Portfolio Construction

Currently our portfolio is allocated like this:



I've explained these different categories previously. Basically "beta" contains mutual funds that are likely to be highly correlated with either the stock or bond market, while "passive alpha" contains funds that are expected to have a lower correlation with general stock market movements and financial stocks whose underlying business is not directly investing in the stock market index. Hopefully, these "passive alpha" investments will generate alpha - a risk adjusted excess return. I call these passive alpha because this is an attempt to earn alpha by investing with other managers rather than through my own trading efforts. Industrial stocks are individual non-financial companies, trading is cash and any very short-term trading instruments, liquidity is cash not dedicated to trading (mostly in Snork Maiden's accounts), asset loans is our rental deposit and car primarily, and borrowing includes margin loans, credit cards etc.

At the moment about 25 percentage points of the portfolio is in stocks within the "beta" category and 43 percentage points are in bonds. When we reach what looks like a bottom in the stock market to me, I plan to switch out of all the bond-heavy funds into stock beta investments. We'll do this by investing in CREF's Global Equities Fund (instead of their Bond Market Fund) and investing in Colonial First State's Geared Share Fund (rather than their Conservative Fund). We'll also shift some of our holdings of the Conservative Fund into CFS's Future Leaders, Developing Companies, and Imputation Funds.

For those who've questioned my judgment that the market is close to a bottom, I'm not planning on buying US stocks in a big way. I will also add individual US stocks in a small way as I did around the 22 January bottom. On the buying list are: IBKR, XLF, BWLD, SSRX, RICK, GOOG, PBD and maybe SHLD, AAPL, and NCT.

I plan on maintaining this same rough allocation between passive alpha and beta, but the beta funds will include a large chunk of a leveraged fund - the Geared Share Fund (geared = leveraged in Australian lingo). In the longer term I plan on having a portfolio beta of about one with a big chunk of passive alpha investments. The goal would be to achieve 10% returns from the stockmarket beta in the long-term and hopefully 10% or so of alpha for a 20% total return. If you use leverage, you can be fully exposed to the stockmarket while also trying other strategies. A simple version of this is the increasingly popular 130/30 funds. A much more sophisticated approach is followed by Bridgewater Associates. What I am attempting is somewhere in between.

Annual Report: Asset Allocation

The table shows our asset allocation at the account and security level at the end of 2007 (before my recent flurry of trades). The split by currency is not perfect - for example the CFS Conservative Fund has foreign (to Australia) investments while Platinum Capital is partially hedged into Australian Dollars. "Passive Alpha" investments obviously have plenty of correlation with the market (I call them "passive alpha" to distinguish them from my own active trading). I include in this category all financial stocks and funds whose performance would be expected to contain significant sources of return which aren't pure stockmarket beta. This includes a fund of hedge funds (EBI), hedgefund like funds (Hussman, TFS, Platinum Capital), real estate funds (Challenger, TIAA, Newcastle), and private equity (Allco). The Clime fund (CAM.AX) is a long-only closed end fund but deliberately does not track market benchmarks and is very focused. My rationale for counting a stock like Interactive Brokers (IBKR) as alpha is that the majority of their income comes from market-making. If this isn't a source of alpha in the financial markets, I don't know what is. There are also fund management companies (Clime and EBB), a bank (HCBK), and insurance companies (Berkshire and Safety). Beta investments are more traditional mutual funds, which can be pure stock plays or diversified or even bonds, which have less stock market beta. We only had one trading position at the end of 2007 - Beazer (a homebuilder) put options. It was doing OK. I only have two non-financial stocks listed under "industrial stocks" - Symbion and FTS. I don't believe that I have an edge in picking individual stocks so I don't do much of it. But investing in a bank stock, for example, is a way of indirectly getting exposure to a financial asset class (loans) that is hard to invest in otherwise. All the other categories of accounts either support our lifestyle or investing (margin loans). By using margin loans we are 98% invested in long-term investments as well as having 6% allocated to trading, while having liquidity for everyday life.

The table doesn't split things down by retirement and non-retirement accounts. 47% of the total is in retirement accounts.

In retrospect, I have been too conservative in my beta investments in the last couple of years, though now it is beginning to pay off to some degree. On the other hand, my passive alpha investments, which had been doing well, took a distinct turn for the worse from the August "quant crisis" onwards. I plan to get more aggressive in my beta investments once there are some clearer signs of a bottom in the stockmarket. I'll also be adding new passive alpha investments and aiming over time to reduce the percentage allocation to Australian Dollars.

How Could I Produce an Alpha of 9%?

A recent discussion on Roger Nusbaum's blog typified the diametrically opposed positions of those who think it is easy to beat the market and those that think it is impossible. I'm targeting an alpha of about 9%, so how do I think I can produce it (apart from pointing at my recent track record)? There are three main potential sources:

1. Active trading: 2-4%. 2% means earning the same amount in trading as last year. One of my annual goals is to beat that number. 4% would be doubling last year's result, which is, realistically, the best result I can imagine at this stage.

2. Passive Alpha: 2-4%. About 40% of my portfolio is dedicated to what I call "passive alpha" investments. These are actively managed funds and other financial companies which I believe can produce significant risk adjusted returns. I assume they could attain 5-10% each. Multiplied by the portfolio share that is 2-4%. 5-10% is not just hypothetical. TFSMX has an alpha of 8%. Berkshire Hathaway has been credited with an alpha of 10%. Man Financial has averaged at least 10%. And so on.

3. Timing and Security Selection: 2-4%. These numbers are purely hypothetical. But let's assume that my portfolio beta was 0.5 for the first two months of the year and I then increased it to 1. I would have avoided half the losses in the first two months of the year by timing. This assumes that the markets are relatively benign for the rest of the year and I timed in the right not the wrong direction. The MSCI lost almost 8% in January and February, while my portfolio lost around 2% in total (both in USD terms). Therefore, avoiding 2-4% of losses here through timing sounds reasonable. Of course, if I never changed the beta upwards then this result would be purely due to low beta. Hopefully, some of my few industrial stock selections will add a little value too.

To explain the timing effect, let's imagine that the market goes down for six months of a year at 10% a year and goes up the other six months at 10% per year. Also imagine that the investor has a true beta of 0.5 when the market is going down and 1.0 when it is going up. If we use a regression to estimate a constant beta for the whole period, we'll come up with the average: 0.75. Then in the declining six months my predicted market return will be -7.5% p.a. but I'll in fact only lose -5% p.a., while in the rising part of the year my predicted return will be 7.5% but I will in fact gain 10% p.a. The investor's alpha from this source will, therefore, be 2.5%.

The average of each of these categories is 3% and adding them all up we get to 9%. Of course "alpha" technically is the average excess return over a period of reasonable length. Looking at just one year is probably stretching the concept. Maybe, I should just say a "risk-adjusted excess return of 9%". But it's easier to say "alpha" :)

November 2007 Report

All figures are in US Dollars (USD) unless otherwise stated. This month saw a fall in net worth in US Dollar terms partly due to the fall in the Australian Dollar and partly to poor investment performance due to the decline in global stock markets this month. Net worth also decreased in Australian Dollars terms. Trading results were negative but I managed a significant turn around in the last few days of the month.

Income and Expenditure



I've introduced a breakdown of investment and trading income for the first time in this month's report. The two sum to "core investment income" which together with "forex" sums to "investment income". I've used different size fonts to try to express this relationship. Not sure that it works :) I've also broken out "core expenditure" which excludes work-related and moving-related expenses.

