Should ETFs form the core of your portfolio?

Exchange-traded funds—commonly known as ETFs—provide a low-cost way to tap into the returns of major markets around the world.

This type of investment works by aiming to track the performance of a basket of investments or a stock market index, such as the FTSE 100 or S&P 500, or a bond index.

As a result, ETFs are unlikely to outperform their reference index, such as some actively managed funds or investment trusts.

But likewise, they should not be too far behind the market. And they’re usually cheap because they don’t have to pay for research or fund managers. This helps keep costs down and means they usually have a low ongoing charge.

For these reasons, many cost-conscious investors choose to have ETFs as the bulk of their core portfolio, along with several other actively managed satellite investments. We explain how to do this and what the advantages and disadvantages are.

How can an ETF be the core of your portfolio?

The concept of core holdings is that they are the central investments of your long-term portfolio, so they should provide reliable and consistent long-term returns.

A broad ETF that invests around the world is often recommended as a low-cost way to do this – and investors who follow the market with their core can often choose to use actively managed satellite investments as well.

The core satellite concept aims to combine the best aspects of index and active management.

When building a portfolio, diversification is key to spreading your risk. ETFs can be an efficient way to diversify your portfolio without having to select a large number of individual stocks or bonds.

They give you access to many different asset classes, regions and sectors. And because an ETF offers exposure to an index that is itself a broad set of securities, your portfolio is diversified.

What kind of ETF fits the account as a core investment?

When looking at investing in the stock market alone, rather than also holding bonds or other assets, a global stock ETF is often seen as a good base choice.

Emma Wall, head of investment analysis and research at Hargreaves Lansdown, recommends that all investors should have exposure to both developed and emerging markets as this offers “opportunities to take advantage of different drivers throughout the market cycle.”

When investing for the first time, you should look for broad market exposure at a low cost. Emma Wall introduces the iShares ACWI ETF, which is invested in more than 2,000 companies from both developed and emerging markets.

This is a great core option for early-stage investors, adding satellite positions that reflect their outlook or interests, she says.

BlackRock offers a low-cost line of multi-asset funds with iShares ETFs called MyMap. There are eight funds to choose from in the range, and each is built with a specific level of risk in mind.

The combination of low-cost index funds and ETFs allows BlackRock to keep MyMap fees low at 0.17 percent for most funds.

Multi-asset funds are a ready-made basket of investments and are generally a popular option for investors.

Kenneth Lamont, senior analyst on Morningstar’s passive research team, says that “broadly diversified exposures such as MSCI World or S&P 500 strategies would be suitable as core portfolio building blocks.” Several ETF providers offer these funds.

Depending on which index you use, the global stock market is made up of different percentages of the major national stock markets, but all of them are dominated by the US.

In the global MSCI ACWI index, about 60.2 percent is the US stock market, followed by Japan at 5.4 percent and the UK at 3.9 percent, while China is at 3.4 percent. This means Apple alone, with 4.4 percent of the ETF, is a larger share than the UK or Chinese markets.

Alex Campbell, Head of Communications at Freetrade, says: “We see many private investors taking a ‘core-satellite’ approach to building their portfolios.”

The rationale behind this approach is to anchor a large portion of your portfolio in a basket of ETFs that generate returns in line with global markets, while allocating a smaller portion to individual stocks or even mutual funds.

How Many ETFs Should You Hold?

When it comes to building the core of a portfolio, sometimes less is more. Each individual investor will differ and it will depend on what your objectives are, but it may be wise to keep it simple.

Investors should also think about asset allocation and how much of their portfolio to put in stocks and how much in bonds.

Alex Campbell says it may be enough for some investors to build a core around one stock-based ETF, or perhaps a mix of one stock ETF and a bond and other asset holding.

He recommends for a UK-based investor an FTSE All World equity ETF for 60 percent of a portfolio, then 30 percent in a short-dated Gilts ETF and 10 percent in an ETF with exposure to a theme or alternative asset class. such as iShares UK Real Estate ETF.

Given the diversification you can achieve across an asset class, region or theme with a single fund, it’s not essential for investors to select dozens of ETFs, he adds.

Ultimately, an approach with too many broad ETF exposures will provide little diversification benefit and will be an overall drag on performance.

When it comes to keeping the numbers down, Laith Khalaf, chief of investment analysis at AJ Bell, says one broad ETF may be enough.

He adds: “It is quite possible for investors to hold just one ETF, such as a global tracker, which offers a fully diversified portfolio across stock, sector and regional levels.”

Narrower ETFs, for example, country-specific ETFs, can also be used as portfolio building blocks, allowing investors to choose their own allocation to specific markets, which will probably amount to about five to ten ETFs.

If you’re starting to mix and match ETFs, be careful about looking for overlaps between index funds, Campbell advises. The same goes for buying stocks or funds for the satellite portion of your portfolio.

For example, while the FTSE All World Index includes thousands of stocks, more than 60 percent of them are listed on the US stock exchange. Once you start adding active funds with a large exposure to the US, you may be duplicating positions.

On the other hand, you have to be careful not to leave the core of your portfolio too concentrated.

What about thematic ETFs?

Thematic ETFs track social, technological or economic themes that often fall outside mainstream investment classifications.

Freetrade notes that there is an increasingly wide range of thematic ETFs being listed in the UK as the industry evolves – from sectors like green energy, AI or even global water to themes like iShares Aging Population ETF.

Kenneth Lamont says thematic ETFs should be “only a small part of an already diversified portfolio.”

Each thematic fund takes a different approach to defining and tracking its theme and investors should understand how thematic exposure is defined and how a fund selects and weights its holdings

He said: “Even funds that claim to track similar themes can have surprisingly little overlap in holdings.”

Alex Campbell points out that certain thematic ETFs, such as iShares Global Clean Energy, can have a relatively small number of holdings.

He said, “These holdings are by definition focused around a theme and a sector, meaning that a negative headline affecting one company could have a disproportionately negative impact on the index and, by extension, the ETF.”

ESG has become a major theme in investing over the past five years. Laith Khalaf points out that investors can choose to pursue this using ethical ETFs, which offer “a more socially responsible stock portfolio, or focus on more specific areas of environmental activity, such as clean energy.”

But investors who opt for thematic ETFs should spend a little more time selecting their funds, he cautions.

These trackers not only track broad, well-known market indices such as the FTSE 100 and S&P 500.

So Khalaf says investors should “make sure they’re happy with the underlying index being tracked to make sure it gives them the exposure they’re looking for.”