Building an Asset Allocation Portfolio

We decided to convert one of our individual IRAs to a portfolio of index-based exchange traded funds (ETFs). We looked primarily at Vanguard and iShares index-based ETFs. We put together a list of candidate ETFs by asset class.

Both family of funds have relatively low expense ratios, with Vanguard being the lowest. Except for two micro cap ETFs, we eliminated any ETFs that had an expense ratio higher than 50 basis points (0.50%). We also built a worksheet to help allocate funds among the various asset classes. You can see the results of this research and the ETF worksheet in a Google spreadsheet or the original Excel spreadsheet.

Building an ETF Portfolio

My spouse and I decided to convert one of our IRAs to a portfolio of index-based exchange traded funds (ETFs). We looked primarily at Vanguard and iShares index-based ETFs. We put together a list of candidate ETFs by asset class.

Both family of funds have relatively low expense ratios, with Vanguard being the lowest. Except for two micro cap ETFs, we eliminated any ETFs that had an expense ratio higher than 50 basis points (0.50%). We also built a worksheet to help allocate funds among the various asset classes. You can see the results of this research and the ETF worksheet in a Google spreadsheet or the original Excel spreadsheet.

Parking Your Safe Money

This is a response to a question by one of my young adult children. She was looking for a place to put some safe money (i.e., funds that she might need in the next 1-3 years) and wanted to obtain a better rate of interest than that offered by her bank.

Vanguard Money market funds are a good place to park money that you may need in the next 1-3 years.  At at low tax bracket, I would not worry about finding a tax-free fund.  Tax free money market funds don’t become advantageous until you reach the 28% tax bracket or higher.  You can ask Vanguard for a check book for your money market account and redeem shares by check. However, the check has to be $250 or more.

Here are three suggestions. The fund are listed with the safest funds first. The spread between the Treasury-based fund and the prime rate fund is very small. It comes out to about a $25 per year difference on $10,000. So you might want to stay with safety (either Treasury or Federal). That way if the world goes nuts, your funds will be secure.

Vanguard Treasury Money Market Fund (VMPXX). It is currently yielding 4.84%.

Description: The Fund invests solely in high-quality, short-term money market securities whose interest and principal payments are backed by the full faith and credit of the U.S. government. At least 80% of the Fund’s assets will always be invested in U.S. Treasury securities; the remainder of the assets may be invested in securities issued by U.S. governmental agencies. The Fund maintains a dollar-weighted average maturity of 90 days or less.

Vanguard Federal Money Market Fund (VMFXX). It is currently yielding 5.06%.

Description
: The Fund invests primarily in high-quality, short-term money market instruments. At least 80% of the Fund’s assets are invested in securities issued by the U.S. government and its agencies and instrumentalities. Although these securities are high-quality, most of the securities held by the Fund are neither guaranteed by the U.S. Treasury nor supported by the full faith and credit of the U.S. government. To be considered high-quality, a security generally must be rated in one of the two highest credit-quality categories for short-term securities by at least two nationally recognized rating services (or by one, if only one rating service has rated the security). The Fund maintains a dollar-weighted average maturity of 90 days or less.

Vanguard Prime Money Market Fund (VMMXX). It is currently yielding 5.09%.

Description: The Fund invests primarily in high-quality, short-term money market instruments, including certificates of deposit, banker’s acceptances, commercial paper, and other money market securities. To be considered high-quality, a security generally must be rated in one of the two highest credit-quality categories for short-term securities by at least two nationally recognized rating services (or by one, if only one rating service has rated the security). If unrated, the security must be determined by Vanguard to be of quality equivalent to securities in the two highest credit-quality categories. The Fund invests more than 25% of its assets in securities issued by companies in the financial services industry. The Fund maintains a dollar-weighted average maturity of 90 days or less.

The expense ratio is 0.29%. Other mutual fund families have similar offerings. For example, see Fidelity’s offerings. Since Vanguard is the only large mutual fund family that is owned by its share holders, I tend to prefer it. Vanguard also offers some of the best index funds and exchange traded funds (ETFs) available.

An ETF Portfolio

ETF Portfolio

Here is a portfolio made up of exchange traded funds. This portfolio has no bond or fixed income component. It provides both relatively high return and moderate volatility making it appropriate for the long term.

The portfolio currently has an asset allocation of: 45% domestic stocks, 35% international stocks, and 20% REITs. The portfolio was rebalanced earlier this year to include greater international exposure.

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Not all ETFs are the same

In a recent letter to the editor of the Wall Street Journal, John Bogle cautions that of the 690 exchange traded funds (ETFs) in existence today, only 12 represent broad market segments, such as the S&P 500, the Dow Jones Wilshire Total (U.S.) Stock Market Index, and the Morgan Stanley EAFE (Europe, Australia and Far East) Index of non-U.S. stocks.

However, he goes on to comment: ETFs, simply put, are index funds that can be traded in the financial markets. In fairness, if they are not traded, they can often be the equal of the classic index funds.

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Active vs. Passive Fund Management

Each quarter, Standard & Poors published a report that compares the performance of professionally mutual funds with the performance performance of the S&P broad market indices. The report is called the S&P Indices Versus Active Funds (SPIVA) Scorecard. The S&P analysis shows that the most mutual funds fail to outperform the market indices. As the time horizon gets longer, the performance by the professional fund managers gets worse. The complete SPIVA can be found here.

Here are some details from the S&P report for the 4th quarter of 2006. (more…)

ETF and Index Investing

While selecting stocks and building a solid portfolio can be rewarding, not everyone has the time or interest to do so. Also, core portfolio assets (e.g., the money you need to retire) deserve special protection. Index funds and exchange traded funds (ETFs) make it possible to build a diversified, tax efficient portfolio that requires little maintenance beyond periodic (quarterly or annual) rebalancing. Using ETFs or index funds to diversify among several asset classes increases the long term rate of return and reduces portfolio risk.

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