Popular Benchmarks May Not Be Best Portfolio Building Blocks

By Ron DeLegge, Editor

May 28, 2008

SAN DIEGO (ETFguide.com) - Unbeknownst to many investors, the mutual funds and exchange-traded funds (ETFs) following major stock and bond benchmarks may not necessarily be the best building blocks for an investment portfolio.

Why?

Part of the problem is that most of these barometers were never intended to be investments. As a result, some benchmarks are incomplete, may be using outdated weighting techniques, or off-beat methods for selecting stock holdings.

Let’s take a closer look.

Dow Jones Industrials

This barometer is the most concentrated of the three major stock benchmarks in the U.S. It contains just thirty stocks including some of America’s best known companies, like Coca-Cola, Microsoft and Wal-Mart.

Problem: As a price-weighted measure, weird things happen with the Dow. For example, the roughly $18 stock price of General Motors (Ticker: GM) gets almost the same weighting as Pfizer (Ticker: PFE) even though GM’s market capitalization is just under $10 billion compared to Pfizer’s $130 billion. There’s no doubting that GM is important, but its economic influence by market size is considerably less compared to Pfizer and other Dow components even though the Dow Industrials don’t say so.

Better: Trying owning a total stock market ETF like (Ticker: VTI), (Ticker: TMW), or (Ticker: IWV) which all have exposure to large, mid, and small cap stocks in one handsome package. And here’s something else you’ll like: These funds follow more broadly diversified benchmarks that even include all of the Dow’s thirty stocks!

S&P 500

Owning 500 stocks, this popular domestic stock index is broader than the Dow Jones Industrials and Nasdaq-100, but still has some missing parts.

Problem: While it contains mostly large company stocks and a few mid caps, the S&P 500 omits stocks with a small capitalization or market size.

Better: Trying owning a total market ETF like (Ticker: VTI), (Ticker: TMW), or (Ticker: IWV) which has exposure to large, mid, and small cap stocks. If you already own an S&P 500 index mutual fund or ETF, be sure to compliment it with exposure to mid cap stocks (Ticker: MDY) and small caps (Ticker: VB).

Lehman Aggregate Bond Index

This is Lehman’s broadest measure of the investment-grade taxable U.S. bond market, including most Treasury, agency, corporate, mortgage-backed, asset-backed, and international dollar-denominated issues.

Problem: Even though this may be Lehman's most comprehensive bond index, it’s still far from complete. It lacks exposure to high yield debt, non-dollar denominated foreign bonds and TIPS.

Better: If you already have exposure to the Lehman Aggregate via an index mutual fund or ETF, compliment it by owning TIPS (Ticker: TIP) or (Ticker: IPE), international TIPS (Ticker: WIP), international treasuries (Ticker: BWX), and high yield debt (Ticker: HYG) or (Ticker: JNK). Also, if you’re in a high tax bracket, don’t forget about the tax free income benefits of municipal bond ETFs.

Don’t be fooled: Even though certain stock and bond benchmarks may be popular in the financial media or with investors, doesn’t necessarily make them the best portfolio building blocks.

Make it your aim to build a truly diversified portfolio that represents an entire market versus just one piece of the market.

And if you can’t find one ETF to do the job, use multiple non-overlapping funds to get the job done.

You can do it!

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