By Peter Pearce
The portfolio strategy outlined in this article is inspired by funds offered by Dimensional Fund Advisors, which relies on fundamental finance research instead of flawed forecasts and even further flawed stock picking. It’s nothing revolutionary, but it’s low cost, low maintenance and is designed to deliver a consistently strong return for your preferred level of risk in the long-term. This article will provide the ground work on construction and allocation. Future articles will explore performance of the portfolio and the individual funds themselves.
The strategy is based on the academic work (pdf) of Eugene Fama and Kenneth French, whose research demonstrated that value stocks (low price-book ratios) and small-cap stocks had risk and returns greater than the market as a whole. Instead of simply tracking indices and allowing them to dictate our strategy or stock picking which is time-consuming, high-cost and requires active management, we’ll look to capture risk and return that has been identified by foundational financial research.
Getting everything in place is simple, and you should be able to build this portfolio through any discount brokerage with minimal fees (assuming you spend 10$ a trade, setting it up will cost approx $120). This strategy is geared towards passive, do-it-yourself investors, and from this perspective, we’ll use ETFs to offer the most cost effective diversification. I’ll offer two example asset allocations: 60% equity, 40% fixed income split and an 80/20 split as well (for you aggressive types!). You can adjust the Equity/F.I. split and the equity weighting of core/small-cap/value according to your risk tolerance (If you’re a beginner, stick with the asset allocations listed below).
NOTE: I currently reside in Canada, so the example ETFs listed below are from a Canadian perspective.
Asset Allocation: 60/40 80/20 Exchange Traded Fund
Domestic large-cap Equity: 12% 15% Claymore Can. Fundamental (CRQ)
Domestic small-cap equity: 8% 10% iShares Small Cap Index (XCS)
U.S large-cap equity: 8% 10% PowerShares FTSE RAFI US 1000 (NYSEARCA:PRF)
U.S value equity: 4% 5% Vanguard Value (NYSEARCA:VTV)
U.S small-cap equity: 4% 5% Vanguard Small-Cap (NYSEARCA:VB)
International large-cap equity: 8% 10% PowerShares FTSE RAFI ex-US (NYSEARCA:PXF)
International value equity: 4% 5% iShares MSCI EAFE Value (NYSEARCA:EFV)
International small-cap equity: 4% 5% Vanguard World ex-US Small-Cap (NYSEARCA:VSS)
Emerging markets equity: 4% 5% Vanguard Emerging Markets (NYSEARCA:VWO)
Global Real Estate: 4% 5% Claymore Global Real Estate (CGR)
Bonds: 40% 20% Claymore 1-5yr Laddered Gov’t Bond (CLF)
Gold: 5% Claymore Gold Bullion (CGL)
The above portfolio is well diversified, holding thousands of stocks, with exposure across multiple asset classes and geographic regions, and is much lower cost than your average balanced fund. The weighted MER of the example above is approximately 0.4%. In the 80/20 Split, I included a 5% exposure to Gold. This is a personal choice to capture some of the current bull market and hedge equity risk.
The graph below taken from Dimensional Fund Advisor’s website, highlighting the returns of small-cap stocks above the market.
[Click to enlarge]
DFA incorporates Real Estate into the portfolio because of its low correlation with both International and Domestic equity, which should lower the volatility of our globally diversified portfolio. The Claymore ETF focuses mainly on Real Estate Investment Trusts with exposures from largest to smallest in the U.S., Asia, Europe and Canada.
Gold should also provide a similar diversification benefit, hedging some of the left tail equity risk in the portfolio. Dimension does not specifically allocate to gold, and I would recommend it only for those heavily weighted in equity. I like to hold a gold ETF that carries physical gold rather than tracking an index. Also note that the Claymore Canadian Fundamentals already includes many gold stocks, so for you non-Canadians, make sure you understand what stocks the ETF tracks and ensure you don’t have excess exposure.
As a final note, the portfolio will be exposed to currency fluctuations through the international equity stocks, if you are unwilling to expose yourself to currency risk, use ETFs such as: WisdomTree International Hedged Equity Fund (NYSEARCA:HEDJ) which use derivatives to smooth out the currency risk in the ETF.