In this week’s ETF Strategist update, I’ll continue answering questions I received after we launched this advisory.
In particular, a reader asked why the specific funds were included in the allocation.
At its very basic, an allocated portfolio is designed to generate a specific return while mitigating risk. The return is calculated on a medium-to-long-term basis, rather than being calculated like a trade. In other words, you’re not looking to snag that expected annualized return in a month.
Let’s use the moderate portfolio as our example.
Based on back-testing, this portfolio has a six-month potential gain of 17.69% and a potential six-month loss of 11.33%. The expected annualized return is 6.36%.
Is that eye-popping? No. But you don’t use a broadly allocated stock-and-bond portfolio in the same way you would a stock-trading account. You use asset allocation to generate the return you need for a specific outcome – usually retirement – while maintaining capital preservation. The goal is to grow capital while minimizing your losses.
Below is a summary of the 60/40 portfolio with a short explanation of what each fund is intended to accomplish as part of the allocation.
- IXN iShares Global Tech 1.5%: This equity ETF gives you exposure to global technology, which is a growth category. Because it includes non-U.S. stocks, you also own stocks outside the usual Silicon Valley big-tech universe, which provides diversification.
- IUSB iShares Core Total USD Bond Market 16%: This gives you broad exposure to the entire U.S. bond market. In general, bonds will dampen the volatility of stocks. This ETF serves that function, while also including instruments such as high-yield bonds that can help boost your return.
- IJR iShares Core S&P Small-Cap 2.5%: Small-cap stocks over time return more than large caps. There are several possible reasons for this, including younger, more nimble companies with more aggressive management, as well as products and services that are new and in high demand. You want a tilt toward small caps in your portfolio.
- USMV iShares Edge MSCI Min Vol USA ETF 1.5%: Equities and volatility go hand-in-hand. You can’t get away from that, but this fund is designed to give you equity exposure while limiting your volatility. This fund replicates an index that tracks the least volatile stocks from the MSCI USA Index, a broad benchmark of large- and mid-cap U.S. stocks.
- GOVT iShares Core US Treasury Bond 9%: Treasury bonds are among the best securities to minimize volatility. This isn’t where you’ll see high returns, but that’s not the purpose of a Treasury fund.
- COMT iShares Commodities Select Strategy 2.5%: Commodities serve to diversify a stock-and-bond portfolio with some alternatives that may trade in a fashion that’s not correlated to the larger asset classes.
- VLUE iShares MSCI USA Value Factor 1.5%: It sounds counterintuitive, but value stocks outperform growth over time. This fund offers exposure to large- and mid-cap U.S. stocks with lower valuations based on fundamentals.
- ESGE iShares MSCI EM ESG Optimized ETF 3%: This fund not only tracks emerging-market stocks, but zeroes in on those with higher ESG ratings than those in the broad MSCI Emerging Markets Index, so you’re getting focused exposure into two different investment themes. Sector and country weightings fall within 5% of their allocation within the broader index. That means you won’t see a large drift into any particular area.
- EFV iShares MSCI EAFE Value 8%: This fund tracks global value stocks. Here again, you have a tilt toward two distinct areas of the market that help with diversification, which smoothes return and gives you access to asset classes that many American stock traders overlook.
- ESGU iShares MSCI USA ESG Optimized ETF 16%: This ETF integrates environmental, social, and governance screening criteria into a broadly diversified, market-cap-weighted, domestic equity portfolio. This accomplishes two things: First, it’s a broad domestic fund, which is important to hold, as U.S. stocks comprise more than 50% of global market cap. Second, it adds an environmental, social and corporate governance (ESG) component to your holdings. Contrary to what many believe, an ESG fund does not typically deliver a lower return.
- IXG iShares Global Financials 1.5%: This is a very targeted investment, included here to take advantage of strength in the financial sector globally, not just in the U.S. This sector has been a strong performer recently.
- FALN iShares Fallen Angels USD Bond ETF 3%: The fund comprises high-yield corporate bonds that at one time were rated investment grade. There’s the “fallen angel” concept. This fund carries lower credit risk than other below-investment-grade funds, so that serves to limit volatility somewhat.
- TIP iShares TIPS Bond 2.5%: With inflation a major concern for investors these days, this is a good addition to your ETF allocation. A TIPS fund’s return will often outpace that of a regular Treasury fund with a similar maturity date during times of higher-than-anticipated inflation.
- EFG iShares MSCI EAFE Growth 5.5%: Although value stocks outpace growth stocks over time, there are lengthy periods when growth leads. We’ve seen that in recent years. This fund offers access to international growth, so you get something outside the usual collection of domestic big techs.
- IVV iShares Core S&P 500 20.5%: This is your basic S&P 500 index. As noted above, domestic stocks comprise a large swath of global market cap, and with many of the world’s largest market-moving stocks tracked by the S&P, this is a convenient way to get access to those equities.
- TLH iShares 10-20 Year Treasury Bond 2%: While Treasury bonds serve to mitigate volatility, the intermediate-to-longer-term nature of this ETF comes with a somewhat higher risk level, which can help boost your return while still limiting downside risk.
- IYE iShares US Energy 1.5%: As with the global financial ETF, this one offers a tilt toward a top-performing sector. This is one that will likely be switched out, eventually, as sector rotation reveals a new leader. For now, this is a case of letting a winner run.