The document discusses using exchange-traded funds (ETFs) to engineer a diversified investment portfolio based on modern portfolio theory, which emphasizes the balance of expected return and risk. It identifies six core asset classes and outlines a method for selecting suitable ETFs while highlighting the importance of risk tolerance assessment and portfolio rebalancing. The document concludes with a reminder that ongoing management is essential to maintain optimal portfolio performance.

1. Engineer Your
Portfolio with ETFs

2. By the end of November 2011, there
were more than 1,400 different
exchange traded funds (ETFs)
accounting for over
$1 trillion dollars invested.

3. You’ve heard a lot about ETFs. They’re an easy and
convenient way to “diversify your portfolio,” but how
about the real questions…
Which should I buy
and how much?

4. Harry Markowitz, PhD
Why not ask a Nobel Modern Portfolio Theory (1952)
Nobel Prize (1990)
Prize winner?
David Swensen, PhD
… and the Chief Yale Endowment CIO (1985-present)
Unconventional Success (2005)
Investment Officer at Pioneering Portfolio Management (2009)
Yale University?

5. Harry Markowitz, PhD
Modern Portfolio Theory (1952)
Nobel Prize (1990)
I invented it.
Use Modern Portfolio Theory
David Swensen, PhD
Yale Endowment CIO (1985-present)
Unconventional Success (2005)
I wrote the Pioneering Portfolio Management (2009)
book on it.

6. A Quick Lesson in Modern Portfolio Theory
Every investment has an expected return
and some level of risk.
Expected Return
Risk

7. A Quick Lesson in Modern Portfolio Theory
Every investment has an expected return
and some level of risk.
Expected Return
Stocks
Risk

8. A Quick Lesson in Modern Portfolio Theory
Every investment has an expected return
and some level of risk.
Expected Return
Stocks
Bonds
Risk

9. A Quick Lesson in Modern Portfolio Theory
You can mix investments to get different
combinations of expected return vs. risk.
Expected Return
Stocks
A
mix
of
Stocks
&
Bonds
Bonds
Risk

10. A Quick Lesson in Modern Portfolio Theory
There are an unlimited number of
investments and combinations.
Expected Return
Risk

11. A Quick Lesson in Modern Portfolio Theory
There is a theoretical maximum expected
return for each level of risk.
Expected Return
Risk

12. A Quick Lesson in Modern Portfolio Theory
The best combinations of investments form
a curve known as the Efficient Frontier.
Expected Return
Risk

13. A Quick Lesson in Modern Portfolio Theory
The only way to get to the efficient frontier
is by mixing uncorrelated asset classes.
Expected Return
Risk

14. Modern Portfolio Theory
If you synthesize the recommendations of experts and look at the
practices of the best institutions, you come up with 6 core asset
classes that are publicly accessible.
 US Stocks  Natural Resources
 Foreign Developed  Real Estate
 Emerging Markets  Bonds
Why not more? More asset classes don’t
materially add more expected return with less risk
for the effort. Additionally, they may not be
uncorrelated or may have too much volatility.

15. Modern Portfolio Theory
Expected Return
Risk
Using Mean-Variance Optimization with the 6 asset
classes allows you to find the optimal portfolio for each
level of risk.

16. Modern Portfolio Theory
Expected Return
Risk
Bonds
US
Stock
Emerging
Markets
Foreign
Developed
Real
Estate
Natural
Resources
100%
90%
80%
70%
60% Which gives us an asset allocation for
50%
40% each point along the Efficient Frontier.
30%
20%
10%
0%

17. Modern Portfolio Theory
Expected Return
?
Risk
Bonds
US
Stock
Emerging
Markets
Foreign
Developed
Real
Estate
Natural
Resources
100%
90%
80%
70% Now, find the
60%
50%
portfolio that has
40% the right amount of
30%
20%
risk for you.
10%
0%
0 1 2 3 4 5 6 7 8 9 10
Less More
Overall Risk

18. To find your risk tolerance, you need to measure your
subjective willingness and your objective ability to take risk.
Using tools on the internet, map your risk tolerance to any
scale you choose. Also, lower your score if you find
yourself providing answers that conflict with each other.
Subjective Score
0 1 2 3 4 5 6 7 8 9 10
Less Risk More Risk
Objective Score
0 1 2 3 4 5 6 7 8 9 10
Less Risk More Risk

19. Subjective Risk Tolerance
Take a risk questionnaire to identify
your comfort with the risks of
investing.
Note: Most questionnaires will likely end with a portfolio recommendation with a
different set of asset classes than we recommend. Your real goal is to figure out
where in the risk spectrum you fall so you can map it back to the Efficient Frontier.
Subjective Score
0 1 2 3 4 5 6 7 8 9 10
Less Risk More Risk
Examples
https://personal.vanguard.com/us/funds/tools/recommendation
http://www.schwabmoneywise.com/public/moneywise/calculators_tools/questionnaire

