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Under the Hood of Our Hands-On and Hands-Free Portfolios

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. It's ETF Investing Week on Morningstar.com, and today we're checking in with Morningstar ETF expert Paul Justice, he's the director of North American research, to find out how Morningstar ETFInvestor's portfolios are positioned.

Thanks for joining me, Paul.

Paul Justice: Thanks for having me.

Stipp: So, you folks run a newsletter, an investment newsletter, called ETFInvestor. You have two model portfolios in that newsletter, real-money portfolios: One is called the Hands-Free and one is called the Hands-On.

Before we get into how they're positioned, can you explain what is the difference between these two portfolios and what they're meant to accomplish?

Justice: Well, I think this is a case where the name actually indicates a lot of what they do. You think of the Hands-Free Portfolio, this is something that we intend to hold most of the things in there forever. This is a very passive portfolio where we're constructing an asset allocation, giving people ideas of products that they can use passively for the long-haul to make sure that they're getting the most of the ETF market. And using ETFs passively, you're really capitalizing on the low cost and tax efficiency of ETFs. So, we help you choose the ETFs that will give you the proper exposure, mainly on a market cap basis, that's going to help you over the longer haul if indexing is something that you subscribe to.

Stipp: Would you say that that's more of a strategic portfolio, so kind of an asset allocation and not necessarily trying to take advantage of inefficiencies in the market, but just have a good allocation and get set and let it go?

Justice: Exactly. We're not making any tactical bets in there ... Well, there are some slight ones in there whenever we think that there is something that's really out of whack in the market. But for the most part, we don't want to over-think the situation in this portfolio. This is something that somebody who really wants to only look at their portfolio maybe once a year, this is something that they could consider, do some annual rebalancing, consider their own asset allocation and then let it reap.

Stipp: What kind of time horizon are you guys looking at for that particular portfolio?

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Justice: Forever.

Stipp: Okay.

Justice: So, I think this is a philosophy that you really have to buy into, and it's been very effective for people over a long period of time. Be realistic in your ability to assess whether or not the market is over or undervalued, or which sections are, and then on the flip side, the timing to get out; it's very challenging. Professionals work really hard at doing this, and the good ones can maybe bat 60%. So, I think it's a good strategy for someone who can give themselves a realistic assessment.

Stipp: Okay. So, let's turn to talk a little bit about the Hands-On Portfolio. I can kind of guess what you might do in that portfolio based on the name, but can you explain the details there?

Justice: Sure. This is a more tactical portfolio, and what we're really doing here is leveraging all the vast resources that Morningstar has to make a lot of our investment decisions. One advantage that we have is, we do have about 80 equity analysts upstairs from us who are covering 1,600 stocks. We accumulate a lot of their data to help us assess whether a certain sector or certain targeted ETF is over or undervalued. So, that's one of the things that we're considering there. We're not limited to that data point, but it's something we focus on a lot, and it's something that really no other provider has the breadth and depth to do. So, we think that's a key differentiator for us.

We borrow a lot of the research that they do, assess it in our own way in looking at ETF structures, and then make recommendations on a tactical basis. Now, most of the time, our holdings there are going to be targeted for about one to two years. Sometimes, we'll do trades faster if our ideas work out, but we really want to really focus also on the practicality of having a tax-efficient portfolio as well.

Stipp: So, let's dig into the portfolios a little bit, learn a little bit about the actual holdings in those two portfolios.

So, the first one, the Hands-Free portfolio, how is that positioned? What kind of investor might you recommend such an portfolio for? What's the asset allocation and your outlook for that?

Justice: Okay. Let me start with the asset allocation piece first, because that's going to be different for everyone. I don't want anybody to just look at our portfolios and say, "that's the right answer for me," because it's probably not. But what you can do with our portfolios, look at it and say, "okay, these are the component pieces to which I can complement my own asset allocation" and build on it that way.

Now, how we're positioned today? You can imagine we're basically more market-cap passive on our equity side. We do have a slight value tilt and a slight large-cap tilt compared to the market at this point in time. We recently took some small-cap bets off the table in our rebalancing. But on our fixed-income side, it's where it gets a little bit different. A lot of people look for maybe--even though most people look and say, "oh, 40% bonds might be a good idea for me," and they will use only one fund for that, we've broken that out into four components.

What we did was we looked at the Bar Cap Aggregate Bond Index, and we believe that there is just not a lot of upside value in intermediate-term government bonds. So, we've really taken that component out of that index entirely and built up our bond portfolio around investment-grade corporate debt, mortgage-backed securities, and two inflation-protected ETFs as well, one internationally-based and one domestically-based. And TIP and WIP are the tickers for those, and that really makes up about 30% of our bond allocation in there.

So, we feel like we've got some shielding from inflation and also would kind of mitigate the impact of some rising interest rates. Finally, we got some gold in there to help complement it. We have no price projection on gold, but we think that it works well in an asset allocation context.

Stipp: So, given your take on the government Treasuries, you are in good company. Bill Gross also told us this week similar bearish take on the Treasuries. So, certainly, you are in good company on that front.

Can you talk a little bit about any recent changes that you made in that portfolio? You mentioned a few things about tilting toward value and toward large cap. Any notable buys or sells?

Justice: Well, this is a buy and hold strategy and we always say, you're missing a word when you say that; it's really buy, hold, rebalance and rebalance is the key.

Some of our recent trades were to help neutralize how large small-cap stocks and mid-cap stocks had gotten in the portfolio given the great run that they had had. So we sold out some of that, got it back into the larger, value side of the ledger and also we evened up our equity-to-bond mix.

Stipp: So, the rebalancing is kind of a tactical-light approach. It's kind of done on the calendar but you are actually saying, okay, this has run up, we're going to take some of those profits, put it back into something that maybe hasn't run up as much and has more potential looking forward?

Justice: Yeah, our rebalancing policy is, try to do it annually unless something is way out of whack, then just take care of it.

Stipp: Okay. So, let's move on to the Hands-On Portfolio so we can get a sense of some of the more tactical decisions that you folks have been making recently. How is that portfolio positioned right now?

Justice: Right now, if you look at it from a style basis, we do have a large-cap value tilt in there, very intentionally done. We feel that small caps have gotten quite rich and also that growth just isn't priced right, right now. So, we're seeing better value in value. We've done so through some broad funds, broadly diversified funds that are focusing on the value side and giant-cap stocks. That's part of the component that we have there.

Now, if we look at it through a sector lens and slice it up that way, really our two major overweights right now are going to be in the health-care space and in the financials space. In the health care, we actually own a medical devices ETF and a global health-care ETF, and we're very comfortable with those positions being our largest overweight right now.

We also within the last six months got into the financial sector; we feel like that there is some significant earnings potential there, and we did sell out of financials back in the summer of 2008. So, we felt very comfortable leaving it at that point in time, but it's a different situation today. So, we're more comfortable with that as well.

Our most recent trades where we took advantage of oil prices; we sold out of our energy ETF just last month, and I feel very good about that decision and instead, we put those funds back to work by buying an industrials ETF. So, now we have some exposure where we feel that there is actually some earnings potential growth in the U.S., specifically, because our fund is targeted within the U.S.

Stipp: Well, Paul, sounds like some really interesting ideas for ETF investors. Thanks for joining me today.

Justice: Thank you.

Stipp: You can also learn more about the ETFInvestor newsletter by downloading a free trial issue. And thanks for joining me today. I'm Jason Stipp for Morningstar.