Portfolio Realignment – Diversification Part 2

I just recently read a couple of fascinating investing books and started listening to new podcasts that opened my mind to novel investing ideas that differ from the traditional dividend investing concept that has treated me so well this past decade. These ideas are fascinating because they appeal to the quantitative part of my brain.

I’m going to attempt to get some of these thoughts to paper by writing a multipart series discussing them. In short, they will be all based on the theme of diversification with an emphasis towards increasing performance as well as decreasing volatility. Yes, dividends will still be a part of them.

What investing books and podcasts peaked my interest? Stick around to find out. I don’t want to spoil the surprises by revealing my sources too soon.

Diversification Series:
Part 1: Home Country Bias
Part 2: Portfolio Realignment

Part 3: Alternative Investments


401k Allocation

This post will be talking about the realignment of my 401k in order to improve diversification. I haven’t talked too much of my company’s profit sharing 401k yet. I have been contributing the maximum (currently $19,000 per year) into a Roth 401k. I recently discovered that I am not limited to the mutual funds provided by the 401k provider. Since September I have been able to transfer up to 97% of the total value of the account into a self-directed account.

The self-directed account is through TD Ameritrade and allows me to access the whole world of stocks and ETFs that TD Ameritrade offers.

There are two ways of rebalancing an account. The first way is to sell off existing assets and then move that capital to where it is lacking. The second is by keeping the current accounts the same and slowly allocating the new capital to where it is needed. I have elected to do the latter and specifically to do it within my 401k.

As of today the value of the 401k is roughly $60,000. I had initially invested this in a Vanguard Target Retirement Date Portfolio of 2055 (which was the latest retirement date that they offered at the time). While Target Date funds are pretty simple, they are not without their problems.

Since I now have access to the entire universe of stocks and ETFs, I have decided to reallocate these funds to a 75/25 split between two low cost ETFs, GVAL and ROMO.

Cambria Global Value ETF

GVAL is a fund offered from Cambria Funds which invests in companies with strong value characteristics in developed and developing countries, following the Cambria Global Value Index. This allows me to start allocating away from solely United States companies and allows me to also invest in foreign companies, specifically focusing on companies in countries with low CAPE ratios.

CAPE Ratio

What is CAPE? It stands for cyclically adjusted price-to-earnings (CAPE) ratio. It is essentially the PE (price-to-earnings ratio) of the market using the 10-year average of “real” (inflation-adjusted) earnings as the denominator. It can be applied to any market but typically has referred to the S&P 500.

Some people use this as a gauge for when to invest or avoid certain markets. It obviously isn’t perfect. One of the major problems with it is that if you followed its advice to the letter, you would have missed out on one of the largest and longest bull markets ever in US history. The CAPE ratio got to about 20 (historic mean is around 17) in 2010. If you got out of US stocks at this valuation and went into cash during this decade, you would have missed out on all the gains from the 2010s. The CAPE ratio has kept getting more expensive throughout the decade but yet the S&P 500 has kept hitting record levels.

Here’s a specific example: Around 1993 the CAPE ratio got to around 20. Had the investor used this as a trigger to sell and go all cash, he would have missed out on 961% in gains from 1993-2018, which includes the Global Finance Crisis loss of 55% in 2008/2009. Save from a brief period during this time when the CAPE ratio dropped below its historic averages, there would have been no opportunity to re-enter the market.

As longterm investors, should we use the CAPE ratio?

Myself and, I’m sure all of the readers here, are very longterm minded and are of the mentality that we can weather drawdowns. In fact, if the market were to crash, we would likely use that opportunity to buy more stock and pick up some great companies at a huge discount. We’d either do that or just hold on to what we have and keep trucking along, collecting those dividends and reinvesting it with even more bang-for-the-buck.

However, consider the investor who did follow the “guidance” of CAPE ratios and rather than transitioning into cash, switched between the cheapest 25% of the global stock markets as identified by the CAPE ratio. This would have resulted in missing out on 961% in potential gains in the S&P 500, but would have returned 3,052% instead! (For more details, please see Meb Faber’s post: You Would Have Missed 961% In Gains Using The CAPE Ratio, And That’s A Good Thing. Here is an excellent podcast discussing this very topic.)

