When it comes to portfolio construction, examples work best. While my last blog lays out general principles, an additional sample portfolio will help readers understand the building process. Let me focus on two critical aspects of portfolio construction.
- Asset Classes: For a well-diversified portfolio, we need to find ETFs that represent the essential asset classes. If you go back to the earliest blogs, I was using 18 asset classes. U.S. Equities ended up with the nine (9) Morningstar asset classes. Including this many is not necessary as most of the nine “tic-tac-toe” asset classes are highly correlated. The “Rutherford 10” does a good job of covering the critical asset classes with few high correlations. This can wait for another analysis.
- Make sure the ETFs in the investment quiver are not highly correlated. We are forgiving in certain areas, but even this is not necessary. For example, U.S. Equities (VTI) and Developed International Equities (VEU) are frequently highly correlated. In the following portfolio analysis, we can reduce the number of arrows in the investment quiver.
Since a number of ITA readers have accounts at Schwab, I plan to use the Pauling portfolio as the example. This portfolio needs a lot of work as too many of the current ETF offerings are highly correlated. Simple is better so it is time to peel off the unnecessary ETFs.
Current Investment Quiver of ETFs and Stocks: Below is a list of the ETFs and stocks available to the Pauling portfolio manager. Looking over the descriptions one can visualize high correlations are likely. For example, SCHB and SCHA are potential candidates for a correlation above 0.80.
I’ll break the following list of securities into two groups as Portfolio Visualizer will only handle so many tickers at a time. Then I will come up with a final list.
Correlation Group #1: For starters, I definitely want to keep SCHB as that is my core U.S. Equities ETF. Using a “correlation cut” I eliminate SCHA, SCHF, SCHD, SCHV, and SCHM. That leaves nine ETFs for the final group. Look over the following correlation table and see which ETFs you would cut from the list.
Correlation Group #2: MTUM and QQQ and highly correlated. VCR is also highly correlated with QQQ and MTUM.. If I were to eliminate one of the three it would likely be QQQ. However, I’ll make an exception as QQQ provides a special entree into high tech companies. Let’s see what happens when the remaining ETFs from Group 1 are combined with Group 2.
Even though I set the beginning date to 2006, Portfolio Visualizer truncated the date as some ETFs do not have a history going back to 2006.
Final Group: One of the first ETFs to jump out as not needed is SCHR as I have this asset class covered with SCHZ. VCR and VFH are only included as they are currently the top performing sectors. Normally, these two ETFs are not included as part of the core holdings. MTUM and QQQ are the two obvious ETFs to eliminate as both are highly correlated with SCHB. I plan to hold both for each serves a unique purpose in the portfolio. This is a judgment call. You may come to a different conclusion.
In the following group these critical asset classes are covered.
- U.S. Equities
- International Equities
- Emerging Market Equities
- U.S. Real Estate
- Treasury Inflation Protection (TIPs)
- Natural Resources
One gap is International Bonds. While not a pure International Bond play, PCY can be added to this group. Taking this list of securities, what might the Pauling look like. That analysis will come in a later blog post.