Building Your Own ETF Portfolio

Building Your Own ETF Portfolio
The best way to take advantage of the benefits of ETFs is to trade them
and build a portfolio yourself. Hiring an investment adviser automatically
adds a layer of fees. And sometimes, it can be very hard to determine what value or service you’re getting for your money. If you’ve gotten through this much of the book, you can definitely build a portfolio by yourself.
You’ve learned the difference between an ETF and a mutual fund. You
know that investing in ETFs is better than investing in single stocks because
you get broad-based diversification with the flexibility and tax efficiency of
equities, but without the single-stock risk. Diversification in one trade makes
ETFs less expensive than buying individual stocks, and usually cheaper
and more tax efficient than mutual funds. You also know you can invest
in alternative asset classes with the same ease as investing in stock or
bond ETFs.
Now it’s time to put that information to good use and build your own investment portfolio. While I can recommend a certain investment strategy, readers will bring their own knowledge and preferences to how long they will hold ETFs and in what manner. You have to determine for yourself the amount of risk with which you feel comfortable. Like the title says, this book is about ETFs for the long run. The long run means buy and hold. Buy your investments, put them away, and let them grow; don’t watch the daily machinations of the stock market. The main benefit of a buy-and-hold strategy is that you don’t incur a lot of trading costs and you never have to worry about being out of the market during an up move. Since the U.S. market over the past century has been in a steady upward progression, betting on the market going up is a calculated bet.
When successful companies grow, so do their stocks. By holding and reinvesting the dividends given off by the stocks in your index, you increase the number of shares you own that can see their value grow. This compounds their value.
A buy-and-hold strategy does not mean buy and forget. Always remem-
ber: past results don’t guarantee future returns. This means that even though
the stock market has advanced over the past century, there’s no guarantee it will in the future.
All investments experience down times. Sometimes these down periods last only months, sometimes they stretch out for years. I’m not recommend-
ing market timing, but it’s good to be aware of the market and the outside world and see how they are affecting each other. Sometimes it’s a very good idea to take profits off the table. If the economic mood is changing, you should reassess your asset allocation and possibly lower your exposure to stocks. The nice thing about ETFs is that they offer many products and op-
portunities that let investors take advantage of both an up and down market.
This chapter will offer concrete suggestions on how to build a portfolio as well as some complicated, more sophisticated strategies. Because I’m not a professional asset manager, I decided to ask some professionals for suggestions on how they put together ETF-only portfolios. It’s rare for financial professionals to offer their portfolios for widespread public consumption like this. It’s what they get paid to do—produce—so I greatly appreciate their contributions. Some are well-respected portfolio managers; others are people and firms I’ve used as sources of information for my articles. They all have a lot of ETF experience. I don’t endorse any one strategy over another, but these are all people I respect.
James Kelly of Kelly Capital Management gives a very detailed road map to determine risk tolerance. I will then outline basic strategic asset allocations for conservative, moderate, and aggressive portfolios. These are precision allocations in that they break down the asset allocations into smaller categories in both the stock and bond allocations.
J. D. Steinhilber of Agile Investments created three easy-to-build strategic asset allocations—conservative, moderate, and aggressive—for the buyand-hold investor saving for retirement. The portfolios take advantage of some strategic ETFs to grab a more diverse market exposure. These creative models provide a nice comparison to the first set of portfolios and show that even two similar strategies, with similar stock and bond ratios, can be constructed in very different ways.
Afterward, I provide two examples of portfolios that depart from the classic format of U.S. stocks and bonds. Ron DeLegge of ETF Guide.com provided his Contrarian Fox portfolio. This provides a good example of a tactical asset allocation and how to construct a portfolio that goes against conventional wisdom. Finally, Burton Malkiel offers a portfolio that is focused entirely on investing in the Chinese economy. Both of these portfolios are riskier than a classic strategic asset allocation.
Altogether, these examples show how ETFs offer investors a lot of
opportunities to be creative in a wide range of portfolio construction possi-
bilities.
The Simplest Portfolio
The easiest and most straightforward portfolio consists of two investments, maybe three.
The first would be an ETF of the entire stock market, such as the SPDR DJ Wilshire Total Market ETF (symbol: TMW) from State Street Global Ad-
visors. This ETF follows the Dow Jones Wilshire 5000 Index. The second investment is an ETF that tracks 10-year U.S. Treasury bonds—for instance, the Vanguard Total Bond Market ETF (symbol: BND). It tracks the Lehman
U.S. Aggregate Bond Index, which measures a wide spectrum of public,
investment-grade U.S. government and corporate bonds. They all have ma-
turities of more than one year, and an average maturity between five and
10 years.
This portfolio is fairly low risk. You adjust the percentages according to
your age. The amount of fixed income you hold is equal to how old you are.
A ten-year-old has the most time to recover from a financial disaster. He can
afford to take on the most risk. So, his portfolio would be 10 percent bonds
and 90 percent stock. A 40-year-old with a house, kids, and looming bills
for college and retirement should put 40 percent in bonds and 60 percent
in stocks. You’re still young enough to take on risk in more than half your
portfolio, but you’re conservative enough so that while a financial disaster
will hurt—a lot—it won’t wipe you out. Then when you’re seventy, you
don’t know if you might live to 90 years old. You still need to take some
risk to grow your money, but you’re not working any more and you need
to make sure you have enough to live. This calls for at least 70 percent in
bonds and 30 percent in stocks.
If you like it simple, stop reading. This portfolio will probably suffice.

