Building a Diversified, Low-Cost, High-Performance ETF Portfolio

In this article you will learn how to build a diversified portfolio of multiple asset classes without having to pay a manager

The stock indexes including the S&P 500 and the Dow Jones Industrial Average have been rising in 2009 but does this mean investors should be all in stock? According to the most recent ‘Survey of Consumer Finances’ that is what almost all investors have done, however, a few exceptions to that trend.

The top 10% wealthiest Americans have continued to own stock but have also increased their holdings in bonds and income investments. The other 90% have moved out of bonds so completely it no longer registers on the survey. Is one population better off for the choices they have made to diversify or concentrate?

Video: Part One of Building a Diversified Portfolio

What adds more interest to this phenomenon is that over the recent survey period the top 10% wealthiest investors have seen an increase of 100% to their portfolios prior to the most recent crash.

The gains for the other 90% were barely a third of that. This is not a coincidence. Despite the marketing hype and the excitement around the earnings-game there is a reason to be invested in more than just stocks.

Asset allocation and portfolio management are difficult subjects for many investors. This is due in equal parts to the fact that there is a lack of consensus among professionals as to the best way to approach these problems and the issues can be complicated.

These complications can be both cognitive (asset allocation requires a learning process) and emotional (greed often conspires against rational investing). However, there are ways to both simplify the issues and to make it achievable for even very small investors to begin understanding and applying the key concepts behind portfolio management.

In this article series I will introduce the basic concepts of asset allocation through a three step process. You will learn these basic principles.

1. Determining allocation percentages
2. Investing in individual securities (stocks, bonds, futures, etc.) or funds (mutual funds or ETFs)
3. Making adjustments and rebalancing a portfolio

Lets start with determining allocation percentages. Most investment professionals will agree that a blend of asset classes within your portfolio is a good thing but how large those allocations are is a much more cloudy issue. There are basically two factors that you have to consider when deciding on your own allocation strategy.

– How much of a bear market burden can you handle
– What kind of future returns do you want

These two factors are difficult to reconcile. Higher return assets like stocks are often accompanied by very large and unexpected corrections to the downside leading to a large bear market burden. While investment grade and government bonds have a great deal of capital protection they offer low long term returns.

Here is a good example of how two hypothetical allocations acted during different market conditions.

1. An 80/20% mix of stocks to bonds lost -34% in the bear market of 2000-20002 and lost -54% in the bear market of 2008-2009 (so far)
2. A 20/80% mix of stocks to bonds gained 7% in the bear market of 2000-2002 and gained 14% in the bear market of 2008-2009 (so far)

When looked at during these periods the bear market burden seems to bias investors towards a more conservative bond portfolio. However, over longer periods of time that include bull markets, the higher risk portfolio will outperform the lower risk portfolio including inflation by a ratio of 2:1. Finding the right mix for you is the real challenge within asset allocation.

In the video above, I look at how to start solving this problem so that you can refine your allocation yourself. You will learn thatn there are more than two asset classes to choose from, and the more uncorrelated asset classes you include the better your diversification will be. You will also learn why considering your age and retirement horizon will give you some insight into how heavily you invest in riskier assets like equities. I will start this video series by creating a fairly general asset allocation strategy that we can refine as we progress.

Part 2: Investing across asset classes is as important as diversifying within an asset class

Asset allocation does not have to be complicated. Current market products and cost structures make self-management and asset class diversification more achievable than ever before. In part two of this article I will walk through the decision-process between utilizing individual securities to achieve asset class diversification or ETFs and indexed mutual funds.

You will find that while both options are perfectly reasonable, small investors often lean towards ETFs and funds, and in the video I will explain why.

Video: Part Two of Building a Diversified Portfolio

Diversification is a multi-layered issue. There is horizontal diversification across asset classes and another layer of vertical diversification within each asset class. For example, investing in just a single stock will not optimize the benefits of diversification in the same way investing in 12-40 stocks will. Within each asset class you will have to spread your risk across more than one security and this can be difficult for small investors.

