Model ETF Portfolio Strategy and Management

ETFs allows investors to build a model portfolio in just a number simple of steps. Before building a portfolio using ETFs, investors first need to develop a portfolio strategy which is a road map for how the investor will achieve the returns that meet their goals. Effective strategies of portfolio management ensure that investment returns are commensurate with the risk of underlying assets. There are a number of steps in portfolio strategy development. However it the goal is not to create comprehensive rules that cover every aspect of money management. Instead it is a set of principles that outline the basic thesis and philosophy towards creating and managing assets. The principals are not something that is developed, fired and forget. It should be something that needs to be periodically reviewed and updated based on changing circumstances.

Using ETFs is one of the most cost effective ways of getting the asset exposure beyond the core component of the portfolio.

Investors should outline an Investment policy (example) which states the goal, risk tolerance and time horizon of the investment process.  Investment policy in contracts to investment principals determines the above in a more detailed fashion. For example on the issue of liquidity, it will list any major liquidity events in the near future so that proportion of investments in illiquid assets will be taken into consideration.

The last thing the investor need is to sell into an illiquid market, where the bid volume is insufficient. If the portfolio is significant in size, using ETF in the portfolio would avoid the liquidity cost of buying and selling of the underlying assets. The daily volume is not only the good days, but also on previous days where the overall market has seen significant declines. If leverage is used, then margin calls of equities could occur. To meet the margin calls, either the investor could add more funds or sell existing assets. If investors are not able to meet margin calls, they would be selling their existing investments at the worst possible time. Therefore the liquidity of assets as well as the nature of liquidity should be factors taken into consideration of portfolio allocation process.

Investment policy also establishes overall risk tolerance where specific exposures such as international equity like Japan or different asset classes like oil.

Once the investment policy is outlined, the next step is asset allocation.

ETF Allocation in Portfolios

Once the investment policy is developed, the next step calls for the allocation of the portfolio over various asset classes. The selection of asset allocation between equities, fixed income and other alternative assets such as commodities or currencies depends on the needs of the individual investor. This is why the investment policy should first be developed, thus asset allocation builds on the first stage in determining what is appropriate for the investor. An asset specific ETFs (such as REIT ETFs) would allow investors to gain exposure to the asset class relatively quickly.

Portfolio allocation examines the determination of asset allocation across various asset classes. It is a form of diversification on the macro level. For example, once total proportion of the portfolio for equity is established. Stock portfolio diversification includes spreading the equity investments across numerous industry sectors.

Diversified ETF Portfolio

Investors can also choose asset allocation between underlying assets or through ETF to gain exposure to that asset class (difference between mutual fund and exchange traded fund). For example, if a portion of the portfolio allocation is to equities. The choice the investor has is to invest in a benchmark ETF or get exposure to equities through manage your own stock portfolio.

This is where the notion of diversification comes in. By using ETF in the portfolio, investors gain diversification in the overall portfolio level on two levels. First by allocating funds across asset classes, it ensures that the portfolio is exposed to a number of asset markets. More importantly, investment is a business of managing risk, more so than returns. Hence by allocating across different asset class, it will cushion the portfolio from adverse market conditions in one particular market.

For example, there is a well-established relationship between bonds and stock returns. Stocks usually outperform bonds during the uptick and mature stage of the economic cycle. However when the economy is slowing down towards the end of the economic cycle, the Fed in response lowers interest rates. Lower interest rates are a positive for bond performance relatively to equities.

Investors also gain additional level of diversification allocation portion of portfolio to ETFs. This ensures that capturing the market beta – the return of the market is a core component of the portfolio.

If investors allocate funds to non-listed funds such fixed income and alternative investments, the standard deviation of the portfolio and underlying volatility can be deceptive as the mark to market frequency will be lower. However the underlying assets are seeing the same volatility as listed equivalent ETF.

The only certainty in the market is uncertainty. A diversified portfolio is one of the most important tents of the investment management. A diversified portfolio minimizes inherent risks that are part of every asset.

For effective implement the idea of diversification, the important factor to note is the level of correlation between the asset returns. If you have assets that are correlated, then you might as well just own the asset alone. Hence, the usefulness of highly correlated assets is limited in a well-diversified portfolio.

The question remaining is to determine the level of diversification. The down side of diversification is the greater number of assets owned, the more research one needs and the expected return and risk of the portfolio would approach market return and risk. Therefore for individuals, the level of benefits diversification up to a point would be decreasing return, where it would just be as good in owning an index tracker.

The optimal level for a stock portfolio should be 15 – 20 stocks with additional ETF allocation. At this level, you can still track the names in your portfolio and the companies’ development without sacrificing flexibility, overwhelmed by information and research needs.

