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ETFs are increasingly the vehicle of choice for IRA and other portfolios. Their flexibility and low expense ratio result in higher returns and the ability to be more nimble in selecting the best funds. In this article, we will show consistent performance improvement by building a diverse portfolio from a wide choice of ETFs.

The ETF portfolios in focus are developed and maintained by MyPlanIQ for FolioInvesting.com. Folio Investing is an online broker offering one-click portfolio buying, selling and rebalancing. Using best in class ETFs with easy to execute modifications makes it possible to build and manage a high performance, low cost portfolio.

There are two types of strategies available – strategic and tactical asset allocation. In this article, we are going to examine how strategic asset allocation can be used to maximize returns while minimizing risk.

The portfolios have the following five different risk profiles:

  • Very Conservative: Target Allocations: 20% risk assets, 80% fixed income
  • Conservative: Target Allocations: 40% risk assets, 60% fixed income.
  • Balanced: Target Allocations: 50% risk assets, 50% fixed income.
  • Moderate: Target Allocations: 60% risk assets, 40% fixed income.
  • Growth: Target Allocations: 80% risk assets, 20% fixed income.

For this example, we will take the moderate risk profile

The portfolio has six asset classes and each class has multiple funds that enable various style exposures.

  • US equities: 25 funds
  • International equities: 5 funds
  • Emerging market equities: 2 funds
  • Real estate: 4 funds
  • Commodities (including gold): 3 funds
  • Fixed income: 16 funds

ETFs don’t have as long a history as many mutual funds but each of the funds have been selected to be the highest quality based on risk adjusted returns, activity and expense ratio. As a result, the overall PlanRatingIQ score is 69/100 which is good – a slightly higher score than the Vanguard All Index Funds Investor Class portfolio.

Having a large number of funds may seem an unnecessary complication given the more static nature of the portfolio but this is where the combination of a hybrid strategy linked to a one-click execution of trades can be used to squeeze some extra juice from the returns.

There are two techniques used to potentially increase returns:

  • While the shape of the portfolio (% of overall investment in which asset class) is fixed, there is opportunity to modify the styles. By monitoring risk adjusted returns of the all of the funds in a class, it is possible to select the funds with the best risk adjusted returns while keeping the overall shape unchanged. As a result, risk adjusted returns can be pushed up a little more.
  • High yield bonds can increase returns but they are a hybrid in the sense that they share properties of both fixed income and equity investments. This approach treats these assets as risky assets and “borrows money” from other assets to deploy them should their market momentum warrant.

This is the asset report for the last five years and it is clear that within asset classes, different styles are deployed. It is also clear that high yield bonds were added 2007-2010 – borrowing from the other asset classes.

click to enlarge images

Table of the style rotation used over a five year period

Graph of how assets were deployed in each class over five years

This graph shows how the asset classes are kept in balance within a given band. There will be fluctuations in between rebalancing.

The historical returns will be compared with two similar portfolios

  • A six asset SIB (Simpler is Better) portfolio same risk profile and strategy implemented with one ETF for each asset class. This will highlight the benefit of being able to rotate funds within an asset class
  • A six asset SIB with the same risk profile and strategy implemented with market index funds for each asset class. This will allow benchmarking of ETFs against index funds
  • A five asset SIB with the same risk profile and strategy implemented with market index funds for each asset class. This will allow benchmarking of six asset classes versus five

Returns of the Five and Six Asset Class Portfolios over Five Years

A snapshot of the results graph is shown above with summary data in the table below.

Returns Table of the Different Portfolios
Annual returns 1 year 3 years 5 years
Folio SAA Moderate 12.43 3.26 8.15
6 SIB ETF SAA Moderate 11.53 2.51 7.89
6 SIB Index SAA Moderate 10.63 1.66 6.72
5 SIB Index SAA Moderate 12.44 2.16 7.00

The five asset SIB provides good returns but is more volatile than the other portfolios. One of the goals of good portfolio design is to achieve high returns with lower volatility and so the six asset SIBs demonstrate better risk properties.

The performance of the Folio portfolio is consistently the highest as it has the opportunity to rotate in the best funds. Where there is a potential issue is in the execution of all of the trades. There will be more activity that would be usual with a buy and hold portfolio because of the fund rotation. This is where Folio Investing helps with a simplified means of executing the necessary trades.

The Folio Investing platform offers one-click portfolio buying, selling and rebalancing, as well as a flat fee for unlimited window trading and fractional share/dollar based investing. These features enable investors to implement the ETF portfolios discussed above . In addition, the ETF settlement in a day frees investors from spending effort to find an opportune time for rebalancing trasactions.

Takeaways

  • Asset allocation delivers good risk adjusted returns with a simple buy and hold strategy
  • ETFs perform very well against market index funds and their low expense ratio are important to maximize what is retained by the investor and doesn’t disappear into “expenses.”
  • A six asset class portfolio has better risk properties while delivering good results
  • Moving to a hybrid model with some elements of the portfolio being dynamically managed squeezed out more juice
  • Having a simple and low means of executing the trades is an essential part of a hybrid approach to make it easy on the investor

Disclosure: No positions

Source: Diversification and Style Rotation Improve Portfolio Performance Without Extra Risk