With hundreds of low-cost ETFs in dozens of diverse categories for investors to choose from, it’s entirely possible to build a complete portfolio of investments with just ETFs.
In this article, we provide guidance on how to build a portfolio of ETFs from the ground up.
How to Build an ETF Portfolio: The 7-Step Guide
Building a portfolio of ETFs is like building a home in that many different designs and building materials can be used. However, the fundamental building process can be the same for almost every investor. The portfolio foundation begins with an investor’s financial goals and risk tolerance; then building from there with an asset mix and ETF selection.
The steps to build an ETF portfolio are to:
- Define investment goals
- Assess risk tolerance.
- Determine the asset mix
- Choose an ETF portfolio structure
- Research and analyze ETFs
- Select ETFs for the portfolio
- Choose an entry strategy to buy ETFs
1. Define Investment Goals
Before choosing ETFs, an investor will need to define the goal or objective of their portfolio. Common investment goals include education savings and retirement. With the goal in mind, an investor can fine-tune the objective with a time horizon, which is the number of years before withdrawals are expected to begin.
2. Assess Risk Tolerance
Risk tolerance is a measure of an investor’s comfort level with fluctuations in the price of their investments. A higher risk tolerance generally means that an investor’s portfolio can have higher allocations to riskier investments, such as stocks. Conversely, a lower risk tolerance would indicate suitability for more stable areas of the market, such as bonds.
For example, an ETF investor who is comfortable with a high degree of market risk, and who wants the potential to receive returns above market averages, may also be comfortable investing in growth ETFs. However, an ETF investor who has a lower risk tolerance may be more comfortable with value ETFs, conservative ETFs, or fixed-income ETFs.
3. Determine the Asset Mix
An investor’s asset mix, or asset allocation, is the mix of investment assets, such as stocks, bonds, and cash, to be included in the portfolio. Each asset will receive a weight, which is measured by a percentage of total assets in the portfolio. A portfolio of investments will generally reflect the investor’s goals, time horizon, and risk tolerance.
4. Choose an ETF Portfolio Structure
Like the blueprints of a house, an ETF portfolio structure outlines what the builder wants the final product to look like. The portfolio structure will include the chosen asset allocation, as well as the percentage allocation to the types of ETFs to be used in the portfolio. Two basic portfolio structures are “core-and-satellite" and “equal-weight.”
- Core-and-satellite portfolio structure: As the name suggests, an investor builds the portfolio around one or two core holdings, which receive the heaviest allocation percentages. The satellite holdings receive smaller allocation weights. Many investors use an S&P 500 ETF for a core holding and add ETFs from diverse categories, such as small-cap stock, foreign stock, various sectors, and fixed-income funds.
- Equal-weight portfolio structure: Another aptly named structure, an investor will assign an equal percentage weight to each ETF in the portfolio. For example, if the investor wants to include five ETFs in their equal-weight portfolio, they will assign a weight of 20% to each fund.
5. Research and Analyze ETFs
When researching and analyzing ETFs, there are some general guidelines that can be followed. For example, many ETFs passively track a benchmark index, which means that among ETFs that track the same index, the one with the lowest expense ratio will generally produce superior returns in the long term.
Other criteria to consider when researching and analyzing ETFs include assets under management and performance history.
Selection criteria for evaluating ETFs include:
- Expense ratio: Lower expenses generally translate to higher returns when comparing ETFs that track the same index or asset.
- Assets under management: ETFs with higher AUM tend to have higher trading volumes, which can lead to superior pricing through lower bid-offer spreads.
- Performance history: Historical returns don’t guarantee future results, but past performance does provide a clue about how closely an ETF tracks its benchmark and how it performs compared to its category peers.
6. Select ETFs for the Portfolio
The selection of specific funds for an ETF portfolio will be guided by the investor’s asset mix and portfolio structure. After evaluating ETFs, the investor will choose the best types of ETFs that are suitable for their portfolio. For help in choosing ETFs, investors can use an ETF screener or see lists of ETFs in the ETF.com channel guide.
Long-term investors may find more guidance in our article, “How to Choose the Best ETFs for the Long Term.”
7. Choose an Entry Strategy to Buy ETFs
An investor’s entry strategy will incorporate the timing of purchases and the chosen ETFs to be included in the portfolio. For example, a long-term investor may want to choose a simple, dollar-cost averaging strategy where shares of ETFs to be held in the portfolio are bought in predominately equal amounts over a periodic basis, such as monthly.
Some investors may want to reach their target allocations immediately and buy the shares necessary to reach those allocations. Other investors may want to choose a timing strategy and wait for market cues, such as a certain price or a degree of price momentum, before entering their ETF positions.
For beginning investors, the ETF price, and whether the investor’s brokerage allows for buying fractional shares, may also be a determining factor for the entry strategy. For example, if an ETF investor wants to begin their entry with an S&P 500 ETF with a share price of $350, but they’re only investing $200 per month, they may need to build cash before buying shares.
There are multiple strategies and structures for building an ETF portfolio, but all of them have one thing in common, which is that the ultimate asset allocation and fund selection will be guided by an investor’s goals, time horizon and risk tolerance.