Investing with Styles Can Pay off

Portfolio construction consists of the following steps

• Decide personal risk profile which determines the target allocation in risk assets.
• Decide asset allocation method: strategic or tactical or both (strategic does not change target asset allocations while tactical can alter allocations more actively)
• Decide target allocation for each asset in a strategic asset allocation
• Periodically rebalancing portfolios

For a portfolio using strategic asset allocation, with long term target allocation being fixed (and only changed when major events such as approaching to retirement and children college education spending, for example), one can further enhance a portfolio return and reduce the risk by rebalancing and fund selection in an asset class. It is reported that adopting proper timing and way to rebalance a portfolio can improve return and reduce risk (see Daryanani opportunitstic rebalancing article).  In this article, we focus on fund selection.

In most retirement or well designed portfolios, it is a popular practice to have funds with various style exposures. In a stock/equity asset, a fund style is defined as value style (growth/blend/value) and size style (large/mid/small cap). The Morningstar 9 boxes of styles are essentially the combinations of the 3 value and 3 size styles. In a fixed income asset, a fund style is a combination of credit risk (junk/investment grade) and interest rate risk (short/intermediate/long) for corporate bonds or a just interest rate risk for treasury bonds.  In an actively managed portfolio, it is a well recognized and widely practiced method to select funds based on style rotation to improve a portfolio alpha or return. For example, in an article published in Journal of Asset Management (May, 2007), B. Arshanapalli , L. Switzer and K. Panju concluded that active multi-style rotation strategies can be devised to outperform the best performing buy-and-hold portfolio.

MyPlanIQ maintains an index fund based plan or an ETF based plan using candidate funds based on those in a lazy portfolio proposed by Fund Advice Paul Merriman and maintained by MarketWatch.com (called Fund Advice Ultimate Buy and Hold Portfolio) (see here for the independently tracked portfolio on MyPlanIQ.com). The candidate funds and the original allocation are as follows

Index	ETF	Allocation
Vanguard Interm-Tm Trs (VFITX)	iShares 3-7 Year Treasury (IEI)	20%
Vanguard Short-Tm Trs(VFISX)	iShares 3-7 Year Treasury (SHY)	12%
Vanguard Intl Val (VTRIX)	iShares MSCI EAFE Value Index (EFV)	12%
Vanguard Dev Mkts (VDMIX)	iShares MSCI EAFE Index (EFA)	12%
Vanguard Inflation-Prot (VIPSX)	iShares TIPS Bond (TIP)	8%
Vanguard Small-Cap Idx (NAESX)	iShares Russell 2000 Index (IWM)	6%
Vanguard Small-Cap Val (VISVX)	iShares Russell 2000 Value Index (IWN)	6%
Vanguard Value Idx (VIVAX)	iShares Russell 3000 Value Index (IWW)	6%
Vanguard 500 Index (VFINX)	SPDR S&P 500 (SPY)	6%
Vanguard Emerging Mkt (VEIEX)	iSharess Emerging Market Stock (EEM)	6%
Vanguard REIT Idx (VGSIX)	iShares Dow Jones REIT Index (IYR)	6%

The funds cover five asset classes: U.S. Equity, International Equity, Emerging Mkt Equity, U.S. REIT and Fixed Income. They have various style exposures for U.S. stock market (equity), International Stocks and Fixed income.

MyPlanIQ Strategic Asset Allocation (SAA) selects funds with the best risk adjusted returns for each asset class when rebalancing.  The following table compares the Strategic Asset Allocation (SAA) moderate portfolios in both index fund and ETF plans as well as the original portfolio (both MyPlanIQ SAA moderate portfolios have 40% allocation in fixed income). We also include the strategic asset allocation moderate portfolio in MyPlanIQ Five Core Asset ETF Plan that consists one fund for each asset class.

