Risk Analysis of Investments

Finding portfolio gaps for a balanced portfolio

/ humblefi / 5 Comments

Since the end of 2016 is almost here, I wanted to see if there are any gaps in my investment portfolio used to produce passive income. If I did find some gaps, then I want to close them out to have a better balanced portfolio. I did some research and found that there are a few ways to find gaps in your portfolio.

Vanguard Portfolio Watch

If you have a Vanguard account and have all your investments in Vanguard, then Vanguard provides a tool called Vanguard Portfolio Watch. This tool will give you recommendations like the following:

  • OK: Your investments in foreign stocks add diversification to your portfolio.
  • CAUTION: The proportions of large-, mid-, and small-capitalization stocks in your portfolio differ from those of the market.OK: Your portfolio is tax-efficient.
  • CAUTION: Your portfolio emphasizes value stocks which puts you at risk of under-performing the market when growth stocks perform well.
  • CONSIDER: Holding more foreign bonds can potentially increase the level of diversification in your portfolio. Allocating up to 20% to 50% of your bond portfolio to foreign bonds is a reasonable amount to capture the diversification benefits.
  • CAUTION: Sectors indicated with a red arrow vary substantially from the benchmark weightings.

You can use the above analysis results to identify gaps in your portfolio and then invest accordingly. If you want to just see the effect of adding a new investment to your portfolio, you can use a tool called Portfolio Tester….also provided free by Vanguard.

Personal Capital Investment Watch

Personal Capital is a wonderful free tool that anybody can use for tracking their investments, spending and a whole bunch more.

  • The one feature I really like is that it breaks down all the funds in your portfolio into the following categories, JUST by taking the names of the different funds like VDIGX, VTCLX, etc. For example,
    • Large cap, mid cap, small cap split
    • Cash and bonds split
    • Alternatives (real estate, etc)
    • US and International split
  • Personal capital pointed out a weakness in my portfolio diversification w.r.t. lack of investment in Alternative Investments like Real estate, hedge funds, commodities, etc. Hence I started looking at how to add a real estate dimension to my portfolio.
  • I wrote about how I found this portfolio gap here.

This tool has something called Investment watch and that is what I use often to see the composition of my portfolio. Take a peek at it and see if it is useful.

Correlation Analysis

Whether you have none of the previous two ways OR you have it and still want to still find portfolio gaps, Correlation Analysis is a super-wonderful way to do it.

  • Two mutual funds (or stocks or any of the asset classes) are correlated means that the investments behave similar to each other i.e. they both reach the same way in the same market cycles…both go up OR both go down. Lets use the following tool to find correlation co-efficient (Asset Correlation Tool)
    • Example 1:
      • Correlation coefficient of VDIGX and VDAIX is 0.98 (98%)
      • This means that VDIGX and VDAIX behave 98% similarly
    • Example 2:
      • Correlation coefficient of VDIGX and VTMGX (International) is 0.77 (77%)
      • This means that VDIGX and VTMGX behave 77% similarly
  • Two mutual funds are not-correlated means that the investments behave differently in diff ways i.e. both react differently in the same market cycle….if one fund goes up, then one goes down. Lets use the following tool to find correlation co-efficient (Asset Correlation Tool)
    • Example 1:
      • Correlation coefficient of VDIGX and VCADX (CA MUNIs) is -0.13
      • This means that VDIGX and VCADX behave totally opposite to each other i.e. they have negative correlation.

A portfolio is a balanced one if it has assets in it that are correlated in different ways i.e. all the assets should not behave the same way. If we are in a bull market, some assets should go up and some may go down….if we are in a bear market, the same should hold true. If you think this does not make sense, go watch this awesome video titled Asset Allocation: Building a Better Balanced Portfolio The video is a long one but worth the time…and quite entertaining too 🙂

Tool for Correlation Analysis

A wonderful and free tool (no login required) for Correlation Analysis of your portfolio is a tool called Correlation Tracker. I chose the option where I type in all my portfolio values and I get a recommendation of different SPDR funds/etfs that correlate positively (same behavior) and correlate negatively (different behavior).

  • I punched in all my mutual funds that generate passive income for me. They are: VCADX, VWIUX, VTMFX, VWELX, VDIGX, VDAIX, VHDYX and VTMFX.
  • Funds that correlate positively:
    • SPDR Select Sector Fund – Industrial                            XLI        Correlation = 0.882
    • SPDR Select Sector Fund – Consumer Discretionary XLY       Correlation = 0.874
    • SPDR Select Sector Fund – Technology                         XLK        Correlation = 0.805
  • Funds that correlate negatively:
    • SPDR Select Sector Fund – Utilities                                XLU        Correlation = 0.311

The last one (XLU) surprised me. The main reason I own so many different Vanguard funds is to diversify risk by acquiring different asset classes and within each asset class, have multiple managers competing for my money. But, a correlation coefficient of 0.311 for XLU indicates to me that my portfolio has a gap with utilities.

Verifying what the Correlation Tool said ….

To verify the gap of utilities in my portfolio, I tool 4 of the stock Vanguard funds I own (VDIGX, VDAIX, VHDYX, VWELX and VTMGX) and plugged them into Vanguard’s fund compare web page: Vanguard Fund Compare.

Fund          VDIGX     VDAIX      VHDYX      VWELX       VTMGX
Utilities     0.00%     2.81%        8.01%         4.23%         3.10%

The above is a clear clear vindication that the percentage of utility stocks in my passive income portfolio is low. The maximum is 8% but that fund does not have the most money. So, the correlation analysis tool correctly predicted a gap of investment dollars in Utilities in my portfolio.

Conclusion

Granted, utilities is not the most sexy of the stock picks, but it is a rock solid foundation on which passive income streams of many other people are built upon. And more importantly, it balances out my portfolio by adding an asset that correlates less with all my existing mutual funds.

