Future Focus: The problem with building a portfolio one ETF at a time
You want a cohesive portfolio, not a jumble of ETFs.
Exchange Traded Funds (ETFs) are becoming increasingly popular with investors. Their popularity stems from lower costs, easy access to diversified portfolios and the ability to get exposure to themes investors find attractive. Without this vehicle, there are some investors that would not have entered the market at all.
However, like any investment, ETFs should be used in a deliberate and holistic manner. Otherwise, you end up with a jumble of holdings in your brokerage account and may pay extra fees and duplicate exposure in your portfolio. Many investors end up with a collection of ETFs that sounded good at the time instead of a well thought out portfolio.
It’s important to acknowledge that when you look at an ETF in isolation its purpose is clear. When they are grouped together, a successful portfolio will have the same outcome – a clear purpose.
The illusion of progress
One of the biggest challenges as an investor is how unproductive it feels to sit on your hands. Investing is a unique exercise where more effort or activity isn’t rewarded. Success usually comes to those that tinker the least amount possible.
It is always tempting to adjust your portfolio for an attractive new opportunity. However, with the continued proliferation of new ETFs designed to appeal to investors’ tendency to chase returns brings more challenges.
You may be tempted into more global exposure, or more diversification, or a concentrated bet in a particular part of the market. There is compelling argument offered for each potential portfolio adjustment.
This leads to building portfolios one ETF at a time. A reactive portfolio that is an assortment of ETFs instead of a portfolio where each piece has a purpose that is intrinsically linked to your financial goals.
None of the ETFs may be the ‘wrong’ choice, but if each decision is made in isolation of the other moving parts you can lose sight of how the entire portfolio behaves as a system. The result is usually overlap, unintended exposure and unneeded complexity.
Just one more!
Just like at a night out at the pub, if you’re saying ‘just one more’, it is a sign you probably don’t need it.
If you don’t have a purposeful path, ETF portfolios tend to grow incrementally. Many investors can’t even justify their holdings to themselves. This matters.
If you can’t articulate why you own each ETF and the role it plays, you’re far more likely to make poor decisions under stress. You don’t know what to rebalance. You don’t know which ETF to top up with additional investments. You don’t know why your portfolio is behaving in the way it does through market volatility.
Complex portfolios demand tough decisions to be made at precisely the moment investors are least equipped to make good decisions.
The clear dilineation between direct equity and ETF investors
If your portfolio is strictly comprised of ETFs, traditional market commentary can often create a perspective that there’s always new and upcoming opportunities.
This is because much of this commentary is based on the behaviour of investors in direct equities who are actively managing portfolios. Many of the shares or sectors they identify as attractive make up a small part of their portfolio or involve a small tilt in a certain direction.
I encourage investors that focus on direct equities to have a ‘wishlist’ of investments that fit their portfolio criteria, and there’s a chance they will come into favour. Characteristics of equities can also evolve to become suitable for your portfolio.
ETFs do not operate like this. Investors with ETF only portfolios should not always be on the lookout for new investments that may fit high level criteria. This is another way to to end up with an overly complex portfolio, likely with overlap and areas of unnecessary concentration.
The risks: Performative diversification
Most ETF-heavy portfolios look diversified - multiple ETFs, different providers, different labels.
In reality, many are dominated by the same underlying exposures. Global equity ETFs currently have heavy weightings to US megacap companies. Australian equity ETFs tilt towards banks and miners. Add a tech-focused ETF, an income ETF or a global growth ETF and you’ll be increasing concentration rather than diluting it.
The risks: Behavioural
If you don’t know how your portfolio will behave during market volatility, it’s important to understand that this could result in suboptimal results in your portfolio. Studies have repeatedly shown that volatility shakes investors and leads to poor decision making.
This risk is compounded if investors are holding securities that they only chose for quick wins. Conviction is only skin deep when you buy an investment because you think it will only go up. That conviction evaporates quickly during a downturn.
There is a large cohort of investors that hold investments that are mismatched with their goals.
We study the difference this makes to investors’ portfolios in our Mind the Gap study. In the last edition of the study, it resulted in 1.2% p.a. less in investors’ accounts due to poor timing and decisions.
Understanding what you’re invested in and how it connects to your financial goals can reduce the impact market volatility has on you, and the frequency of poor decisions.
Start with defining what you’re looking for
To do this right, start with an investment strategy that connects to your financial goals. This requires getting the foundation right. Ensure that you have an emergency fund and a clear budget that has a sustainable surplus that you are able to invest.
Then, go through the portfolio construction process. This involves:
- Defining your financial goals
- Knowing the required rate of return for your portfolio to reach those goals
- Understanding the asset allocation that will achieve that required rate of return
- Selecting the right investments that will fill those asset class buckets
You’ll notice that selecting investments is the last step of the process and not the first. Any investment – including ETFs - are only a vehicle to get you where you need to be. When you’ve done the groundwork, you’ll understand how it fits into your portfolio, and the other holdings within it.
We have further resources on the portfolio construction process here.
I’ve also written an article that can run you through the process of how you develop an investment strategy based on what you are trying to achieve, and how you choose an ETF based on this.
You can find the article here.
What if you’ve got it wrong?
What do you do when you have made ETF investments in the past that are no longer right for what you’re trying to achieve? Transitioning from a speculator’s portfolio to an investor’s portfolio involves considering multiple factors including taxes and transaction costs.
I’ve written an article on what you need to weigh up if you’ve found yourself in this situation.
Invest Your Way
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