Building an ETF Portfolio: From the Simple to the Complex

    by Maria Crawford Scott

    Building An ETF Portfolio: From The Simple To The Complex Splash image

    You can still keep it simple, even if you make it complex.

    There are many different “levels” of portfolios, ranging from a basic, bare-minimum portfolio to one that is very complex. By following an all-index approach to portfolio building, your portfolio can be barebones minimalist or highly intricate—yet still be relatively easy-to-build as well as low cost.

    The simplicity or intricacy of your portfolio really comes down to the amount of time and interest you want to spend managing it, your investment knowledge, and the total amount of dollars you’ll be investing.

    There are, however, several investment constraints that any investment portfolio must follow:

    • First, it must meet your financial goals and match your risk tolerance. Your asset allocation—how much you put into the various asset categories—addresses these financial concerns and is driven by your investor profile.
    • Second, it must be broadly diversified among major market segments.

    With those constraints in mind, the easiest and most cost-effective approach is to build your entire portfolio around index funds. These are passively managed portfolios that do not require you to evaluate the skill of a portfolio manager, provide you with complete diversification within the market the index covers, are low maintenance and have rock-bottom costs.

    And exchange-traded funds provide you with all the tools you need to do it.

    Table 1 illustrates three basic ETF portfolio levels, from the simple, realistic minimum to the complex. The holdings in each portfolio are generic descriptions rather than specific ETFs.

    The Bare Necessities

    Level I contains only three ETFs, but covers substantial investment ground.

    The total U.S. stock market ETF should be just that: an ETF that tracks a broad-based index, with U.S. common stocks of all capitalization sizes—large, mid and small cap.

    While these ETFs hold thousands of stocks, the key is not the number but the weightings. Most indexes are capitalization-weighted, meaning that stocks with large capitalizations (number of common stock shares outstanding times the market price per share) tend to dominate any total stock index fund. Holding one total domestic stock index fund is a bare minimum holding, but you may want to augment it with a Level II mid-cap index or small-cap index ETF so that these segments of the market are not overpowered by the largest stocks.

    While the total domestic market index ETF covers the U.S. markets, your portfolio needs to be global in scope. Foreign stocks add to overall diversification and risk reduction, even if the allocation is small. For that reason, the Level I portfolio includes an all-in-one total international stock ETF that should track a major index covering the primary regional economic zones: Europe, Asia/Pacific, and Latin America. This covers both developed and emerging international economies, but developed economies dominate the index, as does Europe, since capitalization weighting determines exposure and diversification.

    The third component in the Level I portfolio is an intermediate-term government bond ETF. Intermediate-term maturities (average maturity of seven to 10 years) capture most of the yield and total return of a long-term bond fund with substantially less fund volatility caused by changing market interest rates. If your bond holding is in a non-tax-sheltered environment and your tax exposure is significant, you may want to consider an intermediate-term municipal bond ETF.

    The liquidity account is the same for all three levels. Any short-term (less than one-year maturity), liquid fixed-income investment with absolutely no default risk can be used for this purpose. Several brand-new ETFs fit this description, but money market funds and bank accounts fit the bill as well.

    Table 1. Exchange-Traded Fund Portfolio Levels: From Basic to Complex
    Asset Level I* Level II* Level III
    U.S. Stocks Total U.S. Stock Market ETF Large-Cap Stock ETF
    Extended Stock Market ETF
    Large-Cap Stock ETF
    Mid-Cap Stock ETF
    Small-Cap Stock ETF
    Micro-Cap Stock ETF
    Core Holdings:
    Level I or Level II U.S. stock holdings

    Non-Core Holdings:
    Sector or Specialty ETF
    Int’l Stocks Total International Stock ETF European Stock ETF
    Pacific Stock ETF
    Emerging Markets Stock ETF
    Core Holdings:
    Level I or Level II
    international stock holdings

    Non-Core Holdings:
    Regional, Specific
    Country or Global
    Sector ETF
    Bonds Intermediate-term
    U.S. Government
    (or Muni) Bond ETF
    Short-Term Government Bond ETF
    Long-Term Government
    (or Muni) Bond ETF
    Core Holdings:
    Level I or Level II bond holdings

    Non-Core Holdings:
    Corporate High-Yield ETF
    Liquid Acct. Very short-term (less than one year maturity), no default-risk fixed-income ETFs, money market funds or bank accounts Very short-term (less than one year maturity), no default-risk fixed-income ETFs, money market funds or bank accounts Very short-term (less than one year maturity), no default-risk fixed-income default-risk fixed-income ETFs, money market funds or bank accounts
    *Level I and Level II ETFs should track a well-known broad-based index in the chosen asset class, and they should be strategy-neutral.

