Intelligent Diversification with ETFs
Don Dion
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In a testament to their enduring—and increasing—popularity, the Investment Company Institute reports that inflows into exchange traded funds totaled $129 billion over the 12-month period that ended in April, an occasionally challenging year for investors that saw a steep stock market decline in the U.S. and a 100 percent increase in the price of oil. For investors familiar with ETFs, though, the reasons for incorporating these funds into a portfolio are compelling regardless of the market environment: low annual fees; stock-like trading on the secondary market; and instant, low-cost and transparent diversification with a single fund.
When the markets are choppy, as they have been for much of this year, the rationale for adding ETFs to a portfolio may be even stronger. 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 overseas markets.
In addition, there are dozens of innovative ETFs—such as Rydex CurrencyShares, the PowerShares DB commodities funds and leveraged funds from ProShares—that provide access to investment strategies and areas of the markets that used to be either largely off-limits or extremely difficult for do-it-yourselfers to take advantage of.
When it comes to diversification, however, some of us have a tendency to go overboard. Investors who follow the tenets of modern portfolio theory—a set of risk-management principles developed in the middle of the 20th century by Nobel Prize-winning economist Harry Markowitz—know that holding more than about 15 to 20 individual stocks in a portfolio offers relatively few additional benefits and may in fact undermine performance over the long term. For investors using ETFs, the optimal number of funds is likely lower.
With more than 700 ETFs trading on U.S. exchanges—and new funds launching every week—figuring which funds to use for diversification often feels like a daunting task. Taking a systematic approach—and understanding some of the basic concepts that underlie diversification—can make that task more manageable.
Diversification: Why Does It Work?
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 to financial pros as “systematic” or “market” risk—that can’t really be controlled. Interest rates, wars, weather and political instability fit into this category.
The good news is that the other type of risk, sometimes referred to as “unsystematic” risk, can be minimized using diversification. This was one of the key insights of modern portfolio theory. The holy grail of adherents to this theory is the so-called efficient portfolio, an ideal assemblage of securities that achieves the highest possible return with the least amount of risk.
It’s become so commonplace in the investing world that it’s hard to think of a time when investors didn’t use diversification to manage risk, but it’s worth running through a simple example to understand why it’s such a powerful tool.
Imagine your portfolio consisted of a single fund, a biotechnology sector fund like the iShares Nasdaq Biotechnology Fund (IBB). When that industry began booming in the 1980s, the value of your single-fund portfolio would have soared along with it, but you would also have been vulnerable to the cycles of this volatile growth industry. By investing half your assets in a broad-market stock fund, such as an ETF that tracked the S&P 500, then only part of your portfolio would have been affected by the boom and bust cycles of the biotech sector. Adding a bond ETF would decrease risk even further, because stocks and bonds respond differently as economic and market conditions change.
Over-diversification 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.
Core and Explore
The “why” of diversification is clear enough, but what about the “how”? In an increasingly crowded universe of ETFs, what’s the best approach to maintaining a well-diversified portfolio—particularly when there are often several funds from different sponsors competing for the same slice of the market?
To achieve an optimal level of diversification, many investors adopt a “core and explore” approach to portfolio construction. It’s a strategy that helps address the over-diversification problem while keeping investors focused on their goals. In many ways, ETFs are ideally suited for a “core and explore” portfolio.
In an education note published early last year, Swiss banking giant UBS reported that its models demonstrated that an “efficient portfolio” should contain up to 25 percent nontraditional assets, a category that includes real estate, private equity and commodities.
The “core” of a classic core and explore portfolio might consist of large-cap equity and high-quality corporate or Treasury bond ETFs. These funds provide a stable, low-risk base from which the investor can explore other areas of the market. Depending on the risk tolerance of the individual investor, anywhere from 50 to 95 percent of the core and explore portfolio’s assets may be invested in core funds. The remainder is invested in nontraditional asset classes with the best growth prospects. The higher percentage of funds invested in the core, the less aggressive the portfolio.
While many investors may want to use their “explore” funds to make quick, tactical bets on nontraditional asset classes like commodities, currencies and real estate, the same UBS study demonstrated that alternative asset classes can also be effective as long-term investments.
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This article has 4 comments:
- theinvestingspeculator
- 133 Comments
My Website
Jun 08 10:26 AM- Xyrus
- 75 Comments
Jun 08 09:19 PMVery few, and I do mean very few, have beaten market indexes over the long haul. You may be one of those few. Then again, you may be one of those few who win the lottery. The point is, honesty is something that has been lacking in the markets for quite awhile, and I would appreciate it if you were honest.
For example, you're statement of "if you want low returns" is utter crap. VWO has returned over 20% annualized since inception. The commodities indices have done even better. And even the regular S&P yields 9-10% over the long haul.
Even the great Warren Buffet, the Oracle of Omaha, had a hard time topping 30% a year. And those were his good years.
The fees will not eat you up. The Vanguard ETF's have expense ratios down to less than .20%, and some less than .10%.
The simple truth is, for the vast majority of investors simply riding the market will be far more profitable the trying to beat the market. When that changes, perhaps then I listen to yet another ad laden investing site on the internet. But for now, kindly refrain from driving up traffic to your site with inane statements. It just makes you look like yet another "EARN 300% WITH MY SUPER L33T INVESTMENT PLANZ! I AM THE SHIZNIT!" site.
~X~
- souwester50
- 12 Comments
Jun 09 09:38 AM- BlueCollarRoots
- 2 Comments
Jun 10 12:07 PMI few years into my career, I have about 15,000 I would like to invest, separate from my 401k (12% contributions) and my emergency fund.
After a some research on cost effective, fairly stable and decent performance I choose ETFs as my core investment vehicle. Below I have listed my potential picks.
These would be my core holding that I would hold on to and potentially contribute to a lump sum annually.
Vanguard Total Market (VTI) 30% or (SPY)
Vanguard FTSE All World (VEU) 30%
Vanguard Small Cap (VB) 20% or (VWO)
Vanguard Total Bond Market (BND) 10%
The remaining 10% on one of the following with the intention to watch it closely and sell and buy something else when the time is right.
iShares Brazil (EWZ)
iShares Emerging Markets (EEM)
iShares MSCI (EFA)
iShares FTSE (FXI)
I would then use the 5,000 dollars to buy about 5 stocks, 50% large cap blue chips stocks, 50% (discretionary) speculative small cap. I’ll look for feed back on the stock choices once I’ve completed the research and pulled the trigger on the core ETF holdings.
So again what I’m looking for is some feed back on my general approach, potential picks and distribution percentages and anything else I should be thinking about. Also I’m in my mid 20s is this approach too conservative.
Finally if these are the right choices are the timing right, or should a wait a bit to make the buys.