As of 7/2/2010

Portfolio	1 Yr Return	3 Yr Return	5 Yr Return	Since 12/2000
FundAdvice SAA Moderate Index Funds	17%	-1.0%	5.1%	7.4%
FundAdvice SAA Moderate ETF	16.7%	-2.2%	4.8%	7%
FundAdvice Buy and Hold Index Funds	14.5%	-2.4%	4.1%	5.7%
Five Core SAA Moderate	16.9%	-3.4%	3.93%	5.6%

From the above table, we can observe:

• Diversified into styles improves return (FundAdvice Buy and Hold vs. Five Core SAA Moderate).
• Style rotation adds 1.3-1.7% returns over buy and hold (SAA Moderate ETF or Index Funds vs. FundAdvice Buy and Hold).

The above observations are consistent across thousands of plans MyPlanIQ maintains. We should also point out that better fund/style selection does not alter the overall portfolio risk allocation, which is a major advantage over an actively managed tactical asset allocation portfolio.

At the moment, for U.S. stocks, MyPlanIQ SAA favors small cap (IWM), small cap value (IWN). For fixed income, it favors Inflation-protected treasury (TIP).

ETF Selection in CNBC Diversified Global Core Model Portfolio

CNBC reporter Bob Pisani asked three ETF experts--Matt Hougan from IndexUniverse, Tom Lydon from ETF Trends, and Jim Lowell -- to assemble several different Model ETF Portfolios. They came up with six Model ETF Portfolios, all reflecting different sentiments on the direction of stocks and the global economy.This plan is based on the ETFs in their Diversified Global Core portfolio. The portfolios went live on May 19, 2010.
In this article,  we discuss the ETFs selected for this portfolio and how they are compared against a standard five core asset portfolio.
The following funds in the original CNBC Diversified Global Core portfolio cover five major asset classes tilted to some narrower themes:

• US Equity: iShares Russell 3000 (IWV) for U.S. large cap.
• Foreign Equity: Vanguard FTSE All-World ex-US ETF (VEU) for developed country stocks
• Emerging Market: SPDR S&P China (GXC) for Chinese stocks
• Commodities: PowerShares DB Commodity Idx Trking Fund (DBC) for broad base commodities
• Fixed Income: Vanguard Total Bond Market (BND) for broad base U.S. bonds, iShares iBoxx $ Invest Grade Corp Bond (LQD) for U.S. investment grade corporate bonds and SPDR Lehman Intl Treasury Bond (BWX) for international bonds
• Alternative: PowerShares DB G10 Currency Harvest (DBV) for carry trade based currency trading to hedge against U.S. dollar depreciation.

Looking closely at the ETFs, one can make the following observations:

• US Equity: a specific focus on large cap instead of a broad base index fund such as Vanguard Total Stock Market (VTI).
• Emerging Market: focus on China instead of broad base emerging market stock index fund such as Vanguard Emerging Market Index (VWO) or EEM.
• Fixed Income: in addition to Total Bond Market Index (BND), it has specific focus on long term corporate investment grade bond index (LQD). Moreover,  allocating in International Treasury Bond (BWX) is a hedge against U.S. dollar depreciation.
• Alternative: PowerShares DB G10 Currency Harvest (DBV) is a carry trade based ETF that takes long positions in the three currencies with highest interest rates and short positions in the three with lowest interest rates.  In general, carry trade does well in good economic periods but could perform poorly in a sudden economic and market slump, as evidenced in 2008.  Notice also the average daily trading volume of DBV is less 150,000, making it a less desirable key asset holding.

Based on the candidate funds mentioned above, we created a plan that generates both Strategic and Tactical Asset Allocation model portfolios. The following is a comparison between the CNBC core portfolio and the model portfolios using SAA (Strategic Asset Allocation) or TAA (Tactical Asset Allocation) since the beginning of 2008.

