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ETF Selection Criteria – Asset Allocation.


Last time we proposed ETF selection criteria to help the Individual Investor sort through the multitude of ETFs available to make simple, sensible choices for their portfolio. Another criterion is …

Get your Asset Allocation right.

Use a Pension plan as a reference portfolio to guide your portfolio’s asset mix. The default reference portfolio (I think) is the average Canadian Pension Plan asset allocation as per the Pension Investment Association of Canada’s (PIAC). But there are other Pension Plans that might be preferable. (see below). What’s important is that the Individual Investor can piggy back off of all the resources, technology, time and skills of a Pension Plan to build their own ‘Pension Plan’. The Individual’s portfolio won’t look exactly like a Pension Plan’s portfolio. But the Individual’s asset allocation should look ‘somewhat’ like that of most any Pension Plan. If it looks vastly different, why?

ASSET MIX OF PLANS AT DEC 31, 2010 PIAC Allocation
CASH AND SHORT TERM -1.52%
CANADIAN NOMINAL BONDS 26.20%
REAL RETURN BONDS 4.58%
MORTGAGES 0.69%
FOREIGN FIXED INCOME 1.76%
CANADIAN EQUITIES 15.99%
U.S. EQUITIES 6.14%
EAFE EQUITIES 5.84%
EMERGING MARKETS EQUITIES 3.05%
GLOBAL EQUITIES 12.42%
REAL ESTATE 8.86%
VENTURE CAPITAL/PRIVATE EQUITY 7.24%
INFRASTRUCTURE 4.15%
OTHER ASSETS 2.98%
HEDGE FUNDS 1.56%

Most Individual Investor’s portfolio land somewhere between 75% stocks / 25% bonds through 50%/50% to 25%/75%. This will form the portfolio ‘core’. If your portfolio doesn’t ‘resemblePIAC (or the CPP or OMERs or AIMCo or OTPP) … again, why?

Broader diversification is usually better for risk-averse Individual Investors. Why? Broad diversification maximizes the number of opportunities for returns and usually means less volatility.

Some might prefer more focussed or concentrated portfolios. No problem. As long as this investor is aware that the risk characteristics and therefore return pattern will be un-index-like. The key is not to take ‘unintended bets’. An investor can compromise by establishing the ETF core and then complementing it with a more concentrated ‘bet’ (a small-cap stock or other specialty fund, for example).

Start with the largest PIAC allocations first.

If you are building your portfolio with ETFs, look for the ETF that provides broad asset class, region, sector or industry coverage. I.e. Fidelity to strategy. Does the ETF fit the job description? Regarding ETF composition, are the number of securities in the ETF adequate? Do the weighing of the individual holdings allow for prudent diversification? Or is there too much concentration?

Next time?
ETF selection criteria … then a practical example.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
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