Mutual Fund Commentary
DYNAMIC ASSET ALLOCATION USING ETFS
The proliferation of ETFs and supporting research is enabling advisors to be more tactical in putting together portfolios for their clients. But the low-cost, diversified nature is also making it easy to construct strategic ETF portfolios based on risk profiles that are re-allocated periodically to reflect valuation and fundamental factors. S&P Capital IQ's own Capital Appreciation Model Allocation Portfolio (MAP) is an example of the latter approach.
Standard & Poor's Investment Advisory Services' Portfolio Strategy Committee meets on a weekly basis to review and discuss the global outlook for all markets and revises its forecasts of expected returns and confidence levels of 20 indices on a quarterly basis. Qualitative capital assumptions, historical data and market expectations are inputs into the Black-Litterman model. The Black-Litterman output is run through a Mean Variance Optimizer to develop asset allocation models based on six investor risk profiles, after applying real world checks and balances. Based on a 12-month time horizon, Portfolio Manager Michael Carapucci selects investment-style focused ETFs for each asset class.
The strategically focused Capital Appreciation MAP, providing exposure to certain U.S. and international equity and fixed income sub-asset classes, such as large-cap growth, developed international, short-term and high-yield, is managed to avoid unnecessary turnover. Yet, certain styles are favored over others and allocation changes typically occur two or three times a year.
For the Moderate strategy, which has a 60% equity/40% fixed income split, the latest changes were made in mid-August. One such change was to increase the allocation to emerging markets through iShares Core Emerging Markets (IEMG 54 Overweight). SPIAS sees emerging markets as having a relatively attractive valuation to developed international markets and improving macroeconomic trends in key markets such as China, South Korea and Taiwan (the three largest weightings in IEMG). Meanwhile, the allocation to iShares Core S&P Mid Cap (IJH 142 Marketweight) was reduced in August due to valuation concerns.
The largest equity allocation in the Moderate strategy was to iShares S&P 500 Growth (IVW 108 Overweight), which is well diversified, and has its heaviest weightings in the Information Technology and Health Care sectors.
There are six risk profiles in the Capital Appreciation MAP, with the most conservative risk profile (Conservative) targeting approximately 40% equity/60% fixed income allocations and the most aggressive risk profile (Enhanced Growth) targeting a 90% equity/10% fixed income split.
A total of 13 ETFs are used in most of the risk profiles, but the weightings are higher for certain equity styles and lower for fixed income styles as the profiles increase in risk. The average expense ratio for the MAP ranges between 0.17% and 0.20%, providing exposure to what SPIAS views as high-quality, low-cost asset allocation vehicles.
SPIAS uses an open architecture approach to select ETFs to include in its MAP, with a current mixture of iShares and Vanguard ETFs tied to various index providers in the Capital Appreciation models; State Street ETFs are also used in the Current Income models that have greater fixed income exposure. Carapucci explained that ETFs are chosen based on structural characteristics, liquidity and cost efficiency.
For example, IEMG and iShares Core MSCI EAFE (IEFA 61 Marketweight), the developed international equity allocation, replaced Vanguard Emerging Markets (VWO 45 Overweight) and iShares MSCI EAFE (EFA 66 Marketweight) in April 2013 and September 2013, respectively, in the strategy. This followed Vanguard's benchmark change from an MSCI to FTSE benchmark, which would have resulted in no exposure to South Korea. Carapucci also noted that the improved liquidity for the newer, low-cost international products from iShares.
Within fixed income, changes were last made in April 2014. iShares Core Total US Bond (AGG 110 Overweight), with its 2.0%, 30-day SEC yield, is the largest weighted fixed income ETF for the MAPs, providing intermediate-term exposure through a mix of U.S. Treasuries, Mortgages, and Corporates. However, Standard & Poor's Investment Advisory Services tilts the strategy toward short-term and high-yield ETFs, favoring taking on more credit- rather than interest-rate risk for its clients.
Vanguard Short-Term Bond (BSV 80 Overweight) has an average duration of 2.7 years that is lower than AGG's 5.5 years. Meanwhile Vanguard Long-Term Bond (BLV 92 Overweight) has an average duration of 14. The current MAP strategy has allocations to both Vanguard ETFs, but greater exposure to BSV than BLV.
Meanwhile, an allocation to iShares iBoxx High Yield Corporate Bond (HYG 94 Marketweight) provides high yield exposure, with its 4.3%, 30-day SEC yield and 50% weighting in bonds rated the equivalent of Standard & Poor's Ratings Services' credit rating of BB.
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