How to build a portfolio with core funds

A few months ago, FlexShares released its Morningstar U.S. Market Factor Tilt Index ETF (TILT). The fund falls under the header of core funds, as it has exposure to the broad domestic stock market. However, it's different from traditional total stock market funds in that it tilts the portfolio to small-cap and value stocks, which have historically provided higher returns than their large-cap and growth counterparts. As these products become more common, I thought it would be helpful to look at how these funds are structured, and how you can use them in a well-diversified portfolio.

First, let's look at how many investors build portfolios with total stock market funds. It's important to keep in mind that the composition of these funds is based on market-cap weighting. So while there are far more small-cap stocks than there are large-cap stocks, a total market fund might have only about 10 percent of its holdings in small caps and about 20 percent in value stocks. This means that investors who desire to have greater exposure to small-cap and value stocks could use a total stock market fund as the "core" of the portfolio, and then add the appropriate amounts of a small-cap fund, and large and small value funds as well.

Benefits of tilted core funds

Using tilted core funds, such as TILT or the core funds of Dimensional Fund Advisors, investors can reduce (or even eliminate) the need for such diversification across other funds, while providing significant benefits. If you use a single fund, there are two main benefits: lower transaction costs (such as commissions, bid-ask spreads and market-impact costs) and greater tax efficiency. Both derive from lower turnover.

Core funds reduce the turnover that occurs from forced selling as stocks migrate from one asset class to another -- small stocks become large stocks (and vice versa), value stocks become growth stocks (and vice versa), and emerging market countries become developed market countries.

Another important benefit of multi-asset class funds is that they reduce, if not eliminate, the need to rebalance, which can create trading costs and realization of capital gains. Core funds self-rebalance using cash flows and dividends.

Building a portfolio

For building your portfolio, you can choose to stick with the tilts inherent in the fund or construct your own tilts. For example, investors who want more exposure to small-cap value stocks than what's offered in their chosen core fund can add a small-cap value fund in the appropriate amount. If they want a bit less, they can add a total market fund. Either way, it reduces the need for several funds to achieve similar tilts.

This can also be expanded depending on your investing needs. DFA, for instance, has core funds for both domestic and international equities, as well as "tax aware" funds that try to enhance after-tax returns. Vanguard now offers a total international stock market index fund (VGTSX), which combines developed and emerging markets.

Vanguard's offering can be particularly important for international investors who own both developed and emerging market funds in the component style. The reason is that when an emerging market country grows to become a developed market country (as Israel recently did), that transition creates turnover, since the emerging market fund must sell and the developed country fund must buy. This has the potential to create significant trading costs and tax inefficiencies.

For example, of the 21 countries in the MSCI Emerging Markets Index, Korea and Taiwan are on the watch list for possible promotion to developed market status in 2012. If this were to occur, it would be the largest change in the index's history, as the two are the third and fourth largest in the index.

According to analysis by MSCI and the Aperio Group, funds based on the index could see 50 percent turnover, and MSCI EAFE Index funds could see 16 percent turnover. In addition to large transactions costs, any change has the potential to create large capital gains distributions. A total international fund that owns both developed and emerging market stocks wouldn't experience that type of turnover. And it reduces the need to rebalance component funds.

As you can see, how portfolios are designed can make a significant difference in investor returns. Core funds can help reduce the returns lost to turnover and other costs.