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How to use ETFs

to build an investment portfolio

One of the main points to come out from both the recent banking crisis and the MP's expenses claim debacle is how the people at the top tend to excessively enrich themselves at the expense of people they're supposed to be serving.

In the case of the MPs it's the electorate, and in the banking and finance industry it's their clients.

For the financial markets this behaviour is hardly new, as pointed out by the classic book first published in 1940 'Where are the customers' yachts' by Fred Schwed (Amazon link).

As the title indicates the author saw many gin palaces owned by the top people on Wall Street but never saw any evidence of similar sized boats owned by their clients.

The Fund Management industry - why most investors don't need their products
I've long been stating that the fund management business for a myriad of reasons is a great business to work in, but not so attractive if you're a customer. This is mainly due to the high charges they levy in relation to the performance delivered.

For example, some recent research by Virgin showed that over the last 20 years 79% of funds failed to beat the benchmark FTSE All Share Index. Virgin's research is hardly new, there are countless similar conclusions published almost every year.

But it's possibly unfair and wrong to blame the fund managers for charging so much because one can easily argue this is standard business practice. Perhaps the real blame lies with the clients themselves as many of them don't even realise they're being overcharged.

For example, how many of their customers for example pay the ludicrous 5% initial charge without even blinking? This charge is where you pay around 5% for the privilege of having your money managed. Great business if you can get away with it.

Is investing so hard or are people trying to convince us it's hard?
One of the main aims of marketing is to convince us we need a product or a service, even if we don't.

The professional money managers are masters at this art. Most of them will subtly convey that successful investing is hard and complex - it takes lots of time, insider (not illegal) knowledge is critical, plenty of experience is needed. It's obviously in the fund promoters' interests to convince their potential clientele that they shouldn't even consider investing by themselves, better to leave these complex matters to the professionals etc.

But if you break down the investment advice many professionals offer it can probably be summarised in 7 words -

create a balanced fund of mixed investments

And if sensible and logical investing is based on this statement surely most people have it in them to cut out the often expensive middlemen and build their own portfolios using ETFs.

Solid investment portfolios rely on 4 main asset classes
An important goal for an investment portfolio is to make sure that all your eggs don't go in the same basket. This is achieved by allocating money to different asset classes, of which the 4 main ones are -
  • Stocks - and then split into sub classes for example UK stocks - Euro - US - Emerging etc
  • Bonds - both corporate and government
  • Property - in the form of property ETFs not physical property (unless you have a great deal of money)
  • Cash - held in high paying fixed rate bonds and instant access
So if we know the 4 main asset classes and add some common sense the following portfolio can be built -
  • Stocks - 50%
  • Bonds - 30% - 40%
  • Property - 5% - 10%C
  • Cash - 5% - 10%
These weightings offer a sensible balance between higher risk investments, stocks, and lower risk ones like bonds, cash and to a lesser extent property. Property has traditionally been viewed as lower risk than stocks but this hasn't been the case over the last 2-3 years where many property funds and shares are down in excess of 75%.

iShares UK Property ETF (IUKP) - In excess of 75% lower (2007 - present)

Break the stock allocation down
Each asset class can be broken down into sub-asset classes, taking the 50% stocks allocation as an example -
  • UK stocks - 30%
  • US stocks - 20%
  • European stocks - 20%
  • Asian - 20%
  • Emerging - 10%
    Or perhaps you're more favourable towards Asian and emerging markets and so allocate 20% to each with a smaller percentage in the UK stocks. When devising a portfolio there are no set rules to say X% must be invested in UK stocks and Y% in Emerging. But as long as common sense is used, ie don't invest 80% of your funds in China or Turkey, you'll be fine.
    Use ETFs to build the portfolio - I prefer iShares ETFs

    ETFs are perfect tools to use in order to build a portfolio similar to the above as they can be used to invest not just in stocks but also bonds and property as well as other asset classes such as commodities.

    Any investment firm with proper financial backing can setup their own range of ETFs and then list them to trade on the stockmarket. For example, if you take the FTSE 100 there are 3-4 different ETFs to choose from, all promoted by different companies.