	2008	2009	2010	1 Year	Inception
CNBC Global Diversified Core Portfolio	-28.6	28.6	-2.15	16.16	-4.25
Strategic Asset Allocation Growth	-31.2	30.38	-3.14	11.42	-5.57
Tactical Asset Allocation Growth	1.83	12.12	-2.85	11.59	4.29

Compared with the CNBC Portfolio, currently, the Tactical Asset Allocation Growth model portfolio has 30% in LQD, 43% in IWV and 27% in BND. It is quite defensive as this portfolio’s target allocation in risky assets is 80%.
The portfolio's narrower focus makes it less a 'core' portfolio but more like an 'active' portfolio. Moreover, we believe that using carry trade based currency DBV, though serves the purpose of hedging against US dollar depreciation, is not necessary. For example, both commodities and international bonds have negative correlation with US dollar value.
In our opinion, average investors are better served with a portfolio of major assets with enough liquidity. MyPlanIQ has created a Five Core Asset Index Funds Commodity ETF plan that has the following funds:

• US Equity: Vanguard Total Stock Market ETF (VTI)
• Foreign Equity: Vanguard FTSE All-world ex-US ETF (VEU)
• Emerging Market Equity: Vanguard Emerging Market Index (VWO)
• Commodity: PowerShares Commodities Index (DBC)
• US Fixed Income: Vanguard Total Bond Market Index (BND)

The following is a comparison between the Tactical Asset Allocation (TAA) growth model portfolios for both CNBC and the above Five Core Asset plan (for comparison purpose, we also include the original CNBC Core portfolio).

	2008	2009	2010	1 Year	Inception
CNBC Global Diversified Core Portfolio	-28.6	28.6	-2.15	16.16	-4.25
CNBC Tactical Asset Allocation Growth	1.83	12.12	-2.85	11.59	4.29
Five Core Asset Tactical Asset Allocation Growth	-3.7	24.88	-1.8	18.52	6.97

Even though the above comparison is limited to the short history of portfolios due to some ETFs' short history,  one could still see that the Five Core Asset TAA portfolio outperforms the corresponding CNBC TAA one. This is consistent with what we demonstrated in the previous article: just using five or six most liquid assets in a portfolio based on the tactical asset allocation strategy enables one to achieve very respectable returns.
In conclusion, CNBC Diversified Global Core ETF portfolio indeed has a diverse coverage on key assets. Investors could still simplify and be better served with just broad base index funds for major assets.

Usable, Understandable For 401K Asset Allocation

For many, achieving good investment returns is an arcane art for the gifted few. An exclusive club of magicians weave their spells and works their magic with new members appearing from time to time. It's our place to cross their palms with silver to get the benefit of their potions.

In a previous article building a simple portfolio was discussed. This moves this art towards a science that is open to all, because the SIB Portfolio allows us to create a benchmark based on asset allocation. This can be used to compare against other plans and give some measure of the funds available.

Five asset classes are chosen based on well proven academic research and practical proof:

• US Equity
  
• Developed Market Equity
  
• Emerging Market Equity
  
• Real Estate Investment Trust (REITs)
  

• Fixed Income

The claim of asset allocation is that over 90% of the returns are derived from the asset classes and not the selection of the funds themselves. So that if you select the funds that represent the right asset classes from your 401K, you will get better returns than chasing after the highest performing funds from the last 1, 2, or 3 years.

To demonstrate the point, MyPlanIQ created a series of portfolios derived from asset allocation strategies, risk profile and Vanguard index funds for each of the five asset classes.

Table 1 shows the funds available for the SIB portfolios. The mix of the funds will be driven by the risk profile of the individual and the asset strategy selected.

Asset Class	Symbol	Vanguard Name
US Equity	VTSMX	Total Stock Market Index
Developed Market Equity	VGTSX	Total Intl Stock Index
Emerging Market Equity	VEIEX	Emerging Market Stock Index
Real Estate	VGSIX	REIT Index
Fixed Income	VBMFX	Total Bond Market Index

Nothing complex, just a simple portfolio derived from funds that are easy to understand and can serve as a simple benchmark against which more complex (and expensive) portfolios can be measured.

For SAA, the assets were first split into fixed income and risky assets. This split was dictated by the risk profile (fixed income 20% growth, 40% moderate, 60% conservative). Then allocation of risky assets is made equally and there is periodic rebalancing to ensure that the portfolio remains with the correct ratios.

For TAA, the assets were also split into fixed income and risky assets based on the risk profile. However, the allocation of the assets will vary based on economic conditions. In essence, when one asset class is not performing well (for example, emerging markets in a time of financial uncertainty), there will be a shift to other asset classes.

