Portfolio construction and fund selection

This lesson covers how we build portfolios from the ground up — from deciding how much goes into each asset class to selecting the specific fund that fills each slot. Every choice has a documented rationale, and no fund enters a model without clearing the investment committee.

Step 1: Asset class allocation

Model portfolios start with target percentages for each asset class. Our standard models use six to eight asset classes:

| Asset class | Conservative | Moderate | Aggressive | |---|---|---|---| | U.S. Large Cap Equity | 15% | 30% | 45% | | U.S. Small/Mid Cap Equity | 3% | 8% | 12% | | International Developed Equity | 7% | 15% | 22% | | Emerging Markets Equity | 2% | 5% | 8% | | U.S. Aggregate Bonds | 50% | 25% | 5% | | TIPS (Inflation-Protected) | 10% | 7% | 3% | | REITs | 3% | 5% | 5% | | Cash | 10% | 5% | 0% |

These targets are derived from long-term capital market assumptions (expected return, volatility, and correlation for each class), filtered through client risk tolerance and time horizon.

Step 2: Fund selection criteria

Within each asset class, we select a specific fund. The criteria, in order of importance:

1. Expense ratio

This is the primary filter. For core equity and bond positions, we target funds with expense ratios below 0.10%. We will not use a fund above 0.20% without a documented, compelling rationale approved by the investment committee.

2. Tracking error

An index fund should closely track its benchmark. We evaluate rolling 12-month tracking error — any fund that consistently deviates more than 0.10% from its index warrants investigation (sampling methodology, securities lending revenue, fair-value pricing).

3. Tax efficiency

For taxable accounts, tax efficiency matters. ETFs generally distribute fewer capital gains than mutual fund equivalents due to the in-kind creation/redemption mechanism. We default to ETFs in taxable accounts.

4. Liquidity and bid-ask spread

For ETFs, we evaluate average daily trading volume and bid-ask spreads. Thinly traded ETFs with wide spreads impose hidden costs on clients. We stick to large, liquid ETFs with spreads under 0.03%.

5. Fund size (AUM)

Funds below $100M in assets carry closure risk and may have higher tracking error. We prefer funds with at least $500M in assets.

Step 3: ETF vs. mutual fund by account type

| Account type | Preferred vehicle | Why | |---|---|---| | Taxable brokerage | ETFs | Tax efficiency (no capital gains distributions), intraday liquidity | | 401(k) | Mutual funds (often the only option) | Plan menu dictates; auto-invest features require mutual funds | | Traditional/Roth IRA | Either | ETFs for slightly lower cost; mutual funds for auto-invest convenience | | HSA | Mutual funds or ETFs | Depends on HSA custodian's available options |

When the same index is available as both an ETF and a mutual fund from the same provider, the ETF typically has a slightly lower expense ratio. In IRAs where the investor values automatic monthly contributions, we may prefer the mutual fund for convenience.

Step 4: Due diligence checklist

Every fund that enters a Minerva model portfolio must pass this checklist:

• [ ] Expense ratio below 0.10% (or documented exception)
• [ ] Tracks a broadly recognized, market-cap-weighted index
• [ ] Tracking error below 0.10% over trailing 12 months
• [ ] Fund AUM above $500M
• [ ] For ETFs: average daily volume above 500K shares, bid-ask spread below 0.03%
• [ ] No significant capital gains distribution history (for taxable placements)
• [ ] No securities lending risks above industry standard
• [ ] Reviewed and approved by the investment committee

This checklist is documented in Drive and updated annually. Any fund failing one or more criteria requires an exception memo approved by the investment committee chair.

Annual model review

Every January, the investment committee reviews all models:

1. Performance attribution — did each fund track its index as expected?
2. Cost review — have any funds raised or lowered fees? Are cheaper alternatives available?
3. Tax efficiency review — did any funds make unexpected capital gains distributions?
4. Asset class assumption update — do long-term return and correlation estimates warrant any target changes?

Most years, nothing changes. That's by design — frequent model changes create turnover, tax events, and client confusion. Stability is a feature, not a bug.

Key takeaways

1. Models are built top-down: asset class targets first, fund selection second.
2. Expense ratio is the primary fund selection criterion. We target below 0.10%.
3. ETFs are preferred in taxable accounts for tax efficiency; mutual funds in 401(k)s and sometimes IRAs for convenience.
4. Every fund must pass a documented due-diligence checklist before entering a model.
5. Annual model reviews are deliberate and most years result in no changes — stability is intentional.

Glossary

• Tracking error — The deviation of a fund's return from its benchmark index's return. Lower is better for index funds.
• Capital market assumptions — Long-term expected return, volatility, and correlation estimates for each asset class, used to set allocation targets.
• In-kind creation/redemption — The ETF mechanism where authorized participants exchange baskets of stocks for ETF shares (and vice versa), avoiding taxable sales inside the fund.
• Bid-ask spread — The difference between the highest price a buyer will pay and the lowest price a seller will accept for an ETF. Narrower spreads mean lower trading costs.
• TIPS — Treasury Inflation-Protected Securities. U.S. government bonds whose principal adjusts with inflation.
• REITs — Real Estate Investment Trusts. Publicly traded funds that own real estate properties and pass rental income to shareholders.
• Exception memo — A written justification required when a fund doesn't meet standard due-diligence criteria but is still proposed for model inclusion.