How To Diversify Your ETF Portfolio
"ETF" stands for exchange-traded fund. ETFs are financial instruments that allow you to get exposure to different asset classes, often by tracking the performance of a basket of assets. Over the last 15 years, they have proven to be one of the most popular innovations in the investment world.
Deciding how to diversify your ETF portfolio depends on a variety of factors. Investors have to determine what their investment goals are. This includes their desired investment return and their time horizon. The answers to these questions will help you understand the amount of risk you can take with your investments.
Regardless of how you choose to allocate your investment portfolio, a degree of diversification is recommended. Diversification in investing is allocating your money across different kinds of investments. This way, you can gain exposure to multiple asset classes. This allows investors to manage portfolio volatility.
4 Ways to Diversify Your ETF Portfolio
You can take a balanced investing approach. This consists of having a diversified investment portfolio with equal allocation to stocks, bonds, and other assets.
Conversely, you may want to take a more aggressive investing approach. It has a higher allocation to riskier assets like stocks to allow for high return potential.
There are multiple ways to design your portfolio but here are the common asset classes that many investors allocate towards.
1. Invest in ETFs Tied to Stocks
Investing part of your portfolio in stocks allows for growth. If you buy and hold stocks for the long-term, they tend to appreciate in value over time, allowing the value of your investments to increase in value. The more you allocate toward stocks, the more aggressive your investment approach is.
Scene from the New York Stock Exchange (NYSE)
Stocks carry more risk because they have a higher probability for growth. This asset class is volatile in the short-term compared to other assets. There are a number of factors that can influence a change in a stock’s price. These price changes can be nerve-racking for some investors. It's why it’s important to diversify among other asset classes to minimize the fluctuations in your portfolio.
If you are young and far away from retirement, investing a large portion of your portfolio in stocks to allow for portfolio growth is a typical investing approach. However, if you are older and nearing retirement, your allocation toward stocks may be more minimal. This is because your time in the market is much less and you’d want to safeguard your portfolio from volatility. You can offset risk that comes from stocks by allocating toward bonds, commodities and other assets.
2. Consider Investing in Bond Funds
Bonds are another popular asset widely held in a long-term, diversified investment portfolio. Bonds are known for providing income to investors through interest payments that are paid twice a year. Bonds are known for providing stability in a portfolio. Specifically, they help offset investment risk that comes from stock volatility. Bonds perform differently than stocks. They are less volatile and tend to have a lower investment return than stocks.
When allocating toward bonds, investors know that is a safer part of their portfolio and therefore do not expect outperformance. Rather, safety and stability and are seeking capital preservation.
Example of a U.S. Treasury bond
There are different types of bonds with different durations and credit qualities. For example, corporate bonds are debt securities that are issued by companies. Municipal bonds are issued by local government entities. U.S. Treasuries are debt securities issued by the federal government. They are considered the safest type of bond since they are backed by the full faith of the U.S. government.
Investment-grade bonds have a high credit quality. The higher the credit rating, the safer the asset. The lower the credit rating, the higher risk and the higher return potential, also referred to as high-yield bonds. Bonds are a suitable option for investors looking for predictable returns and protection in varying market environments.
3. Buy Shares of Commodities Funds
Another asset class many investors can diversify with is commodities. Commodities consist of oil, gas, agriculture, and precious metals. They are great sources for protecting your assets against inflation because they have a positive correlation with rising prices in the overall economy.
The most popular gold ETF is the SPDR Gold Shares (GLD)
Commodities can be a great diversifier because their correlation is low to stocks and bonds. This means these asset classes do not move in similar directions, which helps reduce volatility in your portfolio. Commodity investments also provide stability in rising interest rate environments.
There is a strong case to add commodities to a diversified investment portfolio since they play an important role in technologies that support a low carbon economy. They also have strong historical performance. Commodity ETFs offer a source of stability during uncertain market conditions.
You can invest in commodities physically by buying physical gold silver and other precious metals. But it might be difficult to buy a barrel of oil or bushels of wheat. This is why investors can buy into commodity funds or directly in companies involved in producing these raw materials.
4. Add REITs to Your Portfolio
Investors an add real estate investment trusts, or REITs, to their investment portfolio. REITs are companies that own income producing real estate properties that can be traded like stocks on major stock exchanges. They are required to distribute at least 90% of their taxable income as dividends. This is an easy way to invest in real estate without the hassle of managing a property.
Real estate is a popular tangible asset for long-term investors.
REITs can provide attractive returns, consistent dividend income, and have a low correlation to other assets in a portfolio. This makes them an ideal asset for diversification.
REITs may be a suitable option in an inflationary environment. In this scenario, rental rates rise, which allows real estate companies to still generate income. REITs can outperform the broader market during periods of high inflation. According to Nareit, in 2021, a year that was considered to have high inflation (7% or greater), REITs beat the S&P 500 by 12.6 percentage points with an annual return of 41.3% compared to 28.7% for the S&P 500.
Takeaways on ETF Investments
There are a variety of funds consisting of different asset classes that can be added to a diversified investment portfolio. When choosing funds, make sure to read the fine print. It should match your risk tolerance and align with your long-term investment goals.
The ultimate balance is combining investments that help minimize the portfolio’s volatility while maximizing your investment returns. By investing in different ETF options, investors have the opportunity to grow their capital over time while navigating the bear market and economic inflation.
Written by Paulina Likos
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