Examining An ETF Strategy For Your U.S. Equity Exposure
Summary Reviewing several ETFs with exposure primarily to the U.S. equity space to see which combination will produce the highest risk-adjusted returns. I have used a mixture of large, mid, and small cap ETFs to get broad exposure to the U.S. stock market. Using fifteen years of historical data, I believe increasing exposure to a smaller-cap ETF will produce higher long-term risk-adjusted returns. With Christmas just around the corner, many investors begin their focus on asset allocation and reviewing their portfolios. It has been a turbulent year for global equities with many different macro events affecting returns throughout the world. With the recent economic news coming out of the U.S., specifically the Friday jobs report and the imminent rate hike from the Fed later in December, I’ve turned my focus onto the U.S. equity space to ensure my exposure to this market is balanced, poised for long-term growth, and well-diversified in terms of sectors. For the purposes of this article, I have narrowed down my selection of ETFs to include those that are simply focused on different market capitalizations within the U.S. equity space. That means I have eliminated funds that may be dividend-focused, value/growth focused, sector-specific, or other specialty funds. I’ve done this to keep my analysis simple and ensure I get as broad and diversified as possible. Once I narrowed it down my list, I had three broad categories – Large Cap, Mid Cap, and Small Cap – as defined by the fund companies themselves. Next, I wanted to focus on just a few from each category to see which performed better. For the Large Cap ETFs, I chose the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ). For the Mid Cap space, I chose the iShares Core S&P MidCap ETF (NYSEARCA: IJH ) as well as the SPDR S&P MidCap 400 ETF (NYSEARCA: MDY ). Finally, for the Small Caps I only had one fund that had enough historical data to do the simulation, so I chose the iShares Core S&P Small-Cap ETF (NYSEARCA: IJR ). Timing When I was narrowing down my list of ETFs, I wanted to ensure they have been active long enough to see some of the more significant events of the last decade and a half. That way, the results would capture the tech bubble, the financial crisis, as well as the bull markets that accompanied them. Since most of the iShares ETFs were launched in May 2000, I chose to begin my analysis on July 1, 2000. SPY data by YCharts Assumptions All the daily share price data was pulled from Yahoo! Finance and I used the adjusted close price for all of my analysis. In addition, I used the 3-month treasury bill rates from the Federal Reserve website for each calendar year to calculate excess returns and risk-adjusted returns. Finally, I pulled the most recent MER information for each fund from Yahoo! Finance as well and reduced each year’s gross returns by that percentage before calculated the excess return information. Analysis Below is the summary of each of the five funds performance over the 15 years of data. To make my analysis easier, I used the last trading day of each year to calculate the yearly portfolio return to compare against the risk-free rate. (click to enlarge) Sources: Yahoo! Finance, Federal Reserve website As can be seen above, the small cap fund IJR offers the highest risk-adjusted return profile of the five funds I analyzed. Furthermore, you should note that as you move from the large cap funds of SPY and DIA to the mid-caps and then small, both absolute and risk-adjusted returns become stronger. I found this to be quite interesting as typically smaller cap funds comparatively have higher risk profiles. Since I wouldn’t recommend having all your U.S. equity exposure in one fund, I calculated some hypothetical portfolios with different weights for each of the three categories. From the data above, I also was able to narrow down which fund to use for each category; DIA for the Large Cap, IJH for Mid Cap and IJR for Small Cap. I also used $10,000 as a starting investment for each portfolio. Portfolio #1 – One third (1/3) invested in each of the three funds Portfolio #2 – 50% invested in the small cap, 25% in the others Portfolio #3 – 50% invested in the large cap, 25% in the others I found it quite interesting, although not surprising, just how much stronger the performance was on portfolio #2, which had 50% invested in the small cap ETF and ultimately how it also offered the strongest Sharpe Ratio. Overall, portfolio #2 outperformed the “standard” portfolio #1 by over 4.3% and the large-cap focused #3 by almost 12%. I also wanted to look at the sector breakdown of each fund to see if there was a significant difference in the three portfolios based on how the funds would be split up. As you can see below, there is some variance in the sector breakdown of each fund as you move from the large to small caps as well as with each portfolios’ hypothetical breakdown, but there is nothing overly significant to note. Most of the funds keep a relatively similar balance in the sectors with the exception of Real Estate which has zero exposure in the DIA. Conclusion I’ve always been well aware of the fact that, over longer periods of time, small cap stocks will tend to outperform large caps. For the most part, I was always of the impression that this higher return came with higher risk. However, after doing this analysis and seeing the results I would be inclined to increase my overall U.S. equity exposure to smaller cap companies as I am looking to hold onto this portfolio for an extended period of time. This sort of analysis is something I will continue to do each year to ensure if there are significant changes in the performance and risk profile of each fund that I capture them and adjust my investments accordingly.