Expenditure was $6,680 but this includes a large work-related expense for Snork Maiden (which resulted in us effectively buying two thousand or so Australian Dollars (expense in US Dollars, reimbursement in Aussie) and port-handling charges in Sydney for both of us. Core expenditure was well under control at $3,280. This included $A59.07 of implicit interest costs of owning a car.

Non-investment earnings ($7,119) included the refund of the work-related expenses from Snork Maiden's employer. She also again got paid by her previous employer. We've told them to stop paying and we may need to pay this money back, but for the moment I am counting it as income. Snork Maiden's retirement contributions were $1180.

Non-retirement accounts lost $19,364 with $8,315 of the loss resulting from the fall in the Australian Dollar. Retirement accounts lost $6,917 but would have gained only $249 if exchange rates had remained constant. This gain is due to the strong exposure to bonds in our retirement accounts and the stronger exposure to equities in our non-retirement accounts. In AUD terms non-retirement accounts lost and retirement accounts gained for the month.

Net Worth Performance
Net worth fell by $US24,563 to $US453,326 and in Australian Dollars fell $A3,171 to $A512,406. Non-retirement accounts were at $US241k. Retirement accounts were at $US212k.

Investment Performance
Investment return in US Dollars was -5.50% vs. a 4.38% loss in the MSCI (Gross) World Index, which I use as my overall benchmark and a 4.18% loss in the S&P 500 total return index. Non-retirement accounts lost 7.46%. Returns in Australian Dollars terms were -0.96% and -3.01% respectively. In currency neutral terms the portfolio lost 2.26%, which is relatively good compared to the performance of the indices. YTD we're up 20.4% (USD) vs the MSCI with 13.4% and the SPX with 6.4%. Our non-retirement accounts are up 24.8%.

The contributions of the different investments and trades are as follows:



The returns on all the individual investments are net of foreign exchange movements. Foreign currency gains appear at the bottom of the table together with the sum of all other investment income and expenses - mainly net interest. My Australian funds all did horribly with Platinum Capital being the worst of all. I also suffered net losses trading SPI (Australian Share Price Index) and ES (S&P 500) futures but gained in NASDAQ trading. PSS(AP) is Snork Maiden's superannuation fund, where we are starting off with a loss...

Progress on Trading Goal

I lost $1,035 in trading following losses of $1,123 in September and $681 in October. The losing streak is depressing even though relative to net worth the numbers are small. The loss is 3.97% of trading capital vs a 6.69% loss in the NDX. My IB account lost exactly 6.69% for the month, though I gained 7.8% or $1,310 in the last week in this account. As far as my goal of achieving breakeven in my 3 US trading accounts, I have currently invested a net amount of $60k and the accounts are currently worth $54,230. At the end of 2006 the value stood at $41,042 so I have made progress even if it is slower than I would have liked.

Asset Allocation
Using the simple method of adding up the betas of each individual investment weighted by their portfolio allocation, at the end of the month the portfolio had an estimated beta of 0.42. Recent performance shows, though, that actual beta of my USD denominated returns is a lot higher than this. My time series estimate using the Kalman filter estimates beta to the S&P 500 at 0.90 and to the MSCI at 1.00. The reason for this is that the Australian Dollar is becoming increasingly correlated with global stock market returns due to the carry trade where traders borrow in low interest currencies like the Yen and buy high yielding currencies like the AUD and stocks. When their "aversion to risk" increases they sell both Aussie Dollars and stocks and buy Yen and US bonds.

Allocation was 29% in "passive alpha", 67% in "beta", 6% allocated to trading, 4% to industrial stocks, 6% to liquidity, 3% to other assets (including our car which is equal to 2.8% of net worth) and we were borrowing 15%. The biggest losses this month were in the funds that I have designated as "passive alpha". Those funds really contain a lot of beta of course too. I include all hedge-fund like and alternative investments under the "passive alpha" label and all long-only equity mutual funds under "beta". Our currency exposures were roughly 60% Australian Dollar, 30% US Dollar, and 10% Other (mainly global equity funds).

February 2008 Report

All figures are in US Dollars (USD) unless otherwise stated. Performance this month was more mixed than in recent months - net worth rose in US Dollar terms but fell in Australian Dollar terms due to the strong rise in the Australian Dollar this month. Investment performance was also positive in USD terms but not in AUD terms. Spending was high due to the wedding and "honeyweek" which took place this month.

Income and Expenditure



Expenditure was $7,271 - core expenditure was $4,067, which is higher than in recent months. This included $334 of implicit car expenses - depreciation and interest.

Non-investment earnings ($11,664) were dominated by the inheritance we received this month.

Non-retirement accounts lost $2,507 with the rise in the Australian Dollar offsetting $6,545 of what would otherwise have been a loss of $9,053. Retirement accounts gained $5,214 but would have lost $1,183 without the change in exchange rates. The differential between these accounts is due to the strong exposure to bonds in our retirement accounts and the stronger exposure to equities in our non-retirement accounts. Trading contributed $782 in realised gains.

Net Worth Performance
Net worth rose by $US7,419 to $US445,174 and in Australian Dollars fell $A12,976 to $A475,156. Non-retirement accounts were at $US226k (a gain of $1,400 or 0.6%). Retirement accounts were at $US219k. So we made progress on our first and third annual goals as net worth increased and non-retirement net worth increased by more than the MSCI index rose for the month (0.3%).

Investment Performance

Investment return in US Dollars was 0.62% vs. a 0.33% gain in the MSCI (Gross) World Index, which I use as my overall benchmark and a 3.25% loss in the S&P 500 total return index. Returns in Australian Dollars and currency neutral terms were -3.65% and -2.34% respectively. Both the MSCI and our portfolio outperformed the the S&P 500 this month due to the fall in the US Dollar. So far this year we have lost 2.07%, while the MSCI and S&P 500 have lost 7.86% and 9.05%, respectively.

The contributions of the different investments and trades are as follows:



The returns on all the individual investments are net of foreign exchange movements. Foreign currency gains appear at the bottom of the table together with the sum of all other investment income and expenses - mainly net interest. This month trades resulted in modest gains or losses. The strength of the resource sector led to a nice gain in the Colonial First State Global Resources Fund. Completion of the takeover of Symbion by Primary Healthcare also produced a decent gain. Major losses were again dominated by the woes of the Australian listed fund sector. In particular the near collapse of Credit Corp (CCP.AX) hit the Clime fund (CAM.AX) hard due to its concentrated position in this company. Clime sold out its position in the middle of the month, but it seems that its other positions which had also been soaring high did not do well in the first couple of months of the year. Concentrated portfolio positions are dangerous when you are not an insider in the company and even then they are risky. I exacerbated things by doubling my position in Clime before it hit bottom. Seems I was as overtrusting in Clime's management as they were in Credit Corp's.

Progress on Trading Goals

Realised gains for the month were $782. This is the first positive month since June 2007! But the gains were entirely in securities trading as I didn't trade futures at all this month. I've only had two losing months in securities trading since last June (October and January). Anyway, it's nice to finally see a positive month in realised gains.

My three US trading accounts lost $1332 (or -2.33% which is better than the S&P 500 at -3.25%) and there is now $8047 to go till I reach breakeven across those three accounts, which is one of my annual goals. My Interactive Brokers account lost 0.77%.

So, I made progress on annual goal 5 (making money from trading) and slipped back on goal 4 (achieving breakeven in my US accounts).

Asset Allocation
Using the simple method of adding up the betas of each individual investment weighted by their portfolio allocation, at the end of the month the portfolio had an estimated beta of 0.52. Using a regression on the last 36 months of returns gives a beta of 0.76 to the MSCI or 0.61 to the SPX. Alphas are 0.9% and 5.7% respectively. A more sophisticated time series method yields a beta of 0.75 and alpha of 10.0% for the MSCI index. Therefore, we are doing well on our second annual goal (positive alpha).

