May 2, 2005

We've been beating the market indexes pretty handily (and with less risk) across our portfolios these past three years, in both up and down markets. As we've noted in recent commentaries (and our latest category favorites report), it's time to lighten up in some hotter areas - something we've been doing in dribs and drabs over the last couple of years as we moved out of areas like microcap and emerging market bonds.

The exact changes we are now making to our model portfolios are detailed under the "changes" tab in each model portfolio section of this site. What we want to discuss here is how to trade a portfolio of funds - a potentially costly and daunting task.

Portfolio Trading

First, we want to direct you to our new model portfolio trading worksheets. These PDFs will help you with our more complex trades. You can find the forms on the changes tab for each model portfolio or by clicking the links below.

<a href=" https://maxadvisor.com/newsletter/worksheets/safety.worksheet.pdf">Safety Portfolio Worksheet</a>

<a href=" https://maxadvisor.com/newsletter/worksheets/conservative.worksheet.pdf">Conservative Portfolio Worksheet</a>

<a href=" https://maxadvisor.com/newsletter/worksheets/moderate.worksheet.pdf">Moderate Portfolio Worksheet</a>

<a href=" https://maxadvisor.com/newsletter/worksheets/growth.worksheet.pdf">Growth Portfolio Worksheet</a>

<a href=" https://maxadvisor.com/newsletter/worksheets/aggressivegrowth.worksheet.pdf">Aggressive Growth Portfolio Worksheet</a>

<a href=" https://maxadvisor.com/newsletter/worksheets/daredevil.worksheet.pdf">Daredevil Portfolio Worksheet</a>

<a href=" https://maxadvisor.com/newsletter/worksheets/lowminimum.worksheet.pdf">Low Minimum Portfolio Worksheet</a>


Fund managers incur certain costs whenever they buy or sell stocks. You're likely to incur similar costs while managing your own portfolio.

We're not going to discuss all the ins and outs of brokerage commissions, short term redemption fees, short and long term capital gains tax rates, or loss carryforwards here. We recently posted a "tip sheet" for trading on the <a href="https://maxadvisor.com/newsletter/mphome.php">Portfolio Commentary home page</a> you may want to read before going any further. Additionally, please read an <a href="https://maxadvisor.com/newsletter/farchives/000024.php">older feature article</a> about such costs.

You need to be aware of your own buy and sell dates, what your broker charges to trade, and your personal tax situation. We almost always own funds for more than one year, so if a subscriber buys exactly when we buy and sells exactly when we sell, they rarely have to pay short term penalties, redemptions fees, or high tax rates. 

Those with IRA and other tax-deferred accounts can often be more reckless with their trading (at least when it comes to taxes). Others should try to avoid making trades and "catch up" with us a few weeks from now if doing so means avoiding a 2% fee for selling a fund. We note relevant short term redemption fees under the changes tab after the trade description.

Here are the broad considerations when following any of our trades:

There are two main variables to consider when mimicking our trades: 1) how complex the trade is 2) how out of whack you are with the model portfolio allocation.

Let's start with easy. Most of the trades we have made in the past are rather simple. Sell XYZ Microcap fund and buy ABC Large Cap with the proceeds. Executing such a trade is easy, you just sell whatever you have in the XYZ Microcap Fund, and use the proceeds to buy the new ABC Large Cap fund.

Slightly more complex is the partial sale. What if we had a 20% stake in XYZ Microcap and wanted to sell it down to a 10% stake, and then use the proceeds to increase our stake in an existing fund like TNT Growth? 

You would simply look at what you have in XYZ Microcap - say $6,350 - and sell half of it. Use the proceeds to buy more shares of TNT Growth - however many shares $3,175 would buy. 

Since you can buy and sell ordinary mutual funds in dollars, the buys are easy. Since you can also sell ordinary mutual funds by shares, selling exactly half is easy - just sell half the shares you own. 

When you buy or sell a fund, you are doing it at that day's closing NAV, or fund price. Since you don't know this figure when the trade is made, selling $3,000 of a $6,000 position will not sell exactly half of your holdings. Why? Imagine the market fell 50% in the last half hour of trading. In all likelihood, your $6,000 stake will be worth around $3,000 after the carnage. A $3,000 sale will be a near total liquidation. If you owned 244.2 shares of a fund, and sold 122.1 shares, no matter what happens you'll be selling half of your stake.

Most of our trades are as easy to make as the above examples. Even more complex trades can be achieved by this same method.

