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ETF Education

How to Use ETFs in a Portfolio

  • Just as the ETF industry has exploded in size, so too have the ways investors use these flexible funds to address critical portfolio needs.
  • ETFs offer several benefits that can enhance the overall performance of your portfolio, such as their inherent diversification, flexibility, lower expense ratios, and greater transparency.
  • When constructing a portfolio with ETFs, it’s important to consider the investor's investment goals, risk tolerance, and overall investment strategy.
7 min read

ETFs were originally conceived to help provide pricing transparency for institutional investors. But as the industry has exploded in size, so too have the ways that investors use these flexible funds to address critical portfolio needs.

Managing Your Portfolio with ETFs

Investors of all types and sizes are employing diverse strategies to construct and manage portfolios using ETFs:

Broaden Asset Allocation

ETFs offer investors a sophisticated tool to gain exposure to broad and targeted market segments covering a wide range of asset classes, equity market capitalizations, styles, and sectors. This enables investors to build or tailor customized investment portfolios consistent with their financial needs, risk tolerance, and investment horizon.

Strategic Asset Allocation

Strategic asset allocation is a target allocation of asset classes you expect to have in place for a long period of time. The target allocation is expected to remain the same and the portfolio is rebalanced to the original allocations when they deviate significantly from the initial settings due to differing returns from the various assets. Strategic asset allocation looks more at the overall risk objective of the portfolio, and therefore takes a long-term view.

Whether you’re looking to cover the broad global equity market, the total bond market, or take positions in specific countries, commodities or real estate, there’s likely an ETF — or ETFs — to help meet your objectives.

Tactical Asset Allocation

Tactical asset allocation is a short- to intermediate-term view that looks for investment opportunities in the market. It allows investors to make real-time adjustments to their long-term asset allocation to take advantage of short-term tactical opportunities.

Tactical adjustments might include increasing allocations to markets and sectors that have become more attractive or decreasing exposures to less attractive ones. Investors can also easily reverse these tactical moves once the opportunities and risks have run their course. ETFs are an efficient tactical asset allocation tool as they offer intra-day trading at typically lower costs.

Core-Satellite Strategies

A core-satellite strategy seeks to replicate the broad market return in the core portion of a portfolio, and uses a satellite strategy to find alpha opportunities and add diversification using non-core market exposures.

Broad, market-based ETFs can be used as the core of an investment strategy. Sector, commodity-based, or other smart beta or active ETFs can be used to add a cost-effective satellite strategy to a portfolio to complement the core. This approach allows an investor to customize their exposure and risk to potentially enhance returns.

Access to Hard-to-Reach Markets

ETFs have democratized investing, giving individual investors the same access to investment solutions as institutional investors — at the same price. The ETF wrapper has opened new doors to:

  • Emerging markets
  • Fixed income
  • Commodities
  • Currencies
  • Managed portfolios
  • And many more

ETFs offer expanded market exposures in a convenient, portable investment instrument.

Portfolio Management

There are several portfolio management options using ETFs:

  • Given their inherent benefits, ETFs are a helpful tool for rebalancing portfolios and keeping them on track to meet long-term strategic asset allocation targets.
  • ETFs can easily be used to refine portfolio strategy and adjust holdings in response to shifting market conditions or an investor's changing needs.
  • Year-end can be an apt opportunity to rebalance portfolios while taking advantage of possible unrealized losses.

Risk Management

The broad array of ETFs available today creates risk management approaches for individuals and smaller institutions that only large institutional investors could access previously.

  • The smaller denominations in which ETFs trade relative to most derivative contracts provide an accurate risk exposure match for portfolios of any size.
  • In the US, ETFs can be sold short, providing greater trading flexibility.
  • Sector ETFs can also be a useful tool for investors who hold a significant number of stock options, allowing them to hedge the exposure to the companies they own by effectively diversifying their risk exposure across the broader equity market.

Tax Management

ETFs can be easily employed to help investors minimize their tax consequences. ETFs are inherently tax efficient vehicles and can be used to harvest tax losses while potentially avoiding the impact of wash-sale rules.

Transition Management

When investors change asset managers, they’re often concerned with how to preserve equity exposure during the transition. One way to achieve this goal is to liquidate the portfolio and then re-invest the assets in an ETF with a high correlation to the benchmark of the active manager. Once a new manager is chosen, the investment professional can sell the ETF shares to fund the purchase of this exposure.

How ETFs May Benefit Your Overall Portfolio

ETFs offer several benefits that can enhance the overall performance of your portfolio, including:

Diversification and Flexibility

ETFs can provide broad or targeted exposure to a wide range of asset classes, such as equities, bonds, commodities, and real estate, allowing investors to diversify their portfolios with just a few trades. ETFs also offer access to specialized investment strategies, such as low-volatility or socially responsible investing, which gives investors the ability to tailor their portfolios to their specific investment goals.

Lower Expense Ratios

Because most ETFs are passively managed, they typically have lower management fees and operating expenses compared to mutual funds. Additionally, ETFs are easy to trade and can be bought or sold on an exchange just like a stock, making them a convenient option for investors who want to buy or sell positions quickly.

Increased Transparency

ETFs offer greater transparency compared to other investment options. ETFs disclose their holdings on a daily basis, allowing investors to see exactly what they are investing in and how their investments are performing.

Click here for a full list of ETF benefits.

Factors to Consider When Constructing Your Portfolio

The types of ETFs in your portfolio will depend on your investment goals and risk tolerance. For example:

  • If you are looking for exposure to a broad range of assets, you may consider adding a broad-market ETF to your portfolio, such as an S&P 500 ETF or a total stock market ETF.
  • If you are looking for exposure to specific sectors, such as technology or healthcare, you may consider adding sector-specific ETFs to your portfolio.
  • If you are looking for exposure to bonds, you may consider adding a bond ETF to your portfolio, such as a total bond market ETF or a high-yield bond ETF.
  • If you’re looking for exposure to real estate, a REIT ETF may be a good option.

It is important to remember that diversification is key to reducing risk in a portfolio. By including a mix of ETF types and asset classes, you can diversify your holdings and reduce your overall portfolio risk.

What Should My ETF Portfolio Look Like?

A diversified portfolio will look different for each investor based on individual risk tolerance and goals. But with ETFs, a simple diversified portfolio can be built using just a few broad exposure ETFs. A diversified portfolio could consist of the following:

These portfolios offer exposure to a mix of different asset classes and investment strategies, allowing for diversification and reducing overall portfolio risks.

How Many ETFs Should be in a Portfolio?

There is no one-size-fits-all when considering the number of ETFs in a portfolio, and will likely depend on the investor's investment goals, risk tolerance, and overall investment strategy. But as a general rule, some investors may choose to have a few ETFs in their portfolio to achieve basic diversification, while others may have a more extensive portfolio with a larger number of ETFs to achieve a higher level of diversification and target specific investment goals.

It is also important to consider each ETF’s underlying holdings and how they fit into the overall portfolio strategy. A well-diversified portfolio should include a mix of different types of ETFs and asset classes to reduce risk and achieve a balanced investment portfolio.

There’s Plenty More to Learn About ETFs

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