How to Build an ETF Portfolio
The ETF industry recently hit a milestone, as assets passed the $1 trillion dollar mark despite uncertain market conditions. The transparency, accessibility and cost efficiency of ETFs have made these products attractive alternatives to index-tracking mutual funds.
When adding ETFs to your portfolio, it is important to be aware how each fund will function as part of your larger investment strategy. The narrowly themed nature of many ETF products can be a double-edged sword. A narrowly themed ETF can help you to target specific regions of the market without stock picking, but it can also lead to increased volatility or over-concentration.
Step 1: Establish a Core
Whether you add ETFs to an existing portfolio or construct a well-rounded portfolio from ETF products, diversification is key. At the core of your portfolio, a broad-based index ETF like the SPDR S&P 500(SPY), Diamonds Trust(DIA) or PowerShares QQQ(QQQQ) helps in providing the foundation for building a complete investment picture.
Step 2: Sector Exposure
Large, liquid sector ETFs allow investors to add emphasis to their investment philosophy. From the Financial Select Sector SPDR ETF(XLF) (XLF) to the iShares Dow Jones US Technology(IYW), heavily traded sector ETFs allow investors to layer on exposure to particular sectors or themes.
As you add sector ETFs to your portfolio, it is important to be mindful of any overlap between your sector holdings and your core positions. Investors starting with the QQQ ETF should be aware of that fund’s emphasis on technology. These investors should consider this exposure before adding a sector ETF that magnifies the emphasis of their core holding.
Keeping track of exposure is key when building a well-balanced ETF portfolio. As you add more ETFs, unintentional pockets of concentration can often emerge when fund holdings overlap.
Step 3: High Touch or Low Stress?
A key step in selecting ETFs for your portfolio should be a fundamental assessment of how much you want to be involved in daily trading.
Because ETFs offer both short- and long-term strategies, it is important for investors to pick ETFs that offer the high-touch daily access or low-stress long-term exposure that they are looking for.
The greatest portfolio problems arise when investors pick ETFs that do not match up with their strategies. While highly-leveraged ETFs such as Direxion’s Daily Financial Bear 3X Shares(FAZ) may be appropriate for a short-term trader looking to hedge exposure on a daily basis, these funds can reek havoc in a long-term portfolio.
Likewise, “smart” indexing strategies, which seek to do more than just track a traditional index, are often better suited for long-term portfolios. While “quant” or “dynamic” strategies may deliver over time, they may not be the most suitable choices for short-term traders who rely on liquidity.
The rise of ETFs has corresponded with a departure from “set-it-and-forget-it” investing strategies and an increasing demand for transparency. A broad range of ETF products offer everything from daily hedging strategies to long-term portfolio strategies. Investors must first understand their own goals before selecting the appropriate ETFs.
