Aug. 21, 2009
This Website has been actively supporting the use of index products like ETFs to build an investment portfolio. The advantages are very clear: on average index funds are significantly better performers than managed products and the costs are much lower.
We have received a large number of reader requests on how to select the right products from an avalanche of new ETF and index products. Just two years ago you would have typically found ETFs only for the large blue chip indices like the S&P 500 or the DJ Eurostoxx50. In the meantime fund firms have been busy in replicating the most exotic index offering ETFs like Powershares Zacks Micro Cap (PZI) or the S&P North American Technology-Semiconductors Index Fund (IGW).
It is quite easy for a private investor to get terribly lost in the mass of newly issued products. In some cases the term “ETF” or “passive” is even used to lure investors, while the underlying index was just developed to support some new product.
In this 2-part series we will first talk about the general rules of how to select the right ETFs. The second part will talk about the specific differences between products of different issuers (fund firms). We assume that you have already thought about your strategic asset allocation. If not: read our series on the right asset allocation or download our guide.
When you think about your product selection, the most important thing is to keep it simple. So here is rule number one:
Rule 1 – Keep it simple. It does not make sense to amass dozens of index products with a 1% share of your portfolio each. It would become very difficult for you to follow and track all those products. In essence, you should have only a maximum of five to seven different ETF products that make up the core of your portfolio (or primary portfolio). So what we are talking about here are for instance three equity ETFs, two bond ETFs and one commodity ETF.
It is very important that you think intensely about which products you allocate as the core of your portfolio because that would make about 60% to 70% of your total holdings. We have seen many investors who had a very strong core in stocks or bonds belonging their home country, a mistake that can be costly. Which brings us to the next rule:
Rule 2 – Avoid home bias, go for diversification. Stock as well as bond indices are now available for every major global region. Make sure that your core portfolio covers at least two or three major regions besides your home country. Many investors at this point wonder which index to choose exactly.
For cost reasons and because of market liquidity we prefer the big, popular blue chip indices. So here is the next rule…
Rule 3 – Go for the big, liquid indices. In Europe this would be for instance the DJ EuroStoxx50. In the US the S&P 500 or the DJIA are our favourites. If you are looking for a worldwide blue chip index the S&P 100 Global should be a good choice. If you look on the bond side you would have similar indices. One good choice if you are looking for relatively safe government treasuries and international exposure is the S&P/Citigroup International Treasury Bond Fund. But there are many others to choose from.
Rule 4 – Have a secondary portfolio for riskier strategies. Once you have selected the right ETFs for your core portfolio you need to think about the remaining part (30%-40%). Let’s call it the secondary portfolio. This smaller part of your portfolio has two main functions: firstly, you can invest in riskier or more exotic assets and secondly you can enhance your portfolio diversification. Strategies are for instance ETFs on small/mid caps, emerging markets stocks/bonds, specific industries that you may have knowledge of or other proven strategies like “Dogs of the Dow”.
All those investment strategies have one thing in common – they are somewhat riskier and historically show a better performance than the overall market in the long-term. Because of their higher risk (higher volatility) they should usually not be part of your core portfolio but you can – over a long-term horizon expect to profit from a better performance.
Watch out for part 2 of this series when we will discuss the differences between seemingly similar or identical ETF products.