The growth in exchange-traded funds (ETFs) was remarkable following their mass introduction in the early 2000s, and they continue to grow in number and popularity. The emergence of investment vehicles has been great for investors, as new low-cost opportunities are now available for almost every asset class in the market. However, investors must now sift through the more than 5,000 ETFs that are currently available globally, which can be a daunting task for the weekend investor.
The goal of this article is to help you understand the basics of ETFs and give you an idea of how you can determine your overall ETF portfolio.
Steps to Build an ETF Portfolio
If you’re considering building a portfolio with ETFs, here are some simple guidelines:
Step 1: Determine the Right Allocation
Look at your objective for this portfolio (for example, 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 Requirements (If you have income needs, you will need 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 into your overall investment strategy determine your asset allocation. If you are savvy about investing, you might be able to handle it yourself. If not, seek a competent financial advisor.
Once you’ve determined the right allocation, you’re ready to implement your strategy.
Step 2: Implement Your Strategy
The beauty of ETFs is that you can choose an ETF for each sector or index to which you want exposure. Analyze the funds available and determine which will best meet your allocation goals.
Since timing is critical when buying and selling ETFs and stocks, placing all buy orders in one day is not a prudent strategy. Ideally, you would want to watch the charts for support levels and always try to buy on the decline. Phase in your purchases over a period of three to six months.
Step 3: Monitor and Evaluate
Check the performance of your portfolio at least once a year. For most investors, the ideal time to do this is at the beginning or end of the calendar year, depending on their tax circumstances. Compare the performance of each ETF with its benchmark index. Any difference, called a tracking error, should be small. If it is not, you may need to replace that fund with a fund that will invest according to its stated style.
Balance your ETF weightings to account for any imbalances caused by market volatility. Don’t overtrade. A quarterly or annual rebalancing is recommended for most portfolios. Also, do not panic about the ups and downs of the market. Stay true to your original allocation.
Benefits of 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, whereas mutual fund transactions don’t take place until the market closes.
Second, expense ratios tend to be lower than mutual funds because many ETFs are passively managed vehicles linked to an underlying index or market sector. On the other hand, mutual funds are more active.
The biggest reason to choose ETFs over stocks is instant diversification. For example, buying a managed. Because actively managed funds typically don’t beat the performance of an index, ETFs arguably make a better alternative to actively managed, higher-cost mutual funds. ETF that tracks a financial services index gives you ownership in one company versus a basket of financial stocks. As the old cliché goes, you don’t want to put all your eggs in one basket. An ETF can protect against volatility (up to a certain point) when certain stocks within the ETF decline.
Another advantage of ETFs is that they can provide portfolio exposure to alternative asset classes, such as commodities, currencies, and real estate.
Over time, markets and individual stocks will fluctuate, but a low-cost ETF portfolio should reduce volatility and help you achieve your investment goals.