Creating a diversified portfolio using exchange-traded funds

22 Aug

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By Greg Boland

 

In my article last month, I gave three tips for investors looking to buy shares as a long-term investment. The tips were to work out your risk tolerance, that time in the market is preferable to trying to time the market and don’t put all your eggs in one basket. This article dwells on this third tip – don’t put all your eggs in one basket. In other words, you should diversify. 

Diversification 

Diversification means creating a portfolio of shares rather than investing in one or two hot stocks which can create unwanted risk to your capital. Diversification is good for an investor because it spreads the risk of investing in shares, and it keeps any part of your investment from being too heavily weighted toward one country, sector, theme or individual company. 

How Exchange-Traded Funds Help You To Diversify 

Exchange-Traded Funds (ETFs) can help an investor who is not sure what stock to buy to diversify as ETFs provide an avenue to establish a balanced portfolio. A balanced portfolio is holding a variety of shares thereby reducing your overall risk while seeking moderate growth over a long-term investment horizon. One way of achieving this diversification is to invest in an index ETF. 

So, let’s take a step back and describe what is an index. A share market index is a hypothetical portfolio of shares that represent a segment of the financial market such as the return of a countries top 30 shares. The value of an index is calculated by referring to the prices of the underlying 30 shares. 

Investors follow different market indexes to gauge market movements. For example, in the US the three most popular stock indexes for tracking the performance of the U.S. market are the Dow Jones Industrial Average (DJIA), S&P 500 Index, and Nasdaq Composite Index. The Standard & Poor 500 (S&P 500) measures the performance of 500 large companies listed on US Stock Exchanges. 

Index ETFs enable people to make investments that reproduce the returns a broad index would provide. Index ETF’s also permit an investor to make one investment rather than having to buy all the individual stocks that make up that index. Putting these concepts together, index ETFs permit an investor to receive exposure and return from a range of companies which have different risk and return characteristics. Thus, by investing in an index ETF, an investor practices diversification which as discussed above, enables risk to be reduced. For an investor to achieve this kind of diversification by buying up individual stocks themselves would likely be cost prohibitive so investing in an index ETF is economically advantageous. 

Further Diversification Through Several ETFs 

Investors can further diversify by buying different types of ETFs. To achieve this, it is recommended you start with a broad-based index ETF such as on the S&P 500. You can then complement that index fund with a few different ETFs of varying risk levels. Your investment choices are virtually endless, such as: 

  • single country - e.g., an ETF that replicates return of a broad country index such as the SPDR S&P 500 ETF Trust (SPY) which invests in the top 500 US stocks 
  • broader global indexes - e.g., an ETF that provides exposure to global share markets such as the iShares MSCI World ETF (URTH) 
  • regions of the world – e.g., an ETF that provides a return similar to a group of countries such as Europe, South America or Asian countries like the Vanguard FTSE Europe ETF (VGK) 
  • sectors – e.g., many share markets can be broken down to sectors such as Healthcare, Consumer Staples, Energy or Technology and each will have a ETF on it such as US based Technology Select Sector SPDR Fund (XLK) 
  • industry – e.g., again the sectors may be further broken down into industries. One example is Semiconductors and an ETF that invests in this industry group is the VanEck Semiconductor ETF (SMH) 
  • theme – e.g., investors seek exposure to particular themes such as water, natural resources, innovation or clean energy with an example of the latter being the iShares Global Clean Energy ETF (ICLN). 

An Exchange-Traded Fund Is A Listed Fund 

What this means is that just like shares, the fund is listed on a Stock Exchange. You can easily buy and sell ETFs just like shares through a broker or on an online app. They usually are very liquid, have lower expenses, are tax efficient and transparent compared to managed funds. 

Exchange-Traded Funds Are Passively Managed 

An ETF is passively managed by the manager who buys and sells shares for the fund to match the index 

only. In so doing the manager does not make any allocation decisions and instead religiously matches the portfolio to the index they are tracking. 

So, when you invest in an ETF, you give someone else, the ETF’s management team, the responsibility of deciding how your funds are invested in keeping within the selected investing benchmark or sector or industry its charter dictates. This is usually easily discerned from the name of the ETF or its strategy description. In other words, the management is passive as opposed to active where a fund manager invests in a portfolio they create and actively manage it in the expectation they can outperform the index benchmark. 

Benefits Of An Exchange-Traded Fund 

There are several benefits associated with ETF s. These are as follows: 

  1. trading flexibility – because they are traded on an Exchange you can buy and sell continuously 
  2. portfolio diversification – you can obtain diversification through investment in specific sectors, industries and countries even though you don’t have expertise in these areas
  3. risk management – by having a range of ETFs you mitigate your risk because you are not exposed to the risk of one company or sector
  4. lower costs – it would be nearly impossible to replicate the exposure to a broad index as costs would be prohibitive 

Popularity Of ETFs 

Today there are a raft of ETFs traded on most Stock Exchanges designed to track broad domestic and international indices, as well as more specialised sector, region and country indices such as those in the list above. 

Globally total ETF assets under management is now more than US$4 trillion. That’s how popular they are. 

Choosing An ETF 

There are over 6000 ETFs listed globally so you are spoiled for choice. So, what is right for you? A good place to start is to visit www.etfdb.com. From this site you can screen different countries, sectors or themes. 

When selecting an ETF consider looking at those that are the most popular and that fit with your investment philosophy. Popularity, index replication and being able to buy and sell at will are very important when investing so you should consider investing in an ETF that has the characteristics noted below and ask yourself the following questions: 

  1. Funds under management should be at least US$10m – is it popular? 
  2. Trading activity or daily transactional volume is very important especially when it is time to exit the ETF – can you buy and sell easily?
  3. The ETF is based on a well-known Underlying Index that contains a large range of household named companies – popularity and diversification
  4. The ETF tracks or mirrors the underlying index that it is based on very closely – does it replicate the index?
  5. Market Position of the ETF – is the ETF the first issuer in a particular sector ? Note this point is often the most important of all the criteria considered in this list of factors. 

SUMMARY 

Hopefully this article benefits you on your investing journey by showing how Exchange Traded Funds can assist you to diversify your assets. 

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