In the last post we began to implement our asset allocation by deciding to:

• Use commingled funds to populate our asset classes
• Use passive ETFs because we are ok with broad asset class expected returns.
• Find funds that track the S&P 500 to represent our US large cap asset class

Let’s continue by finding specific ETFs to represent our asset classes and complete this HYPOTHETICAL exercise.

🚨DISCLAIMER – NOT INVESTMENT ADVICE

***THIS IS NOT INVESTMENT ADVICE ***

I’m not soliciting any action or transaction based on the information in this post. This is a hypothetical exercise purely for illustrative purposes. The goal is to describe the types of research that may help people evaluate the large number of investments in the market. You should not take any investment action without consulting your financial advisor. Past performance is not a guarantee of future results. Do your own research before investing.

Whether you are investing on your own or working with an advisor, I want to arm you with information about choosing investments to help you be a better investor. This is a thought exercise, and some broad assumptions and simplifications will be made.

We’re going to evaluate actual investments that are available to purchase in the market. The portfolios we create in this exercise may not be appropriate for you or any investor.

Financial professionals like me operate within a highly regulated environment. Before we can recommend investments to someone, we must understand their specific situation in order to have a sense of what may be best for that specific individual. This is an article on the internet that anyone can read, and it’s impossible for me to understand the unique circumstances of all potential readers. There are no investments that are universally appropriate for everyone.

You should always do your own research, evaluate prospective investments based on your specific situation (not the author’s), and consult with a financial advisor before taking investment action.

🙌💵

ETF Sponsors

With passive ETFs, there isn’t much specialized research required to pick individual securities as discussed above. Instead, the main concern is that the fund is liquid and easily tradeable so you can buy and sell as needed – remember our investments fund our lifestyle, and we may need money at unexpected times.

We also want to be sure our ETF tightly tracks the index we chose, so that we get the return we expect. This means the manager should have experienced teams who can efficiently operate a passive investment approach. The “sponsor” firm operating the ETF should have enough resources to know the composition of the indexes and capital markets connections to be able to transact in the underlying securities that comprise the index. Ideally the fund will also be large enough that we can be confident the company won’t close it down, leaving us to repeat the exercise of finding another investment. There should be lots of other investors who own the fund.

The largest ETF sponsors are @BlackRock , @Vanguard_Group , and @StateStreetGA . Let’s check their product lists for funds that track the S&P 500.

A “ticker” is an abbreviation used to refer to a stock, mutual fund, or ETF for trading purposes. Below are ticker symbols for S&P 500 ETFs by sponsor along with expense ratios and other information as of July 31, 2024.

BlackRock

• Ticker: IVV
• $490 billion total assets
• 0.03% expense ratio
• Website: https://www.blackrock.com/us/individual/products/239726/ishares-core-sp-500-etf

Vanguard

• Ticker: VOO
• $472 billion total assets
• 0.03% expense ratio
• Website: https://investor.vanguard.com/investment-products/etfs/profile/voo

State Street:

• Ticker: SPY
• $538 billion total assets
• 0.09% expense ratio
• Website: https://www.ssga.com/us/en/intermediary/etfs/funds/spdr-sp-500-etf-trust-spy

Obviously there are other ETF providers out there, and other funds we could look at. This post is for general information on conducting a fund search and we’re keeping it simple by just looking at the top three ETF providers.

US Large Cap

SPY launched in 1993 and was the first ETF ever created. It’s one of the most liquid and frequently traded funds in existence. If you’re a large institution that needs to move big pools of money around (think hedge funds), SPY can accommodate huge trades without moving the fund price.

In this exercise we aren’t looking to trade in/out of our ETFs. We’re holding for the long term. And the slightly higher fee of SPY will eat away our long-term returns.

IVV has been around since 2000 and VOO launched in 2010. Since inception IVV has returned 0.06% or 6 “basis points” less per year compared to the benchmark (7.69% – 7.63%). One “basis point” equals 0.01%. It’s a shorthand of referring to very small numbers, fractions of percentages. VOO has returned 4 basis points less than the S&P on average (14.55%-14.51%) since inception 14 years ago.

