ETFs: Portfolio Building Blocks

ETFs can be the ideal building blocks for a well-diversified portfolio.

Tom Whitelaw 15 January, 2008 | 9:26AM
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Exchange traded funds, or ETFs offer investors the opportunity to spread their risk across entire indices, and can provide a great way of cheaply* building a core portfolio. With many new ETFs (to learn more about ETFs and how they work click here) having listed on the London Stock Exchange in 2007, we will consider what options are now available to UK investors wishing to build their core portfolio.

Core UK Exposure
The most logical place to start for UK investors is with the UK marketplace; after all your portfolio should, to a certain extent, reflect the economic realities of your country of residen

ce. You will get the broadest exposure to UK stocks through Deutsche Bank operated db x-trackers FTSE All-Share ETF, which provides access to the 698 stocks comprising the index. While the FTSE All-Share ETF invests across the market cap spectrum, the FTSE 100 offering offers more-focused exposure to large caps, while Deutche’s FTSE 250 ETF primarily targets mid caps. With a total expense ratio (TER) of 0.40% annually, the FTSE All-Share ETF is the priciest of the options; db x-trackers FTSE 100 has a TER of 0.30% while the mid cap focused db x-trackers FTSE 250 comes in at 0.35%.

Core Global Exposure
If you do not wish to geographically split your core holdings yourself, you can choose an ETF that does it for you. iShares MSCI World , for example, offers exposure to companies invested in 23 countries across the world for a 0.50% TER. It’s worth noting that U.S. stocks comprise the largest chunk of the index—50% of assets—with another 11% in the UK and 10% in Japan. Invesco‘s Powershares also offers a global option in its FTSE RAFI Developed 1000 ETF, but it is much more expensive than the iShares offering, with a TER of 0.75%. (The difference in cost may not seem very big, but it certainly adds up over time.) Nevertheless the reason we mention it is that the index it tracks operates slightly differently to the MSCI World. While the MSCI World weights each of its holdings by size, the FTSE RAFI Developed 1000 uses four factors, dividends, cash flow, sales and book value, to determine each of its constituent’s weightings. However we would plump for the iShares offering as the real world track record of fundamental indexes such as FTSE RAFI is too short to be meaningful. Unlike traditional cap-weighted indexes, they are biased toward somewhat smaller value-oriented stocks which are coming off an extended rally, therefore the back-testing for the RAFI indexes look good, but of course there is no guarantee that such outperformance will continue.

Core European Exposure
Across the European Equity Large Cap and the Eurozone Equity Large Cap categories there are around 20 potential offerings to fulfil your European allocation. However, most of these ETFs also include a smattering of UK stocks, which would overlap with an investors all-UK core holding. An alternative is the iShares MSCI Europe ex-UK ETF, which owns over 400 non-UK stocks across the European Union, Scandinavia and Switzerland and features a relatively low TER of 0.40%

Core North American Exposure
For your core US exposure, the Morningstar US Large Cap Blend category is a good starting point, and again it is iShares offerings which provide the most diversity. iShares S&P 500 focuses on the top 500 US blue chips, while the iShares MSCI North America goes a step further and includes 665 US and Canadian companies covering approximately 85% of the combined market cap of the US and Canadian markets. Both funds have TERs of 0.40%.

Core Japanese Exposure
In Japan, there are two simple ways to cover the market in just one trade. Firstly, the iShares MSCI Japan ETF owns 382 stocks at a cost of 0.59% TER. Alternatively, you could choose the slightly cheaper (0.50% TER) Lyxor ETF Japan (Topix). With more than 1,700 holdings, the Lyxor offering is broader and even more representative of the whole market.

Asia Pacific Ex Japan Exposure
Most Asia countries outside of Japan are still classified as emerging markets. These countries have gained a reputation for increased stability in recent years, but there’s still a potential for great volatility. As such, we would relegate ETFs that focus on them to a small part of a broad portfolio. The ETFs that operate in this space are slightly more expensive with the Lyxor ETF MSCI AC Asia-Pacific Ex Japan costing 0.65% and the iShares MSCI Far East Ex-Japan costing 0.74%, but they will give you broad access to emerging markets such South Korea, China, Taiwan, Hong Kong and more. We will consider niche ETFs in more detail next week.

Core Bond Exposure
Finally, your asset allocation is likely to include a requirement for fixed income, and again ETFs can provide a cheap and easy way to get exposure. iShares offer three different ETFs to suit your needs--iShares £ Corporate Bond, iShares FTSE UK All Stocks Gilt, and for those who want to offset inflation risk, iShares £ Index-Linked Gilts ETF. The index-linked offering is slightly more expensive with a TER of 0.25%, whereas as the others are just 0.20%.

Putting together your ETF portfolio
Once you have decided on your ETF portfolio you can take advantage of Morningstar’s Portfolio X-ray tool to make sure it meets your asset allocation needs. The tool will allow you too double check the country, equity sector and even the individual stock exposure of your new core portfolio.

*Please be aware that if you want to utilise pound cost averaging techniques broker fees can seriously hurt performance (for more information on Pound Cost Averaging check out our article).

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Tom Whitelaw  

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