Historical simulations were run for six portfolios:

Table 2 shows the performance of the SIB portfolios based on the risk profile and asset allocation strategy

Strategic Asset Allocation	1Yr AR	1Yr Sharpe	3Yr AR	3Yr Sharpe	5Yr AR	5Yr Sharpe
Five Core Asset Index Funds Strategic Asset Allocation Growth	43%	233%	1%	-0%	9%	31%
Five Core Asset Index Funds Strategic Asset Allocation Moderate	33%	236%	3%	8%	8%	38%
Five Core Asset Index Funds Strategic Asset Allocation Conservative	25%	275%	4%	24%	7%	52%

 

Tactical Asset Allocation	1Yr AR	1Yr Sharpe	3Yr AR	3Yr Sharpe	5Yr AR	5Yr Sharpe
Five Core Asset Index Funds Tactical Asset Allocation Growth	38%	224%	13%	85%	18%	120%
Five Core Asset Index Funds Tactical Asset Allocation Moderate	30%	241%	11%	97%	15%	127%
Five Core Asset Index Funds Tactical Asset Allocation Conservative	22%	267%	9%	112%	11%	140%

The first thing of note is that the simple portfolios perform very well - demonstrating that asset allocation is key to success. The second thing of note is that tactical asset allocation consistently gives better performance in the long run.

When applying this to a 401K plan, you may have limited choices of funds in each category so that you may not be able to achieve the best of all possible performance - but even with sub-optimal funds, by picking the right asset classes, you should be able to improve your returns.

When I checked my own 401K plan, for which I did what most people did - pick a few funds at random and hope - I have achieved a five year return of 5.19%. If I had used TAA applied to the plan funds I would have seen a return of 10.74% -- remember that an additional 6% a year over a decade will double your retirement money.

Key takeaways:

• Improving your returns is not that difficult - you can understand it and drive it - even with limited choices in your plan, you can do better without having to spend hours learning some secret art - compare your current results with what the SIB portfolios achieved.
  
• TAA has consistently outperformed SAA. More on TAA. More on SAA.
  

• Superior fund selection will return 1-2% extra - for free. More on SIB fund selection.

In future articles, we will start comparing specific 401K plans against the SIB portfolio and derive a league table of best and worst of breed.

labels:investment,ETF, 401K

Symbols: VTSMX , VGTSX, VEIEX, VGSIX, VBMFX,

David Swensen's Six Asset Investment Plan

David Swensen, the Yale Endowment Manager, proposed this one size fit in all model portfolio for individual investors. The major difference between this portfolio and other conventional portfolios is that it emphasizes international equities (including emerging market equities) as well as real estate investment. Compared with various diversified portfolios, an interesting asset class missing is the commodities, which has been considered to be an excellent anti-inflation diversifier. This is complemented with its emphasis on the inflation-protected treasury bonds. In the model portfolio constructed, we assume annual rebalance although Swensen actually pointed out that in Yale's institutional portfolio, they rebalanced daily, which, by his estimate, gave about 1-2% of excessive returns vs. annual rebalancing.

Compared with the Simpler Is Better (SIB) portfolios we discussed in the previous article, Swensen excluded commodities while putting emphasis on using fixed income for the purposes of inflation protection and portfolio hedging. Since commodities ETFs and index funds are still problematic (see this article), Swensen's six assets are the most investable assets.

Note: it has been confusing whether Swensen advocated using long term treasury bonds or just an average duration treasury bonds. In his book Unconventional Success: A Fundamental Approach to Personal Investment, he wrote "The purity of noncallable, long-term, default-free Treasury bonds provides the most powerful diversification to investor portfolios". Based on this sentence, it has been interpreted that he meant to use the long term treasury bond. However, recently, a reader posted a reply from David Swensen on this question in morningstar.com that indicates the average duration of treasury bonds.

