ETF Investment Portfolio Analysis: EUR 100,000 Allocation

Introduction and Client Profile

The objective of this report is to recommend an asset allocation for a client based on an analysis of that client's financial goals. The analysis draws on the client's situation and risk profile, which include lifestyle, character, time horizon, and objectives. The report uses asset allocations grounded in historical returns and the benchmark indices of each asset class. Some factors — such as spending habits — are within the client's control; however, macroeconomic factors such as interest rate fluctuations, market performance, and tax policies are not. Despite these uncertainties, this report provides comprehensive advice to assist the client in meeting his financial goals.

Client's Investment Objectives:

1. To invest in order to supplement retirement income.
2. To seize current opportunities in the financial markets to grow wealth.

The first step in determining appropriate asset allocations is to carry out a situation analysis and risk tolerance assessment of the client.

The investor is a European citizen, aged 54, with 11 to 13 years remaining until retirement. At present, the client is the founder and Managing Director of a consulting company that specializes in supply chain, sourcing, and procurement process optimization across many industries. Before establishing his own company, the client worked for several multinational corporations and held various managerial positions. The client has more than 25 years of working experience across Europe and globally.

Risk Profile: The client is willing to include some calculated risks in his investment profile; however, he is not willing to invest in high-risk assets that carry high volatility.

Character: The client is willing to accept calculated risks in order to grow his investment — in other words, he is comfortable with investment risk. While aiming for higher long-term returns, the investor understands that this approach can lead to sustained periods of poor performance. The investor is therefore ready to accept significant fluctuations in value in pursuit of better long-term returns, higher income, and long-term capital growth.

Lifestyle: The client lives from the income earned through his work while setting aside savings for future investment. His strategic lifestyle profile ranges from medium to higher risk. As a hardworking individual, the investor lives a normal and comfortable life, which enables him to save a significant amount for investment.

Time Horizon: The investor is a moderately high-risk investor whose time horizon is between 5 and 10 years. Given his character, he is ready to tolerate investment fluctuations that may arise during the investment period. It is important to note that macroeconomic factors such as interest rate fluctuations and inflation can reduce investment returns. A medium-to-long-term investment portfolio is therefore associated with a higher degree of risk. The report anticipates that the proposed portfolios may fluctuate within three years; accordingly, the investor is prepared to leave his portfolio invested for three years or more before expecting returns. Costa (2011) recommends that the best time for an investor to expect a return is after three years — a good investor should leave his investment in place for at least three years before expecting returns.

Investment Sum: The client is ready to invest the sum of EUR 100,000.

Justification of ETFs as an Investment Vehicle

Analysis of the client's risk profile reveals that the client will benefit from an ETF (Exchange Traded Fund) investment portfolio. The ETF is typically the best investment option for protecting a client's funds from macroeconomic factors such as inflation, interest rate fluctuations, and recession.

An ETF is a basket of assets or investment portfolios traded on stock exchanges similarly to traditional stocks. It combines assets such as bonds, commodities, and stocks. The ETF is attractive to many investors because of its tax efficiency, low costs, and stock-like features. One key benefit is that it allows diversification across related investment portfolios. A low expense ratio is another advantage — ETF expenses are generally lower than those charged by traditional stockbrokers and mutual funds.

A Deutsche Bank (2013) report shows that the ETF is one of the fastest-growing investment vehicles and has become a global success. Since 2007, the value of ETF funds traded on the London Stock Exchange has increased by 80%, and the volume of traded assets has grown by more than 200%. In the United States, ETFs increased by more than 30% in 2010 and reached $2.04 trillion (Costa, 2011). The popularity of ETF portfolios as a desirable investment vehicle is attributed to their transparency, diversity, flexibility, and liquidity.

Justice (2013) supports this argument by pointing out that investors can achieve strong long-term results from ETFs. However, investors still need to carry out research to select the appropriate ETF in order to avoid disappointment. Justice (2013) compares ETFs with mutual funds and concludes that the low costs and tax efficiency associated with ETFs make them superior to actively managed mutual funds. Costa (2011) also recommends ETFs on the grounds that several mutual funds have failed to outperform their investment benchmarks. The author highlights the high costs associated with traditional stock trading, which can erode investment returns, and notes that nearly 4.5% of mutual funds underperform their benchmark. In Europe, more than 2.4% of mutual funds underperform their benchmark, and only 17% outperform it.

High management fees are a major factor in mutual fund underperformance because elevated management costs directly reduce the rate of return. For example, many actively managed mutual funds charge 2% in management costs, which removes 33.5% from an investor's total returns. By contrast, an ETF with 0.2% management costs will remove only 3.9% from an investor's total returns. Where mutual fund charges are levied against assets and an anticipated 8% yearly return is assumed, 25% of an investor's returns may go toward expenses. By comparison, a 0.2% ETF management cost removes only 2.7% per year from an investor's returns.

