The Downside to Broad-based ETFs as Core Holdings

Roger Nusbaum submits: There were a couple of comments on my ETF portfolio post that expressed preference for broad based ETFs as the core of their portfolio. Obviously this is valid but not ideal for me.

It might be worthwhile to explore the down side, if there really is one, for the broad based products. First, how much of a portfolio is the core? I don't really construct portfolios this way, but I think the amount that is core is very subjective so I'll just pick 50%.

Maybe the core could be three funds as follows:

iShares Russell 1000 (IWB) 15%
iShares S&P 600 Small Cap Value (IJS) 15%
PowerShares Intl Div (PID) 20% -- this is the first foreign DVY

OK, now what?

Well given my belief in gold as a diversifier I would want some GLD as a permanent fixture as well. How much though? I have in the neighborhood of 3% in gold. I have read other opinions that suggest 5-10%. How about 5% for easier math?

So now 55% of the portfolio is allocated.

I am a firm believer in emerging markets as an asset class that should always have some weight in a portfolio. For me, 7% is equal weight but let's just go with 5% for now.

At this point we are up to 60% of the portfolio allocated.

A reasonable idea might be to select a couple of sectors that should do well in the current environment. Today that could mean staples, health and utilities? So perhaps 5% in an ETF for each? Or should it be 10% in each? This, for me, is where problems start to occur. The various sector weightings can get out of whack in a hurry. The decision made right here will result in being very overweight some sectors and very underweight others.

Utilities make up 3.4% of the S&P 500. The 15% allocation to IWB gives you 1.1% overall in utilities, IJS gives another 1.2% overall to utilities, PID gives another 1.8% overall. At this point you are already overweight an interest rate sensitive sector at a time that the middle of the curve could start to go up and hurt prices in the sector. Adding even 5% to a utilities ETF becomes a big bet and I haven't even looked at the emerging market ETF to check for utilities.

Would you add a single country ETF? Many of them are heavy in financials. It is likely you will end up very overweight that sector. The number of portfolios I look at that are unknowingly 30% weighted to financials is very high.

I find it much easier to think of the 10 sectors that make up the market and then to build each sector with the best proxies for those sectors that I can find. Sticking with ETFs (though not my preference for portfolios) and the financial sector it seems easier to start with a sector ETF for a big chunk of the exposure. If you want 15% in financials (this is an underweight) you could put 8% of your portfolio in something like the Financial Sector SPDR (XLF). Perhaps 2% of the portfolio could go into one of the capital markets ETFs and the rest of the sector can come from specialized ETFs. EWA (personal holding) has 47% in financials, iShares Canada has 33% in financials and EEM has 19% in financials.

To me this seems like an easier way to build a portfolio. This can also be an easier way to build in style, yield and beta and average cap size can be managed at the margin with a mega cap ETF like Rydex' XLG or a micro cap ETF like the iShares fund, IWC.

Let the debate begin.