    Ratcheting Up the Minimum

    Level II ratchets up the complexity, if you want to be able to control asset allocation and diversification more precisely, but still employ the efficiency and simplicity of an index approach.

    Level II breaks the total U.S. stock market index into several components: Either an ETF that tracks a major large-cap index plus an ETF that tracks an extended-market index (these indexes include both mid-cap and small-cap stocks), or a large-cap index ETF fund plus an ETF that tracks a mid-cap index, one that tracks a small-cap index and possibly even an ETF that tracks a micro-cap index. By pairing a large-cap ETF with ETFs that cover these other market segments, you can fine-tune the ratio of smaller to larger companies to meet your objectives.

    Note, however, that the suggested breakdowns relate only to the size of the stock market segments—the ETFs chosen for these segments should track indexes that cover all stocks within the market segment, and should not include any indexes that tilt toward any particular strategy or style.

    Similarly, the foreign markets are broken down into an ETF that tracks a major European stock index, one that tracks a major Pacific stock index and one that tracks an emerging markets index, allowing choice in allocation between the more developed markets and the emerging markets of the Pacific Rim and Eastern Europe.

    For the bond holdings, Level II includes a short-term U.S. government bond ETF and a long-term government bond ETF, enabling you to create your own maturity level. A long-term government bond ETF can provide a higher return, although with more volatility; combining it with a more stable, although lower-yielding, short-term government bond ETF allows you to control how much extra risk you are willing to take on for added yield.

    Adding to a Core

    In the Level III ETF portfolio, ETFs that focus on specific sectors or that use semi-active approaches are introduced. The rationale for the complexity of Level III is to allow you to tilt your portfolio toward certain market sectors or strategies you feel you would like to emphasize, while at the same time you remain invested in a solid “core” of diversified holdings. [Whether you really need one of these funds is another question—see related sidebar above.]

    For the domestic stock portfolio, the large-cap index ETF, along with the extended market index ETF (or mid-cap index, small-cap index and micro-cap index ETFs), serves as the core holding. Special sector or specialty ETFs that focus on particular stock strategies can be added, but this non-core section of your portfolio should not dominate the total domestic stock portfolio.

    Similarly, for the international and bond segments of your portfolio, the Level I or Level II international stock and bond holdings should be viewed as the “core” of the international stock and bond asset classes, with specific country or global sector ETFs and corporate high-yield ETFs added on as your risk level dictates—and again not dominating that asset class holding.

    Make sure when adding a sector or strategy ETF that you understand the added risks that you are taking on. Sector funds concentrate on one industry or a few closely related industries, and as such they are not well diversified. Similarly, style funds focus on stocks with either growth or value characteristics; they also tend to be concentrated in certain industries and not well diversified.

    Beyond any additional risk, the trick to master is just which sector or strategy funds to invest in, adding to the complexity of the analysis.

    Remember, too, that when you invest in one of these ETFs, you are most likely decreasing your diversification in that asset class, even though you are adding more funds. For instance, if you add a value-focused stock fund to your U.S. stock holdings, you are moving from a portfolio that is totally diversified among all U.S. stocks in the proper proportion, to a portfolio that includes all U.S. stocks in the proper proportion but also adds in duplicates of only the value stocks—more funds, but less diversification and, therefore, more risk.

    Outside of the traditional index ETFs, the Level III ETF portfolio is a high-maintenance, high-financial-sophistication ETF portfolio, requiring significant selection and monitoring effort to earn the chance for above-index-fund returns.

    Level III can handle significant wealth, but would be impractical for very modest investment sums due to the number of ETFs required for investment.

    Populating Your ETF Portfolio

    Using these portfolios as a guideline, you can create any level you want that comfortably matches your investor profile, yet still remain properly diversified.

    For example, you may want to use a different level for only one segment of your portfolio. You could use the Level III approach for your U.S. stock holdings, but stick with a Level II or even a Level I for your international holdings. How do you know which ETFs to put into your portfolio?

    Although there are over 500 ETFs to choose from, many ETFs either cover specific market sectors (such as financial or energy stocks), or are strategy-specific (for instance, growth or value indexes, or specialty ETFs that focus on specific investment strategies). For the Level I and II market segments, stick with an exchange-traded fund that tracks a widely followed index in the appropriate market segment.

    Remember, too, that you only need to pick one fund for each market segment. Index funds, including ETFs, are by nature fully diversified. For example, you do not need to own two different mid-cap ETFs.

    For the Level III portfolio, non-core selections should be based on your own informed opinion of sectors or strategies you feel may outperform the market enough to justify the added risks. Just make sure you understand the approach taken by the fund and the extra risks involved.