Doing this one stock at a time has one major disadvantage – costs. Buying 12-40 individual stocks is certainly possible but commission costs may become prohibitive. For small traders this issue is exacerbated because commissions, which are usually fixed, are a larger percentage of the total investment.

Alternatively, a low cost ETF or indexed mutual fund can provide exposure to many stocks within a single investment and only one commission needs to be paid. In fact, it is possible for an individual investor to use indexed mutual funds to execute a portfolio strategy like we have described and potentially pay no commissions.

The other issue that investors will need to deal with is access. For example, in the portfolio I have constructing within this article series I included commodities as one of the asset classes to increase its diversification, however, when investors think about commodities they think about the futures market. Investing in futures requires a futures margin account, which comes with its own costs and margin requirements that may be prohibitive to small and mid-size investors.

Fortunately investing in commodities, bonds, stocks and real estate can all be done through ETFs or indexed mutual funds. This reduces trading costs, increases sizing flexibility and makes it possible for individual investors to access several asset classes within a single account.

ETFs and indexed mutual funds always come with some costs but these are usually much more reasonable when compared to the convenience and benefits. They are also usually much less expensive that traditional managed funds. In the game of investing, controlling costs is a major priority.

Part 3: Learn how and when to rebalance a diversified portfolio.

With modern financial products even small investors can diversify across several asset classes. However, once achieved do these allocations need to be adjusted? If adjustments are needed how and when is that done? This part of the article will answer those questions.

Video: Part Three of Building a Diversified Portfolio

Some of the most important things to remember from this series of articles is that successful portfolio management relies on simplified processes and low costs. In the last section that meant that most individual investors should have a bias towards funds and ETFs. In this article the same principle applies to keeping allocation adjustments to a minimum.

Adjusting allocations within your portfolio carelessly is a great way to increase trading costs and may lead to over trading. However, some adjustments are usually necessary once asset values have drifted away from the percentage allocations you originally setup.

There are two general ways to approach adjustments. Some traders will reallocate or rebalance their portfolios tactically while others will adjust more passively.

Tactical Reallocation:
Imagine that you have spread your investments evenly across 5 asset classes including stocks and bonds. Assume that a year from now stocks have performed very well and have risen from 20% of your portfolio to 30% while bonds have dropped from 20% to 10%.

A tactical manager may decide that stocks are likely to continue doing well and that even more money should be reallocated to that class. At the same time a tactical manager may decide to reduce their exposure to commodities that that they have decided will become more risky in the near term.

The new asset allocation structure for a tactical manager is based on forecasts and analysis and may continue to change in the future. Often this kind of management is often called “market timing.”

Passive Reallocation:
As a passive manager you are more interested in trying to maintain your desired exposure levels across asset classes than forecasting the future. That means that in the example above you may wish to increase your exposure to bonds while reducing the stocks component to bring the original allocation back to desired levels.

Passive managers typically reallocate based on a calendar date (every 6 or 12 months for example) or based on investing objectives. A passive manager may reallocate assets if their lifestyle or objectives change or on a regularly scheduled plan. This keeps things very simple and prevents over trading.

The principles presented here are not complicated but they can be very powerful over the long term. They can help reduce major portfolio shocks while producing significant returns. From here we will begin working through the practical issues of asset class diversification. You will learn more about how to decide what percentages are appropriate for you, how to find individual investment ideas and what brokerage services are needed.

Part 4: Diversification is easier than you thought and you can do it without a manager

In the first and second sections of this article I glossed over the percentage allocation problem with a fairly generic allocation of 20% per asset class across 5 classes. If you take a closer look, you will see that the portfolio was evenly allocated across risk categories as well. There are a lot of complicated ways to allocate assets and for determining how they should change over time, but it really doesn’t have to be more complicated than that.

Video: Part Four of Building a Diversified Portfolio

For example, a classic rule of thumb is to allocate the same percentage of your assets as your age to conservative investments like bonds and the remainder to riskier assets like stocks. If you are 35 now that means you should have 35% in bonds and the rest in stocks. Similarly, once you reach age 65, you should have 65% in bonds and the rest in stocks.