    But some ETFs are going to do more business than others so always be on the lookout for those that trade the most volume as it translates into cheaper prices via tighter bid-offer spreads.

    iShares (used to be owned by Barclays) have long been a pioneer in ETFs and their products are normally extremely liquid and so are the ones I favour. Check out their website it's very informative. www.ishares.eu

    How I would build a portfolio using ETFs

    Theoretically speaking if a rich Aunt died leaving me £50,000+ on the condition it's used to build a long term investment portfolio this is exactly how I'd do it.

    Split the £50,000 as follows -

    • Stocks - 60%
    • Bonds - 20%
    • Property - 15%
    • Cash - 5%
    Stocks
    The 60% stock allocation (£30k) would be split 12 ways into the following iShares ETFs -
    ETF Name
    Ticker
    Amount Invested
    FTSE 100
    ISF
    £2,500
    FTSE 250
    MIDD
    £2,500
    DJ Euro STOXX 50
    EUE
    £2,500
    North American
    INAA
    £2,500
    Japan
    IJPN
    £2,500
    MSCI Taiwan
    ITWN
    £2,500
    MSCI Korea
    IKOR
    £2,500
    FTSE/Xinhua China 25
    FXC
    £2,500
    MSCI Brazil
    IBZL
    £2,500
    MSCI Turkey
    ITKY
    £2,500
    MSCI Eastern Europe
    IEER
    £2,500
    MSCI Latin America
    LTAM
    £2,500
    But why have I bought the above, why allocate £2,500 to each ETF? No reason apart from I'm trying to spread the cash around as much as possible. You might prefer to invest slightly more in Asian and Emerging markets and less in Western markets, and it would be hard to argue with this decision.
    Bonds
    The 20% (£10,000) bond allocation would be split as follows -
    ETF Name
    Ticker
    Amount Invested
    UK All Stocks Gilt
    IGLT
    £6,000
    £ Corporate Bond
    SLXX
    £4,000
    Property

    iShares offers 5 property ETFs investing in the following markets -

    • Asia
    • Developed markets (Hong Kong, US, Australia, France, Singapore are the top holdings)
    • UK
    • US
    • European

    The 15% (£7,500) property allocation would be split as follows -

    ETF Name
    Ticker
    Amount Invested
    UK Property ETF
    IUKP
    £2,500
    Asia Property ETF
    IASP
    £2,500
    European Property ETF
    IPRP
    £2,500
    If I had more money to allocate than £7,500 I would have invested in all of the property ETFs and there is no particular reason I've invested in Asia, UK and European. You for example might prefer the US market over European and there would be nothing wrong with that.
    Cash

    The 5% (£2,500) would be held in one of the best paying instant access accounts.

    Cash is important, especially these days with the still perilous conditions of the markets, because if the markets start to fall again you want access to cash to buy cheaper assets, especially the commercial property market.

    How much will the ETF portfolio cost to build

    Buy a fund and many a fund manager will try to skim up to 5% via initial charges (invest £10,000 and only £9,500 goes into the fund). Of all the fees charged by investment managers this is the most outrageous.

    The initial charge is a good example of how if the average retail client ventures into the investment world without knowing what he's doing he's going to be taken advantage of. But let's not be too hypocritical of how the fund managers operate, instead recognise there's a problem with unnecessary and expensive fees and do everything possible to avoid them.

    But ETFs don't levy any such fees because buying and selling them is the same process as trading a share, ie only commission has to be paid plus as a bonus there's no Stamp Duty (at 0.5%)

    The commission bill for buying the 12 ETFs will be somewhere in the region of £70 - £150 depending on how much a broker charges. Personally I use www.interactivebrokers.co.uk and they charge a flat rate of £6.00 a trade for deals up to £50,000.

    So my total cost for building the £50,000 ETF portfolio would be £72 and that is an incredibly cheap and efficient price to pay for getting so much different stockmarket exposure.

