Portfolio construction analysis using ETFs and risk profiling

ETFs

The first step is setting up an investment account is to understand the client. Everything flows from this. The client profile is developed through an extensive interview process, wherein the advisor seeks to gain an understanding of the client's personal circumstances, current and envisioned financial situation, risk tolerance and investment knowledge (Anthony, 2011). With this information, the financial advisor can then build a profile based on the portfolio objectives and risk constraints. For this portfolio, the focus will be on exchange-traded funds. The objective of this exercise is to build the optimal portfolio for the client, taking into account the client's personal circumstances and the variety of funds that are available to build the portfolio.

Client Profile

The client is a male, late 20s, with a long-term girlfriend. They have no current plans for children. They are American, living and working in Miami, and therefore are eligible to purchase securities on American exchanges. The client recently graduated with an MBA in Finance, and has taken a job with an investment bank, the current role doing forex at the Miami office, where the specialty is Latin American currencies. The client has set aside this initial $100,000 for an investment fund. The client has another savings account of $200, 000, but this is earmarked as a down payment for the purchase of a house on a canal. The client has also started a tax-protected retirement fund. So the total investment funds are $100,000 at this point. The client expects that his earnings and those of his girlfriend will be sufficient to cover all living expenses, so the investment fund constitutes money that is not expected to be used any time soon. It is purely a saving account. The time horizon therefore is retirement, which the client expects will be 30-40 years hence.

Armed with a master's degree in Finance and a job in forex, the client is a sophisticated investor. While he has not studied derivatives or arcane instruments extensively, the client has the background knowledge to get up to speed on any investment product quickly. The client is fully aware of market risks, the relationship between risk and return, and other basic financial concepts. He is familiar with and subscribes to the efficient market hypothesis. The client has explicitly stated that with this fund he has a high risk tolerance, owing to his high level of financial knowledge and the fact that the account has a long time horizon.

Asset Allocation

The client has a long time horizon, high level of investment knowledge and high risk tolerance. The client also does not believe that he can beat the market, so is willing to accept funds. Further, because of the client's view, he prefers funds with low MERs, so exchange-traded funds are ideal, since he only pays the upfront transaction cost, and then the transaction cost again upon disposition. An MER is the expense ratio, the fee that is taken by the fund manager for the managing of the fund to cover operating costs. This is expressed as an annual percentage of the fund's value (Investopedia, 2013).

For a client with a long-term time horizon and little risk of needed the money in the short run, the basic assumption is that a riskier portfolio can be constructed. For this client, the stated acceptance of high risk confirms this. The portfolio can be 100% equity at this point, as Costa (2011) notes for the "dynamic" portfolio. Cash can be held during periods of uncertainty but at this point there is little cause for uncertainty in the markets. Within asset classes, there are a mix of risks, so that should be taken into consideration. Not all options are internally diversified. Something like, for example, ProShares Ultra Pro-Financials is a basket of financial companies, so would be affected more by changes in interest rates than would a basket that featured a broad-based index or another industry. The basket therefore should focus on 4-5 different asset classes. A total of 40% in moderate risk classes and then 60% in broad-based ETFs. This portfolio would have a high-risk construction, featuring a beta of at least 1.2 (maybe up to 1.4), thereby giving the client the expectation of returns above the market average. The downside is that these funds will sometimes have MERs, which would reduce the real return on the funds. If they are priced rationally already, then the rational investor might not want to have funds that have MERs, because they would not offer a positive risk-adjusted rate of return. The objective for the client at this point, however, is to earn a higher return over the long run, and to do this we need to invest a portion of the portfolio in higher-risk sectors. This move is expected to yield above-market returns in the long-run. The client can bear this risk because there is no need for the funds in the foreseeable future -- the time horizon is 30-40 years.

Exchange Traded Funds

An exchange-traded fund is a fund that "tracks an index like the Nasdaq 100 Index, the S&P 500 or the Dow Jones" (NASDAQ, 2013). Exchange traded funds have the objective of replicating the performance of their index. ETFs have several benefits. The first is that they provide diversification. With a total portfolio value of $100,000, it will be difficult to get diversification for the client buying stocks directly. The use of ETFs or mutual funds will be required to get a properly diversified portfolio. Another benefit is that the transaction costs are lower with ETFs, compared with building a portfolio. Only a few transactions are needed with ETFs compared with dozens when buying equities, and the diversification will probably be greater. ETFs are a good value method of building a portfolio (Costa, 2011).