Allocation was 35% in "passive alpha", 69% in "beta", 2% allocated to trading, 2% to industrial stocks, 5% to liquidity, 9% to other assets (including our car which is equal to 2.9% of net worth and otherwise mainly receivables) and we were borrowing 22%. Our currency exposures were roughly 58% Australian Dollar, 30% US Dollar, and 12% Other. We reduced exposure to industrial stocks this month and increased further our exposure to private equity and supposed "passive alpha" stock funds.

Summary
We made progress on four out of the five annual goals this month.

May 2008 Report

A good month, though returns were not as spectacular as in April. Mid month, investment returns were more than double what they were by the end of the month following a pullback in the markets. In the chart, month's above the red line have risk adjusted excess returns, while those above the blue line have above average risk adjusted returns:



The gap between the blue and red lines is alpha. May had returns that are typical of good months.

But we are on track to meeting all our annual goals, which are assessed in the first part of this report. Other statistics appear towards the end of the report. All amounts are in U.S. Dollars unless otherwise stated.

1. Net Worth Goal: Reaching $500k We made progress on this goal as net worth rose by $17.7k to $482.3k and in Australian Dollars rose $A11.7k to $A505k. USD results were again boosted by the continued rise in the Australian Dollar.

2. Alpha Goal: Alpha of 8.5% The point of this goal is to earn at least an average wage from risk-adjusted excess returns. Using my preferred time-series method our returns had a beta of 0.85 and an alpha of 10.0% with respect to the MSCI World index, which meets our annual goal. The risk adjusted excess return for May based on this analysis was 1.71%. Multiplying this by net worth gives an income of $8,090. For the year so far the risk-adjusted excess return in dollar terms has been $26,222. Using the estimate of alpha the smoothed annual income is $47,303. In Australian Dollars terms returns are somewhat lower, while they are higher using the S&P 500 as a benchmark.

3. Increasing Non-Retirement Net Worth by More than the MSCI Index The point of this goal is to make sure that we only spend out of non-investment income and excess returns and don't use the normal market return on investments to fund spending. In other words, this makes sure we have positive saving. Non-retirement accounts rose by 5.02%, while the MSCI index rose by 1.68%. So far this year these accounts have grown by 6.51% in excess of the MSCI return.

4. Achieving Break-Even on U.S. Taxable Accounts This goal was achieved. At the end of the month we were $751 above the breakeven point with a gain of $1,311 for the month. The rate of return on these accounts was 1.87%.

5. Make at Least $15,000 from Trading Realised gains this month were $1,586 and so far this year $3,584. I've now had four positive months in a row, which is a record. Earlier today I raised the annual trading goal to $15,000.

Background Statistics

Income and Expenditure



Expenditure was $3,472 in line with recent numbers. Spending included $76 of implicit car expenses - interest only as the car didn't depreciate this month according to RedBook. In addition to her ordinary pay Snork Maiden received her IRS tax refund and stimulus check and Moom was paid a small consulting fee, which raised non-investment income to $6,225.

Non-retirement accounts gained $9,091 with the rise in the Australian Dollar contributing $1,969. Retirement accounts gained $5,613 but would have gained only $3,319 without the change in exchange rates.

Investment Performance

Investment return in US Dollars was 7.75% vs. a 5.65% gain in the MSCI (Gross) All Country World Index, which I use as my overall benchmark and a 4.87% in the S&P 500 total return index. Returns in Australian Dollars and currency neutral terms were 4.47% and 5.21% respectively. So far this year we have gained 2.58%, while the MSCI and S&P 500 have lost 4.04% and 5.03%, respectively.

The contributions of the different investments and trades are as follows:



The returns on all the individual investments are net of foreign exchange movements. Again the biggest gain was in the CFS Geared Share Fund which is our biggest investment. Australian listed fund of hedge funds Everest Brown and Babcock continued to recover from a steep discount to book value but my other "deep value" Australian investments showed little movement or like Challenger Infrastructure and Clime Capital, declined.

Asset Allocation

Allocation was 41% in "passive alpha", 71% in "beta", 3% allocated to trading, 6% to industrial stocks, 3% to liquidity, 3% to other assets and we were borrowing 27%. Our currency exposures were roughly 56% Australian Dollar, 21% US Dollar, and 23% Other and Global. In terms of asset classes, the distribution was:



Due to the use of leveraged funds, our actual exposure to stocks was 118% of net worth. I slightly trimmed exposure to stocks as the market rose while increasing exposures to bonds and alternative assets by a little more, resulting in an increase in borrowing. Cash also increased, mainly due to setting up a new trading account with City Index.

July 2008 Report

Another bad month but not as bad in terms of absolute returns as July. However, the month was worse in risk-adjusted terms. In the chart, month's above the red line have risk adjusted excess returns, while those above the blue line have above average risk adjusted returns:



The gap between the blue and red lines is alpha, which is shrinking towards zero in this sample. July clearly has a more negative residual than June did. In other words underperformance relative to the market was worse.

So there was again negative progress on our annual goals, which is reported on in the first part of this report. Other statistics appear towards the end of the report. All amounts are in U.S. Dollars unless otherwise stated.

1. Net Worth Goal: Reaching $500k In US Dollars we fell back $28,707 to $404,772, while in Australian Dollars we lost $A23,504 to decline to $A429,832. We are down on the year so progress on this goal is very negative.

2. Alpha Goal: Alpha of 8.5% The point of this goal is to earn at least an average wage from risk-adjusted excess returns. Using my preferred time-series method our returns had a beta of 1.09 and an alpha of 6.43% with respect to the MSCI World index, which lags our annual goal and is worse than last month. The risk adjusted excess return for July based on this analysis was -3.5%. Multiplying this by net worth gives a loss of $14,812. For the year so far the risk-adjusted excess return in dollar terms has been $6,794. Using the estimate of alpha the smoothed annual income is $26,970. In Australian Dollars terms returns are somewhat lower, while they are higher using the S&P 500 as a benchmark.

3. Increasing Non-Retirement Net Worth by More than the MSCI Index The point of this goal is to make sure that we only spend out of non-investment income and excess returns and don't use the normal market return on investments to fund spending. In other words, this makes sure we have positive saving. So far this year these accounts have declined by 3.04% more than the MSCI return. In other words, we are now dissaving, by this measure.

4. Achieving Break-Even on U.S. Taxable Accounts After reaching this goal in May we fell back steeply in June and July, though the pace of loss was lower in July than in June. At the end of the month we were $11,665 below the breakeven point with a loss of $2,901 for the month. This means that no net progress has been made since February 2007. The rate of return on these accounts was -3.86%. One positive point was a positive 1.27% return on my Interactive Brokers account. The NDX gained 0.66% for the month.

5. Make at Least $10,000 from Trading Realised gains this month were -$1,783 (a loss) and so far this year $2,089. This negative result follows a record five positive months in a row. Even though I didn't do any active trading I closed out an options position at a loss and I mark to market my CFD position.

Background Statistics

Income and Expenditure



Expenditure was $7,784 in line with recent numbers. Spending included $A1,107 of implicit car expenses as our car depreciated by $A1,100 according to Redbook. We also spent $A3,814 on the China trip. Half of this will be refunded after the trip. Excluding these expenses, core spending was only $3,252. In addition to her ordinary pay Snork Maiden received her Vermont tax refund and Moom received his US Federal stimulus check boosting non-investment income to $4,657

Non-retirement accounts lost $14,249 with the fall in the Australian Dollar adding $2,411 to the loss. Retirement accounts lost $13,236 including $2,303 of exchange rate losses.

