Constructing a well-diversified portfolio is as much an art as it is a science. In the following article I'll lay out a model for portfolio construction by walking readers through a specific example. The underlying thesis for this model is based on the market anomaly known as momentum.
Construction begins with a core portfolio such as the "Swensen Six." The following six ETFs provide global coverage as well as a hedge against inflation. While this portfolio is somewhat risk adverse, the overall momentum model is designed to minimize risk by avoiding poor performing asset classes. Here are the six ETFs that make up the "Swensen Six."
- U.S. Equities (VTI)
- Developed International Equities (VEA)
- Emerging Markets (VWO)
- Real Estate (VNQ)
- Inflation Protection Treasuries (TIP)
- U.S. Treasuries (TLT)
These are not the only low-cost ETFs that fill these asset classes. Consider this to be one example. Some investors prefer to build a portfolio around a core of individual stocks. This model is not security specific.
With the "Swensen Six" as a core portfolio, we move on to selecting Top Tier ETFs which are added to the core portfolio for additional analysis. The five basic asset classes are as follows.
- U.S. Equities - Approximately 40 ETFs are selected to fill this asset class.
- International Equities - Approximately 25 to 30 ETFs, including emerging markets, are identified to populate this asset class.
- Sectors - While there is overlap with U.S. Equities, there are times when specific sectors of the market will spike out of the crowd. Approximately 12 to 18 ETFs are selected for this asset class.
- Commodities - Broad ETF commodities (DBC) are included as are wind, solar, water, timber and gold. Twelve (12) ETFs currently fill the investment quiver for this asset class.
- Bonds and Treasuries - Nineteen (19) ETFs cover the bond asset class. An example momentum screen is shown in the following screenshot. Look under the Position column to see which bond or treasury ETFs are recommended as a Buy.
The following worksheet comes right out of a spreadsheet known as the Kipling LRPC. Securities are ranked based on performance over two look-back periods as well as a volatility factor. A linear regression calculation is used to set up a projection-convolution percentage. The LRPC calculation identifies the general trend of the security as well as providing underlying risk warnings. This information is found in the Proj-Conv column.
Five ETFs are selected from each asset class and from a possible 25 ETFs another momentum screen is used to isolate the top five ETFs. No international ETFs passed the test at this time. Currently, the top five securities are: IWN, IJS, XLE, IHI, and SKYY. These five are added to the "Swensen Six" for the final analysis, shown below.
In the following worksheet, a maximum of six securities are selected to make up the portfolio. Under the Required column are the recommended number of shares to purchase for each asset class. Share numbers are based on a $100,000 portfolio.
There is one final screen I apply to the top tier ETFs and it is a Point and Figure Ratio screen. Here is an example of the IJS:RSP graph where RSP is used as the benchmark. Look for ETFs that are outperforming the equal weighted S&P 500 mirror ETF, RSP. When the X's in the far right-hand column exceed the height of the X's in the preceding column of X's, we have a confirmation of the Buy signal. IJS passes the PnF Ratio screen.
To avoid buying too many shares of a particular ETF, there are additional risk metrics available within the Kipling LRPC spreadsheet. Addition examples of how to use and implement this model can be found at https://itawealth.com.
Disclosure: I am/we are long IHI IJS DBC WOOD STIP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.