One of the first rule of investing is “don’t lose money”. A well designed Conservative ETF Portfolio is for those who are conscious of this rule aiming to preserve capital to invest over the long run rather than trying to time market top and bottoms.
A low risk ETF portfolio of index funds aim to replicate the market rather than trying to beat it. Passive index funds replicate the performance of the market index like the Dow Jones Industrial Average and is one of the easiest and cheapest way for investors to create their own low maintenance investment portfolio. There are also a number of benefits using ETF rather than mutual funds in making the core part of the investment portfolio.
ETFs which track a specific bond and stock index and minimise the risk of the portfolio underperforming the market over the long run. For investors who are taking a conservative approach, beating market should not be the primary motivation in selecting the ETF to add to the portfolio. The goal is the preservation of the investment capital so the purchasing power in real terms grows for as long as possible.
The relative and absolute low cost of ETFs is a major advantage over direct stock or mutual funds. Typical expense management ratio of ETFs for index trackers are close to 0.20% to 0.30% a year compared to 1% for mutual funds. This also does not include the buy in and exit cost of funds which can add up to 2% per trip.
Low expense ratios of simple index ETFs allows investors to capture a larger portion of market returns that would have otherwise eaten by advisor or management fees.
The Bond ETFs that Should be In Every Conservative Portfolio – Conservative Allocation ETFs
Stock market is usually the first thing that comes to mind for investors when they think about the financial market. Did you know that the total size of the bond market is far larger than the stock market?
Up until recently, the only way for investors to invest in bonds was to purchase the bond directly through a broker (direct bond investment was not cost effective for orders smaller than $100k per order) or buying bond mutual funds. Now there is a wide range of cheap and effective ETF options for investors that would like to create a conservative portfolio.
The decision on which bond ETF to include in a conservative portfolio should be partly based on the expected investment time horizon of the investor.
For the risk averse investors with a medium investment horizon and want to first and foremost to preserve capital. Barclays US 7 – 10 Years US Government Bond ETF (IEF ETF) can be considered a good ETF which can form the core component of the investment portfolio.
The time horizon of the bonds held in the IEF ETF span between 7 – 10 years which allows investors a higher level of income than shorter dated US government bonds ETFs. Longer duration ETFs have a higher yield to compensate investors for buying a longer dated bonds but this is balanced by exposure to potential capital losses from day to day fluctuation in the market as future interest rate expectations changes.
With that said, a conservative approach can allocate a smaller portion of the bond portfolio to the longer dated Barclays US 20 + Year Treasury Bond (TLT). TLT tracks the performance of US treasury bonds with a maturity of 20 years and longer which naturally has a higher yield (and risk).
A disadvantage of holding a bond ETF is the static portfolio duration. If an investor buys a portfolio of bonds and hold those bonds to maturity the duration of the portfolio (the sensitivity to interest rate changes which also reflect the life of the bonds) decrease over time.
However a bond ETF as part of the stated strategy aim to maintain certain level of duration. It sells any shorter dated bonds in its portfolio with longer dated bonds to ensure the average age to maturity of bonds matches the benchmark index.
Investors can manage the fixed duration risk through simply use the cash flow (dividends) of TLT to rebalance the portfolio to cash or shorter dated bond ETF over time. Hence as portfolio matures over time, the portion allocated to TLT would decrease and with the right sizing the interest risk of the portfolio would decrease over time as well.
So far the discussion has been focused on funds which owns government debt. If investors are looking to taking on real credit risk or yield, emerging market debt ETF is also an option but ideal in small doses.
iShares Floating Rate Note Fund (FLOT) can also provide protection against future interest rate increases. FLOT invests in investment grade bonds where the coupons are based on a swap rate above the corresponding base rate (i.e 3% above 1 year LIBOR). The maturity of the bonds in the ETF are usually between one month and 5 years. This is an effective way for investors to naturally hedge their long dated bond exposures (potential interest spread risk would still exist in holding floating rate bonds).
