iGlobal’s 10 Rules for Building a Global ETF Portfolio

by: Carl T. Delfeld

1. Liquidity First:

Before you even think of building an investment portfolio, you should set aside about six month of income in a "rainy day" account. This could be put into a money market fund or U.S. Treasury securities. Having this money set aside will ease your mind and allow you to be more open and creative with your global portfolios.

Don’t be overly concerned about sizable cash positions in your global equity portfolio either. In the second half of 2008 our iGlobal Alpha portfolio cash positions exceeded 50% and are currently over 25%.

2. Separate Portfolios:

You should separate your core portfolio from your explore growth portfolios. With the core portfolio, your top priority is capital preservation and growth is a secondary consideration. The core should be well balanced and diversified. Your growth portfolios are more speculative with capital growth as the primary goal and this means a sizable allocation to emerging markets.

If you have a long-term perspective, you might consider annuities specially structured for ETF portfolios as your core portfolio.

3. To Get Ahead, Get Organized:

Most investors would benefit by settling on a simple well thought out strategy. The iGlobal Country Rotation portfolio normally holds 10-15 country ETFs though when valuations are particularly high, cash allocations can be raised up to 30%. No single country allocation can exceed 15% of total portfolio.

Countries are selected and weighted in the portfolio based on a model that challenges conventional backward looking country weightings by incorporating three factors: 1) relative valuations: price to earnings, book, cash flow, 2) liquidity & momentum: fund flow data, moving averages, 3) macro economic: currencies, interest rates, fiscal policies regulatory issues, elections, trade and security matters.

4. Be Careful what Countries You Pick:

You need some guidelines to help keep you from getting carried away and having too concentrated a position in a particular country or region.

In particular, take a good look at the following: 1) the stability and overall political and corporate governance, 2) the legal environment, respect for contracts, low levels of corruption, due process and rule of law, 3) the macroeconomic environment including fiscal discipline and currency strength.

Know what drives specific markets. Chile (NYSEARCA:ECH) is dependent on copper prices, Austria (NYSEARCA:EWO) is a banking play on Eastern Europe, Russia (NYSEARCA:RSX) is highly focused on oil and natural gas and South Korea (NYSEARCA:EWY) is increasingly integrated into China’s economy.

5. Look Forward, Act Now

Keep in mind that the quality of the countries you choose to invest is critical but overreaching when valuations are high is hazardous. The price or valuation of a country's stock market is also extremely important. Oftentimes the best time to buy into a country's stock market is when it is beaten down but there are signs that its economic and political problems will sharply improve.

These value situations also limit your downside risk. I have a sizable core holding in Indonesia for some time, am building positions in Argentina and considering Japan as a good contrarian play. Timing and trends are key which why our Emerging Market Trends advisory service may be useful.

“The job of an investment company is to decide to invest in the right thing in the right place at the right time. But the right thing is the least important. If you picked the very best share in St. Petersburg in 1917 you could be the greatest genius in the world and still go bust…..You have to be able to see the swings in the market.”
— Sir James Goldsmith

6. It’s the Politics

Many otherwise astute investors fail to recognize the importance of politics in global investing. Political change cuts both ways and can present great investment opportunities. Most great bull markets begin with significant economic reform. In emerging markets, regulatory and political risk can swamp traditional portfolio analysis.
Who can dispute that India’s election last spring ignited a tremendous rally or the that the clear and commanding re-election of President Yudhoyono better known as SBY in Indonesia (NYSEMKT:IF) contributed mightily to the 100% plus surge of its market in 2009. Recently, the election of pro-market leaders in Chile (ECH) and Columbia (NYSEARCA:GXG) reassured investors and boosted their respective markets.

7. Minimize Company Risk:

By using our "Buy Countries, Not Stocks" strategy, you minimize company risk. Instead of trying to pick the best three stocks on the Tokyo Stock Exchange, why not just minimize company risk by buying the Japan iShare ETF (NYSEARCA:EWJ) that tracks the Nikkei 225 and spread this risk amongst 225 Japanese companies. Or you could hedge your bets and do both. Japan has lagged but if the Japanese yen weakens in 2010 (as I suspect) EWJ and the inverse Japanese yen ETF (NYSEARCA:YCS) will soar.

If you, like me, enjoy picking stocks and blending them with ETFs - consider putting them in a basket as part of your explore portfolio.

8. Challenge Conventional Index Weightings

Be careful to look under the hood of ETFs to see where your money is going. For example, let‘s look at the iShares MSCI Emerging Markets ETF. It invests in 23 different countries so it is natural to think that you will get broad exposure to all countries. You would be wrong: 50% of your investment in this fund is going to four countries: South Korea, Brazil, Taiwan and China while only about 2% to Indonesia, Malaysia and Turkey. In addition, incredibly, 4.9% is going to one company, Samsung Electronics of South Korea.

The same is true for the MSCI Europe, Asia and Far East (EAFE) index. It contains 21 developed countries but 38% of the money you invest would go to just two: Japan and the United Kingdom. Meanwhile less than 3% would go to Singapore and Ireland! Country specific ETFs such as the new China iShare (NYSEARCA:FXI) can also have a fair amount of concentrated risk. Although the China iShare tracks a basket of 25 companies, the largest 5 companies account for nearly 50% of your exposure.

The same problem applies to the MSCI World index where only 12% of your investment is going to emerging markets even though they represent 355 of Global GDP, 83% of world population, about 30% of global consumer spending and more than 50% of global economic growth.

9. Manage Risk and Cut Losses with Trading Signals, Trailing Stop Loss Policy or ETF Put Options:

We have all been there. You buy a stock or fund and it appreciates in value rapidly. Then it stumbles and begins to decline. What do you do? Should you buy more, let it ride, or sell?

Save yourself a lot of pain and agony by following a simple rule. If a position ever falls more than 12% - 20% from its high, sell it immediately and reassess the situation. And if you invest in an ETF with a sizable downside risk, why not spend a few hundred dollars to purchase a put option as an insurance policy?

Choose and follow a trading signal that indicates that markets may be reversing. When broad ETFs such as SPY and EFA fell through their 200-day and 50-day moving averages in July of 2008, moving to cash, bonds or inverse ETFs would have saved you’re a bundle.

10. Review Holdings, Performance, and Strategy:

At least annually, you need to make some changes so that you are not overly exposed to countries that have higher risk factors and volatility. One way is by selling some shares of your winners and increasing exposure to under performers.

This accomplishes another goal, locking in gains and taking some money off the table. Remember, only a fool holds out for top dollar especially in the more volatile emerging market countries.

The iGlobal Country Rotation portfolio this month reached its three-year anniversary in the black while its benchmark MSCI All World ex-US is down over 15% during the same period.

Building your growth portfolio with low-cost, tax-efficient ETFs is a smart strategy but don't set it on auto pilot.

Disclosure: None