High-Tax Bracket ETF Portfolio
Portfolio Strategy
The High-Tax Bracket ETFdb Portfolio is designed for clients who wish to achieve portfolio growth through diversified market exposure, while also minimizing their tax-burden. Although many investors tend to flock to high-yield dividend funds, individuals already in the high-income tax bracket surely wish to avoid additional income. The portfolio is split between 60% allocation to equities, 35% in fixed income, and 5% in commodities.
With “growth” being the primary goal of this portfolio, heavy allocation to equities is justified. The risk that comes with equity holdings is moderated through international exposure in addition to domestic, as well as diversification among market-caps with regards to the different holdings of the various growth ETFs. The fixed income component of the portfolio serves the clients tax-avoidance needs through investments primarily in municipal bond funds, which are tax-exempt. Minimal commodity exposure provides for the opportunity to capture tremendous growth, given the recent and ongoing rise in commodity prices, while also further diversifying the portfolio as a whole.
This portfolio may be excessively risky for retired investors, but it may also be deemed as being too conservative by younger and more aggressive clients who desire greater international exposure and current-income sources over “tax-saving” features.
- Risk Tolerance: Moderate. Growth companies are typically seen as riskier than value companies, while at the same time the diversification amongst market-caps and countries is a good way to reasonably minimize the risk that comes with holding growth-equities.
- Time Horizon: Moderate. Avoiding tax expenses is key, and the benefits of holding growth stocks come to those with a longer investment horizon.
- Current Income Needs: Low. Since the client is in the high-tax bracket, current income needs are assumed to be low, with growth and tax-savings being primary goals instead.
Portfolio Snapshot
| Ticker | Fund | Asset Class | Allocation | Expense Ratio | Alternative ETFs |
|---|---|---|---|---|---|
| IWF | iShares Russell 1000 Growth | Domestic Equities | 15% | 0.20% | IVW, IWY |
| IWP | iShares Russell Midcap Growth Index | Domestic Equities | 10% | 0.25% | EMG, IJK |
| VBK | Vanguard Small-Cap Growth ETF – DNQ | Domestic Equities | 10% | 0.15% | IWO, PWT |
| EFG | iShares MSCI Growth Index Fund | International Equities | 15% | 0.40% | ADRD |
| EWX | SPDR S&P Emerging Markets Small Cap ETF | International Equities | 10% | 0.65% | ADRE |
| MUB | iShares S&P National Municipal Bond Fund | Municipal Bonds | 25% | 0.25% | BAB |
| HYD | Market Vectors High Yield Municipal Index ET | Municipal Bonds | 10% | 0.35% | BABS |
| LSC | ELEMENTS S&P CTI ETN | Commodity | 5% | 0.75% | BWV |
| Weighted Average Expense Ratio | 0.33% | ||||
Historical Return Analysis
| Ticker | 2008 | 2009 | 2010 | 2011 |
|---|---|---|---|---|
| IWF | -38.3% | 36.8% | 16.5% | 2.3% |
| IWP | -44.5% | 46.3% | 26.1% | -1.9% |
| VBK | -40.4% | 42.8% | 31% | -1.6% |
| EFG | -40.2% | 24.2% | 13.2% | -12.9% |
| EWX | n/a | 94.7% | 23.6% | -30.2% |
| MUB | 1.0% | 7.2% | 0.1% | 13.0% |
| HYD | n/a | n/a | 0.4% | 11.0% |
| LSC | n/a | -12.9% | -7.5% | -15.7% |
| Portfolio | n/a | n/a | 12.2% | -1.4% |
| Compare to SPY | -36.7% | 26.3% | 15.0% | 1.8% |
| Compare to AGG | 7.6% | 3.3% | 6.4% | 7.7% |
The adjacent table provides historical results for each component of this ETFdb Portfolio, as well as backtested results (as available) for the entire portfolio during 2008, 2009, 2010, and 2011. The table also shows how this ETFdb Portfolio performed relative to a popular stock market benchmark (SPY) and bond benchmark (AGG).
Not surprisingly, this ETFdb Portfolio struggled in 2008 amidst a broad market recession. In 2009 and 2010, this ETFdb Portfolio reclaimed much of the ground lost during 2008.
The dismal equity returns during the market slump of 2008 highlights the importance of maintaining even a fairly minimal allocation to fixed income ETFs in this ETFdb Portfolio. Notice how MUB was able to post positive returns during the equity market downturn in 2008 as well as the following years of recovery.
Portfolio Expenses
This ETFdb Portfolio is designed for long-term use consistent with a “buy, hold, and rebalance” strategy. As such, minimization of expenses is necessary to avoid return erosion resulting from compounding costs and capital-gains taxes. To this end, we constructed a portfolio with a weighted-average expense ratio of 33 basis points, which is significantly lower than fees charged by actively-managed mutual funds. The impact of this reduced costs structure over the horizon of this portfolio is significant:
| Growth of $1 Million Over 30 Years @ Annual Return Of: | ||||
|---|---|---|---|---|
| Portfolio | Expense Ratio | 5% | 10% | 15% |
| High Tax Bracket ETFdb Portfolio | 0.33% | $3,932,482 | $15,945,396 | $60,742,740 |
| Actively-Managed Mutual Fund Portfolio | 1.00% | $3,243,398 | $13,267,678 | $50,950,159 |
Holdings Overview
Below is a brief overview of each component of this ETFdb Portfolio.
