A Diversified Portfolio of ETFs

Several weeks ago, I posted an article titled Asset Classes For Portfolio Diversification.  In that article, I presented a chart showing how I categorize investments to determine how well-diversified my portfolio is.

Today I decided to create a sample diversified portfolio using only Exchange Traded Funds (ETFs).  I wanted to use the fewest number of ETFs possible to achieve diversification.  I used ETFs because each ETF invests in many stocks, bonds, options or futures contracts, so that each ETF has its risk spread over many investments.

DISCLAIMER:  I am not recommending that you buy any of these ETFs.  I chose real ETFs to demonstrate how an investor could construct a diversified portfolio and to calculate how that specific portfolio would have performed.  As I discussed in the previous article on diversification, everyone will have their own desired percentages for each investment category.  Any specific example portfolio, such as this one, will not be suitable for everyone.

Although I will discuss why I chose each ETF, and may give alternative choices, the particular ETFs may not be suitable for you.  One website that you can use to select ETFs in various categories is the ETFdb Category Tool.

The Example Portfolio

Category ETF
Symbol
ETF Name Portfolio
Percent
———————————- ———– ————————————————– ———–

Domestic Stocks

VTI

Vanguard Total US Stock Mkt.

13%

Foreign Developed Mkt.

VEA

Vanguard MSCI Euro Pacific

5%

Foreign Emerging Mkt.

VWO

Vanguard MSCI Emerg. Mkt.

7%

Gold/Silver Bullion

IAU

iShares Gold Trust

20%

Gold/Silver Miners

GDX

Market Vectors Gold Miners

5%

Commodities

GCC

GreenHaven Equal-Weight Commodity

15%

Real Estate

VNQ

Vanguard MSCI U.S. REIT

25%

Bonds

BSV

Vanguard Short-Term US Bond Mix

10%
——-

Total

100%

Using these ETFs our Asset Diversification Chart looks like this:

ETF Portfolio Diversification

Notice that there is nothing allocated for Cash.  Any portfolio should have an allocation for Cash, but since that doesn’t affect the performance (measured in dollars) I have left Cash out of the portfolio.

There is also no allocation for Currencies or Other.  That is on purpose.  It’s hard to measure the performance of “Other” investments, and I don’t think most people should fool around with Currencies.

Portfolio Performance

I used a “backtest” tool to see how this portfolio would have performed. [Update: A better backtest tool is the free program EzBacktest, that you can find at http://ezbacktest.blogspot.com.]

Over the past two years, this portfolio would have had a total return of 59.1% compared with 50.1% for the S&P500.  The compound annual growth (CAGR) of this portfolio would have been 26.1% per year compared with 22.5% for the S&P500.

The following chart shows the performance.  The portfolio is in green and the S&P500 is in blue.  $100K invested two years ago would grow to $159,100 vs. $150,100 for the S&P500.  This is 6% better than the S&P500.

ETF Portfolio 2-Yr. Performance

It should be noted that this two-year period is after the crash of September, 2008 to March, 2009.  The following chart shows the performance from February 1, 2008 through May 27, 2011.

ETF Portfolio 2.5-Yr. Performance

Including the crash, the portfolio would have had a total return of 21.9% vs. only 2.6% for the S&P500.  The portfolio’s CAGR would have been 6.1% per year vs. 0.8% for the S&P500.

About the Specific ETFs

In choosing the ETFs for this portfolio, I tried to use Vanguard products, because Vanguard usually has lower management fees than other companies.  If you are a Schwab investor, you can invest in Schwab ETFs with low fees and no sales commissions.  Other brokers have commission-free arrangements with some of the ETFs.

Three of the ETFs weren’t my first choice for the portfolio.  I would have preferred to use GDXJ, the “junior miners” (small cap.) ETF instead of GDX, but GDXJ hasn’t been around long enough to demonstrate performance.

Also, I might have replaced VTI with SCHG and SCHA, two newer Schwab ETFs.  SCHG is large-cap growth, and SCHA is small-cap growth.  Because VTI is classified as a “large-cap blend,” the allocation chart doesn’t show any small cap stocks.  It’s OK for all the foreign stocks to be large-cap, but I would have preferred for about half of the domestic stocks to be small-to-mid-cap.  Schwab also has an equivalent ETF to VWO (SCHE, emerging markets).

In Commodities, the most obvious choices would probably have been DBC or RJI.  However, since I was only going to choose one ETF for this category, I chose GCC, because it has more exposure to Agriculture and less exposure to Energy than the other two ETFs.

Which ETFs Performed the Best?

Over the past two years, the best-performing ETF was VNQ the Real Estate Investment Trust ETF.  Its total return was 106%.  The second-best performers were a tie between VTI (total stock market) and IAU (gold) at 55%.  The worst performers were BSV (bonds 0.8%) and GDX (gold miners 1.6%).

Conclusion

It isn’t difficult to construct a diversified portfolio using eight to ten ETFs.  In the example portfolio, if your total investment was $10,000 then you would still have at least $500 in each ETF.

Our example beat the S&P500, which is usually used as a benchmark for investment performance.  Making 6% more than the benchmark over a two-year period may not seem very impressive, but a 6% beat is not bad.

Also, the example portfolio was slightly less volatile than the S&P500.  Over two years, its volatility was 16.1% vs. 16.6% for the S&P500.  However, in the second timeframe, which included the crash, the portfolio volatility was 21.4% vs. 28.8% for the S&P500.

These eight ETFs may not perform as well in the future, so this is not a recommendation.  In fact, the only one of these ETFs that I own is IAU.  Also, the allocation percentages of my personal portfolio are not the same as the percentages of this example portfolio, so even I am not putting money into this particular portfolio.

[Update: See how this portfolio performed during the first fourteen months after this article was posted.]

Permanent Link to this post: http://richardkinnaird.com/blog/a-diversified-portfolio-of-etfs/

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Sunday, May 29th, 2011 Stocks

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I am not a registered financial advisor. I only offer opinions, and sometimes these opinions veer off at weird angles from conventional wisdom (That's probably why you are here). My advice is, "Don't take my advice." Read my sidelong glances at economic issues and form your own conclusions.

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