Constructing a Portfolio the ETF Way

How much should investors have in ETFs? After the recent ramp in volatility, many investors might be asking that question, but the answer may be more subjective than you'd think.

I write a lot about ETFs because, when used prudently, they empower do-it-yourself investors to more easily build diversified portfolios with greater flexibility.

The thing that most of the media don't understand about ETFs is that they are simply another tool to assist with portfolio construction.

Quite simply, for each part of a portfolio, an ETF can be the best tool or the worst, depending on the individual and what he is trying to accomplish. So the answer to how much weight should be placed in ETFs could be zero, every last nickel or, more likely, somewhere in between.

The ETF Side

The financial sector provides a good example of how to sort through the many ETFs available and weigh the risks and rewards as compared with those of common stocks. Picking either, or both, is valid.

There are domestic ETFs such as the iShares DJ Financial Index Fund IYF and Financial Sector SPDR XLF, both of which are cap weighted and, as a result, very heavy in Citigroup C, Bank of America BAC and JPMorgan JPM.

It may not be ideal for anyone who really dislikes any or all of those names to own a cap-weighted ETF, so perhaps the Rydex S&P Equal Weight RYF ETF would make more sense. The weightings of those three stocks is less than 1.5%, respectively, as opposed to close to 10% each in the cap-weighted funds.