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Portfolio construction consists of the following steps:

  • Decide personal risk profile which determines the target allocation in risk assets.
  • Decide asset allocation method: strategic or tactical or both strategic does not change target asset allocations while tactical can alter allocations more actively)
  • Decide target allocation for each asset in a strategic asset allocation
  • Periodically rebalancing portfolios

For a portfolio using strategic asset allocation, with long term target allocation being fixed (and only changed when major events such as approaching retirement and children's college education spending, for example), one can further enhance a portfolio return and reduce the risk by rebalancing and fund selection in an asset class. It is reported that adopting proper timing and ways to rebalance a portfolio can improve return and reduce risk (see Daryanani opportunitstic rebalancing article). In this article, we focus on fund selection.

In a well designed portfolio for retirement plans (401K or IRA), it is a popular practice to have funds with various style exposures. In a stock / equity asset, a fund style is defined as value style (growth / blend / value) and size style (large / mid / small cap). The Morningstar 9 boxes of styles are essentially the combinations of the 3 value and 3 size styles. In a fixed income asset, a fund style is a combination of credit risk (junk/investment grade) and interest rate risk (short / intermediate / long) for corporate bonds or a just interest rate risk for treasury bonds. In an actively managed portfolio, it is a well recognized and widely practiced method to select funds based on style rotation to improve a portfolio alpha or return. For example, in an article published in Journal of Asset Management (May, 2007), B. Arshanapalli , L. Switzer and K. Panju concluded that active multi-style rotation strategies can be devised to outperform the best performing buy-and-hold portfolio.

MyPlanIQ maintains an index fund based plan or an ETF based plan using candidate funds based on those in a lazy portfolio proposed by Fund Advice Paul Merriman and maintained by MarketWatch.com (called Fund Advice Ultimate Buy and Hold Portfolio) (see here for the independently tracked portfolio on MyPlanIQ.com). The candidate funds and the original allocation are as follows

Index ETF Allocation
Vanguard Interm-Tm Trs [VFITX] iShares 3-7 Year Treasury (NYSEARCA:IEI) 20%
Vanguard Short-Tm Trs[VFISX] iShares 3-7 Year Treasury (NYSEARCA:SHY) 12%
Vanguard Intl Val [VTRIX] iShares MSCI EAFE Value Index (NYSEARCA:EFV) 12%
Vanguard Dev Mkts [VDMIX] iShares MSCI EAFE Index (NYSEARCA:EFA) 12%
Vanguard Inflation-Prot [VIPSX] iShares TIPS Bond (NYSEARCA:TIP) 8%
Vanguard Small-Cap Idx [NAESX] iShares Russell 2000 Index (NYSEARCA:IWM) 6%
Vanguard Small-Cap Val [VISVX] iShares Russell 2000 Value Index (NYSEARCA:IWN) 6%
Vanguard Value Idx [VIVAX] iShares Russell 3000 Value Index (IWW) 6%
Vanguard 500 Index [VFINX] SPDR S&P 500 (NYSEARCA:SPY) 6%
Vanguard Emerging Mkt [VEIEX] iSharess Emerging Market Stock (NYSEARCA:EEM) 6%
Vanguard REIT Idx [VGSIX] iShares Dow Jones REIT Index (NYSEARCA:IYR) 6%

The funds cover five asset classes: U.S. Equity, International Equity, Emerging Mkt Equity, U.S. REIT and Fixed Income. They have various style exposures for U.S. stock market (equity), International Stocks and Fixed income.

MyPlanIQ Strategic Asset Allocation [SAA] selects funds with the best risk adjusted returns for each asset class when rebalancing. The following table compares the Strategic Asset Allocation [SAA] moderate portfolios in both index fund and ETF plans as well as the original portfolio (both MyPlanIQ SAA moderate portfolios have 40% allocation in fixed income). We also include the strategic asset allocation moderate portfolio in MyPlanIQ Five Core Asset ETF Plan that consists of one fund for each asset class.

As of 7/2/2010

Portfolio 1 Yr Return 3 Yr Return 5 Yr Return Since 12/2000
FundAdvice SAA Moderate Index Funds 17% -1.0% 5.1% 7.4%
FundAdvice SAA Moderate ETF 16.7% -2.2% 4.8% 7%
FundAdvice Buy and Hold Index Funds 14.5% -2.4% 4.1% 5.7%
Five Core SAA Moderate 16.9% -3.4% 3.93% 5.6%

From the above table, we can observe:

  • Diversification over styles improves return (FundAdvice Buy and Hold vs. Five Core SAA Moderate).
  • Style rotation adds 1.3-1.7% returns over buy and hold (SAA Moderate ETF or Index Funds vs. FundAdvice Buy and Hold).

The above observations are consistent across thousands of plans MyPlanIQ maintains. We should also point out that better fund / style selection does not alter the overall portfolio risk allocation, which is a major advantage over an actively managed tactical asset allocation portfolio.

At the moment, for U.S. stocks, MyPlanIQ SAA favors small cap (IWM), small cap value (IWN). For fixed income, it favors Inflation-protected treasury (TIP).

Disclosure: Long IYR, LQD, TLT

Source: Asset Allocation: Investing with Styles Can Pay off