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This article is the second in a series of articles about simple portfolio allocations for different levels of risk tolerance. In this article I will be constructing a balanced portfolio of ETFs.

There are two goals I had for constructing the following portfolio:

  1. Make sure the portfolio is diversified as measured by correlations.
  2. Reduce the volatility of the portfolio by weighting the least volatile funds higher than more volatile funds. I used the 3 month average volatility over the last 12 months. [Volatility data is from ETFreplay.com]

Portfolio Funds

Balanced

Symbol

Weight

Volatility

iShares iBoxx $ Invest Grade Corp Bond

(LQD)

25%

4.70%

iShares Barclays TIPS Bond

(TIP)

25%

4.90%

Vanguard Dividend Appreciation ETF

(VIG)

30%

9.10%

iShares MSCI EAFE Growth Index

(EFG)

20%

17.70%

Fund Selection Method

I selected the above funds by roughly following the overall allocation of stocks and bonds, in the corresponding allocation ETF, the iShares S&P Moderate Allocation (AOM) ETF. The fund allocated roughly 58% to bonds, and 42% to equities. For the portfolio I chose to go slightly more aggressive than AOM, by making the portfolio 50% Bonds, and 50% Equities. Because the portfolio is balanced not just balanced a balanced allocation but a balanced amount of risk, I decided to keep the most volatile bond fund in the conservative portfolio so I Included LQD.

For the next fixed income fund I wanted to go out a little further on the risk spectrum to intermediate to long term US Government bonds TIPS bonds, so I chose to include TIP. There were two reasons behind choosing TIP; the first reason was that TIP was slightly more volatile than LQD, which went inline with my portfolio fund selection process of choosing slightly higher volatile funds for each different more risky portfolio. The second reason is that TIP should benefit when interest rates are rising because of Inflation.

For the first equity fund of the portfolio, I wanted to move away from a specific sector like I had chosen in a previous portfolio, and move to a more broad equity fund. To find the best equity fund I used to following guidelines using the TD Ameritrade ETF screener:

  1. Morningstar Category: Large Blend, Large Growth, Large Value.
  2. Total net assets: Greater than $1 Billion.
  3. Dividend Yield greater than 2%.
  4. 3 yr Market Return is greater than 0.
  5. ETF Type is Equities.
  6. Chose the fund with the lowest Standard Deviation.

Based on the above criteria VIG had the lowest standard deviation so I included it as the first equity fund in the portfolio.

Then for the second equity fund I wanted to include international stocks so I used the same criteria but changed the first guideline to foreign large blend, large growth, large value, and changed the ETF type to international. The fund with the lowest standard deviation was EFG, so I included it the portfolio.

Below is a table showing the correlation of each fund to each other as well as each fund the iShares Barclays Aggregate Bond (AGG) and the SPDR S&P 500 (SPY).

Correlations

[Data from ETFscreen.com]

AGG

EFG

LQD

SPY

TIP

VIG

AGG

1

EFA

-0.57

1

LQD

0.5

0.01

1

SPY

-0.57

0.93

-0.01

1

TIP

0.69

-0.38

0.4

-0.43

1

VIG

-0.56

0.92

-0.02

0.99

-0.44

1

Returns and Data

[Data from ETFreplay.com]

The following charts and data show the portfolio compared to the iShares S&P Moderate Allocation ETF:

click to enlarge


Portfolio Challenges

With the bond funds in the portfolio getting slightly more volatile, interest rates become a larger issue because the duration of the bonds held by LQD and TIP are more susceptible to interest rate changes than short term bond funds. With this portfolio there is more added equity risk because VIG is more volatile than the Consumer Staples Select Sector SPDR (XLP) which was the equity fund used for the Conservative Portfolio. Also, another part of the equity risk of the portfolio is the added position in EFG which owns international stocks, and which is almost twice as volatile as VIG. Because of that, EFG holds the smallest position in the portfolio to lessen the impact of that volatility.

Closing thoughts

The returns of the portfolio over the time period have outperformed AOM by a decent margin over the last 4 years. The portfolio I have constructed has accomplished this with less volatility than AOM, but this was to be expected due to the slightly higher allocation to stocks than bonds.

Disclaimer

Source: Simple Portfolio Building: Balanced