Successful investing doesn’t have to be complicated; the most important factor is to find a method and strategy that works for you. Whether that be picking individual stocks or building a portfolio with ETFs.
The growth in ETFs (exchange-traded funds) since their introduction in the 1990s has exploded across the investing universe. Since the first ETF, created in 1993 to track the S&P 500, ETFs have grown to an industry valued at $3.9 trillion.
ETFs continue to grow in popularity partly because of their low fees, simplicity, and ease of use. ETFs allow investors who want to invest in the market but don’t have the interest or time to analyze individual stocks. Over the last 100 years, the returns for the market have hovered around 10%, give or take, and investing in ETFs allows investors to partake in those gains with minimal effort.
In today’s post, we will learn:
- What Is An ETF?
- Pros and Cons of Building an ETF Portfolio
- Five Steps to Choosing the Right ETFs
- Three Steps to Building an ETF Portfolio
- Creating A Sample ETF Portfolio
Okay, let’s dive in and learn more about building a portfolio with ETFs.
What Is An ETF?
Before building a portfolio with ETFs, we need to understand what an ETF is and how they are built.
According to thebalance.com, ETFs are:
“An exchange-traded fund (ETF) is a type of investment security that groups assets together and passively tracks an underlying benchmark index, such as the S&P 500.”
Think of ETFs as a basket of securities with a mix and match of different assets, including stocks, bonds, commodities, and gold.
This makes them similar to mutual funds, which are also a basket of different assets, but unlike mutual funds, ETFs trade like stocks, with prices you can buy at any time in the market.
Mutual and index funds only trade at the end of the trading day; in other words, you can’t buy in the middle of the day, only after the market closes.
ETFs trade on an exchange, like the NYSE (New York Stock Exchange), allowing you to buy and sell shares like you would Apple.
ETF’s versatility makes them the perfect vehicle for investing in broad markets like the S&P 500 or specific sectors like technology, real estate, or commodities. They also enable investing in more focused sectors like SaaS (Subscriptions as a Service) business models, airlines, or companies focusing on the space race.
How Do ETFs Work?
So, how exactly do ETFs work?
ETFs function exactly like stocks, with the buying and selling as easily you can buy or sell your shares of Microsoft. You can buy or sell your ETFs through your brokerage account during normal trading hours. In other words, your Fidelity account will allow you to buy or sell ETFs as easily as stocks.
When you buy or sell an ETF, the operation is the same: you enter your ticker symbol the number of shares you would like to buy or sell, and you enter the trade, and voila!
For example, if you want to buy $500 of a particular ETF, which trades at $50 a share, you’ll need to enter a buy order for ten shares and the ticker symbol (VTI) to execute the buy order.
Vanguard, one of the leaders in the ETF world, with over $7.1 trillion in assets under management, houses some of the more popular ETFs, such as the ticker VTI, which tracks the total stock market. Other popular platforms are:
- Blackrock iShares
- State Street (SPDR funds)
- Invesco QQQ Funds (track the NASDAQ)
And some of the largest ETFs:
- SPDR S&P 500 ETF from State Street (SPY)
- iShares Core S&P 500 ETF from Blackrock (IVV)
- Vanguard Total Stock Market ETF from Vanguard (VTI)
- Vanguard S&P 500 ETF from Vanguard (VOO)
- Invesco QQQ Trust (QQQ)
The best aspect of ETFs is the versatility that allows investors to access broad swaths of the market and or narrow down to invest in specific sectors or subsectors. They also allow investors to build low-cost, efficient portfolios that enable passive investing or more hands-off style investing.
Pros and Cons of Building An ETF Portfolio
As mentioned above, ETFs are baskets of individual stocks that can trade like stocks and have lower expense ratios than mutual funds because of how companies manage their ETFs.
ETFs, whose management is passive, have vehicles tied to underlying indexes or market sectors, such as the S&P 500 or technology. On the other hand, mutual funds struggle to outperform the indices they tie to with their active management. Combine that underperformance with higher fees, leading many investors towards ETFs.
Pros of an ETF Porfolio
- Diversification: by building a portfolio of ETFs, you get instant diversification, which means you are spreading your investment bets around many different assets. In other words, buying a market-matching ETF such as Vanguard’s VTI exposes you to the S&P 500, Dow, and Nasdaq markets, which focus on different markets. For example, the Nasdaq market focuses primarily on technology stocks, whereas the S&P 500 is a little more broad-based, focusing on the top 500 businesses of the US, regardless of sector. By building a portfolio with ETFs, you spread your bets, which helps avoid total portfolio declines in a market crash.
