David Fabian: A little over a year ago I wrote a well-received article about the 5 mistakes to avoid with your ETF portfolio. The tips ranged from not falling in love with your ETFs to trade execution and tax consequences.
Fast forward to today and the ETF universe has expanded in a number of ways that warrant some additional advice in a number of key areas. I share these thoughts as a consequence of my daily research and experience so that you can be better prepared to analyze your holdings and make informed decisions about your ETF portfolio.
Index Construction Is Imperative
The single biggest driver of your returns in each diversified ETF you purchase will be how the index is constructed. That is not to say fees, taxes, and liquidity aren’t important as well. However, the makeup of the underlying holdings will ultimately determine how the portfolio reacts under various conditions and if any outsized holdings will impact returns.
With more than 1,650 exchange-traded products currently available to investors, the slicing and dicing of various indexes is almost limitless. There are ETFs that focus on sectors, industries, market cap, equal weight, fundamental characteristics, momentum data, volatility screens, and a host of other traits.
A great example is the difference between owning the PowerShares S&P 500 High Beta Portfolio (NYSEARCA:SPHB) and PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV). A look at a 3-year chart of these two widely varying indexes shows how strongly they have diverged as a result of their underlying asset allocation.
SPHB selects 100 stocks within the S&P 500 Index with the highest sensitivity to market changes, while SPLV selects 100 stocks with the lowest price fluctuations of their peers. As you can see on the chart, SPHB has outperformed in a strongly rising market because of its exposure to growth-oriented sectors. However, this ETF was susceptible to a great deal more volatility over the years. This is particularly noticeable during 2012 when stocks went through a hiccup and the low volatility index continued to show slow and steady progress.
My recommendation is to carefully analyze the makeup of the holdings along with their weightings within each ETF in your portfolio. Make note of any positions that are overly skewed to a specific company or sector because these will have an outsized pull on the performance of the fund. In addition, don’t be afraid to access targeted ETFs that may have a slightly higher expense if you are confident in the trend, investment thesis, or risk profile of the fund.