“Finding good funds isn’t that hard; putting them together in an effective, low-maintenance, diversified portfolio is a lot more difficult. Too many investors have a collection of funds, rather than a strategic portfolio, where every fund has a role and every new addition is evaluated not just on its own merits, but on what it adds to the big picture.”

“Owning five or 10 mutual funds does not make an investor diversified if most of those issues come in one or two asset classes. Investors need more than a “good” fund; they need funds that enhance their holdings, diversify risk, bring additional asset classes into play and help the portfolio achieve their goals over time. ”

A proper asset allocation has funds that range from U.S., international and emerging market stocks to bond funds, treasury inflation protected bond funds, commodities and REITS.  Dependent on your level of risk, time frame and dollar investment, diversification can be achieved through building a cost effective index or ETF portfolio or choosing from a range of mutual funds that fall into these various asset classes.

But bond investors shouldn’t sleep as well as they think — the protection comes at a very high price.  Bonds provide the lowest rate of return and over the years, inflation eats away a lot of the value of the monthly income.  From 1925 – 2003, US Bonds only appreciated 5.4% per year or 61 times while stocks appreciated nearly 10.4% per year, or 8,000 times.  The other price you pay for holding bonds is inflation – its bad for long term bonds.  If you lend the government $100,000 in 2000 for 5% interest for 20 years and inflation runs rampant at 8% for most of the 20 year period, the government pays you back your $100,000 which might be worth a lot less by the time it is repaid to you.  And all you got was your 5% per year.  While bonds increase in value in a deflationary environment where prices are dropping, this is a rare economic circumstance.

In 2008 it turns out that asset allocation decisions have everything to do with a portfolio performance.

On MarketRiders, we use our own ETF portfolio builder to track some “Celebrity Portfolios” including the “Lazy Portfolios” (published by Paul B. Farrell at Marketwatch). These portfolios mimic allocations based upon Yale University’s David Swensen, Dr. William Bernstein, Ted Aronson, and Bill Schulthesis who wrote “The Coffeehouse Investor.” Community members also have posted many interesting portfolios with unique asset allocations that have held up well in the last few months.

These portfolios use ETFs without active management and we track weighted average portfolio fees. The component ETF fees range from .08% to .50% and the weighted average portfolio fees are between .12% and .21%.

Comparing and contrasting portfolios with similar asset allocations, shows a lot about how to build solid “all weather” allocations that have held up even in 2008. While some of the variance is surely explained by the allocation in non-equities (Bonds, Treasury Inflation Protected Bonds and Cash), a lot of it is explained by the level of diversification amongst the other asset classes.

There’s quite a variance between some of the portfolios – even when their equity exposures are similar. Two portfolios each with 60% equity exposure have dramatically different results.

For example, Bill Schulthesis, a ex-Salomon Smith Barney broker who wrote The Coffeehouse Investor, designed a portfolio with 40% in an intermediate bond index (BND) and 10% in each of 6 stock funds (Vanguad REIT ETF (VNQ), SPDR S&P 500 ETF (SPY), Vanguard Small-Cap ETF (VB), Vanguard Small-Cap Value ETF (VBR), Vanguard Value ETF (VTV), Vanguard FTSE All World ex-US ETF (VEU)). Dr. William Bernstein wrote the “Intelligent Asset Allocator” and “The Four Pillars of Investing” and proposed the same basic allocation. But high exposure to small cap value US stocks and REITs allowed Coffeehouse’s returns to trump Bernstein by over 2 times.

Here are the results as of last night’s close.  These portfolios and the ETFs in them are posted on MarketRiders.

The Best and the Worst Returns

To better understand where the variances lie, we drill down into each asset class to see where returns (or lack thereof) are coming from. Aronson’s portfolio, is the worst so far, down (16.65%) with 80% equity exposure. Unfortunately, Aronson had no REIT exposure and heavy exposure to Emerging Market (VWO) and Foreign Markets (European (VGK) and Pacific (VPL)) which have both been crushed this year. Aronson’s portfolio has performed very well for 5 years on the backs of these asset classes, but 2008 has been his come-uppance.