    Keeping It Simple

    Despite the large number of ETFs available, it is possible to quickly narrow down your choices and build a simple, low-cost portfolio of exchange-traded funds.

    The approach illustrated here allows you to build a portfolio that requires very little time and energy to manage, is relatively low cost, and yet provides substantial diversification. And it can be used with portfolios of any size, from the very modest to the largest holding millions of dollars (don’t we all wish?).

       Do You Need to “Enhance” Your Approach?

    This year’s crop of new ETFs continues the trend in index fund investing to “enhance” the index fund concept. This trend started several years ago, when a number of exchange-traded funds started to track non-traditional indexes. What are the arguments in favor of these new, non-traditional index approaches?

    Non-Traditional Arguments

    Traditional index funds are a direct product of Modern Portfolio Theory, the accepted approach to portfolio management today, and one of its tenets, the efficient market hypothesis.

    The efficient market hypothesis, put relatively simply, is that there are so many investors competing to find undervalued stocks that their prices are driven to reflect fair value, making it virtually impossible to earn a market-beating return with a market-level of risk over the long term by searching for mispriced securities. Advocates of the efficient market theory suggest that, instead of trying to find undervalued securities, investors should buy and hold “the market”—a traditional index fund. In so doing, you would match the market’s gross returns less expenses, which tend to be held to a minimum with a buy-and-hold strategy.

    But criticisms of the approach have arisen over time.

    One criticism of the index approach is that particular stocks tend to dominate the “total market” as it is traditionally defined. The “total market” is defined as the sum of all stocks in the market in proportion to their market capitalization—that is, it is capitalization-weighted. And that means that larger companies are held in greater proportion than smaller companies, with larger stocks affecting the index performance proportionally more.

    A newer but similar criticism is that the capitalization weightings of index funds tend to result in dominance by growth stocks. Since the market capitalization of a stock is the stock price times the number of shares outstanding, this means that a stock’s price dictates how much of each firm is represented in the index, and stocks that have hefty price increases automatically become larger holdings.

    A third criticism with the index concept is that research has poked holes in the efficient market concept. In particular, there is relatively solid research supporting the notion that certain value approaches, particularly combined with a smaller-firm tilt, can indeed provide market-beating returns without additional risk.

    “Enhanced” ETFs

    Many of the newer ETFs track indexes that are designed in response to the criticisms against traditional indexing. There are two broad themes to these non-traditional indexes:

    • Some of the new indexes have been created to change the way stocks are “weighted” in the fund, so that the proportion of a stock in the index is not based on its market capitalization (stock price times number of shares outstanding).
    • Many of the newer indexes have been created to allow the use of fundamental “qualitative” factors to determine stock composition, adding a semi-active flavor to the index.
    ETF sponsors that specialize in these non-traditional indexes include:

    • Rydex
    • WisdomTree
    • PowerShares
    • First Trust
    • Claymore

    Does It Work in the Real World?

    The successful history of traditional index mutual funds indicates that few professional managers can beat the market over the long run. And the odds of an individual investor picking the right manager or investment strategy—in advance, before the returns have been achieved—are even longer.

    But what about the new crop of “beefed up” indexes created for these ETFs?

    Whether they can “beat” traditional index funds is anybody’s guess. You could get a Ph.D. in finance and still not resolve the issue, because the academics are still hotly debating it.

    But here are some thoughts to keep in mind when perusing the new “enhanced” offerings.

    First, it is clear that a single index ETF is not going to provide you with sufficient diversification for your portfolio, whether it be an ETF that follows a traditional market-cap-weighted index or one of the new breed of non-cap-weighted indexes.

    Any market-cap-weighted index will be dominated by larger firms. But you can adjust for this problem when using traditional cap-weighted index funds by making sure you also invest in index ETFs that specifically cover the mid-cap market and small-cap market.

    However, non-cap-weighted indexes are not immune to this problem. They will be dominated by stocks with other characteristics. For example, a number of the WisdomTree dividend-based indexes are heavily populated with REITs. And, of course, they have no stocks that do not pay dividends. Other non-cap-weighted indexes will be dominated by stocks that have the characteristics of whatever selection method they are using. You may want to tilt your portfolio to a particular style because you feel that it will outperform—but just make sure you understand that that is what you are doing.

    Second, the non-cap-weighted ETFs do come with some extra costs attached.

    For one, they tend to have slightly higher expense ratios.

    In addition, unlike cap-weighted index funds that automatically rebalance with market prices change, non-cap-weighted indexes must be rebalanced periodically to reflect market changes. That will result in higher transaction costs in the underlying fund (which must match the index), as well as more tax implications if you hold the fund in a taxable account.

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