An increasing recognition by investors of the power of portfolio diversification would rank among the top reasons for the sustained and fast-growing popularity of exchange traded funds (ETFs).
In short, proper portfolio asset allocation and diversification effectively spreads an investor’s risks and opportunities while ETFs provide one of the easiest, most-effective and lowest-cost means to achieve this.
ASX research shows that the market value of Australian-listed exchange traded products, most being index-tracking ETFs, reached $37.62 billion by the end of April – up from less than a billion dollars a decade ago.
The popularity of ETFs is, of course, a global phenomenon. London-based ETF researcher ETFGI reports that assets invested globally in ETFs rose to $US4.8 trillion by the end of April. This is up from a little over $US700 billion about 12 years ago. (Differences exist between the style of some ETFs listed in Australia and overseas.)
Repeated research, including by Vanguard, has found that a diversified portfolio’s strategic asset allocation– the proportions of its total assets invested in different asset classes – is responsible for the vast majority of its return over time.
The setting of a strategic or target asset allocation for a portfolio and then diversifying within that asset allocation are fundamental steps towards wealth creation.
How can an investor use ETFs to gain their desired asset allocation and diversification for their portfolios?
This strategy involves investing in a selection of index ETFs across different asset classes to construct the core of an investor’s diversified portfolio – adding “satellites” of other favoured investments of typically direct shares and actively-managed funds. (Of course, some investors choose to create portfolios comprising exclusively of index ETFs.)
Another approach is to invest in a diversified index ETF as at least the core of an investor’s overall portfolio.
With a diversified index ETF, investors can obtain a widely-diversified portfolio – covering the major asset classes – with a single trade. Investors can choose between conservative, balanced, growth or high-growth portfolios to suit their goals, risk tolerances and investment time horizons.
Investors can use ETFs to instantly and inexpensively rebalance a diversified portfolio back to its strategic asset allocation. This is to recapture its intended risk-and-return characteristics after movements in investment markets over time.
For instance, an investor following a disciplined and regular rebalancing strategy might buy or sell ETFs in a single asset class, such as Australian shares, in response to sharemarket movements.
Among the key attributes of a diversified index ETF is that its portfolio is automatically rebalanced between asset classes to remain within an investor’s desired asset allocation.
Another way that investors are seeking to add diversity to their portfolios is with active factor ETFs, often labelled smart-beta ETFs.
Equity factor-based investing adopts a systematic, rules-based process designed to capture a desired investment objective such as higher dividend yields, lower volatility, value or higher longer-term growth. It is a form of active investment management.(Factor-based investments should typically only represent a small proportion of an investor’s appropriately-diversified portfolio.)
No matter your approach to investing with ETFs, it is crucial to keep in mind the importance of proper asset allocation and diversification (within that allocation) for investment success.