Sunday, 9 December 2007

Thoughts on How to Start a Portfolio from Scratch

A reader has asked:
"This question is about what to do with your money if you have a lot of it to invest every month. Lets say I had $5k per month to invest, how much would you recommend I save up before I purchase more ETFs and as such, re balance my portfolio? You see, if you read what I have been reading, many people promote the passive strategy (i.e: minimal trades per year, spending less time watching each individual holding etc), I have been reading blog posts, and people have been saying that they wait until they have about 2-3k saved up, and then they "buy more ETF's". But if I did that, I would be buying ETF's every month or 12 times/year, and if I have 6-7 holdings (even at e*trades low cost of 9.99) I'm still spending over $700+ in the year just on trades. So that seems bad right? On the one hand I hear I should wait and just "do the couch potato" and re balance once per year - but I also feel like sitting on $60,000 (saving $5k/month for a year) and just plopping in such a large sum every December would be ridiculous. So the answer must
lie between purchases every month (too often) and purchases once per year (not often enough). What is recommended and why? How often should I purchase more?"

My comments:
  • first, all what follows supposes that the intent is to establish a diversified portfolio with specific proportions of the total portfolio value to be invested in various asset classes; my own portfolio structure is shown at the bottom of my blog - you can see the percentages for each asset class on the Asset Allocation tab and the ETFs I have chosen, as well as alternatives. You can adjust the percentage allocations as you wish, the point is to set a target allocation.
  • for someone who will quickly accumulate a portfolio in excess of $100k, using only ETFs and a broad range of them - I have 16 of them in mine - makes it possible to invest in minor asset classes which can provide greater diversification and higher returns.
  • in practical terms there is a trade-off between trading costs and portfolio balance; since any cost is a certain negative return, I believe that's the most important consideration, especially in the short term (a couple of years) while the portfolio is building. At $10 per trade, the commission on a $5,000 purchase is 0.2% but for $1,000 it is 1.0%, which starts to hurt. Do that twice in a year to re-balance and it takes away an appreciable chunk of returns. For that reason, until two or three years had passed (at your rate, you would have $120k invested after two years) I would be very surprised if any asset class had changed so much that it was necessary to do a trade only for re-balancing, so I would only use new funds to progressively establish the portfolio, asset class by asset class and not bother doing trades specifically for re-balancing
  • I would therefore do one monthly trade - a purchase of one ETF with all of the $5k - to get the funds invested immediately. There is no reason to sit on the cash and wait; the method I outline below is simple enough I believe.
  • I would also start with core asset class ETFs to get the basics in place (sooner rather than later since one never knows when it might be necessary to interrupt the build-up; it will be better to leave an in-progress portfolio that is at all times reasonably balanced ).
    For example to build my portfolio:
month 1 - buy $5k of XIU,
month 2 - buy $5k of VGK,
month 3 - buy $5k of XBB,
month 4 - $5k of VV,
month 5 - $5k of VPL,
month 6 - $5k of VWO,
month 7 - $5k of VGK again,
month 8 - $5k of XBB again,
month 9 - $5k of XIU again,
month 10 - $5k of XSP,
month 11 - $5k of DJP,
month 12 - $5k of VGK again.

Total trading costs $10 x 12 = $120. The first table shows the investments at end of year 1 in terms of dollars, actual percentage of portfolio and the eventual target portfolio percentages for reference. The smaller asset classes are over-invested but that quickly begins to change in year 2. The row and column totals for the assets are already taking shape.
  • Continuing this pattern in year 2 buying $5k per month, month 13 - buy $5k of XBB, month 14 - XMD, month 15 - AGG, month 16 - XRE, month 17 - XSU, month 18 - RWX, month 19 - XBB, month 20 - EFV, month 21 - XBB, month 22 - VGK, month 23 - XIU, month 24 - XBB. Only one non-core asset class remains to enter the portfolio - VNQ, US Real Estate. The row and column totals are getting close to the target allocations.
  • The principle is simply to put each new month's purchase into the asset class that is furthest away from its target percentage. Since the evolution of the markets will move the actual percentages away from their initial purchase value, putting each new purchase into the asset class that is furthest away in actual terms as of the day of purchase will perform re-balancing. As long as you continue to put new money in, I would not see a need to do any annual re-balancing at all. For my model $100k portfolio, in the six months since I set it up in May the furthest any asset class has moved away from the target as of today is VGK, down $930; multiply that by 5 to get a hefty $500k portfolio and that could be re-balanced with one purchase. As time goes on, each $5k purchase represents a smaller and smaller percentage of the total portfolio, and each previous purchase goes down in percentage terms, bringing ever greater accuracy to the portfolio balance, especially among the minor asset classes.
  • With fewer ETFs in the portfolio, it would be even easier to attain the target percentages - instead of VGK, VPL and VWO, you could simply buy VEU, the Vanguard Rest-0f-World (non-US), for XIU and XMD, take XIC, the S&P TSX Composite, for XSP, VV, XSU, buy VTI, Vanguard's US total market fund (though that would mean all your US holdings would be subject to the effects of the US$ fluctuations, something I think is too extreme, preferring to have half of my US large cap equity in the hedged XSP). The only minor one I would always wish to own is real estate due to its proven negative correlation with other asset classes, which thus provides very valuable volatility reductions for the portfolio.

That's it.


Canadian Capitalist said...

Any reason for option VGK + VPL over VEA?

dj said...

