During the past few months, managers at Litman/Gregory Asset Management have been tweaking their index-only fund portfolios.

In particular, the Bay Area-based adviser and money manager has been building positions in high-yield bonds and emerging market stocks, hoping to capitalize on temporary inefficiencies in the market.

"The market is generally efficient. But there are times when prices get out of whack with fundamentals. In the case of high-yield bonds, they sold off dramatically in the fall of 2008," said Alice Lowenstein, the firm's director of managed portfolios. "When an asset class is really beaten down, our process assesses whether it's overdone."

Litman/Gregory manages about $2 billion in assets for outside advisers. It also runs another $2 billion in private accounts and through its Masters' Select family of mutual funds. Besides offering actively managed portfolios, the firm also creates model portfolios that are index-based. The portfolios are generally built using a mix of exchange-traded funds as well as index mutual funds.

Recent Index-Based Portfolio Moves

Litman/Gregory started raising positions in junk bond funds last October by 3-5%, depending on risk levels. In late November 2008 and mid-February 2009, they added to those positions. Both times, the firm's managers used proceeds from the sale of U.S. equities to bump up allocations in bonds to a high point of 15% in the most aggressive portfolios.

"In most of the scenarios we can envision right now over the next three-to-five years, high-yield bonds as an asset class look more attractive than even equities," said Lowenstein. "Of course, conditions can change very quickly in these types of conditions. But we continue to own high-yield bonds and believe their significant yields can offer a short-term cushion if the market falls."

With junk, the firm's 10-member analyst team builds scenarios to test the impact of factors such as how rising default rates and interest rates can impact yield spreads as well as longer-term performance.

"We don't try to predict any particular outcome. We simply try to build models of what we might see happen," said Lowenstein. "Baked into those scenarios are macroeconomic trends that could impact valuations and earnings growth for stocks, for example."

The firm's managers in May also shifted some stock assets into emerging markets, bumping those allocations to between 3-7%, says Lowenstein. Such a tactical move was funded by taking assets from a combination of U.S. and developed international stock fund positions.

Lowenstein says that those kinds of tactical moves only come when analysts see "fat pitches" coming investors' way. "Unlike baseball, you don't have to swing if it isn't a great pitch," she said. "So we don't unless our confidence level is pretty high."

A model index-based portfolio with a neutral target allocation of 60% stocks and 40% bonds (which Litman/Gregory calls its balanced strategy), currently is taking the following tilt:

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