However, if you think about this strategy for a minute you will find that over those years you were, on average, allocating 50% to bonds and 50% to stocks. You could accomplish the same objective without a lot of age-based rebalancing by just allocating this way in the first place and then remaining consistently balanced.

The point behind this example is to show that you don’t need to get too fancy with your allocation strategy. Find a balance that suits your risk tolerance and stick with it. If your life style changes and your risk tolerance changes with it – then make changes. Over thinking the portfolio percentages problem doesn’t ultimately do very much for you.

Finding Investments
In this series we emphasized the benefits of ETFs or indexed mutual funds as a very low cost alternative to individual securities, futures and bonds. However, this still leaves a pretty large pool of choices available.

Broker Issues
This is where many traders make mistakes. Some brokers specialize in attracting the active investor and may penalize low activity accounts with fees or low/no interest payments on cash reserve balances. Alternatively, many brokers specializing in longer term accounts may charge large commissions up front.

Take some time when evaluating your broker or potential brokers by asking them to quote commissions, fees and interest on cash balances based on your portfolio strategy rather than based on their published rates. Published broker rates can be very biased and difficult to understand within the context of your portfolio needs.

There is an investing adage that says; “your life should be interesting and your investing should be boring.” To a certain extent we feel that is true although we think “boring” should be replaced with “simple.” Modern financial products like ETFs and online brokers have put the tools of the professional in the hands of the consumer investor. Get a little education and you can be on your way to becoming a successful portfolio manager.

Part 5: How to use strategic diversification to increase your profitability

In this article we have discussed a simple but effective way to build a portfolio of diversified assets across different classes and instruments. If you want to stop there that is fine and you could easily become a very effective investment manager.

Or you can move on from here and start learning how to implement investing strategies designed to continue reducing account volatility and increase profits. This article will introduce you to the topic of strategic diversification and give you a starting place to begin learning about options strategies.

Video: Part Five of Building a Diversified Portfolio

Diversification is the only free lunch in the market because it comes with benefits and no disadvantages. However, many traders have no idea what diversification actually is or how to maximize its benefits.

As we have discussed in this series, there is more to a diversified portfolio than just a large pool of stocks, and I think it is easiest to think about diversification in three layers;

1. Horizontal Diversification spreads investment capital across several asset classes. An investor using horizontal diversification may have market exposure to stocks, bonds, currencies, treasuries or other asset classes at the same time. Within each of those asset classes, a prudent investor could use vertical diversification to maximize their benefits.

2. Vertical Diversification is what you are doing when you invest money allocated to the stocks asset class across several industry groups or within an indexed ETFs like SPY, IWM or DIA. This helps limit your exposure to unknown disruptions within individual stocks.

3. Strategic Diversification is a way to think about using more than just “long” positions to invest in the market. For example, option investors will sell calls against a long position to reduce account volatility. Stock traders using this strategy call it a “covered call.”

Over the long term, reducing volatility in this way can be shown to increase returns and reduce risk, but this is just an example starting place when beginning to diversify across strategies.

Strategic diversification is the answer to “what’s next?” when thinking about building a diversified portfolio. Many traders start with covered calls and similar strategies and begin building on that knowledge to create a management plan that improves their ability to achieve better returns with less risk than they could have otherwise. Learning Markets exists to help you understand the strategic options available and to help you implement them.

Investing in Real Estate Through ETFs and Stocks

Investing in real estate has been a strategy that falls in and out of favor depending on what the general economy is doing. In 2008 – 2009 real estate investors took a hard hit with prices dropping significantly but now that the economy seems to be performing better, real estate bargain hunters are beginning to reemerge. This article will discuss how a savvy investor can include some exposure to the real estate market within their portfolio without all the headaches.

Video Analysis: Investing in Real Estate through Stocks

Real estate investors are drawn to the market because of the perceived potential for large returns. However, what many investors don’t understand is that the unusually large returns in a strong economy is usually due to the use of leverage through loans and mortgages.

Because of the high cost of real estate, excessive leverage is one of the only ways most individual investors can participate in the market but it comes with significant and often unanticipated risks.

