How to Create a Conservative ETF Portfolio

A well designed Conservative ETF Portfolio is for those who are conscious of first rule of investing. Do not lose money. The main goal on a conservative portfolio is to preserve capital as investors seek to ride the market over time rather than trying to time market top and bottoms.

A low risk ETF portfolio of Index funds aim to replicate the market rather than trying to beat it. Passive Index Funds tracking a market index like the Dow Jones Industrial Average can be one of the easiest and cheapest way for investors to create their own low maintenance investment portfolio. There are also a number of benefits using ETF rather than mutual funds in making the core part of the investment portfolio.

ETFs which tracks specific bond and stock indexes can minimise the risk of the portfolio underperforming the market over the long run. For investors who are taking a conservative approach, beating market should not be the primary motivation in choosing the ETFs that make up the portfolio.  The goal is the preservation of the investment capital so income can be generated to meeting future spend for as long as possible.

The relative and absolute low cost of ETFs is a major advantage it has over direct stock or mutual fund investments. Typical expense management ratio of ETFs for index trackers are close to 0.20% to 0.30% a year compared to 1% for mutual funds. This also does not include the buy in and exit cost of funds which can add up to another 2% per trip.

Low expense ratios of simple index ETFs allows investors to capture a larger portion of market returns that would have otherwise eaten by advisor or management fees.

The Bond ETFs that Should be In Every Conservative Portfolio – Conservative Allocation ETFs

Stock market is usually the first thing that comes to mind for investors when they think about the market. But did you know that the total size of the bond market is a multiple size of the stock market?

Up until recently, the only way for investors to invest in bonds was to purchase the bond directly through a broker (direct bond investment was not cost effective for orders smaller than $100k per order) or bond mutual funds. Now there is a wide range of cheap and effective ETF options for investors that would like to create a conservative portfolio.

The decision on which bond ETF to include in a conservative portfolio should be partly based on the expected investment time horizon of the investor.

For the risk averse investors with a medium investment horizon and want to first and foremost to preserve capital. Barclays US 7 – 10 Years US Government Bond ETF (IEF) can be considered a good ETF which can form the core component of the investment portfolio.

The time horizon of the bonds held in the IEF span between 7 – 10 years which allows investors a higher level of income than shorter dated US government bonds ETFs. Longer duration ETFs have a higher yield to compensate investors for buying a longer dated bonds but this is balanced by exposure to potential capital losses from day to day fluctuation in the market as future interest rate expectations changes.

With that said, a conservative approach can allocate a smaller portion of the bond portfolio to the longer dated Barclays US 20 + Year Treasury Bond (TLT). TLT tracks the performance of US treasury bonds with a maturity of 20 years and longer which naturally has a higher yield (and risk).

A disadvantage of holding bond ETFs is static nature of duration of the portfolio. If an investor buys a portfolio of bonds and hold those bonds to maturity. The duration of the portfolio (the sensitivity to interest rate changes which also reflect the life of the bonds) decrease over time.

However a bond ETF actually maintains certain level of duration. It exchanges any shorter dated bonds in its portfolio with longer dated bonds to maintain the level of average age to maturity of bonds specified to the tracking index.

Investors can managed the fixed duration risk through a simple and effective way. They can simply use the cash flow (dividends) of TLT to rebalance the portfolio to cash or shorter dated bond ETF over time. Hence as portfolio matures over time, the portion allocated to TLT would decrease and with the right sizing the interest risk of the portfolio would decrease over time as well.

iShares Floating Rate Note Fund (FLOT) can also provide protection against future interest rate increases. FLOT invests in investment grade bonds where the coupons are based on a swap rate above the corresponding base rate (i.e 3% above 1 year LIBOR). The maturityof the bonds in the ETF are usually between one month and 5 years. This is an effective way for investors to naturally hedge their long dated bond exposures (potential interest spread risk would still exist in holding floating rate bonds).

A shorter time horizon conservative portfolio should limit overall allocation to long dated bond ETFs. A greater portion of the portfolio can be assigned to short dated government and corporate bond ETFs such as iShares Barclays 1-3 Year Treasury Bond Fund (SHY) or iShares Barclays 1-3 Year Credit Bond Fund (CSJ).

