A 60/40 Australia-Oriented Passive Benchmark

If we create a portfolio invested 50% in VDBA and 50% in VDGR we can simulate a 60/40 passive benchmark:

This requires monthly rebalancing of the portfolio. We ignore the costs of this rebalancing. Over this period, the benchmark portfolio had a compound annual return of 5.60% with a monthly standard deviation of 2.55% compared to Moom's compound return of 7.77% with a monthly standard deviation of 2.32%. Moom's beta to this portfolio was 0.8 with an annual alpha of 2.9%.

Note that our portfolio goes through three different "regimes" during this period. Up to October 2018 we had a portfolio that was about 60% long public equity. Then we received a large amount of cash, which we converted to bonds and then gradually invested in other assets. This phase lasted up to the end of 2020. Since then we have been close to the target portfolio.

Designing a Portfolio for Baby Moomin

I decided that the best provider of investment bonds is Generation Life. This is mainly because they seem to be scandal free, not about to be sold off to an overseas manager, and have lower fees than other providers. Next I needed to pick an investment portfolio from their investment options. I decided on the following rules and criteria:

1. 50/50 equities/fixed income and alternatives
2. 50/50 passive and active management
3. 50/50 Australian and international assets
4. Pick the best fund from alternatives in each of these niches - focusing on long-term "alpha" and in particular their performance during the Global Financial Crisis and the recent December 2018 mini-crash.

This is the resulting portfolio:

50% Dimensional World Allocation 50/50 Trust. Here I compared a Vanguard balanced fund with this fund. In the long run, DFA have done much better than Vanguard:

Here, Portfolio 1 is a DFA stock fund and Portfolio 3 the Vanguard equivalent. The equity curves are for someone withdrawing 5% per year in retirement. Portfolio 2 is a DFA 60/40 stock/bond portfolio. The difference is stunning. Recently, DFA hasn't done as well as value stocks are out of favor. I am betting on them coming back. If there is a major market correction we might shift this core holding to a more aggressively equity focused fund.

10% Ellerston Australian Market Neutral Fund. Ellerston has done horribly in the past year, but prior to that it did very well for a market neutral fund. It now seems to be rebounding. This fund manager originally managed James Packer's money and then branched out.

10% Magellan Global Fund. This has been one of the best Australia based international equity funds. It did particularly well during the GFC.

10% Magellan Infrastructure Fund. This fund seems better than the other real estate options. It didn't do very well during the GFC, but all the others were worse.

10% Generation Life Tax Effective Australian Share Fund. This fund is managed by Redpoint Investments. The idea is to tilt a bit towards tax effective Australian shares given the high taxes on this investment bond overall. The manager is pretty much an index hugger, but the other options for actively managed Australian shares seem worse.

5% PIMCO Global Bond Fund. PIMCO is the gold standard for actively managed bonds. I decided to split my allocation to PIMCO between international bonds and

5% PIMCO Australian Bond Fund, as Australian bonds have actually done very well recently.

EDIF

In the ongoing Everest Financial saga, the "direct investments" in the EAIT fund of hedge funds is being separated out into a standalone fund as of 31 July. 62% of this new fund is invested in Babcock and Brown European Ports Investments and the other investments are also in infrastructure or real estate. Therefore, I'm classifying this as a real estate investment as well as a "passive alpha investment" and as the investment is in my understanding hedged I'm going to continue to count it as an Australian Dollar investment.

Challenger Infrastructure Fund Removes FX Hedging

Challenger Infrastructure Fund (CIF.AX) announced today that it has closed its foreign currency hedges yielding a profit. As it is now unhedged and invested entirely outside of Australia (mainly in the UK) I will now regard this investment as part of my "global currency" investments (not AUD or USD). This is good as our AUD exposure is rising (though the investment is just 1.3% of net worth). The investment is included in our "real estate" investments and under the "passive alpha" category as I don't expect it to be highly correlated with the stock market in the long run.

January 2009 Report

In USD terms we pretty much matched the MSCI index this month. Of course, this was its worst January ever. In Australian Dollar terms performance was flat and net worth increased slightly.

Income and Expenditure



Expenditure was $3,036 ($A5,015). Car repairs cost $A550. We bought a barbeque ($A365) and there were about $A260 of medical expenses which were partly refunded by Medicare in February. And the car depreciated another $A500. Before taking into account foreign exchange movements non-retirement accounts gained and retirement accounts lost money. They both lost in USD terms after taking into account the change in exchange rates.

