The growth in exchange-traded funds (ETFs) was remarkable after their mass introduction in the early 2000s, and they continue to grow in number and popularity. 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, investors now must deal with sifting through more than 5,000 ETFs that are currently available globally, and this can be a daunting task for the weekend investor.

The goal of this article is to 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

ETFs are baskets of individual securities much like mutual funds but with two key differences. First, ETFs can be freely traded like stocks, while mutual fund transactions don't occur until the market closes. Second, expense ratios tend to be lower than those of mutual funds because many ETFs are passively managed vehicles tied to an underlying index or market sector. Mutual funds, on the other hand, are more often active managed. Because actively managed funds don't commonly beat the performance of indices, ETFs arguably makes a better alternative to actively managed, higher-cost mutual funds.

The top reason for choosing an ETF over a stock is instant diversification. For example, purchasing an ETF that tracks a financial services index gives you ownership in a basket of financial stocks versus a single company. As the old cliché goes, you do not want to put all your eggs into one basket. An ETF can guard against volatility (to a point) if certain stocks within the ETF fall. This removal of company-specific risk is the biggest draw for most ETF investors.

Another benefit of ETFs is the exposure they can give a portfolio to alternative asset classes, such as commodities, currencies and real estate.

Choosing the Right ETFs

When determining which ETFs are best suited for your portfolio, there are a number of factors to consider.

First, you should look at the composition of the ETF. The name alone is not enough information to base a decision on. For instance, several ETFs are made up of water-related stocks. However, when the top holdings of each are analyzed, it is clear they take different approaches to the niche sector. While one ETF may be composed of water utilities, another may have infrastructure stocks as the top holdings. The varying focuses will result in varying returns.

While past performance is not always indicative of future performance, it is important to compare how similar ETFs have performed. And even though most fees on ETFs are low, they will vary as well and should be taken into consideration. 

Other factors to pay attention to include the amount of assets under management. This is important because an ETF with low levels could be in danger of closing - a situation investors want to avoid. Investors should also look at daily average volume and the bid/ask spread. Low volume and/or a wide bid/ask spread often indicate low liquidity, which will make it more difficult to get in and out of shares. (See also: The Basics of the Bid-Ask Spread.)

3 Steps for Building an ETF Portfolio

If you are considering building a portfolio with ETFs, here are some simple guidelines:

Step 1: Determine the right allocation.

Look at your objective for this portfolio (e.g., retirement vs. saving for a child's college tuition), your return and risk expectations, your time horizon (the longer it is, the more risk you can take), your distribution needs (if you have income needs, you will have to add fixed-income ETFs and/or equity ETFs that pay higher dividends), your tax and legal situations, your personal situation and how this portfolio fits in with your overall investment strategy to determine your asset allocation. If you are knowledgeable about investments, you may be able to handle this yourself. If not, seek competent financial counsel.

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. According to the three-factor model:

  • 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.)
  • Value stocks outperform growth stocks over time because they are inherently more risky.
  • 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, you are ready to implement your strategy.

Step 2: Implement your strategy. 

The beauty of ETFs is that you can select an ETF for each sector or index in which you want exposure. Analyze the available funds and determine which ones will best meet your allocation targets.

Since timing is 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 levels and always try to buy on dips. Phase in your purchases over a period of three to six months.

At the time of purchase, many investors will place a stop-loss order that will limit potential losses. Ideally, the stop-loss should be no more than 20% below the original entry price and should be moved up accordingly as the ETF gains in price.

Step 3: Monitor and assess.

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 to account for any imbalances that may have occurred due to market fluctuations. Do not overtrade. A once-a-quarter or once-annual rebalancing is recommended for most portfolios. Also, don't be deterred by market fluctuations. Stay true to your original allocations. 

Assess your portfolio in light of changes in your circumstances, but be sure to keep a long-term perspective. Your allocation will change over time as your circumstances change.

Creating an All-ETF Portfolio

If your plan is to have a portfolio made up solely of ETFs, make sure multiple asset classes are included to create diversification. As an example, you could start by focusing on three areas:

1. Sector ETFs, which concentrate on specific fields, such as financials or healthcare. Choose ETFs from different sectors that are largely uncorrelated. For example, choosing a biotech ETF and a medical device ETF would not be real diversification. The decision about which sector ETFs to include should be based on fundamentals (valuation of the sectors), technicals and the economic outlook.

2. International ETFs that cover all regions from emerging markets to developed markets. International ETFs may track an index that invests in a single country, e.g., China, or an entire region, e.g., Latin America. Similar to the sector ETFs, the choice should be based on fundamentals and technicals. Be sure to look at the makeup of each ETF, as far as individual stocks and sector allocation. 

3. Commodity ETFs are an important part of an investor's portfolio. Everything from gold to cotton to corn can be tracked with ETFs or their cousins, 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, so a broad commodity ETF may be better suited to your risk tolerance.

Note that these are simply suggested areas to focus on. It's all about your preferences.

The Bottom Line

Over time, there will be ups and downs in the markets and in individual stocks, but a low-cost ETF portfolio should ease volatility and help you achieve your investment goals.

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