Diversifying Through ETFs
Roger Nusbaum
11/20/06 - 12:07 PM EST
I've written about many exchange-traded funds, and I thought it would be worthwhile to see how these ETFs coordinate to create the equity portion of a diversified portfolio, or at least my idea of one. The following is an actual account, recently implemented, that shows a blend of ETFs, common stocks and even a closed-end fund.
I'm not a fan of all-ETF portfolios, but I'm a big believer in using the best tool to capture a given effect. For some people, the best tool might be an ETF, and for others, it might be a stock. The following represents one person's best way to capture a diversified portfolio. For purposes of this article, I'll go sector by sector, but focus on the funds.
Financial
In the financial sector, the client has 3% in a domestic large-cap bank stock, 3% in an Irish bank stock and 9% in the
WisdomTree Pacific ex-Japan High-Yielding Equity Fund (DNH Quote), which I
wrote about a few months ago. It's less volatile than the
S&P 500 and has a 6% yield.
DNH has 87% of its assets in Australia, which is known for mining, but 50% of the fund is in Australian bank stocks. The chart shows that DNH is really a proxy for Australian financials, as it correlates almost exactly with
National Australia Bank (NAB Quote) and much less so with
BHP Billiton (BHP Quote). Therefore, its total weight in the banking sector is 15%, compared to 21% for the S&P 500.
Health Care
In the health-care sector, a large-cap domestic drug company makes up 3% of the client's portfolio, a big biotech company at 2% of the portfolio and the
WisdomTree International Health Care Sector Fund (DBR Quote). The fund is heavy in the U.K. and Switzerland (both countries I want exposure to) and yields 2%, which is more than any other sector ETF I'm aware of. The client's exposure to health care is 14% vs. 12% for the S&P 500.
Technology and Telecom
Tech is not my favorite part of the market for ETF exposure, but this particular client is not a candidate for any single-stock risk in this sector. Therefore, she owns 6% in
iShares Dow Jones Technology (IYW Quote), 2% in
iShares Goldman Sachs Semiconductor (IGW Quote) and 2% in
First Trust Dow Jones Internet Fund (FDN Quote).
I would rather have domestic exposure only in this part of the market. For now, I think that the cap-weighted nature of IYW is the way to go, as mega-caps
Cisco (CSCO Quote) and
Microsoft (MSFT Quote) have done quite well in this latest rally.
A fund that equal-weights -- for now, that's just the
Rydex Equal Weight S&P Technology Fund (RYT Quote) -- seems like a good replacement in nine to 12 months if, as is usually the case, smaller companies rotate back into favor. I don't use
Semiconductors HOLDRs (SMH Quote) because it's so concentrated in just a couple of stocks.
Telecom is a small component of the market, and this portfolio just uses
Vanguard Telecom ETF (VOX Quote) with a 4% weight. I prefer it over
iShares Dow Jones Telecom (IYZ Quote) because it is less concentrated in mega-caps
Verizon (VZ Quote) and
AT&T (T Quote).
Industrial
For the industrial sector, the client has 8% in the
Rydex Equal Weight S&P Industrial Fund (RGI Quote) and 3% in the
PowerShares Water Portfolio (PHO Quote), which results in an equal weight.
I like RGI because many of the sector funds have huge positions in
General Electric (GE Quote), which I don't want to own. With PHO, I believe in the water theme as a powerful long-term investment thesis.
Energy
Energy is a sector where I want a lot of foreign exposure. As
chronicled earlier, most clients own
WisdomTree International Energy Sector Fund (DKA Quote). This particular client has an 8% weight in DKA and 2% in one of the Chinese oil majors for an equal weight in the sector.
Consumer
For the consumer sector, the one ETF I use is
iShares Dow Jones U.S. Consumer Goods Sector Index Fund (IYK Quote). For this client, it represents 10% of the portfolio, and the rest of the sector is made up of individual stocks.
In this sector, I want mostly domestic exposure, as I feel the brand names are worth owning. While the fund is not perfect, I like the heavier weighting to
Altria (MO Quote). While its 15% weighting in
Procter & Gamble (PG Quote) may not be ideal, the concentration is nowhere near as heavy as a lot of other cap-weighted funds. However, its 1.7% yield is only fair compared to other ETFs in this sector.
Materials
The materials sector is usually a good place to add foreign exposure and assets that have a low correlation to the market. In pursuit of these goals, the client's portfolio has a 3% weight in the
streetTRACKS Gold Trust (GLD Quote) and a 2% weight in
iShares S&P Global Material Index Fund (MXI Quote).
According to PortfolioScience.com, GLD has a -0.12 correlation to the S&P 500, while MXI has a 0.34 correlation. MXI has heavy exposure to large-cap diversified mining companies like BHP Billiton,
Anglo American (AAUK Quote) and
Rio Tinto (RTP Quote).
Utilities
In the utility sector, I prefer a common stock with a 4% weight for its yield over any ETF. This sector is a way to add yield and reduce volatility, and an individual stock often captures this better than a fund.
One last holding to round out the portfolio is a 4% weight in the
Blackrock Global Opportunities Equity Trust (BOE Quote). This is a closed-end fund that buys foreign stocks and sells options in an attempt to offer high yield and capital appreciation with less volatility than the overall market. BOE yields 8.4% and trades at a 1.8% premium to NAV.
The portfolio yields about 2.5%, although dividend information is not available for every fund because some of them are so new. It has a 0.77 correlation to the S&P 500, a beta of 0.64 and a cash position just under 10%, which, after such a big move up for the market, seems prudent. The portfolio is intentionally light on emerging markets as a function of tolerance for volatility.
The point of this is to show how mixing different types of products can create what is hopefully a diversified portfolio. This particular portfolio is probably not ideal for you, but the willingness to explore different themes and different products probably is.
