There is a difference between investing and investments. Investing is a process to help you achieve your goals. An investment is a means to an end. Building a portfolio is more than assembling a random mix of investments that you think will ‘do well’. 

Before selecting investments figure out what you are trying to achieve by setting a goal that includes the return and the asset allocation that will give you a shot at achieving your goal. Based on your goal define an investment strategy that includes security selection criteria to provide a framework for picking from the thousands of available investment options.

I’ve covered the approach for these two steps below:

With the hard work out of the way it is time to build a portfolio based on the asset allocation that is aligned to the return you need to achieve your goal.

Below are the four steps to create an ETF portfolio. 

Step one: Determine how many ETFs will be in your portfolio

There is no right answer to this question. However, there are significant benefits to simplicity.

The adage that less is more certainly applies here. We are programmed to think being a great investor is having a complex portfolio. Get out of this mindset. Being a great investor is accomplishing your goals. You don’t lose any points for doing that in the simplest way possible.

Having a more complex portfolio requires more effort. Keeping track of a wide variety of investments is more time consuming. Rebalancing a complex portfolio becomes more difficult. Adding new contributions to your portfolio can be more challenging as your holdings grow since you need to decide where to funnel new savings.

Having more holdings in your portfolio makes it more likely that you will be tempted to tinker with it more. This makes it harder to acheive your goals. Most investors lower their returns by trading too much.

A simple portfolio involves a single ETF for each asset class that you want exposure to. For most investors shares and a single defensive asset class like bonds or cash will probably suffice. Aussie investors will typically want one ETF for Australian shares and one for global shares plus the defensive asset class.

Here are two examples of 3 ETF portfolios:

Investors considering a portfolio with more holdings should think about the justification for adding each additional ETF. It may make sense to add additional ETFs based on your goals and investment strategy. Just make sure there is a high hurdle for including asset classes like emerging markets, small-cap shares, a thematic or factor ETF and the countless other offerings.

It may sound counterintuitive but just because someone – a reputable financial expert or a mate at a bbq – makes a convincing argument that a certain ETF is attractive is not a good reason to add it to your portfolio. They may be wrong. The opportunity may be short-term when your time frame is long-term. The ETF may not align with what you are trying to accomplish. Don't think about the ETF in isolation. Think about how it impacts the make-up of your portfolio and how it fits with your investment strategy.  

Step two: Research ETFs

Passive ETFs

Some ETFs track an index. Those can be broad ETFs that track well-known indexes like the ASX 200 and the S&P 500. They can be factor and thematic ETFs that track specialised indexes that are designed to capture a certain characteristic or theme that investors may want exposure to.

Each of those indexes has rules that dictate what securities are selected, the weightings of those securities and when changes are made. If you don’t understand how an index works you don’t understand what you are investing in. That guarantees you will not achieve your goals except by dumb luck.

Beware of labels. ETFs with similar names may take very different approaches. Some ETF names are meant to capture investor attention but are unable to effectively match the label.

The good news is that indexes come in all shapes and sizes. Some are simple. Almost every investor can understand them. The ASX 200 invests in the 200 largest companies in Australia and weights them based on their size. Changes are only made if the 201st biggest company becomes larger than the 200th. That is an index that requires little investing knowledge to understand.

Some indexes are very complex. Securities with certain characteristics are being sought like value shares or quality shares or a certain theme is being captured like robotics or AI. If you don’t understand how these indexes work don’t worry. Just don’t invest in those ETFs. Selecting broad index ETFs is a proven way to build wealth and achieve your financial goals.

I've walked through selecting an income ETF as an example.

Active ETFs

Active ETFs are managed by an individual or team of professional investors. There are certain guidelines that dictate what securities they can pick. But ultimately you are relying on the skill of the professional managers. This is harder to assess for the average investor but it is important to understand the strategy. Tread carefully with actively managed ETFs and know that most managers underperform the index.

More information on finding the right manager is available in this podcast.

