Creating Your Own Value Weighted Multiple Asset Index Fund Part 2

In part one we talked about Value Weighted Index Funds and Multiple Asset Index Funds. I believe it is a good way to beat the market and is a fairly passive form of investment. This allows you to stick with a thesis for awhile and only make slight adjustments every now and then. It offers protection as well as it is aimed to profit from short lived trends in the market. Everytime cash flows drastically from one area to another, the rebalancing of the portfolio will take advantage of it by adding shares in the area that have lost weioghting and have gone down in price, while also reducing exposure to the ones that have gone up in price. Since we also weight based partially on fundamentals, adding to the stocks that are lower in price will also be adding to stocks that are more undervalued.

We concluded that value weighted funds alone are somewhat more risky and that by adding more assets you can hedge. Say for example, stocks collapse in value, the question is “where is that money/value going”? The most complete answer is “somewhere else”. With the fed printing huge amounts of money and the government expected to increase it’s deficit at a rate of 18% per year over the next 5 years, you can bet that there are going to be more dollars if the current rate continues. As such that money will go… “somewhere”. Maybe you strongly believe you know where, but unless you are 100% sure you probably should not invest 100% of your wealth in that area. Instead, you should invest in multiple asset classes. If major breakthroughs results in businesses booming, you’re going to want to be in stocks. If a major event happens that causes basic materials and/or precious metals to soar that’s an area you’ll want to be in. If deflation occurs, you’ll want to be in cash. Multiple asset class investing may own 20% oil 20% gold 20% stocks 20% cash and 20% bonds for example. It would be positioned with a confidence that there will be inflation and a 60% confidence in that fact. That is, your investment should be as such if you aren’t sure which areas are going to benefit, but you are 60% sure there will be inflation rather than deflation. Additionally the amount of cash can also be seen as the “margin of error”If you think there is a 20% chance of gold outperforming and a 20% chance stocks will outperform but you are only 5% sure each of these are right, you should have at least 5-10% cash to cover the possibility that your prediction is wrong.

There aren’t a lot of multiple asset class funds available to my knowledge, at least that do so in a way that covers all the asset classes I have in mind. For example there is CVY… The universe of securities within the Index includes:

U.S.-listed common stocks
American depositary receipts (“ADRs”) paying dividends
Real estate investment trusts (“REITs”)
Master limited partnerships (“MLPs”)
Closed-end funds
Canadian royalty trusts
Traditional preferred stocks

MLPs are not really asset classes as much as they are legal types or structures of businesses, closed end funds are funds that can accomplish other areas of investment but aren’t really an asset class in the way I look at things. Royalty trusts and REITs are more types of investment classes but at least cover some exposure during real estate booms. When I refer to asset classes I generally mean what the ultra rich might do. They might have there own company, real estate, cash, metals, and oil wells.
1) Paper assets is one asset class with sub asset classes in things like stocks, bonds, options…
2)Gold/Silver or owning raw minerals or metals is one asset class. This is something that both goes up in value as it’s consumed and becomes scarce, but is something that is similar to savings in the way most people save, in that you store your wealth in this while you await opportunities to put the money to work
3)Real estate and cash flowing investments is another investment that will produce income, and can be leveraged to increase that income through debt.
4)Oil wells or energy related is another that can be an income investment as it produces oil and sells it, you receive the income from it even if oil goes down in price.

These are 4 asset classes that you can get direct exposure to although #2 and 4 are often times seen as sub asset classes within the larger asset class of “commodities”

According To Robert Kiyosaki in the book conspiracy of the rich, there are four basic investment categories that the rich invest in. They are:
1. Businesses: The rich often own many businesses providing passive income, while an average person may have many jobs providing earned income. The difference between owning stock in a business and actually investing in businesses directly through either building one yourself, or finding a private equity business to actually own (or perhaps being a franchise owner) is that a direct business owner has more control, and actually can use the income. Additionally tax laws favor those who actually own a business and issue or sell shares to the public as the public share holder is taking on the tax burden for the most part. The stock owner of a business will only receive cash from the company if he is issued a dividend (which is taxed twice and ineffective) or when he sells, but that assumes that when he sells the public has accurately adjusted for the increase of the companies value, which means a stock owner will have to buy and hold to own the effects of a business, and pay taxes and miss out on the possibility of control and leverage.

2. Income-producing investment real estate: These are properties that provide passive income every month in the form of rent. Your home or your vacation home doesn’t count, even if your financial planner tells you they’re assets. This asset class can somewhat be replicated through REITs. The problem is the most successful real estate businesses will be privately owned because they will buy up the shares as they receive the income, and the public will no longer have the chance to own it.

