Exchange Traded Fund (ETF) portfolios benefit asset allocation investing because of increased diversification and the ability to target specific investment segments. The advantages of ETF investing are real and the reason for the growing popularity of using ETF shares as an investing strategy.

ETF Portfolios

Global and international growth asset allocation is made easier particularly because of the wide variety of regional and country funds now available as ETF portfolios. Additional categories and sectors are becoming available as financial companies offer such diverse categories as frontier and emerging markets, small cap country funds, infrastructure stocks within foreign regions and countries, large cap dividend growth, etc.

For the U.S. domestic investor the choices are almost limitless. This allows a portfolio manager to diversify into very specific market niches or sectors. For example, let’s say an investor believes investing in water is a good investment. Yes, there is several water ETFs to choose from. Almost any sector imaginable is now available in ETF portfolios.

Investment Management and Planning

A portfolio manager should always understand and consider the two big ETF portfolio asset allocation investing disadvantages before implementing an ETF investment strategy. But there is no doubt ETF investing should be a part of asset allocation and risk management analysis. Investment asset allocation is the most important determinant of portfolio returns, and the fact that ETF shares provide substantial benefits to asset allocation investing means every portfolio manager should consider ETF investing.

There are many advantages to Exchange Traded Funds (ETFs).  But there are also some ETF portfolio asset allocation investing disadvantages that a portfolio manager should understand before implementing an ETF investing strategy.

ETF Disadvantages

ETFs are generally not actively managed, but are programmed to follow a specific index, the index and therefore the ETF, may not own the very best stocks. A portfolio manager must weigh the benefits of diversification versus the disadvantages of over diversification in that particular industry or segment the ETF index is following. It may be more advantageous to buy a limited number of the best companies in that industry rather than owning the entire index.

An ETF has the same problem as purchasing Index Funds.. As the winners in an index increase in price they become a larger percentage of an ETF portfolio. At the same time, as some stocks fall in price they become a smaller percentage of the ETF portfolio. If the ETF follows an index instead of being actively managed, it will fail to implement the powerful risk management strategy of portfolio rebalancing. By owning the index you may own more of expensive over priced stocks and less of the bargain underpriced stocks.

Investment Management and Planning

The above disadvantages should not discourage investors from ETF investing. At the same time, understanding the ETF disadvantages and pitfalls, and how each investment correlates with a portfolio’s ETF asset allocation is critical to investment management and planning.

ETFs require research and knowledge to be able to place them in a properly diversified portfolio. ETFs play an important role in the Arbor Asset Allocation Model Portfolio (AAAMP) by providing an inexpensive means to diversify small positions in targeted sectors of the market. The AAAMP usually holds 20-35 individual positions of which typically about one-third is ETFs.

ETF Investing

The number and variety of Exchange Traded Funds (ETFs) are exploding as investors discover and embrace the advantages of ETF Investing. These advantages are even leading some investors to abandon mutual funds and maintain a stock and/or ETF portfolio.

ETF Advantages

Low Costs.  Since ETFs trade like stocks, you can buy a diversified portfolio with the same low commission (typically $6 – $10) as a stock. Also, ETFs typically have lower expense ratios than mutual funds. Why pay up to a 2% a year management fee when an ETF will do it for as little as 0.13%?

Instant Diversification. Whether following a broad index or a specific sector, an ETF provides a basket of stocks with one purchase.

Liquidity.  ETFs trade on a market exchange so they can be traded (intraday) anytime stocks trade, not just at the end of the day.

Tax Efficient.  Since most ETFs are not actively managed, but are programmed to follow a specific index, they don’t have realized capital gains and income that are required to be passed on to owners each year. This means an investor won’t be taxed until they sell the ETF, giving them more control.

Sector Investing. ETFs can segment to very specific or targeted sectors of the economy. This allows investors to have a diversified position in a small slice of a sector they want to be invested in.

Purchased in Small Amounts. Since ETFs trade like stocks, small positions can be purchased either to dollar cost average into a large position or to take a single small position in a particular sector.

Available in Alternative Investments.  ETFs allow investors to take positions in alternative or even exotic investments that are unavailable in any other form to small investors. New products become available regularly and already include ETFs in commodities, hedges, and leveraged short positions in indices and sectors.

The growing popularity of ETFs and ETF portfolios is because the advantages of ETF investing provide tangible benefits to the investor. ETF investing can improve risk management and portfolio optimization through segmentation and increased diversification.

Investment Management and Planning

The advantages of ETFs are so strong that the Arbor Investment Planner uses Stocks & ETFs, but not Mutual Funds in the Arbor Asset Allocation Model Portfolio (AAAMP).  With a combination of stocks and ETFs the AAAMP capitalizes on the advantages of combining these two investments for increased flexibility and cost minimization.

Instead of taking a dividend in cash an investor can choose to re-invest dividends and receive additional shares of stock. There are several advantages every investor should consider to a dividend re-investing strategy.

