What are the best ways to build portfolios using ETFs? It’s a big question, so we decided to create a series to examine the issue and provide some examples for Canadian advisors to review.
To that end, we’ll construct portfolios for a hypothetical investor using each of three popular methods: global macro, core/satellite and risk-based. This exercise will let us examine the process of portfolio construction and ETF selection. These sample portfolios are for illustration only. Further, this exercise is not intended to address the important issues of financial, estate or tax planning except when unavoidable.
About the Strategies
Global macro: describes a traditional, fundamental approach to investing. Often referred to as “top down,” it starts with an economic forecast for global economies and focuses on regions expected to outperform. Sectors are the next level of evaluation based on economic forecasts. Stock selection is not required when using ETFs, so portfolios are populated with products that play specific roles in the strategy, highlighting a region, country, sector or asset class like stocks, bonds and commodities.
The benefit of this approach is that it’s easy to explain, since it follows a logical progression that clients can understand relatively easily. The challenge is that economic forecasting is unreliable at best and projections for future events are fraught with uncertainty. Most critical is timing. Projecting an economic scenario is difficult enough, but relying on events to happen in a predetermined timeframe makes consistency virtually impossible. The goal is to be generally correct most of the time, which usually means getting the asset mix right or at least maintaining it in a diversified or neutral position that will mitigate the effect of getting the timing wrong.
Core satellite: has been popular among institutional investors for decades. It recognizes that returns consist of two main parts: those related to general moves in the market, or beta (β), and those in excess of the market return, or alpha (α). It also recognizes that if several active strategies are combined, they produce overlap that yields an index-like return at full fees! The strategy is to capture market (beta) return in a passive core portfolio at low cost, and make active alpha decisions in the satellite. Alpha can be derived from active asset mix shifts, country/region over- or under-weights, sector/industry/security selection and on the fixed income side from credit quality selection, sector selection (government, provincial, corporate), duration and changes in the shape of the yield curve. If the satellite does not outperform the core over time, it makes decision-making very easy—sell the satellite positions.
The evolution of beta into alternatives that include strategy and style beta in addition to broad market beta make ETFs even more relevant because these elements can be incorporated into the portfolio.
Core-satellite’s benefit is the identification of return by source that allows the two functions to be managed more efficiently. Capturing the return of a long-term asset mix (although increasingly controversial) at low cost in the core leverages the benefit of ETFs nicely. Active sector/industry “bets” in the satellite isolate how a portfolio differs from its performance benchmark. Systematic tax-loss harvesting (for taxable accounts) is another advantage of a core-satellite structure. Tax losses can be realized in the core on an ongoing basis to shelter gains in the satellite portfolio.
Target risk: was once the domain of only a few sophisticated institutional investors, yet managing component portfolio risk has become popular in the wake of the 2008 financial crisis. The current interest in minimum volatility strategies is an offshoot of this school of thought. The premise is that risk can be allocated or budgeted systematically to maintain consistent portfolio exposure over time. Risk is persistent, meaning it’s predictable in ways returns are not. The benefit is that the approach recognizes risk changes over time and with it the shifting correlations between asset classes that make diversification effective (or ineffective as the financial crisis proved). Maintaining consistent portfolio risk avoids catastrophic losses but will lead to missing out on market peaks. The downside is getting out of markets early and getting in a little late. The approach would have led to a defensive portfolio in 1998, two years before the market topped out during the technology boom, and in 2007, a year before the full force of the credit crisis hit. On balance, though, preserving capital has been a winning strategy over time.