Diversification helps prevent total loss of value; typically, some sectors get hit harder than others, with the latest Covid market crash the perfect example. During the Covid crash, sectors such as retail, industrials, and travel were hit extremely hard, but others, such as online retail or subscription-based businesses, thrived. The Nasdaq did quite well, while the Dow and S&P 500 struggled during the Covid crash, and buying different ETFs would have helped you survive the brief drawdown.
- Low-cost and tax efficiency: ETFs operate as passively managed funds, for the most part, and because of that management, there is zero need for costly research or analysis, which reduces management costs. Many ETFs carry expense ratios less than 0.25% or $25 for every $10,000 you invest. Tax efficiency helps lower costs, too, because the ETFs trade in a manner that makes them more tax-efficient for the shareholder. Lowering costs helps make ETFs more attractive and improve shareholder returns over the long term because more money goes towards compounding.
- Market matching returns: By their design, ETFs mean to match the returns of the markets or sectors they track, and because of the passive nature of their investments, they generally return the same returns. Earning 10% over a long-time horizon leads to great returns, and for all investors, that is the goal; the simple fact is most individual investors don’t match or beat the returns of the markets, making ETFs more attractive.
Cons of an ETF Portfolio
- Market matching returns: If you choose to invest in ETFs, you give up the ability to beat the market. By using ETFs, you avoid enjoying the returns of Warren Buffett or 20% over a 56-year career or the wild ride-up of a Tesla in the last year. These are market abnormalities, and there is much to the turtle versus the hare investing style. The simple fact is that ETFs match the returns of the markets or sectors they mimic, and outperformance doesn’t happen. They offer passive investing, less maintenance and upkeep, and lower fees for the individual investor who doesn’t want the stress of finding and analyzing the next Warren Buffett.
- Too much trading: ETFs trade like stocks, and because of that structure, they could lead to too much buying and selling of ETFs like stocks, which increases fees and could lead to underperformance. The ease of use also makes it tempting to dabble in market timing, which is the buying and selling as sectors rise or fall. It causes investors to speculate on prices instead of investing for the long term. The fact of the matter is that the halls of fame of investing contain ZERO market timers. The best returns come from having a long-term investing mindset and investing consistently over long periods, not buying and selling for the short term.
Five Steps to Choosing the Right ETFs
Before choosing the individual ETFs to build your portfolio, we must consider some factors before putting our money to work.
- Composition of the ETF: We need to look under the hood and determine what makes up the ETF; the name alone is not enough. For example, if you are looking at a clean-energy ETF, you need to examine what companies are held inside the ETF. The ETF might contain some combination of wind, solar, and hydro-focused companies, but it might also contain companies that produce natural gas, or it might focus on the infrastructure of clean energy as their top holdings. Each ETF in the clean-energy sector might have a different focus, particularly in their top holdings, which drive most of their returns.
- Past returns: We also need to compare past returns of competing ETFs to give us an idea of how they performed in the past. Even though it does not guarantee future returns, it gives us a view of potential.
- Fees: There is also the matter of fees; we need to compare returns to fees of the different competing ETFs and ensure that there are no big differences between the fees they charge.
- The number of assets under management: The total number that each fund manages tells us how liquid a fund is or how much money they have to buy and sell shares within the fund. We don’t want funds with lower AUM (assets under management) because they indicate lower liquidity.
- Volume activity: We want funds with good trading volume, which means investors buy or sell the funds daily. Low trading volume indicates low liquidity, which means we might have trouble trading in and out of the fund. For example, if something goes south with a large company within the fund, says Google, goes down on some bad news, we might have trouble trading out of the ETF because there aren’t enough people on the other side of the trade, leading to bigger losses.
Three Steps to Building an ETF Portfolio
If you want to build a portfolio using ETFs, here are three simple guidelines to consider:
- Determine the Right Allocation: Before building the portfolio, we need to consider the goals for this portfolio:
- Our retirement
- Child’s college education
- Legacy fund
Other questions, such as our risk and return expectations, time horizon and distribution needs, tax situation, and personal situation, must be considered before creating the portfolio.
The above questions help form our overall investment strategy and what we hope to gain from these investments. They also help form our asset allocation strategy, which helps guide our investment choices.
Another decision to consider is how much risk you want to take because market data shows higher risk equals higher returns. For example, stocks are riskier than bonds, but stocks also give you better returns than bonds over the long term. Generally, the longer your time horizon, the more risk you can endure because you have more time to recover from market crashes. The general rule is if you have a longer time horizon, you will see better returns if you invest in stocks vs. bonds, but the closer you get to retirement, the more you should invest in bonds to avoid any catastrophic losses you could endure closer to retirement.
Remember that more than 90% of your portfolio’s returns come from our asset allocation instead of market timing. Do not try to time the market; research has shown unequivocally that market timing DOES NOT WORK.
- Apply Your Strategy: Now that we have set our asset allocations, we can investigate which ETFs best meet our goals. The beauty of ETFs is they offer a wide palette or range of choices to fill our allocation needs.