1.     By reinvesting your dividends you are regularly dollar cost averaging back into your investment.  When prices are low you buy more shares, and when prices are high you buy fewer shares.

2.     Compound Growth -Your dividends will continue to grow because with each dividend payout you have more shares than the last.

3.     Double Compound Growth – If you own a stock with increasing dividends your dividend per share will be growing in addition to your number of shares growing.

4.     No commissions. It’s an efficient way to add small amounts to your position. Even low commissions are costly when making small purchases.

5.     Dividend reinvestment is easy and automatic. Make this your permanent option and your brokerage account will automatically re-invest your dividends on every stock in the account.

Investors who are retired or require income can take a monthly check from cash and periodically sell positions of appreciated or overvalued stocks to replenish your cash.  This strategy is simple; allows the investor to reap the benefits of re-investing dividends, and promotes the discipline of selling overvalued stocks.

Portfolio rebalancing is a powerful risk management strategy which involves buying or selling investments to achieve a currently desired asset allocation. Rebalancing is one of the most under utilized and under appreciated aspect of Do It Yourself Investment Management.  

The purpose of diversification is to reduce risk by holding investments that will behave differently at different times. Over time, as a portfolio’s assets change in price it can easily move the portfolio to a position that risk and return become inconsistent with an investor’s goals and risk preferences. As some assets increase they make up a larger percentage of the portfolio; at the same time, the declining assets become a smaller percentage. If an investor does not rebalance the portfolio it will gradually move to high return and higher risk investments.

A portfolio rebalancing strategy allows an investor to buy low and sell high. For example, let’s say you have a target asset allocation of 4% for asset A and a target asset allocation of 4% for asset B. Then let’s assume asset A increases 50% and asset B declines by 50%.  Now you own 3 times as much asset A compared to asset B because asset A has increased to 6% of the portfolio and asset B has declined to 2% of the portfolio. After these fluctuations, not only is your asset allocation out of balance, but now you own more of an asset that has just risen 50% and may be overvalued and own less of an asset that may be undervalued. Rebalancing allows an investor to sell overvalued assets and buy undervalued assets.

A tactical or active asset allocation strategy uses frequent rebalancing to take advantage of volatility by being more conservative when an asset price is high and more aggressive when an asset price is low. Take the above example; with asset A up 50% and asset B down 50% an investor may choose to move his target asset allocation to reflect the relative risk of each asset. Instead of rebalancing to 4% each, an investor may decide that asset A, because it is now overvalued should only be 3% of the portfolio, and asset B, because it is undervalued, should be 5% of the portfolio.  If done correctly, the portfolio is still diversified but now has less risk and greater potential for appreciation at the same time.

Flexibility makes an active asset allocation strategy superior to a simple buy and hold strategy. Buy and hold strategies do well as long as the market is rising, but do poorly during periods such what we have experienced this past decade. Those who have followed this favored strategy have lost more than a decade of wealth building.

There are two main differences between a buy and hold strategy and active asset allocation strategy. First, frequent or regular re-balancing is required; and second, an asset allocation decision must be made for each investment category based on the current opportunities and risk. This doesn’t mean the asset allocation has to change, but an investor has the flexibility to change with changing conditions. The only drawback of an active asset allocation strategy is that it requires paying attention to your investment portfolio. Nothing good comes easy, but the reward can be much higher portfolio returns. 

Over diversification is a serious mistake made by investors. Many investors have learned the harmful effects of under diversification and mistakenly believe that the more diversification the better. It has become common to diversify to the point of hurting investment returns.

Most investors have experienced the poor results of over diversification during the past decade because too many stocks in a portfolio results in a portfolio behaving similar to market averages. This is particularly harmful in flat or bear markets such as we have seen since 2000.

Most portfolio analysts believe portfolio diversification strategies having between 15 and 30 different assets is optimal to properly diversify away specific or unsystematic risk. Most institutional vehicles (i.e. diversified mutual funds, pension funds, equity index funds, etc.) are over diversified and simultaneously lack an asset allocation needed for risk management and portfolio optimization in today’s challenging market.

Before identifying the five best investment themes in 2011 we need to review the overriding economic concept that is driving world markets. The concept of biflationary economies where inflation and deflation occur simultaneously, is a worldwide phenomenon. Assets that are owned are experiencing deflationary pressures while items we consume are rising in price. This makes it important to avoid investment assets experiencing deflationary pressures and invest more aggressively in assets that are rising in price.

Here are five investment themes that should be included in your asset allocation in 2011. Each theme has strategic advantages driven by worldwide demand.  Each of these themes has the potential to provide a superior return on investment that transforms your portfolio from average to extraordinary:

ENERGY: Whether we are talking about oil, natural gas, coal, nuclear energy, or new green energy, we will probably need it all.  We already use all the energy we produce worldwide.  The tremendous growth expected in the standard of living of the emerging markets, in addition to worldwide increase in population, will force us to find more ways to produce and deliver energy to an energy starved world.

