However they do it, investors need to think clearly about risk to construct solid ETF portfolios.
This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features James Breech, president and chief executive officer of Toronto-based Cougar Global Investments.
ETFs are just about the ideal tools for portfolio managers. In particular, ETFs that track indexes with a long enough history to calculate probability distributions and correlations are perfect for portfolio construction.
At Cougar Global, we strongly believe constructing a portfolio of ETFs is the most appropriate investment discipline for investors and their advisors.
But there’s a lot that can go wrong in portfolio construction, and much of that has to do with how investors and advisors think about risk.
Broadly, there are two main approaches to portfolio management, both rooted in advanced financial economic theory and research—modern and postmodern portfolio theory.
Firstly, Harry Markowitz won a Nobel Prize for his research and publications regarding modern portfolio theory.
Markowitz’s breakthrough insight is that an efficient set of investments performs in accordance with the investor’s objectives by achieving the maximum expected return for the level of risk the investor is willing to tolerate.
To be sure, constructing a portfolio that will perform in accordance with the investor’s return goals and risk tolerance requires specialized expertise in portfolio construction.
Otherwise, one ends up with an inefficient basket of various securities—ETFs for the purposes of this discussion—that does not achieve the investor’s objective of return for an acceptable level of risk.
Beware Of ‘Diworsification’
My view is that a basket of supposedly diverse ETFs more often than not fails the test of being a portfolio.
This is what I call a “diworsified” basket of ETFs. My advice to ETF investors goes without saying, but I’ll say it anyway: Avoid “diworsifed” baskets of ETFs.
Whether one constructs a portfolio using modern portfolio theory and mean/variance optimization, or postmodern portfolio theory that optimizes expected return for a given level of downside risk requires clear thinking.
The key point is that calculating probability distributions, means, variances and correlations requires a higher degree of investment sophistication than simply tossing a bunch of ETFs into a basket.
It also requires a thoughtful understanding of what “risk” means.