Portfolio Construction Quick Hits

First hit is a mid-week article in Barron's where Rob Arnott says investors should "pour money" into factor funds. I'm certainly not more clued in than Arnott, but trying to figure out the timing of factors is a tough game versus maybe a mix of a couple of different factors including market cap weighting (MCW) and sticking with them. There is a how it should work aspect to when some factors will do well. Value and dividends usually hold up better during downturns, momentum is kind of an early/mid-cycle performer, buybacks seem to outperform randomly and haphazardly while at other times lagging. 

We spent time over the summer looking at a lot of ways to use various types of alternatives to replace fixed income as a way of managing or offsetting equity volatility. With that part gone over many times, the next experiment in the portfolio lab is trying to figure out whether there is a way to blend a couple of factors together in such a way as to get a better risk adjusted result than market cap weighting, so less volatility but a competitive annualized return and maybe a few extra basis points of yield. The potential trap is chasing last year's heat, last year's winner. If you're going to use factor funds, I think you need to stick with whichever one(s) you end up choosing. 

The second hit is from the Barron's cover story gives an update and outlook for various income sectors; things like MLPs, high yield and one of their favorites to mention, convertible bonds. Ages ago I had convertible bond exposure through a closed end fund. The yield was sky high thanks to leverage, it did well for a while then wilted during the financial crisis. The big ETF in the space is the SPDR Convertible Securities ETF (CWB). I've mentioned this fund before. It is not really a defensive hold. It is probably considered a fixed income fund but if you look at it, it has equity-like beta. I was curious to see what including it into a couple of different types of portfolios would do.

 

Note that Portfolio 1 is 100% allocated to Vanguard Balanced Index Fund (VBAIX) which is a proxy for a 60/40 portfolio. Portfolio 2 is a simple return stack portfolio and Portfolio 3 is a mix of different exposures kind of in line with how I build client portfolio (I use narrower exposures but this the portfolio lab after all).

Portfolio 3 blends together the factors of momentum and dividends with CWB being thought of as a lower volatility equity exposure. Then there are a couple of alternative strategies that we've been talking about for ages. Using CWB as a lower volatility equity exposure blended with momentum delivers a good result versus the other two. There's something to this but not quite there yet. I do want to stress that I do not think of CWB as a fixed income proxy. 

I have no interest or intention of buying any of the funds mentioned personally or for clients.