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Tim Middleton

Extra3/31/2009 12:01 AM ET

Dig in: Market won't get much worse

March's upswing gives plenty of reasons for optimism. So, despite serious losses to my model ETF portfolio, I'm mostly standing pat.

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By Tim Middleton
MSN Money

We may not have seen the absolute bottom of the bear market, but we're close enough that we can be comfortable having a lot of our money in stocks.

Oh, the big March rally in global equities wasn't enough to make up for the miserable returns of January and February -- at least not in my model portfolio of exchange-traded funds. But the rally has confirmed the optimistic bent of my portfolio, and I'm going to stay this course. I expect it to blossom with the spring.

Adding gold

I will make one modest tweak to the portfolio for the quarter ahead, however: I'm establishing a position in gold bullion with SPDR Gold Shares (GLD, news, msgs). As I explained a few weeks ago in "Why gold prices will keep rising," massive deficit spending to combat the U.S. recession will boost the risk of inflation. That helps gold.

Despite taking some serious blows to the model portfolio in the first quarter, I'm content to leave it substantially unchanged.

The model finished the first quarter (which for production reasons ended March 25) down 7.1%. That was slightly worse than the performance of the S&P 500 Index ($INX), which declined 6.6%.

But the model's performance over the past year remains well ahead of that benchmark -- or, in real dollars, less behind. The model has dropped 32.9% over the past 12 months, compared with a 37.3% retreat for the S&P 500.

The portfolio's results in the first quarter were affected most negatively by the more than 20% of assets invested in a trio of two-times leveraged index ETFs, all of them down double digits. These are designed to move $2 for every $1 an index rises or falls.

Also, commercial real estate took a particular bashing in the period, dragging my position in iShares Cohen & Steers Realty Majors (ICF, news, msgs) down nearly one-third.

Even bonds, which I had bulked up on at the end of last year, were mostly disappointing. The only really cheerful noises came from commodity and emerging-markets stocks, both of which were rebounding from whippings last year.

Pushing on with leverage

At the end of 2008, I decided to add leverage to the model portfolio, and that decision hurt in the first quarter. I think it will pay off in the next three months to come, however, so I'm not making any changes on that front.

My rationale for adding leverage to my domestic equity exposure was twofold. On the one hand, I expected the leveraged funds to perform reliably, even in the event they experienced some minor tracking errors. (As I've explained in the past about leveraged ETFs, daily compounding tends to exaggerate such tracking errors because 10% up is a different quantity than 10% down.)

On the other hand, leveraging, in effect, gave me more assets to work with, and I expected to use those assets the leverage freed up to build exposure to bonds.

There were, however, some painful problems with the leveraged funds' performance. The S&P 500 was down just 6.6% in the first quarter, so the two-times leveraged ProShares Ultra S&P500 (SSO, news, msgs) should have fallen 13.2%. It actually sank 15.5%. Similarly, the S&P SmallCap 600 Index ($SML.X) went down 12.4%, but ProShares Ultra SmallCap600 (SAA, news, msgs) tumbled 27.3%.

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The tracking error for ProShares Ultra MidCap400 (MVV, news, msgs) was much worse. Its benchmark slipped only 3.6% in the first period, but the leveraged ETF declined more than three times as much, 12%.

The experience of the large- and small-cap ETFs is well within the margin of error I had decided I could live with when I bought them.

The experience of the midcap ETF was far outside the boundary I had expected, as the fund was tested mainly in only one price direction: down. Assuming March's rally continues in the second quarter, I expect this ETF to justify itself. If it doesn't, I'll dispose of it when I next update the portfolio, at the end of June.

Continued: Bond disappointment

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