Investment Performance

Investment return in US Dollars was -6.34% vs. a 2.57% loss in the MSCI (Gross) All Country World Index, which I use as my overall benchmark and a 0.84% decline in the S&P 500 total return index. Returns in Australian Dollars and currency neutral terms were -4.90% and -5.25% respectively. So far this year we have lost 11.31%, while the MSCI and S&P 500 have lost 12.71% and 12.65%, respectively.

The contributions of the different investments and trades are as follows:



The returns on all the individual investments are net of foreign exchange movements. More than half the total loss was due to the CFS Geared Share Fund which is our biggest investment. Resource stocks and broad exposure to the Australian stock market also performed poorly. Airlines and US financials were strong performers, though Australian private equity fund of funds, IPE, was our top performer.

Asset Allocation

Allocation was 46% in "passive alpha", 73% in "beta", 2% was allocated to trading, 10% to industrial stocks, 4% to liquidity, 3% to other assets and we were borrowing 38%. Due to the use of leveraged funds, our actual exposure to stocks was 134% of net worth. Leverage increased mostly because of the decline in the value of our assets. Our currency exposures were roughly 55% Australian Dollar, 22% US Dollar, and 23% Other and Global.

Asset Allocation: The Big Picture

In response to Finance Girl's request I'm going to do a series of posts on my asset allocation. Today's post will look at how I think about the overall big picture and then the next few posts will drill down to the level of individual investments. Most bloggers out there are either stock pickers, traders, or index investors though there are more complex allocations too. My approach is one of those more complex ones. This is how I think about asset allocation at the highest level:



You're seeing my position when I have almost no active trading positions. Let me explain each category in turn:

Passive Alpha This is a bit of a misnomer - as these funds are invested with active managers - these positions are passive from my point of view because it is largely buy and hold. Included in this category are closed end funds, financial firms (including Berkshire Hathaway and Hudson City Bank Corp for example), REITs etc. The point of these investments is to try to generate returns that are relatively uncorrelated with the stock market and uncorrelated with my own trading. That's why I call these investments "alpha". But as you can see I estimate that these investments actually contribute 0.138 points towards my portfolio's total beta. They aren't pure alpha by any stretch of the imagination. I include the financial firms in this category because really a bank, for example, is involved in investing funds in loans to a diversified portfolio of customers. So in some ways it's similar to a closed end fund. There are also fund management companies in here. In the long-run I'd like to increase the proportion of net worth invested in this category from 22% to 40-50%.

Beta Another misnomer - as all the mutual funds in this category are actually actively managed. So they aren't pure beta. The reason they are all actively managed is something of a legacy of the past - and there still aren't many indexed mutual funds available in Australia. In the future I would probably add some ETFs in this category, but as I want to reduce the allocation to 40-50% of net worth, this won't happen any time soon. You'll notice that this "beta" actually contributes little beta to my portfolio. I adjust my holdings in this category over the course of the four year stock cycle. At the moment I am as conservative as I will get and most of what is in here is in fact bonds rather than stocks. I try to hold these mutual funds for at least a year to get the long-term CGT rate in my taxable accounts. The largest part of these funds though are in my retirement accounts.

Trading This includes cash in my trading accounts and open trading positions. This is where I actively try to generate alpha in my portfolio. My policy is not to add any more money to my trading accounts until I can show that I have recaptured the losses I generated earlier in my trading career. At the beginning of the last week there were about $10,000 of losses to recapture. Now we are back to about $13k. The beta of this category can be either positive or negative. My most extreme positions add or subtract about 0.7 beta to my portfolio - taking me from fully long to net short. Trades are generally directional bets on the market and most are held from 1 day to 1 week, though there are also occasionally longer-term trades.

Industrial Stocks This is the extent of my "stock-picking". Any non-financial individual stock is in here. I don't think it is easy to pick stocks that will outperform (at least not for me) and, therefore, I don't do much of it. If I see something that does look good I'll do it. In the past I had much more allocated to this. In the future, I'll probably have even less.

The final two categories are simpler - Liquidity is cash in non-trading accounts - 3% is around $12,000 - this isn't an emergency fund in any sense though. I use credit cards for emergencies. It's just money I haven't decided yet to allocate to investment or spending. Borrowing - the basic idea is that I am 100% invested and borrowing funds to trade with. You'll see the two categories have about the same allocation. Where possible, though, I try to use products with embedded leverage (futures, options, leveraged mutual funds) rather than borrowing explicitly as the interest rates are generally much lower than I can get myself.

My portfolio is also invested in assets associated with different currencies. In the first few years after I returned to the US I sent a lot of savings back to Australia as the Australian Dollar was cheap. Now that the Aussie Dollar has risen a lot I am accumulating all savings in the US and will begin transferring dividends and distributions I receive in Australia back to the US. In the long-term I would like to bring down my AUD allocation to around 40-50% of my net worth. The other category includes some global closed and mutual funds that are not hedged back into a single currency such as AUD or USD.

For another view of my asset allocation you can check out my NetWorthIQ Profile.

June 2008 Report

This was the worst month since the 2000-02 bear market performancewise and in terms of absolute dollar loss of net worth the worst ever.



The MSCI index matched its January performance (-8.18%), but this time we underperformed the market on a risk-adjusted basis. In the chart, month's above the red line have risk adjusted excess returns, while those above the blue line have above average risk adjusted returns:



And July is not shaping up very well either yet. (Lack of) progress on meeting our annual goals is assessed in the first part of this report. Other statistics appear towards the end of the report. All amounts are in U.S. Dollars unless otherwise stated.

1. Net Worth Goal: Reaching $505k In US Dollars we fell back $48,878 to $433,409, while in Australian Dollars we lost $A51,751 to decline to $A453,262. We are down on the year so progress on this goal is very negative. I'm lowering the goal again to $500,000.

2. Alpha Goal: Alpha of 8.5% The point of this goal is to earn at least an average wage from risk-adjusted excess returns. Using my preferred time-series method our returns had a beta of 1.12 and an alpha of 7.02% with respect to the MSCI World index, which lags our annual goal. The risk adjusted excess return for June based on this analysis was -1.05%. Multiplying this by net worth gives a loss of $4,814. For the year so far the risk-adjusted excess return in dollar terms has been $21,508. Using the estimate of alpha the smoothed annual income is $32,129. In Australian Dollars terms returns are somewhat lower, while they are higher using the S&P 500 as a benchmark.

3. Increasing Non-Retirement Net Worth by More than the MSCI Index The point of this goal is to make sure that we only spend out of non-investment income and excess returns and don't use the normal market return on investments to fund spending. In other words, this makes sure we have positive saving. So far this year these accounts have grown by 1.97% in excess of the MSCI return.

4. Achieving Break-Even on U.S. Taxable Accounts After reaching this goal in May we fell back steeply this month. At the end of the month we were $8,861 below the breakeven point with a loss of $9,613 for the month. The rate of return on these accounts was -11.39%.

5. Make at Least $15,000 from Trading Realised gains this month were $231 and so far this year $3,873. I've now had five positive months in a row, which is a record. I doubt July will be positive. I'm lowering the goal to $10,000.

Background Statistics

Income and Expenditure



Investment Performance

Investment return in US Dollars was -10.24% vs. a 8.18% loss in the MSCI (Gross) All Country World Index, which I use as my overall benchmark and a 8.43% loss in the S&P 500 total return index. Returns in Australian Dollars and currency neutral terms were almost identical as the AUD hardly moved over the month. So far this year we have lost 5.43%, while the MSCI and S&P 500 have lost 10.41% and 11.91%, respectively. Over the last 12 months we lost 5.18% while the MSCI lost 8.79% and the SPX 13.12%.