Excessive leverage in a fairly illiquid asset like real estate can become an account killer quickly. This is the situation so many investors find themselves in now. Leverage has left them upside down on their losses and in many cases has wiped out years of profits. In the video we will go into more detail about why this happens and what it means.

The stock market offers opportunities to invest in real estate, including the possibility of large profits, with out the usual problems and expenses. This can be done through Real Estate Investment Trusts (REITs) that are publicly listed as a stock and available to almost any investor.

A REIT invests in real estate and then sells shares of ownership in the trust on the public market. When you buy a share of a REIT you are buying partial interest in a real estate investment. This allows you to buy real estate without having to use leverage in the same way a mortgage borrower would.

Many REITs are specialized in a specific kind of real estate like Plum Creak Timber (PCL) that invests in land used for lumber production or Tanger Factory Outlets (SKT) that owns outlet malls around the U.S. Through REITs you can own a share of stores, commercial properties, residential neighborhoods or other income properties that would be inaccessible to most individual investors otherwise.

If investing in a single REIT or real estate strategy doesn’t offer the level of diversification you desire you may consider REIT Exchange Traded Funds (ETFs). These ETFs pool investments in many REITs so that diversification can be improved. The iShares funds FIO (commercial property) and REZ (residential property) are good examples of these kinds of ETFs.

An ETF or REIT adds the advantages of liquidity, low entry prices and transparency to the possibilities of profits. REITs are often uncorrelated with stocks, which helps to smooth your portfolio’s growth over the long term. While REITs can experience share price growth most profits come from dividends that can reach 10% or more. This makes them an interesting addition to tax sheltered accounts held over the long term.

When compared to the management requirements, financing hurdles, liability and liquidity issues of a real estate investment, REITs present an attractive alternative.

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Avoiding the Traps of Mutual Funds

Understanding the Pros and Cons of Mutual Funds

Investors are often very polarized about mutual funds. Many believe they are a ripoff and others contend the exact opposite. As usual, the truth is somewhere in between. At Learning Markets we feel that funds (as a concept) are a great way to invest and that the debate about whether mutual funds on the whole are good or bad is misdirected and too general to be productive.

VIDEO: Hidden Costs and Risks of Mutual Funds

There are issues with some funds and fund management methodologies that investors should be aware of and avoid. There is also misleading marketing information being promoted by some of the largest fund companies that is causing serious confusion about these issues. This article will explain what these issues are and how to avoid them.

Active Management vs. Indexing

In general, mutual funds are either actively managed or indexed. A mutual fund that is actively managed is designed to outperform their benchmark indexes by “actively” buying and selling securities. On average however these funds have two drawbacks. First, they charge very high fees each year and second they don’t outperform the indexes on average. This is usually the answer to the question that investors ask; “why are my funds up less than the market this year?” The marketing used to sell these funds often suffers from survivorship bias. In the video we will discuss what this is and why it is misleading.

By contrast, indexed funds don’t try to outperform the indexes they try to replicate them. That is generally an achievable goal and because indexes are not changed frequently they do not not need to be actively managed. This keeps costs very low, which makes a significant difference in long term compounded gains. When evaluating a fund it is usually a good rule of thumb to try use low cost index funds. There is no way to tell that an actively managed fund will outperform the index in the future and the averages would tell us that it is a bad bet.

Barriers to Entry and Exit

Funds often come with handcuffs that can make leaving very expensive. It is quite common for a mutual fund to charge a redemption fee of 1-2% (these are limited to 2% by the SEC) if the fund has been held for less than a specific period. These are unnecessary (they limit your flexibility and control) and can add unanticipated costs to your investing.

Quite often mutual funds require a minimum investment amount to participate. Having to invest in such large increments can be prohibitive to many investors and may make you feel trapped within a suboptimal investing solution.

Alternatively, investing in Exchange Traded Funds (ETFs), which are a version of mutual funds listed on stock exchanges can offer solutions to the flexibility problems mentioned above. ETFs are usually indexed and are almost always lower cost than the average mutual fund. They can also be purchased like a stock from any brokerage account.

