Building portfolios with Exchange Traded Funds

Whether you are building a portfolio on your own or with the assistance of a financial advisor, you must complete two basic but critical steps:

  1. Identify your objectives, time horizon, risk tolerance, level of financial knowledge, and personal preferences
  2. Select a range of appropriate investments and decide how much to allocate to each asset class to maximize returns for a given level of risk.

Ideally, you want an optimal portfolio — one that provides maximum potential returns for a given level of risk.

Exchange Traded Funds (ETFs) are a valuable tool that can be used to build more optimal portfolios. An ETF tracks the performance of a specific index, such as an equity or bond index, mirroring its returns. ETFs are ideally suited for use in portfolio building strategies because of their flexibility, low cost and wide range of investment options. The following are four examples of strategies that can be used on their own or in conjunction with one another and the benefits of using ETFs to implement them.

Blend index and actively managed funds
Indexed funds offer market performance which matches the “beta,” or returns of the overall market or of a specific segment of the market. Active management, meanwhile, provides the potential for “alpha” (outperformance relative to the market) through individual security selection, sector rotation or other active strategies. Get the benefits of each type of investment by incorporating both into your portfolio.

Benefits of using ETFs: ETFs provide diversified indexed exposure at a low cost; they are traded throughout the day, which provides added flexibility.

Mix core and satellite investments
The “core” is comprised of major asset classes combined to achieve a particular risk/reward profile. For example, these could include the Canadian and U.S. equities, and domestic investment grade fixed income. “Satellites” have the potential to add value when combined with your core, but may be associated with additional risk. An example of a satellite position includes U.S. high yield bonds. Investors who want exposure to this less correlated asset class with its higher income potential could invest in a TSX-listed ETF that provides the performance of a diversified basket of these securities.

Benefits of using ETFs: Wide variety of equity and fixed income ETF options; easy and efficient access to various markets and market segments; suitable for both core and satellite portions of portfolio, depending on investor requirements.

Employ a tactical short-term strategy
ETFs are an efficient means to adjust portfolio exposure through specific sector or segment investments. For example, if an investor wants tactical access to growth and dividend income provided by the Canadian banking industry, they could invest in a TSX-listed ETF that holds all of the big six banks in an appropriately diversified manner.

Benefits of using ETFs: Low entry and exit cost; easy and efficient access to segments and sectors that you want in your portfolio.

Diversify fixed income holdings
Many investors have built targeted equity portfolios to reflect their world view but have not applied that focus to their fixed income portfolio. A wide variety of fixed income choices are available, including federal, provincial and corporate bonds with different credit ratings and maturities. Depending on the market environment, their personal risk and return preferences, and time horizons, fixed income investors may want to choose specific fixed income sectors and maturities for their portfolios. For example, in the short maturity segment, they may prefer the combination of relatively higher credit quality and income that provincial bonds provide. ETFs are available that would allow investors to get that precise investment exposure in their portfolios.

Benefits of using ETFs: Provide diversification by maturity, credit rating or type; enable investors to take targeted positions to best fit their macro economic expectations (for example, interest rate movements and inflation expectations).

This blog post is for informational purposes only and is not and should not be construed as, professional advice to any individual. Individuals should contact their BMO representative for professional advice regarding their personal circumstances and/or financial position. The information contained in this report is based on material believed to be reliable, but BMO Financial Group cannot guarantee the information is accurate or complete. BMO Financial Group does not undertake to advise individuals as to a change in the information provided. All rights are reserved. No part of this report may be reproduced in any form, or referred to in any other publication, without the express written permission of BMO Financial Group. ®/™ Registered trade-marks/trade-marks of Bank of Montreal, used under license.