Using Exchange-Traded Funds for Portfolio Construction: Overview

Asset allocation refers to the mix of assets such as stocks, bonds, cash, and commodities in your portfolio and being well diversified. The purpose of asset allocation is to improve returns or reduce risk through diversification. Exchange-traded funds can be an easy way to gain this diversification, as they tend to be low-cost and are available in a variety of different asset classes. In addition to broad indexes, ETFs are available in niche areas, covering style, size and sector segments, which can be combined to suit an individual's needs.

Settle on an allocation

While it is common to spend a great deal of time researching individual stocks or fund managers, it is important not to lose sight over the aggregate portfolio, as asset allocation is often more important as fund selection. The first step in building an ETF portfolio is to figure out the right asset allocation. A good place to start is with an assessment of one's goals and risk tolerance. Typically, assets with higher expected returns are risky, while safer assets offer lower returns. In general, investors with a long time horizon should consider a more aggressive approach weighted heavily toward equities, while people within just a few years from needing their money should stick to more conservative investments, such as high quality bonds.

The core-satellite approach

One approach to asset allocation is to use what is called a "core-satellite" approach. Core holdings are those that are strategic in nature and held for the long term. The majority of an asset allocation should be in core holdings. These building blocks do not necessarily have to be large. For example, small cap stocks can be a core holding in an equity asset allocation, despite the fact that small cap stocks will be a small holding. "Satellite" holdings are more tactical in nature. Only a small portion of a portfolio should be invested tactically.