Another benefit of exchange traded funds is that they are suited for passive management, because they are intended to mirror marketing performance. This fits in with the efficient market hypothesis, something my client expressed belief in. Further, the fund managers only need to make periodic changes to the funds, which results in lower management costs (MERs) when compared with actively-managed funds (Costa, 2011). ETFs are a low-cost method of investing for those who prefer the passive management style (NASDAQ, 2013). It should be also noted that ETFs are more tax-efficient than actively managed funds, because there are fewer capital gains accrued in a given year, due to the lower transaction volume (Iachini, 2012).

Flexibility is another advantage of exchange traded funds (ETFs). The fact that they are traded on exchanges enhances liquidity, and perhaps more importantly they can be traded during the day. The client therefore locks in the price at the point of the decision to sell. This contrasts with mutual funds, where prices are set at the end of the day. This can be financially damaging when the market is declining rapidly, because the client is unable to sell during the trading day, and therefore accrues all of the losses that occur after the sell decision has already been made (Hansen, 2006).

Choice of Funds

Morningstar outlines the different ETFs that are available. The first decision is with respect to the 50% that is going to be allocated to a broad-based ETF. The decision here is the choice of exchange. The NASDAQ 100 is weighted towards technology companies, Dow funds represent a sufficient degree of diversification while the S&P 500 provides the greatest degree of differentiation. These indexes have slightly different performance characteristics. With a 40-year time horizon, it is impossible to tell which of these is likely to increase the most, but of them the S&P 500 is the least volatile and the NASDAQ the most.. The NASDAQ's heavier-than-average exposure to tech gives it greater growth potential, but the client intends to use the remaining 60% of the portfolio to pursue growth. This 50% is the safety part of the portfolio, so an S&P 500 fund is going to be chosen. The recommended fund is the Guggenheim S&P 500 Equal Weight. Many S&P 500 funds are weighted towards a specific industry, but that is not the mandate of this part of the portfolio. This fund gives equal weight to the index, rather than the market weight. This means that each stock within the portfolio is given the same weight, subject to occasional rebalancing. Each stock is given 0.2% of the fund. The result is a slightly greater emphasis on smaller-cap stocks with growth potential, while retaining a fund that has mainly large caps. The long-run performance of this fund is superior to the S&P 500 (Morningstar, 2013). This fund is rated five stars by Morningstar and has an MER of 0.4% (Morningstar, 2013).

Another 10% will be allocated to the iShares Dow Jones, which gives exposure to the largest U.S. companies. This fund mirrors the performance of the Dow Jones Industrial Average, so it should be the most stable component of the portfolio. Its role is to provide stability to the portfolio and it will also provide the only exposure to major U.S. large-cap stocks. The fund has a four star rating and an MER of 0.2% (Morningstar, 2013), making it a good value component of the portfolio.

The remaining 30% of the portfolio is to be split among three ETFs, each covering sector that should promise higher growth. Specifically ruled out are the more esoteric funds, such as short funds and highly-leveraged funds. The client may not need this money right away and would understand the nature of these products, but is not wealthy enough to justify the risks associated with high leverage and short-selling at this point. It is recommended that the client take exposure to biotech, as this area holds tremendous promise. The timeframes for advances are unknown and it is impossible to guess which companies will experience the breakthroughs, so a basket of biotech firms is the best way to gain exposure to this sector. In general, the success of the industry is correlated with the economy and the number of critical breakthroughs that are made. Biotech is usually health care, but can involve other industries as well (BIO, 2013). The iShares Nasdaq Biotechnology ETF is a four-star fund that has an MER of 0.48%, which is low for a more actively managed ETF (Morningstar, 2013). The fund is comprised of a basket of 118 biotech firms, each with market caps of at least $200 million (Morningstar, 2013). Morningstar notes that this fund is the most diversified biotech ETF on the market, which is good for the client to gain general biotech exposure in his portfolio (Morningstar, 2013).

