Anatomy of a Portfolio Change – Core Equity Spotlight on SCHF

money on the brainAs part of our ongoing series of spotlighting one of our Investment Model preferred holdings, I would like to provide some color on the Schwab International Equity ETF (symbol: SCHF). SCHF is brand new to our Core Equity Model Portfolio so we thought it may be educational to our readers to go through the mechanics involved during a portfolio change to spotlight some of the behind-the-scenes processes.

Our main investment management goal: participating in “good” times and protecting in “bad” times. To put it in baseball terms, and I must do that as the Chicago Cubs are playing meaningful baseball still here in June, those that have worked with us know that we aren’t focused on hitting “home runs”; instead we are more interested in avoiding unnecessary risk and “hitting steady singles and doubles.”

How we seek to accomplish our goal:

  1. We have three main strategies: our Core Equity, Core Fixed Income, and Liquid Alternatives models.
  2. We use a combination of passive and active styles within our strategies. We generally use passive for our Traditional Core Equity and Fixed models, and use active for our Liquid Alternatives model.
  3. We generally only use relatively low-cost mutual funds and ETFs. (From last month’s blog, you learned that our Core Equity model had a weighted OER of 0.34% (now 0.32% after change described below), and our Core Fixed Model has a weighted OER of 0.37%.)

So, what’s our process? Here’s the short list in layman’s terms:

  1. Keep informed and educated. We stay abreast of the latest by reading a lot, attending conferences and trade shows, and networking with others both inside and outside of the financial industry.
  2. Constantly monitor the investment landscape for what’s new and knowing what’s already out there.
  3. Monitor and track current holdings. Adjust weights if needed.
  4. Analyze if anything out there is better than what we already have in place.
  5. Avoid unnecessary transactions and over-trading: transactions can be costly if not done correctly. Furthermore, it may lead to unnecessary tax ramifications.
  6. Understand where the market cycle is and never fall victim to trading based on emotion. I.e. buying the latest fad (buying high) or selling something temporarily out of fashion (selling low).
  7. Rebalance regularly to get your asset allocation percentages in-line with their target, thus, in concept, buying low and selling high.
  8. Trade efficiently. Strive for best execution. Every client is treated fairly when traded on a global basis.
  9. Ultimately, make thoughtful, wise changes where expected value is apparent. (No knee-jerk reactions).

Now, let’s look at that process in action. Last month, as part of our regular research, we came across a swap opportunity within our Core Equity strategy.

We found some advantages of holding the Schwab International Equity ETF (symbol: SCHF) over one of our then current Core Equity model holdings: the Dreyfus International Stock Index mutual fund (symbol: DIISX). Listed below are the major reasons why:

  • Similar coverage: both seek diversified international developed exposure, something we desire to hold for a minority allocation within this Core Equity strategy.
  • Lower Operating Expense Ratio (“OER”): SCHF has the lowest OER of any of its peers in this space at a ridiculously lean 0.08%.
  • No transaction fee: Typically, ETFs have a $8.95/trade transaction fee, but as part of Schwab’s relatively new ETF OneSource platform, SCHF can also be bought and sold with $0 transaction costs which is the same as DIISX, but…
  • Not subject to a Short-Term Redemption Fee (“STRF”): Mutual funds on Schwab’s OneSource platform generally need to be held for 90 days or are subject to a 2% STRF. STRFs were put in place to prevent “day trading” these funds which in many people’s eyes are meant for the long-term. However, ETFs are a different breed of animal in that they trade intra-day and the day trading issues are really not valid. As such, ETFs both on and off Schwab’s ETF OneSource platform are not subject to any STRF. Fabulous!

DIISX had been good at providing us with diversified international developed exposure while charging a modest 0.60% OER. But in this fast paced age, new products are increasingly becoming available. A lot of them are just a silly variation of something we already have, or something completely unnecessary. But every once in a while something decent comes out which may not be a perfect fit at first, and we keep it on our radar. In the case of SCHF, we needed to make sure that Schwab ETFs would develop a meaningful following and that this security would have appropriate liquidity (measured by its average trading volume) – those are both valid today. Furthermore, the success so far of the Schwab ETF OneSource platform, with its attractive characteristics listed above, made our decision to make a portfolio change an even easier one.

