Saturday, September 23, 2006

A low-maintenance simple portfolio

I am advising an older person on their portfolio allocation for the stock market portion of their investments. Although he's not as old as the still long-term investor, 105 year old Albert Gordon, he's still looking to the future.

And that's smart, because, given his heredity, he may well have another 20-30 years left. And the only thing that'll provide adequate long-term growth over that time, is participation in the markets. I've convinced him that mutual funds aren't the best ticket today, but he still needs broad diversification at his age. So we're looking to some ETFs to fill his ticket.

Readers here know my belief in the power of dividend-paying stocks to produce out-sized market returns, with lower volatility and risk. This has been well-documented in a variety of books, large and small market studies over lengthy periods of time, covering a variety of market conditions. Thus, most of the selections I suggest for this Canadian investor, will fit the mold of having dividend-paying attributes as prime amongst their selection criteria.

Because of potential tax implications, we'll seek suitable Canadian products where available.

We are going to use just four ETFs, a quartet, but this will provide ample diversification by geography and will eliminate individual stock risk. Given that they are ETFs, they will also eliminate so-called "style drift". Finally, we'll use products that use rules-based fundamental indexing where possible, to enhance returns and reduce risk.

Claymore Investments has three of the four products we'll need. Because he's Canadian, it's suitable to try and get returns denominated in Canadian funds if possible, on the basis that cost of living swings might mirror market activity. So here are the products I've suggested:

Claymore Canadian Dividend & Income Achievers (CDZ). Weighted to emphasize stocks that both have a relatively high yield, and also have a good track record of raising their dividends. It tracks the Mergent Canadian Dividend Income and Achievers (fundamental) index. Over the past five years, the index has posted a 15.1% annual gain, versus the S&P/TSX Index return of 11.1% annually. Over ten years, it posted an 18.1% annual return, versus an 11.0% return for the S&P/TSX Index. The underlying holdings are around 55-60 stocks typically. I'm suggesting a 40% weighting for this ETF.

Claymore US Fundamental Index, C$ Hedged (CLU). This ETF also tracks another fundamental index, which tracks the top 1,000 US securities by fundamental value, using the following four factors: cash dividends, free cash-flow, total sales, and book equity. This ETF is also attractive from my point of view, in that I think the US dollar will be lower in 10 years than now, but this ETF hedges against currency changes, meaning that we'll only trap the underlying changes in the index. Over five years, this index has returned a 7.0% rate annually, versus a -3.2% S&P 500 annual return (as converted to Canadian currency). The underlying holdings are around 1,000 stocks. I am suggesting a 20% weighting for this ETF.

Claymore BRIC (CBQ) is the final Claymore product, that portfolio manager Roger Nusbaum has also written about. This ETF isn't fundamentally indexed, but is designed to mirror the BNY BRIC Index, which tracks ADRs from Brazil, Russia, India and China, all powerful emerging economies. Over time, this should be a strong growth component, but one which will also be volatile in nature. This index has returned 33.2% annually over the past four years, versus the more widely known MSCI EM Index, which has returned 19.7% annually over the same period. The ETF has 75 underlying stocks with above average concentration in the first ten stocks, with about 53% of the value held therein. This isn't currency hedged or denominated in Canadian dollars, but this could be a plus if these currencies gain strength against the Canadian dollar over the next decade. I am suggesting a 20% weighting for this ETF.

Finally, for the fourth ETF, I'll suggest a product that trades on the American exchanges, a Wisdom Tree ETF product that tracks the Wisdom Tree International Dividend Top 100 Index (DOO). This is also a fundamental index, based on dividend yield of large and mega cap international companies. Currently, about 80% of the companies in the index are domiciled in Europe, with about 20% in Australia, Singapore and Hong Kong. The index has returned 16% annually over the past five years, as denominated in US Dollars. Conversion to Canadian currency over that time would have considerably diminished these returns to about 8.5% annually (which is still respectable, although not outstanding). While the currency issue may be slightly negative over the next decade, I don't think it's going to weigh down returns like it did over the past five years, or like it might for an unhedged US stock situation going forward. I am suggesting a 20% weighting in this ETF.

Well, that's it. A relatively simple portfolio, with ample geographic representation, and wide corporate representation. The one noteworthy thing about this portfolio is that it's definitely weighted to the financial sector, but I've never considered that a particular problem, since I consider this sector as the backbone of the entire economic system. My theory here is that if this sector suffers some sort of serious long-term decline, so will virtually every other sector of the economy.

Finally, the other noteworthy aspect is the ability of high-dividend paying stocks to resist market downturns, something that might make this particular portfolio even more attractive; certainly, it makes it easier to sleep at night.

In summary, I consider that these four components will produce robust and relatively reliable returns over the medium to long haul, all with overall reduced risk because of the weighting towards the various fundamental indexes.


The Confused Capitalist

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