Just How 'Core' Is iShares' 'Core' Series of ETFs?

Last October, iShares launched its so-called "core" series of ETFs. IShares, and its parent company, BlackRock BLK, have long been well-regarded by institutional investors and financial advisors. However, the firm has been less successful with individual investors, as evidenced by years of market share losses to Vanguard. The launch of the iShares "core" series is part of a broader push by BlackRock and iShares to boost brand recognition among individual investors. But what's the result? Is this just a marketing gimmick, or has iShares created a truly useful set of "core" portfolio building blocks?

What Constitutes a Solid 'Core'?
Most investors' portfolios tend to follow either a strategic or tactical asset-allocation approach, or some combination of the two. The strategic approach is rooted in the efficient markets hypothesis, which suggests that investors weight all assets by their market capitalization and attempt to achieve optimal diversification. Investors' strategic asset allocations will differ on the basis of risk tolerance and income needs. On the other hand, tactical asset allocation allows for the selective overweighting (or underweighting) of certain asset classes or securities that are expected to outperform (or underperform). A portfolio employing a tactical asset allocation will look different than the market portfolio, and different tactical investors will hold different portfolios depending on their market outlook.

Ideal strategic "core" portfolios give broadly diversified exposure to an entire asset class. Highly correlated securities with similar risk and return characteristics are grouped together to eliminate idiosyncratic risks. Index inclusion rules should be liberal. The idea here is to hold the entire market. Turnover should be very low. For stocks, we want to own the entire market from mega-cap to micro-cap. Good fixed-income and commodity indexes can be harder to find, but our options are better today than ever before. These funds should allow us to "set and forget," meaning that the exposure they provide today will be stable over time. Whereas active portfolio managers may "drift" as they feel conditions warrant, a good "core" index fund, by definition, does not stray from its stated objective. Perhaps most importantly, the costs of a solid "core" portfolio should be extremely low.

The Core 10
How does iShares' "core" series measure up against the criteria outlined above? It comes pretty close to the ideal. The core series includes 10 ETFs covering three broad asset classes: United States stocks, international stocks, and taxable bonds. The indexes these funds follow are comprehensive, each holding over a thousand securities. While the stock funds exclude micro-caps, this is a very small omission as micro-caps make up only about 2% of the equity market. Meanwhile, the bond funds exclude Treasury Inflation-Protected Securities and high-yield and international bonds. These omissions reflect the construction of the Barclays Aggregate Bond Index, the most commonly used bond benchmark. S&P, MSCI, and Barclays provide the indexes for the core series. Each offers stable exposure to their target asset class and are among the highest-quality indexes available. Finally, all of these funds are extremely low-cost, charging annual expense ratios ranging from 0.07% to 0.18%.

If You Build It...
As the "core" in their names implies, investors can build a fairly comprehensive and well-diversified portfolio using just three of these ETFs. Such a portfolio could be comprised of iShares Core S&P Total US Stock Market ETF ITOT (30% allocation), iShares Core MSCI Total International Stock ETF IXUS (30% allocation), and iShares Core Total US Bond Market ETF AGG (40% allocation). The resulting 60/40 stocks/bonds portfolio would have a weighted average expense ratio of just 0.10%.

Using historical index data for these funds, this hypothetical portfolio, rebalanced annually, would have returned 6.5% per year over the past 15 years with a Sharpe ratio of 0.44. Using index data ignores the 0.10% expense ratio and costs of rebalancing, but these should be small compared with the total return. The Sharpe ratio is a risk-adjusted return measure that penalizes returns for volatility. The smoother the ride, the more likely you are to stick with your investment plan and ultimately experience returns more reflective of the averages detailed above.

With a 60% allocation to stocks and 40% allocation to bonds, this model portfolio would fall squarely into Morningstar's Moderate Allocation category. Looking at its historical performance, our hypothetical portfolio has fared pretty well when compared with actively managed funds in the category that have a Morningstar Analyst Rating of Gold, such as T. Rowe Price Capital Appreciation PRWCX, Dodge & Cox Balanced DODBX, and Vanguard Wellington VWELX.