How to Create a Diversified ETF Portfolio

Mar 22, 2021 06:20 PM ET
How to Create a Diversified ETF Portfolio

An Exchange-traded fund (ETF) is a diversified fund made of tens of stocks, bonds, commodities, or even cryptocurrencies. The fund is then listed in either the New York Stock Exchange (NYSE) or the Nasdaq. More than 80% of all ETFs are listed on the NYSE. In this article, we will look at the best approach to creating a well-diversified ETF portfolio for long-term investors.

How ETFs work

For starters, the process of creating an ETF starts with a large investment company that comes up with an idea of a fund. The biggest issuers of ETFs in the United States are companies like Blackrock, Vanguard, VanEck, and Schwab. 

After this, these companies use two approaches to creating a fund. First, they can select companies that meet the criteria for their vision. These funds are commonly known as actively-managed ETFs.

Second, they can create an ETF that tracks a certain index. For example, the Vanguard S&P 500 tracks the S&P 500 index while the Invesco QQQ ETF tracks all companies in the Nasdaq 100 index. These types of funds are known as passive since they rarely change. They only change when an index provider adds or removes a company. For example, recently, Tesla was added to the S&P 500 index. This means that all S&P 500 ETFs had to buy the stock, in a process known as rebalancing.

The 3-fund diversified fund

One of the most popular methods of creating a diversified ETF is known as the 3-fund method. This is the simple process of buying virtually all important stocks and bonds. 

First, you can invest in a Total Market ETF, which tracks almost all companies listed in the US. Some of the popular total market ETFs are the Vanguard Total Stock Market ETF and Schwab Total Stock Market ETF. These two popular ETFs are passive in nature and track the CRSP Total Market Index.

Second, you can invest in the total US bond market ETF. These are funds that invest in all investment-grade bonds in the US. They provide a safe avenue for investing in the complete bond market. The most popular type of these funds is the iShares Core U.S. Aggregate Bond ETF and Vanguard Total Bond Market ETF.

Finally, you can diversify this portfolio by investing in a world bond fund that excludes stocks listed in the US. This portfolio will give you access to top-quality international companies like Alibaba and Volkswagen. Examples of these funds are the Vanguard Total International Stock ETF and the iShares MSCI ACWI ex U.S. ETF. 

The most basic approach is to invest 33% of your funds in each of these ETFs. However, you can also mix it up depending on your risk approach. For example, since stocks do better than bonds, you can have 40% in the US and international stocks and the remaining 20%. The chart below shows how your funds would have performed if you had invested in the US, international, and bond ETFs in the past five years.

3-fund portfolio performance

3-fund portfolio performance

Sector ETF diversification

Another simple approach to creating a diversified portfolio is by sector. Fortunately, there are ETFs that target all sectors in the US. There are those that target technology, consumer discretionary, financial, and utility sectors. Therefore, you can do your research on the best performing sectors then come up with a portfolio that has all the top companies in it. 

For example, if you believe that the technology sector in the future, you can invest in an ETF like the Invesco QQQ that tracks all firms in the Nasdaq 100. Since the technology sector has done well over the years, you could decide to increase its weighting to the ETF. 

Next, you can have a consumer discretionary ETF like the Consumer Discretionary Select Sector SPDR ETF. Finally, you can have another  ETF that tracks companies in the financial industry. By doing just that, you will have invested in hundreds of companies by just buying three funds. 

Other popular sectors in US stocks that you can invest in are finance, energy, retail, and transport, among others.

Diversified bond ETF

You can also create a solid diversified bond ETF fund. For starters, bonds are loan-like assets that large companies, municipalities, and government agencies borrow from the market. They then pay back the money over a certain period with interest. While you can buy an individual bond, the best approach to use is to buy a bond ETF. These are funds that have invested in bonds of all types. 

Therefore, if you are into bonds, you can easily create a diversified bond portfolio. For example, you can set some of your funds to invest in convertible bond ETF and others in investment grade bonds, and others in high yield bonds. A convertible bond is one that can be turned into equity depending on market conditions. A good example of a convertible bond ETF is the iShares Convertible Bond ETF. Investment-grade bonds are those of highly-rated companies, while high-yield are those of junk-rated companies. 

Company stage

Another method of creating a diversified portfolio is on the stage of a company. Ideally, companies go through different stages in their lifecycle. For example, relatively young companies with fast growth are known as growth firms. As they mature, their growth slows, and they become value or dividend companies. Therefore, you can create a portfolio based on the stage of a company.

For example, you can divide your funds into four and invest them in the Vanguard Growth Fund, Vanguard Value Funds, iShares Dividend Fund, and ProShares S&P 500 Dividend Aristocrat ETF. By creating this ETF, you will have invested in hundreds of companies. 

Final thoughts

Diversification is one of the most useful strategies in investing. That’s because losses in one asset will be offset by gains in another. ETFs, offer one of the best ways of diversifying, especially when you are looking at long-term investing. In this article, we have looked at some of the simple ways of creating a good and diversified ETF portfolio.

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