Assessing Your Risk
James Kelly is the president of Kelly Capital Management in Philadelphia.
In 2001 he became one of the first, if not the first, asset manager to make
ETF-only portfolios for his clients. Kelly has an excellent track record and is
always accepting new clients. He was kind enough to offer his insights on
creating a portfolio. These are the questions he makes investors answer to
determine their risk profile and what the most suitable investments would
be for them.
These are the questions that a professional money manager asks when
creating a portfolio. If you decide to create a portfolio on your own, these
will be instrumental in preventing you from making disastrous investing
decisions.
How Much Can I Invest, and Will It Be Held in a Taxable Account?
It’s best to put securities that will be taxed the most in tax-exempt accounts such as individual retirement accounts (IRAs), 401(k) plans, or tax shelters. This would include taxable bonds and higher income securities. Securities expected to be sold in less than 12 months and one day should be in tax-
sheltered accounts. If held in a taxable account, the capital gains from these investments would be charged at your base tax rate as ordinary income.
Taxable accounts should hold tax-free debt, unless your tax bracket is so low that the after-tax income is at least as good as the tax-free income from your home-state municipal bonds. Assets with a low turnover, those that won’t be sold for a long time, should be in a taxable portfolio. When they are sold they will be taxed at the lower capital gains tax rate. Currently, this rate is 15 percent.

What Is My Risk Tolerance?
In order for a portfolio to return a profit, one must take on risk. The first variable of risk tolerance is the investment time horizon. How long will it be before you need this money? Can you lock up this money? Can you stay invested a long time if the investment goes through a rough patch?

Can you invest for at least three years?
If the answer is no, don’t invest in securities with a fluctuating market value, such as stock or bonds. Kelly recommends keeping these assets in money-market accounts and certificates of deposit (CDs).
If the answer is yes, then investing in securities with a fluctuating market value is acceptable.
What is the goal for investing this money? Will it be for retirement, a child’s education, a house, or another major purchase?
The longer the time horizon, the more “risky” assets you can use, such as stock ETFs instead of bond ETFs.

What Are My Liquidity Needs?
The second variable of risk tolerance is liquidity. Consider not only how
long before you need the money, but your cash flow needs. How often
do you expect to draw money from your investments? Will you need to
access it immediately or on a regular basis? Liquidity is the ability to access
your money quickly. Stocks are more liquid than a certificate of deposit.
However, your stocks could be trading at a loss on the day you need to
sell. Your liquidity needs will play an important part in determining what
to invest in.