A shorter time horizon conservative etfs limit overall allocation to long dated bonds due to term structure risk. A greater portion of the portfolio can be assigned to short dated government and corporate bond ETFs such as iShares Barclays 1-3 Year Treasury Bond Fund (SHY) or iShares Barclays 1-3 Year Credit Bond Fund (CSJ).
CSJ ETF tracks shorted dated investment grade bonds. Short dated investment grade bonds have lower default risks as buyers are only at risk if the company defaults within 3 years. Any current negative factors around companies which could put the bonds repayments at risk should to some degree already reflect in the current prices (i.e similarly the price investors pays for the ETF units today).
How to Choose the Right Amount of ETF in Portfolio
Bond ETFs are designed to protect the investment capital overtime. There should be some stock exposure in every conservative portfolio to make sure also the purchasing power of the portfolio als increase overtime.
Core asset allocation decisions will make or break the portfolio return over time. The goal of including stocks in a conservative portfolio is for the equity exposure to act as a counterweight to the bonds rather than the traditional balance method of investment management of using the stock ETF as the core unit of the ETF portfolio.
Investors can achieve greater level of diversification through equity ETFs than owning the stocks directly. This can also limit potential stock specific risks that could cause severe damage to investment capital from unforeseeable risks.
The best stock ETF in this example would be the S&P500 SPDR ETF (SPY). SPY tracks the S&P500 Index which includes the 500 largest companies listed on the stock exchange. This is important for conservative investors as it means most of the companies have earnings and cash flows to back up the prices paid by investors.
For a conservative income investor with a shorter investment horizon this means an even lower allocation to stocks (or none at all if time horizon is lower than 3 years). Rather the focus would be purely on using bonds for income. There is limited risk in having short dated bond ETF like CSJ ETF and SHY if interest rate rises (primary risk of owning bonds) however the trade off is lower overall income.
For investors who feel the yield on government bond is too low even a longer time horizon. Alternative options include iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) is the largest traded corporate bond ETF in the US. It limit potential credit risk for investors through holding hundreds of different bonds which results in a well diversified and protect capital from default risk.
There are also options that can improve overall return at the cost of marginal additional risk. Such as lower risk sectors such as utilities or real estate investments trusts. These are low risk sectors that are less volatile than the broader market and comprised of mature and dividend paying companies.
Portfolio diversification can also be improved through including international exposure either country specific like ETF that track companies listed in China or wider regional ETFs.
Conservative ETFs in Portfolio Allocation
Below is an example of portfolio constructed from using a set of conservative ETFs mentioned above. It is intended to act as a template for investors and individuals need to adjust accordingly based on their own risk tolerance and investment horizon.
Conservative ETF Portfolio with Long Term Investment Horizon
| ETF | Ticker | % |
| SP500 SPDR ETFs | SPY | 30% |
| Barclays US 20 + Year Treasury Bond | TLT | 20% |
| iShares iBoxx $ Investment Grade Corporate Bond | LQD | 20% |
| iShares Floating Rate Note Fund | FLOT | 15% |
| Barclays US 7 – 10 Years US Government Bond ETF | IEF | 10% |
In the above conservative portfolio although SPY is the largest single ETF at 30%. The returns of the remainder 70% of the portfolio will be driven by fixed income market which provides a relatively safe cushion for future income. It can be useful for some investors to include dividend ETFs in the portfolio to replace some of the bond ETFs allocation.
Conservative ETF portfolio with Short Term Investment Timeframe
| ETF | Ticker | % |
| Barclays US 7 – 10 Years US Government Bond ETF | IEF | 30% |
| iShares Floating Rate Note Fund | FLOT | 20% |
| iShares Barclays 1-3 Year Treasury Bond Fund | SHY | 10% |
| iShares Barclays 1-3 Year Credit Bond Fund | CSJ | 20% |
| Barclays US 20 + Year Treasury Bond | TLT | 5% |
| iShares iBoxx $ Investment Grade Corporate Bond | LQD | 7.50% |
| S&P500 SPDR ETFs | SPY | 7.50% |
As investment time horizon decreases so should allocation to the stock ETFs. The above conservative ETF portfolio returns is primarily driven by income from government and corporate bonds.