Default Risk Factor

New Bond ETFs Enable All-ETF Portfolios

Default Risk Factor

Barclays Global Investors recently introduced four exchange-traded funds that track fixed-income indexes, and the move represents a critical and long-awaited development for ETF investors. Bonds are an important part of a balanced portfolio because of the income they produce and their lack of correlation with equity market returns. When combined with the wide range of equity ETFs already available, the new bond funds enable investors to construct diversified all-ETF portfolios.

To illustrate the power and efficiency of ETFs, I selected the following funds to represent various asset classes and assigned hypothetical allocation percentages to examine the portfolio's aggregate expense ratio and back-test its performance over the past several years (iShares were selected in this case).

In the aggregate, this portfolio has a 70/30 stock-to-bond weighting. The 70% stock component is 15% international (the Morgan Stanley EAFE index), while 55% domestic. The 55% domestic portion is spread among large-, mid-, and small-capitalization indexes and also includes a value component, because value stocks have historically generated slightly higher returns over time than growth stocks (see Larry Swedroe's Explaining the Value Premium).

This portfolio has a blended annual expense ratio of 0.22%, which means that a hypothetical $50,000 portfolio would incur $110 of annual costs. Of course, it is very important to note that commissions are required to initially establish the portfolio and rebalance it periodically. If an investor uses a low-cost online broker, the total annual commission costs of establishing this nine-security portfolio and rebalancing it semi-annually shouldn't exceed $150-$200. So the total cost drag is still approximately 60 basis points (0.60%) as a percentage of the portfolio. This cost is about half what a typical actively managed mutual fund charges, and this ETF portfolio also has protection against capital gains tax issues that plague traditional mutual funds (see this primer on ETF tax efficiency).

In terms of performance, the following two tables show how this all-ETF portfolio would have performed over four different recent time periods. In addition to annual returns, these tables also include standard deviation data. Standard deviation is a measure of the volatility of a portfolio or a security. For example, a portfolio with a standard deviation of 10% is likely to fluctuate in most years plus or minus 10% around the average annual rate of return. So an investor can expect that the returns from a portfolio with an average annual rate of return of 10% and a standard deviation of 10% will generally range from 0% in poor years to 20% in good years.

The recent past provides an excellent framework within which to evaluate portfolio strategies because the markets have been so volatile. During the past 5-7 years, we have witnessed one of the strongest bull markets and also one of the worst bear markets in history. The above data should provide confidence to any investor that a diversified ETF portfolio such as the one presented here is a sound investment approach because the portfolio:

  • Provides protection during bear markets
  • Reduces volatility (as measured by standard deviation), which is important in terms of an investor's emotions and his or her ability to stick with a strategy during difficult bear markets
  • Does not sacrifice performance over the long term
  • Reduces costs to a minimum