As always, please don’t hesitate to ask any questions about costs, trading, investment vehicles or anything else. And, go Cubs!

Liquid Alternatives: Clarifying Some of the Recent Press

We’ve seen some bad press lately about liquid alternatives saying that in general these new funds have not proven themselves. It’s no coincidence that this comes at a time when the equity markets are at all-time highs after a 5 year bull run. This bad press is unwarranted.

Many of these articles fail to point out exactly why alternatives are a necessary part of one’s portfolio. They are there as a diversifier to the rest of your portfolio; the zig to the zag. This diversification comes in quite handy when equity returns decline, volatility increases, and interest rates rise. All of which could happen sooner rather than later.

It wouldn’t make any sense if alternatives were up say 20% in a year stocks were up 20%. If so, those two asset classes are totally correlated. Alternatives best trait is being non-correlated to other asset classes, be it stocks and/or bonds. Frankly, expectations of alternatives are probably too high for most people. Our expectations for alternatives (as a group) would be around 6-8% per annum. But more importantly, our expectations for alternatives is that they won’t be down dollar for dollar when equities have a 10% or worse correction.

And that’s the real beauty. By using alternatives and avoiding a blow-up like many hard-core equity investors did in 2008, you don’t have a huge hole to dig yourself out of.

Investors should know that alternatives come in two categories:

  1. Alternative strategies – that utilize traditional asset classes (stocks and bonds) in non-traditional ways. Examples: Long/Short Equity, Long/Short Fixed, Market Neutral
  2. Alternative assets – non-traditional asset classes (anything that’s not a stock or bond). Examples: Real Estate, Infrastructure, Commodities

*Some alternative funds combine both strategies and assets. Examples: Managed Futures, Multi-Strategy, Fund of Funds.

Alternatives are typically used for four major reasons:

  1. Reduce Volatility
  2. Generate Income
  3. Increase returns
  4. Address A Specific Risk

Most alternatives may only align with one of the four objectives above. Very rarely will an alternative be able to do all of that. For example, infrastructure is really just a “generate income” play. Whereas Market Neutral isn’t necessarily increasing returns or generating income but there to reduce volatility and limit max drawdown. The table below shows how different these alts can be.

Liquid alts

That being said, you need to know what you own to invest in this area. As a portfolio manager, DWM seeks to understand the risk/return profile, market exposure, correlation to traditional asset classes and the manager skill and experience before we make an addition to our Liquid Alternatives Model. We also identify how one fund correlates (or hopefully doesn’t correlate) with the other funds within the model. We think our model blends the above objectives in a optimized way to benefit our clients’ portfolios. We’ve been working with “liquid alts” for a decade now and they have proven to be quite beneficial for us and our clients.

In conclusion, the bad press we see every once in a while on liquid alts is not warranted and typically comes from the misunderstanding of what can be a complicated area. We hope this article has provided some education. For further information on alternatives, don’t hesitate to contact us.

Liquid Alternative Monthly Investment Spotlight: Pioneer Dynamic Credit Fund (RCRAX)

(Click above for full size image)
(Click above for full size image)

As part of our monthly series of spotlighting one of our Liquid Alternatives preferred holdings, I would like to provide some color on the Pioneer Dynamic Credit Fund (symbol: RCRAX).

On the surface, RCRAX may look like any other bond fund and one may ask what it’s doing in our alternative model line-up. Well, it’s anything like a traditional bond fund once you take a look under the hood. RCRAX is a non-traditional fund utilizing fixed income securities in alternative ways such as shorting or using derivatives, default swaps, event linked bonds, etc. As such, it’s basically an absolute return fund using fixed income vehicles.

Let’s review a little about the credit markets. Income is now a scarce commodity. As a result, investors are forced to take on more risk in order to achieve the same levels of income that they have experienced in the past. Unfortunately, fixed income investors face a more volatile and uncertain investment environment than the last few decades. However, volatility can create opportunities, and a flexible investment approach may be able to capitalize upon these opportunities.

