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

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Includes: EEM, EFA, IDU, IEF, IGE, IJH, IVV, IWM, IXC, RWR, SHY, TLT
by: David Jackson

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.

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