Recent discussions of ETFs on the CompuServe BetterInvesting forum has raised a number of interesting questions. Here are some thoughts on those questions.

1. Including Mid-Cap ETFs in a Portfolio

Equally weighting large-cap, mid-cap, and small-cap ETFs in a portfolio by dollar value will result in over weighting of mid-cap stocks.  Using Vanguard ETFs as an example, a portfolio with equal amounts of large-cap, mid-cap, and small-cap blend or core ETFs will result in an asset allocation of 31% large-cap, 48% mid-cap, and 20% small cap stocks.  In contrast, a portfolio with equal dollar amounts of both large-cap and small-cap blend ETFs will result in an asset allocation of 51% large-cap, 28% mid-cap, and 31% small cap stock.

The reason for this weighting is that both large-cap and small-cap ETFs include some mid-cap stocks. The “X-Ray” feature in the portfolio section of Morningstar is a helpful tool to estimate the actual asset allocation of U.S. stocks in your ETF portfolio. (It does not work well if you include the international ETFs, as it does not distinguish between domestic and foreign stocks.) Also, the prospectus for the ETF should describe how the ETF portfolio is constructed.

Here are two graphic files showing the asset allocation for hypothetical two-ETF and three-ETF portfolios.  You can compare how various Russell core indices did over the past 12 years.

2. Combining Growth and Value ETFs

There does not appear to be any advantage in holding an equal dollar weighting of growth and value funds in a portfolio. A single market (“core” or “blend”) ETF seems to achieve the same return. Looking again at Vanguard large-cap and small-cap ETFs, an equally weighted combination of growth and value provided about the same year-to-date return as a single market (blend) ETF. However, for mid-cap stocks, the combination of growth and value exceeded the market blend ETF by 2.5%. This probably resulted from slight imbalances over the year in growth and value holdings in the three mid-cap ETFs.

Even though growth stocks did much better this year than value stocks, I still prefer a combination of core and value ETFs. This tilts the style weighting toward value. Over most long term periods, value stocks have performed better than growth stocks,

Here is a spreadsheet comparing returns for the various U.S. ETFs.

3. International ETFs

Admittedly, this is a confusing area. There are a number of different international stock indices. In addition, the available ETFs do not necessarily mirror the existing the offerings of the related index mutual funds. To add to the complexity, the fees charged by some international ETFs and many international index funds are high.

One approach for achieving good international stock diversification is to hold a combination of low fee ETFs or index funds for developed markets and emerging markets (with great weight on the developed markets). Developed markets include Europe, Asia, and the Pacific. (See slides 20 and 21 from this presentation.)

By way of example, here are the current Vanguard international ETFs:

  • Vanguard Europe Pacific ETF (70E/30P) (VEA)
  • Vanguard European ETF (VGK)
  • Vanguard Pacific ETF (VPL)
  • Vanguard FTSE All World ex-US ETF (52E/24P/5NA/19EM) (VEU)
  • Vanguard Emerging Markets ETF (VWO)

One can cover the international asset classes fairly well with any of these three combinations: (1) VGK + VPL + VWO, (2) VEA + VWO, or (3) VEU + VWO. Take a look at the Vanguard web site; the ETF summary pages show how they break out by region and country. Note that VEU already includes some holdings in emerging markets.

The spectacular returns these past several years from international stocks reflect, in part, the declining value of the dollar. At some point the dollar will bottom. So I would weight international stocks somewhere between 35% and 50% of the equity portion of the ETF portfolio.

While it is counterintuitive for those of us who have worked hard to master the NAIC methodology, a portfolio consisting of 4-7 ETFs can reduce risk and improve performance (compared to a broad U.S. market index such as the S&P 500).