So I was looking at my portfolio the other day, as I aim to do for the annual rebalancing act, when it struck me that I had a large medley of funds that I collected over the years of chasing performance. Well thought out rational exuberance, I mused. However what this led to was about 20 odd funds in the portfolio, with no coherent investment strategy, and possibly a lot of overlap among the funds. Time for a change.

My strategy for the recent past has been to invest a large part of my portfolio in a broadly diversified ETFs such as iShares MSCI EAFE Index Fund (EFA). I am talking about geographical diversification as opposed to sector or asset class diversification. This base provides my “beta” return. On top of this, I make selected bets in several countries via country specific funds, to seek “alpha” (no pun intended). Left unbalanced, some of these alpha funds have ballooned to occupy quite risky percentages of my portfolio.

Disclaimer: I have been very bullish on the Asia-Pacific, Emerging markets, Latin- America and Eastern Europe for the past few years, leading me to have almost 60% of my portfolio in international investments. This strategy is not appropriate for everyone, as it is very risky and I am sure no financial advisor would recommend such a portfolio. Do not try this at home.

Coming back to the portfolio construction story… so my goal was to: a) reduce the number of funds; b) reduce expenses; and, c) focus the investments according to my latest strategy – a reduced U.S and Western Europe for the beta, a bank-safe 10% yield filling in the bottom (yes, such investments exist, albeit with a currency risk), a dollop of Eastern Europe, Malaysia, some scoops of LatAm, lots of India, and a sprinkling of Japan and China. Phew. That completes step one of two – arriving at a country focused strategy. Flippant as it sounds, these picks come after some non-trivial research on my part.

Simplifying the portfolio was another challenge. Naturally, all of these ingredients don’t come in 1 package in that proportion. So the plan was to figure out the geographic overlap and diversification of a quickly-thrown-together “model” portfolio, and then find a few funds (preferably ETFs) that would best mimic these country allocations. To do this, I used some home grown tools (courtesy of www.fundpeek.com) that spit out the country allocations of the mixture. The next step was to cycle through various combinations of three to five funds that would result in the desired allocations. This is a very compute intensive task, mind you. But once reasonably automated, it is a piece of cake to rebalance and optimize the portfolio based on annually evolving strategies.

I was able to achieve two of my three objectives: realign the portfolio to my latest strategy and reduce expenses – a savings that compounds dramatically over many years. However this came at the cost of increasing the number of funds held in the portfolio.

I have listed a sample fund combination below. The right side matches the country exposure of the left (to within a 5% significance), comes with a savings of 80 basis points and delivered 2.5% more than the left one for 2007. Some other funds that I have similarly deconstructed and reconstructed are FIEUX, WBIGX, NIVLX using combinations of EFA, iShares S&P Europe 350 Index (IEV), Vanguard Pacific ETF (VPL) and a few others.

50% FLATX + 50% PRASX = 64% Claymore's BRIC ETF (EEB) + 10% iShares Mexico (EWW) + 13% iPath MSCI India (INP) + 8% iShares MSCI South Korea (EWY) + 5% iShares MSCI Taiwan Index (EWT)

But note, you lose the active management. So choose wisely.

Disclosure: The author is or has been long some of the funds mentioned above.

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Anurag Wakhlu

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