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Popular Benchmarks May Not Be Best Portfolio Building Blocks

Popular Benchmarks May Not Be Best Portfolio Building Blocks

By Ron DeLegge, Editor

May 28, 2008

 

SAN DIEGO (ETFguide.com) - Unbeknownst to many investors, the mutual funds and exchange-traded funds (ETFs) following major stock and bond benchmarks may not necessarily be the best building blocks for an investment portfolio.

 

Why?

 

Part of the problem is that most of these barometers were never intended to be investments. As a result, some benchmarks are incomplete, may be using outdated weighting techniques, or off-beat methods for selecting stock holdings.

 

Letís take a closer look.

 

Dow Jones Industrials

This barometer is the most concentrated of the three major stock benchmarks in the U.S. It contains just thirty stocks including some of Americaís best known companies, like Coca-Cola, Microsoft and Wal-Mart.

 

Problem: As a price-weighted measure, weird things happen with the Dow. For example, the roughly $18 stock price of General Motors (Ticker: GM) gets almost the same weighting as Pfizer (Ticker: PFE) even though GMís market capitalization is just under $10 billion compared to Pfizerís $130 billion. Thereís no doubting that GM is important, but its economic influence by market size is considerably less compared to Pfizer and other Dow components even though the Dow Industrials donít say so.

 

Better: Trying owning a total stock market ETF like (Ticker: VTI), (Ticker: TMW), or (Ticker: IWV) which all have exposure to large, mid, and small cap stocks in one handsome package. And hereís something else youíll like: These funds follow more broadly diversified benchmarks that even include all of the Dowís thirty stocks!

 

S&P 500

Owning 500 stocks, this popular domestic stock index is broader than the Dow Jones Industrials and Nasdaq-100, but still has some missing parts.

 

Problem: While it contains mostly large company stocks and a few mid caps, the S&P 500 omits stocks with a small capitalization or market size.

 

Better: Trying owning a total market ETF like (Ticker: VTI), (Ticker: TMW), or (Ticker: IWV) which has exposure to large, mid, and small cap stocks. If you already own an S&P 500 index mutual fund or ETF, be sure to compliment it with exposure to mid cap stocks (Ticker: MDY) and small caps (Ticker: VB).

 

Lehman Aggregate Bond Index

This is Lehmanís broadest measure of the investment-grade taxable U.S. bond market, including most Treasury, agency, corporate, mortgage-backed, asset-backed, and international dollar-denominated issues.

 

Problem: Even though this may be Lehman's most comprehensive bond index, itís still far from complete. It lacks exposure to high yield debt, non-dollar denominated foreign bonds and TIPS.

 

Better: If you already have exposure to the Lehman Aggregate via an index mutual fund or ETF, compliment it by owning TIPS (Ticker: TIP) or (Ticker: IPE), international TIPS (Ticker: WIP), international treasuries (Ticker: BWX), and high yield debt (Ticker: HYG) or (Ticker: JNK). Also, if youíre in a high tax bracket, donít forget about the tax free income benefits of municipal bond ETFs.

 

Donít be fooled: Even though certain stock and bond benchmarks may be popular in the financial media or with investors, doesnít necessarily make them the best portfolio building blocks.

 

Make it your aim to build a truly diversified portfolio that represents an entire market versus just one piece of the market.

 

And if you canít find one ETF to do the job, use multiple non-overlapping funds to get the job done.

 

You can do it!

 

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