3. Paper assets – stocks, bonds, savings, annuities, insurance, tax leins, stock options and mutual funds: Most average investors have paper assets because they are easy to buy, require little management, and are liquid – meaning they are easy to get out of. The paper assets vary widely but they are flexible and can be used to get exposure to the other 3 asset classes.

4. Commodities – gold, silver, oil, platinum, etc.: Most average investors do not know how or where to buy commodities. In many cases, they don’t even know how or where to buy physical gold or silver. You can own an oil well or a gold or silver mining company directly and have many benefits which involve debt to gain exposure and the use of the companies income to service that debt, which allows you to leverage and increase your income more.

Getting into all 4 of these asset classes is no easy feat. But what’s important to understand is that with multiple asset class funds, you aren’t seeking to accomplish the income as much as you are seeking to spread your resources so that if cash flows from one area to another, you can gain. If it flows away from one area, you can buy more so that if it flows back to that area, you can profit, and you are still positioned to gain from the areas that continue to do well, because you still will have some exposure there. By weighting value to where you most expect the cash to flow, you can better position yourself to get the gains and better avoid the losses although you are taking more risks in those areas by doing so, so you better be pretty confident. If within those areas you understand a certain area better you might invest more simply because you better understand where the bargains are. For example, if you really understand mining stocks, you may decide to allocate a larger amount of your resources towards that area and actually focus a majority of your capital towards only a select few of the most undervalued companies in that area. Buffett has been quoted as saying “diversification is a hedge against ignorance”. If you know more about an area or about what areas are going up, you can focus more of your capital towards those areas.

The ideal investor would recognize when an asset class starts to become more overvalued and he would begin to reduce, but never elliminate his/her exposure. Accept that it’s impossible to “know” anything so anyone claiming they can “catch the top or bottom” is likely to be somewhat right in that they may have some skill in doing so, but most likely they will not be 100% sure of their choice, and they are not positioned correctly. The question “what if you’re wrong” means you are not positioned to take advantage in the however rare event that you are. The “kelly criterion” is a mathematical set of formulas for risk management that work for investing and horse handicapping. In a horse race say you know the outcome is that one of 5 horses will win. If there were no fees and no “juice” and all horses got the same payout, the kelly criterion explains that you should bet on the horses according to the probability that each will win, and if you do so, you can invest 100% of your cash since one will win. Not only is this going to result in good money management, but it is simple and allows you to risk the maximum amount of capital, and thus the overall “wealth increase” is higher than if you just bet on a horse that was say 60% to win and only risked the “optimal” amount of 52% of your capital, and additionally betting all your eggs in one basket has the problem of increased volitility compared to the evenly distributed among all horses based on their chances of winning. In reality that strategy is never applicable in the world of horse racing, but in the hypothetical scenario given it is, and in the world of stock market investing it’s very close to being applicable. It is a simple and effective way to invest. Investing more aggressively on the one with the more favorable chance of winning would result in great swings in your bankroll when you are wrong to the extent that it would reduce the amount you win in the following time so much so that it would hinder your performance. Bet even more aggressively, and eventually your performance would turn into a losing one over the series of enough bets. Bet too conservatively (extra cash on the side) and your return will suffer over time as well, although you are much less likely to ever be “down” by much also and your personal volatility will be much less as well.

If however, you are not confident in these probabilities, you need to have some cash and probably you should to take account for the possibility that you are wrong about each horse likelihood. In investing this principal can be applied since you know of every dollar that is printed it will go “somewhere”. You don’t know exactly where, but you may have an idea. If you believe your “ideas” have some sort of an edge, you can invest according to how big your edge is. Cash itself is a bet on inflation, and actually by betting in cash rather than bonds, it’s a bet on volatility since you are betting there will be greater opportunities in the future. Betting on bonds you are not only betting on deflation but you are betting that you will get your money back and the government or company that issued the bond will be able to pay you, and it’s a bet that you won’t need that cash for a given number of years. However, the ETFs available make it possible to own foreign currency or have exposure, and the same is true with exposure to bonds, only you can sell ETFs at any time because the fund manager owns the bonds and currency.

Let’s come up with a sample fund.

