007 4/8/2007 6/8/2007 8/8/ /8/ /8/2007

38 An example of poor ETF tracking: USO versus spot crude Price Change (%) from 12/29/2006 to 1/15/ Crude oil spot US Oil Fund (USO) Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2008

39 10/29/ /5/ /12/ /19/ /26/ /3/ /10/ /17/ /24/ /31/2007 1/7/2008 1/14/ % 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% -20.0% Entire DJ-AIG Index Agricultural Industrial Metals Energy

40 Mutual Fund Alternatives Oppenheimer Commodity Strategies Total Return (QRAAX) Active strategies to invest in commodities Pimco Commodity Real Return Fund (PCRAX) Invests in a passive mix of DJ- AIG Commodity Index (same as DJP) and TIPS.

41 Mar-97 Sep-97 Mar-98 Sep-98 Mar-99 Sep-99 Mar-00 Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep Oppenheimer (QRAAX) Pimco (PCRAX) DJP (back-generated)

42 ETFs for Investment Income Preferred stocks: PFF has yielded 7%/year so far. High-yield foreign and U.S. stock ETFs from Wisdom Tree yield more than 5%/year Bonds Junk bonds (ishares HYG) Muni bonds (TFI, MUB)

43 5 Financial Sector SPDR (XLF) Preferred Stock ETF (PFF) Price changes since 3/30/20007 (%,excluding dividends) May June July August September November December2008

44 Selected Wisdom Tree Funds High Yield Emerging Market (DEM) Energy, materials, telecom (yield 5.4%, expense 0.6%) Pacific Ex-Japan High Yield (DNH) Mainly Australian/New Zealand banks (yield 5.5%, expense 0.6%) Small-cap Dividend Fund (DES) Majority financials (yield 5.9%, expense 0.4%) source:

45 High-Yielding Emerging Market Stocks (DEM) not overweighted in financials 20% Total Return (%) 7/13/2007-2/1/ % 10% 5% 0% -5% -10% -15% -20% Wisdom Tree HY Emerging Market (DEM) ishares MSCI Emerging Market (EEM) 7/13/07 7/27/07 8/10/07 8/24/07 9/7/07 9/21/07 10/5/07 10/19/07 11/2/07 11/16/07 11/30/07 12/14/07 12/28/07 1/11/08 1/25/08 Less volatile compared to EEM (but history is very short).

46 Watch your style exposure 80% Total Return (%) 6/2006-1/ % 60% 50% 40% 30% 20% 10% 0% Wisdom Tree Pacific ex-japan High Yield (DNH) ishares Pacific ex-japan (EPP) 6/20/2006 7/20/2006 8/20/2006 9/20/ /20/ /20/ /20/2006 1/20/2007 2/20/2007 3/20/2007 4/20/2007 5/20/2007 6/20/2007 7/20/2007 8/20/2007 9/20/ /20/ /20/ /20/2007 1/20/2008 Both EPP and DNH are heavily weighted in Austrialian banks.

47 High dividends from small caps 25% 20% 15% 10% 5% 0% -5% Wisdom Tree Small Cap Dividend (DES) ishares Russell 2000 Value (IWN) -10% 6/19/06 7/19/06 8/19/06 9/19/06 10/19/06 11/19/06 12/19/06 1/19/07 2/19/07 3/19/07 4/19/07 5/19/07 6/19/07 7/19/07 8/19/07 9/19/07 10/19/07 11/19/07 12/19/07 1/19/08 DES: 56% financials, IWN 34% financials. Yet, the investment behavior has been very similar (6/19/2006-2/1/2008)

48 Municipal Bond ETFs Low costs should be a big advantage. ishares S&P National Muni Fund (MUB) expenses 0.25%, SEC yield 3.4%, average maturity 8.9 years, 56 holdings. SPDR Lehman Muni Bond ETF (TFI) expenses 0.2%, SEC yield 3.3%, average maturity 9.3 years, 81 holdings. Tough competition: Vanguard Intermediate-term Tax Exempt (VWITX) Same yield, lower expenses, less interest rate risk, more diversification--expenses 0.15%, SEC yield 3.4%, average maturity 6.7 years, 1365 holdings

49 Miscellaneous ETFs Water resources (unavailable as a mutual fund) Utilities Large-cap: stick to basics Small-cap: Use Rydex Equal-Weight (RYU)

50 Water resources a unique ETF (PHO) that is like a mutual fund in disguise. 50% 40% 30% PowerShares Water Portfolio (PHO) ishares S&P 400 Growth Index ETF (IJK) 20% 10% 0% -10% 12/7/05 2/7/06 4/7/06 6/7/06 8/7/06 10/7/06 12/7/06 2/7/07 4/7/07 6/7/07 8/7/07 10/7/07 12/7/07 0.7% expense ratio. Tracks the Palisades Water Index (?), whose component stocks are mostly mid-cap and small-cap growth.

51 Sometimes simple is best (utilities) 40% 35% 30% Total Return (%) in Two U.S. Large-Cap Utilities Sector ETFs, 9/21/2006-2/1/ % 20% 15% 10% 5% 0% -5% PowerShares FTSE/RAFI Utilities (PRFU) Utilities Sector SPDR (XLU) 9/21/06 10/21/06 11/21/06 12/21/06 1/21/07 2/21/07 3/21/07 4/21/07 5/21/07 6/21/07 7/21/07 8/21/07 9/21/07 10/21/07 11/21/07 12/21/07 1/21/08 Expenses: 0.23% for XLU; 0.75% for PRFU

52

53 For a free trial to our bi-weekly market newsletter, Systems and Forecasts, visit us at

54 Appel Asset Management Corp.