Another sector that is recommended is small cap, which encompasses a wide range of industries. The Vanguard S&P Small Cap 600 Growth Index ETF is S&P-based, so includes NYSE companies. This four-star fund provides exposure to a wide range of industries, with the growth companies in each being highlighted (Morningstar, 2013). These companies are large enough for the S&P 600, but they are still on growth trajectories. A growth fund is beneficial to the portfolio for a couple of reasons. The first is that it increases the expected return of the portfolio, as growth stocks should have higher volatility. However, growth stocks are often better-positioned to grow even during down markets, if they have innovative products. The alternate view is that they are riskier because their markets are less established (Investopedia, 2013). The higher volatility is something that we are seeking for this part of the portfolio, as growth opportunities are welcomed with the long-term time horizon. The allocation is going to be 10%.

It is also recommended that the company gain some overseas exposure, which will comprise the final 20% of the portfolio. While many U.S. firms do have significant international exposure, it will benefit the portfolio to have better exposure to international growth markets, as much of the world's economic growth is expected to come from foreign markets in the coming decades. It is recommended that 10% of the portfolio is in the Guggenheim China Technology fund. This is a four star fund with an MER of 0.7% (Morningstar, 2013). The fund is focused on technology companies from China, so requires more active management, hence the higher MER. Holdings include both manufacturers and media firms. One of the interesting elements of the exposure here is not just that the fund is exposed to China in terms of its manufacturing but its retail as well (Morningstar, 2013). On the manufacturing side, China is facing rising costs but it is starting to develop expertise that will keep manufacturing jobs in the country (Orr, 2013). With Chinese retail, the fund's largest holding is Baidu, which is an advertising company (it is the Chinese Google). Baidu's revenues are almost entirely in yuan (Baidu 2012 Annual Report, 4). If and when the yuan begins its appreciation in something of a freer float, the value of those revenues will increase significantly. This is a good opportunity for the fund, since some manufacturers might suffer from a rising yuan. Unlike other international funds, there is little downside foreign exchange risk because the yuan is facing inflationary pressure and is likely to increase in value relative to the U.S. dollar, improving the fund's real returns.

Finally, the Energy Select Sector SPDR. With demand for energy expected to rise in the long-run, additional exposure to energy is recommended for this portfolio (Gertler, 2013). This is also international exposure because demand for energy is global, and many of the companies are foreign but bought with ADRs or New York listings. Energy companies are expected to leverage declining supplies of energy and increasing demand. Wherever is an up market in the world is going to need energy, so this is a means of getting into some of those countries. This is a five-star fund with an MER of 0.18% (Morningstar, 2013) which makes it very attractive. It is also diversified throughout the industry, including production, refining, drilling, pipelines and services companies. This component is expected to add returns to the portfolio, given the volatility of energy, but also stronger long-term returns as environmental conditions become even more favorable for energy companies.

Macroeconomic Forces

The objective of this portfolio is to add some risk to market returns, to take advantage of the client's long-term time horizon and ability to handle risk. The portfolio remains, however, heavy on U.S. exposure. The China exposure and the energy exposure give some diversification internationally, and small cap holdings can buck broader economic trends, but in all likelihood this portfolio will correlated with the broader market. This is part of the objective, but it should be noted that as long as there is a link between the GDP and the stock market, this portfolio will capture those movements in the economy, as per the fact that it is diversified. Over the long-run, however, the GDP is expected to increase in the United States (CBO, 2013). This means that over the long run, the portfolio should grow. It is worth noting that even the small cap fund will have a high correlation to the GDP, because it is a diversified fund -- the definition of diversified should be enough since it has 600 funds in it. A single company can enjoy success on the basis of a new innovation even during down markets (Apple, Google), but a diversified portfolio will almost surely track the market.

The portfolio will also be affected by changes in the interest rates. The portfolio has very little bond or cash exposure -- a few percentage points in each fund maybe -- so the exposure does not lie in direct form, because bonds are what has direct exposure to interest rates. The exposure instead lies with the interest rate environment in general. The stock markets have performed well over the past few years, in part because of the low interest rate environment (Krantz, 2013). First, with low cost of capital companies have ample money to invest and this encourages market growth. The second factor is that bond rates are very low. It is almost impossible to earn a positive real return on Treasuries or safe bonds, so investors turn to the stock market seeking returns. This has likely contributed to the run-up in the markets in recent years. When interest rates begin to increase -- and they will eventually -- this should see some money move out of equities to bonds, and it should also see business investment slow down as well. A very rapid rise in interest rates would be disastrous for the markets, so the portfolio does have some indirect exposure to interest rates.