ETFs offer all of the advantages of mutual funds without most of the disadvantages. They trade like a stock and can be purchased in very small increments and traded at will. There are almost no restrictions on how many shares of an ETF you may hold, how long you have to stay invested or how many of them you can have within your portfolio. Many ETFs also have options available on them, which can provide another level of control over your investments.

Using A Strategic ETF to Outperform the Market

There is a difference between an ETF that is mostly passively indexed versus one that is strategically indexed. The ETF SPY is a good example of the former and this article will discuss a another good example of the latter. You may find that the growing pool of strategically indexed ETFs makes an interesting addition to your portfolio.

[VIDEO] Behind the 130/30 Fund

The criteria for inclusion in the S&P 500 stock index includes; market capitalization, location, liquidity, sector representation and some simple fundamental data. The requirements don’t necessarily need to be more rigid to be a very efficient representation of the stock market overall. The SPY is able to replicate this index with a very high degree of efficiency.

By contrast, an ETF that I would call “strategically” indexed would include much more rigorous fundamental and technical criteria. The ProShares 130/30 fund (CSM) is a good example of such an ETF. The fund looks for a lengthy list of positive and negative fundamental characteristics when evaluating stocks to short and stocks to buy.

For each $100 invested in CSM the fund will short $30 worth of stocks that the strategy would indicate have a negative expected return. The fund will then purchase $130 (which includes the $30 proceeds from the short sale) worth of stocks with positive expected returns.

The total portfolio now still has a net market exposure of $100 ($130-$30=$100) but could outperform a more passively indexed ETF. As you can see in the chart below, so far this ETF has been able to outperform the SPY.

There are some unique risks of funds like this that include higher costs and a limited track-record. For example, this fund has an expense ratio of .95%, which may be lower than many mutual funds but is several times higher than the expense ratio of the SPY ETF. This increases the height of the hurdle CSM will have to beat just to match the returns on the SPY over the long term.

Strategically indexed funds may be able to outperform an individual investor trying to execute a similar strategy through individual stocks because they have efficiencies in scale. It is also a lot simpler process to just buy an ETF than to do the required analysis yourself. For these reasons CSM may be an interesting opportunity for investors looking for a little more diversification.


Image courtesy Cia Gould.

Four Ways to Invest in the Stimulus

Currently, the House of Representatives have a $825 billion dollar stimulus spending bill ready for debate and ultimately the new White House’s approval. While some of the specifics will likely be modified a spending bill like this is very likely to be passed and implemented in 2009. The current proposed bill includes a number of measures from investments in infrastructure projects to tax credits for struggling industries. While the bill is relatively broad-based there are a few areas of specific focus that may present the opportunity for growth or at least stronger performance than the recent past.

[VIDEO] Four Ways to Invest in the Stimulus

For the examples in this article I will be referring to ETFs as a way to leverage these opportunities. ETFs, like mutual funds are a great way to invest within a market sector without having to choose individual stocks. When investing in ETFs it is important to look for those with low expense ratios (less than .5%) and small bid ask spreads since these costs can reduce your potential profitability. If you need some help understanding ETFs, click here for some additional info.

Idea #1: Basic Materials

Infrastructure spending could drive demand for basic materials. Demand for chemicals, metals, lumber, cement and other basic building and manufacturing materials could increase if the government succeeds in deploying new infrastructure products. There are several ETFs to choose from in this sector but the low cost leader-Vanguard Basic Materials ETF (VAW) is a good example of the opportunity. Basic materials indexes have been consolidating since the lows of November 2008 and on-balance-volume is confirming buying interest.

Idea #2: Homebuilders

Home builders may get a large tax credit. The proposal includes a provision for builders to apply losses over the last 2 year against gains over the last 5 years. This is a sort of contra-tax that could improve the capital position for these builders allowing them to keep jobs and survive the downturn. The iShares Home Construction Index Fund (ITB) is an example of an ETF with holdings across this sector. This particular fund is off 80% from its introductory values (near the industry’s apex) in early 2006.

