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Find your ideal benchmark with ETFs

Following a dummy portfolio of ETFs makes creating a benchmark easy for all investors
May 24, 2018

Even if you don’t use exchange traded funds (ETFs) in your own portfolio, you can make use of our Top 50 ETF selection to build a passive benchmark. A good benchmark should be investable and representative of assets held, so following ETFs is ideal.

For our Alpha portfolios, we’ve used the Asset Risk Consultants (ARC) multi-asset benchmarks that correspond to the level of equity market risk we’d be prepared to take. The potentially riskier ‘Steady Growth’ (classified as 60-80 per cent of global equity risk) and the ‘Balanced’ (40-60 per cent) IC Alpha strategic asset allocations, based on the ARC benchmarks, are shown in the first two tables. While we’ve cribbed the asset weightings, the specific ETFs used to mimic them have been chosen by us. For the hedge fund allocation, we track the UBS HFRX Global Hedge Fund USD ETF, which doesn’t appear in the top 50 list. This is a more niche ETF and we’re not suggesting it as an investment; it’s there to give representation to hedge funds in our multi-asset benchmarks.

 

Alpha Balanced strategic asset allocation benchmark

ETF Asset classWeighting (%)2018 ongoing charge (%)
SPDR FTSE UK All Share (FTAL)UK equity 20.00.20
HSBC MSCI World (HMWO)Developed global equity22.50.15
iShares Core MSCI Emerging Markets IMI (EMIM)Emerging market equity2.50.25
Lyxor Core FTSE Actuaries UK Gilts (GILS)UK Gilts (mid duration)10.00.07
Lyxor Core FTSE Actuaries UK Gilts 0-5Y (GIL5)UK Gilts (shorter duration)15.00.07
iShares Core £ Corporate Bond (SLXX)Investment Grade Corporate Bonds12.50.20
UBS HFRX Global Hedge Fund USD (0Y22)Hedge Funds10.00.34
Source Bloomberg Commodity (CMOD)Commodities2.50.19
GBP Cash 3M LIBORGBP Cash 5.0 
  Annual weighted portfolio charge rounded 

0.16 per cent (16 basis points)

Source: Investors Chronicle, weightings from ARC Benchmark Balanced portfolio

 

Steady Growth strategic asset allocation

ETF Asset classWeighting (%)2018 Ongoing charge (%)
SPDR FTSE UK All Share (FTAL)UK equity 200.20
HSBC MSCI World (HMWO)Developed global equity350.15
iShares Core MSCI Emerging Markets IMI (EMIM)Emerging market equity50.25
Lyxor Core FTSE Actuaries UK Gilts (GILS)UK Gilts (mid duration)100.07
iShares Core £ Corporate Bond (SLXX)Investment Grade Corporate Bonds100.20
UBS HFRX Global Hedge Fund USD (0Y22)Hedge Funds100.34
Source Bloomberg Commodity (CMOD)Commodities50.19
GBP Cash 3M LIBORGBP Cash 5 
  Annual weighted portfolio charge rounded 0.18 per cent (18 basis points)

Source: Investors Chronicle, weightings from ARC Benchmark Steady Growth portfolio

 

Strategic benchmarks aid the long-term investors’ maintenance of discipline – having an idea of suitable asset allocation for your risk tolerance and objectives discourages bad habits, like buying too many securities on a whim and skewing the overall portfolio balance. You could just invest in the benchmark with ETFs and rebalance the portfolio at regular intervals, but there are two vectors of portfolio management where investors might try to outperform.  

In the first instance, you might try to do better by using tactical asset allocation (TAA) – going over- or underweight from the benchmarks, in assets you prefer for the short to medium term. As well as following your own portfolio, keeping an eye on how the unchanged benchmark would have done is a yardstick for performance; it also gives perspective on how much risk you are adding or reducing, thanks to TAA decisions. The table on page 33 shows TAA tilts from the Alpha Steady Growth strategic allocation, made using Investors Chronicle’s Top 50 ETF selection for 2018. The thinking behind these tactical investing decisions are explained here, but we will in future be comparing their success against the Alpha Steady Growth SAA. 

The second strand of portfolio management is implementation, or the security selection within your asset allocation. It may be that you just stick to strategic asset weightings and buy and sell securities within the weightings. For example, FTSE 100 shares might be 20 per cent of your SAA, but you have concentrated holdings in four or five companies rather than a market-cap-weighted exposure to the whole index. Monitoring ETFs in your SAA highlights whether the active stock selection decisions are working or if you’d have been better off buying a tracker for that asset in your portfolio.

Tactical Adjustments to the Alpha Steady Growth SAA

In practice, there will usually be a mix of TAA and securities selection in most active portfolios. Many central banks are at a strange juncture with their rate tightening cycle, which has meant that we are tactically underweight longer-duration bonds compared to our SAAs, while we are more overweight equities than usual in the balanced portfolio. This means that the TAAs for steady growth or balanced portfolios have converged somewhat, so here we’ll just focus on setting out a TAA for the riskier Steady Growth portfolio.

In our Alpha portfolios we didn’t reduce exposure to hedge funds, but to focus on assets covered by our Top 50 ETF selections we’ll replace the hedge fund exposure in the Steady Growth (10 per cent in the SAAs) mostly with lower-risk developed market government bonds of a shorter duration (an extra 7.5 per cent) and some additional riskier equity exposure (an extra 2.5 per cent).