Net Worth

Net worth fell by $17,337 to $188,160 or in Australian Dollar terms rose by $A735 to $295,060.

Investment Performance

USD returns were -8.92% vs. -8.51% or -8.43% for the MSCI and SPX respectively. In AUD terms we returned -0.19%.



All asset classes lost apart from hedge funds, which gained massively mainly due to the delisting of EBI as EAIT. Returns for both EAIT and the Man managed futures fund are now going to be estimated at the time of writing these accounts reports and adjusted later in the month (mid-month and month's end respectively) after the actual returns are available.

Using my preferred time series method, portfolio beta to the MSCI index was 1.31 with an annual alpha of 1.9%. Other methods now give a negative alpha.

Asset Allocation

At the end of October the allocation was 51% in "passive alpha", 57% in "beta", 0% was allocated to trading, 4% to industrial stocks, 5% to liquidity, 4% to other assets, and we were borrowing 21%. Due to the use of leveraged funds, our actual exposure to stocks was 98% of net worth. When we take into account borrowing by the leveraged funds we are invested in, borrowing per dollar of equity was 60 cents. Looking at asset classes:



Shifts in the allocation are mainly due to relative performance this month. We moved further towards our long-term asset allocation, though not for a good reason, but mainly because Australian stocks underperformed and we are overweight in them.

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.

November 2008 Report

November was another horrible month. The percentage decline was not as bad as in October in USD terms. In fact, only half as bad. But we lagged the market very badly due to forced margin liquidations and in Australian Dollar terms this was our second worst month ever (September 2002 was worse).

Income and Expenditure



Expenditure was $3,800 ($A5,807). This was elevated by a registration fee we had to pay for the China conference. Core expenditure still came in at $3,003 ($A4,588), which exceeded non-investment income of $2,635. Retirement contributions were $1,133 as Snork Maiden's employer began to catch up on some of the missing contributions. They are still behind by three contributions. Total investment losses were $38,789. Foreign currency had little impact this month as the Australian Dollar and Euro were steady though the Pound fell.

Net Worth

Net worth fell by $37,448 to $195,284 or in Australian Dollar terms by $A54,305 to $298.427. This takes us back to mid-2004 levels in US Dollars or late 2004 to early 2005 levels in Australian Dollars. If I can get a decent job in the next year and markets recover a bit we could fix this damage in about 3 years I think.

Investment Performance

USD returns were -16.67% vs. -6.51% or -7.18% for the MSCI and SPX respectively. In AUD terms we returned -15.98%.

Using my preferred time series method, portfolio beta to the MSCI index was 1.43 with an annual alpha of 1.8%. Other methods now give a negative alpha.

Asset Allocation

At the end of October the allocation was 47% in "passive alpha", 59% in "beta", 1% was allocated to trading, 0.5% to industrial stocks, 6.5% to liquidity, 4% to other assets, and we were borrowing 17%. Due to the use of leveraged funds, our actual exposure to stocks was 101% of net worth. Deleveraging continued. In October we were borrowing 28 cents for each dollar in equity; we are now borrowing 17 cents. When we take into borrowing by the leveraged funds we are invested in, borrowing per dollar of equity declined from 75 cents to 63 cents. Looking at asset classes:



Exposure to foreign stocks and private equity reduced as they declined in value against other assets or we were forced to sell. The shares of the stronger performing asset classes increased. As a result, we moved away from our long-term target (A distance of 25% vs. 23% in October). The picture at the position level now looks like this:



There were only three positive performers this month, namely Platinum Capital (PMC.AX), CREF Bond Fund, and the Man managed futures fund. Everything else lost money.

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.

October 2008 Report

In percentage terms October's results are the worst on record but they were heavily influenced by the decline in the Australian Dollar that took place in this period. This has the effect of reducing both our expenses and non-investment income in US Dollar terms and making investment returns in USD terms much worse than in Australian Dollar terms. In Australian Dollar terms the results were bad but no worse than September. Of course, September was horrible.

Income and Expenditure



Expenditure was $3,523 ($A5,340). This was elevated by heavy spending in China on everything from family banquets to hotelrooms. Non-investment income of $7,057 which was increased by a third salary payment this month and by money we received from Snork Maiden's parents. Retirement contributions were $668. Total investment losses were $96,753, which is a record loss. But $37,660 of this was due to the fall in the AUD. In AUD terms we lost $A52,637 - a little less than in September - with a positive $36,866 contributed by the rise in the USD.