Idea #3: Green Energy

For those investors with interest in “green” energy the bill includes billions for renewable energy development and loans. This sector may be more speculative than home builders but investor interest alone could be enough to build some growth momentum. Like most green ETFs, the PowerShares WinderHill Clean Energy Portfolio ETF (PBW) has high costs but could see some value appreciation with increased demand for energy and capital injections from the government.

Idea #4: IT Infrastructure

In addition to physical infrastructure the bill focuses on IT infrastructure. The bill has allocations for IT build outs that could improve health services and broadband access among other things. The makers of this type of equipment have suffered in the decline like the rest of the economy. The iShares North American Networking Index Fund (IGN) is one way to invest across a spectrum of firms (including Cisco, Corning and Juniper) in this sector.

Although some specific ideas were used in this article this is not an exclusive list. The principle is to use the information available about the stimulus bill to start watching for investing opportunities. If the government spending plan is successful and/or economic growth reappears on its own, these industries could have a head start on the recovery due to their access to capital compared to the rest of the market. Do your own research and see if there is an opportunity here to use the House’s bill to “stimulate” your portfolio.


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The Risks of Inverse ETFs

When the stock market is falling or a particular market sector or commodity is struggling individual investors can make bearish trades that will profit from those declines. Traditionally this meant that investors had to be able to short stocks or use options but now there is another way to profit from the downside of the market using inverse ETFs.

[VIDEO] The Risks of Inverse ETFs

Inverse ETFs, like leveraged ETFs have been gaining in popularity very quickly. However, because they carry a unique risk that is often misunderstood they are currently being vilified by some brokers and analysts. We feel that the real fault lies with uneducated investors who use these ETFs like gamblers or in other inappropriate ways.

Inverse ETFs are designed to produce the inverse returns on a daily basis of whatever index they are tracking. For example if the S&P 500 were to fall 10% in a given day, an S&P 500 inverse ETF would be up 10% that same day. Some inverse ETFs are also leveraged and may be designed to deliver twice the inverse return of the index they are tracking.

This sounds like an ideal trading instrument for bearish investors who want to profit from a down market. That is true to a certain extent. If the market is trending strongly and you have a short term horizon these are good ETFs for that purpose. However, inevitably the market channels over the long term and that is when these ETFs can really get hurt.

The best way to explain the problem is with a simple math problem. Let’s contrast what happens in a channeling but bearish market with two ETFs. The first ETF is based on a market index and goes up and down with stocks in general. The second ETF is the inverse of the first ETF.

In the video above I provide even more detail by looking at leveraged ETFs as well.

Normal Indexed ETF

  • Day one starting balance = $100 and the market falls 20%
  • Day two starting balance = $80 and the market falls another 20%
  • Day three starting balance = $64 and the market rises 20%
  • Ending balance = $76.80 for a total loss of -23.20%

Based on this data alone we would expect that the inverse ETF would be up exactly 23.2%. However, as you can see in the calculation below this won’t turn out to be true.

Inverse ETF

  • Day one starting balance = $100 but the market falls 20%
  • Day two starting balance = $120 but the market falls another 20%
  • Day three starting balance = $144 but the market rises 20%
  • Ending balance = $115.20 for a total gain of +15.20%

The inverse ETF did perform better than the normal ETF but it underperformed expectations because the ETF is designed to match the inverse of the daily performance of the other index not its long term returns. This contra-compounding is the unique risk of inverse and leveraged ETFs.

This problem is particularly pronounced during channels when the market is moving up and down a lot. If the market is trending strongly then the inverse ETF should perform close to expectations but it will never be equal to the exact inverse over the long term. In fact over the long term, an inverse or leveraged ETF is almost certain to be a loser no matter what direction the market goes.

Inverse and leveraged ETFs can be great for short term trades but their risks should not be ignored. Make sure that an inverse ETF can meet your trading objectives before you make the trade. Like any investment tool, if you ignore the costs and risks you may be verydisappointed in your long term performance.


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Why Target Date Funds Don’t Work Like You Expect

The Target Date Funds in Your 401K Aren’t Worth the Costs

Target date funds would be great if managers could foresee the future. The actual returns from these products may surprise everyone.