Both VOO and IVV have low fees, lots of investor assets, and tracked the S&P closely over time. VOO has tracked the index slightly better, but IVV has a longer performance history which includes two bad recessions and bear markets in 2001 and 2008.

This is a close matchup to be sure. Either fund should represent our US large cap asset class well. We’ll choose IVV for our US large cap stock ETF since it has stood the test of time longer than VOO. We’ll keep an eye on how closely it tracks the index over time. If need be, we know that VOO could be a nice substitute.

Now we’ll repeat the process to find bond and real estate ETFs to complete our asset allocation.

Let’s review our process we used to choose a passive ETF for the US large cap asset class.

etf selection process

• find index to track
• review funds from top ETF sponsor firms
• select ETF that fits our criteria to represent the asset class

etf selection criteria

• size of fund (total assets)
• what index it tracks
• how well it tracks it
• expense ratio
• sponsor

real estate

There are many types of real estate investments. For this exercise, we’ll limit our scope to publicly traded real estate

investment trusts (REITs). 🙌🏠🏨

REITs are public companies that purchase real estate on behalf of investors. They get favorable tax treatment as long as they distribute income from the properties they own a certain way.

find a REIT index

Casting a wide net increases the odds our index will contain investments that succeed over time. We want to find a broad benchmark for our asset class. One of the most widely-used REIT indexes for performance benchmarking is the FTSE NAREIT All Equity REITs index. Here’s a description from FTSE Russell’s website:

The index “factsheet” on the website contains market cap and other statistics. We can see FTSE NAREIT is a broad index with 137 holdings and over $1.3 billion in total market capitalization of the underlying securities. REITs are a specialized segment of the US stock market, so the size of these indexes will be much smaller than what we saw with US large cap stocks.

As we evaluate REIT ETFs, we can look at the size of the indexes they track to gauge whether they are more or less broad than the FTSE NAREIT index.

review REIT etfs

I did not find any ETFs that track the FTSE NAREIT All Equity REITs index. iShares Core US REIT ETF (ticker USRT) tracks the FTSE NAREIT Equity REITs index, which is similar to the “All Equity REITs” index except it excludes telecom and timber REITs.

Having as many industries as possible in our portfolio increases diversification, and telecommunications is an important economic sector. So USRT is out.

REIT ETFs are more specialized investments than US large cap stock funds like SPY and IVV. There simply aren’t as many to choose from. Again we’ll look at funds from the top ETF sponsors:

iShares US Real Estate ETF (BlackRock)

• Ticker: IYR
• $4.1 billion total assets
• 0.40% expense ratio

SPDR Dow Jones REIT ETF (State Street)

• Ticker: RWR
• $1.4 billion total assets
• 0.25% expense ratio

Vanguard Real Estate ETF

• Ticker: VNQ
• $33.3 billion total assets
• 0.13% expense ratio

IYR tracks the Dow Jones US Real Estate Capped Index. Here’s a description and some characteristics from S&P Dow Jones’ website:

Looks like a fairly broad index, 71 holdings, $1.3 billion total market cap according to the factsheet on the website. With an average market cap of $17 billion versus $9.7 billion for the NAREIT All-REITs, the Dow Jones index appears to contain larger companies.

Remember, we already have a lot of large US company exposure with IVV. Tilting to medium or smaller sized companies would provide good diversification for us.

$RWR tracks the Dow Jones US Select REIT index which, according to the index methodology pdf on the website (see snippet below) excludes cell towers, timber and other types of REITs. As a result its total market cap and average market cap are both lower than the FTSE NAREIT or DJ RE Capped indexes. So RWR tracks a smaller subset of the REIT market compared with IYR.

RWR is out.

VNQ tracks the MSCI US IMI Real Estate 25/50 Index. Reviewing the factsheet on the index provider’s website as we did for the other indexes, it lists 152 holdings and $1.44 billion total market cap. This index encompasses more market value (i.e. it’s broader) than the DJ RE Capped index.

