Sunday, May 4, 2014

Some Tools for Do-It-Yourself Portfolio Managers

By Barbara Friedberg May 2, 2014 2:33 PM
Are you tired of the complicated investing strategies in the media?
Are you confused by the myriad of fund choices?

What if you were to learn that the majority of funds are really irrelevant?
Exchange traded-funds burst on the investing scene less than 20 years ago and continue to command center stage. Simply, an ETF is an investment fund traded on a stock exchange. Although the ETF is similar to a mutual fund and comprised of many individual investments such as stocks, bonds or both, unlike a traditional mutual fund you can buy its shares throughout the day on major stock exchanges. Its price is close to the net asset value, or NAV, or value of the underlying securities.
What's so great about ETFs? If they are similar to a mutual fund, why wouldn't an investor just invest in a mutual fund? ETFs usually sport lower fees than mutual funds and offer greater flexibility. In addition to trading throughout the day, they can also be shorted, bought on margin, or purchased in small amounts.
Why choose an ETF index fund. Index fund investing has become one of the leading investing strategies. This approach recommends that instead of trying to beat the market by choosing an active fund manager (or buying individual stocks and bonds oneself), that the investor is better off buying into the major stock indexes and settling for a market-matching strategy.
The reason for the popularity of the index fund approach is decades of research, most recently a 2014 study by Christopher B. Philips, Frances M. Kinniyr, Todd Schlanger, and Joshua M. Hirt, "The Case for Index Fund Investing," for Vanguard, suggesting the futility of attempting to outperform the indexes. Sure, one brilliant fund manager might beat the Standard & Poor's 500 index one year, or maybe even three or four in a row. But in all known cases, the outperformance stops and the manager underperforms in subsequent years.
ETFs started offering index funds about 20 years ago and have since branched out into various other types of funds.

The research stands, that investing with a diversified portfolio of index will outperform active fund managers over the long haul. But can you have a diversified enough portfolio with just five ETFs?

5 ETFs for a diversified long-term portfolio. How do you decide which ETFs to choose? Harry Markowitz, the Nobel Prize-winning father of modern portfolio theory, explained in his efficient market hypothesis that all investors should choose the same diversified risky portfolio. This risky portfolio would include a combination of stocks and bonds chosen to give the investor the greatest return for the least amount of risk.

Next, the investor adds a risk-free asset, such as a Treasury bill or inflation-protected bond fund to balance out the volatility of the risky portfolio.
Taking a bit of license with this theory, I suggest choosing several diversified (risky) stock and bond funds and one diversified risk-free cash or low-duration bond fund.

Next step, figure out the percent of your portfolio allocated to the risk-free fund depending upon your aversion to risk and possibly your proximity to retirement. Let's assume you're in your 50s and facing the gun barrel of retirement and lack the tolerance for much volatility in value of your portfolio.

You may choose 50 percent in the risk-free asset and 50 percent divided up among the risky assets.
Top 5 ETFs. Culled from Morningstar's "ETF Analysts' Favorites," I've narrowed down the list to my top five. When completing their choices Morningstar analysts considered factors such as expenses, index construction, tax efficiency and diversification.

Fund Name Category Market Return YTD % Market Return 3-year Avg. Avg. Market Return # of Holdings Assets in Top 10% Expense Ratio % Comments
Vanguard Total Stock Market ETF LB 1.1 14 $37,211 3704 14.1 0.05 The quintessential core domestic-stock holding.
Vanguard Small Cap ETF SB -0.24 13.01 $2,773 1477 3.09 0.1 Low fees but extends higher up the market cap ladder than rivals.
Vanguard FTSE All-World ex-US ETF FB 0.18 3.22 $29,469 2410 9 0.15 A low-cost, foreign diversifier with 25% in emerging markets.
Vanguard Total Bond ETF CI 2.51 3.63 -- 15949 5.59 0.1 Low-cost option for tracking BarCap Aggregate Index.
iShares TIPS Bond IP 3.32 3.18 -- 38 44.95 0.2 Protects against inflation, but rising interest rates could still hurt.
1. Vanguard Total Stock Market ETF: As Morningstar so elegantly stated, this ETF is "the quintessential core domestic-stock holding." The reason this is such an optimal core holding is that it diversifies beyond the S&P 500 index and includes smaller capitalization companies as well. It's an ideal proxy for the entire U.S. stock market and has a rock-bottom expense ratio of 0.05 percent.
2. Vanguard Small-Cap ETF: Although the efficient market hypothesis states it's tough to outsmart the market, there has been research that over very long periods of time, small-capitalization stocks have outperformed the market. This is easily explainable due to the fact that it's easier to compound growth on a small base of revenues than for a huge company. This particular fund is somewhat broader than its peers and includes larger "small-caps." This might make it a less conservative small-cap option.
3. Vanguard FTSE All-World ex-US ETF: We live in an interconnected global society. If you include international investments in your portfolio then you'll participate in the growth of both U.S. companies and those from around the world. This type of global stock fund broadens your portfolios diversification at a low cost.
4. Vanguard Total Bond Market ETF: Bonds reduce a portfolio's volatility and correlates less with the movements of stocks. In sum, when stock prices decline, holding a percent of your assets in bonds will shore up your overall portfolio value. This fund covers the entire U.S. bond market, a great choice for one-stop bond shopping.

5. iShares TIPS Bond: This bond fund will protect against inflation as Treasury Inflation-Protected Securities (TIPS) returns are pegged to inflation.
Does fund family matter? Although four of the top recommended ETFs were from the Vanguard fund family, there are comparable funds from other fund families as well. I am not suggesting that
Vanguard has the best offerings, but to give an example of a diversified, low-cost, ETF portfolio. If you have an account with another discount broker with comparable funds, there's no particular magic in sticking with one fund family. There are many good ETF choices from a variety of fund families.

In sum, the fund family is of minor importance.
Personal disclosure: I own or have owned in my personal portfolio or the professional portfolios I manage each ETF except the Vanguard Total Bond Market ETF.
Barbara Friedberg, MBA, MS, is a portfolio manager, consultant, website CEO and author of "How to Get Rich; Wealth Building Guide for the Financially Illiterate." Learn more about money and pick up her newest free investing book at Barbara Friedberg Personal

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