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ETFs 20% allocation blocks only? (max 5 allocations) January 4, 2011

Filed under: Invest — ilcourtilcourt @ 23:05
Freak wrote:Hello Desperatekid and choozm

Desperatekid wrote:Thanks Freak for your replies. If I’m not wrong, you seem to be valuing fees, taxes and expenses much more over the importance of diversification. Is that really a good strategy over long term? Your recommendations only point towards the main broad indexes of Europe and US so far.
choozm wrote:Summary of your post:
Over the long term, mkt coverage of 100% vs 85% vs 60% return similarly, so given the choice, you would go for the solution with the lower cost of investing. In the case of Europe equity, though EUN mkt coverage (60%) is smaller than EFA (85%), its cost of investing is lower thus attractive to you. Am I correct to say so?

Back to Desperatekid’s question: Is that really a good strategy over long term? Is it because of efficient market hypothesis?

Why broad base and not value/growth
First of all, a broad base index is more diversified than value/growth/dividend index. Although there are research showed that value outperformed growth, the value premium is not very stable and reliable. For US stocks, the post tax value premium can be zero over 25 years. For European stocks, my own studies found that value premium seemed to be very stable and positive over time for UK and France stocks. However, value premium is almost zero for Switzerland stocks. For Germany, the value premium over 30 years was positive. However, all the value premium occurred in the last 10 years. Is Germany value premium a one time thing?

Personally, I find value vs growth a very interesting topic. However, more research is needed. Currently, I would rather stick to broad base index rather than overweight value. Note that the moment we invest in value ETF, we have a more concentrated portfolio rather than more diversified portfolio.

What about midcap/small cap?
I love to include midcap and small cap stocks. That why I favour VTI rather than SPY or IVV.

Why Dow Jones Stoxx 50 index rather than MSCI Europe?
Infinity is about 0.5% more expensive than EUN. For EUN (top 60%) and Infinity to give the same return, the bottom (85%-60%)/85%=30% of the stock in MSCI Europe has to outperform the top 70% by 0.5%/((85%-60%)/85%) = 1.7%.

Taking data from “stock for the long run”, from 1926 to 1997, US small cap stocks outperformed S&P 500 by a debatable 1.5%. It is debatable because the main bulk of the extra return occurred in 1975 to 1983. Hence, it maybe a one time thing.

If we assume the (bottom 30% return = top 70% return), then EUN outperforms Infinity.

If we assume the (bottom 30% return = top 70% return + 1.5%), then EUN outperforms Infinity.

If we assume the (bottom 30% return = top 70% return + 1.7%), then both EUN and infinity have comparable return.

By the way, the bottom 30% of the stocks in MSCI Europe is not even small cap stocks yet. They are only mid cap stocks. Hence, for EUN and Infinity have the same return, the European mid cap premium must be higher than the debatable US small cap premium. In this case, I rather use EUN.

Why US and Europe rather than the rest of the world
It is not (US + Europe) VS the rest of the world. In a portfolio, we can replace the US unit trusts and European unit trusts with ETF. For “the rest of the world” unit trusts, there are more things to consider.

First of all, due to ETF portfolio constraint (see below), it is very difficult to use single country ETF, eg Korea. For more detail, see below under “ETF portfolio constraint”. This means we must go for regional EM ETF. For example, global EM and Far East exclude Japan ETF. Note that India is not part of Far East.

Since EM Asia make up 50% of EM Global, an investor who invests in both Asia exclude Japan and EM Global has high exposure to EM Asia. I notice there is greater acceptance of indexing today (at least @ sgforum) as compared to the old FSM days. Even for emerging market, we are talking about indexing.

We need to consider
1) (EM Global + SG + HK) VS (EM Europe + EM America + Asia exclude Japan)
2) Do we want to exchange Aberdeen Pacific Equity for iShare Far East Exclude Japan ETF or Emerging Market VIPERs?

I usually talk about US and Europe is simply because the condition is simpler.
Discard our US unit trusts and replace with VTI.
Discard our European unit trusts and replace with EUN.
It is one to one exchange. The discussion is more that fund level rather than portfolio level.

For “the rest of the world”, we have more things to consider. An ETF investor does not mean he has to invest in ETF only. He can have a portfolio of ETF and unit trusts.

ETF portfolio constraint
Assume an investor makes 4 trades per year for ETF listed in US. If he invests 5% in Korea (using rebalance by new cash), he roughly has 1 Korean ETF trade every 5 years. It is very difficult to maintain the asset allocation of the portfolio at such a low trading frequency. Most of the time, the allocation will be either too low or too high. Hence, we can only use ETF for funds with big allocation in our asset allocation (eg 20%).

For the above reason, ETFs like mid cap, small cap, Korea, Japan, HK, EM Europe, EM America etc are generally not suitable unless one invest 20% of the portfolio in just one of them. For these region, we still need to use unit trusts.


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