The growth of the exchange-traded fund (ETF) sector was remarkable after its mass introduction in the early 2000s, and the number of ETFs continues to expand every year. The emergence of the investment vehicle has been great for investors, as new low-cost opportunities are now available for nearly every asset class in the market. However, on the other side, investors now must deal with sifting through more than 4,300 ETFs that are currently available, and this can be an extremely daunting task for the weekend investor. The remainder of the article will help you grasp the basics of ETFs and give you insight into how you can build your own all-ETF portfolio (See also: Exchange-Traded Funds Tutorial).
Benefits of an ETF Portfolio
The best reason an investor would consider an ETF over a stock is instant diversification. For example, purchasing an ETF that tracks a financial services index it will give the investor ownership in a basket of financial stocks versus on a single company. As the old cliché goes, you do not want to put all your eggs into one basket. As such, an ETF can guard against volatility to an point, even certain stocks within the ETF fall. The removal of the company-specific risk is the biggest factor for most investors.
The difference between ETFs and mutual funds comes down to costs and transparency. The management fees are typically lower for ETFs versus comparable mutual funds. In addition, most ETFs are passively managed. Less than 1% of total ETF assets in 2015 was tied to active management. Mutual funds, however, are more often actively managed. Because actively managed funds don't commonly beat the performance of indices, ETFs arguably makes a better alternative to actively managed, high cost mutual funds.
Another benefit is the exposure an ETF can give a portfolio to alternative asset classes, such as commodities and currencies. Investors can now play the futures market as well as the forex market with ETFs that trade just like individual stocks (See also: Exchange-Traded Fund (ETF) Investing).
Choosing the Right ETF
When determining which ETF is the best for your portfolio, there are a few factors that must be considered. Even though most fees on ETFs are low, there will be differences between comparable ETFs and it must be a factor in the final decision. Almost equally important is the composition of the ETF.
The name alone is not enough information to base a decision on. Several ETFs are made up of water-related stocks. However, when the top holdings of each are analyzed it is clear that each ETF takes a different approach at accessing the niche sector because the stocks that make up the ETF are very different from one another. For example, one ETF may be composed of water utilities and the competitor will have infrastructure stocks as the top holdings. The very different focus will result in varying returns.
Of course, past performance is not always indicative of future performance. However, it is important to compare how similar ETFs have performed versus each other. Other less important factors to consider are the amount of assets the ETF has under management, the daily average volume and the bid/ask spread of the ETF. The amount of assets under management is important because an ETF with low levels could be in danger of closing, a situation investors want to avoid. The average daily volume could be an issue when purchasing/selling large amounts of shares because it will move the bid/ask spread. Finally, a wide bid/ask spread is another display of low liquidity, and will be more costly to investors (See also: The Basics Of The Bid-Ask Spread)
Building the ETF Portfolio
The first step in building the all-ETF portfolio is to make sure all asset classes are included to create diversification. Here's a suggestion to how an investor can build an ETF portfolio by focusing on three areas.
1. The first area is sector ETFs which concentrate on specific fields, such as financials or healthcare. Investors should choose up to three different ETFs, preferably from different sectors and uncorrelated. For example, choosing a biotech ETF and a medical device ETF would not be real diversification. The decision making for the sector ETFs should be based on fundamentals (valuation of the sectors), technicals and outlook.
2. The second area is international ETFs that cover all regions from emerging markets to developed markets. The ETF may track an index that invests in a single country e.g. China, or it could invest in an entire region e.g. Latin America. Similar to the sector ETFs, the choice can be based on fundamentals and technicals. It is also important to look at the makeup of each ETF, as far as individual stocks and sector allocation. Up to three ETFs can make up this portion of the portfolio.
3. The third area is commodity ETFs, an important part of an investors' portfolio. Everything from gold to cotton to corn can be tracked with ETFs or their cousin, exchange-traded notes (ETNs). Investors who believe they are savvy enough can choose ETFs that track individual commodities. However, individual commodities can be extremely volatile, and do not fit into most investors risk tolerance.
Note that these are simply suggested areas to focus on, some investors might prefer to invest in currency ETFs over emerging market ETFs, it's all about preferences. (See also: Profit From Forex With Currency ETFs)
Implementing the Plan
Once you have decided on the ETFs to include in the portfolio, the next step is to begin building the positions. Since timing is very important when buying and selling ETFs and stocks, placing all buy orders in one day is not a prudent strategy. Ideally, you would want to look at the charts for support and always try to buy on days when the ETF is down. This is difficult to do, but it will benefit you in the end. It's fine if it takes several weeks to reach the desired portfolio allocation, since patience is key.
Once a position has been established, the first order of business is to place a stop-loss order that will limit all potential losses. The stop-loss should be no larger than 20% below the original entry price. In addition, if you are lucky enough to pick a winning ETF, the stop-loss should be moved higher, accordingly.
The Bottom Line
Now that you have an idea of how to build your own all-ETF portfolio, the next step is to keep up with the performance of the individual ETFs. Each quarter, the portfolio should be analyzed to determine if the positions offer the best reward-to-risk ratio. If the answer is no, it is time to sell and either move to cash or buy a new ETF that fits the goals and risk tolerance of the portfolio. Over time, there will be ups and downs, but a low-cost ETF portfolio should ease volatility and help you achieve your investment goals.