How to Use ETFs to Maintain a Balanced Investment Portfolio
Your investment portfolio is balanced when it matches your risk criteria. Kevin D. Flynn, a seasoned investment professional, shows you how a mix of the right ETFs can help you accomplish that.
8 min read
Building a balanced investment portfolio begins with a risk analysis of the investor. Since your risk tolerance differs from other investors, a cookie-cutter approach won’t work. You can use a generic portfolio model if you’re self-managing your investments, but your returns won’t be optimal if you don’t account for risk.Let’s delve into this further. A married couple in their forties with two children and a mortgage can’t afford to take on as much risk as a single individual in their twenties. The former might incorporate “safer” investments, like ETFs and mutual funds, into their portfolio. They're also more likely to put money into a savings account as an emergency fund.I’m not saying that ETFs aren’t a good investment for younger people. An ETF investment portfolio can grow exponentially with a decent compounded return rate. In this article, I’ll review the different types of ETFs and provide some tips for choosing the ones that work best for you. I’ll also explain what a “balanced investment portfolio” is and why it’s important.
What is an ETF investment portfolio?
An “exchange-traded fund,” aka ETF, is a collection of securities that trade on an exchange. Think of it as a “bucket” of stocks and bonds. ETFs can be bought and sold at any time during the trading day, unlike mutual funds, which only trade at the end of the day. That makes ETFs a more liquid investment for those worried about solvency.ETFs are managed funds without high management fees. According to the Investment Company Institute (ICI), the average expense ratio of an index ETF in 2023 was 0.16%, while actively managed mutual funds have an average expense ratio of 0.66%. That may not sound like much, but it adds up over time. Cost should always be a factor when selecting investments.An ETF investment portfolio is an investment fund made up entirely of ETFs. Robo-advisors often take this approach to minimize risk. Humans are more likely to mix stocks and ETFs. You could also add bonds, mutual funds, and alternative investments. I’ll get into that in more detail below. For now, here’s a list of the different types of ETFs you can buy:
Equity ETFs: Equity ETFs are popular because they track the performance of a stock market index, sector, or industry. For example, the S&P 500 typically has a double-digit yearly return (10%+), and an S&P 500 equity ETF would match that.
Fixed-income or bond ETFs: Bond ETFs track government, corporate, or municipal bond indices. Fixed-income ETFs are similar because they track fixed-income securities.
Commodity ETFs: Commodity ETFs track the price of commodities like gold, oil, or agricultural products. Some commodity ETFs include futures contracts in their holdings.
Sector and industry ETFs: Sector and industry ETFs are similar to equity ETFs, but they focus on specific sectors, such as technology, healthcare, or energy.
Inverse and leveraged ETFs: Inverse and leveraged ETFs use derivatives like options and futures to increase returns. That means the risk is also higher.
Multi-asset ETFs: This type of ETF is exactly what it sounds like — a multi-asset ETF that could contain stocks, bonds, commodities, or alternatives.
What is a balanced portfolio?
Higher risks can lead to higher returns, but low-risk investments can produce a steady passive income. A balanced portfolio is a strategy where you divide your investments between the two. For instance, you might own some high-risk stocks that could produce double-digit returns, but could also tank and lose money. Buying low-risk bonds could mitigate that loss.A classic example is a 60/40 portfolio with 60% stocks and 40% bonds. That type of mix was a financial advisor's mainstay for decades. In this century, we have more options. The first ETF, the SPDR S&P 500 ETF (SPY), was launched in 1993. Bitcoin, a popular alternative investment, was first introduced in 2008. These options have changed the way we balance portfolios.What hasn’t changed is the concept of risk tolerance. Modern portfolio theory (MPT), which has been around since the 1950s, advocates a weighted distribution of your stock investments across eleven market sectors. That mix is still considered a cornerstone for building a balanced investment portfolio. It mitigates losses but doesn’t necessarily maximize gains.ETFs provide the same diversification that market-sector investing does, without the added burden of tracking dozens of different companies. They’re also more cost-effective. Every sector has at least one ETF. You can even skip the sectors and use equity ETFs that track entire stock market indices. SPY has returned over 90% in the past five years.
Additional benefits of ETF investing
Diversification and cost aren’t the only two benefits of ETF investing. Liquidity is also an attractive feature. ETFs are traded on exchanges just like stocks. You can buy and sell them at any time during the trading day. You can’t do that with mutual funds or hard assets like cars, artwork, and real estate. Those make you less solvent. ETFs are as good as cash.Another appealing element of ETF investing is transparency. Because the fund managers must reveal their holdings, you can see them in real time. ETFs are also more tax efficient because their structure minimizes capital gains distributions. The lower volatility of these “bucket” funds makes them a better “buy and hold” investment.One of the newest additions to this investment strategy are US Spot Bitcoin ETFs. The SEC approved them on January 10th, 2024, and they have already impacted the investment world. I won’t tell you to buy or not buy them, but they’re worth watching. There are several to choose from, with more on the way soon.
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Successful investing requires research and adaptability. Some market conditions are predictable, while others come as a complete surprise. In this century alone, we’ve seen several “black swan events” that have caused extreme market volatility. You can’t avoid those completely, but you may be able to minimize your losses with the following strategies:
The core-satellite approach
The core-satellite approach involves building a “core” of broad-market ETFs that provide stable, long-term growth and adding “satellite” investments with sector-specific or industry ETFs to capitalize on short-term opportunities. This strategy allows you to maintain a solid foundation in your investment portfolio while exploiting market trends that could lead to higher returns.
Dollar-cost averaging
Dollar-cost averaging is an investment strategy in which you invest a fixed amount of money at regular intervals (daily, weekly, monthly), regardless of market conditions. This approach can reduce the impact of market volatility and lower the average cost per share over time. ETFs make this strategy easy to implement because they provide diversified exposure.
Hedging with derivatives and alternatives
This strategy is not for risk-averse or novice investors. Derivatives, particularly put and call options, are complicated and difficult to predict. Alternatives aren’t typically stable either, so they’re a gamble. A good example is the crypto asset class. You could make a bundle of money there or lose it just as quickly. Make sure you know what you’re doing if you’re going to hedge.
Common pitfalls to avoid
There’s no such thing as a “sure thing” in the investment world. ETFs are generally considered a safer investment than most, but risk is still involved. There are also some common pitfalls to avoid when using them to maintain a balanced portfolio:
Over-diversification: While diversification is important, over-diversifying by holding too many ETFs can lead to overlapping holdings and reduced potential for returns. Aim for a balanced approach without excessive complexity.
Ignoring costs: Pay attention to the expense ratios and trading costs associated with ETFs. While ETFs are generally cost-effective, fees can add up and impact your overall returns. There may also be transaction fees if you’re trading on a retail platform.
Chasing performance: Avoid the temptation to chase after high-performing ETFs. Focus on your long-term investment strategy and stick to your asset allocation plan. Most financial advisors recommend the “set it and forget it” approach.
Lack of research: Not all ETFs are created equal. Conduct thorough research to ensure the ETFs you choose align with your investment goals.
Conclusion
The question you need to ask yourself here is, “What is a good ETF portfolio?” The answer is an investment portfolio that matches your risk tolerance, is balanced to minimize market volatility, and takes advantage of the variety of investment products currently available. You might want to consult with a financial advisor if this confuses you. If you manage your own investments, then make sure to do your research and don’t buy anything that looks questionable.
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