Do you need to spend all or most of your money within the next three years?
If the answer is yes, then don’t invest in “risky” assets.
If the answer is no, then you can invest in “risky” assets.
When you begin to take the money out from your investments, how will you take it?
As needed, such as small lump sums on an ad hoc basis.
On a regular basis, such as an annual required distribution from an IRA account.
Like a pension, on a monthly basis. If so, fixed-income oriented ETFs may help smooth the cash-flow generation processes.
Are there legal restrictions on what you can take, such as trusts paying out only income and a limited amount of principal?
How Do I Feel about Losses?
Obviously, no one likes losing money. As described earlier, risk is the measurement of the likelihood of losing money. Risk is also the degree of volatility that the portfolio can be expected to experience. For only through volatility can a portfolio see great growth. The greater the volatility, the greater the moves up and down. A very risky investment is one that has high volatility. For taking on a large risk the investor has the potential to be compensated with huge returns. However, the large risk also means there is a great potential for a huge decline in the asset’s value.
The best way to determine your tolerance of risk is the sleep factor. In
short, how well can you sleep at night when your portfolio is experiencing
large losses? Are you willing to tolerate fluctuations of 5 percent, 10 percent,
15 percent, 20 percent or more in the portfolio’s value in a single year? Can
you stay the course through a market downturn without becoming a nervous
wreck? The greater the tolerance for risk, then the more stock ETFs you
can use.

Are you looking for a long-term inflation hedge? In this case, stock and real-estate ETFs are the best inflation hedges.
Do you tend to look at your investments daily or less frequently? Curiosity is fine, but if you’re a Nervous Nellie then don’t invest much in stock, commodity, or real-estate oriented ETFs.
Are you influenced by the talking heads on financial programs you see on television? These people are entertainers. Take what they say accordingly.

What Is My Tax Sensitivity?
Obviously, no one likes to pay taxes. But some people go absolutely crazy about paying taxes on investment income. If you’ve held long-term investments for many years, you’ve probably accumulated a lot of gains. And once they become realized, the government will want its share. So, the taxes that must be paid after selling assets must be factored into any strategy.

Do you have substantial unrealized gains in low cost-basis securities?
Do you have company stock acquired over many years of employment?
If so, then set up a tax budget to limit the realized gains each year as
you convert your low cost-basis stock into your ETF-based portfolio
strategy.
Did you inherit a security to which you are emotionally attached? For example, a parent or spouse may have left you some stock and you are reluctant to part with it.
Is there an annual limit on how much tax you are willing to pay on capital gains? Generally 10 percent of your portfolio’s market value is a reasonable limit for realized gains.
From where will the funds come to pay the taxes on gains? The portfolio should pay its own taxes. It needs to keep enough liquidity to pay quarterly estimates to the IRS and your state revenue department.

Do Your Homework
ETF providers supply a lot of free information to investors, so look at their websites.
Some sites give you the means to assess your risk tolerance and create mock portfolios to match. In general, one should seek as much risk as one can tolerate and invest for the long term. Set up a tolerance band of about plus 5 percent and minus 5 percent around your long-term target asset mix. Rebalance this mix quarterly if it falls outside your tolerance band.
In general, unless you have a low risk tolerance, Kelly recommends that you place at least 70 percent of your assets in stocks, regardless of your age. Generally a limit of 30 percent foreign stock ETFs is comfortable for most investors with 10 percent being the minimum. The emerging-market stock ETFs give the greatest return, but are more volatile than developed market stock ETFs.
Real estate via ETFs, or specific REITS, should be limited to 10 percent of assets, which reduces the stock target by five percentage points and the fixed income target, if any, by five percentage points.
Commodities are a volatile asset class and a limit of 10 percent in commodities ETFs is tolerable for most individuals. This weighting further reduces the stock target by 10 percentage points.
A sample stock-only, aggressive portfolio might be 70 percent domestic stock ETFs and 30 percent emerging-market stock ETFs.
A sample balanced-aggressive account could be 60 percent domestic
stock ETFs, 15 percent emerging-market stock ETFs, 10 percent real-estate ETFs and 15 percent fixed income ETFs
Be Disciplined
Discipline is the ability to stick to your strategy in the face of strong head winds. Anybody can have a good strategy; it’s the ability to stick with it even as the market goes against you that determines how disciplined you are. People who are not disciplined will take their money out of the market and then invest it back in at exactly the wrong times.
Most people don’t sell at the beginning of a downturn. Instead, they typically suffer through months of declining asset values, hoping that the market will turn around and they will break even. Eventually, the pain of the losses becomes so overwhelming that the investor finally sells. Typically, this is near the bottom of the market, when he or she should be buying. He will get out at the bottom, and not be invested for the eventual upswing. Not believing the rally to be sustainable, the investor sits on his cash until the market proves to him the rally is real. If he invests at that time, he has to pay a higher price to enter the market. This increases the potential for buying just as the market is peaking.