The portfolio consists of the following:

• 30% in Vanguard Total Stock Market Index (VTSMX or Vanguard ETF VTI)
  
• 20% in Vanguard REIT Index (VGSIX or Vanguard ETF VNQ)
  
• 20% in Vanguard Total International Stock (VGTSX) or (15% in VGTSX or Vanguard ETF VEU and 5% in VEIEX or Vanguard ETF VWO)
  
• 15% in Vanguard Inflation Protected Securities (VIPSX or iShares Tip TIP)
  
• 15% in Vanguard Long Term Treasury Index (VUSTX or iShares TLT or Vanguard ETF EDV)

We have constructed both index fund based and ETF based plans using the above funds. Model portfolios using MyPlanIQ Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA) are generated. The following compares the Swensen's portfolio with SAA moderate and TAA moderate model portfolios.  Since the ETF based plan has shorter history, we present here the index fund based portfolios.



SAA moderate model portfolio differs from Swensen's portfolio in both its target allocation and rebalancing frequency. SAA moderate is equally weighted among risky assets US Equity, International and Emerging Market Equity. It rebalances monthly whenever an asset weight deviates 20% from the target weight. The Swensen's rebalances annually.  This, along with the proper selection between VIPSX and VUSTX in the fixed income portion, contributes to the outperformance over the Swensen's portfolio.

TAA has the best performance as it used asset momentum to rotate out of risky equity assets and avoided big loss in 2008 and early 2009. The following table shows its performance from 12/31/2000 to 6/7/2010.

	2001	2002	2003	2004	2005	2006	2007	2008	2009	2010	1 Yr	3 Yr	5 Yr	Inception
Annualized Return (%)	3.31	8.28	24.48	13.65	12.99	15.49	19	-4.49	18.69	-1.66	16.56	7.72	11.2	11.32
Sharpe Ratio (%)	19.32	116.15	353.29	136.95	139.2	126.87	123.7	-72.15	147.98	-10.34	107.23	55.36	84.95	103.24

In conclusion, David Swensen's six assets are the most investable core assets with which main stream asset allocation strategies can be used to achieve reasonable investment results.

Selecting Candidate ETFs for Effective Portfolio Construction

Selecting the right funds in a portfolio strategy is critical for both self-directed investors and administrators of retirement plans such as 401(k) and IRAs. Working with too few funds limits diversification benefits and limits opportunities. On the other hand, too many funds can be confusing and misleading. Getting the right mix is especially important in a retirement plan as participants have a wide range of differing requirements and demands that will drive their financial planning.  For ETF investors,  the ever increasing number of ETFs (the latest tally is $782 billion asset in 810 funds) only exacerbates this problem. 

MyPlanIQ has developed guidelines for providing the optimal investment choices for an ETF based plan or a portfolio. The following are the key criteria to consider when making such choices.

Diversification

Candidate funds should cover major asset classes at least. We consider the following the major classes.

• US Equity
• Developed Country Equity (ex. US)
• Emerging Market Equity
• Real Estate Investment Trusts (REITs, most US)
• Commodities
• Fixed Income

For global investors, we add Foreign Fixed Income as another major asset. Minor assets and styles are also possible candidates if strategies employed handle them effectively. We do not advocate going down to sector or industry levels since their volatile and concentrated nature defeats the diversification purpose

Fund Qualities

Since most ETFs are index funds, the following should be used to select an ETF.

• Liquidity: The minimum requirement should be at least 250K daily average volume in last 3 months – exclude ETFs with low trading volume. The other major factor to consider is the total net asset an ETF is held. In general, we would prefer at least $1 billion asset for a major ETF.
• Tracking error: how closely it tracks its stated index benchmark.  Price/Nav discount/premium and bid-ask spreads are two important factors to consider here. In general, for two ETFs that have the same stated index benchmark, the one has tracks the benchmark more closely should be picked.  
• Fee: all things equal, low expense fee is a key advantage for a long term portfolio. Vanguard ETFs and index funds have set high standard/bars for other ETFs to measure up to.
• Return: again, all things equal, return is another factor to use to distinguish ETFs.

