- Strategic Asset Allocation plan.
- Momentum model.
- Ranking ETFs.
Portfolio construction requires planning and this article provides a brief overview of how one might design and manage a retirement portfolio. Here are bullet points to help investors think through this process.
- Develop a Strategic Asset Allocation (SAA) plan. How many asset classes are necessary to build a well-diversified portfolio? Sixteen are used in this example.
- Determine what ETFs will be used to populate the different asset classes. Thirty (30) index ETFs were selected for this retirement portfolio.
- Will the portfolio be managed passively or actively? If active, follow the momentum model described below.
Strategic Asset Allocation Plan: Below is a Dashboard taken from an actual portfolio that uses a Strategic Asset Allocation plan. Of the nine asset classes in the upper left corner, all are U.S. Equities. These nine asset classes cover large, medium, and small cap sizes as well as value and growth. Only seven of the nine are used in the following example as no percentage is assigned to Mid- or Small-Cap Blend asset classes. Those asset classes are covered by value and growth asset classes. For example, 5% is allocated to Small-Cap Value and currently this asset class holds 5.2%.
Along the bottom of the Dashboard we have the following asset classes: Cash, Bonds & Income, Developed International Markets, Domestic Real Estate, Emerging Markets, Commodities, International REITs, and just above, Precious Metals, and International Bonds. This SAA provides the opportunity to use 18 asset classes, of which 16 are used in this example.
Target limits are set to help the user know if holdings are within the percentage limits. For example, 1% is allocated to Cash (Money Market), but the actual holding is well outside the target limit so the cell is coded red. Precious Metals at 0.8% is well under the 5% allocation so it is coded a pale purple or pinkish color. Target limits can vary from as low as 20% to as high as 40%. The higher the percentage the fewer the trades. Based on 18 years of research, I found that target limits in the range of 25% to 35% work best as it gives better performing asset classes time to run rather than rebalancing too quickly. If one is managing the portfolio passively, rebalancing is rare if the target limits are set to 35% as under performing asset classes can be brought back to target by dividends and new cash contributions to the portfolio. Years can go by without the need to rebalance.
Strategic Asset Allocation Dashboard: The following Dashboard brings the SAA to life. The target percentages have a white background and the colored backgrounds show the actual percentages held in the portfolio. Commodities (NYSEARCA:DBC) has a target limit of 5%, but the current portfolio is under target with a 2.6% holding.
Readers will note this portfolio is tilted toward value and has a higher than average percentage allocated to small- and mid-cap stocks. This reflects research from Fama and French. Some investors might not be interested in holding Precious Metals (NYSEARCA:GLD) or Commodities. The SAA will reflect the risk and requirements of the investor. Allocating only 9% to bonds is far too risky for some investors, while other investors will consider bonds to be a high risk investments in this environment.
ETF Rankings: The following table lays out 30 "critical" ETFs one might use to populate this retirement portfolio. Not only does this table provide a source of possible ETFs to cover the 16 asset classes, but it also ranks the ETFs based on performance over the past three and six months. In addition, a volatility factor (20% weight) is worked into the ranking system.
The ranking table provides the information needed to answer the second and third bullets above. Take two examples, International Real Estate (NYSEARCA:RWX) and Precious Metals (GLD or IAU). RWX is the critical ETF for International REITs and this asset class is within the target limit so no further action is required. Precious Metals is below target and we have two choices, GLD or IAU. The absolute acceleration or momentum (far right-hand column) is slightly greater for GLD than IAU so we will add sufficient shares of GLD to bring the asset class back into balance. Not shown in this article is a table built into the TLH Spreadsheet that calculates exactly how many shares of a "critical" ETF are required to bring the asset class back to target. If the portfolio is passively managed, the strategy is to keep the asset classes within the target limits at all times.
For investors willing to put in a bit more time and wish to reduce portfolio risk, we examine where a particular ETF is positioned with respect to SHY as that is our cutoff ETF of choice. SHY is a low volatile treasury and serves as a good performance bellwether ETF.
As of 4/4/2014, only one ETF among this group of 30 ETFs is under performing SHY. VBK is the "critical" ETF for Small-Cap Growth and while that asset class is in balance, we would sell off VBK since it is under performing SHY. In addition, VBK has a negative absolute acceleration percentage. This means that over the past three months its growth rate slowed compared to what it was over the past six months. If one is actively managing the portfolio, ETFs performing below SHY are sold out of the portfolio regardless of the SAA plan.
Four exponential moving average (EMA) values are included in this table. We track the 13-, 49-, and 195-Day EMAs. The X/O column is the "Golden Cross" or the price position of the 13-Day EMA with respect to the 49-Day EMA. If the 13-Day is higher than the 49-Day the column is a + and coded green. The cell is red when the 13-Day EMA is priced below the 49-Day EMA, as is the case with GLD, IAU, and SHY.
Whether one chooses to actively or passively manage the portfolio, using ETFs from the following list to construct the portfolio will go a long way toward insuring a better retirement. This assumes one is following The Golden Rule of Investing.
Additional disclosure: I hold most of the ETFs listed in the ETF ranking table.