When you finally make the transition from individual stocks and traditional mutual funds to exchange-traded funds (ETF) as the bulk of your investment portfolio, the next step is to start thinking about asset allocation. While it is perfectly reasonable to expect that a handful of ETFs could be sufficient to ensure a solid long term return, it isn’t so much fun if you’ve ever enjoyed “playing the markets” over the years. So the chance to add a little alpha, if you are so inclined, is still possible. Even with an ETF portfolio.
As an example of how this works, let’s propose we become socially responsible investors. No, seriously, in one way or another, we all tend to embrace some investments and shun others for motives more emotional than logical. As noted here at Invest-Notes previously, tobacco stocks are eschewed. This is not a particularly smart decision; over the last five years Reynolds American (RAI) has doubled in price while offering a dividend north of 3%. But something just doesn’t feel right about profiting from a company whose primary product is cancer. Then again, as a long time owner of Heineken (HEINY), the same could be said about a company whose business is selling alcohol – and their five-year return isn’t nearly as compelling.
Okay, so you have an S&P 500 ETF, a couple of others offering international exposure and maybe even a bond fund (don’t laugh, think about it). Yet within the S&P are eleven clearly defined sector groups such as health care, energy, consumer staples and the new kid on the block, real estate investment trusts (REIT). Since the associated sector funds can move independently from the overall direction of the market (and the S&P 500), there can be opportunities to increase dividend yields, bargain hunt among sectors or lower volatility.
Here are two ways to think about framing your search criteria for investment options. First, consider the example above; no tobacco stocks. A decision is made to exclude an industry (or sector) based on personal preferences, not expected performance. A compelling example, despite your feelings about Islam, are the several U.S. mutual funds boasting impressive track records that look to sharia law to determine what stocks to exclude from their portfolio, such as alcohol and traditional banking stocks (because, loan interest = usury).
A second option is to include sector funds – or individual stocks – because they bring added value to your portfolio. The most obvious application is adding a sector fund that has recently underperformed. This is not unlike rebalancing, where on a regular basis winners are pared as losers are added, benefiting from reversion to the mean over time (while not personally a fan of this technique, it remains a viable option for inactive investors in retirement accounts). Another option is to include an individual equity for providing a meaningful dividend. I have some REITs and old fashion blue chip stocks for this role.
If you are less inclined to pick and choose, a variation of this idea is to split your regular investment in a core fund to 75/25, with 75% going to your core holding and 25% going to one of the sectors currently underperforming. Again, this is a way to harness the potential of mean reversion over time.
Yet regardless of whether you choose to hold a small group of well diversified ETFs that you purchase regularly over time, or take a flyer – regularly or occasionally – on a couple of additional holdings with a potential to provide value, your decisions should be made thoughtfully, and in keeping with your overall investment goals.
What, you have no investment plan? Ignore all of the above and get to basics.