The MarketRiders “Low Risk” portfolio is doing the best so far this year – down only (1.83%) – but with 25% exposure to equity and Real Estate (RWR). A strong US allocation (iShares S&P SmallCap 600 Index  (IJR) and SPY) over Foreign Developed and Emerging Markets (VEU) helped dampen the losses.

It’s Time to Rebalance!

Today, we’re rebalancing a few of these portfolios where actual allocations now vary greater than 20% off our targets. The most out of balance portfolio is the one built by John Spense and Rick Ferri on MarketWatch. Emerging Markets, Foreign Markets, TIPs and Small Cap US stocks are all out of whack so this portfolio and others will be brought back to their targets.

Stay tuned.  At the end of the year, we’ll report back and show you how these portfolios did.

Martin Sosnoff

Oil at $100 a barrel is a wakeup call for investors and politicians alike. You can’t blame ExxonMobil for making $11 billion quarterly. Prices are set by the futures market, not in boardrooms or coffee houses in Riyadh.

Normally,
I avoid commodity plays, but I’ve joined the crowd. I despise gold,
copper, iron ore, potash and coal because, after all, mines are just
holes in the ground. It’s more elegant to analyze tech houses. Mining
or finding oil is capital intensive, while tech houses like IBM (nyse:
IBM -
news -
people ), Google (nasdaq:
GOOG -
news -
people ) and Apple (nasdaq:
AAPL -
news -
people ) are brain trusts with loads of free cash flow.

The
weighting of energy and commodities in the S&P 500 Index
approximates 16% of its valuation and over 20% of earnings.
Technology’s weighting is the equivalent of energy and commodities, so
if you’re overweighted in tech and underweighted in holes in the
ground, you could suffer sizable underperformance. The value sector
this year has pulled ahead of Russell’s Growth Index, reversing last
year’s wide disparity.

Suddenly, I’ve got religion, rapidly building up my participation in energy and commodity plays.

If
you want to dream about oil prices long term, the go-to guy is Matt
Simmons, chairman of Simmons and Company International. Simmons’ thesis
called “the Peak Oil Thesis” is awesomely simplistic: The elephantine
oil fields of Saudi Arabia peak out in a few years. Unfortunately, this
is only a working hypothesis.

Saudi Aramco technocrats won’t let
Simmons near their reservoirs or seismic research data. They claim a
reserve margin of several million barrels a day. Simmons’ competition,
Cambridge Energy Research Associates in Massachusetts takes the Saudi
side of the argument, but the market these days is siding with the
bears on net worldwide incremental production possibilities.

The
next five years will tell the story. I’m leaving out the demand side of
the U.S. equation. If you believe our next president and the Congress
will draft a cohesive energy policy that curbs demand and successfully
encourages new energy sources, you don’t want to play in this game.
Just be mindful that we have over 100 million cars on the road, gas
guzzlers, and they’re going to hold the road over the next 10 years.

Oil
now accounts for 95% of transportation energy, and Simmons and others
believe future growth in oil demand is inexhaustible. I never knew
anyone who could predict the price of oil accurately for more than six
months. The consensus historically runs wide of the mark, expecting
demand to peak and prices to collapse from supply sources. The classic
magazine cover story in The Economist in March 1999 projected
$5 a barrel oil, that the Saudis would flood the world with cheap oil
and demand would peak. How wrong can you get it?

Actually, oil
demand the past 10 years grew 1.5 million barrels per day, and the cost
to find new oil keeps rising. The problem for many oil producers is
that they fail to replace reserves. Exxon keeps its exploration budget
flattish. If they didn’t, profit margins would drop meaningfully. For
most oil operators, costs are rising 10% to 15% annually.

