Portfolio manager says those who’ve kept a level head in rough times should be well-positioned now to take advantage of attractive valuations. 

Kenneth Smith has been spending
a lot of time lately trying to make sure that market volatility doesn’t send investors into a tail spin.

As a result, the chief investment officer
at Seattle-based Empirical Wealth Management says that the high net-worth and institutional
clients he works with aren’t ready to panic yet.  

But he credits such realistic expectations to not only this year’s educational push. Smith explains that he has been sounding a similar theme when markets were running strong from 2003 through late last year. The difference, he says, is that during bull markets the message has been to not chase asset classes that are performing well. 

Now, conditions are different. But the veteran advisor and portfolio managers says keeping a level head and remaining unemotional as market volatility remains high is as important as ever. Through good times and bad, he and his
co-managers at Empirical emphasize that they stick to the same process of monitoring asset class correlations and watching trends in global
market capitalization sizes.

And with most segments of
equities pummeled this year, Smith believes that investors who’ve been disciplined
about rebalancing their portfolios according to a long-term asset allocation
plan can find plenty of good buying opportunities right now.

“The valuations right now in some areas of the
market are very reasonable,” said Smith. “Earnings could drop and valuations
could change. But we’re encouraging our long-term orients clients, especially the
younger ones, to use these current market conditions to raise their stock
allocations back to proper levels.”

In fact, Smith says he has been scrambling
to come up with extra money to put into stock funds for the portfolios of his
daughters.

“Even for investors with shorter
investment horizons, conditions right now offer a good buying opportunity in
stocks,” he said. “We’re not telling older investors closer to retirement to go
overboard and load-up on stock funds. But unless their circumstances and goals have
changed, we think it’s a good time for people to rebalance portfolios at
attractive valuations.”  

The firm’s average allocation
for his 500-plus clients is around 60% equities right now, says Smith. He
prefers exchange-traded funds and passively managed portfolios from Dimensional
Fund Advisors. A typical investor at Empirical might have 35% to U.S. large-cap
funds. That’s down from about 45% a few years ago.

In large blend categories, Smith
likes the Vanguard Large Cap ETF (NYSE: VV). 
He also tilts to the DFA U.S. Large Cap Value Fund (DFLVX).

The advisor targets another 20%
to U.S. small-cap funds, which is relatively consistent with allocations of
past years. That’s divided across micro-caps, small-cap blend funds and
small-cap value funds. Smith uses the iShares Russell Microcap Index (NYSE: IWC)
and the Vanguard Small Cap Value ETF (NYSE: VBR) to fill those shoes. Smith
also likes to include the Vanguard Small Cap ETF (NYSE: VB) and the DFA U.S. Small
Cap Fund (DFSTX).

Some 25% of client stock assets
now go into developed international markets. “In 2003, it started at around 16%
and gradually has been bumped up,” said Smith.

He uses four different funds in
those areas. One of this is the Vanguard Europe Pacific ETF (NYSE: VEA) for
large-blend international markets. The advisement firm mixes that with the DFA International
Value Fund (DFIVX). For exposure to smaller foreign stocks, it’s implementing in
portfolios the DFA International Small Company Fund (DFISX) and the DFA
International Small Cap Value Fund (DISVX).

In emerging markets, Smith will
add about 10% of a typical client’s stock assets into the DFA Emerging Markets
Core Equity Fund (DFCEX). He also likes the Vanguard Emerging Markets Stock ETF
(NYSE: VWO) for some portfolios.

“In early 2005, we started
bumping up emerging markets allocations from around 4%,” said Smith. “But
emerging markets got up to about 12% of world markets based on capitalization
levels at the beginning of this year. The year before it was close to 7%.”

He added:  ”We’ll be evaluating that asset class again at
year-end to see if it needs more adjusting based on global capitalization
rates, correlations and valuations.”

Smith is also putting his
clients into the Northern Global Rest Estate Index Fund (NGREX). On average,
client portfolios will have about 5% of its stock assets in that fund,
according to Smith.

“It’s just a straight index
mutual fund,” he added. “It came out about two years ago and was the first
passively managed index fund that provided exposure to global REITs. It holds
both U.S. and international real estate companies.”

Finally on the equity side,
Smith puts about 5% of an average client’s assets into the iShares S&P GSCI
Commodity-Indexed Trust (NYSE: GSG). “We like the exchange-traded notes in
the commodities area,” he said. “But until there’s a ruling that changes the
tax structure of commodities ETNs, we’re sticking to the ETFs. And we also don’t
want to take on the credit risks with ETNs right now.”

Empirical is rebalancing client
assets into both stocks and commodities now. “But we’re not big fans of buying
into big pools of gold or metals. We don’t focus on any one sector – we want
exposure to a broad range of commodities,” said Smith.

And the GSG’s index weights commodities
based on global production, he adds, “which is the most straight-forward and
pure weighting methodology among commodities ETFs and ETNs.”

Empirical rebalances portfolios based
on a banding system. If an asset class shifts anywhere from 10% to 25% off its
target allocation, then Smith and his team will consider making changes. Each
asset class and fund is given different bands within a portfolio, he says.

“We’re not market timers. But we
review valuations for every asset class. So we do make adjustments, but it’s
not based on macroeconomics. It’s based on changing correlations and valuations
of different asset classes over longer periods of time,” said Smith.

For bonds, Empirical focuses on constructing
portfolios that are as non-correlated to stocks with as little risk as
possible. “We keep it very simple using shorter-term durations and very
high-quality funds,” said Smith.

Empirical has four basic ETFs it
includes in client portfolios. Those include the iShares Lehman 1-3 Year
Treasury Bond Index (NYSE: SHY) and the iShares 3-7 Year treasury Bond
Index (NYSE: IEI). The other two are the iShares 1-3 Year Credit Bond Index
(NYSE: CSJ) and the iShares TIPS Bond Index (NYSE: TIP).

The firm’s investment policy
committee has just changed allocations within fixed-income because of narrowing
spreads between TIPs and nominal Treasuries, says Smith.

It’s now allocating about 30%
into TIP, up from 20% a month ago. Targets for the other three are: SHY (20%);
IEI (15%) and CSJ (35%).

“We want the average duration of
portfolios to be around five years or less. If you have a greater number of
longer-termed bonds in a portfolio, correlations with stocks go up. And the
longer the maturity of bonds, the greater the interest rate risks. So we find
that five years or less poses the best risk-reward profile,” said Smith.

– This article was submitted by IndexUniverse.com’s Murray Coleman. 

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