ETF Portfolio Building

“Cooking Recipe” ETF-Portfolio (Focus Stock Markets)
We hear often one question: How to build an ETF portfolio with X €? Basic information are summarized in this guideline.

Introduction 

ETFs (Exchange Traded Funds) provide a cost effective investing opportunity in different stock markets in order to diversify the financial investment and make it less susceptible to risk. Usually investors decide for a certain allocation e. g. markets A, B, C with 50%, 30%, 20%. Therefrom, every market is reproduced by one or several suitable ETF.

Rebalancing

Every six or twelve month investors check the portfolio development. If the target allocation is clearly deviating from the present (above 5% or 10%), there should be rebalancing done. Rebalancing indicates a good number of ETFs. If the 20% share deviates by 10%, this is only 2% of the overall investment sum. 10,000 € overall investment results in 200 € deviation. One single 200 € trade goes along with high costs. This example points out the question, if you really need three ETFs or two would be more suitable. New ETFs could be also bought later, when the portfolio has grown. A portfolio should be rebalanced between asset classes (equity, bonds) and also within asset classes between single markets. Best practises for relbalancing can be found here at Vanguard.

Markets

Basic investment classes are equity, bonds, raw materials and real estate. How net worth is distributed between those investment classes, should choose everybody by his or her personal situation and risk appetite. In this post the focus lies within the asset class equity where public traded stocks are a way to participate. Other classes are only discussed shortly in the following.

Bonds

In the currently witnessed low interest period, some market participants choose secure overnight funds or other fixed-income products instead of bonds (detailed information, work in progress).

Raw materials 

The use of investments in raw materials is discussed heavily and investments should be well-thought-out. They usually provide more in-depth understanding, especially due to not intuitively real return principals (detailed information, work in progress).

Real estate

We are not talking about owner-occupied real estate, where usually other criteria are used compared to financial investments. We only mention REITs (real estate investment trusts) without going in-depth (detailed information, work in progress).

Stocks

How do you invest in stocks? ETFs usually follow curtain countries or regions due replicating indexes. Usually those are distinguished by Europe, North America, Pacific, Emerging Markets and Frontier Markets.

As you can imagine, the allocation of regions come along with countless possibilities. Often this is done by market capitalization or GDP. Allocation with the last GDP per mile has no real effect. Furthermore, it is hard to argue that joint stock companies like Volkswagen, Deutsche Bank or SAP relate closely to the German GDP. One pragmatic approach could be:

1 ETF (low total investment or minimum effort):

MSCI All Country World (Investable Market) Index (ACWI or IMI). Weighted with market capitalisation (Cap).

2 ETFs (standard):

(Developed) world: 70%
Emerging Markets: 30%

3 ETFs (closer to worlds GDP):

(Developed) world: 50%
Europe (or eventually EMU) 20%
Emerging Markets: 30%

4 ETFs:

Europe: 30%
North America: 30%
Pazific: 10%
Emerging Markets: 30%

6 ETFs:

Europe: 26%
North America: 26%
Pazific: 8%
Emerging Markets: 26%
Frontier Markets: 4%
Small Caps: 10%

Underlying Indexes

For single stock markets several indexes exist, in which can be invested due to ETFs. Exempli gratia some are presented here:

Europe: STOXX Europe 600, MSCI Europe
North America: MSCI North America, MSCI USA, S&P 500
Asia: MSCI Pacific
Emerging Markets: MSCI Emerging Markets
Frontier Markets: MSCI Frontier Markets
Small Caps: MSCI World Small Caps, MSCI Emerging Markets Small Cap, MSCI Europe Small Cap, MSCI USA Small Cap, S&P Small Cap 600, Russel 2000

MSCI defines those constructions:

The MSCI Standard Indexes cover all investable large and mid cap securities across the Developed, Emerging and Frontier Markets and target approximately 85% of each market’s free-float adjusted market capitalization.

The MSCI Mid Cap Indexes cover all investable mid cap securities across the Developed, Emerging and Frontier Markets and target approximately 15% of each market’s free-float adjusted market capitalization.

