Before embarking upon the journey of building effective ETF portfolio combinations, advisors should have a logical framework. This means keeping the investors’ goals foremost in mind, regardless of what type of investors they are.
What’s Your Framework?
To that end, FlexShares, the sponsor of several ETFs, argues having the right framework “aids the portfolio construction process” along with helping advisors to select appropriate investments.
Aside from the usual factors such as time horizon, risk tolerance and age, there are other questions to be answered. FlexShares identifies four important aspects of developing an optimal portfolio building system: capital appreciation, income generation, risk management and liquidity. Each of these factors plays a vital role in the portfolio construction and management process.
A financial advisor without a framework, is like a baseball slugger without a bat. Not only is it impossible to get hits without foundation, but it’s impossible to succeed without tools. Now let’s look at the tools.
Ideal Bond Mix
On the fixed income side, finding the correct balance of bond exposure in a client’s investment account is always a challenge. The Fixed Income Portfolio Builder tool at iShares.com is a good place to start.
The tool allows you to choose a target yield that aligns with the risk tolerance and duration needs of the client. After inputs are entered, it generates a suggested bond ETF mix based upon different interest rate levels and credit risk. The tool also allows advisors to enter a customized bond portfolio for comparison purposes.
For a moderately risk-tolerant investor with target effective duration of 10 years, the simulator suggested an 49.99% allocation to the iShares Emerging Markets Corporate Bond Fund (CEMB), 36.52% to the iShares Barclays 20+Year Treasury Bond Fund (TLT) and 13.49% to the iShares Barclays 7-10 Year Treasury Bond Fund (IEF). The blended average holding period for bonds in the underlying ETFs worked out to be 15.18 years.
The Bigger Picture
Many brokerage platforms offer online portfolio building tools that cater to ETF focused advisors. For example, the Fidelity ETF Portfolio Builder tool allows you to construct a customized ETF portfolio with funds across various families. Weightings of the actual ETF holdings inside the portfolio can be modified and benchmarked against corresponding market indices.
Another choice is to outsource portfolio construction. Folio, based in McLean, VA, offers over 100 pre-designed investment portfolios called “Ready-to-Go Folios.” Each combination is built around a particular investing strategy—like an industry sector, investing style, geographic region or retirement goal. Every Ready-to-Go Folio has an overview of the securities within the investment portfolio along with performance tracking.
Another comprehensive portfolio tool is called the AllocationADVISOR from Zephyr. This software program allows advisors to dynamically allocate assets among various asset classes using either classic mean variance optimization or the sophisticated Black-Litterman model to build portfolio efficient frontiers using any of over 50,000 supplied indices. Since most ETFs are index linked, plugging them into portfolio models is a natural step.
Other features of the AllocationADVISOR system include the ability to compare an existing or proposed portfolio to alternative portfolio allocations along with estimating the probability of meeting a client’s investment goals with the Monte Carlo simulation module. Reports can be created with graphs and tables that can be exported to Microsoft Word, Excel, PowerPoint or Adobe PDF.
The Tax Factor
Selecting the right ETFs along with the right asset mix aren’t the only chores in building optimal portfolios. Conscientious financial advisors are wise to spend effort in determining good “asset location.”
Asset location can be defined as the deliberate step of strategically placing ETP investments in taxable and tax-deferred accounts with the goal of reducing the investor’s tax liabilities.
Smart asset allocation, for example, involves holding tax inefficient assets like bonds and REITs inside tax-deferred accounts like 401(k) plans and IRAs. Why? Since the majority returns delivered from bonds and REITs is from dividend income, they’re subjected to potentially less favorable ordinary income tax rates. And that’s where “asset location” saves the day! It minimizes the burden of paying annual income taxes on dividends coming from these sources. What about equity ETFs? Because most index based stock ETFs are tax-efficient, the optimally designed portfolio can hold them in taxable brokerage accounts. These types of ETFs have low portfolio turnover and the trading activity of other shareholders does not negative affect buy-and-hold investors. Furthermore, the unique redemption/creation process of ETFs allows fund managers to pass capital gains to institutional investors that redeem creation units, thereby eliminating capital gains distributions at the end of the year for ETF shareholders.
While constructing optimal ETF portfolios for clients is important, it shouldn’t be an all-consuming exercise. Savvy advisors understand this and for that reason have taken steps to deliver high quality solutions in an efficient manner. This may include hand crafting ready-made or pre-designed ETF portfolios.
“I’ve built 8 ETF models which give me an accurate idea of risk/return parameters for each portfolio,” says Kirk Kinder, CFP with Picket Fence Financial in Bel Air, Md. Kinder then evaluates what amount of market exposure that each client should have based upon their investment objectives. “Once I have the percentage of asset classes I then screen and select appropriate ETFs.” From there, Kinder customizes each ETF model to specifically match the client.
Using carefully pre-designed ETF models and adapting them to each clients’ needs can save time and energy. This isn’t to say customized portfolios built from scratch can’t be optimal. They can be, but efficiency, in the name of portfolio customization, should not be sacrificed.
Building optimal ETF portfolios begins with a good foundation. Develop a framework that works for you. The next step is to use the array of financial tools available to help you execute. Work with the tools that streamline your efforts. And finally, pay special attention to smart asset location. When combined with asset allocation, it will minimize taxes and maximize gains. And the end result will be optimal ETF portfolios.