Asset Allocation

Allocation was 43% in "passive alpha", 69% in "beta", 4% allocated to trading, 10% to industrial stocks, 6% to liquidity, 3% to other assets and we were borrowing 35%. Our currency exposures were roughly 57% Australian Dollar, 20% US Dollar, and 23% Other and Global. In terms of asset classes, the distribution was:




Due to the use of leveraged funds, our actual exposure to stocks was 119% of net worth.

Monthly Report: April 2008

This month I'm trying out a new format, which focuses on how we are doing in meeting our annual goals. Other statistics appear towards the end of the report. All amounts are in U.S. Dollars unless otherwise stated.

1. Net Worth Goal: Reaching $500k We made progress on this goal as net worth again rose over $450k. Net worth rose by $US33,685 to $US466,625 and in Australian Dollars rose $A21,318 to $A495,461. The US dollar gain is my largest ever. USD results were strongly boosted by the rise in the Australian Dollar.

2. Alpha Goal: Alpha of 8.5% The point of this goal is to earn at least an average wage from risk-adjusted excess returns. Using a regression on the last 36 months of returns gives a beta of 0.71 to the MSCI or 0.58 to the SPX. Alphas are 5.26% and 10.32% respectively. A more sophisticated time-series method yields a beta of 0.91 and an alpha of 9.62% for the MSCI index, which meets our annual goal. The risk adjusted excess return for April based on the latter analysis was 2.58%. Multiplying this by net worth gives an income of $11,624. For the year so far the risk-adjusted excess return in dollar terms has been $21,952. Using the estimate of alpha the smoothed annual income is $43,300. In Australian Dollars terms returns are somewhat lower, while they are higher using the S&P 500 as a benchmark.

3. Increasing Non-Retirement Net Worth by More than the MSCI Index The point of this goal is to make sure that we only spend out of non-investment income and excess returns and don't use the normal market return on investments to fund spending. In other words, this makes sure we have positive saving. Non-retirement accounts rose by 10.07%, while the MSCI index rose by 5.65% So far this year these accounts have grown by 3.99% in excess of the MSCI return.

4. Achieving Break-Even on U.S. Taxable Accounts At the end of the month we were $559 from the breakeven point with a gain of $5,379 for the month. The rate of return on these accounts was 7.68%. Following the month's close we met this goal. The chart shows the remaining gap to reaching breakeven over the last year and a half:



5. Making More Money from Trading Than in 2008 Realised gains this month were $915 and so far this year $2,062. I've now had three positive months in a row. Futures trading though has not been going well, but I have been making money trading stocks and options. Last year I made $9,500 from active trading. Currently, I'm lagging behind last year's performance but I think the goal still may be achievable.

Background Statistics

Income and Expenditure



Expenditure was $3,996 in line with recent numbers. Spending included $334 of implicit car expenses - depreciation and interest. Snork Maiden was paid three times this month and Moom paid his New York State Taxes, which we treat as negative income :(

Non-retirement accounts gained $21,661 with the rise in the Australian Dollar contributing $6,201. Retirement accounts gained $11,911 but would have gained only $7,108 without the change in exchange rates.

Investment Performance

Investment return in US Dollars was 7.75% vs. a 5.65% gain in the MSCI (Gross) All Country World Index, which I use as my overall benchmark and a 4.87% in the S&P 500 total return index. Returns in Australian Dollars and currency neutral terms were 4.47% and 5.21% respectively. So far this year we have gained 2.58%, while the MSCI and S&P 500 have lost 4.04% and 5.03%, respectively.

The contributions of the different investments and trades are as follows:



The returns on all the individual investments are net of foreign exchange movements. There are no clear patterns this month in what gained and what lost. The biggest gain was in the CFS Geared Share Fund which is our biggest investment. Australian listed hedge funds such as Everest Brown and Babcock and Platinum Capital began to recover from steep discounts to book value.

Asset Allocation

I completed the switch from bonds to stocks this month and we are now as long stocks as I think we will ever be.

Allocation was 40% in "passive alpha", 71% in "beta", 3% allocated to trading, 5% to industrial stocks, 3% to liquidity, 3% to other assets and we were borrowing 25%. Our currency exposures were roughly 55% Australian Dollar, 23% US Dollar, and 22% Other. In terms of asset classes, the distribution was:



Due to the use of leveraged funds, our actual exposure to stocks was 113% of net worth.

What Does Alpha Really Mean?

In my recent posts analysing Madame X's portfolio I used various indicators to assess the performance of mutual funds. One, alpha, is the "risk adjusted return relative to the benchmark index" we are comparing the fund to. We use regression analysis to find how much the monthly percentage returns of the fund respond to the percentage returns of the index. For example, the fund might return -4.3%, -1%, and -0.2% for the first three months of this year while the S&P 500 returned -6%, -3.25%, and -0.43%. Clearly, the fund did a lot better than the index, but how much of this is due to being less invested in the index and how much is unrelated to the market? A simple regression (same as fitting the best straight line when the fund returns are on the Y axis of a graph and the index returns are on the X axis) shows that for a 1% rise in the index the fund only goes up 0.73%. In other words this fund is taking on only 73% of the market return. The intercept term on the Y axis, or regression constant, is 0.54%. This tells us on average how much return the fund derived from other sources, such as manager skill in timing and security selection per month. For a whole year, this works out to 6.6%. This number is "alpha".

But what does that really mean? One way to look at this is to imagine investing 73% of your money in the S&P 500 index and 27% in 90 day government bonds (T-Bills) - this is a passive investment with the same amount of market risk as the fund in question. The average difference between the return on this investment and your returns from investing in the fund are "alpha". If you invest $10,000, this manager will deliver you additional income of $660 per year above what the risk-adjusted passive investment will return you. On average. There will be months and years where he or she will produce higher or lower excess returns.

I routinely compute my own alpha relative to the MSCI All Country World Index and S&P 500 (with all dividends reinvested in each case - the total return indices). Against the S&P 500 my advanced time series model (Kalman filter) estimates my beta at 0.87 and my alpha at 17.8%. Our net worth is currently $464,000. This means that I am earning $82,500 a year above what I would get from investing 87% of our money in the S&P 500 and 13% in T-Bills. A regression for just the last 36 months gives an alpha of 10.23% or $47,500 per year. Returns relative to the MSCI are not as spectacular - ranging from $24,750 to $44,900. A big caveat is that this past performance may not continue going forward, but it gives some idea of the value derived from actively investing instead of passively investing. If you actively manage your portfolio you should ask a similar question about how much value you are adding.

The nice thing about investing/trading is that these returns can scale up. There is no reason why I couldn't do exactly the same thing with several million dollars instead at some time in the future. This is one of the reasons that trading is an attractive career option to me.

August 2008 Report

This month was OK, we lagged the MSCI index by about 1% resulting in a negative return and loss of net worth in US Dollar terms and gains in Australian Dollar terms, due to the 9% fall in the Australian Dollar over the month. The pound fell 8% and the Euro 6% against the USD.

As result, total returns (or accumulation index) in Australian Dollar terms have now caught up with total returns in US Dollar terms, which had been outperforming in the last few years, as measured from the 1996 inception point:



MSCI total returns are now also back in line with SPX total returns over the entire period though still outperforming over the last 5 years. It's depressing that we've made very little progress since the beginning of this decade, but neither have the major stock indices. The SPX has returned just 0.22% per year (this includes dividends) since 31st December 1999 while the MSCI has returned 1.98% per year. I've returned 4.66% per annum in USD terms and 2.10% in AUD terms. After taxes and inflation all of these are probably negative returns. In Australian Dollars the MSCI has returned -1.15%.

