Constructing a Portfolio the ETF Way

ETFs provide an effective way to diversify your portfolio.
Author:
Publish date:

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) - Get Report

and

Financial Sector SPDR

(XLF) - Get Report

, both of which are cap weighted and, as a result, very heavy in

Citigroup

(C) - Get Report

,

Bank of America

(BAC) - Get Report

and

JPMorgan

(JPM) - Get Report

.

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) - Get Report

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.

Perhaps the ideal holding is a foreign fund, so the

WisdomTree International Financial Fund

(DRF)

should be studied. Here again, though, there are composition issues to be aware of. The fund has a 6.6% weight in

HSBC

(HBC)

, the largest holding, which has made news of late for subprime issues in the U.S. Anyone considering DRF should probably have an opinion on HSBC.

Maybe the answer is the

iShares S&P Global Financial Sector

(IXG) - Get Report

ETF. It is cap-weighted, but the largest holdings only comprise 3% each within the fund.

There are also several ETFs that primarily reflect other themes but, as a secondary effect, capture the financial sector, such as the

WisdomTree Pacific ex-Japan High Equity

(DNH)

ETF. I have

written about this fund before and own it for a few clients because I believe it serves as a proxy for the Australian banks due to high correlation and its 43% weight in Aussie financials. The Australian banks are a very important theme.

Some other ETFs that have secondary effects include

iShares MSCI Taiwan

(EWT) - Get Report

for foreign tech,

PowerShares Water Portfolio

(PHO) - Get Report

for smaller-cap industrials and the

First Trust IPOX 100 ETF

for small-cap growth.

Mix 'n' Match

There are other segments that might be desirable but are not easily accessed in an ETF. For example, themes that I own or have owned in the past include Ireland and Chile. There is no way I know of to access these countries in an ETF, and so a common stock becomes, in my opinion, the best way to access those countries.

This creates an obvious scenario where a mix of ETFs and common stocks would seem reasonable and probably practical.

Another plausible scenario could be that an investor might be very comfortable owning individual bank stocks but not comfortable taking single-stock risk in more volatile parts of the sector, such as investment banks. This person might then have a mix of bank stocks and own one of the capital markets ETFs:

iShares Broker Dealers Fund

(IAI) - Get Report

or

KBW Capital Markets

(KCE) - Get Report

ETF.

Looking at this another way, there are many different ideas about how many stocks make a diversified portfolio. My number is around 40; some folks would say more, and some would say less. Any number of stocks that is close to 40 -- even 25, for that matter -- becomes a daunting task of time management keeping all of these holdings in order.

Incorporating ETFs into the mix becomes a time saver. Using the example of HSBC from above, if you own an ETF with HSBC as a large component in it, you probably only need to be in touch with current events. If you own the stock individually, you need to know a whole lot more. Now multiply that "whole lot more" by 40 stocks.

In the accounts I manage, I use whatever tool that I believe is the best way to capture the intended effect and that fits in with anything unique to the individual client. ETFs can be an effective, though not the only, way to accomplish this. You are your own client and should take advantage of all of the vehicles available to achieve your goals.

At the time of publication, Nusbaum was personally long PowerShares Water Portfolio and his clients were long Bank of America, PowerShares Water Portfolio, iShares MSCI Taiwan, iShares Broker Dealers Fund, KBW Capital Markets ETF and WisdomTree Pacific ex-Japan High Equity ETF, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

click here

to send him an email.