A lot of people believe that diversification helps reduce non-market risk for a security and they build portfolios of assets in order to avoid “putting all eggs in one basket”. Intermediate-level and sophisticated investors usually tend to do their own security analyses and select assets in accordance with their strategies (e.g. value or growth stocks). I have also noticed that a lot of writers on various web resources who specialize in building portfolios for specific purposes tend to wisely use fundamental analysis for security selection but do not pay enough attention to portfolio composition with respect to risk/reward considerations.

I am not a mathematician myself but I have had significant exposure to intermediate statistics at university and I know Excel quite well. Hence, I decided to use my skills to optimize a portfolio of securities with respect to certain constrains and investment goals. First of all, I limited the number of securities to 17. Quite many mutual funds and ETFs do hold more that this number (usually about 25-30 or even more depending on the size and scope of the fund) but academic research has shown that the benefits of adding another security to a portfolio that already holds about 15 assets are negligible (marginal utility reduces dramatically after a certain threshold has been reached). The following illustration summarizes this theory:

Secondly, I decided to use ETFs and closed-end funds traded on the exchange as the components of my portfolio. This enables me to reach a “second-degree” diversification as these products are well-diversified themselves. The first criterion for the selected securities was that they must have been in existence for at least 10 years. This allowed me to assess their behavior over the full business cycle as well as see how they did during the financial crisis of 2008-2009. From a technical point of view, a larger sample (in this case, years) provides a more reliable output. Secondly, when such a list of ETFs or funds was available, I chose the ones that had the highest current yield and a sizeable capitalization (hundreds of millions of dollars at least). StockRover served as my screener for the most part.

The results of the structuring were remarkable: the portfolio yielded a small alpha over the broader S&P 500 at comparable volatility, while providing a decent dividend yield of roughly 4%. The weighted-average beta was below the market:

To remind, beta is the volatility relative to the overall market, while a portfolio’s volatility is the standard deviation of returns with respect to itself. For optimization purposes, I used expected portfolio returns equal to weighted-average returns on assets within the portfolio: it makes sense to value recent returns higher than the returns at the inception of a fund.

Holdings

The portfolio holds funds invested in international equity markets, US equity markets, high-yield debt, emerging markets debt, corporate debt (mainly US corporations), precious metals, and US sovereign debt. More than half of the funds are invested in international markets (equity and debt). High-yield debt, while bearing the most volatility, provides the lion’s share of the portfolio’s dividends. Precious metals serve as a hedge during market downturns on par with US Treasurys. Despite expected volatility, the portfolio in fact has had an insignificantly higher volatility of returns than S&P 500, while delivering alpha in 8 years out of the last eleven. This can be partially explained by the fact that assets held are uncorrelated among each other (see Covariance Matrix in the model). Now let us have an overview of the holdings.

iShares MSCI Hong Kong Index Fund (ETF)

The exchange-traded fund invests in the Hong Kong market and yields a 3.0% dividend yield. It has a beta of 0.98 and a market capitalization of about $2.3B. The fund’s advisor is Blackrock Fund Advisors.

iShares MSCI Emerging Markets Index (ETF)

The fund invests in global emerging markets and has a modest 2.13% dividend yield. The fund’s beta is 1.29. This holding has the biggest market capitalization among other holdings in the portfolio: $38.2B. The ETF did very well during the recovery period but has been slagging during the last two years. The fund’s advisor is Blackrock Fund Advisors.

iShares MSCI South Africa Index (ETF)

The ETF’s investment geography is South Africa. The dividend yield provided by the fund is 2.58%, while the beta is 1.27. The market capitalization stands at a little over $500M. Morgan Stanley Capital International reviews the South African Index in which the ETF holds a representative sample. The fund’s advisor is Blackrock Fund Advisors.

iShares MSCI Belgium Investable Market(ETF)

The fund invests in publicly-traded securities in the Belgian market (covering 99% of the investable securities) seeking price and yield performance. The current dividend yield is 4.62%. The fund’s beta is 1.13 and the market capitalization is a little over $67M. The fund’s advisor is Blackrock Fund Advisors.

iShares MSCI EAFE Index Fund (ETF)

The exchange-traded fund invests in MSCI EAFE Index developed by MSCI Inc. The Index holds stocks from Europe, Australasia, and Far East. The fund invests in a representative sample of stocks held in the Index. The market cap of the fund is above $53B. The fund yields 2.54% as of yesterday and has a beta of 1.2. The fund’s advisor is Blackrock Fund Advisors.

iShares MSCI Germany Index Fund (ETF)

The fund seeks to provide investment returns based on the MSCI Germany Index, which measures the performance of the equity market in Germany. The fund has one of the lowest yields in our portfolio: 1.37%. The market cap is 6.34B, while the fund’s beta is 1.58 (one of the highest in group). Clearly, this fund in weighted towards capital appreciation. The fund’s advisor is Blackrock Fund Advisors.

iShares MSCI Mexico Inv. Mt. Index. (ETF)

The fund invests in the same stocks as the MSCI Mexico IMI 25/50 Index. The market capitalization is almost $2.6B and the fund’s beta is 1.34 (one of the highest in group). The dividend yield is a modest 2.01%. The fund’s advisor is Blackrock Fund Advisors.

iShares Barclays 20+ Year Treasury Bond (ETF)

The fund tracks the investment returns of an index composed of US Treasurys with maturities exceeding 20+ years. The ETF has a market cap of $2.3B and a dividend yield of 3.18%. It has a negative beta of -0.35. This means that for a 1% increase in the broad equity market the ETF is expected to decrease in price by 0.35%. The fund has a negative covariance with the entire portfolio and was one of the few ones that delivered positive returns in 2008 and 2011. BlackRock Fund Advisors serves as investment adviser of the Fund.