So there was again negative progress on our annual goals, which is reported on in the first part of this report. Other statistics appear towards the end of the report. All amounts are in U.S. Dollars unless otherwise stated.

1. Net Worth Goal: Reaching $500k In US Dollars we fell back $12,979 to $391,463, while in Australian Dollars we gained $A27,728 to reach $A457,209. Despite the increase in Australian Dollars, we are still way below the year's starting point at $A511,281.

2. Alpha Goal: Alpha of 8.5% The point of this goal is to earn at least an average wage from risk-adjusted excess returns. Using my preferred time-series method, our returns had a beta of 1.07 and an alpha of 6.0% with respect to the MSCI World index, which lags our annual goal and is worse than last month. The risk adjusted excess return for August based on this analysis was -0.8%. Multiplying this by net worth gives a loss of $3,124. For the year so far, the risk-adjusted excess return in dollar terms has been $3,982. Using the estimate of alpha, the smoothed annual income is $23,715. Most other performance metrics are equally poor in recent months. I "re-equitised" too soon and then didn't "de-equitise" enough at the May peak though I did do some rebalancing. I then increased leverage again too early in the down wave from the May high to the July low.

3. Increasing Non-Retirement Net Worth by More than the MSCI Index The point of this goal is to make sure that we only spend out of non-investment income and excess returns and don't use the normal market return on investments to fund spending. In other words, this makes sure we have positive saving. So far this year these accounts have declined by 5.11% more than the MSCI return so that we are dissaving, by this measure.

4. Achieving Break-Even on U.S. Taxable Accounts We made a $1,636 or 2.26% gain this month on US Taxable and Roth IRA accounts. My Interactive Brokers account gained 9.24%. The NDX gained 1.26% for the month. We are still more than $10,000 from breakeven after achieving breakeven in May.



5. Make at Least $10,000 from Trading Realised gains this month were $1,059 and so far this year $3,149. Even though I didn't do any active trading I closed positions in PSPT and NNDS and I mark to market my CFD position.

Background Statistics

Income and Expenditure



Expenditure was $3,598, which is what it typically is when there are no unusual expenditures and just day to day living costs. Non-investment income was also at baseline levels. Non-retirement accounts had $3,579 in underlying gains while retirement accounts did much better this month with $9,383 in gains. Foreign currency movements removed $25,348 from USD net worth.

Investment Performance

Investment return in US Dollars was -3.06% vs. a 2.11% loss in the MSCI (Gross) All Country World Index, which I use as my overall benchmark. Returns in Australian Dollars and currency neutral terms were 6.71% and 3.20% respectively. So far this year we have lost 14.05%, while the MSCI has lost 14.55%.

The contributions of the different investments and trades are as follows:



The big winner was Australian shares as represented by the CFS Geared Share Fund, Conservative Fund, Developing Companies Fund, and Future Leaders Funds as well as Clime Capital, the SPI CFD, and Qantas among others. Takeovers of NDS and PeopleSupport also generated nice returns. The worst performer was the EBI listed hedge fund of funds whose decline mostly represents an increase in the discount to net asset value. On the other hand, Allco Equity Partners saw a decline in its discount. Resource stocks also declined and the former Loftus Capital Partners continued its miserable share price performance. At least the company is buying back stock.

Asset Allocation

Allocation was 47% in "passive alpha", 73% in "beta", 2% was allocated to trading, 8% to industrial stocks, 3% to liquidity, 3% to other assets and we were borrowing 36%. Due to the use of leveraged funds, our actual exposure to stocks was 134% of net worth. Leverage declined and we increased exposure to private equity and reduced exposure to stocks:



The first two columns of percentages in the table indicate how much of net worth was allocated to investment in each asset class in July and August. The fourth column gives the percentage of total underlying assets in each asset class. In other words, rather than accounting for a levered share fund by how much we are investing in it, we are counting the shares that they own. In total we are borrowing an additional 85 cents explicitly or implicitly for each dollar of net worth. Due to using levered stock funds and derivatives the shares of the non-equity asset classes are lower than their shares in net worth. I didn't account for leverage in non-equity funds, but probably I should in future. I also broke out managed futures for the first time under "commodities". We have less than 1% exposure to this asset class.

Our currency exposures were roughly 54% Australian Dollar, 24% US Dollar, and 22% Other and Global.

Long-Short Funds

I just saw an interesting post on levels of competence in investing. In this passive alpha section of my portfolio I am being an evaluator - the second level of competence. I think I am getting better at it. The third level applies to my trading. That is an ongoing struggle and I don't think I have proved yet that I am a consistent performer. But I have a good idea of what is needed there.

On to today's passive alpha investments. I have three long-short funds: Hussman Strategic Growth, TFS Market Neutral, and Platinum Capital (HSGFX, TFSMX, PMC.AX). Each of these has very different strategies and so they make sense as complementary investments. I've discussed the first two before, for example here and here. Hussman is long individual stocks and then hedges using derivatives based on his research on past market conditions. The fund does very well in bear markets and quite well in strong bull markets but seems to underperform in moderate bull markets as we have seen recently. Hussman is good at picking stocks. His stock picks have outperformed the index. I am concerned though that economic conditions may have changed and he may be too bearish. He argues that the share of profits in GDP must return to its historic levels. I am not so sure. It is possible there has been a permanent change in the economy. I don't know for sure. I wouldn't make a bet on this either way at this point.

The TFS Market Neutral Fund is much smaller and mainly invests in smaller cap stocks. It is always long and short stocks and doesn't alter its hedging in response to market conditions. Recent returns have been much better than at Hussman. But the track record is much shorter. Both these mutual funds are invested in US stock markets.

Platinum Capital is a closed-end fund that is invested in stock markets globally. They are also always short some stocks but have a long bias. They change the weighting they give to different countries based on their assessment of global macroeconomic conditions. They also actively hedge foreign currencies. But interestingly they don't just hedge foreign exposures back into Australian Dollars. They may hedge into Yen, or Euros or any other currency. So this fund is also a bet on currencies. As Platinum Capital is a listed fund its price relative to NAV varies. But unlike most closed-end funds it usually trades at a significant premium to NAV. I believe this is due to the fact that the fund has considerable undistributed profits, which under the Australian taxation system have attached "franking credits". In Australia closed-end funds pay taxes (unlike the in the U.S.). When they pay out dividends, those dividends have credits for those taxes paid. Platinum Capital reports the franking balance. I maintain a spreadsheet that regresses the share price on NAV and the franking balance and tells me when PMC is under or over-valued. I buy when the stock is undervalued and sell some when it is overvalued. This has significantly boosted my returns over a buy and hold strategy. BTW, trading closed end funds is one of TFS's strategies too. Because of all my trading in and out it's hard to come up with an accurate estimate of my rate of return. Also I invested in 2001-2 and then again in April 2004. In the recent period it's been about 20% annualized. Platinum Capital does charge a performance fee with a hurdle of beating the MSCI World Index. Like Hussman, they performed better in the past. The MSCI has returned 20% p.a. over the last two years. I matched it by trading PMC, the fund itself has not performed as well.

