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The New Global ETF Investor - back to Contents >
Chapter 4:
ETF Portfolio Basics
Recap
We have come a long way together, understanding how the investment business has evolved in the last 30 years and learning about the powerful advantages of putting together a portfolio using iShares and other ETFs. Using ETFs as your core investment tool is the third of Chartwell’s seven investment edge principles that will increase the likelihood of reaching your long-term investment goals.
Bottom Line Investment Edge
Principle#3
Use ETFs as your core investment tool in building your global portfolio.
This chapter describes more investment edge principles you need to build your ETF global portfolio. These principles will help you select the most appropriate blend of ETFs, closed- end funds, and other investments given your time frame, appetite for risk, financial goals and personality.
Our overriding goal is to identify and put in practice a strategy that tilts the odds of long-term investment success in your favor. In the end, it is your money and your call but Chartwell can help you pull it together and execute a plan.
The Importance of Asset Allocation
Asset allocation is the process of deciding how you will distribute your investment resources over the different asset classes. For example, how much will you invest in large companies, small companies, bonds, cash, international, real estate, growth or value companies.
Numerous academic studies have shown that over a period of 10 years or so, asset allocation, not stock picking or market timing, accounts for more than 90% of the variance in investment performance. This is because different asset classes move in different ways in various stages of the economic cycle. Some asset classes may be out of favor for years, some are more affected by changes in interest rates, the value of the U.S. dollar, commodity prices or a slowdown in the economy. If you have all your money in one or two of these baskets you might win big or suffer greatly. To balance risk and return, most investors intuitively choose to spread their money over a variety of asset classes.
Keep in mind that your asset allocation decisions should be tied to your investment objectives. Is your primary goal capital growth, preservation of capital or income? Your overall goal should be to put the odds of achieving your objective in your favor; of getting more return than risk for your investable dollar. This is obviously easier said than done.
For the vast majority of investors, the key goal should be consistency. If your portfolio is up 10% three years in a row and then suffers a 10% decline in year four, your average annual return drops to 4.6%. A good analogy might be to a professional golfer. They realize that scores of 68, 72, 69 and 76 rarely win a major tournament. Far better to score four 69s or four 70s which might be good enough for a victory.
The Key Issue: Conservative Core vs. Satellite Growth
Before deciding on an appropriate asset allocation strategy, investors must confront the key issue of distinguishing between their core portfolio and their growth portfolio. This, apart from using ETFs as the primary investment tool, is perhaps the most distinguishing characteristic of the Chartwell approach.
Most investors and financial advisors will look at your investments as one pool of money and will struggle to decide how to allocate these resources. The reason it is such a struggle is that investors know intuitively that their money is not all the same. For some of it, capital preservation is the primary goal and any real growth, a bonus. For some of it, they are willing to take on greater risk for the chance of higher rewards. They, actually, have two portfolios whether they realize it or not.
Chartwell recognizes this crucial distinction and builds its model portfolios around it. The Conservative Core Model Portfolio is for the portion of an investor’s portfolio that has, as its primary goal, preservation of capital and secondarily, capital growth. It is well diversified, has substantial allocations to fixed income, high dividend paying and value-oriented equities and exposure to asset classes that are likely to appreciate if stocks decline. The other five model portfolios have as their goal, capital growth and represent the risk capital of the investor. The Conservative Core Model Portfolio is at the center, the capital growth model portfolios are satellites around it.
Let’s look at a snapshot of the characteristics of the Core Conservative versus the Capital Growth model portfolios.
Conservative Core Model Portfolio
- primary goal of capital preservation, secondary goal of capital growth
- value approach and highly diversified
- goal of consistent performance and somewhat of a defensive posture
Capital Growth Satellite Model Portfolios
- primary goal of capital growth
- value approach but more focused and less diversified
- accepts more cyclical performance and takes offensive posture
Case Studies in Asset Allocation
To illustrate these distinctions and to help you separate your own investment resources, let’s look at how four hypothetical individuals and families made their choices.
Jim and Susan
Background:
Jim and Susan are married in their mid-thirties with two young children. They have a combined income of $85,000 and total savings of $155,000. Both have life insurance policies with a face value of $1 million. Outside of a $120,000 mortgage on a home appraised at $190,000, they are debt free.
