Constructing Portfolios for Risk Adjusted Superior Returns Using ETFs

Active ETF Portfolio Construction — The Challenge for Superior Returns

The key benefits of investing in an ETF portfolio are similar to those of index investing-manage risk through diversification, lower managed expenses, and flexibility in making changes or rebalancing the portfolio to stay on track with portfolio goals.

The unique capability of ETFs is that a manager can easily construct a basic portfolio based on a risk orientation that would have broad allocations in it i.e., US Equities, International Equities, and Fixed Income. Or a manager can build a portfolio focused on a particular slice of a sector, asset class, or geographic area.

Saddle River Capital Management has marketed five broadly allocated portfolios, with a three year track record, to the retail market and to other advisors. These portfolios are based on risk or lifecycle and represent from an aggressive growth strategy to an income preservation one.

ETF Portfolios Can Be Tailored To Client Needs

Because of the broad scope of ETFs, their index tracking capabilities, flexibility and lower expense, a manager can also build portfolios based on a limitless variety of strategies tailored to the client’s needs. For instance, one can focus on an asset class (e.g. Small Cap Portfolio), a sector allocation (based on the weighting in each sector of the S&P 500 Index), or a regional allocation (e.g. International or Pacific Region) to name a few.

An international portfolio can be based on the orientation of country to its major MSCI Index and weighting the portfolio based on the ETF country performance versus the major index.

For example: The major international indexes are the MSCI EAFE Index, and the MSCI Emerging Markets Index. The EAFE Index Countries and Weightings in the Index are:

United Kingdom 23.8%, Japan 23.44%, France 9.44%, Switzerland 7.03%, Germany 7.02%, Australia 5.32%, Spain 4.08%, Netherlands 3.94%, Italy 3.88%, Sweden 2.44%, Hong Kong 1.68%, Finland 1.43%, Belgium 1.31%, Ireland .95%, Singapore .82%, Norway .77%, Denmark .74%, Austria .56%, Greece .45%, Portugal .44%

The Emerging Markets Countries and Weightings in the Index are:

South Korea 16.47%, Taiwan 10.72%, Brazil 10.25%, Russia 9.91%, China 9.81%, South Africa 9.16%, Mexico 7.64%, India 5.49%, Israel 4.01%, Indonesia 2.69%, Thailand 2.50%, Hungary 2.01%, Chile 1.97%, Czech Republic 1.92%, Philippines 1.52%, Turkey 1.02%, Hong Kong .99%, Peru .33%, Egypt .30%, Malaysia .07%

However the returns for each of these countries differ widely. For instance in the EAFE Index the UK is up 26.7% year to date through November 2006, while Japan is up only 2.1%. These are the two highest weighted countries in the index.

On the other hand Singapore is up 38.9% year to date while it is only .82% of the EAFE index. Obviously, by weighting the strong performers higher in the EAFE index one can outperform it.

Asset Allocation

The key to a successful optimum portfolio lies first in the allocation or weightings given to the sectors or asset classes in the portfolio. This is the key to what a successful portfolio manager brings to any portfolio.

With ETFs it is important to select the weightings of the classes in the portfolio without concern of individual stock selection. This allows the portfolio manager to focus on the allocation between classes and concentrate on achieving superior performance in relation to the benchmark used to measure return.

In the case of an international portfolio using the countries of the EAFE Index and the Emerging markets Index, the key to success and risk adjusted optimal performance lies in weighting the countries in the portfolio to out pace the underlying indexes.

Also, the overwhelming benefit of using ETFs in an asset allocated portfolio is the flexibility of changing the allocations without having to sell many stocks. It is only in making a few trades of ETFs that a portfolio can be readjusted and rebalanced at a much lower cost and efficiently.

This same portfolio strategy allows Saddle River Capital Management to build portfolios of any strategy using its research methodology and experience to outperform the benchmarks used to measure performance of the strategy and help each client reach its portfolio goals with a minimum of risk and expense.