Credit can provide strong returns, but one must tread carefully as downturns in the credit cycle can cause large a drawdown, the peak-to-trough decline during a specific record period of an investment. The traditional response to a credit downturn is to increase credit quality and/or add Government Bonds. The former can hurt the portfolio due to transaction costs as market liquidity deteriorates. The later may be less effective in the future given how compressed the yield curve is. We think a more effective risk management strategy for an all-credit portfolio lies in what Pioneer calls their multi-layered hedging approach. This multi-layered hedging strategy seeks to buffer volatility and provide a measure of protection from extreme market dislocations. And as our clients know, protection is one of our number one goals at DWM.

Put it all together and you have a multi-sector credit portfolio designed to adjust allocations in order to take advantage of opportunities based on valuations, volatility, dislocations and market timing across credit markets. Portfolio construction, allocation, and security selection are driven by an integrated quantitative and fundamental research framework. We get excited about this fund because it can and does short different parts of the bond market, which means it can take advantage of rising rates! It also plays in areas that the standard traditional bond funds don’t, like convertible securities, floating rate securities, and currencies.

This approach has landed RCRAX in the top quartile of the non-traditional bond category as determined by Morningstar since its inception in 2011. And of course this approach has given us reason to give it a seat in our Liquid Alternative model.

Again, alternatives provide an additional asset class that can produce new sources of returns with lower correlation and reduced volatility. We expect volatility and returns for the alternative portion of one’s portfolio to be somewhere between what you would expect of stocks and bonds, with an extra bonus emphasis on downside protection. We continue to watch this exciting area of investment management for continued opportunities and use this forum as an educational tool.

Please don’t hesitate to reach out to the DWM team if you have a particular question on liquid alternatives and/or just want to say ‘Hi’!

Liquid Alternative Monthly Investment Spotlight: AQR Managed Futures (symbol: AQMNX)

Graph picAs part of our monthly series of spotlighting one of our Liquid Alternatives preferred holdings, I would like to provide some color on the AQR Managed Futures Mutual Fund (symbol: AQMNX). There are a few different ways to get exposure to managed futures. We think the best liquid and cost-efficient way to do so is by using a single manager option vs. a multi-manager option, which means there are not multiple layers of fees. Although this fund is managed systematically, the firm’s principals have been managing trend-following strategies for institutional clients since the mid-1990s. We are big fans of the managers who have some of the best alternative experience in the business. AQR was founded in 1998 and is headquartered in Greenwich, CT, and also have satellite offices in Chicago, London, and Sydney. I personally visited their Chicago offices and was very impressed with everything, particularly the culture. Their philosophy and approach is deeply grounded in empirical finance research.      

Managed futures investing is an alternative investment strategy in which portfolio managers look to profit from identifying short and/or long term trends via the use of future contracts. Introducing futures into a portfolio reduces risk because of the negative correlation between asset groups.  

This managed futures fund invests in commodities, equities, currencies, and fixed income – they gravitate to the spot where the research is identifying the best trend. They also work in both short-term trends (one to three months) and long-term trends (up to 12 months). Both long and short positions are employed. Of course, we think the best part of this strategy is the non-correlation it brings to the table which ultimately offers more protection to your overall portfolio should the stock market fall off. If stocks head south, this fund has no correlation and is doing its own thing. In 2008 when stocks got torn apart, managed futures was one of the only strategies that really excelled. With the equity bull market being “long in the tooth” and with fixed income not the most attractive place to be right now, we really like holding this position within our Liquid Alternatives Model and clients’ portfolios.

Again, alternatives provide an additional asset class that can produce new sources of returns with lower correlation and reduced volatility. We expect volatility and returns for the alternative portion of one’s portfolio to be somewhere between what you would expect of stocks and bonds, with an extra bonus emphasis on downside protection. We continue to watch this exciting area of investment management for continued opportunities and use this forum as an educational tool.

Please don’t hesitate to reach out to the DWM team if you have a particular question on liquid alternatives and/or just want to say ‘Hi’!  

Liquid Alternative Monthly Spotlight

saupload_MLP-ETFsThis month: Master Limited Partnerships (MLPs)

For the next few months, I will spotlight a strategy utilized within our Liquid Alternatives model to give the reader a better idea of what “alternative” means and how it adds value. To start our series off, we will talk about MLPs.

