Asset allocation is one of the most important decisions that you make as an investor. Having the right mix of stocks, bonds, cash, and commodities in your portfolio, and being well diversified within each asset class, can have a profound impact of your returns. ETFs are an easy way to gain this diversification. They can be cheap, flexible, and may help you gain access to sectors and asset classes that would otherwise be closed off to individual investors.
The first step in building an ETF portfolio is to figure out the right asset allocation. In general, investors with a long time horizon should consider a more aggressive approach weighted heavily toward equities, while people within a few years of needing their money should stick to more conservative investments like bonds.
If you want to see the asset allocation of your current investments, enter your holdings into Morningstar's Portfolio Manager. From here you can run the X-Ray tool, which will reveal your current allocation and show you how your holdings are distributed among stock sectors (such as health care or media), stock types (like high yield and slow growth), and across countries.
Armed with your asset allocation decisions, you can use Morningstar's Fund Quickrank to discover which securities will help you achieve your goals.
For core stock exposure, many investors could be well served by ETFs. There are several inexpensive, broad market ETFs that track major large-cap indices, like the DJ Euro Stoxx 50. This can be a very cheap way to gain exposure to the broad market, but investors who are regularly investing small amounts over time should carefully watch broker fees that are incurred when buying ETFs, as they may push the overall costs of the investment over that of a traditional index fund.
ETFs can help you gain outsized exposure to undervalued areas of the market. Oftentimes, the short-term gyrations of the market leave certain sectors and subsectors trading for less than their intrinsic worth. Using sector ETFs in combination with your core holdings could help boost your returns over time, as we anticipate that undervalued sectors will, in the long run, converge to our estimate of their worth.
Another important role that ETFs can play in your portfolio is to provide access to alternative asset classes like commodities and currencies. These areas, which used to be available only to institutional investors and high-net worth individuals, can help further diversify your portfolio. Although most investors would want these asset classes to represent only a tiny fraction of their overall holdings, their presence in a portfolio can be helpful because they can be uncorrelated to broader stock market returns.
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