I found one Vanguard utilities mutual fund (VUIAX) but minimum is $100K 🙂 No way that I have that kind of money. But there is a corresponding ETF called VPU. I just invested one share in this ETF….hopefully, I can save some more money and add a few more shares to my portfolio. I am happy to have added an asset that has only 30% correlation (0.311) with my existing funds. Wish me luck for some awesome passive income for years to come via this new asset vehicle called Vanguard Utilities ETF (VPU).

Risk analysis of my Mutual Fund Investments (Beta Coefficient)

/ humblefi / 5 Comments

Introduction

I recently wrote about my plan to prepare for the next recession which, in my opinion, is due soon. While thinking about that, a question that came to my mind was: how will my mutual fund portfolio deal with the upcoming recession? To answer that, I wanted to do a risk analysis of the mutual funds that I am using to generate Passive Income Streams. I wrote about my implementation of passive income streams here.

The mutual funds and/or cash driving my passive income streams are listed below for reference. Before I do a risk analysis of my portfolio, we need to understand some terminologies. Lets dive into that next.

Investment Vehicles (Last Updated on 10/18/2014)
Risk Bucket Name Investment Vehicle 1 Investment Vehicle 2
Risk 1 (Cash in banks) Smarty Pig (online) Credit Union (brick & mortar)
Risk 2 (Bonds) VCAIX (ca munis) N/A
Risk 3 (Balanced Funds) VTMFX (has natl munis) N/A
Risk 4 (Dividend Investing) VDIGX (div growth) VHDYX (high curr div)
Risk 5 (Capital Growth) VTCLX (large+mid cap) VTMSX (small cap)
Risk 5 (International Funds) VTMGX (large blend) N/A

 

Risk of a mutual fund

When we talk about the risk analysis of a mutual fund OR the volatility of a mutual fund, we often compare it to the market as a whole. For example, if the market goes through a volatile phase, will the mutual fund also be volatile OR will it be stable OR will it reach inversely to the market?

Consider one example. In a recession OR a down market, most people will conserve money and not buy new cars. Most people will repair their current cars and postpone purchase of a new car to when the market is up.

  • If you own stocks of companies that manufacture new cars, when the market goes down, such stocks will also go down.
    • Greater risk in a down market, but greater reward in an up market
  • If you own stocks of companies that manufacture automotive replacement parts, then when the market goes down, replacement parts companies make money and hence such stocks will go up.
    • Greater risk in an up market, but greater reward in a down market.
  • If you own stocks of companies that provide water supply to people, such stocks remain calm when the market goes up or down.
    • Low risk, Low reward.

A metric used by many investors to compare a mutual fund/stock/portfolio to the entire market is called the Beta Coefficient.

Beta Coefficient

If you had asked me last year, I would have said that “beta coefficient” looks like a very geeky mathematical name i.e. something I had ignored often as too complicated. It is complicated math but I have found a nice and easy way to understand it. Lets define it my way.

Beta Coefficient of a mutual fund/stock/portfolio is a measure of the risk that shows up when the mutual fund/stock/portfolio is exposed to different types of market conditions like an up market, down market, recession, etc. 

Some common values of Beta Coefficient will help make it clearer:

  • A beta of less than 1 means that the mutual fund/stock/portfolio will be less volatile than the market.
    • The water company example above
  • A beta of greater than 1 indicates that the price of the mutual fund/stock/portfolio will be more volatile than the market.
    • If a stock’s beta is 1.5, it’s theoretically 50% more volatile than the market.
    • For example, the new car company stocks.
  • A negative beta indicates a counter-cyclical sector that moves inversely with the broader market.
    • The replacement auto parts company example.

My portfolio’s Beta Coefficient

I gave the search “VCADX beta coefficient” on google and google finance displays the beta coefficient for VCADX so easily that I repeated the same procedure for the remaining mutual funds in my portfolio and here are two tables.

Table 1: Income Portfolio

  • Mutual funds that primarily generate dividends, capital appreciation is secondary
  • 64% of my passive income streams portfolio is in this category
Beta Coefficient of my Income portfolio (updated 03/31/2015)
Investment Vehicle 1 year Beta 3 year Beta 5 year Beta 10 year Beta
VCADX (CA Munis) 0.93 0.93 0.96 0.93
VTMFX (Balanced fund) 0.69 0.73 0.72 0.76
VDIGX (Dividend Growth) 0.87 0.90 0.81 0.80
VHDYX (Current Dividend) 0.93 0.92 0.84 n/a
Average 0.86 0.87 0.83 0.83

 

Table 2: Capital Appreciation Portfolio

  • Mutual funds that primarily invest for capital appreciation, any dividends are secondary.
  • 36% of my passive income streams portfolio is in this category
Beta Coefficient of my Capital Appreciation portfolio (updated 03/31/2015)
Investment Vehicle 1 year Beta 3 year Beta 5 year Beta 10 year Beta
VTCLX (Capital Appreciation) 1.04 1.02 1.04 1.03
VTMSX (Small Cap) 1.32 1.13 1.19 1.18
VTMGX (International) 0.99 1.03 1.02 0.97
Average 1.12 1.06 1.08 1.06

Conclusion

Consider the Average beta values for both the income and cap appreciation portfolios:

  • Income portfolio
    • Average beta is less than 1 => my Income portfolio will be less volatile than the market.
  • Capital Appreciation portfolio
    • Average beta is greater than 1 => my Capital appreciation portfolio will be more volatile than the market.

Based on the above numbers, I can conclude that when the next recession comes, my Income Portfolio should continue to generate approximately the same amount of income (give or take a few percent) because it is less volatile OR less risky that the overall market.

Appendix