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By Michael Rawson, CFA

There are two approaches to asset allocation, and ETFs' characteristics make them suited for use in both methods. In this article, we will discuss the two approaches to asset allocation, the advantages of ETFs for each approach, and because this is Ideas Week at Morningstar, we will highlight three tactical trade ideas.

The first approach is called strategic asset allocation. After establishing an investment objective and exploring one's tolerance for risk, a portfolio is constructed with exposures to different asset classes. It relies on the efficient market hypothesis, and, while its proponents may not agree that the market is always efficient, they at least believe that it is difficult to consistently beat the market net of fees. This approach seeks to maximize the benefits of the only free lunch in investing: diversification. ETFs are ideal for strategic asset allocation because they are offered in a variety of different asset classes, they track broad indexes (so you do not have to worry about style drift or management turnover), and, most importantly, they have low fees.

Christine Benz has constructed several strategic asset allocation portfolios using ETFs here and here.

There are also ETFs available that package different funds together and attempt to provide a complete asset-allocation plan within one fund, such as iShares S&P Conservative Allocation (NYSEARCA:AOK).

There are several ETFs that we use as building blocks in our ETF Investor Hands-Free Portfolio. Because we like the ability to fine-tune our market-cap exposure (for example, to be light in small-cap stocks), we have chosen to use Vanguard Mega Cap 300 (NYSEARCA:MGC), Vanguard Mid-Cap (NYSEARCA:VO), and Vanguard Small Cap ETF (NYSEARCA:VB) for our U.S. stock exposure. For commodities, we use iShares COMEX Gold Trust (NYSEARCA:IAU). While smaller in assets than SPDR Gold Shares (NYSEARCA:GLD), it recently cut its fee to 0.25% from 0.40%. Because we felt that U.S. Treasuries were somewhat overvalued, we decided not to hold the Barclays Aggregate Bond Index but rather to disaggregate our bond holdings into iShares Barclays MBS Bond (NYSEARCA:MBB) and iShares iBoxx $ Investment Grade Corporate Bond (NYSEARCA:LQD). For inflation protection, we hold both iShares Barclays TIPS Bond (NYSEARCA:TIP) and SPDR DB International Inflation-Protected Bond (NYSEARCA:WIP).

The second approach to asset allocation is more tactical and tends to be more aggressive. It also requires a more active view of the markets and tends to be riskier. This approach can begin with the strategic asset-allocation plan but will take larger deviations based on some investment process or idea. This can also be called a core-satellite approach, where the core, or bulk of the portfolio, is made up of the strategic portfolio and the satellite represents small shifts in allocation based on investment ideas. For those willing to do their homework, ETFs are useful in tactical asset-allocation plans for several reasons. They allow the investor to focus on investment research rather than researching fund managers. They trade likes stocks, so they can be traded throughout the day and used in combination with options or limit orders. Despite the fact that they tend to follow passive indexes, they can be used actively by varying the timing or amount of exposure.

Below we highlight several tactical investment ideas, some of which we have implemented in our own ETF Investor Hands-On Portfolio.

Technology Sector
New orders for durable goods are down 17% from three years ago, while new orders in tech are down just 6%. Despite the fact that tech spending has held up better than average, tech currently trades at a price/earnings multiple of about 15.2 times, less than the 18.4 times average over the past six years. The market as a whole is trading at a price/earnings ratio of 14.3, only a slight discount to its 14.9 six-year average. Several tech stocks are currently on Morningstar equity analysts' Best Ideas list, including Cisco (NASDAQ:CSCO), Hewlett-Packard (NYSE:HPQ), Applied Materials (NASDAQ:AMAT), Advanced Micro Devices (NYSE:AMD), and ATMI (NASDAQ:ATMI). IShares Dow Jones US Technology (NYSEARCA:IYW) owns them all. Our analysts build a complete discounted cash flow model that allows them to estimate a fair value price for the stock. Cisco currently trades at a price/fair value of just 0.64 and has a wide-moat rating. (Economic moat is Morningstar's measure of a firm's sustainable competitive advantage.)

Large Caps Over Small Caps
Morningstar's equity analysts provide valuation ratings for about 483 of the stocks in the S&P 500, comprising 99% of the assets. They currently see the S&P 500 trading at a price/fair value of about 0.92. On a price/earnings basis, the S&P 500 trades at 14.3 times, while the Russell 2000 trades at 17.3 times. Despite the fact that small caps are riskier than large caps, they trade at a premium. This premium could be justified if they could grow earnings faster in the future. But as we enter the new normal economy of slower growth, this faster expected growth priced into small caps might not materialize. In addition, large caps have greater exposure to faster-growing international markets that may also have favorable exchange-rate movements. To implement this trade, one could buy SPDR S&P 500 (NYSEARCA:SPY) or iShares S&P 500 Index (NYSEARCA:IVV) and short iShares Russell 2000 Index (NYSEARCA:IWM). Despite owning less-liquid underlying securities, IWM is one of the most heavily traded ETFs and should be fairly easy to short. It is frequently used by portfolio managers who want to quickly gain access to small-cap stocks. Rather than going out and buying hundreds of small-cap stocks, they can simply buy IWM.

A Yield Curve Mean Reversion Play
This last trade idea involves a slightly more complicated structure. The term spread, or slope of the yield curve, is the spread between long-term and short-term interest rates. There are a number of factors that are forcing this spread to be wider than normal. (The spread is currently around 250 basis points compared with the average of 83 basis points.) The Fed's actions to keep short-term rates low, combined with investors' expectations that rates will rise in the future, lead to a wide spread. Low current inflation, combined with an expectation for higher inflation in the future, could also cause this spread to be wide. Eventually, this spread should return to its historic average. Speculating on the reversion of the spread back to its average level would require buying a long-term bond and selling a short-term bond. IPath US Treasury Flattener ETN (NYSEARCA:FLAT) does this for you within one security. A nice feature of this trade is that the spread is uncorrelated with stock market returns. For more on this ETN, read "How to Take Advantage of a Steep Yield Curve" by Timothy Strauts.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: ETFs for Strategic and Tactical Portfolios