Today’s low-return environment requires a low-cost solution to portfolio construction. Exchange traded funds (ETFs) are the modern investment vehicle making portfolio construction cheap and simple. With them you gain or shed exposure to broad market indices, particular sectors, geographical regions, certain commodities, and even specific rules based strategies.
ETFs are equally useful as a core portfolio holding or part of a tactical weighting. In the simplest case you can construct a core portfolio utilizing only two ETFs. For example, with 60% allocated to the Vanguard Total Stock Market and 40% allocated to the Vanguard Total Bond Market ETFs you will create a totally diversified traditional 60/40 portfolio.
Once-a-year rebalancing would be the total of all portfolio management decisions ever needed, in my opinion. Management fees are effectively cut to less than 0.20%.
However, as many studies have concluded, the traditional 60/40 stock bond portfolio no longer delivers the best risk-adjusted returns over time. Many strategists suggest adding real estate, commodities, foreign securities and other asset classes to the modern portfolio. All of this is easily accomplished utilizing various ETFs from the several thousand available.
Today, effective ETF selection requires portfolios attuned to top down macro-economic trends. I believe that pairing the foreseeable consequences of economic trends with bottom-up ETF analysis results in effective security selection. The process is much like that of single-security portfolio managers. But using ETFs, which are baskets of securities, rather than single securities, provides portfolio diversification. The downside is the potential for over diversification and a resulting lack of performance.
In my view, in order to create additional value using ETFs, it is necessary to limit the amount of widely diversified ETFs to a portion of the overall portfolio. I suggest that this portion be 60% and be composed of broad indices such as the S&P Large, Mid and Small cap indices. The proportions of each index may be adjusted to account for individual preferences with regard to portfolio volatility. Larger capitalization stocks in the S&P 500 are less volatile than the Mid Cap 400 or the Small Cap 600. But over the longer term smaller capitalization companies provide higher returns.
In addition, I think the makeup of these core holdings should account for the existing age of the market and economic cycle. During late stage bull markets smaller capitalization stocks are the earliest casualties. Therefore, a tactical approach to core holdings would be to pare back holdings of smaller stock ETFs adding the proceeds to holdings of the larger cap ETFs when markets are extended and conditions call for an prolonged decline in prices. This would leave the core 60% of your portfolio fully invested at all times, avoiding the temptation to time the market.
The other 40% of your portfolio could be invested in specific targeted ETFs designed to take advantage of top down trends. This portion of your portfolio might not always be fully invested, but on occasion hold a significant amount of cash. Using portfolio management techniques espoused by Gerald Loeb this portion of your portfolio will add alpha while cushioning your investments against the volatility of today’s markets.
Management of the tactical portion of your portfolio will follow these rules. The 40% allocated to tactical methods will be divided into eight separate amounts each representing 5% of your total portfolio. Each pool will be invested in a separate ETF representing a different investment idea. Once fully invested no new idea may be purchased until an existing one is sold. The number of tactical holdings will be limited to eight. No new idea may be substituted for one currently held unless its potential benefit is greater than that of a current position. This assures your capital is always concentrated in the best potential investments. Capital commitment to any one idea is limited to 5% in order to limit potential losses to the portfolio. Should one of these ideas fall 20% in value overall portfolio loss is limited to 1%.
The intention is to hold investments until the key or “Ruling” reason for purchase is no longer valid. At that point the position is sold and proceeds are held in cash until a suitable replacement is found. In extended markets, none may be available leaving you in cash at high points in the market cycle.
I believe that tactical investing can add greatly to your returns over time. It requires portfolio management discipline and bottom up analysis of your investment ideas. Analysis includes scrutiny of the details of a prospective ETF investment. You should know the basic facts. Is it an Exchange Traded Fund (ETF) or Exchange Traded Note (ETN)? What are its top holdings? How old is the fund? How does it perform against its index. What are its management costs? Is it liquid? This information is relatively easy to obtain. Much is found at sites such as etfdb.com or Morningstar or the web page of the fund’s issuer.
While top-down thinking provides the area for investment the bottom-up analysis identifies the best investment vehicle for your capital.
A recent example is the sharp bottoming and recovery of oil prices. That event provided investors with several opportunities. One was investment directly in large cap energy companies using the SPDR Energy Fund. The other was buying the iShares High Yield Bond fund which holds the debt of many smaller energy companies. The selection of either or both ETFs depended on your investment preference.
Combining the investment discipline of Gerald Loeb’s methods with observation of current events and your own bottom-up analysis will continue to provide timely ideas for the tactical portion of your portfolio. And combining the passive indexing of the majority of your portfolio with active management of its tactical portion provides you with an effective answer to the question of how to invest now. One that works any time in any market, in my view.
ABOUT THE AUTHOR
CJ Brott is Chairman of Capital Ideas, an investment adviser and Portfolio Manager of the Capital Ideas Macro Plus Income portfolio on Covestor, an online investing marketplace where investors can copy the trades of experienced investors. CJ has more than 45 years of investing experience and lectures on financial topics at Southern Methodist University.