Building an ETF Portfolio:From the Simple to the Complex
Portfolio Strategies By Maria Crawford Scott You can still keep it simple, even if you make it complex.
is very complex. By following an all-index approach to portfolio
The Bare Necessities
building, your portfolio can be barebones minimalist or highly
The simplicity or intricacy of your portfolio really
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comes down to the amount of time and interest you want an ETF that tracks a broad-based index, with U.S. common to spend managing it, your investment knowledge, and the stocks of all capitalization sizes—large, mid and small cap. total amount of dollars you’ll be investing.
While these ETFs hold thousands of stocks, the key is
There are, however, several investment constraints that not the number but the weightings. Most indexes are capital-
ization-weighted, meaning that stocks with large capitaliza-
)LUVWLWPXVWPHHW\RXUÀQDQFLDOJRDOVDQGPDWFK\RXU tions (number of common stock shares outstanding times
risk tolerance. Your asset allocation—how much you put
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
6HFRQG LW PXVW EH EURDGO\ GLYHUVLÀHG DPRQJ PDMRU with a Level II mid-cap index or small-cap index ETF so
that these segments of the market are not overpowered by
With those constraints in mind, the easiest and most the largest stocks.
cost-effective approach is to build your entire portfolio
While the total domestic market index ETF covers the
around index funds. These are passively managed portfolios U.S. markets, your portfolio needs to be global in scope. For-that do not require you to evaluate the skill of a portfolio HLJQVWRFNVDGGWRRYHUDOOGLYHUVLÀFDWLRQDQGULVNUHGXFWLRQPDQDJHUSURYLGH\RXZLWKFRPSOHWHGLYHUVLÀFDWLRQZLWKLQ even if the allocation is small. For that reason, the Level I the market the index covers, are low maintenance and have portfolio includes an all-in-one total international stock ETF rock-bottom costs.
And exchange-traded funds provide you with all the HFRQRPLF]RQHV(XURSH$VLD3DFLÀFDQG/DWLQ$PHULFD
This covers both developed and emerging international
AAII Journal Table 1. Exchange-Traded Fund Portfolio Levels: From Basic to Complex Level II* Level III U.S. Stocks Total U.S. Stock Market ETF Int’l Stocks Total International Stock ETF
Non-Core Holdings:Corporate High-Yield ETF
Liquid Acct. Very short-term (less than
ETFs, money market ETFs, money market ETFs, money market
*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
indexes that cover all stocks within the
Level II ratchets up the complexity, market segment, and should not include
if you want to be able to control asset any indexes that tilt toward any particular
ernment bond ETF. Intermediate-term simplicity of an index approach.
Level II breaks the total U.S. stock DPDMRU(XURSHDQVWRFNLQGH[RQHWKDW
to 10 years) capture most of the yield market index into several components: WUDFNVDPDMRU3DFLÀFVWRFNLQGH[DQGand total return of a long-term bond (LWKHUDQ(7)WKDWWUDFNVDPDMRUODUJH
fund with substantially less fund volatil-
cap index plus an ETF that tracks an index, allowing choice in allocation
ity caused by changing market interest extended-market index (these indexes between the more developed markets rates. If your bond holding is in a non-
include both mid-cap and small-cap DQGWKHHPHUJLQJPDUNHWVRI WKH3DFLÀF
tax-sheltered environment and your tax stocks), or a large-cap index ETF fund Rim and Eastern Europe. H[SRVXUH LV VLJQLÀFDQW \RX PD\ ZDQW plus an ETF that tracks a mid-cap in-
dex, one that tracks a small-cap index includes a short-term U.S. government
and possibly even an ETF that tracks a bond ETF and a long-term govern-
micro-cap index. By pairing a large-cap ment bond ETF, enabling you to create
all three levels. Any short-term (less than
ETF with ETFs that cover these other your own maturity level. A long-term
RQH\HDUPDWXULW\OLTXLGÀ[HGLQFRPH PDUNHWVHJPHQWV\RXFDQÀQHWXQHWKH government bond ETF can provide a investment with absolutely no default ratio of smaller to larger companies to higher return, although with more vola-risk can be used for this purpose. Several
tility; combining it with a more stable,
Note, however, that the suggested although lower-yielding, short-term
breakdowns relate only to the size of government bond ETF allows you to
the stock market segments—the ETFs control how much extra risk you are
October 2007 Portfolio Strategies Do You Need to “Enhance” Your Approach?
