16 Critical ETFs.
Emphasis on Value, Small-Cap and Momentum.
Risk Reduction Model.
Using the principles of Fama-French, Swensen, and Novy-Marx, the following portfolio places an emphasis on value or low price/book securities, small-cap size, global diversification, and a risk reduction model based on momentum. Why select these metrics for portfolio construction?
Fama and French's celebrated Three-Factor Model, shows that smaller size and value stocks outperform markets on a regular basis. An excellent explanation of the small size and value tilt can be found in Chapter 1 of Robert A. Haugen's book, The New Finance: The Case Against Efficient Markets.
David Swensen lays out a simple six asset class portfolio in his book, Unconventional Success. The following portfolio, while a little more complex to increase diversification, follows the general asset allocation plan presented by Swensen, and later slightly revised.
From an interview with Phil DeMuth, Dr. Robert Novy-Marx, professor at the Simon Business School - University of Rochester, is quoted as follows: "Arguably, the most important thing an investor can do is to diversify, whether it is across geography, assets classes or factors and styles. Profitability needs to be traded with value, and once you're trading value you really should also trade momentum. Over time, tilts towards value, momentum and profitability have outperformed the market, and due to the diversification benefits, a combined portfolio of these three has provided much higher reward per unit of risk and a significant reduction in extreme risk or losses. Thus, an approach that combines these three themes using an integrated, straight forward methodology that is designed to endogenously and efficiently capture these themes and take advantage of their natural synergies is ideal."
Notice the emphases on value, diversification, and momentum. Profitability (Gross Profits to Assets), what Novy-Marx is most noted for, is found through individual stock screens rather than index ETFs so this portfolio, while skewed toward value, does not capture all the benefits of profitability.
Here is the breakdown of the portfolio showing the critical ETFs for each asset class. Investors will adjust these percentages to their own situations. One change I might make is to increase the percentage assigned to Emerging Markets and decrease the allocation to Developed International Markets.
- U.S. Equities - VTI - 15% This ETF covers all asset classes of the U.S. market.
- Mid-Cap Value - VOE - 7% This is a tilt toward both value and smaller cap size, the point emphasized by both Marx and Fama-French.
- Small-Cap Value - VBR - 8% Inclusion of this ETF further skews the portfolio toward small-cap and value stocks.
- Cash - Money Market or SHY - 1% There is always cash lying around in a portfolio. The goal is to keep this percentage below 1%.
- Bonds - 24% This asset class is spread out over BND, BIV, LQD, JNK, TLT, and TIP.
- Developed International Markets - VEA - 15%
- Emerging Markets - VWO - 5%
- Domestic Real Estate - VNQ - 15%
- International Real Estate - RWX - 5%
- International Bonds - BWX and PCY - 5%
While these are the target percentages, I use target limits of 25% to 30% so asset classes have the opportunity to run for extended periods before rebalancing is required.
ETF Ranking-Momentum Table: Momentum, as advocated by Novy-Marx, serves as a portfolio risk reducer in the following manner. If an ETF is performing below SHY, when the portfolio comes up for review, sell it out of the portfolio. VEA is an example in the following table. QQQ and SPY are included as references to show how the ETFs are performing with respect to these broad markets.
Another risk reducer is to sell the ETF if its price drops below its 195-Day Exponential Moving Average. That indicator will show up as red in column 14 when this condition is activated. In this market we do not have that condition showing up.
Here we have a relatively simple (16 ETF) portfolio that emphasizes diversification, value, smaller-cap stocks, and momentum. Portfolio principles advocated by Swensen, Fama-French, and Novy-Marx are combined in a simple well defined package.
Disclosure: I am long VTI, VNQ, VOE, VBR, RWX, VEA, VWO, TIP, TLT, PCY, JNK, LQD. 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. I hold shares in all 16 ETFs.