Portfolio Building

In addition, it is critical to see how these selected funds work with each other. For example, consider the following two choices: US Equity, Emerging Market Equity and Fixed Income vs. US Equity, Developed Country Equity and Fixed Income. How would these asset classes work together? How would the actual funds behave when putting them together? MyPlanIQ uses a proprietary method to perform historical simulation to evaluate portfolio effectiveness.


Let’s try to select candidate ETFs for a simple core portfolio that consists of 6 key major assets mentioned above. We will build two funds – the one we think is the best and compare it with the most popular in each asset class.

US Equity: there are plenty choices here. The first comes to mind is the Wilshire 5000 Total Return index. Claymore launched an ETF (WFVK) to track this index in March 2010. However, since this is a fairly new ETF, its trading volume is light and thus is excluded. The other venerable index would be Vanguard Total Stock Market Index ETF (VTI). Its average daily trading volume in the past 3 months is more than 2 million shares. Another choice is the oldest and most popular S&P 500 ETF: SPDR SP 500 (SPY). This is the most liquid ETF and it has the least bid-ask spread. It has more than 200 million shares change hands daily. SPY, however, is a large cap index, not a broad base index. We prefer VTI over SPY.

Developed Market Equity: MSCI EAFE index (EFA) and Vanguard FTSE All-World ex-US ETF (VEU) are the two candidates. Vanguard Total World Stock (VT) is a one for all equity ETF that covers all of three equity asset classes (U.S. Developed and Emerging Markets). We prefer VEU over EFA, considering the low expense Vanguard charges for VEU.

Emerging Market Equity: iShares MSCI Emerging Market Index (EEM) and Vanguard Emerging Market Equity (VWO) are the two candidates. Matt Hougan from IndexUniverse and others have written several articles discussing both ETFs. Again, Vanguard VWO is clearly a winner after taking cost into account.

Real Estate Investment Truse (REITs): Dow Jones U.S. Real Estate Investment Trusts (IYR) is the most popular while iShares Cohen & Steer Realty Majors (ICF) is more concentrated on major REITs. Vanguard REIT Index ETF (VNQ) has the lowest expense, wide diversification and high trading volume. VNQ is clearly the choice here.

Commodities: Powershares DB Commodity Index ETF (DBC) and iShares S&P GSCI Commodity Index (GSG) are the two main choices. It is interesting to see that DBC has higher expense (1.3%) than GSG (0.75%) while GSG is more concentrated on energy commodities (74% vs. 55%). In general, DBC is more balanced though GSG has wider exposure among many commodities. This article has some more detailed writeup on the comparison between the two ETFs. DBC, though not as diversified as GSG, is more balanced in major commodities. We prefer DBC.

Fixed Income: for a broad base fixed income exposure, iShares Barclays (Lehman) Aggregate Bond (AGG ) and Vanguard Total Bond Market (BND) are the clear two candidates. With its lower expense cost (0.11%), BND is better than AGG (0.2% expense). This article compares the two ETFs in more detail.

MyPlanIQ has created two plans for the core portfolios. The candidate funds for Six Core Asset ETFs Most Popular are chosen  based on their popularity (history and liquidity). The candidate funds for the other plan Six Core Asset ETFs are chosen  based on more detailed criteria outlined above. The following table shows the selections of the two plans:

	Six Core Asset ETFs	Six Core Asset ETFs Most Popular
US Equity	VTI	SPY
Developed Market Equity	VEU	EFA
Emerging Market Equity	VWO	EEM
REITs	VNQ	IYR
Commodities	DBC	DBC
Fixed Income	BND	AGG

The following table shows the performance of model portfolios: one Strategic Asset Allocation (SAA) Moderate and one Tactical Asset Allocation (TAA) Moderate portfolio are chosen for each plan.

	1 Year Annualized Return	1 Year Sharpe Ratio	3 Year Annualized Return	3 Year Sharpe Ratio	5 Year Annualized Return	5 Year Sharpe Ratio
Six Core SAA Moderate	17%	116%	2%	5%	7%	32%
Six Core Most Popular SAA Moderate	13%	88%	-2%	-15%	5%	17%
Six Core TAA Moderate	18%	116%	12%	82%	16%	102%
Six Core Most Popular TAA Moderate	17%	99%	10%	64%	13%	89%

From the above table, one could clearly see that the selection of candidate funds for constructing a portfolio plays an important role in portfolio returns. The 2-3% difference of annualized returns in the past 5 years between the two corresponding portfolios is striking. It clearly shows that it pays to put more efforts in selecting funds.

