How ETFs Can Help Your Asset Allocation

If there’s one lesson we hope you get from reading our blog posts, it’s this: Asset allocation is at the heart of portfolio management. Want risk-efficient returns over a long time period? Diversify your holdings and rebalance regularly.

In this post, we’ll explain how Exchange Traded Funds (ETFs) can help you diversify.

Let’s look at an example of a “Core/Periphery” strategy. Here’s the concept behind it: a large chunk of your portfolio should reflect stable equities and fixed income (stocks and bonds). This is the “core” component, and it helps your portfolio stay grounded.

A smaller percentage can hold “exotic” exposures that are probably more volatile and high-risk. Diversifying the types of investments within your “periphery” component can help you hedge the risk that one of your cyclical bets is way off the mark.

There is no single accepted split between core and periphery, but for purposes of this exercise let’s construct a portfolio with 85% core holdings and 15% periphery. Our first task is to build a stable core.

The core should mostly consist of traditional equities and fixed income holdings. The specific stock/bond allocation depends on your risk profile. Let’s assume you’re growth-oriented and you have a long time horizon, so you’d like to hold some riskier assets. You decide that equities will comprise 50% of your total portfolio and fixed income will make up 35%. (Note: this adds up to 85 percent, which is your “core.” The other 15 percent is your “periphery.”)

We could stop there and provide one broad-market equities and one broad-market fixed income exposure, such as the iShares Russell 3000 Stock Index (ticker IWV) and the iShares Barclays Aggregate Bond Index (ticker AGG) respectively. Easy as pie.

However, we know there can be benefits to diversifying into style-specific asset classes. We might want to split the pie between different valuation style (value versus growth) and capitalization (large versus small).

So perhaps we break down that 50% core equities component as follows: 25% large value, 15% large growth and 10% small cap.

But wait! We forgot something!

Our core portfolio is still limited to domestic US stocks. We know that most of the growth in the world is happening overseas. We want a piece of the action (and we’re willing to stomach the risk).

Now our core equities exposure is more defined along both style and geographic lines. Our 50% core equities component may now hold 15% large value, 10% large growth, 10% small cap, 7.5% developed overseas markets like Europe and 7.5% emerging markets.

Next question: Do we want to diversify the 35% core fixed income component away from just one single broad-market exposure? First, ask yourself one question: Do you see bonds as a safe haven, or as an active opportunity for increased returns?

If you’re just looking for safely, it can be perfectly appropriate to leave that entire 35% in the broad-market Barclays Aggregate (AGG) holding. But for the sake of looking at a more active example, let’s see how a more diversified approach would look.

Let’s say that you divide that 35% into the following slices: 12.5% intermediate-term Treasuries, 12.5% investment-grade corporate bonds, 5% high-yield bonds, and 5% non-US bonds.

Our total core portfolio now looks like this:
Core Equities: 50%
of which
US Large Value 15%
US Large Growth 10%
US Small Cap 7.5%
Non-US Developed 10%
Non-US Emerging 7.5%

Core Fixed Income 35%
of which
Intermediate Treasuries 12.5%
Investment Grade Corporate 12.5%
High Yield 5%
Non-US Government 5%

Our final step is to select the 15% peripheral component. As we noted above, this component will be much more dynamic than the core. Here you can tap into your inner market pundit.

For example, you may think that the property and financial markets in Asia are set for a boom. You want a slice of that, so you take a position in a Developed Asia Global REIT Index and the MSCI Far East Financials Sector.

But hold on, you think. That boom may not come to pass, so let’s hedge part of that exposure with a relatively uncorrelated asset like gold.

Equally weighting these three periphery assets lets us complete the portfolio:

Periphery Exposures: 15%
of which
Asia Global REITS 5%
Far East Financials 5%
Gold 5%

Voila! You now have a diversified portfolio allocated along risk tolerance guidelines. You’ve stuck to ETF investing, you’re tracking well-known benchmark indexes, and you’re well-allocated.

Do you invest in periphery exposures? Tell us what you think.

Important disclosures: The above example is used for illustrative purposes only and does not represent a recommendation or solicitation by the author for this or any other specific asset allocation strategy. Investors should carefully weigh their own return and risk considerations before investing in ETFs as well as heed the transaction costs, tax implications and other material factors. Past performance is not a meaningful predictor of future returns.