Where ETFs can fit in an overall investing approach

From humble beginnings just over 30 years ago, exchange-traded funds (ETFs) are now a mainstay of the investment universe. This success isn’t a surprise because ETFs have a lot going for them: lower costs compared to most mutual funds¹, portfolio transparency², and the ability to buy and sell them during the trading day (daily liquidity).³ Add in the fact that ETF can offer investors exposure to a wide variety of sectors, countries, and asset classes, and it’s easy to understand the popularity of these innovative investment vehicles.

All these potential benefits can be thought of as the “why” for ETFs. But what about the “how?” How can investors use ETFs in their portfolios to help reach their objectives? Like many tools, ETFs can be utilized in different ways depending on the goals of the user. Several considerations for using ETFs in portfolios are listed below:

1. Spread your eggs around different baskets (i.e., diversify)

Stories like “The Big Short” can make people dream of putting all their eggs in one basket and making a fortune. Reality, alas, is rarely as lucrative. For most investors, a more conservative strategy is to build a broadly diversified portfolio for the long term. ETFs have many attractive features as portfolio building blocks. Diversification can be achieved in different ways, but it often involves owning a mix of stocks and bonds covering a wide range of sectors. Investors can conveniently purchase a basket of different ETFs through their brokers just like buying stocks. At the highest level, ETFs that invest in bonds are generally used for income and a more defensive role in the overall portfolio, while equity ETFs like Invesco QQQ are typically used to pursue potential long-term growth.

2. Invest in entire sectors instead of individual companies

Some investors use sector ETFs to gain exposure to entire industries like technology or consumer discretionary rather than researching and purchasing individual stocks. Another potential drawback of picking an individual stock is that it may underperform its industry due to company-specific risks such as a failed product or CEO departure. Over the years, ETFs have provided access to more and more sectors of the market that have been traditionally difficult to access. They have also helped make it easier to implement sector rotation strategies that favor sectors that may perform better due to the current phase of the economic cycle.

3. Using a core-satellite approach

Some investors like to divide their portfolios into main “core” and “satellite” holdings. The core aspect is central to the overall portfolio and some investors use low-cost, passively managed ETFs that follow well-known benchmarks like the Nasdaq-100 Index, which QQQ tracks. Don’t forget about actively managed ETFs, which are growing in both number of offerings and assets. Meanwhile, the satellite portion typically consists of investments tracking narrower, niche corners of the market. In other words, the satellite allocation may be where investors look to potentially increase overall performance with ETFs tracking areas of the market that are riskier than the core. With nearly 3,000 ETFs listed in the US, employing a core-satellite approach with ETFs has never been easier.

4. Potentially limit your tax bill

Tax efficiency is one of the principles investors like best about ETFs. In a nutshell, the way that ETFs create and redeem shares helps prevent the ETF from selling stocks and realizing capital gains in the way that mutual funds do. For example, 61% of US equity mutual funds paid capital gains distributions in 2022.4 The inner workings of ETFs may help limit the capital gains taxes that investors have to pay every year. ETFs are also a popular instrument in tax-loss harvesting strategies that can potentially lower tax bills by taking advantage of losses in a portfolio and offsetting gains.

5. Building model portfolios

Since ETFs can help investors efficiency access many parts of the market, they are often employed in model portfolios geared to an investor’s age, risk tolerance, goals, and other specific characteristics.

The Swiss Army knife of the investment world

When they were first introduced in the US in 1993, ETFs were akin to a hammer. They had one job (track a broad index) and did it well. Today, however, ETFs are more like a Swiss Army knife and they have more uses than the five discussed here. How exactly ETFs are used in portfolios depends on who is using them — and why.

The Bottom Line

• ETFs have many potential uses in portfolios due to their flexibility and growing selection of strategies to choose from.
• How particular investors use ETFs in portfolios depends on their unique situations and goals.
• Some common uses of ETFs include achieving broad diversification, tracking a particular sector, and constructing model portfolios.