An average market cap of $8.7 billion for MSCI 25/50 compared with $17 billion for the DJ RE Capped indicates the MSCI index contains more small companies. This should nicely complement our large cap exposure in IVV.

With 152 names the MSCI index has the most companies of the three indexes reviewed so far (Dow Jones Select RE had 102 holdings, and DJ RE Capped index had 71). VNQ’s holdings on Vanguard’s website list both telecom and timber REITs. So it offers broad sector diversification.

Of the funds we’ve looked at, this is the closest to the wide exposure of the FTSE NAREIT All Equity REITs index. And with over $30 billion in assets VNQ is the largest REIT fund of the three. Looking at the returns on Vanguard’s website, VNQ has closely tracked its index since inception, only 3 basis points on average per year behind the benchmark (7.66% vs 7.69%). For IYR the difference is closer to 40 basis points per year.

Remember index returns are hypothetical. Index providers like MSCI and Dow Jones don’t have to go into the market and buy/sell securities to build indexes. For funds that seek to track index returns, you should expect to underperform the index by roughly the amount of the expense ratio over time. Also, since VNQ contains smaller REITs, the portfolio is likely more expensive to trade. This affects tracking as well.

choose a REIT etf

We’ll choose VNQ to represent our real estate asset class due to its:

• Diversified exposure to REITs of different sizes, operating in a wide variety of industries
• Low expense ratio indicating efficient management
• Large asset size indicating operational stability
• Close tracking of the underlying index

Next we’ll go through the same exercise for bond ETFs and complete our three-asset portfolio implementation.

passive Etf Selection process 🧐

• find index to track
• review ETFs from top sponsors
• select ETF that meets our criteria

PASSIVE ETF CRITERIA 📝

• size of fund (total assets)
• what index it tracks
• how well it tracks it
• expense ratio
• sponsor

find a bond index

Remember from the last post that our three-asset portfolio consists of US Large Cap Stocks, Real Estate, and Core Bonds. “Core” is shorthand for high-quality, investment-grade bonds. Issuers of these bonds are considered stable. The market is less concerned about their ability to make scheduled payments, as compared with high yield, AKA “junk” bonds.

The Bloomberg US Aggregate Bond index is by far the most widely used core fixed income benchmark. Unlike S&P and MSCI, Bloomberg doesn’t provide index factsheets on their website. I can tell you, having researched the Bloomberg “Agg” index at various points in my career that it has history going back to the 1970s, and is mostly comprised of US government, corporate, and securitized bonds (i.e. backed by loans). For more information about the Bloomberg US Aggregate Bond index we can simply review the websites of ETFs that track it. We’ll do this below.

High yield or “junk” bonds are below investment-grade. High yield issuers are considered riskier, with less stable cash flows. These bonds typically carry higher interest payments, and there is less assurance the investor will receive all payments. “Core-plus” refers to strategies that contain both investment-grade and high yield bonds.

Which type of bonds will better complement our stock and real estate assets over time?

We know that over the long term, stocks have historically been a powerful wealth building asset class.

Stock prices can bounce around a lot over short time periods, but over the long term, stocks have returned much more than bonds, cash or inflation.

Takeaway: if you want your money to grow more than inflation over time, stocks give you the highest odds of success pic.twitter.com/arLCgDFZWS

— Matthew Gagnon, CFA (@fin_empowerment) June 9, 2023

However, stock prices also bounce around a lot. It would be nice if our bond asset class was able to smooth the investment experience, and support the portfolio when stocks underperform.

Let’s look at the Horizon CMAs we used to generate the asset allocation and note the correlations between core and high yield bonds, large cap stocks, and real estate. Remember, higher correlations mean investments tend to move in the same direction.