If you're fairly new to investing or you're asking yourself what the heck VWO or XBB is, or you would like something a little simpler:

open a TD mutual fund account and buy 4 eFunds every month.( Canadian bond index, Canadian equity index, US equity index and International equity index)

Once or twice a year, have a look at the totals. If the ratios are way out of whack, either change the monthly contributions to each fund or switch money between funds to re-establish your desired allocation.

Then relax and every time you get the urge, or are told to do something different, simply ask why? If you understand why and it saves you money (and isn't too much of a bother) then go ahead and change from this version of the ole' couch potato.

Good luck.

CanadianInvestor said...

DJ, nothing wrong with the ultra-simple approach; sometimes what seems simple to folks who have been looking at it for years, looks quite complicated to a real new investor.

CC, the reason for holding VGK and VPL instead of only VEA, which has the same basic country exposure in different proportions, would be to take advantage of their non-correlation and further diversify the portfolio. I wouldn't think this is a huge difference, however, and again it could be a simplifying substitution to only hold VEA.

TFB said...

Mutual funds would be simpler. But if someone wants to use ETFs, I do the same as suggested here. 1) Come up with an allocation; 2) Make one purchase per month; 3) Buy into the position furthest below the target percentage.

CK said...

Thanks for the reply.

I am now curious about why you are buying 3 ETFs instead of the VTI. Looks like 2 of the 3 are in CDN funds - does that have anything to do with your decision, or is it more that they are hedged? My plan was actually to buy VTI but where can I read more to understand why purchasing those 3 would provide me similar returns (or better) and still have the same amount of market coverage?

Also, looking up XSU seems like it has not been around long? Cant seem to find much data on it.


CK said...

I mean that it looks like 2 of the 3 are purchased in Canadian dollars - and are you looking to keep most your purchases (when you have the choice that is) in Canadian dollars since you are going to retire in Canada. Just asking since I am Canadian and am thinking about putting 40% of my stock portfolio in VTI (which is purchased using US Dollars) - seems like you have a way to invest that may track similar to VTI but you keep more of your holdings in Canadian dollars.

DavidS said...

Unless you have at least $1M to invest in individual stocks, or you are a great stock picker (unlikely), funds should be used to achieve diversification. The most efficient funds are the broad index ETFs, unless you are a great fund picker (unlikely).

The main costs of investing in ETFs are commissions, spreads, and fund expenses. If you have a low cost broker, you can pay something like a few basis points in commissions. If you buy the most liquid ETFs through a broker with fair execution, the spread cost could also be something like a few basis points. If you buy ETFs with low expenses, the cost of holding the ETF could be something like 7 to 30 basis points per year. So, if you use a low cost broker to buy low cost ETFs with high liquidity and small spreads, and hold for several years, the main cost would be the fund expenses, and the total cost could be something like 20 basis points per year. That's a total of around $2,000/year on assets of $1M. Such an efficient portfolio could contain, for example, just XIU (the only Canadian ETF with low expense and good liquidity), SPY and VEU.

In contrast, Canada's mutual fund fees are the world's highest, an average of 2.56%/year, or $25,600 per year on assets of $1M. Since those fees are around the expected equity risk premium, I extrapolate and claim that, in aggregate, in the long run, virtually all of Canadian mutual funds returns are siphoned off as fees by the financial institutions.

dj said...

I agree with everything DavidS says but I still think that there is or can be, a role for index mutual funds from TD (MER .48%) or CIBC (MER .32% with 150K in assets). Even if they only receive your monthly contributions (and re-invest small distributions at no cost)and annually (or whatever) the money is then moved to ETFs, I think they make sense for many(most?) people.

CanadianInvestor said...

dj, yes I agree that there can be a place for index mutual funds. The MER advantage of ETFs may be overcome by trading costs for rebalancing, purchases or redemptions. If you spend $100 (10 at $10 each) on trades in a year and your total portfolio is $50,000 that represents 0.2% of extra expense, which means a mutual fund could cost you up to that much more in MER and you would be further ahead. When your portfolio gets much larger and you don't do a lot of trading, the value of ETFs really comes out. It's just arithmetic. It's the main reason I think index mutual funds make sense for smaller portfolios.

For larger portolios, ETFs make sense because of costs but also because of the ability to diversify more since there is a larger selection of ETFs than mutual funds with passive indexing (US investors are lucky to have mutual funds like Vanguard which covers a wide range of US and international passive indices).

ck, that's why I chose, instead of only VTI, VV (Vanguard's large cap ETF), along with XSP (iShares currency hedged/neutral S&P 500 tracker), XSU (iShares Russell 2000 US small cap), and VBR (Vanguard US small cap). For those four ETFs, I get currency hedging on half my US holdings (and pay an extra 0.5-07% annually in fees and tracking under-performance) and a heavier weighting in small cap and value equities whose higher expected excess (i.e. relative to the risk) return should help my portfolio's performance. Some places you could read about the benefits of small cap and value include the IFA website (see link in the sidebar of this blog), as well as the book Asset Allocation by Richard Ferri, or the source itself, scholarly articles by Fama and French (search Three Factor Model). As for market coverage, despite the title, the Vanguard VTI "Total Market" fund only includes the 1300 largest US companies, c. 95% of total market value. The S&P 500, the 500 largest companies was about 82% in 2005. VV includes the 750 largest companies, while XSU is the smaller 2000 among the Russell 3000, which covers 98% of total market cap. You can buy IWV to own a Russell 3000 tracker, though its MER is 0.20% vs only 0.07% for VTI. There are always trade-offs and I've gone for what I hope is return-enhancement through my somewhat imperfect (missing about 250 mid-cap companies) US market coverage.

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