How brisk has the business of launching new exchange-traded products been this year? Through September, a total of 165 new ETPs were introduced, according to ETFguide’s FirstLook ETF market report. But instead of tracking and mimicking broadly diversified indices, the vast majority of these new product launches are either investing in niche markets or attempting to outperform traditional benchmarks by handpicking securities based upon factors.
One example is the recently launched Fidelity Dividend ETF for Rising Rates (FDRR), which joins an already crowded roster of dividend focused ETFs, but with its own unique angle that uses a proprietary indexing strategy to rank and choose stocks based upon high dividend yield, low dividend payout ratio, high dividend growth, and positive correlation of returns to increasing 10-year U.S. Treasury yields.
FDRR’s dividend strategy is perhaps not too radically different from other dividend focused ETFs with their own proprietary formulas. But its existence, along with the push away from traditional indexing and toward factor-based investing, reinforces the trend of product proliferation in the ETF marketplace. This in turn reinforces the need for financial advisors to employ a disciplined framework for portfolio construction. Let’s examine one method for building architecturally sound ETF portfolios.
The Core Portfolio
A portfolio’s “core” refers to its foundation. And all foundations, whether they be for buildings or retirement plans, must be built on solid footing. To that end, ETFs linked to traditional market cap indexes have established themselves as the correct building blocks for a person’s core investment portfolio. These types of funds are renowned for their low costs, tax-friendly structures and broad diversification.
Here’s another huge benefit: Financial advisors who use index ETFs as the core for client portfolios don’t sacrifice performance.
Indeed, over the five-year period ending June 2016, 91.91 percent of large-cap managers, 87.87 percent of mid-cap managers, and 97.58 percent of small-cap managers lagged their respective benchmarks, according to the SPIVA U.S. Scorecard by Standard & Poor’s.
A well-built core portfolio should offer global diversification that covers the four major asset classes: stocks, bond, commodities, and real estate. The role of advisors is to help clients determine the right asset mix.
Non-Core Portfolio
If an investment client’s core portfolio is the “main course,” then their non-core portfolio is logically the “appetizer.” (“Non-core” is commonly referred to as “satellite in institutional circles,” but I prefer calling it non-core because it’s less complicated for clients to understand.)