Searching for Optimal ETF Portfolios

Other Tools

Another comprehensive portfolio tool is called the AllocationADVISOR from Zephyr. This software program allows advisors to dynamically allocate assets among various asset classes using either classic mean variance optimization or the sophisticated Black-Litterman model to build portfolio efficient frontiers using any of over 50,000 supplied indices. Since most ETFs are index linked, plugging them into portfolio models is a natural step. 

Other features of the AllocationADVISOR system include the ability to compare an existing or proposed portfolio to alternative portfolio allocations along with estimating the probability of meeting a client’s investment goals with the Monte Carlo simulation module. Reports can be created with graphs and tables that can be exported to Microsoft Word, Excel, PowerPoint or Adobe PDF. 

The Tax Factor 

Selecting the right ETFs along with the right asset mix aren’t the only chores in building optimal portfolios. Conscientious financial advisors are wise to spend effort in determining good “asset location.”

Asset location can be defined as the deliberate step of strategically placing ETP investments in taxable and tax-deferred accounts with the goal of reducing the investor’s tax liabilities.

Smart asset allocation, for example, involves holding tax inefficient assets like bonds and REITs inside tax-deferred accounts like 401(k) plans and IRAs. Why? Since the majority returns delivered from bonds and REITs is from dividend income, they’re subjected to potentially less favorable ordinary income tax rates. And that’s where “asset location” saves the day! It minimizes the burden of paying annual income taxes on dividends coming from these sources. What about equity ETFs? Because most index based stock ETFs are tax-efficient, the optimally designed portfolio can hold them in taxable brokerage accounts. These types of ETFs have low portfolio turnover and the trading activity of other shareholders does not negative affect buy-and-hold investors. Furthermore, the unique redemption/creation process of ETFs allows fund managers to pass capital gains to institutional investors that redeem creation units, thereby eliminating capital gains distributions at the end of the year for ETF shareholders. 

Time Constraints

While constructing optimal ETF portfolios for clients is important, it shouldn’t be an all-consuming exercise. Savvy advisors understand this and for that reason have taken steps to deliver high quality solutions in an efficient manner. This may include hand crafting ready-made or pre-designed ETF portfolios. 

“I’ve built 8 ETF models which give me an accurate idea of risk/return parameters for each portfolio,” says Kirk Kinder, CFP with Picket Fence Financial in Bel Air, Md. Kinder then evaluates what amount of market exposure that each client should have based upon their investment objectives. “Once I have the percentage of asset classes I then screen and select appropriate ETFs.” From there, Kinder customizes each ETF model to specifically match the client. 

Using carefully pre-designed ETF models and adapting them to each clients’ needs can save time and energy. This isn’t to say customized portfolios built from scratch can’t be optimal. They can be, but efficiency, in the name of portfolio customization, should not be sacrificed. 

Conclusion

Building optimal ETF portfolios begins with a good foundation. Develop a framework that works for you. The next step is to use the array of financial tools available to help you execute. Work with the tools that streamline your efforts. And finally, pay special attention to smart asset location. When combined with asset allocation, it will minimize taxes and maximize gains. And the end result will be optimal ETF portfolios.