Develop a thick skin; don’t overreact to short-term swings in market value.
Control risk by rebalancing across the ETFs you have selected and across the asset classes they represent.
Assess why things are going right and why they are going wrong. Don’t change the asset mix target frequently.

Strategic and Tactical Asset Allocation
Two common strategies for creating portfolios are Strategic Asset Alloca-
tion (SAA) and Tactical Asset Allocation (TAA). According to Investopedia, strategic asset allocation is a method that establishes and adheres to what is a “base policy mix.” This is a proportional combination of assets based on expected rates of return for each asset class. “Because the value of the assets can change given market conditions, the portfolio constantly needs to be re-adjusted to meet the policy. For example, if stocks have historically returned 10 percent per year and bonds have returned 5 percent per year, a mix of 50 percent stocks and 50 percent bonds would be expected to return
7.5 percent per year.”1
Putting 60 percent of the portfolio in equities and 40 percent in bonds is your strategic asset allocation. This can be broken down further into many different stock and bond ETFs. Once you’ve researched the funds and created the asset allocation, you buy them. Then you hold them. This is a passive strategy.
Over the course of the year the weighting of each ETF in the portfolio
changes depending on how the markets perform. At the end of the specified
time period, usually the calendar year, the investor rebalances the portfolio
to get back to the strategic asset allocation’s original weightings. Most people
wait until the end of the year to rebalance the portfolio and bring it back
to its original allocations. For example, let’s say your portfolio is 75 percent
stocks and 25 percent bonds. Over the next year, you invest more into the
fund and stock market rallies. The stock allocation grows to 85 percent
of the portfolio, while bonds fall to 15 percent. To bring the allocation
back into its proper weighting of 75 percent, you would sell some equity
ETF shares. Then you take the money from selling stock ETF shares and
buy enough shares in the bond ETFs to bring their allocation back up the
model’s desired 25 percent.
Rebalancing is a way of keeping your model at the appropriate risk level. In addition, it is a disciplined way to take profits in the investments that have been doing well and buy shares in the investments that are out of favor. Typically, these investments have been beaten down and trade at much cheaper prices. This is a systematic, disciplined way to force you to buy low and sell high.
The strategy is relatively rigid, but for many people that works. They want to set up their investments, then go about their daily lives. However, economic conditions often favor one asset class over another, creating un-
usual investment opportunities. In tactical asset allocation, the portfolios aren’t passive. The investor, or asset manager, makes short-term, tactical deviations from the strategic mix to take advantage of these opportunities.
Tactical asset allocation, according to Investopedia, can be described as a moderately active strategy, since this flexibility adds a component of market timing to the portfolio. Tactical movements allow you to then make precise shifts in and out of the asset classes. This allows the asset manager to add value and reduce risk by taking advantage of “security misevaluations across the asset classes.”TAA requires much more work and discipline than regular strategic
asset allocation, because the portfolio must be rebalanced to the original
long-term SAA when the short-term opportunities disappear. Such a strategy
can be difficult for the individual investor. It will also add to your transac-
tion costs.
A big problem with creating asset allocations with mutual funds is that you never really know what a mutual fund holds, so you never really know what your exposures are. ETFs bypass all that. The ETF’s transparency allows for incredible risk management because ETFs offer the ability to create strategic allocations with great precision.
You can model these portfolios exactly or use them as a launching point. Feel free to add other ETFs in allocations appropriate to the model’s benchmark ratio of stocks to bonds
Classic Conservative Portfolio
A portfolio is considered conservative if it has an equity allocation of less than 50 percent. In this case conservative isn’t a political philosophy, but an investing one. Conservative investors shy away from risk and are very concerned with not losing any of their principal investment. Many live off the income produced by their holdings.
In this portfolio, the strategic asset allocation is 40 percent equities, not including real estate trusts. This is a reasonable amount for a person with a fairly low risk tolerance. Most of the portfolio sits in bonds, about 51 percent. Unless you’re nearing retirement, this is probably too little to be holding in stocks. But it’s worthwhile to look at a conservative portfolio to give a base line for more aggressive portfolios.
The final 9 percent could be held in real-estate ETFs or commodity ETFs. For this example it won’t hold commodities, because with expense ratios around 0.5 percent to 0.6 percent, these remain too high for the portfolio.

