Diversification made easy with ETFs

CATEGORIES: Investment Planning

One of the fundamental rules of prudent portfolio management is to focus on asset class diversification rather than stock picking or market timing. Study after study has confirmed that asset class allocation is the most consistent predictor of portfolio performance over time.

In this regard it would seem that exchange traded funds (ETFs) were designed specifically with the prudent asset allocator in mind. ETFs have been one of the most dynamic investment products ever to be introduced, growing from less than $100 billion in total volume in 2000 to over $1 trillion in 2010. Over this time ETFs have come into their own as a liquid, accessible means to obtain exposure to equities, fixed income and alternative assets in an ever-expanding array of asset classes and subclasses across almost all industry sectors, geographic regions and economic themes. There are certainly risks to investing in ETFs, as with any investment vehicle, but also some very compelling benefits that should make them a staple of any modern diversified portfolio.

One of the principal benefits of ETFs from an asset allocation standpoint is that they are for the most part purely passive vehicles, meaning that if you choose an ETF as a proxy for a certain asset class then you should expect its performance to very closely track that of the benchmark. Consider the following table, showing the performance of the iShares Russell 1000 Large Cap Value ETF (IWD) versus the benchmark index (the Russell 1000 Value index).

The difference between the benchmark and the ETF is effectively little more than the management fee charged by the ETF. Which brings us to another significant benefit of ETFs. The annual  expense ratio of IWD, the iShares ETF shown above, is 0.20% – significantly below the fees charged by actively managed mutual funds in the large cap value space (which can exceed 1%), and in the vicinity of the fee levels typically charged by passive (indexed) mutual funds.

So if a major part of portfolio performance can be attributed to asset allocation rather than stock picking or market timing, as the studies demonstrate, why would anyone pay 80 basis points more in fees for a stock picker or market timer, which are two of the more commonly-employed active management strategies? There are plenty of reasons, including tradition (active mutual funds have been around for decades, while ETFs are a much more recent innovation), good advertising (especially by the large financial institutions that spend heavily on TV, print and Internet ad slots) and behavioral investment tendencies (irrational tendencies by humans to believe they can consistently outperform the market). But as the rapid growth in ETFs clearly shows, the benefits of ETFs as efficient portfolio instruments are gaining plenty of traction among investors of all stripes.

Because of this popularity the ETF market has, predictably, seen its share of new offerings piling into the market offering all sorts of novel exposures to the “flavor of the day”. Just remember that risky assets are not less risky when they come in ETF form. SLV, the iShares ETF offering exposure to silver futures contracts, has lost 26% since April 29 when the silver market started to fall apart – there’s no cushion or hedging with ETFs when the benchmark gets routed.

A good hedging strategy for any portfolio should include a handful of exposures in each of the main categories of equities, fixed income and alternative assets. Here is a representative example at how such a diversified portfolio might look (please note that this is a hypothetical example only and not a recommendation or solicitation to buy on the part of the author). We include indicative ETFs from iShares (tickers shown in brackets) – there are similar ETFs offered by other institutions such as PowerShares, SPDRs and Wisdom Tree.

Equities – 55%

US Large Cap Blend (IWB)

US Small Cap Blend (IWM)

US All Cap Growth (IWZ)

US All Cap Value (IWW)

International Developed – EAFE (EFA)

International Emerging Markets (EM)

Fixed Income – 30%

Barclays US Aggregate Bond (AGG)

High Yield Corporate Bond (HYG)

Emerging Markets Bonds (EMB)

Alternatives – 15%

GSCI Commodities Index (GSC)

Realty Majors Index Fund (ICF)

Diversified Alternatives Trust (ALT)

It is possible with a relatively small number of individual ETFs to obtain the kind of prudent diversification across a broad range of asset classes shown here. Of course some investors will want to apply more sophisticated techniques including tactical overlays, sector concentrations, currency hedges and other approaches. The beauty of ETFs is that they can be as simple or as complex as you want, while focusing undistracted attention on the all-important business of intelligent asset allocation.


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About the Author

Katrina Lamb is a CFA for Jemstep. She has over 25 years experience in economics, finance, international development and management strategy, with a strong focus on global markets. She provides a voice of clarity, logic, and reason in an environment characterized by high uncertainty.

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One thought on “Diversification made easy with ETFs

  1. Pingback: BullseyeMicrocaps.com » Avoiding The Pitfalls Of ETF Investing

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