Real Estate Investments

Continuing in the "passive alpha" theme we get today to my real estate investments. These include the TIAA Real Estate Fund, Newcastle (NCT), Challenger Infrastructure Fund (CIF.AX), and Hudson City Bank Corp (HCBK). The TIAA fund, which TIAA-CREF call very confusingly a "variable annuity" - it can be automatically converted to a variable annuity when you retire as I understand it - is effectively an open-ended mutual fund directly invested in real estate. They own office, retail, industrial, and residential properties around the US (and one overseas investment). Currently I put 50% of my incoming 403b contributions into this fund. It has performed excellently since September 2002 when I first invested with an annualized 11.4% rate of return and a very low variance. It's had only two slightly negative months. As a result, its Sharpe Ratio is an almost unheard of 4.5! My annualized rate of return is 12.9% as I've changed my contribution rate over time. It also has only a 0.078 correlation with the returns of my overall portfolio. I'm thinking to roll over my 403b into a Roth IRA when I one day quit my current job, but it is certainly tempting to hold onto this fund!

I've held the other investments for shorter periods and they haven't been as good as this one. I bought into Challenger Infrastructure around the time of its IPO (I couldn't participate due to being non-resident in Australia) in August 2005. It's returned 9.7% annualized since then. CIF is a closed end fund that is invested in infrastructure assets in Britain - gas distribution networks and broadcasting towers etc. It is supposed to be a global fund but ended up only investing in the UK for some reason. It's accounts have been pretty impenetrable. I originally bought 3000 shares and when the fund was trading below NAV I bought 2000 more. Later I sold 3000 due to the factors I mentioned above. I like to understand how an investment makes money and be confident in management's strategy. I didn't sell all my shares as I believed the investment was still udnervalued but I sold some to reduce my risk. Maybe I should think about selling the rest? One thing I do like about this investment is that the management company is heavily invested in the fund itself.

NCT and HCBK have both lost me a little money so far. Newcastle is a mortgage REIT managed by the Fortress Investment Group (FIG). It is mainly invested in commercial mortgages. I figured that in a real estate slump this fund could gain by buying assets cheaply. The assets it already held were high quality. And it has begun buying up assets from distressed institutions. So I'm going to hold for now. It also has a very high dividend yield - 9.9%. HCBK's main assets are high end residential mortgages. It also has immense amounts of cash and stockholder equity for a bank. So it has been buying back shares and I figured it too could win in a real estate slump. Also I anticipated it being added to the S&P 500 index. This has now happened but was a non-event as far as the stock price went.

The only passive alpha investment left to discuss is Berkshire Hathaway... and I don't think I need to explain that one! :)

Position Level Allocation

After all the changes of the last couple of months, I'm posting my position level allocation as at the end of October. This is one the main spreadsheets I maintain to see where I'm at across the whole portfolio. The primary breakdowns are according to currency and investment mode or function. "Passive alpha" are investments that are usually expected to have low correlation with stock or bond markets (including all individual financial sector stocks) while "beta" investments are funds and ETFs which are either index funds or mutual funds that are close to closet indexers. Some of these are sector funds (e.g. XLF, PBW, Global Resources Fund), some country funds (e.g. IFN), some capitalization funds - small and large cap Australian stock funds, and asset class funds (CREF Bond Fund). I break out individual non-financial stocks as "industrial stocks". The point of this post is mainly just to show what I'm currently holding in what proportion.

Positions that have done relatively well have grown into rather large percentages of net worth. In particular, the TIAA Real Estate Fund is now more than 9% of net worth and regarded as a "passive alpha" investment. It provides the bulk of our real estate exposure. It is a "direct property investment" as it is a non-exchange-listed open ended fund that directly invests in property. Direct property investments behave very differently from exchange listed property investments. They have a lower correlation to the stock market. Our only other exposure to direct property is through Snork Maiden's retirement account (PSS(AP)), which currently is still a very small exposure. Our other "real estate investments" are NCT (mortgage REIT), CIF.AX (Infrastructure Fund), BT Property Investments (a REIT mutual fund), and 3% of the CFS Conservative Fund. I'm rather loathe to cut exposure to the TIAA Fund given how well it has performed and our limited other opportunities currently for real estate investment. We could increase the share of Snork Maiden's retirement account in direct property, but the total amount to play with there is still rather small. Our other accounts are rather "liquidity constrained" :) So despite the single fund manager risk, I'm going to keep the current allocation.

Target Portfolio

This is the target portfolio I hope to get to by next month or so by continuing to switch funds and invest:



I classify our portfolio three ways:

• By conventional asset class - stocks, bonds etc.

• By function - passive alpha, beta, trading etc.

• By currency exposure.

It's by no means a final portfolio - that will always be evolving - in particular, I want to bring down the amount of borrowing from 29% and the amount of cash from 9%. Borrowing is high currently because I believe we are near the bottom of a stock market cycle. The margin rates I am paying are too high for keeping these loans in the long-term IMO. We'll always need some cash used in trading and some in liquidity, but the liquidity category can probably be halved from 7% in the long term. Prerequisites are increasing the credit limit on our Australian credit card and rationalizing Snork Maiden's U.S. accounts.

On currency allocation, I'd like to get to around 50% of the portfolio being exposed to the Australian Dollar and then rebalance from there. The US Dollar/other currency balance is fine. We've come a long way in the last year.

Though only 81% of assets are allocated to stocks, portfolio beta is estimated at 1.16 as a substantial chunk of that allocation will be in a levered fund. I'm planning to maintain around a 10% allocation to bonds in the meantime. Australian bonds in particular might be a good bet in the near future if interest rates come down here as eventually they'll have to. Otherwise, there is a 26% allocation to alternative investments, via a variety of funds and listed stocks. The main planned change is the addition of the Man Eclipse 3 fund which will take the hedge fund exposure to 15%. I don't have particular goals for the subcategories here, it really depends on the opportunities I see. The remainder of the "passive alpha" category includes financial stocks (Total stocks at 81% = beta - bond allocation + financial stocks + "industrial" stocks).

Passive Alpha

I promised a series on asset allocation, here is the next installment. I'll cover the investments I call passive alpha first. As I mentioned before, it's a bit of a misnomer. This category includes all actively managed funds that aren't broad bets on stocks or bonds or aren't strongly correlated with an underlying benchmark index as well as all other financial stocks. The individual investments are as follows:



There is a mix of Australian and US investments here. Though the Australian investments won't be of direct interest to most readers, the reasons why I invested in them may be. I hope to discuss that in more detail in future posts.

Real Estate TIAA Real Estate, Challenger Infrastructure, and Newcastle are three different sorts of real estate funds. Hudson City Bank Corp can also be thought of as a real estate fund. Both it and Newcastle have mortgages as their primary assets though Newcastle is a REIT and HCBK a bank.

Closed End Funds Clime Capital, EBB Investment Trust, and Platinum Capital are all exchange traded closed end funds but they are all rather different. Clime is a long-only stock fund, EBI is a fund of hedge funds, and Platinum Capital is a long-short hedge fund.

Hedge Funds TFS Market Neutral and Hussman Strategic Growth Fund are mutual funds that employ quite different hedging strategies. Platinum Capital and EBI are also of course hedge funds - and as they charge incentive fees they are more traditional ones. Challenger Infrastructure also charge a performance fee. Is it a hedge fund?

Management Companies Everest Brown Babcock is a hedge-fund-of-funds management company that among other things manages EBI.AX. Clime Wealth Management is also a fund management firm and included in its managed funds is Clime Capital.

Insurance Berkshire Hathaway is an insurance conglomerate. But clearly, people don't invest in it just to invest in insurance, or even the many unrelated subsidiary businesses BRK owns outright. Money management by Warren Buffett is a big part of the attraction.

As you can see it is a little tough to exactly classify all the entities in this category. But none of them is your traditional long only stock or bond mutual fund. And that is why I've placed them here.

