Perhaps no vehicle is helping to change the investment landscape more than the exchange-traded fund (ETF). ETFs are baskets of individual securities much like mutual funds with two key differences. First, they can be freely traded like stocks, while mutual fund transactions don't occur until the market closes. Secondly, expense ratios tend to be lower than those of mutual funds because many are passively managed vehicles tied to an underlying index or market sector.

The primary benefit of ETFs is that they can be used to construct entire portfolios that can be traded easily. Also, they are usually well diversified because they are designed to replicate a specific index or sector. (To learn how ETFs are formed, see Introduction To Exchange-Traded Funds and An Inside Look At ETF Construction.)

Building an ETF Portfolio
If you are considering building a portfolio with ETFs, here are some simple guidelines:

1. Determine the Right Allocation. Look at your objective for this portfolio, your return and risk expectations, your time horizon, your distribution needs, your tax and legal situations, your personal situation and how this portfolio fits in with your overall investment strategy to determine your asset allocation. (See Three Simple Steps to Building Long-Term Wealth for a more detailed explanation that incorporates a process recommended by the CFA Institute.)
   
   
2. Implement your Strategy. Analyze the available funds and determine which ones will best meet your allocation targets. Phase in your purchases over a period of three to six months.
   
   
3. Monitor and assess. Once each year, evaluate your portfolio's performance and your allocations in light of your circumstances. (To keep reading about allocation, see Asset Allocation Strategies and Choose Your Own Asset Allocation Adventure.)

We will break down each of these steps in the following sections.

Determine the Right Allocation
If you are knowledgeable in investments, you may be able to handle this yourself. If not, seek competent financial counsel. In determining the right allocation, consider the following:

1. What is your objective (purpose) for the portfolio (e.g., retirement versus saving for a child's college tuition)?
2. What are your risk/return objectives?
3. What is your time horizon? The longer it is, the more risk you can take.
4. What are your distribution needs for the portfolio? If you have income needs, you will have to add fixed-income ETFs and/or equity ETFs that pay higher dividends.
5. Do you have any legal or tax issues that will have an impact on allocation?
6. How does this portfolio fit in with your overall plans and unique situation? It is important to know how this portfolio ties in with your other investments and how much of your net worth will be invested in this portfolio.

Finally, consider some data on market returns. Research by Eugene Fama and Kenneth French resulted in the formation of the three-factor model in evaluating market returns. The three-factor model says the following:

1. Market risk explains part of a stock's return. (This indicates that because equities have more market risk than bonds, equities should generally outperform bonds over time).
2. Value stocks outperform growth stocks over time because they are inherently more risky.
3. Small cap stocks outperform large cap stocks over time because they have more undiversifiable risk than their large cap counterparts.

Therefore, investors with a higher risk tolerance can and should allocate a significant portion of their portfolios to smaller cap, value-oriented equities.

Remember that more than 90% of a portfolio's return is determined by allocation rather than security selection and timing. Do not try to time the market. Research continually has shown that timing the market is not a winning strategy. (To read more about this subject, see our Financial Concepts tutorial.)