Portfolio Construction Logic: A Concrete Example With ETFs

by: Lowell Herr

Several key ingredients such as diversification, growth orientation, and risk limitation go into the portfolio building process. In a global economy, diversification takes on a worldwide implications. Access to international ETFs makes this part of the construction process easier than it was just twenty years ago. How one addresses growth orientation is best handled when one delves into the mathematics of diversification. Limiting risk is tied to asset selection as well as breaking from the buy and hold investing model.

A few broad guidelines or portfolio goals are that it be growth oriented, diversified all over the world, and have some investments that temper risk. While I use as many as seventeen (17) asset classes, to keep this discussion simple I'll confine the number of asset classes to eight, but spread the investments into thirteen different ETFs. Each asset class holds a sufficient percentage to make a difference in portfolio return, yet not such a large percentage to overburden the portfolio with undue risk. The selected asset classes satisfy the worldwide diversification requirement, while providing protection against both inflation and deflation.

Approximately 70% of this portfolio is equity oriented with 30% allocation to U.S. Equities, 20% to international markets, and 20% to real estate. The remaining 30% is allocated to TIPS, U.S. Treasuries, and commodities. These are the risk inhibitors.

The 30% devoted to U.S. Equities is broken into a minimum of five ETFs with a tilt toward value. The international holdings include both developed and emerging markets. Likewise, the 20% allocated to REITs is spread between domestic and international, again emphasizing exposure to world markets.

More specific numerical goals to create this portfolio where the projected return is at least one percentage point above that projected for the S&P 500. This satisfies the growth orientation goal. To hold down portfolio volatility, the projected standard deviation should come in below 15%. This is even high for an investor approaching retirement or already retired, so some sort of risk reduction model needs to be put into place. Faber and Richardson explain one possible model in their Ivy Portfolio book. Another option is the ITA Risk Reduction model.

Two more metrics available to users of Geoff Considine's Quantext Portfolio Planner software are Diversification Metric (DM) and Portfolio Autocorrelation (PA). When constructing a portfolio, the goal is to see DM exceed 40% and PA come in under 20%. These numerical goals serve a clues as to how well the portfolio is diversified and what kind of volatility one might expect from the portfolio over the next six to twelve months.

Below is the QPP analysis of an eight asset class (13 ETF) portfolio. While a three-year period was used for this analysis, similar results are projected for return and risk when a five-year period is analyzed.

Click to enlarge

Disclosure: I am long VTI, VOE, VBR, VO, VB, VEU, VWO, VNQ, RWX, DBC, PCY.

Additional disclosure: I have no connections with Quantext Portfolio Planner other than a user of the software.