etf-portfolio-construction4

Investor profile

  • Portfolio size: $1,000,000
  • Tax status: taxable
  • Time horizon: over 10 years
  • Risk: moderate
  • Objective: growth

Benchmark

  • 20% Canadian equities (S&P/TSX Composite)
  • 20% U.S. equities (S&P 500)
  • 20% International equities (MSCI EAFE)
  • 40% Canadian bonds (DEX Universe)

If it is possible to build a reasonably effective portfolio with three to five ETFs, what is the value of adding more? Regardless of the investment strategy used, the simple answer is diversification. But nothing is simple in today’s interconnected global markets.

Diversification is the most frequently used tool to manage risk but 2008–2009 taught us the limitations. When investors need protection most, correlations tend towards one. In other words, everything moves in the same direction at the same time, usually down.

Many institutional portfolio managers have moved towards adding asset classes as a remedy. In 1980, for example, the Harvard Management Company (HMC) listed three asset classes in its policy portfolio: domestic stocks, domestic bonds and cash. By 1991, this list had grown to six (adding real estate, foreign equities, private equity) and in 2013, the list is up to 13.

The good news for those of us with less than the $32 billion that HMC manages for the Harvard Endowment is that asset classes that were once only available to institutions are being replicated by ETF sponsors. While some of this diversification is useful, the jury is out on the value of continuously adding new asset classes.

Finding an asset class with low historical correlation to other asset classes identifies a static relationship in a dynamic world. In our research, we have found that while selected additional ETFs add incrementally to diversification, the costs, both management expense ratios and trading, beyond the 20th holding can exceed the incremental benefit.

The three portfolios presented here use only Canadian-traded ETFs. Many high-net-worth portfolios are taxable so involve tax issues related to owning U.S.-traded products. Most brokerage firms settle U.S.-dollar denominated trades in Canadian dollars charging an FX spread ranging from 0.25% to 1%. To minimize these costs, we chose Canadian-traded ETFs whenever possible. There are simple remedies to these issues but we leaned towards simple solutions. There is a depth to the products offered in the U.S. that could be useful and may be considered.

Global macro

The global macro portfolio is balanced with a focus on long-term growth.

Fixed Income: The major portion of the fixed-income portfolio is balanced between a broad aggregate bond index (VAB) and Canadian short-term corporate bonds (VSC). This reflects a conservative duration positioning against a rise in rates over the next few years. Small positions in high-yield (XHY) and emerging markets (ZEF) allow for participation in growth and yield assuming the economic recovery continues.

Equities: The equity part of the portfolio is a balance between low-cost Canadian (HXT), U.S. (VFV) and international (VEF) stocks. Adding modest positions in emerging markets minimum volatility (XMM) adds growth and diversification. Real estate (CGR), agricultural commodities (ZCA) and junior gold shares (ZIG) round out the portfolio. We added a modest position in the VIX Short Term Inverse Futures that has similar risk characteristics as U.S. equities but offers a premium because of volatility rolling. If volatility picks up (over 20 for VIX), sell the position.

Weight Ticker Exchange Name Mgt Fees Benefit
16% HXT Canada Horizons S&P/TSX 60 Index ETF 0.05% Resource-driven, Canadian equities provide inflation protection. Relative economic strength. Overweight
14% VFV Canada Vanguard S&P 500 Index ETF 0.15% Recovering U.S. economy with U.S. dollar exposure. Overweight
9% VEF Canada Vanguard FTSE Developed ex-North America Index ETF (CAD-hedged) 0.28% Diversified exposure to international equities. European credit issues persist. Underweight
5% XMM Canada iShares MSCI Emerging Markets Minimum Volatility Index Fund 0.79% Diversified exposure to the growth of emerging markets mitigated by minimum volatility overlay. Overweight
3% ZJG Canada BMO Junior Gold Index ETF 0.55% Buy on weakness
5% CGR Canada iShares Global Real Estate Index Fund 0.74% Exposure to the recovering global real estate sector
3% HVI Canada Horizons BetaPro S&P 500 VIX Short-Term Futures™ Inverse ETF 1.15% Exposure to the premium generated by short volatility rolling
5% ZCA Canada BMO Agriculture Commodities Index ETF 0.65% Diversifying and inflation-hedging exposure to the agriculture commodities
5% XHY Canada iShares U.S. High Yield Bond Index Fund (CAD-Hedged) 0.60% Diversified exposure to high-yield U.S. bonds with moderate interest rate risk as measured by a duration of approximately four years
5% ZEF Canada BMO Emerging Markets Bond Hedged to CAD Index ETF 0.50% Diversifying exposure to emerging fixed-income markets
10% VAB Canada Vanguard Canadian Aggregate Bond Index ETF 0.20% Broad Canadian fixed-income component
5% XFR Canada iShares DEX Floating Rate Note Index Fund 0.20% Cash equivalent further shortens interest rate sensitivity
15% VSC Canada Vanguard Canadian Short-Term Corporate Bond Index ETF 0.15% The short three-year duration of this corporate bond portfolio provides a hedge for interest rate risk in low interest rate environment
100% 0.32%*

*weighted