Constructing a portfolio of ETFs takes a considerable amount of knowledge, research, and discipline. Too often people spend more time researching their next HD TV purchase than weighing the options available for their investment portfolio. While the instant gratification of technology may be more exciting, the long-term health of your portfolio decisions should not be left in question.
There are numerous factors to consider when selecting ETFs to make up your investment accounts. Asset allocation, fees, tax considerations, risk management, investing experience, and many other factors converge when deciding which funds to purchase. The overwhelming trend based on asset flows and indexing research is a shift from high-fee actively managed funds to streamlined passive investments.
Firms such as Vanguard and Charles Schwab have been the recipients of billions of dollars in new money as investors have sought equity and fixed income strategies with the lowest fees possible. This makes perfect sense when selecting core holdings that will be the building blocks for your asset allocation.
If you want diversified exposure to domestic or international equities in a variety of market cap styles, then you should certainly consider these providers for a portion of your assets. A broad-based ETF such as the Vanguard High Dividend Yield ETF (VYM) only charges an expense ratio of 0.10% and gives you exposure to nearly 400 dividend-paying stocks. That type of simplicity and value just can’t be beat.
However, more sophisticated investors will also want to supplement these low-cost core holdings with tactical or special situation positions. Often times these types of holdings can offer a level of alpha in their index construction or targeted exposure to an asset class that may be deemed undervalued. In doing so, you may find yourself eschewing cost as your primary driver and focusing instead on active management, smart beta, or niche ETF providers.
Fixed-income in particular has been an area where active management has trumped passive benchmarks over multiple time frames. For example, the PIMCO Total Return Bond ETF (BOND) is deemed a core intermediate-term bond fund and managed by the world-renown Bill Gross. BOND charges an expense ratio of 0.55%, which is nearly 7 times higher than the 0.08% fee that the Vanguard Total Bond Market ETF (BND) charges on an annual basis.
However, over the last two years, BOND has been able to thoroughly trounce the performance of its passively managed peer. During that time frame, BOND has gained 9.25%, while BND has risen only 3.02%. Clearly in this instance the higher fee has been worth the managers’ expertise in research, security selection, and sector allocation.
Income investors may also be looking to enhance the yield on their portfolios with unconventional strategies such as the YieldShares High Income ETF (YYY), PowerShares U.S. Preferred Stock ETF (PFF), Market Vectors Mortgage REIT ETF (MORT), or Alerian MLP ETF (AMLP). Each offers access to tactical high yield sectors that are not found in most traditional dividend equity or fixed-income approaches. You can even find a combination of these asset classes in a broadly diversified fund such as the Guggenheim Multi-Asset Income ETF (CVY).
Implementing strategic exposure to these areas will likely come at a greater cost in the total expense of portfolio; however it can also provide a significantly higher level of income or capital appreciation under favorable circumstances. Selecting and sizing the right mix of tactical asset classes to supplement core positions will likely depend on your risk tolerance, goals, and current prices in relation to other available opportunities.
When I am initially scaling into new income ETFs for clients, I favor starting with small positions that I can add to over time. This is particularly important when it appears that prices are over extended and changes in interest rates or equity direction may become a factor. In this manner, you can use time and price to your advantage to average into an attractive cost basis.
Disclosure: The author is long PFF at the time this article was published.