10 Reasons To Add ETFs To Your Portfolio

Exchange-traded funds (ETFs) can be a valuable component for any investor's portfolio, from the most sophisticated institutional money manager to a novice investor who is just getting started. In the core/satellite portfolio strategy, an investor chooses a core ETF (such as an ETF based on an index such as the S&P 500), and then selects individual securities that are expected to outperform the benchmark to form the satellites around the ETFs. Read on as we discuss the benefits of this strategy.

For more on the core/satellite investing strategy, see A Guide To Core/Satellite Investing.

Typically, the average investor who buys stocks tends to have a poorly diversified portfolio. There is often a concentration in sectors or types of stocks with very similar risk characteristics. Using an ETF to buy a core position provides instant diversification and reduces overall portfolio risk. (For more insight, read The Importance Of Diversification.)

It is widely accepted that a large portion (more than 50%, by most accounts) of professional money managers underperform the stock market. The average individual investor typically fares worse. An investor who sells some stocks and replaces them with a broad-based ETF core holding may be able to improve the portfolio's overall performance. (For related reading, check out Pump Up Your Portfolio With ETFs.)

A change in an investor's asset mix is easier to implement when an ETF is used as the core position. If an investor wants to increase his or her equity exposure, the purchase of additional shares of an ETF makes it easy. (To read more on portfolio rebalancing, see Rebalance Your Portfolio To Stay On Track.)

The more stocks there are in a portfolio, the harder it is to monitor and manage; after all, there are more investment decisions that have to be made and more factors to be considered. With an ETF or index fund representing a core position, the number of stocks can be decreased, resulting in a portfolio that is less complex and easier to understand.

Investors should consider the impact of taxes on their returns. A portfolio containing all stocks tends to generate more trading activity as the market and investment outlook changes. With more trading activity, more capital gains are realized, creating a higher tax liability for the investor. ETFs are very tax efficient and, with a larger proportion of the portfolio in a single core ETF, fewer capital gains will be triggered. (Be sure to read A Long-Term Mindset Meets Dreaded Capital-Gains Tax for more information.)

With fewer stocks, there will be fewer trades and fewer commissions. The small annual management fee ETFs carry is easily recovered from the savings on commissions. In an account at a full-service broker, the reduction of commissions could be dramatic. This might be why many investment advisors do not like ETFs. (For more on ETF benefits, read Uncovering The ETF Wrap.)

For the typical investor with an ETF representing a core holding, the overall portfolio will likely be less volatile than one made up entirely of stocks. This is because an ETF is, in itself, diversified, making it less likely to suffer the price swings that are possible for a stock. (Learn to adjust your portfolio when the market fluctuates to increase your potential return in Volatility's Impact On Market Returns.)

In any well-designed and diversified portfolio, an investor will have to invest in sectors or stocks that he or she does not like, but is required to own for diversification purposes. Using an ETF for a core position provides the necessary diversification, allowing the investor to focus on stocks in his or her preferred sectors. (For more on sectors, read Sector Rotation: The Essentials.)

Investment strategies such as enhanced index strategies, risk budgeting, portfolio insurance, style tilts, hedging strategies and tax loss harvesting become easier to implement with a core/satellite approach.

The proper implementation of a core/satellite strategy requires a certain degree of knowledge and understanding about risk, market indexes, benchmarks and portfolio management techniques. As investors gain the knowledge and experience of applying a core/satellite strategy, the process will, in the end, make them better investors.