Building more efficient portfolios with ETFs

Why are ETFs useful portfolio building blocks?

Exchange Traded Funds (ETFs) have become essential building blocks used extensively by financial professionals in constructing diversified investment portfolios. ETFs can offer broad or targeted, precision exposure to a wide range of asset classes providing investors with levers to pull when tailoring bespoke investment strategies to meet their varied investment goals.

ETFs are known for low expense ratios compared to traditional mutual funds whilst also delivering daily transparency, allowing investors to see exactly what assets they own and how their money is being invested. Additionally, the liquidity of ETFs permits investors to buy and sell shares throughout the trading day at determined prices, providing flexibility and ease of access. Tax efficiency is also an important consideration driving investors into ETFs.

Building more efficient portfolios with ETFs

Before making any investments, investors can first consider their investment horizon, their objectives and how much they’re willing to budget in the risk they’ll take and the fees they’re willing to pay all to meet those objectives. Once investors are ready for the implementation stage, they can consider all strategies spanning single securities, active managers, passive strategies, and alternatives.

ETFs can be invaluable tools as part of this implementation stage in the investment process thanks to their characteristics of providing liquidity, transparency, and granularity in the exposures they offer, all typically for a low cost.

Let’s begin by constructing our strategic asset allocation (SAA) around which we will base, and measure the performance of, our portfolio. One approach to this could begin by blending broad market equities and fixed income exposures as defined by the MSCI All Country World Index (ACWI) and the Bloomberg Global Aggregate Index (Agg).

Next, we can break down these broad markets into their constituent parts – for equities we might look at regional, country or even sector exposures and for fixed income we might like to take a sector and currency approach (e.g., US exposure in fixed income could span treasuries and credit exposures).

Taking a 60/40 approach and utilizing some simple optimization techniques, we end up with the below benchmark.

Already we can see this asset allocation provides us with granularity whilst maintaining practicality for the implementation stage. For our next step in creating our strategic asset allocation, we can incorporate any views we have on markets where we think we can capture return opportunities or mitigate against risk.

As an example, we can blend into our global government bond allocation exposure to short duration and long duration US Treasury bonds, say 0-1 year and 10+ year, because we’d like to capture yield opportunities on the short end of the yield curve but also position ourselves to capture capital appreciation opportunities from any US rate cuts.

In our global corporate bond allocation, we could incorporate senior bank loans and AT1 bond allocations thanks to their attractive risk and yield profiles and the diversification benefits they can deliver.

For our US equity sleeve, a space where active managers typically struggle to deliver alpha, investors might like to incorporate innovative strategies, like that seen in the NASDAQ 100. They could also incorporate an equal weighted approach to gain more balanced exposure to the broader US equity market where concentration across the top 10 securities is at historical highs in the market cap weighted index. Finally, for downside protection and to balance our growth-oriented NASDAQ 100 exposure, a low volatility strategy could be added into this sleeve.

Now we have our strategic asset allocation which we can implement using a variety of instruments spanning ETFs and active funds. Where investors are cost focused, do not want to stray too far from their SAA, and are seeking to achieve diversified, broad market exposure, utilizing ETFs to exclusively implement this portfolio is a logical solution.

Investors can construct robust, multi-asset portfolios to solve for a variety of outcomes. ETFs can be used exclusively to build portfolios, or they can be paired with active strategies where investors see alpha opportunities along with alternative strategies where investors are seeking illiquidity premiums. 

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Invesco Solutions develops CMAs that provide long-term estimates for the behavior of major asset classes globally. The team is dedicated to designing outcome-oriented, multi-asset portfolios that meet the specific goals of investors. The assumptions, which are based on 5- and 10-year investment time horizons, are intended to guide these strategic asset class allocations. For each selected asset class, we develop assumptions for estimated return, estimated standard deviation of return (volatility), and estimated correlation with other asset classes. This information is not intended as a recommendation to invest in a specific asset class or strategy, or as a promise of future performance. Estimated returns are subject to uncertainty and error, and can be conditional on economic scenarios. In the event a particular scenario comes to pass, actual returns could be significantly higher or lower than these estimates.