Exchange-traded funds (ETFs) have grown significantly after their large-scale launch in the early 2000s, and their numbers and popularity continue to grow. The emergence of investment tools is of great significance to investors, because almost all asset classes in the market now have access to new low-cost opportunities. However, investors must now screen more than 5,000 ETFs currently available globally, which may be a difficult task for weekend investors.
The purpose of this article is to help you master the basics of ETFs and give you an in-depth understanding of how to build an all-ETF portfolio.
- ETFs are multi-purpose securities, each of which can access a wide range of stocks or other investments, such as a wide range of indices or industry sub-sectors.
- Since ETFs usually represent an index of asset class or sub-category, they can be used to construct efficient and passive index portfolios.
- ETFs are also relatively cheap, provide higher liquidity and transparency than some mutual funds, and are traded around the clock like stocks.
- Choosing the right ETF portfolio can create the best investment portfolio for your long-term goals.
Build an all-ETF portfolio
Advantages of ETF portfolio
An ETF is a basket of personal securities, much like mutual funds, but with two main differences. First, ETFs can be freely traded like stocks, while mutual fund transactions do not occur until the market closes. Second, the expense ratio is often lower than that of mutual funds because many ETFs are passive management tools related to the underlying index or market sector. On the other hand, mutual funds are more often actively managed. Since actively managed funds usually do not exceed the performance of the index, ETFs can be said to be a better alternative to actively managed, higher-cost mutual funds.
The primary reason for choosing ETFs over stocks is instant diversification. For example, buying an ETF that tracks a financial services index allows you to own a basket of financial stocks instead of a single company. As the old saying goes, you don’t want to put all your eggs in one basket. If certain stocks in the ETF fall, the ETF can prevent volatility (reach a certain point). For most ETF investors, this elimination of company-specific risks is the biggest attraction.
Another benefit of ETFs is that they can provide exposure to alternative asset classes such as commodities, currencies, and real estate.
Choose the right ETF
There are many factors to consider when determining which ETFs are best for your investment portfolio.
First, you should look at the composition of ETFs. The name alone is not enough to provide a basis for decision-making. For example, several ETFs consist of water-related stocks. However, when analyzing everyone’s largest holdings, it is clear that they have taken a different approach to niche industries. Although one ETF may be composed of water companies, another ETF may mainly hold infrastructure stocks. The focus of each ETF will result in different returns.
Although past performance does not always predict future performance, the performance of relatively similar ETFs is important. Although most of the fees for ETFs are low, it is important to be aware of any significant differences in the expense ratio, which may cause the cost of the ETF to exceed the necessary level.
Other factors to be aware of include the number of assets under management. This is important because low-level ETFs may face the danger of liquidation-investors want to avoid this situation. Investors should also check the average daily trading volume and bid-ask spread. Low volume usually indicates low liquidity, which will make it more difficult to get in and out of stocks.
Steps to build an ETF portfolio
If you are considering using ETFs to build a portfolio, here are some simple guidelines:
Step 1: Determine the correct allocation
Look at your goals for this portfolio (for example, retirement or saving for your child’s college tuition), your return and risk expectations, your time horizon (the longer the time, the greater the risk you can take), your Distribution needs (if you have income needs, you will have to add fixed income ETFs and/or stock ETFs that pay higher dividends), your tax and legal circumstances, your personal circumstances, and how the portfolio fits your overall Investment strategy to determine your asset allocation. If you have a certain understanding of investment, you may be able to handle it yourself. If not, please seek a competent financial advisor.
Finally, consider some data on market returns. The research of Eugene Fama and Kenneth French led to the formation of a three-factor model for evaluating market returns.According to the three-factor model:
- Market risk explains part of stock returns. (This shows that since stocks have greater market risk than bonds, stocks should generally perform better than bonds over time.)
- Over time, value stocks have outperformed growth stocks because they are inherently riskier.
- Over time, small-cap stocks outperform large-cap stocks because they have more non-diversified risks than large-cap stocks.
Therefore, investors with higher risk tolerance can and should allocate a large portion of their investment portfolio to value-oriented small-cap stocks.
Remember that more than 90% of the return on the portfolio is determined by allocation, not by security selection and timing. Don’t try to time the market. Research continues to show that timing the market is not a successful strategy.
Once the correct allocation is determined, you can implement your strategy.
Step 2: Implement your strategy
The beauty of ETFs is that you can choose an ETF for each industry or index you want to invest in. Analyze available funds and determine which funds best meet your allocation goals.
Since the timing of buying and selling ETFs and stocks is important, placing all buy orders in one day is not a prudent strategy. Ideally, you should look at the support levels of the chart and always try to buy on dips. Purchase in phases within three to six months.
When buying, many investors will place a stop loss order to limit potential losses. Ideally, the stop loss should not be less than 20% of the original entry price, and should be adjusted upward as the ETF price rises.
Step 3: Monitoring and evaluation
Check the performance of your portfolio at least once a year. For most investors, depending on their tax situation, the ideal time to do this is at the beginning or end of the calendar year. Compare the performance of each ETF with the performance of its benchmark index. Any difference (called tracking error) should be small. If not, you may need to replace the fund with a fund that is more in line with its established investment style.
Balance your ETF weights to resolve any imbalances that may occur due to market fluctuations. Don’t over trade. For most portfolios, it is recommended to rebalance quarterly or annually. Also, don’t be intimidated by market fluctuations. Stay true to your original distribution.
Evaluate your investment portfolio based on changes in your circumstances, but be sure to keep a long-term perspective. As your circumstances change, your allocation will change over time.
Create a full ETF portfolio
If your plan is to have a portfolio consisting only of ETFs, make sure to include multiple asset classes to achieve diversification. For example, you can focus on three areas first:
- Industry ETFs focus on specific areas, such as finance or healthcare. Choose ETFs from different industries that are largely unrelated. For example, choosing a biotechnology ETF and a medical device ETF is not truly diversified. The decision on which industry ETFs to include should be based on fundamentals (industry valuations), technology and economic prospects.
- International ETFs covering all regions from emerging markets to developed markets. International ETFs can track indexes that invest in a single country (such as China) or the entire region (such as Latin America). Similar to industry ETFs, the selection should be based on fundamentals and technical aspects. Be sure to check the composition of each ETF, in terms of individual stocks and industry distribution.
- Commodity ETFs are an important part of investors’ investment portfolios. From gold to cotton to corn, everything can be tracked through ETFs or similar products exchange-traded notes (ETN). Investors who believe that they are smart enough can choose ETFs that track individual commodities. However, the volatility of individual commodities can be extremely high, so a wide range of commodity ETFs may be more suitable for your risk tolerance.
Please note that these are recommended areas of focus. It all depends on your preference.
Roboadvisors, which are becoming more and more popular, usually build all-ETF portfolios for their users.
Over time, the market and individual stocks will have their ups and downs, but a low-cost ETF portfolio should alleviate volatility and help you achieve your investment goals.