Core bonds correlation to large cap stocks: 0.26

Core bonds correlation to real estate: 0.25

High Yield correlation to large cap stocks: 0.64

High Yield correlation to real estate: 0.45

High yield correlations to stocks and RE are higher. Core bonds returns are expected to move differently than those of the other assets in our portfolio. Core bonds should give us more diversification.

review bond etfs

Let’s review bond ETFs from the top sponsors that track the Bloomberg US Aggregate index.

iShares Core US Aggregate Bond ETF (BlackRock)

• Ticker: AGG
• $115 billion total assets
• 0.03% expense ratio
• Contains 11,813 bonds

10-year annualized total return is 0.03% less than the benchmark (equal to the expense ratio). Tight tracking, check. The larger difference between the benchmark and fund total return since inception in 2003 (3.2% – 3.08% = 0.12% on average per year) is explainable by the fact that ETF expense ratios have dropped substantially in recent years. This fund (and many others) used to be more expensive.

Vanguard Total Bond Market ETF

• Ticker: BND
• $107.3 billion total assets in the ETF share class. There are $320 billion total assets if you count the mutual fund share classes as well.
• 0.03% expense ratio
• Contains 11,220 bonds

10-year annualized total return is 0.04% less than the benchmark (slightly more than expense ratio). Tight tracking, check.

SPDR Aggregate Bond ETF (State Street)

• Ticker: SPAB
• $8 billion total assets
• 0.03% expense ratio

10-year annualized total return is 0.06% less than the benchmark (2x the expense ratio). Tracking is not as good as BND or AGG (though interestingly tracking is better since inception going back to 2007).

choose bond etf

We’ll choose AGG to represent core fixed income in our portfolio based on:

• closely tracks the index return over time.
• low expense ratio indicates efficient management
• more complete replication of the index (contains more bonds than either BND or SPAB)
• large asset size indicates operational stability. AGG has less assets than BND if you count the mutual fund share class, but both are gigantic funds.

As with VOO/IVV, this is a close call. You could make a good case for either BND or AGG, either would represent the US Core Bonds asset class well.

Build portfolio

Congratulations! We now have actual securities (ETFs) that we can plug into our asset allocation “template” to represent our asset classes. Now our portfolio is investable.

To put money into the portfolio, simply open a brokerage account, deposit funds, and buy the ETFs in proportions suggested by our “template” / asset allocation.

Below are the asset allocation mixes we ended with in part two. Five portfolios dispersed across the risk spectrum from lower to higher risk. I’ve included a column for the ETFs representing each asset class, how they allocate across the portfolios, and what an allocation would look like for a $10,000 investment (ETF prices as of August 09, 2024). If you had a different dollar amount you wanted to invest, just multiply that amount by the percentage allocations for IVV, AGG, and VNQ in each portfolio and you’ll get the dollar amounts of each fund to purchase. Then you would simply open an investment account, fund it with cash, and purchase the ETF shares.

Here’s how these portfolios would have performed over the last 10 years. Obviously we didn’t invest in them 10 years ago and we don’t have a time machine, so these are purely hypothetical numbers.

Notice how the line graphs of the more aggressive portfolios jump around more (more volatile) but also ended up with a higher value at the end. This is a nice way to visualize the tradeoff between risk and return.

🚨this is NOT INVESTMENT ADVICE

I’m not soliciting any action or transaction based on the information in this post. This is a hypothetical exercise purely for illustrative purposes. You should not take any investment action without consulting your financial advisor. Past performance is not a guarantee of future results.

This is a thought exercise, and some broad assumptions and simplifications will be made. The investments discussed may not be appropriate for you or any investor.

There are no investments that are universally appropriate for everyone. Investments involve risk including loss of principal.

You should always do your own research, evaluate prospective investments based on your specific situation, and consult with a financial advisor before taking investment action.

Thanks for reading

That’s a wrap! In this post we went through a hypothetical exercise of selecting ETFs to represent US large cap stocks, publicly traded real estate (REITs), and core US bonds.  Then we plugged the ETFs into our asset allocation to create investable portfolios.

The last four posts (part one, two, three, and this one) together comprise a professional portfolio management workflow.

• Selecting asset classes
• Gathering market data
• Building an asset allocation
• Evaluating investments in the market
• Selecting investments and allocating funds

I hope it was educational, possibly even fun! Subscribe to the blog and follow me on X for more posts about investing, personal finance, and business.

Send money-related questions via the contact form [LINK] or email matt@empowermenttools.net

Thanks for reading!