P.S. 9:03pm

I just bought 4000 more shares of EBI.AX @ $A3.75 taking my holding up to 4.73% of net worth - financed by an increase in my margin loan. Today is the ex-date for a rights issue that is part of a capital raising. The price of shares under the rights issue is $A4.07 while institutional investors are paying $A4.29. The price today opened at $A4.1 and then plummeted as low as $A3.65. Now it is true that the rights offer also includes 1 EBB share (the management company) for free for every 4.5 EBI shares bought. But from my understanding the rights offer and placement doesn't reduce the net asset value of the fund per share at least not below $A4.07. The NAV at the end of February was $A4.29 at the end of February. So this seems irrational. Even if there is something I don't understand here I can't see that I am paying more than NAV. Therefore, the purchase this evening. I am not allowed to participate in the rights issue because I am not resident in Australia. This is one of the pitfalls of direct international investing.

P.P.S. 10:55pm

And then EBI was put into a trading halt when the price was at $A3.85 pending an announcement from the company. It can't be anything very bad as shares in the management company EBB are up 5.23% on the day at this point and not in a halt. I am guessing they want to either: Calm the market and say there is no grounds for the price drop, or one of the hedge funds they invest in (there are around 20 in the fund) blew up and therefore some fall in price was justified in fact. Those are my guesses of best and worst case scenarios. We'll have to wait and see. They did a trading halt last week to announce that the placement was oversubscribed. These things are common in Australia. But I still remember when Croesus Mining went into a halt so it makes me nervous. But there has to be a floor to the share price for a closed end fund of this sort.

March 2008 Report

The crisis in the financial markets seems to be abating and so does our own personal mini financial crisis. Though we made a net loss this month and net worth is down again, I made gains in trading, the wedding etc. is paid for and our credit lines and bank account are freed up, and I have a lot more buffer available between me and a margin call on my Australian margin loan. Earlier in the month, while I waited for payment from Primary Health for the Symbion takeover I was into the 5% buffer where you can't buy more shares but they don't give you a margin call yet.

All figures in the following are in US Dollars (USD) unless otherwise stated.

Income and Expenditure



Expenditure was $4,573 - core expenditure was $3,349 - in line with average months. Spending included $324 of implicit car expenses - depreciation and interest. The non-core expenses were paying for our wedding photos and spending from the wedding present money my Mom gave us. The latter is included in the "other income" of $4,964 as well as Moom's US Federal tax payment, which we treat as a negative income item and Snork Maiden's salary.

Non-retirement accounts lost $11,501 with the fall in the Australian Dollar contributing $3,815 to the loss. Retirement accounts lost $843 but would have gained $3,057 without the change in exchange rates. Trading contributed $2,794 in realised gains.

Net Worth Performance
Net worth fell by $US12,034 to $US432,934 and in Australian Dollars fell $A799 to $A474,146. Non-retirement accounts were at $US215k. Retirement accounts were at $US218k. So we did not make progress on our first and third annual goals as net worth decreased and non-retirement net worth fell by more than the decline in the MSCI index.

Investment Performance

Investment return in US Dollars was -2.77% vs. a 1.42% loss in the MSCI (Gross) World Index, which I use as my overall benchmark and a 0.43% loss in the S&P 500 total return index. Returns in Australian Dollars and currency neutral terms were -0.24% and -1.04% respectively. So far this year we have lost 4.80%, while the MSCI and S&P 500 have lost 9.18% and 9.59%, respectively.



The contributions of the different investments and trades are as follows:



The returns on all the individual investments are net of foreign exchange movements. This month trades mostly resulted in gains. The biggest gain was in the CFS Geared Share Fund which I've been switching into from the CFS Conservative Fund at what I think are low points in the market. The latter experienced a loss partly as a result of this switching, which has so far managed to time the market well. Time will tell whether it was a good idea longer-term. Several Australian financial stocks were again major losers. However, the proposed takeover of the Challenger Infrastructure Fund gave that fund a nice boost.

Progress on Trading Goals

As I've mentioned, realised gains for the month were $2,793.

My three US trading accounts gained $1,315 (or 2.35%, which is much better than the market) and there is now $6,731 to go till I reach breakeven across those three accounts, which is one of my annual goals. My Interactive Brokers account gained 7.82%.

So, we made progress on annual goal 5 (making money from trading) and goal 4 (achieving breakeven in my US accounts).

Asset Allocation
Using the simple method of adding up the betas of each individual investment weighted by their portfolio allocation, at the end of the month the portfolio had an estimated beta of 0.92. Using a regression on the last 36 months of returns gives a beta of 0.74 to the MSCI or 0.59 to the SPX. Alphas are 1.4% and 5.9% respectively. A more sophisticated time-series method yields a beta of 0.79 and alpha of 8.8% for the MSCI index. Therefore, we are doing well on our second annual goal (positive alpha).

Allocation was 39% in "passive alpha", 70% in "beta", 2% allocated to trading, 6% to industrial stocks, 5% to liquidity, 3% to other assets and we were borrowing 25%. Our currency exposures were roughly 55% Australian Dollar, 27% US Dollar, and 18% Other. In terms of asset classes, the distribution was:



After all the changes in investments and trading this month here is an update on our exact portfolio allocation:



Summary
We made progress on three out of the five annual goals this month.

December 2008 Report

Finally an up month, and a market beating one at that, in US Dollar terms at least. However, due to the rise in the Australian Dollar this month we lost in AUD terms and AUD net worth also declined.

Income and Expenditure



Expenditure was $5,181 ($A7,420). We bought a TV (Samsung 32", Full HD (1080), LCD, about $A,1400), some furniture (about $A400), a bike for Snork Maiden ($A750), and health insurance for her stepfather who will be visiting Australia (about $A350). Non-investment income of $6,465 due to the refund of Snork Maiden's China trip costs. Retirement contributions were $684. Before taking into account foreign exchange movements non-retirement accounts gained and retirement accounts lost money. They both gained in USD terms after taking into account the change in exchange rates.

Net Worth

Net worth rose by $10,158 to $205,660 or in Australian Dollar terms fell by $A4,202 to $294,558.

Investment Performance

USD returns were 4.12% vs. 3.67% or 1.06% for the MSCI and SPX respectively. In AUD terms we returned -2.41%.Using my preferred time series method, portfolio beta to the MSCI index was 1.36 with an annual alpha of 1.4%. Other methods now give a negative alpha. Individual investments made the following contributions to the result:



International and small cap Australian stocks made positive contributions. The top performer was the Challenger Infrastructure Fund which made an asset sale at carrying value during the month boosting confidence in its valuations. The fund is still trading at a massive discount to NAV. A similar positive valuation effect was seen for NDS following the European Union approving the buyout by News Corp and Permira. However, private equity funds MVC, 3i, and IPE all fell as did the TIAA Real Estate Fund and Everest Brown and Babcock despite the seeming resolution of the negative issues surrounding the fund.

Asset Allocation

At the end of October the allocation was 46% in "passive alpha", 60% in "beta", 1% was allocated to trading, 3% to industrial stocks, 5% to liquidity, 5% to other assets, and we were borrowing 20%. Due to the use of leveraged funds, our actual exposure to stocks was 104% of net worth. We regeared slightly. In November we were borrowing 17 cents for each dollar in equity; we are now borrowing 20 cents. When we take into borrowing by the leveraged funds we are invested in, borrowing per dollar of equity rose from 63 cents to 65 cents. Looking at asset classes:



Exposure to non-US foreign stocks rose due to market gains and purchases and exposure to hedge funds fell mainly due to the poor performance of EBI. We moved slightly towards our long-term asset allocation. The story of total assets (includes assets owned by leveraged funds) over the last few months is shown in this chart:



Our ownership of US stocks was particularly badly hit (13% of gross assets in August 4% now) due to market declines and subsequent margin calls.