engineer your portfolio with etfs

Engineer Your Portfolio with ETFs

By the end of November 2011, there were more than 1,400 different exchange traded funds (ETFs)

accounting for over $1 trillion dollars invested.

Which should I buy and how much?

You’ve heard a lot about ETFs. They’re an easy and convenient way to “diversify your portfolio,” but how about the real questions…

Harry Markowitz, PhD Modern Portfolio Theory (1952) Nobel Prize (1990)

Why not ask a Nobel Prize winner?

David Swensen, PhD Yale Endowment CIO (1985-present) Unconventional Success (2005) Pioneering Portfolio Management (2009)

… and the Chief Investment Officer at Yale University?


Use Modern Portfolio Theory David Swensen, PhD Yale Endowment CIO (1985-present) Unconventional Success (2005) Pioneering Portfolio Management (2009)

I invented it.

I wrote the book on it.

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Every investment has an expected return and some level of risk.

A Quick Lesson in Modern Portfolio Theory


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Stocks


Bonds

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You can mix investments to get different combinations of expected return vs. risk.

A mix of Stocks & Bonds

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There are an unlimited number of investments and combinations.

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There is a theoretical maximum expected return for each level of risk.

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The best combinations of investments form a curve known as the Efficient Frontier.


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The only way to get to the efficient frontier is by mixing uncorrelated asset classes.


If you synthesize the recommendations of experts and look at the practices of the best institutions, you come up with 6 core asset classes that are publicly accessible.

  US Stocks   Foreign Developed   Emerging Markets

  Natural Resources   Real Estate   Bonds

Why not more? More asset classes don’t materially add more expected return with less risk for the effort. Additionally, they may not be uncorrelated or may have too much volatility.

Modern Portfolio Theory

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Using Mean-Variance Optimization with the 6 asset classes allows you to find the optimal portfolio for each level of risk.


0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

100% Bonds US Stock Emerging Markets Foreign Developed Real Estate Natural Resources

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Which gives us an asset allocation for each point along the Efficient Frontier.


0% 10% 20% 30% 40% 50% 60% 70% 80% 90%


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?

Now, find the portfolio that has

the right amount of risk for you.

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Overall Risk

To find your risk tolerance, you need to measure your subjective willingness and your objective ability to take risk. Using tools on the internet, map your risk tolerance to any scale you choose. Also, lower your score if you find yourself providing answers that conflict with each other.

Subjective Score

Objective Score

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Take a risk questionnaire to identify your comfort with the risks of investing.

Subjective Risk Tolerance

Note: Most questionnaires will likely end with a portfolio recommendation with a different set of asset classes than we recommend. Your real goal is to figure out where in the risk spectrum you fall so you can map it back to the Efficient Frontier.

https://personal.vanguard.com/us/funds/tools/recommendation http://www.schwabmoneywise.com/public/moneywise/calculators_tools/questionnaire

Examples

Subjective Score 0 1 2 3 4 5 6 7 8 9 10

More Risk Less Risk

Objective Risk Tolerance

Use a financial planning tool to ensure you’ll have more investment income than spending needs when you retire.

The lower your investment income relative to your spending needs, the less risk you can take.

http://www.smartmoney.com/retirement/planner/

Example

Objective Score 0 1 2 3 4 5 6 7 8 9 10

More Risk Less Risk

Your Overall Risk Tolerance Score is the minimum of your subjective and objective risk scores. Using this score to help design your portfolio will help you avoid risk that you are unwilling or unable to take.

Overall Score

Subjective Score

Objective Score

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More Risk Less Risk

0 1 2 3 4 5 6 7 8 9 10 More Risk Less Risk

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Plot Your Risk Level

You are here.

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Back to choosing ETFs… We need to pick ETFs that represent each of the 6 core asset classes and buy them in percentages dictated by your risk tolerance.

Now which ETFs should I buy?

Filtering the universe of all ETFs only to candidates that represent the core asset classes gives you about 100 to choose from.

The rest will be ranked by three important characteristics.

Selecting ETFs

  Low Costs – favorable expenses

  Minimal Tracking Error – matches the underlying index closely

  Market Liquidity – can be traded

quickly and easily

Many investors look at expenses but neglect to look at tracking error and liquidity.

Selecting ETFs Three Important Characteristics

Wealthfront regularly surveys the ETF landscape and ranks ETFs in each asset class using the criteria described in the prior slide. Vanguard ETFs often come out on top. Wealthfront receives no compensation for recommending Vanguard products or any other ETFs.

  US Stocks – VTI

  Foreign Stocks – VEA

  Emerging Markets – VWO

  Real Estate – VNQ

  Natural Resources – DJP

  Bonds – BND

That’s how we got to our current recommendations: ( which you can also find at www.wealthfront.com )

Risk Level 5


David Swensen, PhD Yale Endowment CIO (1985-present) Unconventional Success (2005) Pioneering Portfolio Management (2009)

Now you have to

maintain it!

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2011

2012

The value of your investments will naturally drift over time as the market moves.

Rebalancing

Example •  Green increases in value. •  Yellow decreases in value. •  Blue stays the same.

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The new mix of asset classes will have a different risk and expected return.

Rebalancing

Rebalance

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Rebalance your portfolio to get back to your desired risk level with the highest expected return.

Rebalancing

Rebalancing Time-based or Threshold-based You can rebalance based on a variety of criteria. Some choose to rebalance after a predefined duration. We recommend rebalancing whenever any asset class deviates from a portfolio’s allocation by more than a certain percentage, depending on the type of account.

  For tax-deferred accounts: 4-6%

  For taxable account: 6-10%

… but with the following caveats

  Tax implications

  Impact of commissions

  Changes in your risk profile

Keep in mind…

Rebalancing Considerations

Most individual investors don’t rebalance because they struggle with these issues.

  Construct the Efficient Frontier

Allocate to the six core asset classes, select low-cost ETFs, and allocate optimally

  Place your portfolio on the Efficient Frontier

Understand your subjective willingness and objective ability to take risk and find the portfolio that’s right for you

  Keep your portfolio on the Efficient Frontier

Rebalance your portfolio weighing taxes, commissions and changes in your risk profile

To Recap:

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Nothing in this presentation should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Photographs do not depict actual Wealthfront clients. Financial advisory services are only provided to investors who become Wealthfront clients pursuant to a written agreement, which investors are urged to read and carefully consider in determining whether such agreement is suitable for their individual facts and circumstances. Past performance is no guarantee of future results, and any hypothetical returns, expected returns, or probability projections may not reflect actual future performance. Investors should review Wealthfront’s website for additional information about advisory services.

Disclosures

engineer your portfolio with etfs

Economy & Finance

pioneering

modern portfolio

expected return

expected return

asset classes

efficient

objective

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