Risk-embracing investors tend to increase exposure to equities as an asset class. Many advisors recommend being overweight on stocks during early stages of life (e.g. during one's twenties). Some even suggest that the allocation of one's portfolio to equities should be according to a formula "120-Age." In any case, since diversification is the only "free lunch on Wall St.," I have decided to construct an equity portfolio consisting of ETFs focused on various categories of stocks. In the portfolio, ETFs come from six distinct equity classes: Large-Cap, Mega-Cap, Micro-Cap, Mid-Cap, Multi-Cap, and Small-Cap.
There are a number of reasons why I chose classes by size instead of filtering by industry, geography, growth vs. value, stage of product development, etc. First of all, all "Caps" encompass companies from various industries, which provides for additional diversification and smoothening over the business cycle. Market timing becomes unnecessary. Secondly, some of the funds listed below include international equities and add geographical diversity. Essentially, the more different qualities an equity class can contain the better for covariance purposes. On the contrary, analyzing classes by sizes of their constituents allows investors to compare long-term growth rates and corresponding risks. Also, they may formulate hypotheses around these assertions and test them. Finally, there tend to be a lot more ETFs based on the sizes of equities that they include than for any other parameters. Hence, there is more room for choice and analysis.
As always, the funds included are those that have performed in the market since pre-crisis years (ideally, before 2007, although this year suffices as the inception year). This means that other ETFs that readers may consider more attractive and/or less risky are not looked at. In total, the portfolio holds 15 securities which is sufficient to eliminate non-market (idiosyncratic) risk almost entirely and is relatively cost-effective for medium-to-small-sized portfolios (i.e. transaction costs not exceeding $10 per trade). Historical data shows that expected returns for the constructed sample of portfolios are in the low-to-mid teens, while standard deviations (i.e. price risk) are in the mid-to-high teens. Let us proceed to the list of holdings and examine the output of the model.
This group includes 5 funds that hold equities of companies identified as large-cap public corporations. Hence, if equally weighted, one-third of the portfolio is exposed to this asset category.
First Trust IPOX-100 Index Fund (FPX)
The fund tracks performance of the IPOX-100 U.S. Index, which measures performance of the top 100 U.S. corporations quarterly. It has a beta of 1.01 and offers a dividend yield of 0.49%. Historically, it has had an average return of 17.6% on a standard deviation of 26.9%.
Guggenheim S&P 500 Pure Growth (RPG)
The ETF seeks to replicate the performance of the S&P 500 Pure Growth Index using passive investment strategy. It has a beta of 1.1 and offers a yield of 0.52%. It has returned 14.5% annually on average with a risk of 25.7%.
Guggenheim S&P 500 Equal Weight (RSP)
Formerly the Rydex S&P 500 Equal Weight, this ETF seeks to replicate as closely as possible, the daily performance of the S&P 500 Equal Weight Index. It has a beta of 1.17 and offers a dividend yield of 1.25%. Over the course of its existence, the fund has returned 13.52% on average with a risk to capital of 22.7%.
First Trust Value Line Dividend Index Fund (FVD)
First Trust Value Line Dividend Index Fund seeks investment results that correspond generally to the price and yield of an equity index called the Value Line Dividend Index. The fund has a beta of 0.85% and a dividend yield of 2.27%. Since inception, the security has returned 11.19% annually on average (excluding dividends) and has demonstrated a standard deviation of returns of 16.6%.
PowerShares Dynamic Lg. Cap Value (PWV)
PowerShares Dynamic Large Cap Value Portfolio seeks investment results that correspond generally to the price and yield of the Dynamic Large Cap Value Intellidex Index. It has a beta of 0.94 and currently yields 1.84%. Historically, the fund has shown performance of 11.56% excluding dividends and demonstrated risk of 15.9% on average.
This group includes 2 funds that have exhibited decent returns at modest risks among its peers.
SPDR Dow Jones Industrial Average (DIA)
SPDR Dow Jones Industrial Average ETF Trust, formerly Diamonds Trust, Series 1 is a unit investment, which issues securities called trust units or units. It seeks to provide investment results that, before expenses, generally correspond to the price and yields performance of the Dow Jones Industrial Average. The fund has a beta of 0.92 and offers a yield of 2.16%. Over the course of 13 years, it has shown a weighted-average return of 8.5% with a standard deviation of 17.6%.
