The Anti White Paper

The latest Journal of Indexes is up at IndexUniverse and as usual there is plenty of meat on the bone but I wonder if there might not be a little too much to chew on.

I looked at two articles in particular, one called The Future of Portable Alpha and the second was How To Kill A Black Swan.

Both articles are very long and very difficult to read as they read like text books. A short definition of portable alpha is best given as an example; deposit $100,000 into an account and instead of putting it all into the S&P 500 SPDR (SPY) spend just a little of the cash buying some sort of derivative that replicates $100,000 worth of equity exposure and put the remaining cash into treasuries or TIPs. Theoretically this allows for capturing the market's upside of the equity market plus a little extra.

I believe PIMCO has a fund (maybe more than one) that does this and if memory serves it has not done very well. Anyone who knows more about these funds is encouraged to leave a comment spelling it out better.

There is a quote attributed to Albert Einstein where he said something like if you can't explain something simply then you don't know it well enough. Peter Lynch says something similar in saying the you should be able to explain your rationale for buying a stock to a child. I am not asserting that the authors of the articles in question don't know their subject and I would say it depends on the child but there is an argument for keeping things simple. This is especially true for do-it-yourselfers that do not want to spend 80 hours a week watching the markets.

Investing can be a complicated or simple as you want to make it. The Portable Alpha article is almost 4400 words--true white papers are even longer than that. One of the building blocks of the strategy chronicled on this site is the effort to keep things simple. Simple is one of the reasons why I think top down portfolio construction is the way to go. It starts simply with whether the market is healthy or not.

From there it flows toward assessing countries, sectors, themes and where the stock market and economic cycles are. There is work involved with this but there is nothing white-paper complicated about realizing the economy is slowing down or that the price of some commodity just skyrocketed. I think making decisions based on these sorts of on the ground indicators is much simpler than what is spelled out in both articles.

I talk about building portfolios at the sector level. I think this is simple other folks have weighed in via the comments that it is not simple. You can decide for yourself but there are some pretty reliable fundamental indicators that stand up in cycle after cycle about what to overweight when or what to underweight and when.

The way I look at things the financial sector warned of trouble years before things actually started to meltdown, first when financials grew to 20% of the S&P 500 and then when the yield curve first inverted in early 2006. There was an avalanche of commentary saying that the inversion didn't matter because it was being caused buy Chinese buying. The simpler answer turned out to be correct.

Anyone wanting to stop at that point and not convert these things into a portfolio of individual stocks can capture a lot of speciality via ETFs or other exchange traded products. Recently iShares has listed two very interesting funds; the Emerging Markets Infrastructure Fund (EMIF) and the Peru ETF (EPU). A few weeks ago Market Vectors listed a Small Cap Brazil Fund (BRF) and a while back Claymore launched a Small Cap China Fund (HAO). I don't use any of those funds for now but I am especially intrigued by those first two for future use.

The industrial sector currently makes up about 10% of the S&P 500. If you were using stocks to build the sector you might have a defense stock, a water equipment company and some sort of big cap conglomerate. All three have multiple ETF choices to pick from. In addition to those subsectors there are also multiple choices nuclear, alternative energy (both of those are more industrial than energy) and some of the infrastructure ETFs are heavy in industrials stocks. These industrial subsectors and themes are far from obscure.

Most of the sectors can be dissected this way and invested in just as precisely.

I know there is disagreement on constructing portfolios in this manner but from the top down knowing when the market might be unhealthy (read Hussman), having a sense of how the market usually works (read Bespoke) and being in touch with current events (read Alphaville and Marketbeat) is not that complicated. Despite what some would have you believe you don't have to be as confused about investing as the orangutan above is about being in the pool.