Master Limited Partnerships, or MLPs for short, are limited partnerships that are publicly traded. The majority of MLPs currently operate in the energy infrastructure industry, owning assets such as pipelines that transport crude oil, natural gas and other refined petroleum products. MLPs typically generate fee-based revenues, which tend not to be directly tied to changes in commodity prices. In other words, these companies are like toll-keepers, picking up a fee every time someone has to transport a product. We like this because it is not about the commodity that they’re transporting – those tend to be quite volatile – it is really just about the steady, consistent “toll” they bring in.

In our Liquid Alternative model, DWM uses the JPMorgan Alerian MLP Index ETN (symbol: AMJ) for this MLP exposure. AMJ tracks a variety of different types of MLPs: petroleum transportation, natural gas pipelines, propane, exploration/production, and gathering and processing. These firms operate at various stages of the transportation of energy. The largest MLPs own several businesses to capitalize on their scale and offer start-to-finish services. Kinder Morgan is an example of an MLP like this and a company you may have heard of before. Federal regulations require new energy projects to undergo a rigorous vetting process, so economically unviable pipelines are rarely built. As a result, most pipelines and processing facilities run by MLPS are local monopolies and are quite lucrative.

We like MLPs for a number of reasons. First, they provide relatively low correlation to the traditional asset classes of equities and bonds. Second, they have produced attractive yields – current yield of AMJ is around 4.68%. Third, in the past few years besides the nice coupon, there’s also been price appreciation. In fact, AMJ’s 3 yr annualized total return as of 6/12/13 was 20.91%.

Some people knock MLPs because typically the burdensome K-1 forms are associated with them. But because we use AMJ, which is an exchange traded note from JPMorgan, investors get the friendlier 1099 tax form. Another advantage of AMJ is the diversification it provides: the Alerian MLP Index is a market-cap weighted, float-adjusted index that covers the major players (Enterprise Products, Kinder Morgan, Plains All American Pipeline, Magellan, etc) within the MLP space.

As you can see, MLPs are a different breed and we think make for a compelling investment opportunity. As such, AMJ is a star player on our Liquid Alternative team. Next month we will introduce you to some other stars also on that team!

Core and Satellite Investing

From The Charleston Mercury, November 15, 2012

Let’s face it. We probably will have at least a few more years of slow growth along with world and investment environment uncertainty. Seems to me you have three choices: sit in cash (and make almost no return while inflation erodes your purchasing power), stay in your current asset allocation of stocks and bonds (and hope your portfolio doesn’t get hit like it did in 2008), or consider a core and satellite portfolio (designed to participate when the market goes up and protect your assets when the market goes down.)

Try to visualize your total portfolio as a car tire, viewed from the side. The rim and everything within is the core; the tire itself is the “satellite” portion. The core is composed of traditional equity and fixed segments seeking to provide higher expected returns with lower risk in a cost-efficient manner. The satellite portion is composed of investments that do not correlate with the traditional markets. The satellite seeks to provide solid returns and provide diversification and downside protection for the overall portfolio.

The core investments are in low-cost, tax efficient passive mutual funds and ETFs. Research, primarily the Efficient Markets Hypothesis, has shown that active management cannot consistently add value through security selection and market timing in efficient (traditional) markets. For the five years ended December 31, 2011, roughly 75% of actively managed mutual funds underperformed their benchmarks. There are three reasons for this: higher fees (operating expense ratios), more transaction costs, and more tax ramifications. Of these, the fees are the biggest culprit. Actively managed funds cost about one percent per year more than passive funds. That one percent shortfall ultimately results in underperformance and costs investors lots of money.

Therefore, a passive strategy in the core portfolio of traditional investments produces, on average, better returns.

On, the other hand, active management, can be more appropriate in inefficient markets. One good example is liquid alternatives. These publicly traded securities are non-correlated to the stock markets, are easily redeemable and may follow hedge-fund like strategies. The liquid alternatives should be considered for the satellite portion of the portfolio. These funds are specially designed to participate in up markets and protect in down markets. They have been shown to be particularly valuable in limiting losses during bear markets.

