The purpose of asset allocation is to own minimally correlated assets, which tends to reduce portfolio volatility while delivering the return of the blended classes.

Within the major equity category, asset classes are often thought of as US, non-US developed, and emerging country stocks.

Correlations between those major categories have converged somewhat in the past, but in 2008  they approached unity.

If equity class correlations equal “1″ there is no allocation benefit relating to diversifying the volatility within the equity class.

This correlation table for 1-year returns for various Vanguard mutual funds (with ETF proxies for those mutual funds) shows major and minor equity categories lining up in 2008 with correlations approaching “1″.

Securities listed in image: VFINX, VTSMX, VFWIX, VDMIX, VEURX, VPACX, VEIEX, SPY, VTI, VEU, VEA, VGK, VPL, VWO

Asset allocation with regard to equities will work better when correlations begin to diverge.

Richard Shaw QVM

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Some of our readers have asked for a list of top yielding stocks by sector.  We built a screen for that and present the five stocks with the highest trailing dividend yield in each sector plotted with the related S&P 500 sector fund.

This does not constitute a recommendation of any kind.  It is a screen that produces food for thought only.  There are probably some stinkers in the list and maybe some good opportunities.

The reason to use the screen would be to find positions that could yield more than buying the index, and that could be balanced among the sectors differently than stocks are balanced within dividend funds (such as DVY, SDY, and VIG).

Before presenting the results, here are the criteria we used to build the screen, showing how the universe reduced as more criteria were applied:

All stocks covered by S&P Outlook (9,969) Market price >$5 (5,281) Paid dividends since 1998 or ...

This chart of five key classes gives pretty good synopsis of 2008 (Jan 1 - Dec 31):

US stocks world stocks ex US US equity REITs global commodities US aggregate bonds.

click image to enlarge

Richard Shaw QVM Group LLC

As the bond markets improve, and equities makes attempts to rise, convertible securities hold an interesting and potentially attractive position within the capital structure of speculative companies.

Among the convertible securities funds, we like Vanguard Convertible fund the best (symbol VCVSX).  Unlike most other types of bonds, there are no ETF products for convertible bonds, although there are some preferred securities CEF products. We have no current opinion about the CEFs, except to say that generally we prefer mutual funds or ETFs over CEFs.

VCVSX versus convertible CEFs:

Those convertible CEFs with over $100 million of assets and 5 years or more of history are: JQC, NCV, AVK, CHY, and CHI. Here is how their recent performance compares to VCVSX (shown in solid black line).

Convertible Funds versus Other Bond Fund Types and the S&P 500:

We prefer VCVSX for convertible bond (and some preferred)

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Oil as a commodity is an interesting real asset. What investments most directly create the economic effect of owning oil itself?

The best answer would be to own an oil well, or better yet, own an entire oil exporting country.  However, neither of those options is a practical answer for most investors, certainly not owning a country (unless, of course you are born into the right family).

So what are the practical options for the rest of us?  Among others, they include:

futures contracts funds that invest in futures contracts exchange traded notes that are priced to a futures index royalty trusts that own oil in the ground integrated oil companies oil & gas exploration companies oil & gas production companies general energy funds alternate fuels options on any of the above.

Options are a speculation that expire in time, so we’ll exclude them from the “ownership” consideration.  Futures provide a 1:1 price participation, but they also expire with time, and rolling from

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The table below presents the SEC 30-day yield and the portfolio yield-to-maturity reported for most of the Barclay’s iShares bond ETFs.

Note, that unlike an individual bond with a fixed interest yield and yield-to-maturity, bond funds have turnover which causes portfolio yields to change.

To provide some historical perspective, the following charts plot the 19 year history of US Treasuries with maturities from 1 month through 30 years.

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Several US bonds types have mostly recovered from the steep losses of October.  The differences in recovery generally correspond to the position of the bonds in the capital structure, or to credit quality.

Aggregate US Bonds:

Aggregate bonds (excludes short-term and muni bonds) are ahead, due to the strong performance of Treasuries.

The two leading ETFs for the Lehman Aggregate US Bond index are AGG from Barclays and BND from Vanguard.  The Barclays product has more trading volume, and uses limited sampling to track the index.  The Vanguard product has lower fees and holds many more securities in its sampling.

click images to enlarge

[shown: AGG, BND]

US Bond Types:

Treasuries are bubbly and showing fatigue at the long end (see prior articles: 12/24/2008 and 12/25/2008).  Mortgage-backed securities (MBB: mostly from FHLMC and Fannie, with some GNMA; and VFIIX: primarily GNMA) are

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Treasury Inflation Protected Securities (TIPS) are more attractively priced than ordinary Treasuries of the same maturity.

About Ordinary Treasuries

Ordinary Treasuries pay a fixed amount of interest twice per year and mature at a fixed principal amount.  Treasury interest for US-persons is exempt from State and local income taxes, but not Federal income taxes.  Treasuries can reasonably be held in taxable or tax deferred accounts.

About Treasury Inflation Protected Securities (TIPS)

The principal amount of a TIPS adjusts to increase with inflation or decrease with deflation, as measured by the CPI. However, the maturity value of a TIPS is the original principal amount (”par”) or the adjusted principal, whichever is greater.

TIPS pay interest twice a year, at a fixed rate (not a fixed amount). The fixed rate is applied to the inflation/deflation adjusted principal.  Therefore, the interest payments rise with inflation and fall with deflation.

If inflation occurs while you hold TIPS, each interest payment

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In a recent post about “bubbly” Treasuries, we got some comments that deserve attention.

First, this is briefly what we said;

“Treasuries have reached bubbly levels, both in terms of low yield and the rate of change of price.

Interest rates will rise when the economy recovers, or when bond buyers demand more long-term interest to absorb trillions of new issues to fund recovery programs. Rising interest rates mean Treasury prices will fall.

… For investors who invest only “long”, closing long positions in long-dated Treasuries, or being alert to a trend reversal necessitating the closing of those positions is recommended.

… For investors who also invest “short”, being alert to a trend reversal creating a shorting opportunity is recommended. The current trend is strongly upward, but could reverse dramatically …”

Some commenters agreed and some did not.

A supportive comment was;

“The safe haven play into Treasuries is demonstrating a true example of a parabolic

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Treasuries have reached bubbly levels, both in terms of low yield and the rate of change of price.

Interest rates will rise when the economy recovers, or when bond buyers demand more long-term interest to absorb trillions of new issues to fund recovery programs. Rising interest rates mean Treasury prices will fall.

Consider these charts plotting the interest rate on 10-year  and 30-year Treasuries versus the price of 10-year and 30-year Treasuries. Price and yield are near perfect mirror images.

The 19-year history of the monthly yields shows a steady decline, followed by a precipitous drop in Q4 2008. There is little room for further decline, and reasons to believe that rates must rise. Long-term investors, for example, cannot be expected to be content to earn 2+% forever.

Long-term history of rates shows there is much more room for rates to rise than to fall. We don’t know when rates will

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