First of all we want to come up with a thesis that works with our time frame. If we plan on investing for 5 years we would say “what is the probability of the stock market outperforming all other assets in 2011 to 2016. That portfolio should change as our confidence changes which should happen based on our time horizon. I’m going to say my time horizon is 10 years. So I believe stocks will be higher and there will not be deflation that takes them below the current mark. Since I am about 70% confident in inflation occurring over that time, and factor in an extra 10% cash for my probability of being wrong about these estimates, I will invest 60% into asset classes that benefit from inflation. Now “inflation” is an objective term because it doesn’t really define whether it refers to asset inflation, or the inflation in the amount of dollars available. But I believe that the fed will print more money and the money supply will expand and that money will go somewhere other than stay in cash. So 60% inflation based assets to me are Stocks, real estate and commodities. I am a BIG believer in commodities outperforming because of the scarcity of oil and scarcity of metals. If business is to expand, materials will. However I also believe it’s a strong possibility that technological breakthroughs will greatly extend that by reducing the consumption of commodities, and you also have to account for the fact that financial institutions will benefit from real estate boom plus there are real estate stocks and commodity based stocks in any major index fund that includes stocks anyways… So overall I want to bet slightly more on stocks then commodities then real estate. I will say 30% stocks 25% commodities 5% real estate.I am a believer in real estate, it’s just that as far as stock based real estate investments and REITs, they seem to be more one area of stocks, and not be completely representative of real estate itself. Plus many investors already own a home which may profit from rising real estate prices, but not rising rents. I believe the cost of rent will be squeezed, but that more people that own homes may be forced to sell and rent as aging baby boomer population looks to sell their houses and move into smaller ones, or even start renting.
Now we have 40% in deflation based assets. Deflation is about people moving towards necessity. Unfortunately investments themselves are luxury items and will be sold so unless there is a sustainable period of deflation after a crash wipes out 90% of the credit that is going to be deflated already, the only real investment in deflation unless you are going to bet against the market is cash and bonds. I already said we want to take into account the possibility that we are wrong. So put away 10% of your cash. We want to take account for the need to add more shares although selling other assets is possible, we may want to add 5% or so. Then we want to take into account the possibility that bonds will not do well. Interest rates may rise, and the government may in fact lose it’s credit rating. I want to emphasize that if there is inflation and the cash becomes trash which is likely to happen if bonds lose their value, inflationary assets are likely to take care of that. However, there is the possibility that all the credit created collapses, all the faith in the credit in general collapses, people don’t want to loan at all, the government doesn’t want to borrow and the fed makes it more and more difficult to do so, and the US government possibly might not honor it’s status or may be unable to pay and default on it. The chances are very slim of all that happening, but I at least want to add 5% for that possibility to be safe. Now we have 20% cash leaving 20% bonds. But wait a minute… When I say “cash” I want to account for the possibility of owning foreign cash too. Add another 5% and 25% is in “currency” in some form, leaving 15% for Bonds+treasuries.

(SideNote: In true crash scenarios in both hyper-inflationary and deflationary crashes you should have enough food locked away and enough physical cash and physical silver as well as self defense systems such as security alert system and a weapon stored away. Although “cash is king” in deflation, it’s not really if there is chaos on the streets and you can’t even go out to get food without risking your life. The probability of such an event occurring is very slim, but the idea of this model is cover all bases anyways, and that happens to be one.)

This may be a little bit extreme, but say 5% of your wealth to stock up on things like this or at least enough of your wealth to create an adequate supply may be a good idea.

Now that we have our allocation
30% stocks
25% commodities
5% real estate
25% currency
15% for Bonds+treasuries

It’s time to come up with a vehicle for investment in those areas. Note that this is my personal preference and you may have a completely different allocation model. I haven’t got a ton of confidence in this in that I don’t have a ton of numbers to back it, but You can follow along with your own models of weighting by portfolio. If you feel you have information that will llow you to get higher returns in a certain area, obviously you would gain from that information and should take advantage of it by focusing more of your cash towards that area. One final thought, value weighted indexing does not quite acheive the exact result of weighting by probability that it’s average return is greater than the rest, and instead is based on more of the “expected return”. For example, it’s possible that over a 10 year period a particular stock is going to have twice the value of another, but if it’s highly likely that those earnings estimations are accurate for both of those, we actually should invest very little in the “2nd best” stock, so from that perspective Buffett is even more right. The more predictable a companies earnings, the more confident we can be that the projected stock earning more in a particular area actually will earn more, and the more concentrated that portfolio should be. Buffett has really “pushed his luck” over the years compared to other investors in that regard. He has bet heavily on Coca-Cola and continues to do so. If you want to do your due diligence and forecast a “high and a low range” of earnings for each quarter, and assign a confidence interval to that range, you may in fact find that one stock you can say with a 95% confidence is worth more than the other. Maybe you can be only 80% confident that in a year prices will actually reflect that, but even so that would indicate that you should invest MUCH more than a value weighted might suggest in a particular stock. So There are points to be made by both Joell Greenblatt who shared of this “value weighted indexing” and Buffett who talks about his focused non diversified value approach.