The impressive performance of Six Core Asset ETFs supports the maxim ‘simpler is better’.

ETFs for 401K Portfolio Building

ETFs have become increasingly popular in taxable or self-directed IRA portfolios. A flurry of  introducing commission free ETFs will only accelerate ETF. There is another less visible but significant move to make ETFs a staple in traditional company sponsored retirement plans such as the 2.7 trillion 401(k) sector.

iShares (recently acquired by BlackRock) established iShares401k.com to promote ETFs within the 401(k) industry. Two vendors AdvisorETF401k and Ascensus have signed up to provide iShares ETFs for 401(k) plans.

It is interesting to note that Ascensus provides an aggregate ETF trading platform for participants. Based on a document on the Ascensue web site, "All trades submitted for the day for each ETF on the Ascensus platform will receive the same average share price. The average share price is calculated based on the market price received for actual shares traded plus the fees noted below. This method allows for automation of trades, which minimizes trading costs, and enables participants to own whole and fractional shares of ETFs." That certainly makes ETF trading more like traditional mutual fund end of day settlement.

Sungard provides an ETF 401(k) platform also allows late day processing for ETFs: i.e. ETFs trades are treated as mutual funds and they are settled using market close prices at 4pm EST. This restriction/feature is arguable but certainly makes ETFs more like long term portfolio building elements instead of intra-day trading vehicles. The other salient feature for Sungard's solution is that it allows participants to hole fractional ETF shares, much like mutual funds. This is very important for small accounts, which are typical in retirement 401(k) accounts.

Interested readers are referred to MyPlanIQ's iShares ETFs plan to see how these ETFs could be used in constructing a portfolio. There are a total of 187 iShares ETFs that cover major asset classes including US Equity (various Russell 1000, 2000, 3000 ETFs including IWF, IWB, IWD, IWZ, IWV, IWW, IWP, IWS, IWO, IWM, IWN, IWC, IWR and S&P large/mid and small cap ETFs), Foreign Equity (EFA, SCZ, ACWX), Emerging Market Equity (EEM), Real Estate (IYR and various foreign REITs such as IFGL) and US Fixed Income (AGG and many well known bond funds such as TLT, IEF, SHY, TIP, MBS, MUB, LQD, CFT, CSJ, HYG) and foreign bonds (EMB, IGOV). As in Vanguard's ETFs, the only major asset class missing is commodities. That, however, is a major asset class not covered by traditional mutual funds in most 401(k) plans anyway.

Another noticeable ETF 401(k) provider is ShareBuilder401K whose goal is low cost. It is sponsored jointly by ING Direct and ShareBuilder, a discount brokerage. Costco recently launched a Costco ShareBuilder 401k plan that has become popular among small businesses. The ShareBuilder401K consists of 15 ETFs. One noticeable major asset missing is Real Estate Investment Trusts (REITs). It would also be improved with more coverage on asset classes such as fixed income and foreign bonds. MyPlanIQ has constructed a plan to help participants in ShareBuilder401K in portfolio building. Both iShares ETFs plan and ShareBuilder 401K Plan have shown that it is possible to achieve very reasonable performance if proper portfolio strategies such as the Strategic Asset Allocation and Tactical Asset Allocation strategies provided by MyPlanIQ are used.

In an effective retirement plan using mutual funds or separately managed accounts, the key factors to select candidate funds in a plan are low cost, quality of funds and quality of diversification. With ETFs, low cost is a standout factor but it still varies from one ETF to another. The uality of funds include how close those ETFs track their intended benchmarks (so called tracking errors), liquidity and bid-ask spread (trading friction). The quality of diversification or coverage is about how many major and minor asset classes are covered by the candidate funds, as discussed above. A follow up article will give more detail on how to construct and rate a good ETF plan.