If your portfolio is focused on fixed income, the above applies as well. Even more so, the focus is spreading the credit risk across various sectors and credit ratings, from junk bonds to BBB to AA. Owning a spectrum of the credit curve would insulate the damage from inevitable defaults. However for risk adverse investors, returns can be sacrificed for security by focusing on investment grade level bonds. As bonds are harder to own, most diversification can be attained from a bond fund. Make sure the fee levels are reasonable since high fee structure could erode most of the fixed income returns.

Portfolio Construction

Allocation and diversification are important requirements in the continual process of portfolio management. The construction phase focuses on how the allocation positions are built up overtime. The emphasis of portfolio construction is on the speed of reaching the desired size of the assets in the portfolio. This idea can be applied to either fund invested asset classes or individual stocks. Once research and amount to be invested has been decided, this step seeks a balance between buying too soon, missing investment opportunities or selling to low.

One method in the construction of the portfolio is to step into a full position over time. The exact time frame between purchases of each portion is more of art than science. Just like diversification reduces portfolio risk across various assets. Stepping buying positions 1/2s or 1/3s at a time, depending on the direction of the ETF reduces chance of losses if the stock has not bottomed. Inversely, if you are chasing a market then the level of aggressiveness in adding to full position depends on the length of the rally so far. The argument for caution is that there are always opportunities to make money. In this business, you get ahead by not losing it.

The stepped approach can also applied to selling positions as well. This similarly depends on the momentum, and outlook of the position. If the market has reached beyond your target price, then you could let go 1/3 if the positive sentiment is set to continue. If the target is aggressive then I would not hesitate to let go 2/3 or the whole position.

Stepping into positions is a framework of portfolio construction. How you use it depends on personal preference, approach towards risk and market environment. We do not recommend using inverse ETFs as a long term position in the portfolio.

Portfolio Performance

The stages of strategy development, research and asset allocation are just the beginning steps of the ongoing portfolio management process. Portfolio performance review is the feedback process to ensure that the assumptions made in the previous stages are acting as predicted in action.

RelatedHow do ETF pay dividends?

Passive ETFs returns should not deviate from the benchmark significantly. Active ETFs performance should be reviewed based on the timeline of the investment horizon. Returns that deviate significantly from the benchmark should be investigated in detail. This applies to over as well as under performance. If an asset class outperforms its benchmark significantly, you could be taking excessive risk beyond tolerance outlined in the investment policy. The difficulty part is to separate the aspects of the performance between genuine investment skill of the manager or excessive risk taken.

If the portfolio is under performing, the question should be asked is that has there been significant change in the underlying thesis of the invested assets, changes in the asset management team or a dislocation between the invested assets in the portfolio with those that constitute the benchmark. It is important to emphasis here that it is fine for invested assets to deviate from constituents of the benchmark, if based on research the alternatives are more attractive.

The difference between the portfolio’s performance and the outset benchmark is called tracking error. As noted previously, it is important to compare the tracking error over the investment horizon rather than quarter to quarter basis.

ETF Portfolio Rebalancing

Portfolio performance is the analysis of the investment progress according to existing plan. Portfolio re balancing is the process of adjusting positions based on the previous performance. Some Smart ETF auto rebalance based on pre defined mandate.

The rebalancing process seeks to adjust the overall composition of the portfolio towards the desired asset allocation portions outlined in the previously developed investment strategy. The goal is to ensure that the composition of the portfolio overtime is appropriate for the investor.

The two primary aspect of portfolio rebalancing is addressing the issue of what to do with ETFs that grew beyond their desired weighting and under performance leading to underweight certain asset classes. If over weighting is attributed to strong returns of a specific asset classes, rebalancing calls for either selling or send funds to the underweight ETFs or maintain the overweight. The action taken would depend on the future outlook of the asset, if the view is that returns are mean reverting and it has a poor outlook. Then it is obvious in this instance you would be selling the winner and buying the loser.

The options from selling the overweight portion of the portfolio are either reinvesting in the under performed asset or leave in cash to wait for new opportunities. The course of action depends on the trade of between the existing options with the associated margin of safety and the option of holding cash to enable to take advantage of opportunities in the near future. The course of action would depend on specific circumstances, the investor based on previous experience and skill will perfect the decision making process overtime.

Portfolio Optimization

Portfolio management is a continual process. Diversification, performance measurement, and rebalancing are parts of a circular process. Portfolio optimization is a continual of monitoring the actual performance with the original expectations. Overtime by continual optimization, issues that were not foreseen such as overestimated correlated returns between assets or higher/low expected risk of particular assets could be addressed.

The goal of optimization is the practice of balancing between risk and returns. It is important to examine the investment periodically. By being aware of what you’re investing and its progress, you could avoid pitfalls of unexpected losses. Also by knowing what you’re invested in, you could avoid the error of selling assets during market downturns. Hence optimization is a positive feedback loop that enhances your long term performance.

Some good sources to keep up with the latest research in portfolio management to continue to develop portfolio management skill.