Having read through the book, “A Random Walk Down Wall Street”, by Burton Malkiel, I am convinced that one of the best ways to achieve a long-term diversified portfolio would be to invest via index-tracking funds.
That said, I have to say that if you are willing to put some time to do some research and homework on the stock market, you will be able to find the diamond in the rough. However, the chance of Joe Regular is being able to get strike gold and find tomorrow’s Apple Inc. or Amazon.com Inc. can be relatively low.
Besides, for an investor to beat the benchmark index, be it the KLCI, S&P 500, the Dow Jones Industrial, the Hang Seng Index, etc., Mr. Investor will probably need to devote at least 36-48 hours per week to research.
Even with the work done, there is still the likelihood that the portfolio may not beat the market ALL the time. That fact alone convinces me that the best course of action for MOST investors will be to have their CORE asset base invested in index-tracking funds.
Over the long-run, even seasoned professionals such as Benjamin Graham, Peter Lynch and Warren Buffett agree that index-tracking fund is the best investment option for the man on the street.
For more insight into this interesting subject, I would definitely recommend you the book I mentioned, “The Time-Tested Strategy for Successful Investing: A Random Walk Down Wall Street”.
Now, let’s get started with the basics for constructing a cost effective global investment portfolio.
Global Portfolio – The Main Purpose
As we all know, a global portfolio is probably the best way for us to diversify our investment because it gives the investment a better opportunity and potential to grow by tapping in to the economic growth beyond our shores.
The main reason for this thought is the fact that economies around the world, although co-related, have different cycles of growth. By diversifying globally, you will also give yourself the opportunity to increase your investment’s return without and not risk depending solely on one country’s economy stability.
To illustrate, imagine if ALL your investments are focused in the SE Asia market in early 1996. Regardless of the quality of the domestic company you invested in, your investment is 100% exposed to the risk and economic uncertainties of one region while the rest of the world such as Europe and US recovered and chugged along to further growth.
Investing globally also gives you the opportunity to tap into the high growth emerging market economies such as Brazil, Russia, India and China (also known as BRIC).
Of course, there is the remote probability of a global meltdown; if that happens, the flight to quality / safety will normally means capital flight to developed market’s capital such as treasury bills and bonds offered by Western European countries and USA.
With a globally diversified portfolio, a portion your investments will be sheltered (or may even buck the downtrend) from a total portfolio meltdown, as opposed to a 100% disintegration if you had invested 100% domestically.
Global Portfolio Construction – the Primer Components
To construct a portfolio of stocks that covers the world over based on a typical man’s payroll is virtually impossible. After all, how can you invest in the economy of every single country in the world? Even Mr. B Gates will very likely have some trouble doing it.
So, how can D Joe Regularis achieve his objective of “GLOBAL DOMINATION” !!! … err (must have got a bit too excited there),… I meant, global diversification without having to become as rich as Mr. Gates? The answer – Exchange Traded Funds (ETFs) and/or Mutual Funds.
A Mutual Fund is an investment vehicle comprising of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market securities and similar assets.
One of the main advantages of a mutual fund is that it gives small investors access to a well-diversified portfolio of equities, bonds and other securities, which would be quite difficult to create with a small amount of capital. Each shareholder participates proportionally in the gain or loss of the fund.
Mutual fund units or shares, are issued and can typically be purchased or redeemed at the fund’s latest net asset value per share, which is calculated at the end of regular business day.
The mutual and/or unit trust funds issued by the domestic financial institutions include PB Mutual’s PB Funds, Affin Funds, CIMB, etc.
Exchange Traded Fund (ETF)
A typical ETF is definted as a security that tracks an index, a commodity or a basket of assets like a mutual fund, but trades like a stock on a listed exchange.
Unlike a Mutual fund, however, an ETF does not have its net asset value (NAV) calculated every day. As it is traded on a listed exchange, you don’t have to wait until the end of the day for a NAV get that sale order you processed.
By owning an ETF, you get the diversification of an index or mutual fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund.
The only downside, you will need to pay a broker commission on any ETFs you trade on, just like trading on a common stock.
Given the choice of using either a Mutual Fund or ETF to construct my portfolio, I would normally have a preference to ETF as my choice first.
Expense Ratio – Why It Matters?
The expense ratio is the measure of what it costs an investment vehicle to operate. It is determined through an annualized calculation, with the fund’s operating expenses divided by the average dollar value of its assets.
A fund’s operating expense typically include recordkeeping, custodial services, taxes, legal expenses, and accounting and auditing fees, with the largest component relating to investment management fee. Some funds will have a marketing cost, also known as 12b-1 fee, which is included as operating expenses.