- IWF: This ETF tracks the Russell 1000 Growth Index, which handles large cap growth equities.
- IWP: This fund tracks the Russell Midcap Growth Index, dealing with mid cap growth equities.
- VBK: This ETF seeks to replicate the performance of the MSCI US Small Cap Growth Index , which allocates its assets in small cap growth equities.
- EFG: This fund tracks the MSCI EAFE Growth Index, by investing in foreign large cap equities that exhibit characteristics of growth companies.
- EWX: This ETF follows the S&P Emerging Markets Under USD2 Billion Index , which covers small-cap emerging markets equities.
- MUB: This bond ETF allocates to national municipal bonds by tracking the S&P National AMT-Free Municipal Bond Index, a broad-based measure to U.S. municipal bonds.
- HYD: This ETF also offers exposure to municipal bonds, focusing on those that offer a higher dividend yield by seeking to replicate the Barclays Capital Municipal Custom High Yield Composite Index.
- LSC: This commodity ETF seeks to replicate the S&P Commodity Trends Indicator – Total Return by applying a long/short strategy to different commodity sectors.
Portfolio Risk Analysis
This ETFdb Portfolio has a moderate risk allocation, with the greatest source of risk being the growth-equity ETFs. Allocation is tilted towards domestic large/mid-cap companies to minimize risk by pursuing stability, while also providing the lucrative return of holding various small/mid-cap emerging market equities.
The emerging markets equity allocations represent the riskiest component of this portfolio, but the volatility is nicely complemented by holding 35% of the total portfolio in fixed income securities. Allocation to municipal bonds helps the client minimize tax-burdens, while also reducing the portfolio’s risk level as a whole, given the historically lower volatility of bonds over equities. Moreover, minimal commodity allocation serves as a great hedge to the entire portfolio, as this asset class is known to be a great diversifying agent. Lastly, the portfolio has no exposure to real estate, as the majority of these ETFs pay out dividends.
Equity Overview
This ETFdb Portfolio contains an allocation of 60% to equities, including domestic and international stocks. The portfolio is well diversified in geographic terms, with domestic equities comprising the majority, while international exposure is still significant. In terms of market cap, roughly half of the companies are giant/large cap; mid-caps comprise just over a third, with small/micro-caps filling in the remainder.
Giant and large cap equities tend to be less volatile than mid cap stocks, but also typically offer less impressive returns. Although correlation amongst growth stocks of all sizes is still relatively high, the inclusion of small and micro cap equities in this portfolio does improve diversification, and also offers exposure to significant growth opportunities.
IWF [Fact Sheet]
As one of the core holdings of this portfolio, IWF, provides exposure to giant/large cap companies within the U.S. equity markets. Holdings of this ETF include Exxon, Apple, IBM, Coca-Cola and a handful of other industry giants, which are truly global firms that generate a significant portion of revenues from domestic operations, but still maintain the capacity to grow overseas. This provides some degree of international diversification, while still relying on the stability that comes with holding domestic large-cap growth companies. The fund has a beta of 0.93, which makes it a good proxy for general U.S. equity market performance, while also boasting a low expense ratio of just 0.20%.
IWP [Fact Sheet]
IWP offers domestic mid-cap exposure to the growth sectors of the U.S. equity market. When comparing returns between IWP, IWF, and the S&P 500 over the last decade, IWP has consistently been the top performer following periods of economic recession. We believe mid-caps offer a unique return profile, given that their historical performances shows that the risk-return trade off can be of a great advantage to portfolios willing to take on moderate levels of risk.
VBK [Fact Sheet]
VBK gives exposure to a universe of mainly small-cap companies within the growth sector of the domestic equity market. Small-cap performance is usually stellar when compared to broad based indexes like the S&P 500, with the key trade off being a higher appetite for risk and usually the patience and ability to hold securities for a longer time. We selected VBK not only because of its growth potential, but also because it provides deep exposure to the small cap equity market by maintaining just over 1,000 individual holdings.
EFG [Fact Sheet]
We selected EFG as a means to gain international exposure, while not entirely subjecting the fund to overwhelming emerging-market risks. The fund tracks a growth index of companies located in European, Australasian, and Far Eastern markets, but is more targeted than popular ETF options such as VEA or EFA. We think this fund is a good choice since investors can gain exposure to foreign markets that have not historically experienced the volatility characteristic of emerging markets. EFG has close to 600 holdings, and 80% are giant/large cap companies, which is essential in ensuring low volatility, given that current economic conditions in European markets are less than ideal considering the ongoing debt crisis.
