Investment strategy of the SmallTrades ETF Portfolio

February 14, 2014

An index ETF is designed to capture the investment returns from a financial market.  The SmallTrades ETF Portfolio (“Portfolio”) uses index ETFs to invest in several financial markets.  The goal of the Portfolio is to earn returns at a faster rate than possible by investing in risk-free bonds or the broad market of U.S. stocks, thereby ensuring that the accumulation of returns outpaces the inflation of prices in the American economy.  Success is measured by the following benchmark indices:

Investment strategy

The Portfolio is a high-risk, high-return investment in ETFs that duplicate well-established market indices for global stocks, U.S. bonds, U.S. real estate investment trusts, and gold bullion.  Twenty five percent of the portfolio’s market value is allocated to each index.  The ETFs generate at least 99% of the portfolio’s value and any remaining value is stored in a money market fund.  The ETFs will be held indefinitely except when faced with the advantage of replacing one with a more suitable ETF for the same index.

Table of holdings

ETF trading symbol Market Allocation
 AGG   U.S. bonds 25%
 GLD   Gold bullion 12.5%
 SGOL     Gold bullion 12.5%
 VNQ     U.S. real estate investment trusts 25%
 VT  Global stocks 25%

Expected return

Unfortunately there is no 50-100 year history of ETF performance that enables the forecast of an expected return.  To compensate for this limitation, two models were used to test the allocation plan shown in the table of holdings.  In one model of the 15-year recovery from the 1997 Asian Financial Crisis, the allocation plan outperformed the U.S. stock market.  In the other model of the 5-year recovery from the 2008 Global Financial Crisis, the allocation plan underperformed the U.S. stock market.  Among both time periods, the lowest return of the model portfolio was 8.5%.

  • MARKETS portfolio of financial-market returns from 1997 to 2011: The global-stocks market was simulated by a mixture of 75% U.S. large capitalization stocks and 25% emerging markets stocks.  Trading and management fees were excluded from the model.  The annualized return of the portfolio was 8.5% in comparison to the 5.7% annualized return of U.S. large capitalization stocks.
  • ETF portfolio of historical prices from 2008-2013: Trading fees, but not management fees, were included in the calculations (– management fees are charged in the primary market before ETFs are listed in the stock market).  The annualized return of the portfolio was 10.9% in comparison to the 17.8% annualized return of SPY, an ETF that tracks the Standard & Poor’s 500 Total Return.

Risk management

The holding period will be at least 5 years.  Fluctuation in market prices is the main risk of investing in index ETFs.  The likelihood of incurring a loss from a declining market decreases as the length of the holding period increases (– e.g., the risk of loss from stocks and bonds declines by 50% as the length of the holding period increases from 1 to 5 years; and, the risk declines by 80% when the holding period is extended to 10 years (1)).

The Portfolio will be rebalanced as needed to maintain the allocation plan within an acceptable limit of 28% error.  The Portfolio is concentrated in 4 markets and losses may occur when one or several markets decline.  The 25% allocation plan assigns equal weightings to each financial market in order to smooth the effect of market declines.  After accounting for trading fees, the strategy of rebalancing a large allocation error is more cost-effective than using a rebalancing schedule.

The Portfolio holdings are investable, have established reputations, charge low management fees, and are safely structured.  Although there’s no guarantee that the index ETFs will sustain their historical performance, the stock market, bond market, and real estate market ETFs provide diversified investments in underlying assets.  The risk of investing in these ETFs is lower than the risk of investing in an underlying asset.  Gold bullion ETFs are non-diversified investments in the volatile gold market.  Gold bullion is theoretically susceptible to physical damage by theft or fire.  This risk is diminished by investing in two funds, GLD and SGOL, that store the bullion in separate vaults located in London and Lucerne.

The investor’s tax burden can be reduced by holding these index ETFs in a tax-deferred retirement account.

Copyright © 2013 Douglas R. Knight


1.           James B. Cloonan, A lifetime strategy for investing.  American Association of Individual Investors, Chicago, 201

ETF risk, investment strategy

June 20, 2012


ETFs rely on a market index for the development of an investment strategy and standard of performance.  The standard of performance is measured as an annual percentage change in index value.  The ETF investment goal is a statement of the desired performance of the fund’s portfolio relative to the performance of the market index.  Investment strategy is the fund’s stated plan for achieving its investment goal.  Most ETFs use the investment strategy of physical replication.

Physical replication (passive management)

Most ETFs are index funds that seek to match the performance of a securities market index by the process of passive management.  Passive management attempts to earn a return equal to the index performance, less fund expenses, by investing in equities or bonds.  Tracking error is used to grade how closely the fund matches its index.  The ideal tracking error is 0, but an acceptable tracking error is 0.25%/year.  One risk of index funds is the volatility of share prices in parallel with fluctuations of the market index1,2.

Physical replication involves SECURITY REPLICATION or SECURITY SAMPLING of the market index.

  • SECURITY REPLICATION is used to acquire every security listed in the market index in proportion to a weighting factor3.  The fund’s tracking error is expected to be minimal.
  • SECURITY SAMPLING does not acquire every security listed in the market index; instead, managers choose a representative sample of the market index.  Sampling is used when thousands of different securities in the index (some of which are likely illiquid) make replication impractical if not impossible.  Managers must adjust the sampling process to minimize tracking error2,3.