    Advantages of the ETF portfolio
    • Simple to build - Common sense says spread your money around so why think too much? And anyway even if we do think, possibly long and hard, there's no guarantee we'll be right

    • The cheapest running costs possible - Never discount the role that costs play on an investment's overall performance. Even a saving of 0.5% a year can have a significant effect on a portfolio's performance over the long run

    • Multiple of asset classes - The portfolio has a nice mix of global assets and I think that's important these days as it can only help with diversity
    Disadvantages of the ETF portfolio
    • ETFs can't outperform - the advantage that all fund managers have over ETFs is they can deliver out-performance, although not many do. For example, if the FTSE All Share rises 10% one year an active fund can return 11%, 12%, 15% or even 30%. However an ETF tracking the FTSE All Share by definition can't return more than 10% and will normally return around 9.5% when tracking errors and costs are taken into account

    • Boring and too simple - Many people trade or invest in the markets, whether they realise it or not, for excitement. Winning, losing or finding diamonds in the rough is exciting etc. But this ETF strategy is probably the most boring investment strategy around. Boring when investing though is often a virtue

    • No individual stocks - All of the stockmarket related ETFs track a major index such as the FTSE 100 or Euro Stoxx 50 (one of the main continental stock indexes). Some people like to invest in stocks feeling that a company is easier to research than the overall market
    Don't be afraid to play with the portfolio allocations
    The above portfolio weightings are how I would approach the matter of building a long term investment fund. You for example might feel that with commercial property taking such a beating, the UK property ETF (ticker IUKP) is down about 70% over the last 2 years. So the property portfolio weighting should increase from 15% to 25% and the bond allocation lowered. There would be nothing wrong with that decision as it doesn't breach any law of common sense.

    You also might want to allocate slightly more money to Japan, Korea or for whatever reason Turkey. Again, as long as your investments are spread around nobody is going to argue with these sorts of decisions.

    You might want to take age into consideration

    The young can afford to take financial risks in life, less so for the older generation. For example, if a 30 year old lost his life savings via risky investments that would be a major problem but there's plenty of time to make the money back. Not so for somebody who's 65 and retired.

    It's therefore a good idea for the mixture of assets held within a portfolio to change depending on age. For example, the older one gets the less risk should be taken, again this is common sense. One simple way to determine how to invest in the mixture of the 4 asset classes is to use the percentage age rule.

    Subtract your age from 100 and use that percentage to invest in stocks, the balance in income producing securities (bonds, property, cash etc) -

    • So if you're 30 use your portfolio to invest 70% in stocks (100 - 30 = 70)
    • If you're 50 the percentage should be 50% and so on
    The goal therefore of a portfolio that changes with age is to reduce overall risk and it's hard to disagree with this logic.
    Consider using ISAs - But look at the figures first
    ISAs (Individual Savings Accounts) can be used as long term investing/savings accounts but their tax-free benefit is sometimes overly hyped. For example -
    • If you've built up £10,000 in Cash ISA accounts over the years the tax saving this year assuming a 3% yield will be £200 for a higher rate taxpayer - helpful but not that noticeable
    • If £10,000 invested in stocks via ISAs the portfolio is unlikely to double over a year which slightly defeats their tax-free point as we all have a capital gains tax allowance of £9,600 per year

    However, if ISAs are used as part of a long term investment/savings plan, the idea being to accumulate large amounts of money over the years, then they're a great financial product.

    Summary

    This has been an exercise in both simplicity and common sense. ETFs are simple products and the ETF portfolio is based on common sense - and it's my belief that proper long term investing doesn't have to be any harder.

    Yes, we often think that complex = better but I have seen little evidence of this over the years. In fact complex seems to be used as a dubious excuse to charge higher fees, hedge funds being a classic example.

    Ultimately the strength of the ETF portfolio lies in its low costs, less than 0.5% pa whereas a similar portfolio built with funds/unit trusts would probably charge a minimum of 1.75 and sometimes an outrageous 3%-4%+.

    High fees are never a problem if excellent returns are delivered.

    Who would balk at paying a fund manager a 5% management fee and 30% of the profits if he constantly delivered? Most would consider it a great investment. So it's the charging of high fees for continued poor performance that we should be on the lookout for.

    I would therefore expect my portfolio to outperform a similar one built via traditional funds and unit trusts. Not because the ETF portfolio picks better markets to invest in, I doubt it does. Not because its portfolio weightings are superior, I doubt they are, but purely because of the low costs.

    The role the cost savings play might not be so noticeable in the short term but when you can save 1%, 2% or even better 3% a year and compound those savings over 5+ years the difference in performance can be significant.

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