EQUITIES The first thing to determine is how much of your stock portfo-
lio will go to domestic stocks and how much to foreign stocks. Once the domestic allocation is determined, many investors choose to seek precision by breaking domestic stocks into three ETFs based on the size of the com-
panies: large-cap stocks, mid-caps, and small-caps. Each one has different behavioral aspects and usually one sector will do better than the others. Small-caps usually lead bull markets, while large-caps are usually better during market turbulence and a good place to make defensive moves.
Another reason for breaking down stocks and bonds this way is for tactical asset management. This lets the investor or asset manager be more active in the portfolio management. They can take advantage of market opportunities by tactically tweaking the individual sectors up or down. If, for example, small stocks are doing better than large-cap stocks, the large-
cap weighting of the portfolio could decrease by five percentage points
while the small-cap portion could increase by the same amount.
FIXED-INCOME The nonequity portion of the portfolio is generally divided
among real estate, short- and long-term treasuries, corporate debt, and Trea-
sury Inflation Protection Securities, better known as TIPS. These are U.S.
Treasury bonds that adjust their principal and interest payments to protect
investors from inflation. Fixed-income refers to bonds. It means these as-
sets give off a steady stream of cash in the form of interest, also known as
income.

Short-term bonds mature within five years, and have less risk than
long-term bonds. Short-term bonds make up 32 percent of the port-
folio. The Vanguard Short-Term Bond ETF (symbol: BSV) is a good
choice. It tracks the benchmark index, the Lehman 1-5 Year U.S. Gov-
ernment/Credit Index. This index includes all medium and larger public
issues of U.S. government, investment-grade corporate, and investment-
grade international dollar-denominated bonds that have maturities be-
tween one and five years. The average maturity shouldn’t exceed three
years, and is typically two years. The ETF holds about 700 securities.
Long-term bonds typically have maturities greater than 10 years. The
Vanguard Long-Term Bond ETF (symbol: BLV) follows the Lehman
Long U.S. Government/Credit Index. It would hold 4 percent of the
portfolio.
The iShares Lehman Credit Bond Fund (symbol: CFT), which tracks the eponymous index, holds 5 percent. This index measures investment grade corporate debt and non-U.S. agency bonds with a maturity of greater than one year.
The iShares Lehman TIPS Bond Fund (symbol: TIP) makes up 10 percent of the SAA.

ALTERNATIVE INVESTMENT A broad real estate ETF such as the Vanguard REIT ETF (symbol: VNQ) makes up 9 percent of the portfolio. This follows the MSCI US REIT Index, which covers about two thirds of the value of the entire U.S. real-estate investment trust (REIT) market. The fund invests 98 percent of its assets in REIT stocks and the rest in cash. In light of the current situation in the housing industry, an investor might be better off .