Vanguard Mega Cap 300 Growth Index (MGK)
Vanguard Mega Cap Growth ETF, formerly Vanguard Mega Cap 300 Growth Index ETF, seeks to track the performance of a benchmark index that measures the investment return of the largest-capitalization growth stocks in the United States. The ETF has a beta of 0.97 and currently offers a dividend yield of 1.28%. Over the past six years, the fund has returned 13% annually (beware of the short-history bias) and has shown a risk of 22.5%.
This segment only includes one fund. I have not been able to find a sufficient number of ETFs according to this criterion that would also meet requirements, which I have set at the foundation of my analyses.
iShares Russell Microcap Index (IWC)
The Fund seeks investment results that correspond generally to the price and yield performance of the Russell Microcap Index (the Index). The Index measures the microcap sector of the United States equity market. The ETF holds equities that range from $50M to $550M in market capitalization. These companies represent 3% of total U.S. stock market. The fund has a beta of 1.27 and offers a yield of 0.98%. Historically, it has returned over 10% annually on average and has shown a standard deviation of 24.3%. In 2013, the fund returned over 36%, a significant alpha over the broader market.
This group of funds represents an investment in the market niche that consists of companies considered mid-cap (generally, $2B to $10B). There are three funds in this sector.
Guggenheim S&P MidCap 400 Pure Growth (RFG)
This ETF seeks to replicate as closely as possible the performance of the S&P MidCap 400 Pure Growth Index. The Index is narrow in focus, containing only those S&P MidCap 400 companies with strong growth characteristics as selected by S&P. The fund has a beta of 1.16 and yields 0.64% annually. Over the course of its existence in the market, it has returned 16.2% annually on average (highest on the list) with an average risk of 27%, 2nd highest in the portfolio.
Vanguard Extended Market (VXF)
Vanguard Extended Market ETF is an exchange-traded share class of Vanguard Extended Market Stock Index Fund, which employs a passive management or indexing investment approach designed to track the performance of the Standard & Poor's Completion Index, a diversified index of stocks of small and medium-sized United States companies. The fund has a beta of 1.18 and yields 1.11% annually. Over the last eleven years, the fund brought 14% a year on average at an annual risk of 25.3%.
iShares Morningstar Mid Growth Index (JKH)
The Fund seeks investment results that correspond generally to the price and yield performance of the Morningstar Mid Growth Index. The Growth Index measures the performance of stocks issued by mid-capitalization companies that have exhibited above-average growth characteristics as determined by Morningstar's index methodology. The ETF has a beta of 1.0 and currently yields 0.35% a year in dividends. Over the past nine years, the security has delivered 13.4% on average per year at an annual risk of 22.8%.
This fraction of the portfolio seeks returns from assorted equities, including both U.S. and international stocks. There is only one fund deemed worthy to be in the portfolio that has satisfied the necessary criteria. Although there is a number of long-term ETFs in this sector, most of them do not justify the risk that investors have to take to earn returns comparable with "safer" classes. Most of them in the group that I gathered have posted single-digit annual returns over the course of their lives, having forced investors to undergo risks exceeding 20%. I believe higher risk should lead to higher returns, not one-sided.
Guggenheim Insider Sentiment (NFO)
The fund invests at least 90% of its total assets in common stocks, ADRs and MLPs that comprise the index and depositary receipts representing common stocks included in the Sabrient Insider Sentiment Index. It generally invests in all of the securities comprising the index in proportion to their weightings in the index. The ETF has a dividend yield of 0.92% and a beta of 1.35. Since 2006, the fund has returned 14.1% per year on average and showed a risk of 27.2%. This is the highest return in the peer group at an above-average risk.
Small-cap stocks have historically posted the highest returns, although also have forced investors to undergo the highest levels of volatility. Small-caps play an important part of any investor's portfolio in that they bring a significant amount of capital appreciation at a fraction of total allocation. I have included three noteworthy funds in my list.