The
analyst consensus for oil hangs in the mid-$80 range. If oil stays
above $100, earnings estimates are 15% too low for 2008. This could be
one of just a few upside surprises for a major sector of the market
this year. Long-term forecasts range much lower–$70 to $85 a barrel.
Commodity traders taking the long side on far out futures contracts
took home fortunes the past few years.

The demand side for oil is
compelling when you look at incremental increases for China, India and
other emerging economies. Demand could grow by 1.5 million barrels a
day for the next 10 years. Considering the decline rate in existing oil
fields, the world needs some 37 million barrels of new capacity to keep
pace. This is a big number. To the extent it’s unfulfilled, oil prices
will rise until they trigger demand destruction. So far, demand
destruction remains a vague, iffy concept.

Meanwhile, the North
Sea oil fields are in rapid decline. Output from Mexico’s Cantarell
Field, second largest in the world, has already fallen 41%. Oil
discoveries peaked in the 1970 to 1980 decade. Very little production
comes from fields discovered since 2000. Only 15% of production is from
fields discovered in the 1990s.

The decline rate for the world’s
oil fields remains a debatable issue. Cambridge Energy Research
Associates charts it at 4.5% per annum. It may be much higher, but the
Mideast situation remains unfathomable. If Middle East oil production
flattens out within a few years, world production could easily decline
5% over the next 20 years. Maybe the Saudi claim of production
enhancement is true, but they will make the world pay if they are the
sole major swing producer.

Alternative energy supplies don’t
cover the transportation sector. Nuclear power, solar energy and wind
create electricity. Who knows when we’ll see a viable battery-driven
car that’s acceptable in terms of power, range and price point.
Railroads are more efficient than trucks. I own Union Pacific (nyse:
UNP -
news -
people ) as a play on rising grain and coal shipments worldwide.

The
deep basic is the world’s oil supply probably won’t ever exceed 100
million barrels a day, but demand could reach 100 million barrels by
2015. If oil prices for the U.S. go to $150 a barrel, oil costs would
move from 8% of gross domestic product (GDP) to the 10% level.

Rising
oil prices could reduce GDP by half a point, annually. This condition,
hopefully would precipitate a new consensus that the demand side for
oil must be dealt with even if the states and federal government tax
auto producers, car buyers and car owners, forcing conversion to 40
miles per gallon automobiles. GDP in China and India would come in a
couple of percentage points lower on $150 oil, crimping the case for
commodity plays of all kinds.

The law of unintended consequences applies here.

I’ve
come full cycle, so I want to be careful what I wish for. Conceptually,
I prefer technology plays like Apple and Google because they make us
more efficient and comfortable. The Internet enriches our lives
seamlessly; iPhones get cheaper and faster with 3G spectrum coverage
coming soon. Filling your gas tank with $5 a gallon flashing on the
pump won’t make you happy unless you own a refinery.

Twenty-five
years ago, the energy sector reached 25% of S&P 500 valuation. At
its low it was 6%, now 11%. If oil surges back to 25% of the index, it
will happen in the next couple of years.

Oil falls into the value
sector of the market, not where I normally function, but I have to play
the game. In the 1950s and 1960s, T. Rowe Price made his reputation
“discovering” natural resource plays of all kinds. Price believed they
were growth stocks. Fifty years later he may be right.

Martin T. Sosnoff is chairman and founder of Atalanta/Sosnoff
Capital, a private-investment management company with over $8 billion
in assets under management. Sosnoff has published two books about his
experiences on Wall Street, Humble on Wall Street and Silent Investor, Silent Loser. He was a columnist for many years at Forbes magazine and for three years at the New York Post. Martin
Sosnoff owns personally, and Atalanta/Sosnoff Capital owns for clients,
the following stocks cited in this commentary: Apple, Google, IBM,
Vale, Transocean, Occidental Petroleum, Freeport-McMoRan Copper,
Mosaic, Potash and Union Pacific.