INFRASTRUCTURE:  No state or nation is able to thrive without infrastructure investment  to support growing economies and populations.  Airports, railroads, highways, communications, etc. are all needed to move people, products, and information efficiently.  Developed countries have old and neglected infrastructure needs.  Emerging markets have unending needs for new infrastructure.

FOOD / NUTRITION: One of the top global trends is the growing needs for food, nutrition, and investment in agriculture. As third world nations develop they require more and higher quality food.  This process is already under way.  Add world population growth and you have ever increasing demand for good nutrition and quality food for decades to come.

DEFENSE / TERRORISM/WAR: We live in a dangerous world.  Trends that include an increasing number of fanatics willing to kill innocent people will require technology and diligence to defeat.  Add to the fact that as we have become more global and mobile we have needed more resources to keep the peace, not less. 

HEALTH / ENVIRONMENT: The uncertainty of Obamacare has hurt the valuations of health care stocks and created some opportunities for value investors. Due to population growth in the developing markets, higher standards of living being demanded by emerging countries, and the aging of the developed nations (particularly the U.S. and Japan); the demand for health care and need for environmental services are expanding rapidly.

Each of these five themes have the potential to provide extraordinary investment returns because the demand created by the global market place will require these needs to be met. If you have demand that outstrips supply, the return on investing in that product or service will have to be higher than average to attract investors into investing and meeting that need.

Definition of Diversification

The definition of diversification is the act of, or the result of, achieving variety. In finance and investment planning, diversification is a portfolio strategy combining a variety of assets to reduce the overall risk of an investment portfolio. Risk management and portfolio optimization is the purpose of asset allocation and a portfolio diversification strategy.

Diversification and Risk

Diversification can lower the volatility (risk) of a portfolio because not all asset categories, industries, or stock, move together. Holding a variety of non-correlated assets can nearly eliminate unsystematic risk. In other words, by owning a large number of investments in different industries and companies, industry and company specific risk is minimized by diversification. In addition, diversification can reduce portfolio losses in bear markets, preserving capital for investment in bull markets.

Diversification Advantages

Diversification advantages include reducing portfolio risk and simultaneously increasing portfolio returns through portfolio optimization. Holding a variety of assets enables the portfolio manager to invest in more aggressive assets without increasing the risk of the overall portfolio. Optimization can be achieved because proper diversification lowers portfolio risk, allowing an investment manager to invest in higher risk, higher reward assets, and still maintain a desired target amount of total portfolio risk.

Both under diversification and over diversification are harmful mistakes made by investors. Achieving proper diversification that mitigates the various forms of risk takes time and expertise. Investors who believe in the advantages of Do It Yourself Investment Management may want additional guidance and helpful resources from an online investment service.

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Asset Allocation Management and risk management  analysis will be the key to successful investing in 2011. An assessment of the current long term investment environment is the first step. The last 11 years have seen two bubbles; the dot.com bubble, and the housing bubble. Both bubbles produced extreme stock market volatility. I believe we are in a 15-20 year bear market that began in 2000, and have one more bubble still left to deflate; that being local, state, and federal governments.

All three levels, local, state and federal governments, have increased their expenditures and unfunded liabilities to unsustainable levels. The government at every level has exploding deficits, soaring debt, and mounting unfunded liabilities. Each level of government has to look at solutions to overcome short term and structural deficits. Cutting government services, employee layoffs, tax increases, restructuring of pension promises, defaults, and bankruptcies are all possibilities across the country.  Anyway you look at it, all the options will involve pain, economic dislocations, and probably more stock market volatility for several years to come.

Buy and hold strategies work well when the stock market is rising in a cyclical bull market. Bear markets require a tactical or active asset allocation strategy which rebalances the percentage of assets in investment categories based on market forecasts and valuations. The goal of an active asset allocation management strategy is to improve the risk-adjusted rate of return of a portfolio as compared to a passive investment management strategy. The objective is to overweight asset classes that are undervalued and/or expected to outperform and underweight asset classes that are overvalued and/or expected to underperform.

In 2011, there are many reasons to employ a more conservative asset allocation. “The Case Against Bonds” is compelling because historically low interest rates are destined to rise the next few years. Precious Metals charts have the look and feel of an investment bubble, and the stock market has just retraced approx. 2/3 of the 2007-09 bear market. This is a common ending place for bear market rallies. “Ten Reasons to Be Fearful When Others Are Greedy” provides additional reasons why a conservative asset allocation is the prudent strategy in 2011.

The current investment environment makes risk management and portfolio optimization critical to preservation of capital and long term performance. Having the ability to be flexible is the biggest benefit of a tactical or active asset allocation management strategy.