8 ETFs And The Risk Reduction Model

by: Lowell Herr

Investors looking for a simple portfolio with global coverage can accommodate this goal using eight basic ETFs. Those ETFs are Vanguard Total Stock Market ETF (NYSEARCA:VTI), iShares Russell 2000 Value Index (NYSEARCA:IWN), Vanguard FTSE All-World ex-US ETF (NYSEARCA:VEU), Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO), Vanguard REIT Index ETF (NYSEARCA:VNQ), SPDR Dow Jones Intl Real Estate (NYSEARCA:RWX), PowerShares DB Commodity Index Tracking (NYSEARCA:DBC), and PowerShares Emerging Mkts Sovereign Debt (NYSEARCA:PCY).

VTI covers the entire U.S. equities market and we supplement that broad coverage with IWN so as to emphasize small-cap value. The logic behind the 20% allocation to IWN is the research from Fama and French.

Exposure to international markets is covered by VEU and VWO. We believe emerging markets will see greater growth over the next five to 10 years, and that is why the larger allocation is assigned to VWO.

Domestic and international REITs are represented by VWQ and RWX, respectively. The portfolio is rounded out with commodities and emerging markets sovereign debt .

TD Ameritrade clients may buy and sell these eight ETFs with zero commissions, if signed up for this service. It makes sense to take advantage of this cost-savings opportunity.

Where are the bonds? This is a reasonable question, particularly when one looks at a correlation matrix and sees that all but DBC and PCY are highly correlated and the projected standard deviation or portfolio uncertainty is a very high 19.7%.

The projected return for this simple portfolio is 2.4 percentage points above the 7.0% projected for the S&P 500. For this rate of growth, the inherent risk is expected to be high. However, we intend to temper the portfolio uncertainty using a modified version of the Ivy Portfolio described by Faber and Richardson in a book by the same title. For an explanation of the ITA risk reduction model, check out this blog.

By avoiding major selling periods, we should be able to lower the high volatility expected from this portfolio. Minimizing losses with a selling strategy is not always going to work, so one needs to be prepared to give up some gains during periods of maximum protection.

The portfolio asset allocations are shown in the following screen shot, an analysis prepared using Quantext Portfolio Planning software developed by Geoff Considine. The diversification metric is a low 18%, due in large part to not holding low correlation assets such as bond and treasury ETFs. When the risk reduction model calls for selling one or more of the equity ETFs, we will move into ETFs such as iShares Barclays Aggregate Bond (NYSEARCA:AGG), iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT), or iShares Barclays TIPS Bond (NYSEARCA:TIP). These income-type ETFs are also commission-free to TDA clients.

Click to enlarge image.

Click to enlarge

The following Delta Factor data table is a probability check on the current valuation of the market, and which asset classes used in this portfolio are likely to do well over the next six to 12 months. Looking at the following table, the projections are for modest returns. The market appears to be fairly valued when using 54 months of data. The reason for choosing this period is to capture maximum data for PCY and to include the entire recent bear market.

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If one is not interested in applying a timing model to reduce expected portfolio volatility, then a different asset allocation is called for. Reducing exposure to equity ETFs and adding AGG, TLT and TIP as part of the initial portfolio plan make sense. Using either model, we have a global plan built into the portfolio.

Disclosure: I am long VTI, IWN, VEU, VWO, VNQ, RWX, DBC, PCY.