That’s what I’m trying to accomplish by investing a portion of my 401k in GVAL. It invests in these “cheap” world markets. That is about 75% of my 401k.

Newfound/ReSolve Robust Momentum ETF

The other 25% is invested in ROMO, the ticker symbol for the Newfound/ReSolve Robust Momentum ETF. I became aware of this strategy after reading Gary Antonacci’s Dual Momentum book (book; blog). The theory behind this strategy (which backtests well and even performs great in out-of-sample tests), is that you invest in either the S&P 500, the world ex US, or an aggregate bond fund. It is quite simple to implement. You rotate your investment into the strongest performer.

You first compare the past 12-month performance of the S&P 500 to a “risk free investment,” which he uses as the performance of the 3-month treasury bills. This is the absolute momentum component. If the S&P 500 performs better than you invest everything in either the S&P 500 or the world ex US, whichever has performed better over the past 12-months (relative momentum component). If S&P 500 performance is lower than treasury bills, then you invest in aggregate bond funds, like the Vanguard Total Bond Market ETF (BND). This strategy would have avoided the tech crash of the 90s and most of the more recent global financial crisis.

You can see the monthly and annual returns in table form. It has held up quite nicely.

Source: Analysis by ReSolve Asset Management. Data from MSCI, Standard and Poor’s, Barclays, Russell Investments. Benchmark consists of 45% S&P 500, 28% foreign stocks and 27% bond aggregate consistent with original article.

ROMO implements a similar strategy but uses an ensemble approach with multiple lookback periods and can split the investment among S&P 500, world ex US, aggregate bonds, or cash. For example, as of 12/9/2019, it is approximately 73% in IVV (S&P 500 ETF) and 27% in IEFA (iShares Core MSCI EAFE ETF).

Summary

My international exposure will be in GVAL as well as in ROMO, when performance of the international ETF dictates. The approximately $1600/month that I am automatically contributing into my 401k will be split 75/25% into GVAL and ROMO, respectively. This will be rebalanced annually.

How will this affect dividends?

This blog has been the story of how I have invested in dividend growth stocks and how dividend reinvestment is contributing to outsized gains. Am I turning away from that strategy? No. I am choosing to allocate my money where I think it will grow the fastest, allowing the dividends to either compound through reinvestment or organically by fueling internal growth.

Both GVAL and ROMO pay dividends and these dividends will be reinvested in a 75/25 allocation as they are paid. GVAL has a yield of around 2.68% and pays quarterly. This is greater than the S&P 500, which pays a yield of around 1.9%. ROMO pays annually and since it is so new, has not yet paid a dividend. The annual dividend will be determined by the time spent in each of its component ETFs. With the weighting of above split between IVV (1.94%) and IEFA (3.04%), the current yield is 2.24%.

As of today, I have approximately $45,500 invested in GVAL, bringing in annual dividends of $1205. I have approximately $15,100 invested in ROMO, bringing in annual dividends of $344. At current levels, dividends will lead to roughly one extra month of contributions! Pretty cool and this will only go up from here.

Upcoming Part 3 of the Diversification Series

In Part 3 of this series on diversification I will be discussing alternative investments and how that plays into my overall investing strategy.

Sources:
1) Target-date funds are more expensive and less effective than this simple investment plan
2) Cambria Global Value ETF
3) Cambria Global Value Index
4) You Would Have Missed 961% In Gains Using The CAPE Ratio, And That’s A Good Thing
5) Episode #184: You Could Have Missed…
6) Gary Antonacci's Dual Momentum book (book; blog)
7) Global Equity Momentum: A Craftsman's Perspective - Executive Summary
8) Newfound/ReSolve Robust Momentum ETF

1 Response

  1. TradingGator says:

    Great article again guys! The momentum strategy has been so dominant in recent years, much due to the adaption of index funds by institutions. One wonders when the reversion to value comes.
    TradingGator recently posted…Finding the Best Forex Broker in EuropeMy Profile

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