What we'll cover
What is an ETF
Things to consider when choosing ETFs
How to build an ETF investment strategy
The world of investing can be intimidating with its acronyms and buzzwords. Fortunately, investing doesn’t have to be overly complicated (or expensive).
Whether you’re new to investing or a market veteran, you can build a portfolio that includes exchange-traded funds (ETFs). With their ability to diversify a portfolio and their liquidity, range of asset classes and low expense ratios, ETFs are a favorite among many investors.
What's an ETF?
ETFs are funds that pool together the money of many investors to invest in a basket of securities that can include stocks, bonds, commodities, etc. That means when you invest in one ETF, you’re exposed to all the underlying securities held by that fund (which can be hundreds).
ETFs are traded like stocks on the stock exchange (hence, the name exchange-traded fund) – they’re bought and sold throughout the trading day. That means the price of an ETF share can fluctuate above or below its net asset value (NAV) based on supply and demand.
How much of a portfolio should be in ETFs?
If you’re interested in building an all-ETF portfolio, keep in mind, even though an ETF itself is inherently diverse in nature, you’ll still need to diversify your entire portfolio. If you only own one ETF, you’re putting all your eggs in a single investing basket. Fortunately, it’s fairly easy to diversify a portfolio with ETFs.
ETF diversification
Portfolio diversification is an important investment strategy that may help you better manage the risk of market volatility. Since ETFs consist of numerous holdings (sometimes spanning many industries) within a single fund, the negative effects of any up and down swings in the market are typically less severe.
What’s more, you can achieve diversification by investing across asset classes, industries and countries or by choosing funds with holdings in different asset classes.
For example, you could invest in a government bond ETF, a precious metal-tracking commodity ETF and a foreign currency ETF.
The cost of ETF investing
ETFs are typically passively managed (compared to actively managed mutual funds). This means that instead of a fund manager using their knowledge to select the investments in the ETF, they simply select securities to try and keep pace with a major benchmark, like the Dow Jones Industrial Average or the Russell 2000.
Since they’re less time-intensive for brokerages, ETFs tend to have lower expense ratios (a.k.a. the cost for operating and managing a fund) than many other investment choices.
Even better, when you invest in ETFs, you’re able to invest in hundreds or even thousands of securities with just one transaction. Not only does this allow ETF investors to hold portions of stocks they might not be able to afford otherwise (like Berkshire Hathaway), but it can also mean commission-free trading.
Before you invest, you should carefully review and consider the investment objections, risks, charges and expenses of any ETF you are considering. ETF trading prices may not necessarily reflect the net asset value of the underlying securities.
What to consider when choosing the right ETFs
Before you can build an ETF portfolio, you’ll need to think through these factors.
Your investment goals
Are you socking away for retirement, saving for a splurge in the short-term or collecting cash for college tuition? Defining your goal – whether long- or short-term – makes a difference to your ETF investment strategy. For instance, long-term investors with a larger investment time horizon can consider taking on more risk.
Your risk tolerance
Knowing what level of risk you’re willing to tolerate can help you determine your asset allocation – that is, how the assets in your portfolio are allocated to balance risk and reward. Your risk tolerance is determined by several factors including age, net worth and even why you’re investing.
Your current income needs
Determining how investing fits into and feeds your budget is another crucial consideration. What kind of cash do you have available to invest? Are you looking to bring in a steady stream of returns now? If so, you might want to add a mix of dividend-paying or fixed-income ETFs to your portfolio.
4 steps to build an ETF investment strategy
Open a self-directed trading account. Start with a self-directed trading account. That puts you in the driver’s seat of your trading strategy, decisions and transactions.
Determine your allocation. Asset allocation is an investment strategy that aims to strike a balance between risk and reward and to attempt to reduce risk in your portfolio by investing across different asset classes. Depending on your goals, you may find you’re comfortable investing more heavily in bonds (often a lower-risk investment) than stocks, for example.
Apply your strategy. After determining an asset allocation that fits your goals, it’s time to apply your investment strategy. That means:
First, determining how or how often you want to invest funds – whether it’s a fixed amount of money at regular intervals (like paying a bill), an annual investment or somewhere in between
Second, selecting ETFs that align with your goals and allocation. Our ETF screener can help you investigate thousands of ETFs
Track your performance. Once you’ve built your portfolio, it’s crucial to track its progress against your goals. If the portfolio isn’t performing as well as you want, you can adjust your allocations. Remember, many factors like market conditions, business performance and even international events can impact how a portfolio performs, so it’s a good idea not to make adjustments more than once or twice a year.
ETFs are a great way to take some of the complication and confusion out of investing. Not only do they give you access to stocks that may be too expensive to purchase individually, they’re also passively managed (often incurring lower fees than their mutual fund companions) and can be bought commission free — making them a less complicated, more affordable alternative for investment novices and pros alike.