Personality and Psychological Outlook:
Jim is fairly conservative and wary of the markets while Susan is more optimistic that with a good strategy, they can build considerable wealth over the next twenty years. Susan plans to go back to work when the kids are in school full time and she views this as a fallback if markets under perform her expectations. Jim is willing to meet Susan halfway.
Decision:
Of their total savings of $155,000, they decide to allocate $95,000 to Conservative Core Model Portfolio and $60,000 spread over three capital growth satellite model portfolios.
Evelyn
Background:
Evelyn is a retired 68 year old living in an assisted living complex. She was as teacher for 35 years and her pension, social security and long- term care insurance will more than cover her living expenses. She has $900,000 in savings partly derived from the proceeds of a life insurance policy. She has three grown up children all of whom are financially independent. Her main interest is pre-school education and she would like to financially support worthy college student at a local university specializing in this area.
Personality and Psychological Outlook:
Evelyn is more than comfortable with her financial situation and feels fortunate to have this ample nest egg. Her first priority is to leave a sizable gift for her children but she is keenly interested in making a lasting impact at the local university.
Decision:
Evelyn decides to set aside $200,000 for each child invested 75% in Core Conservative Model Portfolio and 25% in the capital growth model portfolios. An additional $100,000 will be kept in a liquid money market and bond fund for any personal contingencies that might arise. The remaining $200,000 will be dedicated to a scholarship fund at the local university with 50% invested in Core Conservative and 50% spread equally across the capital growth model portfolios.
Ann and Stuart
Background:
Ann and Stuart are a healthy couple in their late 50’s. Their three children have completed college and are starting careers. Ann is enjoying her real estate job and plans to work part time for another 5-10 years. Stuart is a tenured business school professor and plans to work for three more years and then do some consulting. Their house is almost paid off and they have $450,000 in portfolio investments. Stuart has $600,000 and Ann has $400,000 of life insurance.
Personality and Psychological Outlook:
Ann and Stuart have been aggressive investors and suffered some sharp declines in their portfolios from 2001-2003. They have good liquidity and substantial earning power in their professions even if they work part time.
Ann is worried about the rapidly increasing costs of long term care and Jim believes that the US will be facing fierce global competition which he believes will lead to reduced profitability and lower stock prices over the next decade.
Decision:
First off, Ann and Stuart purchase a long-term care policy they can share if necessary. During the next five years, they will sell their home and move into a condo freeing up substantial capital. For the time being, they have decided to invest $150,000 in Treasuries, $150,000 in Conservative Core Model Portfolio and $150,000 in Global Opportunity Model Portfolio. They have also decided to adjust the holdings of the Global Value Model Portfolio by eliminating any exposure to emerging markets.
Paul
Background:
Paul is a single 27 year old working as an account executive for an advertising firm in Chicago. He loves his job but wants to be financially independent and hopes to start his own agency by age 40. Paul believes he can make globalization work for him by seeking multinational clients and investing in faster growing international markets. He is renting a downtown apartment but hopes to purchase a condo in the next few years. His savings total $75,000 and he has $10,000 in low interest student loans and $3,000 in credit card debt.
Personality and Psychological Outlook:
Paul is optimistic, exuberant, and entrepreneurial. He realizes that he needs to curb his enthusiasm somewhat when it comes to investing but wants to build wealth, not just protect it.
Decision:
After thinking it over, he decides to pay off all credit card debt, allocate $22,000 to Core Conservative Model Portfolio which he may use a a down payment for a condo in a few years. Of the remaining $50,000, Paul will pay off his student loan and invest $20,000 each in the Global Opportunity and Asian Opportunity Model Portfolios.
Bottom Line Investment Edge
Principle #4
Separate your core portfolio from your capital growth portfolios.
Value vs. Growth
The value versus growth debate is a seemingly endless and inconclusive debate over investment style and historical data. While both styles of investing share the objective of capital appreciation, there are many differences in approach.
Growth investors buy companies and funds based on the expectations that profits will rise fast and perhaps faster than the market anticipates. The valuation and price of the fund or stock is weighed relative to the expected growth rate.
