We take a closer look at iShares' low-cost suite of portfolio building blocks to find an answer.
Last October, iShares launched its so-called "core" series of ETFs. IShares, and its parent company, BlackRock
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
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
Morningstar's Moderate Allocation category has a total of six funds with a Morningstar Analyst Rating of Gold. Over the past 15 years, the average Sharpe ratio for these funds was 0.45. These funds' current average annual expense ratio is 0.61%. Had the ETFs been available historically, we could have mimicked that performance with just three iShares ETFs for a cost of 0.10%. Of course, the return numbers are net of fees, so the core series did no better than the Gold-rated funds despite the cost advantage.
By Asset Class: U.S. Stock
The broad U.S. stock market is represented by ITOT, which follows the S&P 1500 Index. While iShares calls this a total stock market fund, it's really more of a broad market fund as it excludes most micro-caps as well as a handful of other companies on the basis of S&P's strict index inclusion rules pertaining to domicile, required float, and IPOs. Examples of well-known firms currently excluded from the benchmark include General Motors
Within the iShares core series, the U.S. stock category is further broken along lines of size to include ETFs covering the large-, mid-, and small-cap spectra of the U.S. market. When iShares announced the core series, they cut the expense ratio on iShares Core S&P 500 ETF
Meanwhile, iShares Core S&P Mid-Cap ETF
Finally, small-cap stocks are covered by iShares Core S&P Small-Cap ETF
IXUS is decomposed into a pair of ETFs that track stocks from developed and emerging markets. Unlike the existing and hugely popular iShares MSCI EAFE Index
For investors that want to more closely monitor and manage their interest-rate risk, the taxable bond asset class is further subdivided into two buckets on the basis of duration. IShares Core Long-Term US Bond ETF ILTB and iShares Core Short-Term US Bond ETF ISTB offer more-targeted exposure to different parts of the yield curve. Unlike the indexes that the stock ETFs in the core series follow, these two bond ETFs do not sum up to the broader index tracked by AGG, the Barclays U.S. Aggregate Bond Index. ISTB includes bonds with maturities between one and five years, while ILTB includes bonds with maturities greater than 10 years. In addition, both exclude mortgage-backed securities.
It's Not All Sunshine, Lollipops, and Rainbows
Lower expense ratios are almost always a good thing for investors, so there's a lot to like about iShares' new lineup. However, iShares chose to launch the new iShares Core MSCI Emerging Markets ETF
Additionally, the core series represents just 10 out of iShares lineup of 280 ETFs. We would have liked to see fee reductions on more ETFs, particularly in iShares international and fixed-income lineup. To iShares' credit, more of the ETFs that they have launched recently come with attractive price tags, even in areas with little direct competition. For example, iShares MSCI EAFE Minimum Volatility
It is important to note that cheaper and equally high-quality core funds exist from providers such as Vanguard and Schwab--the same funds whose success, in part, prompted iShares to launch its core series in the first place. Still, the differences in these funds' expense ratios are becoming increasingly small. For example, Schwab U.S. Broad Market ETF SCHB has an annual expense ratio of just 0.04% and Vanguard Total Stock Market ETF