The Alpha strategic allocations track the FTSE All Share for UK equities. For our Top 50 ETF Steady Growth TAA, however, we’ll split our exposure to UK shares between the iShares Core FTSE 100 UCITS (ISF) and Vanguard FTSE 250 UCITS (VMID). The reasons for using these two ETFs in our tactical asset allocation and not the SPDR FTSE UK All Share (FTAL) is because they are cheaper. Given the weighting of blue-chips in the All-Share is so high, it is unlikely returns from FTAL are going to be much better than ISF after charges anyway, even if smaller companies in the All-Share index do well.

On the basis of market capitalisation, we are in effect going overweight on mid-cap shares in the TAA portfolio, but in practical terms it is not worth having a piecemeal-size holding in the FTSE 250. In practice, UK equities is an obvious area for a UK-based investor to seek to generate alpha. Within this portion of a portfolio therefore, one might prefer to pick stocks from the breadth of the market cap scale. 

For the Top 50 ETF Steady Growth TAA, we’ve gone for more granularity than in the global developed equity allocation in the Alpha SAAs. We’ve chosen, in the TAA, to tilt away from the global market-cap-weighted bias towards US stocks, which are expensive. We didn’t want to be out of the US entirely and, as correlations between global equity markets tend to rise in sell-offs, reducing the US as a proportion of total equity holdings isn’t a risk reduction measure. It is undeniable, however, that the US is priced for a smaller forward rate of return than in the past or against some other developed markets. In effect, our TAA US holding is roughly half of the SAA benchmark, so we’re very underweight, but there is still a sizeable holding in case our caution towards US valuations is misplaced. Compared with holding a world equities ETF in our Alpha Steady Growth SAA, our Top 50 ETF TAA has roughly half the US equity exposure, so we’re very underweight. Nevertheless a 10 per cent US position is sizeable, in case our caution on valuation is misplaced. 

For European stocks, we’ll go for Vanguard FTSE Developed Europe ex UK (VERX), rather than Xtrackers Euro Stoxx 50 UCITS ETF (XESC). Even though XESC is three basis points cheaper, VERX has 432 holdings – still large enough to be liquid, but giving a greater spread of companies. Japan is targeted with the Xtrackers Nikkei 225 UCITS ETF (XDJP); The rest of Asia-Pacific with Vanguard FTSE Developed Asia ex Japan UCITS ETF (VAPX); and emerging market equities are bought using iShares Core MSCI Emerging Markets IMI UCITS ETF (EMIM). For these smaller holdings, in more niche areas such as Asia-Pacific and emerging markets, there is a case for using an active fund, to take advantage of a manager’s local knowledge and expertise. In practice, investors prefer to use investment trusts or other active funds for these regions. With this TAA, however, because a major benefit of passive investing is low costs, in each case we have just gone for the cheapest in class.

In the fixed-income space we are very conscious of the rising interest rate environment and, for the Top 50 ETF Steady Growth TAA, favour shorter-duration holdings. In practice, this means funds where, due to the size of expected coupons or because issues held had a short time until maturity, the capital value of the fund is less sensitive to interest rates rising. When rates rise bond funds with a longer average duration can fall in value, as the price of bonds must go down so their effective yield matches investors’ requirements. We remain underweight to duration risk with our TAA allocation, choosing the iShares £ Corporate Bond 0-5yr UCITS ETF (IS15) for investment-grade corporate bonds.

 

Top 50 ETF Steady Growth tactical asset allocation

ETF Asset classWeighting (%)2018 Ongoing charge (%)
iShares Core FTSE 100 (ISF) UK Equity10.00.07
Vanguard FTSE 250 (VMID) UK Equity10.00.10
iShares Core S&P 500 (CSP1) US Equity10.00.07
Xtrackers Nikkei 225 (XDJP)Japan Equity10.00.09
Vanguard FTSE Developed Europe ex UK (VERX)Eurozone Equity 10.00.12
Vanguard FTSE Developed Asia ex Japan (VAPX)Asia Pacific ex-Japan5.00.22
iShares Core MSCI Emerging Markets IMI (EMIM)Emerging Market Equity5.00.25
Lyxor Core FTSE Actuaries UK Gilts 0-5Y (GIL5)UK Gilts (short duration)15.00.07
Lyxor Core iBoxx $ Treasuries 1-3Y  (U13G)US Treasuries (short duration)10.00.07
iShares £ Corporate Bond 0-5yr (IS15) Investment Grade Corporate Bonds5.00.20
Source Bloomberg Commodity (CMOD)Commodities5.00.19
 Cash5.0 
  Annual weighted portfolio charge rounded 0.11 per cent (11 basis point)

Source: Investors Chronicle

 

Playing around the yield curve and deciding when to go long or short duration is a difficult task and many investors will prefer to use managed strategic bond funds for riskier fixed-income positions. With more niche debt issues, there can be issues with liquidity as well as credit risk so it is debatable whether passive ETFs are the best way to access this asset class. For shorter duration and more liquid bond holdings from low-risk issuers such as gilts (UK government bonds) or US Treasuries, however, ETFs are a cheap and effective tool.

Finally, in the commodity space we plump for Source Bloomberg Commodity UCITS ETF (CMOD). This is the only synthetic ETF we are using, but it is the cheapest on our list and it seeks to replicate a diverse commodity index. Commodities are only ever going to be a small component of our portfolios and, in any case, unless you hold a physical asset there are going to be derivatives involved however you invest in them.

 

To view the IC Top 50 ETFs 2018 by category, please click on the links below:

UK equities (four ETFs)

US equities (six ETFs)

European equities (six ETFs)

Japanese equities (four ETFs)

Global equities (six ETFs)

Asian equities (three ETFs)

Emerging market equities (four ETFs)

Ethical equities (three ETFs)

Government bonds (six ETFs)

NEW: Sterling corporate bonds (two ETFs)

NEW: Global bonds (three ETFs)

Commodities and precious metals (three ETFs)