Financial professionals and management firms are not always as forthcoming as they should be about the subtle but material details that you should know before investing in their funds. Some products have significant flaws that negate any benefits but they may be hard to identify unless you know what to look for. This article will discuss one such flawed investment product called a “Target Date Fund.”

Investing Scams: Target Date Funds

Many traditional financial managers believe that you should have a lot of exposure to risky and growth oriented assets (like stocks) early in your investing life and that over time you should reduce that exposure in favor of lower risk assets like bonds.

A target date fund essentially automates a portfolio reallocation strategy for you based on some date you set in the far future so that you don’t have to do it yourself.

This all seems reasonable but it rests on an erroneous premise. If stocks perform well in the early days of your investing life, then the strategy works very well. But what if stocks perform poorly in the early days and very well at the end towards your target date?

In the last case you will have maximized your losses and minimized your gains by using a target date fund! The real problem is that we don’t know which will happen and yet a target date fund’s managers are acting as if they do.

This is a backwards form of market-timing, which has been shown to be a very speculative thing to do. The only thing we really know for sure is that this strategy will accumulate higher fees to pay for the endless adjustments performed by the fund’s managers.

There is an alternative that still takes advantage of diversification and compounding returns but doesn’t results in the same kind of fees. Rather than reallocating your exposure each year of your investing life you could hold your exposure to each asset class constant.

We can make an easy comparison of the two strategies over a 20 year period by averaging the yearly stock and bond exposure from the reallocation strategy into a static portfolio. This is a simplified allocation but the principle is the same regardless of the number of asset classes used.

Strategy #1: Reallocation – 20 year target

Year 1 – Stocks 70%, Bonds 30%
Year 2 – Stocks 68%, Bonds 32%
Year 3 – Stocks 66%, Bonds 34% … and so on.

Strategy #2: Static allocation – 20 year target

Year 1 – Stocks 50%, Bonds 50%
Year 2 – Stocks 50%, Bonds 50%
Year 3 – Stocks 50%, Bonds 50% … and so on.

If we assume that up and down years for stocks occur at random with a slightly positive bias you will find that the probability for large and small returns at the end of the 20 year period is equal between the two strategies. Neither one has an advantage over the other. If stocks perform very well in the early years then strategy #1 performs better, however, if stocks perform more evenly or better towards the end of the period then strategy #2 performs better.

However, the average fees for a target date fund is a full 1% higher than a good index fund. If we were to include that in our calculations you would have effectively given away almost 17% of your total portfolio through additional fees to managers, over the target period. These managers cannot show that they are providing any value to justify those fees. This flaw should be disclosed to investors but isn’t.

The bright side to all of this is that strategy #2 is easy. You can do it yourself.

Covered Calls the EZ Way

In the current market environment, volatility is very high and most traders are spending as much time on risk control as on any other activity. This is appropriate but there can be some challenges in that, especially for smaller traders.

Video Analysis: Covered Calls the E-Z Way

For example, one of the most popular options strategies for retail investors are covered calls but they typically require you to buy at least 100 shares of stock to sell a single call contract. This is because a single call contract represents 100 shares of stock.

If you were selling covered calls against the SPY (S&P 500) ETF you could be out $9,000 or more for 100 shares. That may be out of reach for smaller traders. You can learn more about how a covered call works here.

There are solutions to this problem that preserve the benefits of selling a covered call without requiring a large capital investment. The same company that lists the popular QQQQ (Nasdaq) ETF also lists the S&P 500 buy-write (PBP) ETF.

This ETF replicates the results of selling covered calls each month on the SPY but is only $18 per share and can be purchased as a single share or several thousand shares depending on your capital and needs. This allows smaller traders to harvest the benefits of a covered call without the minimum capital requirements.

Investing with covered calls has been shown to provide the same long term growth potential over the long term in a diversified stock index but reduces volatility. Reducing volatility means that you are risking less for similar returns.

This is usually what traders are talking about when they say thier strategy is generating “alpha” or excess returns. In the video I will walk through an example of how a covered call strategy like PBP compares to simply investing in a stock index.