This year’s crop of new ETFs PDUNHWµ LV GHÀQHG DV WKH VXP RI DOO
vesting to “enhance” the index fund their market capitalization—that is, it is
This trend started several years that larger companies are held in greater
fundamental “qualitative” factors to
A newer but similar criticism is that these non-traditional indexes include:
of these new, non-traditional index the capitalization weightings of index
talization of a stock is the stock price
product of Modern Portfolio Theory, this means that a stock’s price dictates the accepted approach to portfolio KRZPXFKRI HDFKÀUPLVUHSUHVHQWHG Does It Work in the Real World? management today, and one of its te-
in the index, and stocks that have hefty
price increases automatically become index mutual funds indicates that few
7KH HIÀFLHQW PDUNHW K\SRWKHVLV larger holdings.
put relatively simply, is that there are
A third criticism with the index ket over the long run. And the odds of
VRPDQ\LQYHVWRUVFRPSHWLQJWRÀQG concept is that research has poked an individual investor picking the right undervalued stocks that their prices are
KROHV LQ WKH HIÀFLHQW PDUNHW FRQFHSW manager or investment strategy—in
GULYHQWRUHÁHFWIDLUYDOXHPDNLQJLW In particular, there is relatively solid advance, before the returns have been virtually impossible to earn a market-
research supporting the notion that achieved—are even longer.
beating return with a market-level of certain value approaches, particularly
risk over the long term by searching FRPELQHGZLWKDVPDOOHUÀUPWLOWFDQ “beefed up” indexes created for these for mispriced securities. Advocates of indeed provide market-beating returns ETFs?WKHHIÀFLHQWPDUNHWWKHRU\VXJJHVWWKDW without additional risk.
securities, investors should buy and “Enhanced” ETFs
hold “the market”—a traditional index
Many of the newer ETFs track resolve the issue, because the academics
indexes that are designed in response are still hotly debating it.
market’s gross returns less expenses, to the criticisms against traditional
which tend to be held to a minimum indexing.
There are two broad themes to “enhanced” offerings.
But criticisms of the approach these non-traditional indexes:
“weighted” in the fund, so that the folio, whether it be an ETF that follows
to dominate the “total market” as it
proportion of a stock in the index a traditional market-cap-weighted index
LV WUDGLWLRQDOO\ GHÀQHG 7KH ´WRWDO
of Level III is to allow you to tilt your the large-cap index ETF, along with the portfolio toward certain market sectors extended market index ETF (or mid-cap
Adding to a Core
or strategies you feel you would like to index, small-cap index and micro-cap emphasize, while at the same time you index ETFs), serves as the core holding.
In the Level III ETF portfolio, remain invested in a solid “core” of Special sector or specialty ETFs that
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focus on particular stock strategies can
or that use semi-active approaches are ally need one of these funds is another be added, but this non-core section of introduced.
For the domestic stock portfolio, total domestic stock portfolio.
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Make sure when adding a sector a different level for only one segment
or strategy ETF that you understand of your portfolio. You could use the
the added risks that you are taking Level III approach for your U.S. stock
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Sector funds concentrate on even a Level I for your international
one industry or a few closely related holdings.
ZHOOGLYHUVLÀHG6LPLODUO\VW\OHIXQGV put into your portfolio?
value characteristics; they also tend to to choose from, many ETFs either cover
be concentrated in certain industries VSHFLÀFPDUNHWVHFWRUVVXFKDVÀQDQFLDO
Beyond any additional risk, the (for instance, growth or value indexes,
strategy funds to invest in, adding to investment strategies). For the Level
Remember, too, that when you an exchange-traded fund that tracks a
invest in one of these ETFs, you are widely followed index in the appropriate
most likely decreasing \RXUGLYHUVLÀFD-
you are adding more funds. For to pick one fund for each market seg-
instance, if you add a value-focused ment. Index funds, including ETFs, are
you are moving from a portfolio that you do not need to own two different
LV WRWDOO\ GLYHUVLÀHG DPRQJ DOO 86 mid-cap ETFs.
portfolio that includes all U.S. stocks core selections should be based on
in the proper proportion but also your own informed opinion of sectors
adds in duplicates of only the value or strategies you feel may outperform
Outside of the traditional the approach taken by the fund and the
index ETFs, the Level III ETF extra risks involved. Keeping It Simple
transaction costs in the underlying fund
the chance for above-index-fund available, it is possible to quickly narrow
/HYHO ,,, FDQ KDQGOH VLJQLÀFDQW low-cost portfolio of exchange-traded
wealth, but would be impractical for funds. very modest investment sums due
to the number of ETFs required for you to build a portfolio that requires
Similarly, for the international and investment.
is relatively low cost, and yet provides
Populating Your ETF Portfolio
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the “core” of the international stock and
ERQGDVVHWFODVVHVZLWKVSHFLÀFFRXQWU\ line, you can create any level you want holding millions of dollars (don’t we or global sector ETFs and corporate that comfortably matches your inves-
Maria Crawford Scott is editor of the AAII Journal. October 2007
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