Tone down risk in your investment portfolio–and buy international bonds

My model portfolios delivered sparkling returns in November as the bull market of 2009 finished its ninth month. Let’s celebrate by taking profits in our riskiest holdings and use them to buy something less risky, but also attractive in terms of total returns.

The model exchange-traded fund portfolio I created in 2003 finished the month with a gain of 4.6%, bringing the return so far this year to 28.6%. That’s a bit better than the 3.6% return of my model 401(k) portfolio, which while similar is not identical. In both, however, I propose to lower our risk profile the same way–by halving exposure to emerging markets, which have run up so far, so fast, they are vulnerable to bad news.

And bad news is already in the air, with the government of Dubai all but reneging on its sovereign debt, reminding those of us with long memories of the mischief done by Russia in the 1990s and Argentina earlier in this decade.

Here’s how the ETF model finished November:

Equities, especially emerging markets, soar

Notice that domestic small and mid-size stocks didn’t do nearly as well as big caps. That’s a clue that investors’ appetite for risk is abating. Vanguard Emerging Markets ETF, meanwhile, has shot up 104% since the lows of March 9. Trees don’t grow to the sky. Let’s sell this holding and deploy the proceeds elsewhere.

Notice we’re not eliminating our exposure to emerging markets: Claymore/BNY Mellon BRIC continues to provide exposure to the classiest (i.e., least risky) developing countries, notably China, Brazil and India. But by locking in profits they can become available for something new, and I’ve got something in mind.

Meanwhile, here’s how the 401(k) model finished the month:

A pleasing, but ticklish, advance in emerging markets

We don’t own a BRIC (Brasil, Russia, India, China) fund in this portfolio because they are rare to nonexistent in 401(k) plans, so we own correspondingly more of T. Rowe Price Emerging Markets Stock. But for the reasons already cited, let’s take profits here, both to lock in the 28.3% gain we’ve had since we began with this model at the end of June, and to protect ourselves from a correction in this frothy domain.

Note that in both models our bond holdings, as a percentage of the total, have shrunken as equities have performed so well. So let’s add to our bond holdings in both portfolios.

Buying bonds when interest rates are at extraordinarily low levels, however, is dangerous. Almost certainly, the Federal Reserve will begin raising interest rates in 2010 to combat the spectre of inflation. Every blip upwards in rates takes bond prices down. Treasury bonds, which are roughly one-third of the market, are most sensitive to rates, so they are what we most don’t want to own.

International bonds, on the other hand, will give us some diversification away from the Fed and the U.S. economy. Also, foreign interest rates are already higher than they are here, both because some economies (like Australia) are already more vigorous, and others (the euro zone) are already more worried about inflation than we are.

We have very attractive investment opportunities in both the ETF and 401(k) world.

Among ETFs, my choice would be SPDR Barclays Capital International Treasury Bond (BWX), which as the name suggests owns the sovereign debt of foreign nations, specifically developed nations. The average credit quality is nearly Triple-A and duration, or interest-rate risk, is a little more than 6 years, putting it in the intermediate-maturity range, avoiding the extra risk of very long-term bonds but yielding considerably more than short-term paper. The fund currently yields 2.2%, after its expenses of 0.50%.

The proceeds of the sale of the emerging markets fund, plus the cash we’ve accumulated since our last rebalancing, in June, is sufficient to buy 154 shares at the Nov. 30 closing price of $60.27. Here’s how the portfolio looks after this change:

Boosting the allocation to fixed income, to reduce risk

Among mutual funds widely available in 401(k) plans, Templeton Global Bond A (TPINX) is by far the largest–and among the most successful–such funds, up 25.5% in the last year. It has the flexibility to own emerging-markets sovereign debt, which is one reason it has done so well. This is a risk, but this is also an actively managed fund, meaning a team of professionals can apply their judgment to what the fund owns, and doesn’t. This is a luxury index funds–and ETFs are index funds–cannot afford.

Here’s how the 401(k) portfolio looks after slashing back risky equities and adding foreign bonds:

Templeton knows foreign bonds

I expect equity markets to become dicier in the months ahead, and bonds won’t be much more reliable. But investing involves risk, and this seems to me a good balance of risk and potential reward.

Housekeeping: Dividends are not reinvested in the ETF portfolio, because that’s not the norm there, but they are in the 401(k) portfolio.

Disclosure: I own the following securities mentioned in this article: T.Rowe Price Mid-Cap Value, T. Rowe Price Emerging Markets Stock, T. Rowe Price Real Estate, Claymore/BNY Mellon BRIC, Vanguard Emerging Markets ETF and Vanguard Total Bond Market Index.