Value investors primarily seek companies that are selling at prices less than their value based on earnings, dividends, book value or cash flow. A low price relative to value is the overriding consideration. The second step is to wait for the company to improve its performance and for the market to reflect the value of the company in its stock price.
The value and growth styles tend to come in and out of favor based on performance. In the short term, it is impossible to predict which will perform better. In the long term, most studies of historical data have concluded that a value approach has yielded better returns and presents other benefits to investors.
Think of it this way. If you go to a carnival, you may ride the roller coaster. You will move rapidly up and down at high speeds but after a while you will have had enough and want to get off. It is also difficult to get off at the top. This may be viewed as an extreme version of pure growth investing.
Next you head to the steam engine train with your kids. It is certainly a slower ride with less ups and downs but you move steadily towards your destination. You could ride this train all day long.
An analogy in the sports world would be the debate over which is more important: the passing or running game. The passing game can be explosive and a team can score quickly. The running game takes more time but you have more control over the clock, probably less turnovers plus more consistency. A solid running game also sets the stage for and opens up the opportunities for the passing attack. No matter how talented, a team that passes all day is unlikely to win the Super Bowl.
You can see that the debate is not just over the performance numbers or logic. It is a reflection of our personalities and psychological outlook. The problem is that investing by emotions, either fear or greed, is a dangerous game and unlikely to deliver superior long-term results. Most investors need to be, to some degree protected from themselves.
This emotional equation underlines why value will likely beat growth over the long haul. By their nature, growth stocks have a premium price which reflect their anticipated superior growth prospects. Sometimes it works out and sometimes even better than expected but just as often, results will be disappointing and hit stock value hard. With value investing, your goal is a price discount relative to earnings or assets and therefore, you have less downside risk. The value investor patiently waits for the stock to be fairly valued or over valued.
I believe that investors should lead decisively with the value approach particularly with their core portfolio where capital preservation is a key goal. Building more growth-oriented portfolios around your core makes sense as well, as long as you realize that it represents risk capital and you can stomach the greater volatility.
Here is the reasoning behind our recommendation for leading with the value approach:
Value investing over the log haul lowers your portfolio risk and volatility relative to pure growth strategies. This should increase the likelihood that you will stay with your plan rather than bail out during tough times or try to time the market.
The value approach tends to lower trading costs due to the relatively longer holding periods and lower turnover.
The third benefit based on market history should be performance numbers and more consistency over the long term. The logic of buying companies at low prices relative to their value is compelling.
Large Company vs. Smaller Company
The large company versus smaller company debate is one of the important yet least understood issues by independent investors. By and large, most investors believe that large companies present more attractive investment opportunities and pose less risk than smaller companies.
How true is this? Well, if by risk one means the chances of the company going out of business, then this is likely to be true. But, if by risk one means the risk/reward ratio comparing the potential reward of capital appreciation weighed against the risk of capital loss, then it is an open question at best.
Think about it. Would you rather have $10,000 in one so-called blue chip company like Merck or $1,000 invested in each of ten smaller companies representing good value and high growth prospects? Which portfolio is more risky? Which portfolio has more potential to build wealth and independence? I know I would choose the ten smaller companies. A tougher question is, would you choose ten large companies or ten smaller companies? Many of you are probably thinking that a blend of large and smaller companies would be the best.
Companies are usually segmented in terms of size by their market capitalization. It sounds complicated but is quite simple. Market capitalization is current stock price times the number of shares outstanding. For example, if the price of a stock is $20 and there are 10 million shares outstanding, the market cap is $200 million. Today, this would be considered a micro cap stock. The largest company in the U.S. , in terms of market cap, is GE at about $300 billion.
The generally accepted breakdown is as follows: a market cap of $1 billion or less is a small cap company, $1 billion to $10 billion is a mid cap company and over $10 billion a large cap company. Of the 10,000 publicly traded U.S. companies, 9,000 have market caps below $1 billion. Why would you want to exclude all of these companies as potential investments?