EWX [Fact Sheet]
The riskiest component within the equity portion of the portfolio is certainly EWX, as the fund tracks growth equities in emerging markets. More specifically, EWX captures the full universe of institutionally investable stocks in developed and emerging markets with float-adjusted market capitalizations of at least $100 million. The top countries in which EWX has equity holdings in are Taiwan, China, South Africa, India, and Brazil. While many investors have a variety of choices when it comes to emerging market exposure, we believe EWX makes for a great fit because the fund is primarily invested in industrial materials and consumer goods companies, which are known to offer unparalleled growth potential, especially in environments where income and urbanization levels are rising.
Most ETF investors seeking emerging markets exposure may gravitate towards funds such as EEM or VWO, which are dominated by large cap holdings. We see EWX as more of a pure play on emerging markets, and as such have elected to achieve exposure to this critical asset class through the small cap fund. Investors seeking more balanced exposure may wish to also use a large cap fund in conjunction with EWX.
Fixed Income Overview
Despite diversification across sizes and geographic regions within the equity component, the majority of the holdings are still quite positively correlated to one another. In order to tame overall volatility and further increase risk-adjusted returns, we have allocated 35% of this ETFdb Portfolio to two fixed income funds: MUB and HYD.
MUB [Fact Sheet]
This ETFdb Portfolio achieves the majority of its fixed income exposure through MUB, which seeks to replicate the performance of the investment grade segment within the U.S. municipal bond market. MUB avoids exposure to high risk debt, such as “junk” bonds, and none of its holdings are rated lower than “BBB”, with the majority being “AA” and “AAA”.
This ETF also focus on holdings with longer duration, in fact, over one third of the holdings have a maturity of 20+ years. MUB has a total of 1,142 holdings, which give it tremendous diversification amongst state and local issuers. Given the moderate risk tolerance of this ETFdb Portfolio, we deemed that a focus on longer-duration holdings with high credit quality would be appropriate.
HYD [Fact Sheet]
In addition to investing in high-quality municipal bonds, this portfolio has also allocated space for riskier fixed-income products. HYD, comprises less than half of the total fixed-income allocation, and it tracks the Barclays Capital Municipal Custom High-Yield Index. The underlying index has a 25% weighting in “BBB” bonds, while the remaining 75% is allocated to non-investment grade bonds. HYD’s holdings primarily offer coupons with yields upwards of 5%, which is considered “high-yield” when compared to MUB, which emphasizes credit-quality and longer-duration instead. This ETF also has just over 100 holdings, and given the nature of its underlying index, it is certainly the highest risk product within the portfolio as a whole.
Overall, this ETFdb Portfolio’s fixed income holdings are dominated by high quality bonds with long duration. Allocation to riskier products is present, however exposure to these “high-yield” instruments is minimal and well diversified in terms of the total fixed-income allocation.
Commodities Overview
Commodities have proven to have a place in nearly every portfolio, they serve as excellent diversifying agents given their low correlation to equity and bonds. This alternative asset-class has attracted tremendous investments given the outlook for rising food and energy prices. Recent political turmoil overseas has further sparked interest in precious metals and crude oil. While commodities can often times be quite volatile, over time they can certainly improve your portfolio’s risk-adjusted returns.
LSC [Fact Sheet]
This ETF tracks the S&P Commodity Trends Indicator Index, which applies long/short strategy to the six commodity sectors spread out across 16 different futures contracts. LSC will either long/short a certain sector each month, based on the price movements over the prior seven months. For example, the fund will long grains when the sector’s current price is equal to or greater than the exponential average of the past seven monthly price inputs. LSC provides “hedge-fund” style commodity exposure, in the sense that it seeks to capture momentum trends, as opposed to simply following an index of commodity prices which is representative of a “buy-and-hold” approach.
LSC makes for a great addition to the portfolio given the essential commodity exposure that it provides, coupled with the funds dynamic nature which sets to capture momentum trends within different commodity sectors.
ETF Correlation Matrix
Diversification is a key component of any client portfolio. The above chart shows the correlation between each component of the High-Tax Bracket ETFdb Portfolio over the last two years.
As expected, there is a fairly strong correlation between the equity components in this ETFdb Portfolio. The fixed income funds of this portfolio add beneficial diversification given their relatively low correlation with equity returns. The commodity exposure from LSC is also a diversifying agent in terms of balancing out volatility from the highly-correlated equity holdings. Overall, this portfolio has a moderate degree of diversification resulting from an attractive mix between equities, bonds, and commodities.
Disclaimer
The information herein is not represented or warranted to be accurate, correct, complete, or timely. Past performance is no guarantee of future results. All investors should read applicable prospectuses before investing.
From time to time, the authors of this report or other employees of ETF Database may have a long or short position in securities referred to herein. The factual statements herein have been taken from sources we believe to be reliable, but such statements are made without any representation as to the accuracy or completeness or otherwise.[/hide]
iShares Russell 1000 Growth
ETF Database is not an investment advisor, and any content published by ETF Database does not constitute individual investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. From time to time, issuers of exchange-traded products mentioned herein may place paid advertisements with ETF Database. All content on ETF Database is produced independently of any advertising relationships. Read the full disclaimer here.