Foundation Portfolios
Another early adopter of the all-ETF portfolio, J. D. Steinhilber, contributed a series of model portfolios to this book. They are very straightforward, simple to understand, and easy to put together. Most investors can use these as a foundation for their own investments, or follow them exactly.
Previously an investment banker doing corporate finance at Nashville, Tennessee, regional bank J.C. Bradford & Co, Steinhilber started Agile Investments, his asset management firm, in 2001, following the popping of the Internet bubble. It was a bear market in full growl.
Building his business in the wake of the iShares launch, he decided
he would never use single-company stocks for client portfolios, only ETFs.
Once in a while, he adds a mutual fund to the ETFs. When he does, he
chooses a fund that gives its portfolio manager wide latitude to add value
to the fund.
The Nashville investment advisor likes the transparency of ETFs and
believes their ability to track the market with broad indexes and low expense
ratios is the best way to build a nest egg. But he doesn’t call the firm Agile
for nothing. Even though he uses passive vehicles, he employs an active
management style called tactical asset allocation. That means the portfolios
are fluid.
Depending on the economic backdrop and fundamentals at the asset class level, he re-evaluates different slices of the market, and tweaks the asset allocations to take advantage of the current market conditions. The strategy appears to work. The aggressive model portfolio he used from 2002 through 2007 saw an average annual return of 9.9 percent, in contrast with the S&P 500’s 6.0 percent.
Steinhilber’s belief in lower fees doesn’t change when it comes to charg-
ing his own clients. He typically requires a client to have a minimum invest-
ment of $250,000 to invest with his firm. His fees start at a very reasonable
0.6 percent of assets for the minimum-sized portfolio, and decrease as the portfolios grow in size.
I asked him to design three fundamental strategies that a typical buyand-hold investor could use as a foundation for a long-term portfolio. These models—conservative, moderate, and aggressive—are designed for an investor saving for retirement.
All three of these models are suitable for an average investor. All the ETFs are liquid. The average expense ratio is very low, with the two bond funds and the domestic REIT fund charging only 0.11 percent. The ETNs charge 0.75 percent or 0.85 percent, but they make up for it in tax efficiency. Which model you choose will be determined by your risk comfort level.
The buy-and-hold portfolios provided by Agile Investments are strategic asset allocations just like the classic portfolios, only these are more high concept. Instead of breaking up the stock portion into funds of differentsized companies, he buys a total market index, so that he can take advantage of ETFs that offer creative strategies.
While both the classic and foundation models are basically stock and bond portfolios, comparing the Agile portfolios with the portfolios in the previous section provides us with a great opportunity to see how two portfolios with similar risk tolerances and strategic asset allocations can be set up in completely different ways.
The Conservative Growth ETF Model
This model is good for investors with a low risk tolerance. They could be very wary of the stock market’s direction or very concerned with protecting capital. Typically, people nearing or just entering retirement might like this model. Capital protection seems to be the overriding theme, but the equity components provide the potential to capture some outsized returns should stocks rally. (See Table 10.4.)
According to Steinhilber:

This portfolio is suitable for clients willing to assume a level of market risk and volatility typical of a traditional balanced investment portfolio. Although asset class weightings will vary based on our tactical asset allocation methodology, and alternative asset classes, such as real estate investment trusts or precious metals, may be employed, an appropriate benchmark for this portfolio is 60% equities and 40% fixed income.

The portfolio presented here breaks down into:

Equities: 40 percent
Fixed-Income: 45 percent
Alternative Investments: 15 percent

The Moderate Growth ETF Model
The Moderate Growth ETF Model and the Aggressive Growth ETF Model
are variations on the theme. They both start with the Conservative Growth
ETF Model then make a few adjustments to increase the profit potential by
taking on more risk. The equity component makes up a greater proportion
of the portfolio, while the total of fixed-income investments decreases.
The Aggressive Growth ETF Model
The Aggressive Growth ETF Model takes on much more risk. Steinhilber describes the Aggressive Growth ETF Model as “suitable for clients willing to sustain substantial volatility and assume a high level of risk in pursuit of higher returns. Although alternative asset classes may be employed, an

