By the end of November 2011, there were more than 1,400 different exchange traded funds (ETFs) accounting for over$1 trillion dollars invested.
You’ve heard a lot about ETFs. They’re an easy andconvenient way to “diversify your portfolio,” but howabout the real questions… Which should I buy and how much?
Harry Markowitz, PhDWhy 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?
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.
A Quick Lesson in Modern Portfolio Theory Every investment has an expected return and some level of risk.Expected Return Risk
A Quick Lesson in Modern Portfolio Theory Every investment has an expected return and some level of risk.Expected Return Stocks Risk
A Quick Lesson in Modern Portfolio Theory Every investment has an expected return and some level of risk.Expected Return Stocks Bonds Risk
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
A Quick Lesson in Modern Portfolio Theory There are an unlimited number of investments and combinations.Expected Return Risk
A Quick Lesson in Modern Portfolio Theory There is a theoretical maximum expected return for each level of risk.Expected Return Risk
A Quick Lesson in Modern Portfolio Theory The best combinations of investments form a curve known as the Efficient Frontier.Expected Return Risk
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
Modern Portfolio TheoryIf you synthesize the recommendations of experts and look at thepractices of the best institutions, you come up with 6 core assetclasses 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.
Modern Portfolio TheoryExpected Return Risk Using Mean-Variance Optimization with the 6 asset classes allows you to find the optimal portfolio for each level of risk.
Modern Portfolio TheoryExpected Return Risk Bonds US Stock Emerging Markets Foreign Developed Real Estate Natural Resources 100%90%80%70%60% Which gives us an asset allocation for50%40% each point along the Efficient Frontier.30%20%10% 0%
Modern Portfolio TheoryExpected Return ? Risk Bonds US Stock Emerging Markets Foreign Developed Real Estate Natural Resources 100%90%80%70% Now, find the60%50% portfolio that has40% the right amount of30%20% risk for you.10% 0% 0 1 2 3 4 5 6 7 8 9 10 Less More Overall Risk
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 RiskObjective Score 0 1 2 3 4 5 6 7 8 9 10 Less Risk More Risk
Subjective Risk ToleranceTake a risk questionnaire to identifyyour comfort with the risks ofinvesting.Note: Most questionnaires will likely end with a portfolio recommendation with adifferent set of asset classes than we recommend. Your real goal is to figure outwhere 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 RiskExampleshttps://personal.vanguard.com/us/funds/tools/recommendationhttp://www.schwabmoneywise.com/public/moneywise/calculators_tools/questionnaire
Objective Risk ToleranceUse a financial planning tool toensure you’ll have more investmentincome than spending needs whenyou retire.The lower your investment income relative to your spending needs, the less risk youcan take. Objective Score 0 1 2 3 4 5 6 7 8 9 10 Less Risk More RiskExamplehttp://www.smartmoney.com/retirement/planner/
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 RiskObjective Score 0 1 2 3 4 5 6 7 8 9 10 Less Risk More RiskOverall Score 0 1 2 3 4 5 6 7 8 9 10 Less Risk More Risk
Plot Your Risk LevelExpected 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
Back to choosing ETFs…We need to pick ETFs that represent each of the 6 coreasset classes and buy them in percentages dictated by yourrisk tolerance. Now which ETFs should I buy?
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.
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.
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 – BNDWealthfront regularly surveys the ETF landscape and ranks ETFs in each assetclass using the criteria described in the prior slide. Vanguard ETFs often comeout on top. Wealthfront receives no compensation for recommending Vanguardproducts or any other ETFs.
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 tomaintain it!
RebalancingThe value of your investments will naturally drift over time as themarket moves. 2012Expected Return 2011 Example • Green increases in value. • Yellow decreases in value. • Blue stays the same. Risk
RebalancingThe new mix of asset classes will have a different risk andexpected return. 2012Expected Return 2011 Additional Risk Risk
RebalancingRebalance your portfolio to get back to your desired risk level withthe highest expected return.Expected Return Rebalance Risk
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
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.
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
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DisclosuresNothing in this presentation should be construed as a solicitation or offer, orrecommendation, to buy or sell any security. Photographs do not depict actualWealthfront clients. Financial advisory services are only provided to investors whobecome Wealthfront clients pursuant to a written agreement, which investors areurged to read and carefully consider in determining whether such agreement issuitable for their individual facts and circumstances.Past performance is no guarantee of future results, and any hypotheticalreturns, expected returns, or probability projections may not reflect actualfuture performance. Investors should review Wealthfront’s website for additionalinformation about advisory services.
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