How to use ETFs in your portfolio

How to use ETFs in your portfolio


I have been thinking about ETFs recently as I discovered that more and more providers are starting to offer thematic ETFs, which are not necessarily based on investment theses. I in this post, I talk about ETFs themselves and how you can use them in your portfolios.

What are ETFs
ETF stands for Exchange Traded Fund, which is a type of collective investment instrument that is traded on an exchange, like a single stock. They can be a cheap way to access very wide (or more focused) exposures in your portfolio with more flexibility than traditional mutual funds.
Historically, and maybe less so today, ETFs aimed to replicate certain indexes or benchmarks such as the S&P 500. Because there is no investment skill involved in replicating an index, ETF providers were able to offer these products at a fraction of the price of actively managed mutual funds. For investors who do not want to pay management fees or simply don’t believe that active managers are worth it, ETFs are a great solution.
25 years or so after the first ETF began trading, there is no doubt about the popularity of ETFs. The world’s largest asset managers such as Fidelity, BlackRock and Vanguard all offer ETFs. Providers love to sell ETFs because of their scalability and investors love to buy ETF because of several advantages:

1. As we saw above, ETFs are a cheap way to gain exposure.

Because management fees are lower and costs from running an ETF can be easily scaled and lower than mutual funds, the total cost can be as low as 0.03% per year! That can compare to up to 4% per year for an actively managed specialised fund.

2. ETFs are tax efficient because of their low turnover.

Essentially, because indexes such as the FTSE 100 or S&P 500 are made up of well-established companies are use smoothing rules to include and exclude members (as to lower the frequency to which stock go in and out of the index), the index membership is relatively stable over time, and the fund doesn’t have to sell stocks often and pay taxes on realised gains.

3. ETFs can be bought like stocks at any time of day

while the market is open while mutual funds are only traded once a day or week. I don’t consider this a powerful advantage, but it can be useful if you want to sell an exposure quickly.

4. ETFs can provide a variety of exposures.

As I said above, most ETFs replicate indexes. These indexes can be stocks, bonds, currencies or commodities indexes, but not only. Stock ETFs can replicate “style indexes”, which are based on certain investment filters such as small-cap (small firms), growth (firm with high earnings) or value (firms that are trading below their estimated value) to list a few. This can become handy when fine-tuning a market exposure. You can also construct your own version of the S&P 500 and tilt away or toward a certain sector by investing in sector ETFs (health care, financials, etc.). More recently, “smart-beta” and “thematic” ETFs have started to gain traction. These ETFs are a bit more expensive than index tracking ones because they are based on trading rules that are more difficult to track. For instance, Global X is offering an ETF that is based on lithium and battery. The fund managers will look at the broad market a define which companies are exposed to lithium and battery. HOWEVER, and this is very important, they will not make a judgement on which company should do worse or better. The end product will be a fund that includes ALL businesses that do business based on lithium and battery. Another example is the ageing population, in which healthcare stocks are key constituents.

How to use ETFs in your portfolio
The list below organically results from what we’ve discussed just above, so it should be easy to follow.

1. Invest in indexes and broad exposures
Let’s say you want to invest in the US market but do not want to purchase an active fund or single securities. You can buy a single ETF that covers the whole equity market, or buy a combination that covers the whole equity and bond market.

2. Invest in areas not accessible with mutual funds
It would be challenging to find some exposures using mutual funds. Say you want to construct a custom portfolio of Asian equities. With ETFs, you would be able to buy a Thailand ETF and a Vietnam ETF for instance, and you would have control over their weight. This approach would give you more flexibility than buying a pan-Asia ETF where Thai and Vietnamese equities would only represent a fraction of the index.

3. Invest in themes
Taking the example of Global X, some ETF providers are starting to explore themes in ETFs. If you believe in robotics and automation for instance and think they would make a helpful addition to your portfolio, iShares has a product for that.

4. Actively manage a portfolio of passive funds
Wait, what? Yes. You can make your own judgement and actively manage your exposures using ETFs. Because you can trade them at any time of day and pay little taxes on them, you can actively manage your exposures and manage an active portfolio of passive ETFs.

I personally think that ETFs should be a part of one’s portfolio, and not constitute the whole portfolio, and everyone will have a different opinion. I am worried that index providers (on which ETFs base their stock list on) are starting to have too much power: MSCI recently decided to include China in their EM index, and all the investors that are tracking the MSCI EM index will all at the same time essentially buy Chinese equities, creating a disruption in the market. On top of that, as more people invest passively, the less prices will move because no one will be buying stock going up and selling stocks going down. In a loop, the stocks going up won’t go up anymore and the stocks going down won’t go down anymore (I am exaggerating).

How do you use ETFs in your portfolio?