The Curious Investor

Now that we’ve been through most of the exchange traded products out there. Let’s take a look at how we can use them. The most popular use of ETFs these days has been for passive indexing sometimes referred to as an ETF wrap. For those of you who are familiar with mutual fund wraps the ETF wrap is not very different. It’s just the use of ETFs to achieve passive indexing and asset allocation goals as opposed to using index mutual funds. It sounds rather boring doesn’t it? Well, for anyone that’s read A Random Walk Down Wall Street knows how important passive indexing can be. For those that need a refresher, check out this article, Active Mismanagement, from TheStreet.com.

ETFs real benefits for those interested in passive indexing. While their liquidity probably doesn’t mean much for anyone who is applying a passive indexing/asset allocation strategy as the goal is typically to buy-and-hold and rebalance only when necessary, ETFs do offer the ease and liquidity of stocks which allow you to apply timing strategies or to sell to raise cash in a bind.

More importantly are ETFs’ effectiveness as indexing tools. Theoretically speaking, ETFs should also provide better tracking as compared to index mutual funds as the fund managers don’t need to worry about keeping cash available for investor redemptions. Also, they have expense ratios nearly half of those found in index Mutual funds. For example, Vanguard’s S&P 500 mutual fund has an expense ratio of .18% whereas iShares’ S&P 500 ETF has an expense ratio of .09%. While it doesn’t seem like much, over the long run, it adds up. Finally, since ETFs have become so popular of late, they offer very broadly diversified options for asset allocation. A lesson learned in The Intelligent Asset Allocator (read my review) is that the more specific you are with the assets in your asset allocation, the more precisely you can manage risk and extract return.

So, how do can you create your own asset allocation? Well, I would suggest reading The Intelligent Asset Allocator (read my review) for details on how to crunch risk-return numbers and create optimal allocations. The book leaves out exactly where to get details on prospective assets for an allocation and that’s where ETFs really shine, especially those offered by iShares. iShares details all historical returns data for every one of their ETFs. Most importantly, it allows downloading of raw data for each ETF and manipulate it in Excel. As index-linked ETFs have strictly defined investment methods and are typically very broadly diversified (within their given discipline), they can each be treated as a statistically unique asset class. As a result, historical risk and return should exhibit relatively stable long-term behavior. The beauty of ETFs is that this strategy allows you to be able to add something like value or growth style funds into an asset allocation without compromising your passive tracking. The one caveat is that since ETFs have not been around for very long, using them as a substitute for real asset class data (i.e. using the S&P 500 ETF data in lieu of historical data on the S&P 500) is limited by the amount of data that is available on them. As with any statistical analysis, the larger the sample size the better. I would suggest only using ETFs as a substitute for real asset class data if they have been around for more than 5 years.

Passive indexing is understandably boring for those interested in managing their own money. After the initial gathering of returns data and crunching of numbers, one usually has to commit to at least 5 years of an asset allocation in order to ensure that the allocation will realize its goals. For the next few years, the amount of time spent on the allocation might not even eclipse 30 minutes a year for re-balancing. In the end, the results can also be a bit boring in that passive indexing is beta focused. That is, one designs the allocation with an inherent level of volatility in mind returns should rarely deviate from an intended range. This can be especially frustrating in poor markets. The surprising thing about passive investing is that it ultimately takes a lot more discipline than one would expect. Winning assets must be sold during re-balancing and losers must be bought. In times of volatility and trouble, the allocations demands that the investor sit still and watch.

So, how can you mitigate some of the temptations to actively manage? Set up your overall investment strategy using a core-satellite approach. The core should be made up of a passive asset allocation designed to provide the portfolio with steady, dependable returns (beta). The satellite can be your actively managed strategy designed to be uncorrelated with the market and provide excess return (alpha). The end result is a balanced portfolio which will provide strong returns with managed risk exposure.

Bookmark to: