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’.