Transparency is another feature that makes ETFs recommendable. Transparency means that funds are required by law to disclose their investment strategy, costs, and holdings. Liquidity is a further ETF feature of note. Diversification — spreading investment across shares, stocks, and other assets — is also an important ETF characteristic.

Availability is an additional benefit. Many traditional mutual funds refuse to accept investment applications from foreign investors; for example, U.S. financial law is complex, causing many mutual funds to decline foreign investors. By contrast, there are no geographical constraints on ETF investment. With this justification established, the next step is to determine asset allocations that balance risk and return for the client.

Asset allocation is the strategy of meeting an investor's financial goals, risk tolerance, objectives, and time horizon by mixing different investments — such as bonds, stocks, cash, and other securities. Asset allocation assists in diversifying the investment portfolio to protect investors from potential losses. In contrast to the benefits associated with ETFs, some mutual funds and brokerage firms recommend individual "hot" stocks for their clients. This report considers such recommendations generally unsound, as these stocks may not be able to withstand the effects of macroeconomic conditions. Asset allocation is therefore the cornerstone of sound investment.

Asset allocation is a proven method of controlling portfolio risk by mixing between 7 and 10 classes of well-balanced assets. The benefit of this approach is that the chosen assets react differently to macroeconomic factors and market conditions — including interest rate fluctuations, inflation, and recession. This is distinct from a simple diversification of 100 stocks drawn from only one or two asset classes, such as large-cap or mid-cap stocks. The shortcoming of such an approach is that these stocks would react to macroeconomic or market conditions in the same way and move in tandem with market events. Similarly, investing only in top-performing funds without considering asset allocation is also a mistake: even if an investor holds 20 top-performing funds, those funds will generally react similarly to market conditions (David White & Associates, 2011).

The benefit of diversification through asset allocation is that bonds, stocks, and cash do not react to market forces in the same direction. A combination of various securities will therefore allow the investor to benefit from smoother investment returns.

This report divides the investor's fund of EUR 100,000 across different investment classes. The diversification will help offset potential losses and volatility that might arise from investing in a single asset. Moreover, the chosen assets are drawn from different industries and different geographic locations, which means they are less likely to be simultaneously affected by market forces that impact a single industry or region.

Table 1 reveals the dynamic asset allocation — 65% of the fund is invested in stocks, 30% in bonds, and 5% in cash.

Table 1: Asset Allocations

Asset Allocation Strategy

Stocks: 65% | Bonds: 30% | Liquidity (Cash): 5%

Tables 2 and 3 reveal the specific investment vehicles selected and the fund allotted to each.

Table 2: Investment Vehicle Allocation

Equities (65%):
"CS ETF (IE) on NASDAQ 100 (IE00B53SZB19 / CSNDX)" (Morningstar, 2014, p. 1) — 15%
"iShares Core S&P 500 Index Fund ETF (IVV)" (Morningstar, 2014, p. 1) — 20%
"SPDR Emerging Asia Pacific ETF (GMF)" (Morningstar, 2014, p. 1) — 15%
"Comstage ETF Commerzbank Commodity EW Index TR" (Morningstar, 2014, p. 1) — 15%

Bonds (30%):
"Schroder ISF Euro Bond A Acc — Active Managed Fund" — 10%
"iShares Barclays Capital $ Treasury Bond 7–10 ETF" — 10%
"iShares Euro High Yield Corporate Bond UCITS ETF" — 10%

Cash: 5%

Table 3: Allocation Detail

15% — CS ETF (IE) on NASDAQ 100 (CSNDX) — 3-Year Return: 106% — EUR 15,000 invested
20% — iShares Core S&P 500 Index Fund ETF (IVV) — 3-Year Return: 20.76% — EUR 20,000 invested
15% — SPDR Emerging Asia Pacific ETF (GMF) — 3-Year Return: 9.46% — EUR 15,000 invested
15% — Comstage ETF Commerzbank Commodity EW Index TR — 3-Year Return: −4.07% — EUR 15,000 invested
10% — Schroder ISF Euro Bond A Acc — 3-Year Return: 29.72% — EUR 10,000 invested
10% — iShares Barclays Capital $ Treasury Bond 7–10 ETF — 3-Year Return: 6.6% — EUR 10,000 invested
10% — iShares Euro High Yield Corporate Bond UCITS ETF — 3-Year Return: 33.54% — EUR 10,000 invested
5% — Cash (Goldman Banking Index: Exchange Traded Scheme) — 3-Year Return: 103% — EUR 5,000 invested
Total: EUR 100,000 | Average Rate of Return: 38%

All ETFs selected have established track records. The key metrics for the SPDR Emerging Asia Pacific ETF (GMF) are as follows: Net Assets (as of 5 December 2014): $6,569,032,217; Index Ticker: LT09TRUU; Shares Outstanding: 62,500,000; Beta: −0.05; Expense Ratio: 0.15%; Price/Earnings: 15.7%; Return on Equity: 11.5%; CUSIP: 464287440; Closing Price: $105.10.