Net Worth

Net worth fell by $90,408 to $234,430 or in Australian Dollar terms by $A43,074 to $355,305. This chart, in Australian Dollars, does look a bit less scary than the US Dollar chart posted on NetWorthIQ:



Medium term balance is just non-retirement accounts and superannuation is retirement accounts (including US ones as well as Australian ones).

Investment Performance



We are now trailing the MSCI All Country Gross Index across all of these time frames. Returns just fell off a cliff in September and October compared to any previous period:



Whatever way you look at it:



Using my preferred time series method portfolio beta to the MSCI index was 1.27 in October with an annual alpha of 3.1%. This alpha is hugely down on past estimates but still positive.

Asset Allocation

At the end of October the allocation was 52% in "passive alpha", 58% in "beta", 2% was allocated to trading, 6% to industrial stocks, 6% to liquidity, 4% to other assets, and we were borrowing 28%. Due to the use of leveraged funds, our actual exposure to stocks was 105% of net worth, which was down sharply this month due to "forced deleveraging". In September we were borrowing 29 cents for each dollar in equity; we are now borrowing 28 cents. The change is much bigger when we take into borrowing by the leveraged funds we are invested in. In total, borrowing per dollar of equity declined from 82 cents to 67 cents. Looking at asset classes:



Exposure to stocks reduced as they declined in value against other assets or we were forced to sell. At the end of September currency exposures were roughly 51% Australian Dollar, 27% US Dollar, and 21% Other and Global.

September 2008 Report

I'm still waiting for one final piece of data for the October report, so in the meantime here is the much-delayed September report. This report will be pretty short as I'm no longer comparing results against annual goals and there'll be more detail in the October report. Also, these results are so bad I don't really want to analyse them too much!

Both September and October's results are heavily influenced by the decline in the Australian Dollar that took place in this period. This has the effect of reducing both our expenses and non-investment income in US Dollar terms and making investment returns in USD terms much worse than in Australian Dollar terms.

Income and Expenditure



Expenditure was $2,996 ($A3,674). Non-investment income of $3,618 ($A4,436) mainly consisted of Snork Maiden's salary. Retirement contributions were $539. Total investment losses were $71,412, which is a record loss. $11,648 of this was due to the fall in the AUD. In AUD terms we lost $A64,651 with a positive $8,641 contributed by the rise in the USD. The currency neutral loss is worse than the estimate of October's loss.

Investment returns are reported pre-tax. Australian retirement account earnings are taxed at 15% (10% for long-term capital gains). A fall in the value of the account reduces the tax liability and so the actual account value falls by less than our estimated pre-tax investment returns on the account. Reduction in the tax liability on these accounts kicked in $2,756 to the change in net worth.

Net Worth

Net worth fell by $67,496 to $324,821 or in Australian Dollar terms by $A59,849 to $398,358. At month's end retirement accounts stood at $172,541 and non-retirement accounts at $152,280 ($A211,603 and $A186,755).

Investment Performance



Investment return in US Dollars was -18.2% vs. a 7.59% loss in the MSCI (Gross) All Country World Index, which I use as my overall benchmark and a 8.91% loss in the S&P 500 total return index. Returns in Australian Dollars and currency neutral terms were -14.11% and -15.23% respectively. My previous worst return was in September 2002 when the loss was 17.96% (17.13% in AUD terms).

So far this year we have lost 29.47%, while the MSCI has lost 21.04%. We are still beating the market over 5 years and 10 years in USD terms but trailing in all the more recent timeframes.

Asset Allocation

Allocation was 49% in "passive alpha", 63% in "beta", 1% was allocated to trading, 8% to industrial stocks, 4% to liquidity, 4% to other assets and we were borrowing 29%. Due to the use of leveraged funds, our actual exposure to stocks was 128% of net worth. Leverage declined due to the restructuring following the margin call from CommSec. In August we were borrowing 36 cents for each dollar in equity; we are now borrowing 29 cents. Taking into account leveraged funds borrowing declined from 89 cents to 82 cents per dollar of equity. Looking at asset classes:



We halved exposure to bonds but kept stock exposure as a fraction of gross assets constant. I've also included a tentative long-term allocation for the first time. We're not going to move our allocation towards these targets in the short-term, but they indicate where we'd like to be a few years from now. I've allocated 10% to each of bonds, hedge funds, private equity, commodities, and real estate, which is totally arbitary. We would like to have about half of total assets in these categories as against about 30% now. But I really don't know if 5% or 10% is say the appropriate allocation to private equity given the limited options available to retail investors. I am pretty sure though that more real estate and managed futures would be good.

