Sometimes, more can be a little too much. That extra glass of wine or slice of pizza. The 400th season of Real Housewives of Orange County.
Sometimes, there’s no way around it: more is better. Especially if it means you could get more bang for your buck. Not in a bargain basement “why did I buy all this stuff I don’t need” way, I’m talking about lower taxes, money that could last longer in retirement. You know, stuff you really care about.
Well, drumroll, please...Ellevest uses 21 different asset classes across our goal-based investment portfolios, which is more than most other digital advisors. Having more asset classes gives us more options for building you a balanced portfolio. And it may help protect your portfolio from curveballs that can come your way while you’re investing: market downturns and, in some cases, inflation.
Our Chief Investment Officer Sylvia Kwan, in collaboration with Morningstar Investment Management, LLC, selected these 21 asset classes after serious research. In this third behind-the-scenes look at Ellevest’s take on investing (here are parts 1 and 2), we’re diving into these asset classes and how we use them to build you low-cost, diversified, goal-based portfolios.
Why 21 Matters
Ok, let’s start with the basics. What do we mean when we say we use 21 asset classes? Think of it this way: We have 21 different groups of investments to choose from when we’re building your investment portfolio. Each asset class has its own risk/return profile — some are high-risk and may offer high returns; others are low-risk with lower return potential. And since they all have different risk and return characteristics, we expect them to perform differently in the market at any given point in time.
We don’t use all 21 asset classes in each investment portfolio. But because we have so many available to us, we can be more selective and only choose asset classes that we believe give you a better chance of reaching your specific goal.
Here are two real-world examples of how we use our asset classes. If you’re investing for a down payment on a home in six years, we think you should be invested in a low-to-moderate risk investment portfolio since it’s a relatively short-term goal. We’d put together a portfolio that’s exposed to asset classes with those risk and return characteristics.
On the other hand, if you’re decades away from retiring, we believe that you can afford higher risk early on because it’s likely that you will have enough time to weather any downturns that come your way. Your portfolio would then have exposure to asset classes with higher risk and return potential.
Portfolio Anatomy 101
Now onto what’s actually inside your portfolio. Unless you have an emergency fund — in which case, your portfolio is 100% cash (and fee-free) because you should take on ZERO risk with it — your Ellevest portfolio is made up of exchange traded funds (ETFs).
An ETF is a basket of investments — think stocks, bonds, real estate, gold, etc. — that is similar to a mutual fund but trades like a stock. ETFs are pretty popular these days, and they’re relatively inexpensive investing vehicles. They’re often cheaper than actively managed mutual funds, which, on average, have fees ranging from 0.13% to 0.77%. The management fees for ETFs in an Ellevest portfolio range from 0.10% to 0.15% of assets.
By the way, we didn’t choose the 21 ETFs we consider for each Ellevest portfolio simply because their management fees are low. Yes, saving on expenses is important. If you’re spending 0.68% in fees on a mutual fund, that’s going to eat into your returns significantly over the next couple of decades. But we look for ETFs that are the least expensive in terms of overall costs, so that means taking into account more than just management fees. We do the extra work of factoring in the fees and costs associated with trading to get a more complete picture of how much you’ll actually end up paying for each ETF.
And while low fees are great, that’s not the only reason why we like ETFs. Investing in ETFs exposes you to more diversification than stock picking, though it takes some thought and research to create a truly diversified portfolio. (This matters...you’ll see how we do this for you below.)
How Your Portfolio Gets Its ETFs
You could probably spend a couple of days or weeks researching how to invest in ETFs online and come up with a list that looks good in your portfolio. But creating a truly customized investment portfolio, especially one that’s constructed with an eye toward helping you reach a specific goal, involves more than simply picking ETFs.
For starters, there’s determining the best tax scenario for your investments. This way, more of your money goes toward that dream home, or that restaurant you always wanted to open, or a retirement so epic it would make “Present You” jealous — and less of it goes to Uncle Sam.
We do this for you by putting investments with less favorable tax treatment — such as a corporate bond ETF — into a tax-deferred account like a traditional IRA. Corporate bond ETFs often pay out interest in monthly dividends that are taxed at a higher rate than realized gains. Placing that ETF in an IRA delays when you have to pay those taxes, giving your money more time to grow without taxes eating into it.
Building an investment portfolio is also about choosing ETFs that work together to maximize your returns while taking on the amount of risk you can afford given your goal and timeline. Which brings us to...
The Big Picture: Diversification & Asset Allocation
You know the saying, “Don’t put all your eggs in one basket”? Asset allocation is the same idea wrapped in finance lingo. Basically, you don’t want to put all of your money into one type of investment — stocks, bonds, etc. — because if that investment class tanks, it will hit you much harder than it would if only part of your money were in that investment. And if the market does well, you’ll miss out on gains from other investments since all of your money will be wrapped up in one place.
Diversification takes asset allocation to the next level by making sure your portfolio is composed of assorted investments that behave differently in various market conditions. Why? Because this is the best way to maximize your returns while protecting your portfolio — as much as possible — from the uncertainty of the future. Let’s say there’s a market-moving event that causes a specific group of investments to drop sharply. If you have a truly diversified portfolio, the impact of that event should vary across your investments because you’re exposed to a wider cross-section of the market.
Let’s look at a couple of different scenarios to see how diversification can play out. Take two hypothetical portfolios courtesy of Morningstar: both are 45% stocks and 55% bonds, though one is diversified across 19 asset classes and the other isn’t. According to analysis, the diversified portfolio outperformed the non-diversified portfolio by 19% between 1980 and 2014. When you shorten that timeframe to the ‘90s, the diversified portfolio still outperformed — though just barely after underperforming in 1998. If you look at the 2000–2009 window (and factor in the 2008 financial crisis), the diversified portfolio outperformed the non-diversified portfolio by 27%.
Not bad at all. But here’s a kicker: The diversified portfolio outperformed the non-diversified portfolio around two-thirds of the time between 2000 and 2015.
We think that having 21 asset classes to pull from gives us a leg up when it comes to diversification. Take your retirement goal, for instance. Because we believe global real estate investment trusts (REITs), commodities, and Treasury inflation-protected securities (TIPS) have the potential to protect your money’s purchasing power from rising prices, we can include them in your portfolio to help you prepare for inflation. (Some digital advisors don’t even offer the first two asset classes.) You may not care much about inflation protection now, but trust us — it matters a lot when you’re at peak Blanche Devereux-time and need to get the maximum value out of your retirement savings.
And there you have it. Now you know why we have 21 asset classes — plus some of the thoughts that were running through Sylvia’s head when she chose them — and how we pick your ETFs.