Steinhilber describes the Moderate Growth ETF Model as “suitable for clients seeking potentially higher return opportunities and willing to assume a level of market risk and volatility somewhat higher than a traditional, balanced investment portfolio. Although alternative asset classes may be employed, an appropriate benchmark for this portfolio is 75 percent equities and 25 percent fixed income.”8
The Moderate Growth ETF Model is the exact same basket of ETFs as the Conservative model, but the allocation of each ETF is different. In the Moderate Growth Model the total equity allocation jumps to 60 percent from 40 percent, while fixed-income’s allocation drops to 25 percent from 45 percent. The proportion of Alternative Investments remains the same at 15 percent of the portfolio, with the same five ETFs each making up just 3 percent of the total portfolio.
In the equity portion of the moderate-risk model, the Vanguard Total Stock Market ETF allocation rises to 25 percent of the portfolio from 15 percent in the conservative portfolio. The Shares Dow Jones Select Dividend ETF and iPath CBOE S&P 500 BuyWrite Index ETN both remain at 5 percent, bringing the total domestic stock allocation to 35 percent. The Vanguard FTSE All-World ex-U.S. ETF remains the only international equity fund. It now comprises 25 percent of the portfolio, up from 15 percent.
In the fixed-income section, the Vanguard Total Bond Market ETF drops
from 20 percent to 15 percent of the total model, while the Vanguard Short-
Term Bond ETF takes an even bigger hit, falling to 10 percent from 25
percent.
appropriate benchmark for this portfolio is 90 percent equities and 10 percent fixed income.”
In the aggressive model, the equity portion jumps to 73 percent of the total portfolio from 60 percent in the moderate portfolio, and just 40 percent in the conservative model. Bonds drop to just 7 percent of the total strategy. That’s a huge decline from the moderate model’s 25 percent and the 45 percent in the conservative one. Alternative investments jump to 20 percent from 15 percent.
Not Following the Herd
Contrarian investing is choosing to zig when the rest of the market says
“zag”—or more precisely, trying to profit by doing the opposite of the
market’s conventional wisdom. Essentially, contrarian investing is defying
the crowd.
One of the old sayings of Wall Street is that the market climbs a wall of worry. This means the best time to buy stocks is when people are fearful. When there is widespread optimism and most people believe the market will keep going higher, the contrarian investor says the securities are probably fairly priced or overpriced and now is the time to sell. On the other hand, when everyone decides to sell and market pessimism is at high levels, the contrarian finds that a perfect time to buy. Prices are low and if everyone has sold, they can’t go much lower.
Value investing is a kind of contrarian investing because it looks for out-of-favor securities with low P/E ratios.
In this section are two portfolios that don’t follow the herd. These are not the classic portfolios that consist predominantly of U.S. stocks and bonds. Both the Contrarian Fox and Active China Strategy are high-concept portfolios. They each take the idea that the broad U.S. stock market is not the best place to be invested. The Contrarian Fox picks a few under-the-
radar sectors that it expects to outperform the U.S. market. The Active China Strategy essentially says China is where the best growth is, so why bother
with the United States? Both of these portfolios are very risky, but they are presented to offer examples of the kinds of creative portfolios that ETFs make possible.

Contrarian Fox Portfolio
Ron DeLegge, the founder and editor of ETF Guide.com, a Web site focused on the ETF industry, offers sample portfolios to subscribers. DeLegge, a former portfolio manager, agreed to let me publish his contrarian portfolio to give people an idea of what such a portfolio might hold. DeLegge says the objective and strategy of the Contrarian ETF portfolio’s is to “identify and select ETF asset classes that are out-of-favor or undervalued and which exhibit positive growth characteristics and a pending rebound.”10
This is a snapshot of what the portfolio looked like in March 2008. At this time, the U.S. economy was said to be entering a recession. The
U.S. stock market had already fallen 15 percent off its high. The bubble in
the housing market had popped as the subprime mortgage crisis caused
large amounts of homeowners to lose their homes in foreclosure. Across
the country, the real estate market was falling in value. The financial sector,
especially commercial and investment banks, suffered from the fall-out in
the housing market. Many had taken on huge amounts of risk buying and
selling mortgage-backed assets. By this time, many banks had written off
losses in the billions of dollars. Meanwhile, the dollar continued its decline,
sending the price of gold up 25 percent over the previous six months to
$1,000 an ounce.
While a typical portfolio seeks to give an investor a broad overview of
the stock market, this portfolio presents a different picture.
The Contrarian Fox model isn’t a buy-and-hold portfolio. Instead, it is
more of a tactical asset allocation model. The investor or portfolio manager
buys and sells assets to take advantage of the changing market trends.
In buy-and-hold investing, you set your strategic asset allocation and stick with it, for the most part, in both up and down markets. The reason behind holding the same assets and allocation in a down market is that you never know when the market will rebound. You could be out of the market at the wrong time and miss a big move up. However, if you stay pat, you will catch the rebound.
The tactical asset allocation attempts to increase returns by taking advantage of changes in the market. These asset allocations can change often and it is not advisable to copy this portfolio exactly. However, it provides an example of how a portfolio can be structured in a declining stock market.