Using ETFs in Asset-Allocation Models

February 4th at 6:32am by Tom Lydon

One of the most popular uses of index-based ETFs is plugging them into asset-allocation models. Investors and advisors like utilizing low-cost diversified ETFs as portfolio building blocks.

“While it is common to spend a great deal of time researching individual stocks or fund managers, studies have shown that asset allocation can add at least as much value as selection within an asset class. There are two general approaches to asset allocation: strategic and tactical,” Michael Rawson wrote for Morningstar.

Strategic asset allocation has its roots in Modern Portfolio Theory and relies somewhat on the belief that markets are efficient, with re-balancing occurring only when an investor’s risk tolerance changes. Tactical asset allocation takes the changing market environment into account and uses shorter-term forecasts to propose changes from the strategic allocation. This is an active approach that attempts to avoid market inefficiencies, so it uses a strategy that develops a return forecast beyond taking the average historical return, reports Rawson. [Stock ETFs Rally as Investors Turn to Risky Assets]

The following ETFs are a sample of an asset allocation strategy using only ETFs. Wayne Ferbert for Minyanville reports that the following 7 ETFs are large enough to have ample liquidity and that the options market is strong for all of them:

  • SPDR S&P 500 (NYSEArca: SPY)
  • SPDR S&P Mid- Cap (NYSEArca: MDY)
  • iShares Russell 2000 Index (NYSEArca: IWM)
  • iShares MSCI Emerging Markets Index (NYSEArca: EEM)
  • iShares MSCI EAFE Index (NYSEArca: EFA)
  • iShares iBoxx Investment Grade Coporate Bond (NYSEArca: LQD)
  • SPDR Barclays High Yield Bond (NYSEArca: JNK)

The above ETFs represent the most important asset classes and give exposure to the bond market as well as emerging markets. From the top down, there are large-cap, mid-cap and small-cap ETFs, emerging and developed broad market indices with corporate and high yield junk bonds rounding out the mix. [Are Emerging Market ETFs Raising a Red Flag?]

Investors should consider strong exposure to all asset classes, since the year has started off strong for the equity market. Mid-cap and small-cap in particular are distinctly outpacing the large-cap arena: + 7.5% and +6.5% vs. +5.5%, respectively, reports Ferbert. [2012 Was the Year of the Bond ETF]

As the stock market continues to mend, and hits some multi-year highs, investors should re-consider their asset allocations and strategy before the momentum gets going much  more. Most of all, if it has been at least 6 months since your portfolio has been reviewed and re-balanced, there is no better time to do it because the market has shifted.

Tisha Guerrero contributed to this article.

Full disclosure: Tom Lydon’s clients own SPY, IWM, LQD, JNK, EEM.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.