Building an investment portfolio: using ETFs to build a low-cost diversified portfolio
It has never been as easy or as cost—effective to build a well—diversified investment portfolio for yourself. Exchange traded funds allow you to spread your investments across indices, sectors, asset classes and other investment areas easily.
Many studies have demonstrated that actively managed investment funds struggle to beat their benchmarks consistently over the long term. Research from S&P Dow Jones Indices, for example, showed that in the decade to the end of 2017, the majority of active fund categories in Europe underperformed, and only 15% of active pan—European equity funds beat the S&P Europe 350 index. In the US, research found that between 92% and 96% of small, mid and large—cap US active equity funds struggled to meet their respective benchmarks over a 15—year period to the end of 2017.
This suggests that finding an active fund that can outperform and justify its higher management fees can be a bit of a minefield. No wonder then, that building a portfolio of passive funds has been such an attractive option for investors, who have poured more than $5 trillion into exchange traded products globally.
Why build a portfolio of ETFs?
Exchange traded funds (ETFs) are one way to achieve diversification at a low cost. There has been an escalating price war in the passive fund space in recent years, with providers competing in a race to the bottom on fees. The largest providers, such as BlackRock and Vanguard, have used their economies of scale to drive down prices. By the end of last year, the average expense ratio of an index equity ETF hit a record low of 0.21%, according to the Investment Company Institute. This is very important from the perspective of your portfolio’s returns, because high fees can rapidly erode your gains.
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ETFs are liquid and easy to trade. They also give you an advantage when it comes to diversification because they are designed to follow an index or group of stocks or bonds, so you hold a large basket of securities rather than individual ones. This means you could benefit from any positive returns while spreading your risk. Make sure you understand the type of ETF though — physical ETFs actually hold the securities they track, while synthetic ETFs use financial instruments called derivatives to replicate the performance of those securities.
Read more about leveraged ETFs
What are the downsides?
There is a huge amount of choice in the ETF market. With over 5000 products on offer globally, investors might find it a daunting task even knowing where to begin. Comparing prices and understanding exactly what you want your ETF to do can help you narrow your focus. You will also need to understand what exactly you are holding when you buy a particular ETF, to make sure you are not doubling up on exposure in your portfolio.
Explore ETFs using IG’s ETF screener
You also face market risk. Because an ETF is a passive product, it can’t take any action to mitigate losses in falling markets like an active fund could, meaning you just have to ride out the ups and downs.
Another factor to consider is that some markets, such as emerging, frontier or small—cap, are under—researched and come with their own specific set of risks which are hard to navigate without local knowledge. Active managers argue that it is worth paying more for their long track record and on—the—ground analysts meeting regularly with company management teams. This expertise and experience can mean the active manager might stand a better chance of picking winning companies and avoiding the losers in certain markets.
How to get started
Think about what you want your portfolio to achieve, and over what timescale, as this will affect your risk tolerance and therefore the kind of investments you should hold. The asset mix will depend on your age too, as this will influence the level of risk you can afford to take — younger investors have more time to make up any losses.
Assuming you have a reasonable timeline of a few years and at least a moderate appetite for risk, you could choose a selection of ETFs giving you exposure to the major bond and equity markets. You can keep it simple, with just three or four very broad ETFs covering say, developed equity markets, emerging equity markets, and global bond markets. Or you could go for a slightly more granular approach, with UK, US, European and emerging market (EM) equity funds, and a mix of small, mid and large—cap exposure. Your bond portfolio might include developed market government bonds, high—yield bonds, and international investment grade corporate bonds. You might choose a property or commodities ETF, or an even more narrowly themed, sector—specific one focusing on robotics, healthcare, water or financials for more targeted exposure. The high level of choice in the ETF market is a plus point as well as a downside, it just means you need to do your homework.
Read more about our top 50 ETFs for 2018