Beginner's Portfolio: Using Optimization And Momentum Tools With A 10 ETF Portfolio

by: Lowell Herr

The following portfolio is built around ten equity ETFs using a portfolio optimizer combined with a momentum indicator. No bonds are part of this portfolio as volatility is controlled by employing the ITA Risk Reduction model and the momentum tool, explained below. Momentum strategies are not new to Seeking Alpha readers. Here are a few recent articles on this subject and one PDF file.

The core of the portfolio is built around Vanguard's Total Market Index ETF, VTI. If one is a TD Ameritrade client, all but one (NYSEARCA:DBC) of the ETFs can be traded commission free. Other discount brokers provide similar services.

Efficient Frontier: To initially start the construction process I selected shares for each of the ten equity ETFs that one might find in an average portfolio. Round lots were used in most cases. In the following efficient frontier graph the diamond dot is the Return/Volatility position for the current portfolio and the red dot is the optimized portfolio given the constraints placed on both asset classes and individual ETFs.

ETF Rankings: While the ten ETFs provide global exposure the choice of ETFs definitely has a bias toward value vs. growth. In fact no growth ETFs are included in this basic portfolio. Were one to double the number of ETFs to twenty, growth ETFs would be included. Right now the growth ETFs do not rank as high as value ETFs.

In the following ranking or momentum tool, 50% of the weight is tied to performance over the last three months. A weight of 30% is assigned to performance over the past six months and a weight of 20% is allocated to volatility. We are looking for strong performing ETFs with minimum volatility. The highest ranking ETF in this portfolio of ten is VOE.

This momentum/volatility tool is used in combination with a portfolio optimizer to come up with a recommended asset allocation.

Buy-Hold-Sell Ranking Filter: Buy, Hold, and Sell recommendations are provided in the following ranking filter. For example, the optimizer recommends adding 72 shares of VOE as the number one momentum ranking ETF. The picture is less clear for VNQ, the domestic real estate ETF. The optimizer recommends selling 232 shares, but as the second ranking momentum ETF, a Buy is signaled. A judgment call is required by the money manager of this portfolio as to what to do with VNQ. One option is to set several sell limit orders in an effort to work VNQ toward the goal of holding around 100 shares.

Similar conflicts show up on the sell side with VEU, VWO, and DBC. VWO and DBC involve smaller amounts of money and can easily be neglected for that reason. VEU is a completely different situation as the optimizer is calling for an addition 433 shares so as to improve the Return/Volatility ratio. However, as the 8th ranking ETF the momentum indicator is calling for a Sell. Once more the money manager needs to make a judgment call. One might set limit orders to purchase several round lots over an extended time frame hoping the momentum picture changes and VEU improves performance.

The optimization and momentum tools are being tested with several portfolios on the ITA Wealth Management blog.

Disclosure: I am long VTI, VTV, VOE, VBR, IWN, VEU, VWO, VNQ, RWX, DBC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.