After understanding the index or active strategy see how it plays out in real life. I’ve outlined a process below that walks through an examination of the allocations to certain countries, sectors and the top holdings. Below is an example for one of Australia’s most popular ETF, the Vanguard MSCI International Shares ETF (ASX: VGS):

This ETF invests in global shares from 22 different countries but is dominated by the US. 

Country exposure

Below is the allocation to companies operating in various sectors. Technology is the largest sector given the high allocation to the tech-heavy US market.

Sector allocation

The largest positions are large US technology companies. Each of the top 10 holdings are US shares.

Top 10 holdings

Finally look at the fees. Minimising fees is one of the easiest things that all of us can do to increase our returns.

Step three: Beware of overlap

If you are adding additional ETFs to a portfolio they need to serve a purpose. As new ETFs are launched the marketing teams at product providers kick into overdrive to get investor attention. Each new ETF is portrayed as a great addition to a portfolio or a better way to get exposure to a desirable part of the market. There are countless ways to slice and dice the market but the underlying drivers of returns may be similar.

We have a tool for Morningstar Investor subscribers called portfolio x-ray which shows the overlap between various ETFs. The good news is that you can investigate overlap on your own with a little effort. Below are the steps that investors can take by looking at the product provider websites or the website of the underlying index that the ETF tracks:

  1. Start with country level asset allocation (for global ETFs): Most global ETFs are heavily weighted to the US given how well the US has performed over the past 15 years. Regardless of the name of the different global ETFs they often provide 60 to 70% exposure to the US market. This is not necessarily a bad thing but having multiple ETFs that are driven by US returns is likely unnecessary.
  2. Look at sector weightings: The Australian market is dominated by miners and banks. The returns of many ETFs with Australian equities will be driven by the performance of these sectors. No need to double up. Globally, US technology shares are often the largest positions. For instance, the iShares S&P 500 ETF (ASX: IVV) has a 30% allocation to technology shares. The Vanguard MSCI International ETF (ASX: VGS) has a 25% allocation to technology shares. The BetaShares NASDAQ 100 ETF (ASX: NDQ) has a 50% allocation to technology shares. Do you need all three of these ETFs in your portfolio? I would argue you don’t. They have slightly different tilts but significant overlaps. Pick one and move on.
  3. Look at the top 10 holdings: Most ETFs track indexes that are market capitalisation weighted. This means that bigger companies make up larger percentages of the ETF’s underlying holdings. In Australia BHP (ASX: BHP), CBA (ASX: CBA), CSL (ASX: CSL) and other banks dominate many ETFs. Globally the largest companies are US tech shares including Microsoft (NAS: MSFT), Apple (NYSE: AAPL), Nvidia (NAS: NVDA), and Amazon (NAS: AMZN). Make sure that you aren’t holding multiple ETFs that have large percentages allocated into the same shares.

Can’t decide which ETF to buy when there are similar countries, sectors and individual shares that make up large percentage of holdings? One simple decision-making criteria is the ETF with the lowest fees.

Step four: Resist the urge to change or add on to your portfolio

There are more than 300 ETFs available in Australia. By the time I finish typing this sentence a new one will probably be launched. If 300 choices sounds overwhelming be thankful you don’t live in the US where over 3,000 ETFs are available.

Remember that each new attractive sounding ETF doesn’t make it right for you. The ETF wouldn’t have been launched if there wasn’t a compelling narrative to use for marketing. Core ETFs have been available for years. Most new ETFs can be ignored.

As part of your investment strategy include criteria for making changes to our portfolio. That criteria should not include performance. Come to terms with the fact that a holding in your portfolio is not going to be at the top of the performance charts all the time - or even any of the time. That does not mean you aren’t going to earn high returns and meet your investment goals. More often than not achieving your goals involves less activity and not more.

Building a portfolio isn’t easy. But it is not an insurmountable task. 99% of the difficultly is self-induced. We all need to overcome our preconceived notion that a portfolio is supposed to be complex and that a good investor nimbly adjusts a portfolio based on an interpretation of current conditions. Do less and end up with more. 

Want more on ETFs?

 

Have questions about ETFs? Email me at mark.lamonica1@morningstar.com