There are specific asset classes that need to be part of every portfolio. Here is a list of the basic group I include in every portfolio. While the ETFs shown below serve as examples, every portfolio will eventually include these five asset classes.
- U.S. Equities – VTI
- Domestic Bonds – BND or AGG
- Developed International Markets – VEU or EFA
- Emerging Markets – VWO or EEM
- Domestic REITs – VNQ or ICF
Are these five asset classes sufficient to build a well-diversified portfolio? To answer the question, we run a Quantext Portfolio Planner (QPP) analysis to gain clues.
The following correlation matrix is not encouraging as all but AGG, the bond asset, are highly correlated. REITs (VNQ) provides some diversification, but not what is required to come up with a well-diversified portfolio. Values 80% and higher are considered to be highly correlated.
The following slide gives additional information for what I would call a Basic Portfolio. For this particular analysis, I used the last five years of historical data and the S&P 500 was assumed to grow at 7.0% over the next year. Note that this portfolio will not keep up with the 7.0% growth. While the projected volatility is below 15%, the Return/Uncertainty ratio falls well below our goal of 0.60. While we can reduce the percentage held in bonds to boost the projected return, that move will also raise the standard deviation percentage. We simply need to broaden out the number of asset classes.
The final factor telling us we need additional asset classes is the Diversification Metric (DM). DM stands at a dismal 17%, whereas our goal is 40% or something very close to that percentage.
Without running a QPP analysis, this portfolio looks to be well-diversified. However, keep in mind we are using the principles of extrapolation and there is always danger in that activity. Even so, we are better off using probability arguments that are in our favor rather than flying blind.
The portfolio construction challenge is to come up with a set of ETFs that generate an 8% return if the S&P 500 is projected to grow at 7%. In addition, the projected SD should be lower than 15% and the Return/Risk ratio greater than 0.60. The last metric is to see the DM equal to or greater than 40%.