Exchange-traded Funds as a Tool in Asset Allocation
Asset allocation takes portfolio diversification to another level; just as classic portfolio theory demands diversification between stocks and bonds and like investments, modern portfolio theory calls for diversification among varying asset classes. With exchange traded funds come ease and simplification of the process of allocating investment among differing assets. Indeed, the decision of divvying the portfolio among asset classes is more or less taken entirely out of investor hands with an ETF investment, as are the innumerable choices required daily of the stock market player.
Selecting from among the thousands of firms trading on open markets means that decisions are made with available information about each and every individual company. In exchange traded fund investment, the reverse is true: With strategic roots in the above-mentioned Modigliani-Miller theorem, little or no heed is given to the type of stock and all consideration goes to the company’s asset in an effort to further diversify. In turn, states modern portfolio theory, the small losses accrued can be balanced, for a portion of the portfolio invested in a second area cushions the fall.
The importance of asset allocation was detailed in the 1986 Brinson Partners, Inc. study in which is was demonstrated that investment performance can be determined to a rate of ninety-five percent based solely on selection of asset class. Over the long haul, implies the Brimson study, investments should mostly take place on the large scale, as the average investor will see returns on investment at a rate slightly lower than that shown by the market at large. The study also shows that the average ETF will outdo the average mutual fund, based as the ETF is in indices.
In tandem with Sharpe’s capital asset pricing model, the superiority of an investment in index funds as opposed to individual stock was simply demonstrated. Sharpe dealt with volatility and assets extensively, eventually coming to the conclusion that investment in individual stock is futile in the long term; in the short term, individual stock investment is risky at best and only becomes more a question of luck as the time period grows shorter and shorter. In modern portfolio theory, everything answers to asset allocation. While so much time and energy is devoted to choosing individual stocks, such personal resources would be more appropriately devoted to type of stock and seeking investment funds. Sharpe’s theory bears this out.
The identical potential rewards and risks of any given security, says the Sharpe theory, can be reproduced a lot more efficiently and easily by merely finding a proper asset class and balancing with the appropriate amount of cash. Not only is this solution elegant, it’s nearly foolproof. Starting with a ninety-five percent advantage, five percent points of uncertainty can be chipped away at with a small hedging of cash. Choose nearly any asset class and an exchange trade fund within that class will increase in value. With a little cash thrown into the mix, any smaller losses (which are mostly what have been seen in the ETF world since the funds’ genesis) can be compensated for.
As in so many areas, the exchange traded fund cannot be beaten in terms of simplicity and investor peace of mind. Markowitz’ equations regarding volatility and Sharpe’s capital asset pricing model show greater inaccuracy when more variables are introduced, meaning again that a more complicated portfolio carries no evident advantage except for diversification itself, a feature now offered in even more secure fashion in exchange traded funds. This complexity is utterly unnecessary: When a stock achieves positive results, stocks from within the same asset classes invariably – on the whole – duplicate the successful results, and therefore choosing an asset class is enough to beat the average fund investment. Asset allocation is not particularly easy, but the time, attention and stress saved the private investor makes exchange traded funds even more attractive. With a modicum of vigilance, the ETF investment rarely fails.
The sheer amount of competition on all major markets worldwide obscures clear vision and in the end just adds to the complexity to the private investment game, as though a roulette wheel were to take on another one hundred numbers to choose among: The odds of an individual investor succeed decrease with the number of options available. An ETF investment not only reduces the private investor’s choices to an absolute minimum, that same investor automatically gets all the plusses of both the dynamic market and dynamic movement within an entire asset class. And along with the amount of competition comes the service industry to support that competition. Stock analysis today is so abundant, so conflicting and so often beyond ready availability that the private investor in the stock market must react quickly and often blindly in periods of high fluctuation. Multiply this by the number of firms represented in the portfolio and the further complexity is easily seen.
Choosing among the thirteen accepted primary asset classes in which ETFs are currently available allows proper examination of markets and true investor confidence in the decision. These primary asset classes are small-cap stocks, middle capitalization stocks, large-cap stocks, emerging market stocks, international stocks, national stocks, short-term bonds, mid-term bonds, long-term bonds, and real estate trusts.
“Large-cap stocks” refers to the largest firms within a given market, carrying the highest market value. As can be expected, middle capitalization and small capitalization stocks are the following levels in terms of size and current market value. Again, the high risk / high return teaser bears out the theory that small-cap stocks will outperform but of course only when the gamble pays off.
Growth / value demarcation is an oft-used vehicle to measure opportunities in future earnings and the remainder of the above-listed primary asset classes fall under the rubric of the demarcation. Emerging market stocks are stocks of developing countries and are usually high-risk but just as often carry low price per earnings and substantial potential earnings growth. National and international stocks run along the same lines as emerging market stocks but are representative of the more stable economies and much lower potential growth of the western nations. Investment in international ETFs has provided many a success story, the peak of which was probably achieved by The Coolcat ETF & Fidelity Select Report, a portfolio that has “taken the ETF world by storm,” mostly thanks to its international ETF investments in Brazil (a key factor, doubling in value inside of fifteen months), Mexico, South Africa and emerging markets. Today in America, indices tied into the economies of Australia, Austria, Belgium, Brazil, Canada, France, Germany, Hong Kong, Italy, Japan, Latin America, Malaysia, Mexico, the Netherlands, Singapore, South Africa, South Korea, Spain, Sweden, Switzerland, Taiwan and the United Kingdom are readily available.
Growth stocks represent the half of a market’s companies with above-average stock price-to-earnings ratios. Value stocks are the opposite, covering firms in the lower half, with below-average stock price-to-earnings ratios. Sector stocks cover an entire industry’s worth of firms and represent perhaps the most popular form of ETF investment.
When all that is required is selection of asset class, most of the guess work, dependence on brokers and consultants, and commission fees are eliminated. And due to the Brinson rule of the direct relationship between asset class selection and results, the investor in ETFs steadily avoids an entire level of difficulty. And so the philosophy of modern portfolio theory can be summarized in four words: Less can be more. Exchange traded funds nicely fulfill this credo.
