Building an All-ETF Portfolio

The emergence of exchange-traded funds (ETFs) over the recent past has been great for investors, as it has made low-cost opportunities available for nearly every asset class in the market. However, their success also means investors are confronted with about 10,000 ETF choices, a daunting task for the weekend investor.

You don't have to choose just one. Once you know the basics of ETFs, you can consider building an all-ETF portfolio that meets your tolerance for risk and your financial goals while retaining the low investing fees that made ETFs so popular in the first place.

Benefits of an ETF Portfolio

ETFs are baskets of individual securities, much like mutual funds but with two key differences. First, ETFs are traded on exchanges like stocks, while mutual fund transactions don't occur until the market closes for the day. Second, expense ratios tend to be lower.

Most ETFs are passively managed vehicles that simply reflect the contents of an underlying index or other benchmark. They should virtually duplicate the performance of the benchmark.

Many mutual funds are actively managed. They usually have higher fees because there are financial professionals behind the scenes buying and selling assets from day to day. Their goal is to beat the performance of a particular benchmark, but there's no guarantee that they will.

In any type of fund, the chief benefit is diversification. Investing in an ETF that tracks a financial services index gives you ownership in a basket of financial stocks versus a single financial company. As the old cliché goes, you do not want to put all your eggs into one basket.

An ETF can guard against volatility (up to a point) if some 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 top holdings of the ETF. The name alone is not enough information. For instance, a number of 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 this niche sector. While one ETF may be composed of water utilities, another may have infrastructure stocks as the top holdings. The focus of each ETF will result in varying returns.

While past performance is no guarantee of future results, it is important to compare how similar ETFs have performed.

And, though most ETFs have low fees, watch out for any notable differences in expense ratios that can cut into your returns.

Another factor to pay attention to is the total amount of assets under management (AUM). An ETF with low AUM could be in danger of liquidation. Also look at the daily average volume, and the bid/ask spread. Low volume indicates low liquidity, which will make it more difficult to get in and out of shares.

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

Consider your objective for this portfolio (e.g., retirement or 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 within your overall investment strategy. All of these factors go into determining your asset allocation. 

If you are knowledgeable about investments, you may be able to handle this yourself. If not, seek help from a financial adviser.

Then 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 this model:

• Market risk explains part of a stock's return. For example, stocks have more market risk than bonds, so stocks should generally outperform bonds over time.
• Value stocks outperform growth stocks over time. This is because they are inherently riskier.
• Small-cap stocks outperform large-cap stocks over time. 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 small-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.

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.

Placing all your buy orders in one day is not a prudent strategy. Ideally, you would want to look at the charts for support levels and 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 stay truer to its stated style.

Do not overtrade. A once-a-quarter or annual rebalancing is recommended for most portfolios.

Don't be deterred by short-term 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 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 may focus on emerging markets, developed markets, or both. International ETFs may track an index that invests in a single country, such as China, or an entire region, like Latin America. Similar to 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). Unless you have expert knowledge in a particular commodity, a broad commodity ETF can be a good choice.

Note that these are 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 portfolio made up entirely of ETFs could ease volatility and help you achieve your investment goals.