ETF portfolio ends 2009 with 30% gain

Investing was a wild ride in 2009, but the win was worth it, as global markets soared and my model portfolio of exchange-traded funds did even better.

The new year is going to be tougher. The portfolio’s large holdings of bonds–which have beaten the pants off stocks for the last decade–took a pasting in December because markets expect interest rates to begin rising. Further declines lie ahead.

And stocks are increasingly vulnerable to a correction, having shot up for nine unbroken months. So it’s time to go over the portfolio with a skeptical eye, to see what changes should be made in this new year.

The Standard & Poor’s 500 index rose 23.5% in 2009, but my model did one-quarter better. That was due mostly to the portfolio’s basic design, which favors small-company stocks over big ones, and acknowledges the importance of foreign equities, as well. But a portion of the outperformance was due to tactical decisions like overweighting corporate bonds, which rallied hugely as recession ended.

Beating the market by more than a quarter

iShares iBoxx $ Investment Grade Corporate Bond shot up 8.6% last year, half-again as much as the overall bond market. And bonds in general were winners, though not in December.

Last month the entire portfolio was held back by terrible results from its fixed-income component. The domestic market contracted roughly 2%. SPDR Barclays Capital International Treasury, which I added last month, plunged 5.3% as the U.S. dollar rallied substantially, beating down the currencies in which this ETF’s holdings are denominated.

The dollar did a flip-flop in December when the Federal Reserve announced a timetable for drying up a large portion of the extra liquidity it had been injecting for more than a year to fight recession. That damped down fear of inflation, a bond investor’s worst enemy.

At the same time, rising interest rates make American bonds more competitive from a yield standpoint, and they are purchased with dollars. I am a long-term dollar bear, because I think huge and growing deficits, including trade deficits, will continue to erode its value. But I’m a short-term dollar bull, because the United States has done a strikingly good job of avoiding depression in 2009 and actually leading global economic recovery. The dollar’s status as the world’s reserve currency of choice was under serious attack last year; now it is not.

All of this good news was reflected in the stock market, and those gains were magnified in this model’s holdings. Note that in December small and mid-cap stocks greatly outperformed domestic large caps. Over long periods they always do, though not quite this dramatically, which is why I overweight them.

Looking ahead, it would be normal for bonds to remain unloved because higher interest rates push down their prices, and for stocks to deliver above-average returns as the economy rebounds. But I’m in no hurry to take profits from fixed income securities and redeploy them into equities because I think a correction in stocks is overdue.

When I was running this model at MSN Money I could only update it quarterly, but here at True/Slant I can act oftener if I like. So having made a slight portfolio adjustment at the end of November I’ll hold off making any others for awhile.

Patience is usually an investor’s friend, and I have been slow to make changes in this portfolio since it was launched at MSN at the end of 2003. Frequent trading is never a good idea in an investment portfolio, which by its nature is a long-term enterprise, and time erases the volatility that trading is meant to exploit.

Instead, this portfolio relies on a strategic approach, accepting above-average risk in categories like small-company and emerging-markets stocks, and diversifying risk among equities, bonds and alternative asset classes, like energy and real estate.

This approach has been very successful. Over the last three years, the portfolio has lost an average of 1.9% of its value annually, but the S&P 500 went down 4.7%. Over five years, the portfolio is ahead, while the market is down 1.7% at an annualized rate. Since inception, the S&P is up at a 0.9% rate, while the portfolio has risen at a 5.0% clip.