ETFs for the Forgotten Asset Classes

As ETFs have become increasingly popular among more active traders in recent years, it may be easy to forget that the vehicle was originally designed with the long-term buy-and-holder in mind. For those who take stock in the numerous academic studies indicating that active management generally destroys value over the long haul, cost-efficient vehicles that own the market have obvious appeal over pricey funds that attempt to beat it. While ETFs are now components of sophisticated and short-term trading strategies, they remain as critical portfolio building blocks of retirement portfolios and other longer-term investment objectives [see also ETF Alternatives to the World's Largest Mutual Funds].

The immediate diversification and broad scope of many of the ETFs ideal for construction of long-term, buy-and-hold portfolios has greatly simplified the asset allocation process; a portfolio offering exposure to various asset classes and thousands of individual securities can now be constructed with only a handful of ETFs. But some all-ETF portfolios may not be as well rounded as they first seem, as many of the most popular ETFs overlook asset classes that may add valuable return enhancement and diversification benefits. Consider the following all-ETF portfolio, constructed using just six ETFs:

Ticker ETF Weighting Exp. Ratio
(NYSE: SCHB  ) Schwab Broad Market ETF 30% 0.06%
(NYSE: VWO  ) Emerging Markets Index Fund 15% 0.27%
(NYSE: VEA  ) Europe Pacific ETF 15% 0.16%
(NYSE: AGG  ) Barclays Capital Aggregate Bond ETF 30% 0.24%
(NYSE: DBC  ) PowerShares DB Commodity Index 5% 0.75%
(NYSE: RWO  ) Global Real Estate ETF 5% 0.50%

At first glance, the portfolio outlined above appears to be perfect for a cost-conscious investor with a long-term focus. The six-ETF portfolio includes exposure to all major asset classes, including small-, mid-, and large-cap U.S. equities (through SCHB), emerging markets (VWO), ex-U.S.-developed markets (VEA), and fixed income (AGG). Minor allocations to global real estate and commodities round out the fund, which has an effective expense ratio of less than 20 basis points.

For a buy-and-holder focused on avoiding what Vanguard founder Jack Bogle once called the "tyranny of compounded costs," this portfolio may appear to be a thing of beauty. But upon further review, there are a few holes in this all-ETF asset allocation strategy. If your portfolio is similar to the one outlined above, there are some overlooked asset classes that might be worth a closer look.

Canada
Canada is one of the world's ten largest economies, but many investors have little or no "Northern Exposure" in their portfolios. The EAFE region, one of the most popular ways to access developed markets outside the U.S., focuses on stocks in the European, Australasian, and Far East markets. Canada obviously doesn't fall into any of those regions, and as such doesn't make its way into portfolios of those who rely on EFA or VEA for international developed markets exposure.

Along with Australia, Canada is home to one of the most commodity-intensive developed economies in the world, making it a potentially important component of a truly diversified portfolio. Canada's large natural gas and oil reserves make it one of the few net exporters of energy outside of South America or the Middle East. Boasting the second largest oil reserves on the globe, Canada is also the leading producer of zinc and uranium. And Canada is more than just a commodity-intensive economy; the country is home to some of the most stable financial institutions in the developed world [see Do You Need a Canada ETF?].

ETF Options: For investors looking to add exposure to Canadian equities, there are two primary ETF options. The iShares MSCI Canada Index Fund (NYSE: EWC  ) focuses primarily on large-cap stocks, while the IQ Canada Small Cap ETF (NYSE: CNDA  ) invests in small-cap Canadian companies. While both of these companies offer exposure to the same economy, the composition of the two is quite different. EWC is tilted towards banks, a common bias in cap-weighted international funds. CNDA, on the other hand, has major allocations to the materials sector, potentially making it a better "pure play" on the resource rich Canadian economy.

Frontier Markets
Emerging markets have received increasingly large allocations in recent years thanks to the widening "growth gap" relative to developed markets. While interest in the BRIC economies has surged (as well as interest in quasi-developed markets such as Taiwan and South Korea), investors have been slow to embrace ETFs offering exposure to the world's frontier markets. A frontier market is defined as "pre-emerging," meaning it may face political instability, poor liquidity, inadequate regulation, substandard financial reporting and large currency fluctuations. Because of these attributes, many of these investments are pegged as excessively risky. But while frontier markets probably shouldn't make up a huge chunk of a portfolio, a minor allocation may be able to add both diversification and return enhancement.

Many of today's frontier markets are currently in the position that China was in 50 years ago: facing tremendous obstacles, but showing potential for tremendous economic expansion. Though the possibility exists that a market will never be able to climb above the frontier level, many frontier markets are on their way up thanks to favorable demographic shifts and increased availability to foreign capital. Moreover, some frontier market economies simply have lower market caps and less liquidity, and are not necessarily a huge gamble as an investment [see also Why Frontier Market ETFs Are Not as Risky as You Might Think].

