How to Diversify Your Portfolio With ETFs

An Exchange Traded Fund (ETF) is a marketable security that tracks an index, commodity, bonds, or a basket of assets, trading like a common stock on a stock exchange. These investment funds hold multiple underlying assets and can be bought and sold throughout the trading day. Portfolio diversification involves spreading investment risk across various investments to minimize exposure to any single asset or risk and reduce volatility. ETFs offer an accessible and cost-efficient way to build a diversified investment portfolio, providing immediate exposure to a basket of securities.

Foundations of ETF Diversification

Diversifying a portfolio using ETFs involves spreading investments across various dimensions to manage risk and enhance potential returns. Diversification across asset classes, such as equities (stocks), fixed income (bonds), and alternative assets like real estate or commodities, helps reduce overall portfolio volatility. Different asset classes often perform distinctly under varying market conditions. For example, when stock prices decline, bonds may sometimes increase in value, balancing the portfolio.

Geographic diversification involves spreading investments across different countries or global regions. This strategy helps mitigate country-specific economic or political risks. Investing internationally can provide exposure to different market behaviors and growth opportunities, such as the stability of developed economies or higher returns in emerging markets. ETFs can offer broad exposure to various regions, from international markets to specific countries.

Diversifying across industry sectors helps avoid over-reliance on a single industry’s performance. Sector-specific ETFs allow investors to gain exposure to different segments of the economy, such as technology, healthcare, consumer staples, financials, or energy. By adding ETFs from various sectors, the portfolio reduces exposure to specific risks within any given industry. If one sector experiences a downturn, gains in other sectors might help offset losses, stabilizing overall portfolio performance.

Market capitalization and investment style are further dimensions for diversification. Market capitalization refers to company size, allowing for diversification across large-cap, mid-cap, and small-cap companies. Large-cap stocks tend to be more stable, while mid-cap and small-cap stocks might offer higher growth potential but with increased risk. Diversifying by investment style, such as growth-oriented versus value-oriented companies, captures different market dynamics, providing a balanced risk and return profile.

Building a Diversified ETF Portfolio

Constructing a diversified ETF portfolio involves selecting and combining specific types of ETFs. A widely used strategy is the core-satellite approach, which combines broad-market ETFs as the “core” with more targeted ETFs as “satellites.” The core typically consists of low-cost, broadly diversified investments like total stock market or total bond market ETFs, providing a stable foundation for the portfolio.

Satellite holdings enhance diversification or gain specific exposure not fully covered by the core. These can include sector-specific, country-specific, or specific bond type ETFs, allowing for tactical positions or higher-risk, higher-reward opportunities. For example, a total U.S. stock market ETF provides broad domestic equity exposure, while an emerging markets equity ETF adds geographic diversification. An investment-grade corporate bond ETF offers fixed income exposure, and real estate investment trust (REIT) ETFs can be used for alternative asset exposure.

Equity ETFs, such as those tracking the S&P 500 or a total stock market index, offer broad stock market exposure. International equity ETFs provide diversification outside the domestic market, including developed and emerging markets. Fixed income is covered by aggregate bond ETFs, which can include government bonds, corporate bonds, or high-yield bonds. Commodity ETFs or real estate ETFs (REIT ETFs) can be used to diversify into alternative asset classes.

When selecting specific ETFs, several factors warrant consideration. The expense ratio, the annual fee charged as a percentage of the fund’s average net assets, impacts overall returns. Lower expense ratios are preferred. Liquidity, or the ease of buying and selling ETF shares without significantly impacting their price, is also important. Tracking error, the difference between an ETF’s returns and its underlying index, indicates how closely the ETF replicates its benchmark.

Managing Your Diversified ETF Portfolio

Ongoing management of a diversified ETF portfolio ensures it aligns with investment goals and risk tolerance. Regularly monitoring the portfolio’s performance and composition is important. This involves periodically reviewing how the overall portfolio is performing and assessing the individual performance of each ETF component. These reviews help identify deviations from the initial investment strategy and inform necessary adjustments.

Rebalancing strategies maintain the desired asset allocation and diversification levels. This process involves adjusting holdings to bring the portfolio back to its target percentages, such as selling overweighted assets and buying underweighted ones. Common rebalancing methods include time-based rebalancing, where adjustments are made at set intervals like annually or semi-annually. Alternatively, threshold-based rebalancing involves reallocating only when an asset class deviates from its target allocation by a certain percentage.

Rebalancing helps control risk and ensures the portfolio aligns with long-term objectives. If stocks have significantly outperformed bonds, the stock allocation might grow beyond its target percentage, increasing the portfolio’s overall risk. Rebalancing by selling some stock ETFs and buying bond ETFs helps restore the original risk profile. New contributions can also be directed toward underweighted assets.

Adjusting the diversification strategy due to major life changes is important for portfolio management. Life events, such as nearing retirement, can alter financial goals and risk tolerance. These changes may necessitate a re-evaluation of the target asset allocation. For example, as retirement approaches, investors shift from growth-oriented investments to more conservative, income-generating assets like bonds. Regularly reviewing and adapting the investment strategy ensures it remains relevant to evolving needs.