Derivative replication

DERIVATIVE REPLICATION (‘synthetic’ replication) involves investing in derivatives to match the performance of a commodities index.  Managers of synthetic ETFs use a proprietary model to invest in futures, asset swaps, options, and other derivatives.  Beware of synthetic ETFs (called ETNs) that purchase contracts or notes which guarantee payment of the total return of an index from a counterparty bank.  The bank supplies collateral that might be illiquid assets unrelated to the investment goal of the fund.  The documents of the synthetic ETF should disclose this strategy and the type of collateral supplied by the counterparty bank.  DERIVATIVE REPLICATION incurs the risks of counterparty default and acquisition of illiquid collateral assets1,4,5,7.

Inverse strategy

The INVERSE STRATEGY seeks the opposite performance of a market index.  For example, the successful inverse fund achieves a 10% increase in value when its market index declines by 10%, or a 10% decrease in value when the index rises by 10%4.  Purchasing an inverse index fund can yield profits from a declining market by shorting the market or buying derivatives.  Shorting the market means to sell borrowed stocks and repurchase them later at a lower price.  The profit is the price difference between sale and purchase2.

Leverage strategy

The LEVERAGE STRATEGY uses debt to increase investment performance.  Leveraged ETFs (so-called geared funds) seek to multiply the performance of a market index by a stated numerical factor.  For example, the successful 2X leveraged fund achieves a 20% increase in value when its index increases by 10%.  Likewise, the 2X leveraged-inverse fund seeks a 20% increase in value when its index decreases by 10%.  The borrowed money is used to buy financial assets in anticipation that the return from purchased assets exceeds the cost of the loan.  Otherwise, the fund will underperform the market.  The best case for a leveraged fund is when interest rates decline (i.e., lower cost of borrowing) and the stock market rises (i.e., higher return).  The worst case for a leveraged fund is when the stock market declines and interest rates rise.  The fund manager of a leveraged-inverse fund borrows money to purchase extra assets when the market is declining2.

Leveraged funds are risky and leveraged-inverse funds are extremely risky2,4,6,7 for two reasons:  1) the investor risks a magnified loss.  2) Leveraged ETFs are designed for day trading, not for longer holding periods.  The risk of a compounding loss increases with holding a leveraged ETF beyond one day.

Active management

Only a few ETFs (e.g., some bond funds) seek to outperform the market index by process of ACTIVE MANAGEMENT.  The active manager neither replicates nor samples an index to match its performance, but instead creates a unique mix of investments to satisfy the investment objective8.  The risk of ACTIVE MANAGEMENT is a failure to outperform the market based on inherent inability to accurately predict the future.  Poor predictions and selections of assets lead to under-performance of the market2.

Copyright © 2012 Douglas R. Knight


1.  BIS Working Papers No 343: Market structures and systemic risks of Exchange-traded funds. Srichander Ramaswamy, Monetary and Economic Department of the Bank for International Settlements, April, 2011.

2.  All About Index Funds, second edition.  Richard A. Ferri, CFA. McGraw Hill, 2007

3.  Investment Company Factbook, 50th Edition, A Review of Trends and Activity in the Investment Company Industry. Investment Company Institute, 2010.

4.  Potential financial stability issues arising from recent trends in Exchange-Traded Funds (ETFs).  Financial Stability Board, 12 April 2011.

5.  Exchange-traded funds: A good idea in danger of going bad. The reckless expansion of “synthetic” funds requires a few new rules, June 23rd 2011, The Economist.

6.  SEC Looks Into Effect of ETFs on Market, Scott Patterson, Wall Street Journal, September 7, 2011.

7.  Exchange-Traded Funds: Too much of a good thing. The risks created by complicating a simple idea, June 23rd 2011, The Economist .

8.  2012 Investment Company Factbook, 52nd Edition. Investment Company Institute, 2012.

Buy ‘low’ and sell ‘high’, and other AXIOMS

April 16, 2012

[updated on 11/21/2013 with additional text; on 7/30/2014 with a counterargument; updated on 10/18/2016 with additional text and revised title]

AXIOM #1: Markets are a human necessity.  corollary:  There will always be a volatile stock market.

AXIOM #2: The most basic stock-investment strategy is to buy shares at a discount price and sell them at a premium price.  In other words, buy ‘low’ and sell ‘high’.  corollary:  Buy shares that are in ‘low demand’ and sell those in ‘high demand’.  The share price will increase with demand.  This is the fundamental principle of “Contrarian” investing.

AXIOM #3:  Good companies attract investors.

AXIOM #4:  Good companies reward investors.

Capitalism 101:  Companies sell common shares of stock to raise money for their businesses.  Investors buy the stocks in order to share the business profits.  The first-generation investors are venture capitalists in the primary market who aim to resell their shares to second-generation investors in the secondary market.  Second-generation investors hope to earn dividends from the company’s profits and capital gains from stock sales in the marketplace.  Capital gains are earned by selling stocks at a higher value than the total cost of purchase.  The stock market price is governed by forces of supply-and-demand.

After the companies are financed, why should they care about the shareholders? Because common shareholders are beneficial owners who have the right to 1) vote on issues of governance, 2) seek rewards, and 3) seek damages.  Shareholders also provide a measure of crowd-protection from hostile takeover of the company.

Good companies reward investors by paying dividends and/or raising the value of tradable shares (e.g., issuing stock splits, repurchasing shares, growing the business).  These rewards are endangered by stock price fluctuations, declining business profits, corporate greed, and additional uncertainties.


The buy ‘low’ and sell ‘high’ strategy is difficult to practice in times of financial panic when investors lose interest and tend to pull out of plunging markets.  At the very moment when their prospect for future returns is highest, investors are out of the market 1,2.


  1. Buttonwood: No easy answers | The conundrum of asset allocation. Jul 19th 2014. The Economist
  2. William Bernstein, Rational Expectations: Asset Allocation for Investing Adults.   2014.

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