ETF Options: In the world of frontier markets, there are two primary ETF options available. The Guggenheim Frontier Markets ETF (NYSE: FRN  ) tracks markets that classified as "frontier" based on GDP growth, per capita income growth, inflation rates, privatization of infrastructure, and social inequalities. FRN tends to focus its assets on the financial sectors of these up-and-coming markets. There is also the PowerShares MENA Frontier Countries Portfolio (PMNA), which seeks to invest in specific frontier economies like Egypt, Lebanon, Qatar, and United Arab Emirates.

Junk Bonds
Most investors view funds in the Total Bond Market ETFdb Category (including AGG) as "one stop shops" for fixed income exposure. And while these ETFs include debt from a variety of issuers and across different maturities, they focus only on investment grade securities. That includes Treasuries, debt issued by agencies of the U.S. government, and corporate debt that is rated above a certain threshold. Not included, however, are high-yield bonds, debt securities deemed to exhibit both greater yield potential and greater risk of default than investment grade counterparts. With interest rates at record lows -- and projected to stay there for the foreseeable future -- junk bonds can allow yield-hungry to enhance the current portion of their return.

Of course, the holdings of these funds are called "junk bonds" for a reason; they come with their fair share of risk. Nearly all of the credit qualities in these funds lies in "BB" territory or below, generally indicating that the chances of defaults are far higher. Taking the obvious risks into account, these funds still have the potential to be a valuable addition to the fixed income component of a portfolio [see Investors Can’t Get Enough Of Junk Bond ETFs].

ETF Options: In the world of junk bond ETFs, there are a handful of options available to investors. The largest fund by total assets is the iShares iBoxx $ HY Corp Bond Fund (NYSE: HYG  ) , while the SPDR Barclays Capital High Yield Bond ETF (NYSE: JNK  ) is also a popular choice. An alternative to funds linked to market value-weighted benchmarks is the Fundamental High Yield Corporate Bond Portfolio (NYSE: PHB  ) from PowerShares. This ETF replicates the RAFI High Yield Bond Index, which is constructed using a methodology that considers fundamental measures of firm size, not just the amount of debt outstanding [see PHB: A Different Kind of Junk Bond ETF].

International Bonds
In recent years, investors have expanded exposure to international equities, shedding their "home country bias" to increase allocations to emerging markets and other non-U.S. stocks. An equity portfolio lacking international exposure is considered to be dangerously incomplete, yet when it comes to fixed income many investors are completely lacking allocations beyond U.S. borders. Foreign bonds are an under-utilized asset class that often boast higher yields than comparable U.S. securities, and can add diversification benefits as well. Moreover, foreign bonds can perform well when the U.S. dollar struggles (assuming, of course, that the debt is denominated in local currencies) [see International Bond ETFs to Diversify Fixed Income Exposure].

ETF Options: There are several options for investors looking to add a little geographic diversity to their fixed income portfolios. The International Government Bonds ETFdb Category, which includes four different funds, includes primarily debt issued by governments in developed markets. The Emerging Markets Bonds ETFdb Category also includes four ETFs, all of which obviously target debt from issuers in emerging markets. This group includes both funds that invest in dollar-denominated debt and those that focus on issuances denominated in the local currency of the issuer.

Small-Cap International Stocks
A domestic equity allocation consisting entirely of the S&P exposure and lacking any allocation to small or mid cap equities would hardly be considered a well-rounded portfolio. Yet when it comes to international equity exposure, many investors seemingly have no problem settling for large cap exposure and overlooking the smaller companies in both developed and emerging markets. That can result in a big hole in a portfolio, especially since small cap international equities often feature risk/return profiles that are very different from their large-cap counterparts.

Many international equity ETFs, such as EFA and EEM, are dominated by mega-cap equities. This group tends to include multi-national firms that do business all over the world, not just in the country their stock is primarily listed or where headquarters are located. Moreover, many of these large cap-heavy funds have a heavy tilt towards the energy and financial sectors, while underweighting consumer and health-care companies.

Small-cap international funds may offer more of a "pure play" on local economies, as smaller firms generally depend more heavily on local consumption and demographics to drive growth. Moreover, adding small-cap funds to a portfolio can help to diversify sector exposure away from banks and oil companies, providing a more complete representation of the market [see Playing the Emerging Markets Through Small Cap ETFs].

ETF Options: There are a number of ETFs offering exposure to small-cap equities, including about a dozen country-specific or region-specific options [use the ETF Screener to identify]. For investors looking to maintain a simple portfolio, there are a couple of broad-based options that may be appealing. The SPDR S&P Emerging Markets Small Cap ETF (NYSE: EWX  ) tracks an index that offers exposure to a number of small firms based in emerging markets, while the iShares MSCI EAFE Small Cap (NYSE: SCZ  ) measures the performance of small-cap stocks in European, Australasian, and Far Eastern markets. EWX can be thought of as a complement to EEM or VWO, rounding out emerging markets exposure. Likewise, SCZ can be used in conjunction with EFA or VEA to ensure that investors have more complete access to developed markets outside the U.S.

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Disclosure: Photo courtesy of Ricardo Liberato. No positions at time of writing.

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