Long-term strategic asset allocation probably doesn't get the attention it deserves from many investors. This is understandable in today's 24-hour news cycle, where it is a lot more exciting to speculate on the latest trends and short-term market moves. But the core part of your investment portfolio is responsible for doing the bulk of the heavy lifting throughout your overall investing lifetime. As such, let's take the time to review the basic framework behind a strategic asset allocation strategy and how it can be easily implemented with exchange-traded funds.
A popular and effective way of segmenting your investments is the "core and satellite" approach. Here, you might categorize 80% of your overall portfolio as the "core" and the remaining 20% as the "satellite." The satellite portion of the portfolio is where to express your tactical views on the market. Examples might include opportunistic investments like overweighting a particular sector or industry, or portfolio tilts like focusing on yield.
On the other hand, your core portfolio -- which is the focus of this article -- should be invested according to your long-term strategic asset allocation strategy. The good news is that maintenance is fairly light thanks to the longer-term nature of the portfolio. Evaluating the portfolio once a year and rebalancing from time to time, as needed, will suffice.
For simplicity, we will look at a generic portfolio that holds 60% of its core in stocks and 40% in bonds. Keep in mind that suggested allocations and percentages are just a baseline, offered simply for the sake of illustration. Your actual portfolio should depend on things like risk tolerance, time horizon and financial goals.
With ETFs like Vanguard Total World Stock Index VT , which represents 85% of the world's total investable stock capitalization, it would be possible to take care of your equity allocation with a single ETF. It doesn't get much simpler than that. But, VT currently only trades in the United States, which means there is currency risk since the fund is priced in U.S. dollars. For our examples we will stick with Canadian-listed products.
Thanks to rapid product proliferation, the market has been sliced and diced so finely that the selection process can seem daunting for the do-it-yourself investor. But it doesn't have to be, as long as you know what you're looking for before you go shopping. We're not looking for anything fancy here: passive, low-cost and broadly diversified equity exposure from a plain-vanilla fund.
The first step is to define what type of equity exposure you are looking for. The two most common ways to break down the equity universe are by size (large-cap, mid-cap and small-cap) and style (growth to value). From there stocks are often segmented even further by economic status (developed, emerging and frontier) or geographic region (Europe, Asia-Pacific, Latin America, etc.)
In our case, we are looking for comprehensive exposure by geography. We don't need to get too granular in our strategic core portfolio by delving into size and style tilts. Such investments or tilts are more appropriate as tactical investments in the satellite portfolio.
That said, investors can achieve a broadly diversified global portfolio by evenly dividing the equity allocation into three subsets: Canadian stocks, U.S. stocks and foreign stocks. For example, putting 20% in each of the three equity groups would make up the entire 60% equity allocation in a 60/40 portfolio.
For comprehensive domestic equity exposure investors could look at a fund like iShares S&P/TSX Composite Index XIC , which tracks about 260 of the largest Canadian stocks and reaches all the way down into mid-cap territory. Another solid option that may appeal to cost-conscious investors is Vanguard MSCI Canada Index VCE , which tracks the top 100 Canadian stocks for an MER of just 0.09%. While its number of holdings is considerably lower than XIC's, we would note that VCE still covers 85% of Canada's total equity market capitalization.
Next, for the most broadly diversified exposure to U.S. stocks, you can't beat Vanguard MSCI U.S. Broad Market Index (CAD-Hedged) VUS , which tracks more than 3,000 stocks and covers 99.5% of the total U.S. equity market capitalization for a rock-bottom MER of 0.15%. This fund takes indexing to its logical extreme by owning the entire market.
There is no need to look very far for the third and final slice of our equity allocation. Vanguard MSCI EAFE Index (CAD-Hedged) VEF offers broad exposure to foreign stocks and charges an MER of 0.37%. The MSCI EAFE Index, which stands for Europe, Australasia and the Far East, is the industry standard benchmark for tracking developed markets outside of North America.
What about emerging markets? Adding emerging markets stocks can help diversify your portfolio. But due to their higher volatility, as well as regulatory and geopolitical risks, the most risk-averse investors may choose to confine them to the satellite portion of their portfolio, or avoid investing there altogether. If you do decide to include emerging markets stocks in your core portion, make sure it gets a much smaller weighting than the other equity allocations. From our example above, this could mean dropping the allocation to Canadian, U.S. and foreign stocks to 18% each from 20%, freeing up 6% of the portfolio for a stake in emerging markets stocks. In the spirit of keeping it simple and cheap, I would suggest that investors take a look at Vanguard MSCI Emerging Markets Index VEE , which charges an MER of 0.49%.
Just like in the stock market, the performance and risk profiles of the different segments of the fixed-income market can vary significantly. Bonds are first categorized by the type of issuer -- government, corporate, sovereign, etc. -- and then by credit quality and maturity. Relative to stocks, the typical individual investor isn't as familiar with how the bond market operates. This is because the over-the-counter nature of the bond market and lack of homogeneity across securities make it far less transparent. There is no central exchange where bonds are priced and traded; they still trade over the phone, not electronically.
That highlights part of the beauty of bond ETFs: they bring transparency and liquidity to the market by bringing bonds on to the exchanges. ETFs also help make bonds more accessible for the masses. There are often high minimum investments and wide spreads associated with buying individual bonds. Along with the costs involved, this pretty much makes achieving adequate diversification unattainable for everyday investors.
However, with just one ETF we can achieve diversified exposure to the broad Canadian bond market, including investment-grade Government of Canada, provincial and corporate bonds across all maturities. Here, investors can look to the oldest and largest broad bond market ETF: iShares DEX Universe Bond Index XBB , which holds a portfolio of more than 600 bonds and charges an MER of 0.30%. The DEX Universe Bond Index is the industry standard benchmark for domestic bonds.
Ok, so now what?
The strategy is simple and boils down to three words: buy, hold and rebalance. We have established a basic framework for constructing our core strategic portfolio with as little as four ETFs (five if you're including emerging markets). To determine if and when you should rebalance the portfolio, it's important to consider the target portfolio weights we established at the get-go.
Over time, the weights of the portfolio will naturally shift based on the performance of the various asset classes. But, that doesn't mean you would necessarily have to rebalance the portfolio every year and absorb the associated transaction costs. A good way to control turnover is to establish a rule that you will only rebalance the portfolio when a position has moved 15% away from the target weight. Again, we are just offering an example; you may select whatever threshold is most appropriate for your situation.
Adhering to such a strategy helps ensure that investors are "buying low and selling high." Underperforming asset classes will have decreasing weights, and the top performers will have increasing weights. By rebalancing we're simply taking some of the winnings off the table and reallocating it to the laggards. It's an intuitive process.