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Portfoliostrategies.pdfBuilding 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
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 7KH WRWDO 86 VWRFN PDUNHW (7) VKRXOG EH MXVW WKDW 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 LQWRWKHYDULRXVDVVHWFDWHJRULHV³DGGUHVVHVWKHVHÀQDQ- index fund. Holding one total domestic stock index fund is FLDOFRQFHUQVDQGLVGULYHQE\\RXULQYHVWRUSURÀOH 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. WKDWVKRXOGWUDFNDPDMRULQGH[FRYHULQJWKHSULPDU\UHJLRQDO 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
U.S. Stocks Total U.S. Stock Market ETF
Int’l Stocks Total International Stock ETF
/HYHO,RU/HYHO,,LQWHUQDWLRQDOVWRFNKROGLQJV 5HJLRQDO6SHFL¿F&RXQWU\RU*OREDO6HFWRU(7) 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 FLVHO\EXWVWLOOHPSOR\WKHHIÀFLHQF\DQG 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, EUDQGQHZ(7)VÀWWKLVGHVFULSWLRQEXW 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
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 Non-Traditional Arguments
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
FRXOGJHWD3K'LQÀQDQFHDQGVWLOOQRW 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: VXIÀFLHQWGLYHUVLÀFDWLRQIRU\RXUSRUW- “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 (7)V WKDW IRFXV RQ VSHFLÀF VHFWRUV GLYHUVLÀHGKROGLQJV>:KHWKHU\RXUH- 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. AAII Journal
WRU SURÀOH \HW VWLOO UHPDLQ SURSHUO\ 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 %XW \RX FDQ DGMXVW IRU WKLV SUREOHP 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 RUHQHUJ\VWRFNVRUDUHVWUDWHJ\VSHFLÀF Beyond any additional risk, the (for instance, growth or value indexes, WULFNWRPDVWHULVMXVWZKLFKVHFWRURU RUVSHFLDOW\(7)VWKDWIRFXVRQVSHFLÀF 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 E\QDWXUHIXOO\GLYHUVLÀHG)RUH[DPSOH 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
VXEVWDQWLDO GLYHUVLÀFDWLRQ $QG LW FDQ 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.
Schizophrenia Schizophrenia is a serious mental illness that changes how a person thinks, feels and behaves. It also changes how they perceive the world, themselves and other people. About 1% of the population of most countries has schizophrenia although symptoms may differ from culture to culture. Symptoms vary widely between people who have schizophrenia. They may be mild or severe.