There is a bit more science behind the equity allocations. The Australian equity exposure is double the foreign exposure. The allocation to large cap vs. small cap reflects the 78% of Australian market capitalization in the ASX 200 stocks. The breakdown between US and rest of the world stocks reflects that 50% of world market capitalization is in the US.

Anyway, in the next few years I plan to scale back exposure to large cap Australian stocks and increase exposure to real estate, bonds, and commodities if and when global stock markets recover. I'd also like to get overall leverage down to about 30% or so.

At the end of September currency exposures were roughly 54% Australian Dollar, 24% US Dollar, and 22% Other and Global.

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.

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.

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.

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.

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.

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" :)

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.

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.

Madame X: Summing Up

Here are all the posts I've written on this topic:

Miscellaneous Funds
U.S. Large Cap
U.S. Mid Cap
U.S. Small Cap Funds
International Stock Funds
Bond Funds
Individual Stocks
Asset Allocation
Portfolio Overview

Overall, the portfolio is OK as a stock-bond portfolio for someone of Madame-X's age. It is reasonably well diversified across US and international stocks and stock capitalization classes and has a reasonable allocation to bonds. It has some good actively managed funds and some poor ones as well as index funds.

I've suggested increasing the international and large cap allocation a bit using new contributions as well as dumping some losing funds and getting a more rational allocation to actively managed and index funds in some cases.

I would also look at diversifying further. This can be hard to do without losing exposure to the stock market - as long as the additional asset classes have good expected returns this shouldn't be a real problem. The other solution is using leverage to gain more than 100% exposure. I invest in a variety of funds and financial firms that I classify as "passive alpha" - these are all investments which I expect to have a lower correlation with standard stock or bond index funds. They include:

• Real estate

• Hedge funds

• Private equity

• Commodities

• Very actively managed stock funds - where the manager makes no attempt to benchmark against an index. Examples are FAIRX and CGMFX. All those readers who think it is impossible to identify a good fund, have a look at these two. I also like Fidelity's Contrafund (which has nothing to do with Nicaragua :)) and Janus' Contrarian Fund.

• Other financial firms - such as Berkshire Hathaway - an insurance conglomerate - or Interactive Brokers - a market maker in the financial markets.

You have a strong exposure to real estate through your condo - though that is just one investment in one market. As real estate prices fall, funds that invest in real estate could become attractive.

Hedge funds are obviously usually out of bounds to retail investors in the U.S. But there are mutual funds that take short positions. I have shares in TFS Capital's Market Neutral Fund. I also have the Hussman Strategic Growth Fund, but I'm not recommending it :).

Private equity is another hard to access asset class. I don't recommend investing in Blackstone. On the other hand, Leucadia National is in effect a private equity company.

Commodities - you have an energy fund - there is also the option to buy ETFs exposed to commodities like gold. I don't have any in my portfolio - my exposure to a resource fund and the Australian Dollar and Australian stock market is sufficient I think. A non-energy mining oriented fund might make sense in addition, but that's very optional I think.

I'd look at 5-10% in any of these categories in the long-term.

Remember - all these suggestions are what I would do but aren't necessarily what you should do. As they always say - seek a second opinion, I am not a qualified/registered investment adviser.

Madame X: International Stock Funds

On to Madame X's international stock funds and a hopefully interesting lesson in passive vs. active management:



(something seems to be seriously wrong with Yahoo's index return figures for the last few years).

ETINX and FSIIX are both international (developed countries) index funds and as you can see almost exactly replicate each other. Madame X has both of these because they are in different accounts. The Fidelity one is just slightly better than the E-Trade version until this last year when it has slightly underperformed. On the other hand FDIVX, an actively managed fund has positive alpha (market-risk adjusted return) and better performance than either of the index funds despite its much higher expense ratio and much larger size. Low expense ratios are not the be all and end all of fund selection. This fund was in the upper quartile of its category in the last 5 years but has drifted downward in performance in the last few years. I wouldn't sell it, but it wouldn't be on my buy list either.

VEIEX is an emerging markets index fund. Its alpha and beta are measured relative to the developed country international index - its performance relative to emerging market funds is not as fantastic, but still respectable - in the last year it was in the top 20%. It's probably not a bad fund for exposure to emerging markets.

None of these international funds could be responsible for the possibly negative performance of Madame X's portfolio.