Asset allocation is at the heart of the portfolio management process.  For investors seeking to enjoy risk-efficient returns over a long time period, prudent allocation decisions are most likely the most important component for sustained success.  With this post we continue the recent focus on the role of Exchange Traded Funds (ETFs) and suggest how in the course of conducting effective ETF research you can put together an intelligent allocation strategy based on individual ETF exposures.

As a model for asset allocation we use the example of a Core/Periphery strategy.  The basic thinking behind Core/Periphery is simply this: a large segment of your portfolio should reflect fairly stable, seldom-changing exposures to diversified traditional equities and fixed income asset classes.  This is the core component.  Then, with a smaller percentage of total holdings (so as not to put too much of your total assets at risk), you can identify more “exotic” exposures where you think returns may be particularly attractive over shorter cycles, and trade in and out of these positions more frequently as market conditions suggest.  By diversifying the asset classes contained in the periphery component you also hedge the risk that any one of your cyclical bets may prove way off the mark.

There is no one accepted split between core and periphery, but for purposes of this exercise let us seek to construct a portfolio with 85% core holdings and 15% periphery.  The first task is to build out the stable core.

The core should consist largely of traditional equities and fixed income holdings.  The percentage allocations to each asset class, as well as the extent to which the core should contain traditionally riskier assets like emerging markets equities or real estate investment trusts (REITs), depends on the investor’s risk profile (note: in a forthcoming posting we will be talking more about the formation of an investment policy for asset allocation based on investor risk objectives and risk tolerance).

Let’s assume here that the investor has a somewhat growth-oriented objective and a long-enough time horizon to justify the inclusion of some riskier assets.  We will thus start by determining the percentage split between equities and fixed income for the core component, which as we noted above is to be 85% of the total portfolio.  Of that 85%, equities will comprise 50% and fixed income will make up 35%.  Now, we could simply stop there and provide one broad equities and one broad fixed income exposure: say, the iShares Russell 3000 Stock Index (ticker IWV) and the iShares Barclays Aggregate Bond Index (ticker AGG) respectively.  Quite easily done.

However, we know from earlier discussions on style investing that there can be distinct benefits to segmenting exposures into style-specific asset classes.  For example, we might want to incorporate both valuation style (style versus growth) and capitalization style (large versus small).  A good selection here may be the iShares Russell 1000 Value Index (IWD) and the Russell 1000 Growth Index (IWF) for value-versus-growth exposure, and the Russell 2000 Index (IWM) to capture the small-cap component.  We have heard about the so-called “value effect” (see our June 24 post “A Practitioner’s Guide to Style Investing (3)” for a discussion about his phenomenon) and would like to strategically overweight this asset class.  Using this approach we may break down that 50% core equities component as follows: 25% large value (IWD), 15% large growth (IWF) and 10% small cap (IWM).

In this case our core portfolio is still limited to domestic US stocks, however, and we know that most of the growth in the world is taking place elsewhere.  We believe that a core exposure in non-US stocks is also warranted.  This should reflect both developed non-US markets, for example the MSCI EAFE – Europe, Australasia and Far East Index (ticker EFA) and the MSCI Emerging Markets Index (EMM).  Now our core equities exposure is more precisely defined along both style and geographic location lines.  Our 50% core equities component may now look like this: large value (IWD) 15%, large growth (IWF) 10%, small cap (IWM) 7.5%, developed non-US (EFA) 10%, and emerging markets (EMM) 7.5%.

Now we have to decide if we want to diversify the 35% core fixed income component away from the single broad-market exposure.  This depends on several factors: many investors see bonds as a safe haven rather than an active opportunity for increased returns.  Under this way of thinking it can be perfectly appropriate to leave that entire 35% in the broad Barclays Aggregate (AGG) holding.  But since we can diversify the fixed income component let’s see how that could work: for example, intermediate term US Treasuries (iShares Barclays 3-7 Year Treasury – ticker IEI), investment-grade corporate bonds (Barclays Intermediate Credit – ticker CIU), high yield bonds (iBoxx High Yield Corporate – ticker HYG), and non-US exposure (S&P/Citigroup International Treasury – ticker IGOV).  Let’s divide these as follows: intermediate Treasuries (IEI) 12.5%, investment-grade corporates (CIU) 12.5%, high yield (HYG) 5%, non-US bonds (IGOV) 5%.

So our total core portfolio now looks like this:

Core Equities:                           50%

of which

US Large Value                         15%

US Large Growth                       10%

US Small Cap                           7.5%

Non-US Developed                   10%

Non-US Emerging                    7.5%

Core Fixed Income                   35%

of which

Intermediate Treasuries          12.5%

Investment Grade Corporate   12.5%

High Yield                                   5%

Non-US Government                   5%

The final step is to select the 15% peripheral component.  Now, as we noted above this component is expected to change on a much more dynamic basis than the core component.  Here is where you can tap into your inner market pundit and see if your read of global macroeconomic, geopolitical and socio-cultural influences on markets is correct or not.  For example, you may have a view that the property and financial markets in Asia are set for a boom and want to be a part of that. You could take a position in the FTSE EPRA/NAREIT Developed Asia Global REIT Index (ticker IFAS) and the MSCI Far East Financials Sector (ticker FEFN).  But hold on, you think, that boom may not come to pass, so let’s at least hedge part of that exposure with a relatively uncorrelated asset like gold: iShares Comex Gold Trust (ticker IAU).  Equally weighting these three periphery assets lets us complete the portfolio:

Periphery Exposures:                15%

of which

Asia Global REITS                      5%

Far East Financials                       5%

Gold                                            5%

Voila!  You now have a diversified portfolio allocated along risk tolerance guidelines comprised of ETF exposures tracking well-known benchmark indexes.

Important disclosures: The above example is used for illustrative purposes only and does not represent a recommendation or solicitation by the author for this or any other specific asset allocation strategy.  Investors should carefully weigh their own return and risk considerations before investing in ETFs as well as heed the transaction costs, tax implications and other material factors.  Past performance is not a meaningful predictor of future returns.