Consider a core and satellite portfolio, with passive investments in the core and actively managed liquid alternatives in the satellite. You get diversification, lower volatility and a portfolio designed to protect your assets and grow them. Something we all need in these uncertain times.

Les Detterbeck is one of a small number of investment professionals in the country who has attained CPA, CFP®, and CFA designations. His firm, DWM Financial Group, Inc., a fee-only Registered Investment Adviser, has offices in Charleston/Mt.Pleasant and Chicago. Les may be contacted at (843)-577-2463 or

DWM 2Q12 Market Commentary

Detterbeck Wealth Management sherpaAfter the investor party that took place in the 1st quarter, 2q12 started like a bad hangover with most stock indices getting hit hard in May. Fortunately the best month of June (at least for the S&P500) since 1999 helped recoup some of the early losses. 

For the record, the average US diversified stock fund posted a -4.6% return for the second quarter yet remains up 7% so far this year! That’s pretty amazing given the soft economic conditions here in the U.S. and the turmoil overseas. And speaking of overseas, the international markets continued to lag the domestic markets in the second quarter as evidenced by diversified international stock funds dropping 7.1%, yet still up 3.8% Year-To-Date (“YTD”). It should be noted that international outperformed domestic in the month of June, a trend we expect to continue. Another note was value outperformed growth in 2Q12. 

With stocks trending down most of the quarter, investors gravitated to safety as expressed by the relatively strong showing in the bond world. The Barclays Capt’l US Aggregate Bond Index was up 2.1% for the quarter and now up 2.4% YTD. Yields on 10-year Treasury notes fell to 1.5% last week, near the lowest levels in generations, reflecting market dreariness about the economy and also possibly the anticipation of more action by the Fed. 

Turning toward alternatives, our DWM Liquid Alternatives portfolio did its primary job of protecting first, participating-in-upside second, up almost 1% for the quarter and now up almost 5% on the year. During the quarter, we successfully merged in alts like real estate, gold, and other commodities that were held in strategic models into the LA portfolios for more-focused strategy tracking moving forward.    

Going forward, there are many challenges: 5 of 17 Eurozone countries have received a financial bailout in the last 2½ years with more on the horizon. Let’s face it, its not just the PIGS (Portugal,Ireland,Greece, and Spain) that we need to worry about; the whole Eurozone faces recession. Move Far East, and even China is slowing down. Back in the homeland, our latest readings show slowing new orders, production, etc. Three years after the end of the nation’s most recent recession, the U.S.employs almost 4 million fewer Americans than when the recession began and 12.7 million people remain jobless. And the worst is that Joe Consumer is not spending as much as he did just last year. In the political arena, we are now in the Presidential Election wait-game with not much getting done in Washington D.C.before that wraps up. And frankly there’s a lot that needs attention politically… Did you know that Federal spending on Social Security, Medicare and Medicaid has risen from 16% of total government spending in 1967 to 41% of spending in 2011 and the percentage is only going to go higher unless serious changes are made?

The good news is that almost all of the major global central banks are taking steps to bolster economic output. U.S. Fed Head Bernanke said last month “We are prepared to do what’s necessary”. We think they’ll keep this attitude for the near future and hence don’t anticipate rates/inflation moving up any time soon. This should create an environment where stocks are volatile, bonds have modest returns, and alternatives are the key driver in your portfolio’s total return.  

In conclusion, here are a few more general comments on the stock market. Of course, stocks (equities) only represent a minority allocation for our clients’ portfolios. Diversification amongst stocks, bonds, and alternatives is the key to achieving a stable, long-term return. But equity is the asset class that gets the most headlines. So I thought it would be fun to remind people that as gloomy as the stock market may seem, the S&P500 is now entering its 41st month in the current bull market and has gained 115% (total return) since bottoming 3/09/09. Here’s another tidbit: The average bull market for the S&P500 since 1950 has lasted 58 months. It’ll be fun to see if this current run, even though it may not feel like one, can eclipse the average. As a reminder, if you haven’t already done so, please download the DWM Mobile App to your smartphone so you can see your portfolio at any time and take advantage of the many features within. Enjoy your summer and we hope to connect with you again soon!