Many investors are shifting their allegiance from mutual funds to ETFs. ETFs offer more transparency and, almost always, lower fees than mutual funds.
The question for the thinking investor is how to combine ETFs to build a portfolio that makes sense – meaning, one that has the best chance of achieving the returns you want, with a level of risk you can stand. Wealthfront recently created a slide show presentation, which we show to various companies around Silicon Valley through our seminar program, offering a primer in how to use Modern Portfolio Theory to combine ETFs. We hope that watching it helps you put your own diversified portfolio together, or enables you to ask an investment advisor better questions.
The slide show complements our whitepaper on our investing strategy.
A couple of notes on Modern Portfolio Theory – which most individual investors have heard of, but few have taken the time to understand. Many institutional investors – the Yale Endowments of the world — base their investing strategies on Modern Portfolio Theory. Harry Markowitz introduced the theory in 1952, and in 1990 shared the Nobel Prize in Economics for its development with Merton Miller and William Sharpe, who, along with Wealthfront’s co-founder Andy Rachleff, is a faculty member at Stanford Graduate School of Business.
There has been a lot of work around Modern Portfolio Theory, but basically put, the theory prescribes combining asset classes that have different return, risk and correlation characteristics rather than choosing particular stocks or securities to maximize returns for any level of risk.
Wealthfront uses the Black Litterman model to estimate the inputs that need to be fed into a mean-variance optimization framework to find the ideal mixture of asset classes for each level of risk. The model is freely available through open source, although you must have at your disposal the data and a software development team that knows how to make it useable. (On another Nobel note, one of the creators of the Black Litterman model was Fischer Black, best known as the co-author of the Black Scholes option pricing model. Mr. Black died too soon to receive the Nobel for his work on the de facto standard for pricing all options; Myron Scholes accepted the prize in 1997. Robert Litterman was Mr. Fischer’s collaborator on the Black Litterman model.)
You might be wondering why we’ve taken so much time to build a slide show that shows you how to construct your own diversified portfolio. Wealthfront offers an online financial advisor service that implements Modern Portfolio Theory and offers continuous monitoring and periodic rebalancing for an advisory fee well below what traditional financial advisors charge- our fee is 0.25% of your assets, with the first $25,000 free.
Our platform never naps, never goes on vacation. We continuously monitor your portfolio and rebalance your investments when necessary, taking known tax implications and trading costs into consideration. Our goal is to ensure the optimal return based on your profile.
We’re building our business with an open-source approach. If you want to become a client, great. If not, we’re happy to help you go do it yourself using our website, our online tools and the information on our blog.
Good luck, and please let us know what you think of us!
About the author(s)
Journalist Elizabeth MacBride is Wealthfront's editor. Her work has appeared in Crain's New York, Advertising Age, the Washington Post and the Christian Science Monitor, among other publications. View all posts by Elizabeth MacBride