A Well-Balanced Portfolio Including Alternative Investment ETF Allocation

by: Carlton Chin, CFA

The benefits of portfolio optimization and Modern Portfolio Theory are well-documented. In this article, we review a well-balanced portfolio and several low-fee ETFs that can be used to implement the asset mix.

Of particular interest, the portfolio mix includes an ETF allocation specializing in an “alternative investment” strategy. Alternative investment strategies such as “managed futures” are gaining in popularity because they offer increased diversification benefits – due to lower correlations – versus traditional assets such as stocks and bonds.

The asset allocation mix is based on concepts of portfolio optimization, combined with the results of several proprietary trading models. Disclosure: my firm specializes in alternative investments and in particular, quantitative and managed futures trading strategies. Trading strategies are used to adjust stock and bond exposures – as well as to trade the currency, commodities, and futures markets.

For the purposes of this article, the model inputs are chosen for a longer-term asset allocation mix. Some other factors we consider when we run asset allocation models:

  • We minimize rebalancing to reduce tax events and improve tax efficiency.
  • We focus on low-fee funds that are on the low side within their categories. Vanguard shines in this area; however, they do not have ETFs in some of the sectors we like (such as alternative assets).

Here are some ETFs – and suggested allocations – for a well-diversified portfolio:

  • 15% US Stocks – still the bread and butter for many U.S.-based investors. Some good Vanguard ETFs include the Vanguard S&P 500 ETF (NYSEARCA:VOO) and the Vanguard Small Cap ETF (NYSEARCA:VB).
  • 15% International Stocks – although the correlations between foreign and U.S. stocks has risen over the years, international stocks still offer balance to well-diversified portfolios. In addition, depending on your trading systems and/or viewpoints, you can choose to focus on certain sectors. For instance, we currently like the Vanguard MSCI Pacific ETF (NYSEARCA:VPL). Vanguard also has a Europe ETF (NYSEARCA:VGK).
  • 10% Emerging Markets – this sector is related to equities, and the emerging markets sector has offered increased diversification in recent time periods. The Vanguard MSCI Emerging Markets ETF is a solid addition to most portfolios (NYSEARCA:VWO).
  • 15% Bonds – although bonds are less exciting to many investors, they DO offer good long-term risk-return benefits and diversification versus equities – especially during times of financial stress. Portfolios with long-term time horizons may like the Vanguard Long-Term Government Bond fund (NASDAQ:VGLT). If you have a view – or trading systems – that predict rising interest rates, you may want to shorten the duration of your bond exposure.
  • 10% REITs – real estate and real estate investment trusts (REITs). The Vanguard REIT Index ETF (NYSEARCA:VNQ) is a good proxy for this sector.
  • 15% International REITs – a relatively new REIT category is the international real estate sector, excluding the U.S. The Vanguard Global Ex-US Real Estate ETF (NASDAQ:VNQI) looks promising in terms of long-term growth and diversification potential.
  • 20% Commodities – The S&P Commodities Trend Index (CTI) gives some exposure to the commodities and managed futures sector. A good ETF fund that implements this strategy is the Elements S&P CTI (NYSEARCA:LSC).

Some notes on the asset allocation mix:

  • Bonds are good for balancing the portfolio, but after the strong run-up in bonds, our asset allocation model has a slightly lower allocation to fixed income.
  • Our trading model remains bullish on bonds. However, if you believe interest rates will rise, you should invest in a short-term bond fund instead of the long-term fund we list. Vanguard has various government bond funds such as their Total Bond Market ETF, with an intermediate-term duration (NYSEARCA:BND) and their Short-Term Government Bond Fund (NASDAQ:VGSH).
  • Real estate and REITS have a higher allocation than the “neutral” position.
  • Equities remain a good long-term investment, and interestingly, the emerging markets have shown good strength on “down” days for the general stock market.
  • There are currently several ETFs that offer exposure to plain-vanilla alternative investments. Alternative investment strategies such as “managed futures” have been gaining in popularity due to their relatively low correlation to stocks and bonds.
  • Managed futures strategies have treaded water the past several months, but historically, they add good diversification potential, especially during times of financial turmoil. Accredited investors may prefer more “actively-managed” hedge funds within the alternative asset sector.

This portfolio mix is just a guideline. Some investors may prefer different families of funds. Others may want to include additional categories to improve diversification. Most importantly, investors with lower risk appetites should reduce the allocations to stocks, REITs, and alternative investment strategies – and increase the allocation to fixed income and short-term bond funds.

Diversified portfolios may not be as “exciting” on the upside when the markets run-up, but they offer better risk-return characteristics than “focused portfolios.” In the long-run, prudently-diversified portfolios should earn solid returns with better balance – allowing investors to sleep better at night.

Disclosure: I am long VOO, VB, VPL, VWO, VNQ, VNQI, managed futures, commodities, and bonds.