CSJ tracks shorted dated investment grade bonds. Short dated investment grade bonds have lower default risks as buyers are only at risk if the company defaults within 3 years. Any current negative factors around companies which could put the bonds repayments at risk should to some degree already reflect in the current prices (i.e similarly the price investors pays for the ETF units today).

Selecting the Right Amount of Stock Exchange Traded Funds in Your Portfolio

Bond ETFs aim to protect the original investment capital overtime. There should be some stock exposure in every conservative portfolio to make sure also the purchasing power of the portfolio is also not being eroded. Core asset allocation decisions will make or break the portfolio return over time. The goal of including stock ETF in a conservative portfolio is for the stock ETF to act a counterweight to the bonds rather than the traditional balance method of investment management of using the stock ETF as the core unit of the ETF portfolio.

Investors can achieve greater level of diversification through stock ETFs than owning the stocks directly. This can also limit potential stock specific risks that could cause severe damage to investment capital from unforeseeable risks.

The best stock ETF in this example would be the S&P500 SPDR ETF (SPY). SPY tracks the S&P500 Index which includes the 500 largest companies listed on the stock exchange. This is important for conservative investors as it means most of the companies have earnings and cashflows to back up the prices paid by investors. It is recommended for investors not allocate more than 20% of the conservative portfolio to equity market exposure if they are afraid of market volatility.

For a conservative income investor with a shorter investment horizon means an even lower allocation to stocks (or none at all if time horizon is lower than 3 years). Rather the focus would be purely on using bonds for income. There is limited risk in having short dated bond ETF like CSJ and SHY if interest rate rises (primary risk of owning bonds) however the trade off is lower overall income.

For investors who feel the yield on government bond is too low even a longer time horizon. Alternative options include iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) is the largest traded corporate bond ETF in the US. It limit potential credit risk for investors through holding hundreds of different bonds which results in a well diversified and protect capital from default risk.

There are also options that can improve overall return at the cost of marginal additional risk. Such as lower risk market sectors such as utilities or health care ETF suitable for conservative portfolios. These are low risk sectors that are less volatile than the broader market and comprised of mature and dividend paying companies. Portfolio diversification can be improved through including international exposure either country specific like ETF that track French companies or wider regional ETFs.

Model Conservative ETF Portfolio Allocation

Below is the model allocation is an example of conservative portfolio constructed from using the ETF mentioned above. It is intended to act as a template for investors. Investors need to adjust accordingly based on their own risk tolerance and investment horizon.

Conservative ETF Portfolio with Long Term Investment Horizon

ETF Ticker   %
SP500 SPDR ETFs SPY 30%
Barclays US 20 + Year Treasury Bond TLT 20%
iShares iBoxx $ Investment Grade Corporate Bond LQD 20%
iShares Floating Rate Note Fund FLOT 15%
Barclays US 7 – 10 Years US Government Bond ETF IEF 10%

In the above conservative portfolio although SPY is the largest single ETF at 30%. The returns of the remainder 70% of the portfolio will be driven by fixed income providing a relatively safe cushion for future income. It can be useful for some investors to include dividend ETFs in the portfolio to replace some of the bond ETFs allocation.

Conservative ETF portfolio with Short Term Investment Timeframe

ETF Ticker   %
Barclays US 7 – 10 Years US Government Bond ETF IEF 30%
iShares Floating Rate Note Fund FLOT 20%
iShares Barclays 1-3 Year Treasury Bond Fund SHY 10%
iShares Barclays 1-3 Year Credit Bond Fund CSJ 20%
Barclays US 20 + Year Treasury Bond TLT 5%
iShares iBoxx $ Investment Grade Corporate Bond LQD 7.50%
S&P500 SPDR ETFs SPY 7.50%

As investment time horizon decreases so should allocation to the stock ETFs. The above conservative ETF portfolio returns is primarily driven by income from government and corporate bonds.

Additional ETFs that can be included in the conservative portfolio

Emerging Market Debt ETFs – for income focused investors higher up in the risk profile

Some of the Best Inverse ETFs can hedge a portfolio – depending on investor comfort in using hedges.

Investors that are conscious of inflations can use commodity ETFs to hedge inflation risks.