Portfolio options
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WILEY GLOBAL FINANCE
There are endless ETF portfolio options. Here we will look at three:
- A Core Holder strategy
- An Armchair Investor, and
- An Autopilot approach
The Core Holder Portfolio
The Core Holder typically owns 12 to 16 ETFs, with broad-based funds such as the SPY, DIA, or the QQQ as core holdings. Although this investor is hands-off — trading infrequently — he or she needs to understand what these core holdings represent; for example, that the DIA will track the Dow components and the QQQ is very heavily weighted toward technology.
The Core Holder then uses a few ETFs to layer on additional exposure to certain sectors or subsectors. For example, in addition to the technology exposure of the QQQ, a Core Holder may decide to buy a subsector fund that enables this investor to gain exposure to semiconductors or the Internet. As with any portfolio strategy, overlap will be an issue. However, by using targeted subsector funds, the Core Holder can minimize overlap by seeking exposure just to those types of companies that he or she wants to hold.
The Core Holder will most likely follow a basic indexing strategy such as market capitalization or perhaps a customized approach that weights on the basis of revenue or dividends. High transparency appeals to the Core Holder, provided that he or she does the necessary research to understand a fund’s objective and to examine its core holdings.
The Core Holder, like other investors, would do well to consider all alternatives within an investment theme or sector. As more ETFs are launched, fees are being driven down as lower-cost alternatives are introduced. Although “first-mover status” is important from a marketing standpoint, there may be a cheaper alternative to consider. For example, the iShares MSCI Emerging Markets Index Fund (EEM) that was introduced in April 2003 had an expense ratio of 0.72 percent. The Vanguard Emerging Markets ETF (VWO), introduced in March 2005, had an expense ratio of only 0.27 percent. Although the funds are not exactly alike, investors would do well to consider which fund offers the exposure they desire along with an affordable fee.
A sample portfolio might be weighted as follows:
ETF | Symbol | % Weighting |
---|---|---|
SPDR S&P 500 | SPY | 10 |
PowerShares QQQ Trust | QQQ | 10 |
SPDR Dow Jones Industrial Average | DIA | 10 |
Fidelity MSCI Health Care ETF | FHLC | 5 |
iShares Russell 2000 | IWM | 10 |
Vanguard REIT | VNQ | 5 |
Vanguard Emerging Market | VWO | 10 |
Market Vectors Agribusiness | MOO | 5 |
SPDR Financial sector | XLF | 5 |
SPDR Industrial Sector | XLI | 5 |
SPDR Short-Term Bond | SHM | 10 |
iShares BC 1-3 Treasury | SHY | 15 |
The Armchair Investor
An Armchair Investor will be even less involved in ongoing investing than a Core Holder. Like the Core Holder, the Armchair Investor will tend to hold broad-based ETFs to gain exposure to the major indexes.
The Armchair Investor will want to be aware of sector exposure; for example, using QQQ to invest in technology, but that is about as granular as it gets. The Armchair Investor is not looking to slice-and-dice a sector down to subsector components in order to gain short-term exposure, unlike the Core Holder.
Typically, the Armchair Investor would have about eight ETFs that he or she looks at quarterly, since that is when most ETFs are rebalanced. At each quarter, the Armchair Investor looks at performance and decides whether or not to make a change. Although trading is very infrequent, the Armchair Investor likes the flexibility that ETFs offer in case of lifestyle changes or dramatic market shifts.
A sample portfolio might include the following by weight:
ETF | Symbol | % Weighting |
---|---|---|
SPDR S&P 500 | SPY | 15 |
PowerShares QQQ Trust | QQQ | 10 |
SPDR Dow Jones Industrial Average | DIA | 10 |
iShares S&P Mid-Cap 400 Growth | IJK | 10 |
Vanguard Total World | VT | 15 |
iShares Russell 3000 | IWV | 10 |
SPDR Short-Term Bond | SHM | 10 |
Vanguard Total Bond Market | BND | 15 |
iShares BC 1-3 Year Treasury | SHY | 15 |
The Autopilot Investor
The least active type of portfolio is one that is effectively on autopilot. Autopilot Investors use ETFs but are most likely to do so as part of a buy-and-hold approach. They typically use funds that track the broad-based indexes as well as those that have a particular investment style such as large-cap growth or international.
Because the Autopilot Investor is so hands-off, he or she may be interested in pursuing funds that promise to generate alpha — or performance over and above the underlying index benchmark. Therefore, the Autopilot Investor would be a good candidate for dynamic or actively managed ETFs. For Autopilot Investors, having a fund manager do all the work — albeit in return for a higher fee — is preferable than trying to do the portfolio management themselves. The Autopilot Investor’s mantra is “I am much more comfortable putting my faith in a smart strategy than trying to understand it myself.”
A sample portfolio might include the following by weight:
ETF | Symbol | % Weighting |
---|---|---|
First Trust Large Cap Core AlphaDex
|
FEX | 15 |
PowerShares Dyn Market
|
PWC | 25
|
Guggenheim S&P 500 Pure Growth
|
RPG | 25
|
iShares Russell MidCap Growth Index
|
IWP | 15 |
iShares MSCI EAFE Index Fund
|
EWA | 10 |
PowerShares DWA Em Mkts Tech
|
PIE | 10 |
Whatever your portfolio preference, broad-based ETFs such as the SPY, QQQ, or DIA can be important building blocks for your portfolio. Although these ETFs are considered to be the plain vanilla within an increasing array of fund choices, passively indexed funds are easy and low-cost ways to gain broad market exposure. These are the funds that can “keep you on the highway” and tracking the overall market. The last thing you want to do is put together a portfolio consisting only of narrowly defined exotic choices that crash while the overall market is rallying. By using the plain-vanilla indexes at the core of your portfolio, you can pursue other funds that have the potential to increase your overall performance.
You will also want to consider diversification so that losses in one particular holding do not derail your investment plan. Most do-it-yourself investors know that diversification is one of the keys to better portfolio performance, and ETFs are an easy way to add exposure to a wide range of stock and bond indexes, industry sectors, and developed and emerging markets overseas. In addition, there are dozens of innovative ETFs that provide access to investment strategies and areas of the market — such as currencies and commodities — that used to be either largely off-limits or extremely difficult for do-it-yourself investors.
All investments carry a certain amount of risk. From low-risk Treasury bonds to highly speculative initial public offerings, there is always a chance that an initial investment will decline in value. The bad news for investors is that there is one type of risk — known as “systematic” or “market” risk — that cannot really be controlled. Interest rates, wars, weather, and political instability fit into this category. The good news, however, is that the other type of risk — sometimes referred to as “unsystematic” risk — can be minimized using diversification.
Over-diversification, however, can offset the benefits of a well-constructed, well-diversified portfolio. When assets are spread across too many investments, the potential for a big gain to boost overall performance is diminished. In addition, a big portfolio can be difficult to manage and can generate excessive trading fees as investors tweak their positions.
As your portfolio grows and changes over time, keep aware of the balance among the assets with “nothing to excess” so that you remain well diversified to increase your chances of success and mitigate the impact of a downturn in one particular area.
Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.