All in, operating expense is a charge to the investment fund’s asset base and over time, it lowers the investor’s return; the higher the expense ratio, the more of a drag it will be on the investor’s return on capital over time. So, what is a typical operating expense ratio of an investment fund?
Operating Expense – the Domestic Take
Here’s some food for thought – the operating expenditure for the Malaysia EPF is 2.37% (source: 2006 annual report). How do I get the number? Group-level Operating Expenditure on pg 165 of RM$688,586 divide by (Group-level) Member’s Fund on pg 164 of RM$289,452,716. If you use the EPF-level, you will very likely get an operating expense ratio of 1.60%.
If you are curious how much the EPF is making for its members, here’s the weblink to the website, which is pretty well-constructed: http://www.kwsp.gov.my/
For financial information, please navigate into the Financial Statements section within the “About EPF” domain. Being curious, I also took a quick look at the expense ratio of the Public Mutual fund group (link: http://www.publicmutual.com.my/).
Looking at the numbers, I guess it’s typical for the domestic fund managers to fetch a nice 1.60% p.a. on the average asset under management.
So, the question at hand – how much you are willing to pay for the professional portfolio manager’s investment management expertise? In a nutshell, I believe the domestic investor is willing to incur no more than 1.60% p.a. on his/her capital to generate a suitable premium return over the regular (risk-free) fixed deposit return at the local bank.
Global Portfolio Construction – Assembling the Components
Without further ado, let’s see what a typical investment portfolio that spreads and diversify your investment risk and yet, gives you the opportunity to partake in the bountiful economic growth all over the world.
I have constructed a fairly aggressive global-oriented portfolio consisting of 7 (ViPER) ETFs from the Vanguard Investment Group; it comprises:
VEU – Vanguard FTSE All-World ex-US ETF (15%)
VGK – Vanguard European ETF (10%)
VWO – Vanguard Emerging Markets Stock ETF (15%)
VV – Vanguard (US) Large Cap ETF (20%)
VO – Vanguard (US) Mid Cap ETF (15%)
VB – Vanguard (US) Small Cap ETF (10%)
VXF – Vanguard (US) Extended Market Index ETF (15%)
The above portfolio will provide the investor with a 60% / 40% US / Rest of World exposure. Depending on the risk-appetite of the individual investor, the % in Emerging Market or Rest of World ex-US can be increased at the expense of the US market exposure.
And by back-testing the portfolio all the way back to Jan 2 this year, the portfolio mix seems to have provide Joe Regular a YTD (year-to-date) return of approx. 14.5% thus far (Oct, 25, 2007), outperforming the Dow Jones Industrial and S&P 500 by at least 2% points so far.
The only index that could have beaten it thus far is the US Nasdaq 100 which has been on fire lately. Alternatively, if you are more into US-based Growth-oriented, you can opt for the Growth variety of the Mid-Cap and Small-Cap ETFs, which are represented by the ticker symbols VOT (Vanguard Mid-Cap Growth) and VBK (Vanguard Small-Cap Growth).
I chose the Vanguard ETFs only as an example. If you do some research, you will see more ETF providers ETF which caters to various investment profiles. Even with only 7 (equity-focused) ETFs to work with, you can see as illustrated how versatile the world of ETF can be for an investor to work with.
The main reason I opt for the ViPERs in this example is their expense ratio, which is very low – less than 0.5% p.a.!
The US Small, Mid and Large cap ETFs have expense ratios of 0.1% to 0.13% p.a. whereas the emerging markets and international funds charges on average of 0.2% to 0.5%! And as you can see, there are many combinations for an investor to tailor his/her portfolio in relations to his/her appetite for risk.
Compare that to the expense ratio of 1.6% p.a. charged by most domestic mutual / unit trust funds – you should at least give try and take the opportunity to let part of your investment portfolio participate in the global growth.
And by the way, there are even ETFs out there that track security types (bonds or bank debts, anyone?), commodity markets, and even lets you short the major stock index such as DJ S&P 500 (?!), and much, much more!
The possibilities to use ETFs as a tool to improve your investment return are endless and can be used in many ways to broaden your investment reach.
Hopefully, the introduction to the versatility and opportunities of ETF as an investment diversification tool will spur you to look at the various ETF resource centre on the finance website within Yahoo! Finance or MSN Finance that you can use to find out more about this useful investment tool.
So, go out there and explore the variety of investment options available to you with this investment instruments alone.
Until the next time, invest well and enjoy.