A well-diversified portfolio should have a healthy dose of small and mid cap companies. Many investors think they have a diversified portfolio but when they come in for a portfolio review, it is oftentimes six different large company growth mutual funds. It is not the number of funds in your portfolio but rather how they blend together to reduce portfolio volatility and increase consistency.
Read any small cap mutual fund prospectus and you will find an outline of the particular risks of small cap investing; mainly, the potential for greater volatility and lower trading liquidity. These are legitimate concerns but must be weighed against the potential for impressive capital gains buttressed by the historical record. From 1926-1993, The S&P 500 average annual return was 10.3% while the small and mid cap indices averaged 11.66%. This difference, compounded over thirty years would result in roughly 40% more money.
Furthermore, there are steps you can take to reduce and manage the perceived risk in small cap investing. First, you could take a value approach to small cap investing thereby reducing your risk by buying only smaller companies trading at a discount to their intrinsic value. Finding value in the small cap universe of companies is easier than with large companies because they tend to be overlooked and neglected by Wall Street analysts. Second, instead of buying a few smaller companies you could buy thousands of them. One idea is to buy the iShares Russell 2000 which tracks the smallest 2000 companies in the Russell 3000 index. If instead, you buy the iShares Russell 3000, only 8% of your investment will go to these 2000 companies.
Bottom Line Investment Edge
Principle #5
Be careful with just investing in broad based index funds or ETFs. Look under the hood to see where your money is going and be wary of too much concentration of risk.
Market Timing vs. Fully Invested
When I bring up the topic of market timing in seminars, investors immediately think of day traders trying to turn a profitable trade by lunch. This is a type of market timing but more commonplace is investors trying to guess whether the overall market is going to go up or down by reading and listening to pundits or “trusting their gut”.
What is Market Timing?
Market timing is the frequent buying and selling of securities or funds with the intent of buying low near the troughs and selling high near the peaks. The investor tries to anticipate price movements through technical, macro or fundamental analysis.
The Cost of Market Timing
Legendary investors such as Peter Lynch, the former portfolio manager of Fidelity’s Magellen Fund think this is a waste of time. Moving in and out of the market is the primary reason why according to a recent Dalbar study, the average investor earned a paltry 2.6% annualized gain between 1984 and 2002 compared to 12% for the S&P 500.
The reason is that research shows that 80%-90% of equity returns occurred in spurts that represent about 5% of holding time. If you missed just 40 of the best performing days of the S&P index during the 1990’s, you would have earned only a 6% average annual return versus 18% if you had stayed fully invested. This is big money!
Basing Market Timing Decisions on Emotions
Getting out of the market is easy, deciding when to get back in painful. Driven by emotion rather than logic, most investors buy and sell at precisely the wrong time in the investment cycle. When do they sell? When a bear market lowers share prices to a point when they start to get attractive. When do they buy? When stocks have moved sharply upward and are perhaps overvalued. Stay out of this trap!
It Can be Risky Not to Invest
While “safer” investments such as cash or money market funds can protect you at times from market declines, they have also led to disappointing long-term returns.
According to Ibbotson Associates, cash (Treasury Bills) has beaten stocks and bonds in only 12 of the past 77 years.
$1 invested from 1926 through 2000 grew to $17.48 if invested in T-bills but to $1,775 if invested in the S&P 500.
Being in cash or money markets may lead to missing the beginning of a bull market. A Ned Davis Research study of bull markets over the past 70 years showed average Dow Jones Industrial Average (DJIA) returns of 43.6% during first half of a bull market compared to 16.8% during the second half of a bull market.
What is being Fully Invested and an Exception to the Rule
Being fully invested does not mean never selling a security or fund. It is normal and wise to adjust to circumstances by rebalancing and reallocating assets in your portfolio. However, moving sharply from a portfolio of equities to an all cash position should be a rare occurrence. One reason might be a strong conviction that equity markets are way overvalued. Even in this case, it is probably smarter to keep a small position in equities, a sizable fixed income position and consider asset classes that are negatively correlated to stocks.
Bottom Line Investment Edge
Principle #6
Stay as fully invested as possible and don’t try to time the market. Build suitable global core and capital growth portfolios and stick with them making only marginal changes along the way.
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