The MSCI Investable Market Indexes (IMI) cover all investable large, mid and small cap securities across the Developed, Emerging and Frontier Markets, targeting approximately 99% of each market’s free-float adjusted market capitalization.

The MSCI Small Cap Indexes cover all investable small cap securities with a market capitalization below that of the companies in the MSCI Standard Indexes, targeting approximately 14% of each market’s free-float adjusted market capitalization.

The MSCI Micro Cap Indexes cover approximately 5,000 micro cap securities across Developed Markets countries, using size and liquidity requirements specific to this size segment.

The MSCI IMI Indexes are combined with the MSCI Micro Cap Indexes to form the MSCI All Cap Indexes across the Developed Markets countries.

This allocation is not eternally fixed, which guarantees the optimal distribution. It is only a stating line.

Around a Core-ETF-Portfolio further ETFs can be admixed in a Core-Satellite-Strategy based on personal preferences. Only some to mention: large caps, small caps, value, dividend, growth, single industries or countries. Some investors are in favor for the home market, where some do it unconsciously (home bias) and others knowingly expecting another risk return ratio. In the past(!) small caps had higher returns with higher price volatility in general. But nobody knows how future will look like. With larger portfolios, small caps should be considered to add.

ETF Constructions and Costs

ETFs can include all stocks of the reconstructed index (replicated ETF, physic), a selection of stocks (optimized ETF) or replicated the index with SWAP contracts (SWAP based ETF, synthetic). Swap based ETFs issuing companies are holding stocks completely outside the index and have an SWAP agreement with a counterparty (usually a bank). This goes along with a trade of the performance of the held stocks for the index performance. Every construction has its own pros and cons. At the end, investors has to choose what to buy. Many ETFs are using securities lending, so the fund company (issuing ETFs) lending their holdings for outside parties for a curtain fee (usually collateral) and therefrom the administrative ETF costs (of the fund company) can be covered or even overcompensated by this income. Some investors deny such ETFs.

ETF costs are measured and published by the TER (total expense ratio). Unfortunately not all costs are included in the TER. ETFs can have further costs like transactions costs, SWAP costs or lending income(negative costs). This should be always(!) checked at the fund company website (fact sheet). Important in this sphere is also the tracking difference (TD) which measures the performance deviation between the ETF and the perfect index. The TD includes all costs and some fund companies show even an expected TD. The exact TD can only be calculated afterwards. Some ETFs (mostly indexes created by the fund company) have further costs. Be aware that TER and TD can change over time.

ETF Currency

The ETF valuta like € or US$ is not relevant. Currency volatility changes the valuation of the stocks and subsequently the valuation of the index.

Taxes

Taxes have to be checked for every country separately. Some ETFs retain profits and others distribute them. Every country has its own tax systems and they are changing rapidly, so this point we cannot analyze globally. Please check this carefully for your specific situation.

Fund Company and Online Sources

ETFs are in favor and many websites provide information. Some words of warning: Not all data are correct. So please double check always(!) with the information by the fund company, especially costs (see fact sheets). In case the fund company goes bankrupt the capital attached to the ETF is not lost since this capital is not included in the insolvency estate.

Buy and Sell

ETFs can be traded through a bank or a broker. Usually they are not presented in customer pitches by banks because ETF margins and subsequently provisions are low. The opposite can be observed with active fonds. ETFs are usually not bought at the issuing company, but rather at the ETF markets same as stocks. Prices are usually set by a market maker with a certain ask price and volume (like 100,000 US$).  So it can be cheaper to trade over the counter, esp. if you want to trade larger volumes.

Let’s get Started

You have saved cash and want to invest larger volumes. Should you buy one or step-by-step? Through investing equidistant in equal chunks you can reduce the market timing risk and reduce possible losses and profits as you can read here in a Vanguard study. Usually we advice to buy between two and five chunks every half a year with larger sums.

Savings Plan

Many broker offer cheap or free savings plans, but always only a selection of ETFs. Saving plans provide a very effective way to rebalance by adjusting the recurring contributions, reduce market timing risk and last but not least to budget the earned income stream (psychological factor).

Further information

A Guided Tour of the European ETF Marketplace (Morningstar)

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