Intelledgement, L.L.C.

Intelligently hedged investment

Portfolio Diagnosis for Jane & John Doe

Summary of John & Jane Doe’s investment portfolio performance from 2005 to 2010:

Account 30-Dec-05 29-Dec-06 31-Dec-07 31-Dec-08 2008 ROI 31-Dec-09 31-Dec-10 ROI CAGR
Merrill Lynch/Fidelity (domestic equities) 39,967.71 48,227.87 52,717.29 36,118.67 -35.25% 46,797.46 55,257.52 10.51% 2.02%
Vanguard REITs 8,993.56 12,580.35 11,059.22 7,886.98 -32.64% 10,126.06 12,897.93 15.02% 2.84%
Ameritrade (foreign developed market equities) 15,986.67 20,914.10 23,737.55 15,325.77 -38.84% 19,752.86 21,964.39 9.97% 1.92%
Ameritrade/Fidelity (foreign emerging market equities) 5,030.25 6,863.72 9,373.44 5,181.31 -47.39% 8,732.96 10,231.97 62.82% 10.24%
Vanguard Bonds 25,046.91 27,286.22 30,172.87 33,536.08 7.00% 35,632.36 38,841.64 24.04% 4.40%
cash 5,000.00 5,297.00 5,636.65 5,922.76 1.00% 6,227.47 6,472.50 7.18% 1.40%
Overall 100,025.10 121,169.67 132,697.03 103,971.57 -25.42% 127,269.16 145,665.95 16.51% 3.10%
GAI Macro Hedge Fund Index 1,440.77 1,530.10 1,724.42 1,641.65 -4.80% 1,794.32 1,949.15 35.28% 6.23%
S&P 500 Index 1,248.29 1,418.30 1,468.36 903.25 -38.49% 1,115.10 1,257.64 0.75% 0.15%

Account = group of securities the portfolio owns

Date (e.g., “30 Dec 05”) = value of that account as of that date

2008 ROI = on a percentage basis, the performance of this portfolio from 31 Dec 07 to 31 Dec 08

ROI (Return-on-Investment) = on a percentage basis, the performance of this portfolio between 2005 and 2010

CAGR (Compounded Annual Growth Rate) = annualized ROI for this account between 2005 and 2010 (to help compare apples to apples)

Notes: You requested a combined report on your respective retirement investments, which actually are spread across seven accounts. You were both 39 years old in 2005 and combined, had approximately $100,000 in retirement investments as of 31 Dec 2005. You have strived to maintain a balanced allocation (40% domestic equities, 9% real estate, 21% foreign equities, 25% bonds, 5% cash), and between you contributed an additional $5000 annually, invested accordingly. The benchmark we agreed to use for your portfolio is the the S&P 500 index, which since January 1950 has produced a CAGR of around 7.4% (not including dividends, which is the way it is traditionally tracked day-to-day…FYI, including dividends, the ROI for the S&P 500 index from 2005 to 2010 was 10.88% instead of 0.75% and the CAGR was 2.09% instead of 0.15%). For comparison’s sake, we also show the Greenwich Alternative Investments Global Macro Hedge Fund Index, which historically (1988 to 2010 inclusively) provides a CAGR of around 13.8%. Note that for your portfolio’s positions, dividends are added back into the value of the pertinent account (and not included in the “cash” total; this gives a more accurate picture of the ROI for each investment class). Also, the “Cash” figures include interest on the listed cash balance (not that it amounted to much). Finally, you also requested an analysis of how your portfolio performed during the 2008 crash, and that is shown in the “2008 ROI” column.

Transactions: We did not have time to track and analyze the performance of individual equities (e.g., your investment in Petroleo Brasileiro/PBR). Thus we did not catalog any of your buy and sell transactions or dividends. What we did do was to categorize your investments by asset class and tracked the overall performance of each class. You made no withdrawals from your portfolio but you did make several contributions, amounting to $5000/year. In order to (greatly) simplify our calculations, we accounted for these contributions as if they were made on the last trading day of each year. This has the effect of very slightly overstating your CAGR (because in reality some of the money was deposited earlier and thus your ROI is slightly less impressive; obviously an ROI of 16% in one year would normally be very good while an ROI of 16% over five years…not so much).

Performance Review: Your portfolio had an overall CAGR of 3% (meaning you had an overall annual gain of 3%). Even if you add dividends back into the S&P 500 index, your portfolio still beat it by 50% (+3% to +2%) over five years. During the 2008 crash, when you were -25%, you also beat the market which was -38% (or, counting dividends, -35%). Overall, therefore, you are doing better than average.

Tactically, the best performing asset class over the last five years has been your emerging markets investments (CAGR of +10%…unfortunately, this is the smallest of your asset classes). Your bonds were +4%, your real estate trusts +3%, and US and non-US developed markets each +2%. You made about 1% on your cash.

You were 15 points ahead of the market in terms of total return-on-investment for the last five years: +17% for you and +2% for the S&P 500 counting dividends. However, you are trailing the GAI Global Macro Hedge Fund Index, which is +35%. In terms of CAGR, the GAI hedgies are at +6%, compared with +3% for you and +2% for the S&P 500 counting dividends.

Diagnosis: The good news is you beat the market. The bad news is that a CAGR of a paltry 3% for the last five years has jeopardized your odds of producing a nest egg sufficient to generate 70% of your current income in constant 2010 dollars by the end of 2026. Presuming the target is $70,000 in 2010 constant dollars (70% of your current income) and an inflation rate of 2.2% on average between now and then, you will need a nest egg capable of generating approximately $101k in annual income starting in 2027. But presuming CAGR of 9% for your stocks (assuming the market does +8% and you continue to slightly beat it) and 4% for your bonds between now and then with your current allocations (75% stocks/25% bonds), your current $145k of savings will amount to only $648k, which is good for only about $49k of income presuming you keep the allocations the same…if you tapped the nest egg for the 70%-of-pre-retirement-income, you would tap it out by 2033.

Looking at it another way, since 2005, the dollar is down more than 13%. It works out to -2.82% on a CAGR basis…and you are +3.10%. Essentially, you are barely holding your own, valuation-wise.

Recommendations: Some combination of boosting returns and delaying retirement (in order to provide additional time for growth) appears advisable in order to boost the nest egg.

You may want to consider adopting a macro hedge fund strategy with some of your funds. During the last five years, in contrast to your allocation macro strategies generally included [a] a materially higher allocation to emerging markets—where most analysts project the lion’s share of economic growth to occur for the foreseeable future (you currently have 5%)— [b] significant positions in precious metals to protect against the depreciation of fiat currencies in general and the dollar in particular (you currently have none), and [c] targeted tactical use of short positions to achieve capital preservation during downturns (you did not employ this tactic in 2008 and were down 25% while the average macro hedge fund lost only 5%).

You may also wish to consider decreasing the bond allocation. Normally, folks nearing retirement increase their bond allocations, as bonds are considered less risky, and presuming the funds in the nest egg are nearly sufficient to generate the requisite income stream, capital preservation is more important than growth. However, [a] you need more growth and [b] in the current environment of potentially rising interest rates, bonds appear to be more risky than usual.

Let’s schedule a time to discuss this portfolio diagnosis in detail and address any questions you might have.