ETF Cores and Satellites

One way to explain the relationship between a person's core and non-core portfolio to clients is like this: A person's non-core portfolio is the appetizer, the core is the main course. Who in their right mind would overstuff themselves on appeatizers and leave no room for the main meal? For this reason, it's logical to expect that a person's non-core ETF investments would represent no more than 49% of a portfolio's total value. Why? Because if it accounted for anything more, it would wrongly overtake the role of the core portfolio as the foundation of the client's assets.

Portfolio Implementation

How an advisor goes about implementing ETF portfolios is a matter of philosophy. Some advisors like to maintain strict control by keeping the entire process in-house whereas others farm out the work to third-party managers.

In his bestselling book "Unconventional Success: A Fundamental Approach to Personal Investment" (Free Press, 2005) legendary investor David F. Swensen, Yale University's chief investment officer, popularized one relatively simple portfolio implentation strategy.

Swensen described a "well-diversified and equity oriented portfolio framework for investment success" as one that holds exposure to stocks in foreign developed, emerging markets and the U.S., plus real estate, U.S. TIPS and U.S. Treasuries.

Using Swensen's formula, David S. Kreinces, founder and portfolio manager at ETF Portfolio Management, built a series of ETF models he calls "investable benchmarks." The investable benchmark are three all-ETF portfolios that are developed into income, growth and income and growth buckets. "These are meant to be core portfolios with maximum diversification with low cost," said Kreinces.

The three equity asset classes used by Kreinces are U.S. equity, foreign developed and emerging markets, along with two bond positions (intermediate U.S. Treasuries and U.S. TIPS) and U.S. REITs. "The reason why Swensen applied these asset classes, is the fact they aren't highly correlated, which thereby reduces risk and increases diversification," he states.

All the investable benchmarks use ETFs from iShares and Vanguard to invest in these asset classes. The iShares are the bond companents while Kreiences uses Vanguard for the other holdings.

Kreinces' portfolios are available as separate accounts via Charles Schwab. His fee is 0.25% annually and the underlying ETFs charge another 11 to 16 basis points for a total cost near 0.36% to 0.40%. He combines these portfolios with a trend following strategy. He argues that indexing and trend following are doing the same thing but at different speeds.

"ETFs have grown to where ETFs are the choice vehicle for portfolio management by both institutional and retail investors. That should enable ETFs to offer clients a more efficient solution at a lower cost."

Summary

Dividing a portfolio into core and non-core parts helps advisors to build, manage, and organize client portfolios. Each distinct container is complementary and avoids needless duplication because it serves a different function by deliberately doing something different.

The core portfolio will always aim for maximum diverisfication across the major asset classes. And the most tactical a core portfolio will ever be is when it rebalances or adjusts its exposure to each asset class. In contrast, the non-core portfolio takes a tactical approach by investing in assets that are more risky, volatile, and narrow with a return profile that should be equally high.