The best place I have found to investigate the best ETFs is ETF.com; they offer the ability to screen for specific sectors or markets you want to buy. You can also compare different ETFs for fees, past performance, AUM, trading volume, etc. There is also the ability to see what companies make up the majority of the fund or which companies have the biggest impact on returns, usually the top ten companies, and to dig deeper and see every company in the fund.
Other great resources are the ETF sites themselves, such as:
Here, you will screen for different funds and see all the pertinent information for each fund. You can also invest directly through their sites if you choose. I suggest housing as much of your investment portfolio under one roof for easier tracking; for example, you can buy all Vanguard ETFs through your Schwab brokerage account.
It is time to start investing once we narrow our asset allocation choices. My favorite way is to put the dollar cost average or consistently put money into the market regularly. It helps build a pattern, like paying any bill and keeps you disciplined and focused on meeting your goals.
- Monitor Your Portfolio: Now that we have built our ETF portfolio, we need to track the performance. Assessing how the portfolio progresses toward our goals at least once a year is best. We can compare the portfolio to the different benchmarks and see if we want to make any adjustments.
Many of those decisions will depend on our goals and how those ETFs match those goals. We also need to consider the factors that might affect the returns, such as economic conditions, market conditions, or business changes.
If the portfolio is not moving in your desired direction, you can consider adjusting the different funds or allocation amounts to fit your goals. Adjusting the portfolio to meet your desired weightings is something you want to consider at least once a year, maybe twice a year at most. Rebalancing is adjusting the different funds to meet your desired goals. For example, if you have a:
- 30% allocation to S&P 500
- 30% allocation to Nasdaq
- 40% allocation to Dow Jones
And if those allocations change to 35% to the Dow Jones, you can either sell some shares to rebalance or focus more of your future investments in that fund to bring it back its desired weighting.
Creating a Sample ETF Portfolio
Creating a portfolio based on ETFs needs to start with our asset allocation plan, how many assets we want to carry, and how much we want to invest in each portfolio.
You can make this part of your plan as simple or complicated as you want, but it needs to meet your goals and risk tolerance.
You can, for example, create a portfolio with as little as two or three ETFs: one to track the whole market, one to track the S&P 500, and maybe one to track the emerging markets or abroad. Remember that this is US-focused, but the idea can translate to any local market and expand.
None of these suggestions are investment advice; they are meant as examples to help illustrate the idea.
If we take our three ETF ideas and want to allocate them to the above allocations, we could do the following:
- 50% Vanguard Total Market ETF (VTI)
- 30% Vanguard S&P 500 ETF (VOO)
- 20% Vanguard Emerging Markets (VWO)
You could easily shift the different ETFs to different weightings or swap out the emerging market fund for a bond fund; this theme has many variations.
Other choices are working with different fund providers, such as picking the ETFs from a mix of funds such as Fidelity, Schwab, and Blackrock.
Or you could use the above as your base fund, which you allocate money to every month, and then branch out from there, maybe adding some tech-focused ETFs, energy-focused ETFs, or even more exotic funds like cannabis. It would help you decide what works best for you because it is your money and risk tolerance.
You could also build a portfolio based on all the asset classes and the above base allocation. For example, including an ETF with a focus on:
- Real estate
- Cash and equivalents
The world is your oyster; the possibilities and combinations are endless if investing in ETFs is the way you wish to go. It is best to make it as simple as possible, something you can manage and stick to over the long term.
Building a portfolio with ETFs is fairly simple once you understand your goals, what ETFS are, and what to look for when picking specific ETFs.
The combinations and possibilities are endless; you can build the portfolio to your goals and needs. One word of caution: try not to go overboard and make a complicated portfolio for the shake of complicated. Albert Einstein once said you should make everything as simple as possible but no simpler.
Instead, focus on your goals what you are willing to manage, and keep you interested in the long game.
ETFs provide flexibility, ease of use, and low fees for any investor, and they can be a great way to invest if you don’t have the time or interest to pick individual stocks.
That doesn’t mean you must choose one or the other; you can easily mix and match ETFs with individual stocks. If you want to make your major investments a portfolio of ETFs, but you want to dabble in individual stocks for fun, you can easily do that, and it is a great way to stay interested in investing. It could also lead to more interest and take a bigger role in choosing your investments.
The main objective is to remember your investment goals, time horizon, and risk tolerance and stick to those because that will lead you to success. Investing consistently over the long term is the way to win this game.
And with that, we will wrap up our discussion on building a portfolio with ETFs.
As always, thank you for taking the time to read today’s post, and I hope you find some value. If you need any assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,
Dave, a self-taught investor, empowers investors to start investing by demystifying the stock market.