Exchange-Traded Funds (ETFs) have become popular investment vehicles for their flexibility and diversity. Here are three distinct approaches to building an ETF portfolio.
Pros and Cons of an All-ETF Portfolio
As highlighted by Marco Santanche, an ETF strategist and author of the newsletter Quant Evolution, there are compelling reasons for investors to consider building an all-ETF portfolio. “ETFs play a pivotal role and serve as a primary avenue for gaining exposure to macroeconomic themes while providing access to professionally-managed portfolios,” says Santanche. “Effectively managing a stock portfolio demands specific expertise, often lacking in individual investors, making ETFs an invaluable tool in this context.”
However, all-ETF portfolios also present their distinct challenges. "One notable disadvantage lies in the challenge of customizing portfolios to suit individual preferences," notes Santanche. "While ETFs offer diversified options, tailoring a portfolio to specific needs may prove difficult."
Despite this challenge, returns and risk-adjusted returns from all-ETF portfolios tend to be favorable, consistently outperforming do-it-yourself (DIY) approaches — particularly for individuals without professional experience in the field. Consequently, careful consideration of the advantages and disadvantages of an all-ETF portfolio becomes crucial, aligning with individual investment goals and expertise.
Option 1: Simple ETF Portfolio
Investors favoring a straightforward approach can implement a two-ETF strategy to attain a balanced and diversified portfolio. Allocate 60% to a stock market ETF and the remaining 40% to a bond market ETF. Consider SPDR S&P 500 ETF Trust (SPY) for exposure to the U.S. market or iShares MSCI ACWI UCITS ETF (SSAC) for international market exposure within the stock component. For the bond market portion, options like Vanguard Total Bond Market ETF (BND) provide exposure to the U.S. dollar-denominated, fixed-rate taxable bond market, while iShares Global Govt Bond UCITS ETF (IGLO) offers enhanced international diversification.
Read More: An Introduction to Asset Allocation
The advantage of this approach lies in its simplicity, making it easy to rebalance and keeping trading costs low. However, one drawback is the lack of fine-tuning, as the portfolio may not cater to specific preferences such as a larger allocation to U.S. stocks or inclusion of other asset classes like Treasury Inflation Protected Securities (TIPS) or non-dollar-denominated international bonds.
Option 2: Multi-ETF Approach
For investors seeking a middle-ground between simplicity and customization, an six-ETF portfolio provides broader exposure. Divide your equity allocation into large-cap U.S., small-cap U.S., international developed-market, and emerging-market ETFs. Enhance your core bond allocation with high yield, emerging market and international bonds.
Some examples for the equity component include:
Large-Cap U.S.: SPDR S&P 500 ETF Trust (SPY), and iShares Core S&P 500 ETF (IVV).
Small-Cap U.S.: iShares Russell 2000 ETF (IWM), and Vanguard Small-Cap ETF (VB).
International Developed-Market: iShares MSCI EAFE ETF (EFA), and Vanguard FTSE Developed Markets ETF (VEA).
Emerging-Market: iShares MSCI Emerging Markets ETF (EEM) and Vanguard FTSE Emerging Markets ETF (VWO).
Read More: Fixed Income ETFs: A Comprehensive Guide
For the fixed income component, examples include:
High Yield: iShares iBoxx $ High Yield Corporate Bond ETF (HYG), and SPDR Bloomberg Barclays High Yield Bond ETF (JNK)
Emerging Market: iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB), and Vanguard Emerging Markets Government Bond ETF (VWOB).
International Bonds: Vanguard Total International Bond ETF (BNDX), and iShares International Treasury Bond ETF (IGOV).
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This approach allows for greater balance and adjustment flexibility without overwhelming complexity. While not as simple as a two-ETF strategy, it offers a wider range of asset classes, catering to diverse investment preferences.
Option 3: A Tailored Portfolio
At the other end of the spectrum is the fine-tuned portfolio, designed for investors seeking precise exposure to specific market segments. This strategy is an extension of the multi-ETF approach but further divides allocations into narrower slices. For example, U.S. large-cap stocks can be segmented by sectors or industries such as Financials, Tech and Utilities, and international developed market stocks can be divided into geographic areas such as Europe and Japan.
Similarly, the fixed income component can also be further divided into treasuries, mortgage-backed securities, and corporate bonds.
To enhance portfolio diversity, investors may introduce alternative investments or quant-based ETFs, expanding beyond traditional asset classes. This can be achieved by incorporating:
Commodity ETFs such as gold ETF and uranium ETF
Real Estate ETFs
Trend Following ETFs
Factor-based ETFs such as growth, value or quality-oriented ETFs
Read More: Trend Following ETFs: A Deep Dive
The advantage of this approach is the ability to precisely tailor your exposure to different market segments. However, the complexity and potential trading costs associated with managing a portfolio of 10 or more ETFs may be challenging. It requires diligent tracking to avoid losing sight of overall allocations and careful consideration of bid-ask spreads. It's essential to regularly review and adjust your portfolio based on changing market conditions and your evolving financial objectives.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
