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Using Exchange-Traded Funds for Portfolio Construction: the Core-Satellite Approach

Using Exchange-Traded Funds for Portfolio Construction: the Core-Satellite Approach

For core portfolio exposure, many investors could be well served by exchange-traded funds (ETFs). There are number of inexpensive, broad market ETFs that track major indexes, like the S&P 500 or Barclays Aggregate Bond Index. This can be a very cheap way to gain exposure to the broad market. But investors who are dollar-cost averaging (regularly investing small amounts over time) should carefully watch broker fees that are incurred when buying ETFs, as they may push the overall costs of the investment over that of a traditional index mutual fund.

Things To Know

  • ETFs can serve both core and satellite purposes.
  • ETFs can also give you access to alternative assets.

Consider them for the satellite portion too

The variety of ETFs available and the ease in which they can be traded makes them ideal for "satellite" purposes and allows tactical investors to manage their own portfolio more actively. Satellite holdings are typically shorter term and attempt to take advantage of an investment idea rather than be held for an extended period. For example, if an investor feels a certain industry is undervalued, instead of buying dozens of stocks in the industry or researching a mutual fund manager with the same view, she can buy a sector ETF. Although it is difficult to time the market, investors so inclined can move in and out of ETFs quickly. ETFs can also be used to hedge existing holdings or for pairs trading.

Look at other asset classes

Another important role that ETFs can play in your portfolio is to provide access to alternative asset classes like commodities and currencies. These areas, which used to be either more difficult to trade or available only to institutional investors and high-net worth individuals, can help further diversify your portfolio. Although most investors would want these asset classes to represent only a tiny fraction of their overall holdings, their presence in a portfolio can be helpful because they can be less correlated to broader stock market returns over long periods of time.

Asset allocation and diversification do not eliminate the risk of experiencing investment losses.