Let's say this is your portfolio:

20% XYZ Microcap

50% Cheapo Short Term Bond

10% TNT Growth

20% ABC Large Cap

Suppose we decided to cut the XYZ Microcap fund down to 5% (from 20%) and add a 10% stake in RX HealthCare and increase our TNT Growth allocation to 15%. Our new portfolio would look like this:

5% XYZ Microcap

50% Cheapo Short Term Bond

15% TNT Growth

20% ABC Large Cap

10% RX HeathCare

How do you get from point A to point B? You would need to sell 75% of your stake in XYZ Microcap. 75% is the same as going from 20% to 5%. Imagine you had a stock that was $20 per share, and it fell to $5-you lost 75% of your investment. It's the same math: Take the new value, divide it by old value, and subtract the result from one:

1 - (5% / 20%) = .75 or 75%

Take .75 (75%) and multiply it by how many shares you own in XYZ Microcap (or how much money you have, although this is slightly less accurate as it is a moving target) and sell that much.

If you had 143.21 shares of XYZ Microcap, you would need to sell 107.4 shares (or just 107 shares-you can round away decimals). Or, if you had about $2,413 in the fund, you would need to sell about $1,810 worth.

As for the buys, you're to add a new 10% stake, and increase another fund's stake by 5%. This makes sense because you reduced another stake by 15% of the total portfolio. You could use algebra (2x+x=$1,810 because you're putting twice as much into one fund) to figure out how much to add. Or you could just break up the $1,810 (the amount you got from selling a chunk of XYZ Microcap) into two funds, placing 10% in one and 5% in another (or three 5% chunks). To do this, divide your $1,810 by three (about $600) and put $600 into the existing TNT Growth Holding to get to 15% from 10%, and $1,200 into the new RX HealthCare holdings for a 10% stake.

There are two problems with the above trades: For one, as the trades get more complex, it gets a little hairy. 

The bigger problem has to do with balance. Nowhere above do you step back and say "Wait a minute, I don't even have 20% of my portfolio in the XYZ Microcap fund". 

In fact, none of your holdings will be in perfect sync with our model portfolios because funds change in price every day. While this effect is slow at first, particularly in a flat market, over time you can be totally out of proportion - and therefore at the wrong risk level - if some funds climb while others fall. Your whole stock/bond split can get out of whack.

A good example is the hypothetical XYZ Microcap fund above. If that fund was Bridgeway Ultra Small Company Market (a micorcap fund we owned in some of our model portfolios for a few years to about a 100% gain), you may have 30% or more of your money in that fund, not 20% - simply because it beat the other funds.

Even with a simple trade where we sell the Microcap fund for a large cap growth fund, you would be carrying forward the discrepancy. If you sold your Microcap fund, which was 30% of your portfolio and not 20%, and put the proceeds in a new fund to be 20%, you would then have 30% in the fund and not 20%.

With minor changes in the fund's value you can largely ignore this effect and just make simple trades (although you may find a rebalance trade easier if the actual trade is multi-step). There is no point in making things more complicated because you have 21% of your money in a fund, instead of our 20% allocation. The goal here is to have the right funds in roughly the proper weights. But as time goes by, as your portfolio moves further out of balance, you may want to do what we call a rebalance trade.

To do a rebalance or complete trade, you need to determine what your entire portfolio should look like after the trade. This is the type of trade we detail for each model portfolio in our new worksheets.

Step one is to total up your portfolio by simply adding up the current dollar value of all your fund holdings (the old funds you own before the trade). If that value was $100,000, you would need to determine how much should be in each of the funds (including new funds) given the new percentage allocations. The following is an example using the new sample portfolio from above: 

5% XYZ Microcap - $5,000

50% Cheapo Short Term Bond - $50,000

15% TNT Growth - $15,000

20% ABC Large Cap - $20,000

10% RX HeathCare - $10,000

Total: $100,000

Next, figure out what you currently have in each of these funds:

XYZ Microcap - $27,000

Cheapo Short Term Bond - $48,000

TNT Growth - $9,000

ABC Large Cap - $16,000

RX HeathCare - $0

Total $100,000

Note that you have nothing in RX HealthCare because it is a new holding. Notice your percentage allocations are not really in sync with the original portfolio allocations (you have 27% in XYZ Microcap) because of fund price movements.

The next step is to subtract the desired value from the current amount in each fund:

Fund Current $ - Target $ = Amount to buy or sell 

XYZ Microcap  $27,000 - $5,000 = $22,000

Cheapo Short Term Bond  $48,000 - $50,000 = (-$2,000)

TNT Growth  $9,000 - $15,000 = (-$6,000)

ABC Large Cap  $16,000 - $20,000 = (-$4,000)

RX HeathCare  $0 - $10,000 = (-$10,000)

The resulting figure is the amount you have to buy or sell, in dollars, in each fund. A negative number means you have to buy (because you are under the desired allocation) a positive number is the amount you have to sell.

According to the math above, you will have to place five trades to get in sync with the new portfolio allocations:

XYZ Microcap:  SELL $22,000

Cheapo Short Term Bond:  BUY $2,000

TNT Growth:  BUY $6,000

ABC Large Cap:  BUY $4,000

RX HeathCare:  BUY $10,000

The exact math for each model portfolio is detailed in each portfolio's worksheet. Use the worksheets to make your trades and you'll be fully allocated and rebalanced in the new portfolio.