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.

Tutorial: ETF Investing

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.)

Once you have determined the right allocation for you, you are ready to implement your strategy.

Implement Your Strategy
The beauty of ETFs is that you can select an ETF for each sector or index in which you want exposure.

Once you know the basics, you are ready to select your ETFs. In making your selections, look for products that:

  1. Most closely meet your allocation needs for each sector or index
  2. Have the most favorable expense ratios

There are a number of product offerings. Following are links to the American Stock Exchange, which has more than 200 listed ETFs, as well as some of the largest ETF managers:

American Stock Exchange:

  1. Claymore: Offers ETFs designed to provide the investment performance delivered by specialized investment indexes.
  2. First Trust: Offers ETFs benchmarked against a number of styles, sectors and special situations.
  3. iShares: Owned by Barclays. Offerings across every major domestic index and sector, including fixed income, as well as international ETFs.
  4. Powershares: Style, industry, commodity currency specialty access and broad-market ETFs, including the QQQQ (formerly the QQQ).
  5. Pro Shares: Uses derivatives, short (selling the asset) and long (buying the asset) index ETFs, including leveraged index ETFs.
  6. Rydex: ETFs that seek to capture the performance of equal weighted and segmented indexes and sectors.
  7. State Street Global Advisors: Standard and Poor's Depositary Receipts (SPDRs), specific sector and index ETFs (including fixed income) and the Streettracks ETFs, as well as tools to help build a portfolio.
  8. Van Eck Global: Market Vector brand of ETFs based on special market sectors and countries.
  9. Vanguard: Domestic and international index ETFs that cover a range of market segments, investment styles, sectors and industries including bond the bond market.
  10. Wisdom Tree: Index ETFs with a fundamental approach toward dividends and core earnings.

The next step is execution. ETFs trade during market hours, so any broker can execute your trades. More often than not, it is prudent to phase in new purchases. Data from The Stock Trader's Almanac show that, generally, the equity markets are strongest from November to April and weakest from May to October, which means you may choose to speed up your phase-in time during strong periods and slow it down during weaker months.

Monitor and Assess Your Portfolio

  • At least once a year, check the performance of your portfolio. For most investors, depending on their tax circumstances, the ideal time to do this is at the beginning or end of the calendar year. Compare each ETF's performance to that of its benchmark index. Any difference, called tracking error, should be low. If it is not, you may need to replace that fund with one that will invest truer to its stated style.
  • Balance your ETF weightings for any imbalances that may have occurred due to market fluctuations. Do not overtrade. A once-annual rebalancing is recommended for most portfolios.
  • Do not be deterred by market fluctuations. Stay true to your original allocations. Certain styles will stay out of favor for a while, while others will log abnormally high returns for extended periods.
  • Assess your portfolio in light of changes in your circumstances. Keep a long-term perspective. Your allocation will change over time as your circumstances change.

Remember, there are three steps to successfully building a portfolio with ETFs. One, determine the right allocation for you. Two, implement your strategy. And three, monitor and assess your portfolio in the context of your situation. If you follow these steps, you should be able to build a portfolio of ETFs that meets its intended objective.

To keep reading on ETFs, see Exchange Traded Notes - An Alternative To ETFs, How To Use ETFs In Your Portfolio and Advantages Of Exchange-Traded Funds.

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