20. Objective Risk Tolerance
Use a financial planning tool to
ensure you’ll have more investment
income than spending needs when
you retire.
The lower your investment income relative to your spending needs, the less risk you
can take.
Objective Score
0 1 2 3 4 5 6 7 8 9 10
Less Risk More Risk
Example
http://www.smartmoney.com/retirement/planner/

21. Your Overall Risk Tolerance Score is the minimum of your
subjective and objective risk scores. Using this score to help
design your portfolio will help you avoid risk that you are
unwilling or unable to take.
Subjective Score
0 1 2 3 4 5 6 7 8 9 10
Less Risk More Risk
Objective Score
0 1 2 3 4 5 6 7 8 9 10
Less Risk More Risk
Overall Score
0 1 2 3 4 5 6 7 8 9 10
Less Risk More Risk

22. Plot Your Risk Level
Expected Return
You are here. Risk
Bonds
US
Stock
Emerging
Markets
Foreign
Developed
Real
Estate
Natural
Resources
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
0 1 2 3 4 5 6 7 8 9 10
Less More
Overall Risk

23. Back to choosing ETFs…
We need to pick ETFs that represent each of the 6 core
asset classes and buy them in percentages dictated by your
risk tolerance.
Now which ETFs
should I buy?

24. Selecting ETFs
Filtering the universe of all ETFs only
to candidates that represent the core
asset classes gives you about 100 to
choose from.
The rest will be ranked by
three important characteristics.

25. Selecting ETFs
Three Important Characteristics
 Low Costs – favorable expenses
 Minimal Tracking Error – matches
the underlying index closely
 Market Liquidity – can be traded
quickly and easily
Many investors look at expenses
but neglect to look at tracking
error and liquidity.

26. That’s how we got to our current recommendations:
( which you can also find at www.wealthfront.com )
 US Stocks – VTI
 Foreign Stocks – VEA
 Emerging Markets – VWO
 Real Estate – VNQ
 Natural Resources – DJP
 Bonds – BND
Wealthfront regularly surveys the ETF landscape and ranks ETFs in each asset
class using the criteria described in the prior slide. Vanguard ETFs often come
out on top. Wealthfront receives no compensation for recommending Vanguard
products or any other ETFs.

27. Risk Level 5

28. Harry Markowitz, PhD
Modern Portfolio Theory (1952)
Nobel Prize (1990)
David Swensen, PhD
Yale Endowment CIO (1985-present)
Now you Unconventional Success (2005)
Pioneering Portfolio Management (2009)
have to
maintain it!

29. Rebalancing
The value of your investments will naturally drift over time as the
market moves.
2012
Expected Return
2011
Example
• Green increases in value.
• Yellow decreases in value.
• Blue stays the same.
Risk

30. Rebalancing
The new mix of asset classes will have a different risk and
expected return.
2012
Expected Return
2011
Additional Risk
Risk

31. Rebalancing
Rebalance your portfolio to get back to your desired risk level with
the highest expected return.
Expected Return
Rebalance
Risk

32. Rebalancing Time-based or Threshold-based
You can rebalance based on a variety of
criteria. Some choose to rebalance after
a predefined duration.
We recommend rebalancing whenever
any asset class deviates from a portfolio’s
allocation by more than a certain
percentage, depending on the type of
account.
 For tax-deferred accounts: 4-6%
 For taxable account: 6-10%
… but with the following caveats

33. Rebalancing Considerations
Keep in mind…
 Tax implications
 Impact of commissions
 Changes in your risk profile
Most individual investors don’t
rebalance because they struggle
with these issues.

34. To Recap:
 Construct the Efficient Frontier
Allocate to the six core asset classes, select low-cost ETFs, and
allocate optimally
 Place your portfolio on the Efficient Frontier
Understand your subjective willingness and objective ability to take
risk and find the portfolio that’s right for you
 Keep your portfolio on the Efficient Frontier
Rebalance your portfolio weighing taxes, commissions and changes
in your risk profile

35. Want us to do this for you?
Visit .com to get started.

36. Disclosures
Nothing in this presentation should be construed as a solicitation or offer, or
recommendation, to buy or sell any security. Photographs do not depict actual
Wealthfront clients. Financial advisory services are only provided to investors who
become Wealthfront clients pursuant to a written agreement, which investors are
urged to read and carefully consider in determining whether such agreement is
suitable for their individual facts and circumstances.
Past performance is no guarantee of future results, and any hypothetical
returns, expected returns, or probability projections may not reflect actual
future performance. Investors should review Wealthfront’s website for additional
information about advisory services.