An Optimised Portfolio Using Only ETFs (IVV, IJH, IWM, EFA, EEM, SHY, IEF, TLT, RWR, IDU, IXC, IGE)

One of the questions most frequently asked by retail investors is "How should I allocate my portfolio?" The Radical Guide to Investing includes a careful discussion of asset allocation, and points out that asset allocation should vary depending on an individual's circumstances. (For example, if you have a mortgage -- effectively a negative bond position -- you should consider paying down your mortgage before buying bonds.)

Yet despite the importance of customisation, many individuals still appreciate hearing suggestions for a general model portfolio.

I was therefore intrigued when Geoff Considine sent me a paper he wrote that takes the Core Portfolio ETFs from A Better Way to Invest and generates an optimal asset allocation using econometric (Monte Carlo) simulations. The Core Portfolio ETFs are:

ETF Ticker	Fund Name	Fund Description	Expense Ratio
IVV	iShares S&P 500 Index Fund	Large cap US stocks	0.09%
IJH	iShares S&P Mid Cap 400 Index Fund	Mid cap US stocks	0.20%
IWM	iShares Russell 2000 Index Fund	Small cap US stocks	0.20%
EFA	iShares MSCI EAFE Index Fund	Large cap foreign developed market stocks	0.35%
EEM	iShares MSCI Emerging Markets Index Fund	Large cap emerging market stocks	0.75%
RWR	streetTRACKS Wilshire REIT Index Fund	Real estate investment trust index fund	0.25%
LQD	iShares GS $ Investop Corporate Bond Fund	US corporate bonds	0.15%
SHY	iShares Lehman 1 to 3 Year Treasury Bond Fund	US short-term Governement bonds	0.15%
IEF	iShares Lehman 7 to 10 Year Treasury Bond Fund	US long-term Governement bonds	0.15%
TIP	iShares Lehman TIPs Bond Fund	US Governement inflation-protected bonds	0.15%

Geoff's allocation among these assets is as follows:

IVV 8%
IJH 10%
IWM 10%
EFA 20%
EEM 10%
SHY 10%
IEF 7%
TLT 10%
RWR 15%

He then finds that adding three more ETFs to the mix -- IDU, IXC and IGE -- improves returns and lowers volatility. These three ETFs are sector ETFs (iShares Utilities, iShares Real Estate, and iShares Goldman Sachs Natural Resources funds.) Adding them to the portfolio, on top of the broad market ETFs IVV, IJH and IWM, has the effect of altering the sector weighting of the equity part of the porfolio to reduce volatility. His final portfolio is as follows:

IVV 5%
IJH 5%
IWM 10%
EFA 10%
EEM 0%
SHY 0%
IEF 15%
TLT 15%
RWR 10%
IDU 10%
IXC 10%
IGE 10%

(The original version of this article contained a transcription error in Geoff's percentage allocation to each ETF, so the total added up to more than 100%. Thanks to Roger Nusbaum for catching this.)

In Geoff's words,

Many investors have now heard of Monte Carlo models for determining how much income you can safely draw from a portfolio, but Monte Carlo models are also valuable tools for examining portfolio allocation and in determining the optimal asset mix. Quantext, a portfolio management consultancy, has developed a Monte Carlo tool for individual investors for both of the tasks mentioned above. In a recent paper, the Monte Carlo model was used to examine the portfolio characteristics of the ETF mix suggested by the Radical Guide to Investing. While the initial core portfolio is quite good, some tuning of the portfolio increases expected return, while reducing risk. Further, the Monte Carlo analysis suggested that adding some low-Beta stock ETF’s to the portfolio would further enhance return and reduce risk levels. The analysis yielded enhanced allocations that result in a portfolio that can support an additional five to ten years of retirement with no additional savings.

Geoff's full paper in PDF -- certainly worth reading -- is here. Readers' comments on the paper and Geoff's ideas are welcome.

Comments

[ardano:]

The original concept used to advance the theory of this piece is important. What has changed since its original publication is that new EFT's have been created to both fill the gaps and negatively correlate with the basic allocation model. Therefore, investment professionals can now add carefully add alpha and further test the mpt theory.

2008 Mar 02 03:24 PM

[Geoff Consi...:]

To Ardano:

I agree totally. New ETF's can provide powerful tools for better portfolios. Bogle warns that these new etf's can encourage speculation. Sure. But...they also provide powerful potential benefits in portfolio construction.

2008 Mar 02 06:50 PM

[Barb G:]

Where is the TIP ETF in the model portfolio?

2008 Mar 18 08:07 PM

[Geoff Consi...:]

Hi Barb G:

I have come to fully appreciate the power of TIPS as diversifiers since I wrote this article. I discuss TIPS in many of my later articles.

2008 Mar 19 01:42 PM