Tom Lydon has written several good articles on ETFs in 401(k) such as this and this. In addition, IndexUniverse.com has done excellent coverage on this topic such as this article.

Commission-free ETFs Enable Portfolio Building Using Asset Allocation Strategies

The latest Vanguard announcement on offering all the company's 46 ETF trades commission free marks a new era for ETFs. In our opinion, with trading costs removed, ETFs are now a viable alternative to index and actively managed mutual funds in portfolio building and asset allocation.
Three brokerage firms, Vanguard, Fidelity and Schwab, have announced commission-free ETFs. Let's first compare them in the following table:

Asset Classes	Sub Asset Classes	Vanguard	Fidelity	Schwab
US Equity	Large Cap	MGC, MGK, MGV, VTI,VTV, VUG, VXF,VV,VIG, VYM	IWD, IVV, IWB, IWV, IVW, IWF,IVE	SCHB, SCHX, SCHG, SCHV
US Equity	Mid Cap	VO, VOT, VOE	IJJ, IJH, IJK
US Equity	Small Cap	VB, VBK, VBR	IJS, IWN, IJR, IWM, IJT, IWO	SCHA
Foreign Equity		VT, VEU, VSS,VEA,VGK,VPL	EFA, ACWI, SCZ	SCHF, SCHC
Emerging Mkt Equity		VWO	EEM	SCHE
REIT		VNQ
US Fixed Income	Treasury Government	VGSH, VGIT, VGLT, EDV, VMBS	TIP, MUB
US Fixed Income	Corporate	VCSH, VCIT, VCLT	LQD
US Fixed Income	General	BSV, BIV, BLV, BND	AGG
Intl Fixed Income		N/A	EMB
Sectors		VPU, VOX, VAW, VGT, VIS, VHT, VFH, VDE, VDC, VCR

From the table, one could see that Vanguard commission free ETFs covers most of major and minor asset classes. Schwab, on the other hand, offers limited coverage. Schwab's ETFs have relatively short history but,  given Schwab's reputable mutual funds, one would expect these ETFs would offer competitive performance compared with iShares and Vanguard's ETFs.  Among all of the offerings, asset class foreign bonds and commodities are noticeably missing. From diversification point of view, we would like to see those asset classes are covered. 
The significance of commission free ETFs should not be understated: periodically rebalancing of a portfolio using strategic asset allocation is now free and at will, no more redemption and round trip charge (though we are not advocating frequent trading), no more lockup period and various fund classes (remember those class A, B, C, D, Y, Z  shares?).
Commission free ETFs make very good instruments for constructing a portfolio using a good tactical asset allocation strategy. Remember academic research keeps reminding people of the trading cost? It is gone. Now, one could build an ETF based portfolio using some of best tactical asset allocation strategies. For example, on MyPlanIQ.com, it offers a Vanguard ETFs plan that has several model portfolios based on Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA). The following table shows the comparable performance among VBINX (Vanguard Balance Fund Index, a 60% stock and 40% bond portfolio), SAA moderate portfolio and TAA moderate portfolio.
The following illustrates the performance comparison among TAA, SAA and VBINX.



The performance comparison is as follows:

	1 yr AR	1 yr Sharpe	3 Yr AR	3 YR Sharpe	5 YR AR	5 YR Sharpe
Vanguard ETF TAA (P_16707)	27%	1.8	11.6%	0.74	15.6%	1.01
Vanguard ETF SAA (P_15214)	30%	2.06	5%	0.2	10%	0.46
Vanguard Balance Fund Index (VBINX)	18.1%	1.7	-1.75%	-0.15	3.4%	0.11

Commission free ETFs are not free of problems. The major remaining issue is the trade friction or so called bid and ask spread: with an index mutual fund, one has no such a problem. This problem is exacerbated by low volumes for some ETFs. Care should be still given for those ETFs. We expect, however, the growing volume and popularity of ETFs will eventually make these problems less serious. 

We applaud the recent industry moves and are looking forward to more such moves to make them completely free.  We believe this represents a significant step forward to further level play fields between retail investors and professional investors.