Exchange-traded funds have taken the investing world by storm. Their flexibility and cost-effectiveness can make your portfolio both simpler and better performing. But with hundreds of different ETFs to choose from, how do you decide the best way to incorporate ETFs into your overall portfolio?
The number of different ways you can use ETFs as part of your investing is as vast as the universe of ETFs itself. But when you boil down most strategies, you come up with two primary situations in which ETFs can really help you achieve your financial goals.
Method 1: Building the core
It may seem downright quaint now, given how specialized ETFs have become in recent years, but the first ETFs focused on giving investors broad exposure to large portions of the stock market.
Just as Vanguard's flagship 500 Index Fund (VFINX) pioneered index mutual funds by seeking to track the broad S&P 500 stock index, so too did the SPDR Trust ETF use an S&P 500-tracking strategy in order to gain market share and introduce a new way of investing to the public.
Nowadays you can get a wide selection of broad ETFs. Funds that cover small-cap, mid-cap, and large-cap U.S. stocks are plentiful, with various ETFs using different methods to identify potential losers and boost holdings of promising stocks. International ETFs of various flavors make it easy to invest across the world, often in hard-to-buy securities of foreign companies. Broad-market exposure to entire other asset classes, such as bonds and commodities, is also available through ETFs.
For perhaps the ultimate in one-stop shopping, global ETFs like the Vanguard Total World Stock Fund (VT) offer a selection of stocks from around the globe. This Vanguard ETF tracks the FTSE All-World index, which includes 2,900 companies. Stocks from the U.S. make up over 40% of the fund's assets, with ExxonMobil (NYSE: XOM) and Microsoft (Nasdaq: MSFT) predictably leading the fund's holdings. But foreign companies like BP (NYSE: BP), Nestle, and Mitsubishi UFJ Financial Group also play prominent roles in the ETF's portfolio.
The core method works well, especially for investors who aren't looking to invest in individual stocks. But if you plan to also own individual stocks within a larger portfolio, then ETFs can play a much different but equally valuable role.
Method 2: Filling in the gaps
If you like investing in individual stocks, chances are that you have a particular circle of competence in which your experience pays off the most. Whether it's stocks in a certain industry, companies in a particular location, or certain-sized businesses that define your area of expertise, you may find yourself with a portfolio that's overly concentrated within a narrow swath of the overall market.
In some cases, that may be just fine with you -- as long as you're prepared to handle the risks of a concentrated portfolio. But if you're looking for a quick way to diversify your portfolio without a lot of extra effort, ETFs can act as a stopgap measure unless or until you decide to find individual stocks to take their place.
For instance, say your specialty is recognizing traditional value stocks. You may feel most comfortable researching classic large-cap value plays like Chevron (NYSE: CVX). But you also want some growth stock exposure without having to research an unfamiliar area. In that case, a growth-oriented ETF like iShares Russell 1000 Growth (IWF) would easily get you into companies like Apple (Nasdaq: AAPL).
Similarly, looking through your portfolio, you can identify missing sectors and fill in gaps using ETFs. For example, if you found yourself without any utility stocks, you could buy an ETF like the SPDR Utilities ETF (XLU) and own interests in Exelon (NYSE: EXC) and Dominion Resources (NYSE: D) to round out your portfolio.
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