As the exchange-traded fund craze continues, can it be long before all-ETF portfolios are yesterday's headline? Probably not. Why? Maybe it's the fact that ETFs often have lower expense ratios versus active and passive mutual funds. They are also transparent, trade throughout the day and, because they are known for avoiding taxable year-end capital gains distributions, they don't monkey with your tax planning. Such factors make ETFs one of the easiest ways to diversify a portfolio, says Wayne Connors, principal at 3D Asset Management.But just because there are ample temptations to chuck mutual funds and individual stocks in favor of ETFs, don't do so without careful planning, experts say. "Start your portfolio construction by considering your long-term financial plan, which should drive your asset allocation decisions," says Jerry Miccolis, chief investment officer at Brinton Eaton and co-author of Asset Allocation for Dummies. "Your goals, stage of life and other considerations will determine which buckets you need to invest in, such as stocks, bonds, commodities and real estate and how much should be in each bucket," he adds.
You must also have a macro model. "Mine is 40% domestic core, 30% sectors and 30% internationals," says Jack Reutemann, a certified financial planner and founder of Research Financial Strategies. "Do not excessively concentrate in any one position or sector. I live by the 5% rule per any one ETF position, and do not violate it," he adds.
The Broad vs. Narrow Approach
Basically, there are two ways to play the all-ETF portfolio. Broad, or seeking ETFs that have securities that run the gamut from micro to large, international emerging markets, single country, bonds and commodities, explains Michael Iachini, director, Charles Schwab Investment Advisory (SCHW). "This is an efficient way to buy the market at the best possible cost and for the investor who is not looking for tactical positioning," he adds.
On the other hand, going narrow is for the active investor who thinks he or she can beat the market. "There are ETFs where you can get pure exposure to exactly what you want. It does require more work and research," says Iachini.
Indeed it won't be all fun and games. ETFs are effective building blocks for managing portfolios; however, they can also be dangerous to investors who attempt to "pick winners" by speculating on which industry or market segment may outperform this year.
The best solution, Connors says, is a professionally managed portfolio that is globally diversified across broad asset classes that precisely invest in companies by size and style. "Investors should make sure that each asset class provides a diversification benefit to reduce overall portfolio volatility. The mix between equity and fixed income exposure (for example, 60% equity allocation) is of paramount importance to an investor and should be designed to mirror an investor's risk tolerance," he adds.
Investor, Know Thyself
Be honest with yourself about how much time you have to devote to your investments. "Most people do not have the time or technical skills to appropriately research and review each ETF option and often include various ETFs without understanding their full risk factor or how they correlate to each other, thus increasing the overall portfolio risk component," says Mike Saghy, director of investments for PNC Wealth Management.
Can you control yourself? There can be a tendency to get carried away. "ETF trading can be intoxicating," says Doug Kreps, principal and managing director at Fort Pitt Capital Group. "The ease of flipping from gold and then to oil and then to the S&P 500 over the course of a few days can cause investors to deviate from their long-term investment goals. Just because it is easy, does not mean it is right."
How do you plan to invest? ETFs are subject to transaction costs at each buy or sell of the security. This could be an issue for you if you want to dollar-cost average into your portfolio. Transaction costs are often a flat fee that can have a larger impact on small dollar amounts, points out J.J. Schenkelberg, a senior portfolio manager with CLS Investments.
Because of commissions, which can add up, small investors might be better suited for no-load mutual funds, says Iachini. Going strictly ETF is possible and for some it's preferable. Says Iachini, "The all-ETF portfolio will likely grow in the future."
Basics of Diversification
Learn one of the fundamental concepts of building a portfolio.View Course »