"Asset allocation is not everything. It's the only thing."
One of the harshest lessons of the Global Financial Crisis was that when the going gets tough, correlations trend to one, giving even diversified investors very few places to hide. It wasn't about whether or not you got burned, it was a more a question of degree.
While there's a time and a place for active stock selection, from a portfolio construction perspective, it's the active management of the overall asset allocation that affects the outcome.
Using ETFs for portfolio construction
The growing popularity in Exchange Traded Funds is in part because of their elegance in providing broad, liquid, efficient and cost-effective market access to most major asset classes with a single trade. We now have a broad range of building blocks with which to construct a diversified portfolio.
As a result, the problem for investors has shifted from "How best can I access a broad choice of markets?", to "How do I create a portfolio that suits my needs?"
How many ETFs are needed to create a portfolio?
To create a portfolio with too few ETFs would mean there is limited scope to create different asset allocation strategies. To create a portfolio with too many ETFs introduces additional complexity, oversight requirements, and a higher degree of trading costs if the portfolio is to be regularly rebalanced.
So what is the minimum number of ETFs needed to create a well-diversified portfolio?
A Strategic Core
For a strategic portfolio for a UK investor with £100,000 to invest and a desire to keep trading and ongoing costs to a minimum, we believe that advisers can construct strategic asset allocation models using the following “Magnificent Seven” broad asset classes alongside cash: UK Government Bonds, UK Corporate Bonds, Global Corporate Bonds, UK Property, UK Equities, Global Equities and Emerging Market Equities.
All 7 of these asset classes can be accessed through BlackRock's iShares range, mostly from their cost-efficient Core range.
Importantly, these ETFs are 'cash-based' or 'physical' meaning that they actually own the underlying holdings (unlike some ‘swap-based’ or ‘synthetic’ ETFs).
Liquidity and diversification
The fund sizes of these ETFs ranges from approx £400m to £4bn meaning external liquidity is high. Internal liquidity is as good as the underlying securities the ETF and index holds.
While investors see only seven holdings, a portfolio containing these 7 large and liquid ETF building blocks represents a diversified portfolio of some 6,901 individual securities, all of which are fully disclosed for each fund.
Strategic or Tactical
After creating a strategic asset allocation model, ETFs mean that tactical asset allocation changes can be executed in real-time, which can give significant implementation advantage in these volatile times.
As a starting point for advisers look to provide low-cost portfolio construction, using ETF building blocks for these key seven asset classes are a helpful first step.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of date of publication and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Elston Consulting to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Elston Consulting, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. ©2016 Elston Consulting Limited. All rights reserved. BirthStar, Elston Gamma, and Elston Strategic Beta are registered trademarks of Elston Consulting Limited. All other marks are the property of their respective owners.