PowerShares FTSE RAFI U.S. 1500 Small-Mid (PRFZ)
The ETF seeks investment results that correspond generally to the price and yield of the FTSE RAFI U.S. 1500 Small-Mid Index. The Index comprises approximately 1,485 United States stocks. The Index is designed to track the performance of small and medium-sized United States companies. The fund has a beta of 1.4 (one of the highest on the list) and offers a dividend yield of 0.94%. The ETF has posted average annual gains of 15.7% (3rd highest on the list) at a corresponding standard deviation of 31.3% (highest in the list).
iShares Morningstar Small-Cap Growth (JKK)
The Fund seeks investment results that correspond generally to the price and yield performance of the Morningstar Small Growth Index. The Growth Index measures the performance of stocks issued by small-capitalization companies that have exhibited above-average growth characteristics as determined by Morningstar Inc.'s index methodology. Historically, the fund has returned in excess of 13% per year at annual risk of ~22%. The fund has a beta of 1.14 and offers a yield of 0.52%.
iShares S&P Small-Cap 600 Index (IJR)
The ETF seeks investment results that correspond generally to the price and yield performance of the Standard & Poor's Small-Cap 600 Index. The Index measures the performance of publicly traded securities in the small-capitalization sector of the United States equity market. The component stocks in the Index have a market capitalization between $300 million and $1 billion, and are selected for liquidity and industry group representation. The fund has delivered on average 13.1% a year since inception at a standard deviation of 21.6%. It has a beta of 1.17% and a dividend yield of 1.01%.
The following samples serve as examples of possible allocations given set expectations. Weights are assigned mathematically by the "Solver" function in Excel. Readers may download the model (linked above) and further explore the constraints I used specifically for each portfolio. As a rule of thumb, I generally limit short and long exposure to 5%-25%, depending on whether the solver can actually produce meaningful results. Typically, extremes such as Minimum Variance and Maximum Returns portfolios are purely theoretical and cannot be practically implemented due to regulations imposed by brokers (e.g. margin requirements, portfolio leverage, etc.). However, this updated edition of the Scenarios includes Maximum Beta Portfolio. I added the Maximum Dividend Portfolio to the table in my last article. Here, I wanted to test the hypothesis that higher beta leads to higher returns in the long run. However, at least in the selected sample, the higher beta portfolio yielded an insignificantly higher return (60+ bp) compared to the enhanced dividend portfolio, while significantly increasing risk (200+ bp). It also did poorly compared to a more balanced "5% to 15%" portfolio, which earned 30+bp extra at 10+ bp less risk. Overall, I incline towards either the enhanced dividend version or the more balanced "5% to 15%" portfolios on both the risk-minimized and return-maximized sides of the table.
The covariance matrix used for optimization is illustrated below for readers' reference:
Here are the risk/return profiles of the sample portfolios compared to the broader market (S&P 500):
All minimum-risk sample portfolios have shown much higher returns at considerably less risk. The Maximum-beta portfolio has historically demonstrated a marginally higher risk than S&P 500, but delivered a substantial alpha of approximately 400bp. All returns include current dividend yield. Readers should take a note of diversification ratios, which range from mid-70s to mid-80s across the table (the closer to zero the better). When compared to broader portfolios, such as those included in my previous article, they are a lot higher. This can be explained by the fact that portfolios in this instance are 100% equity versions. This suggests that investors who hold various uncorrelated asset classes tend to have better-diversified portfolios with reduced market risk with comparable returns (and sometimes even better returns depending on weights assigned to each class). It means that, although equities tend to perform better in the long run, investors should not be overweight on them, even the younger ones. Essentially, be open to opportunities across asset classes, geographies, industries, etc. After finding potentially profitable investments be sure to construct equally profitable portfolios of these investments, do not neglect this step.
In conclusion, I would like to remind readers that past results, including data for both risk and return, do not imply continuity. Even so, I believe that broader and well known asset classes such as equities will continue to do well in the future staying in the trend, especially in the U.S. The key here is to stay with the market unless your investment mandate is based on finding value/growth among less-known companies and less popular markets.
Descriptions of funds are partially obtained from Google Finance and Yahoo! Finance.