Is it possible to build an investment portfolio just using ETFs?

ETFs offer a low-cost solution for investors wanting instant diversification
Thursday 08 Feb 2018 Author: Emily Perryman

An exchange-traded fund (ETF) can give you access to a huge range of stocks in one, low-cost product.

It’s possible to build an entire portfolio just using ETFs, although there are situations when actively-managed funds are worth considering.

IS AN ETF-BASED PORTFOLIO A GOOD IDEA?

There’s a growing trend for investment platforms, financial advisers, fund managers and robo-advisers to offer portfolios that exclusively invest in ETFs.

Part of the attraction is that ETFs are very low cost. An ETF that tracks the FTSE 100 can cost as little as 0.1% in annual fees and the average charge is around 0.25%.

One ETF can give you access to hundreds of underlying investments in one trade, which means you can get instant diversification.

ETFs also offer transparency in the form of real-time, intraday pricing and up-to-date disclosure of their portfolio holdings. They can be bought or sold on an exchange during the day at a price that is clearly visible on a screen.

WHERE DO I START?

Before you invest any money you should always ensure the products are suitable for your individual circumstances.

Russ Mould, investment director at AJ Bell Youinvest, says you should answer four questions: Why am I investing? What is my target return? What is my time horizon? And what is my appetite for risk?

‘The answer to these four questions will help to shape your portfolio in terms of asset allocation and what sort of themes, countries or sectors are most suited to your particular needs and preferences, be they low risk or high risk, income or capital gains or a broad mix,’ he explains.

You can choose from thousands of ETFs. We’d suggest you start by building up a diversified core of assets.

Adam Laird, head of ETF strategy, Northern Europe at Lyxor ETF, says this core could be three simple low-cost options: a global equity ETF, a UK equity ETF and a gilt ETF.

Examples include Source MSCI World UCITS ETF (MXWO), iShares Core FTSE 100 UCITS ETF (ISF) and Vanguard UK Gilt ETF (VGOV).

‘The more risk you can bear the more equity you might hold, with fewer bonds and gilts,’ Laird says.

Once you’ve built a solid core you can then start to add in other ETFs which increase your weight to markets or strategies that suit your views and investment profile.

Mould says you shouldn’t buy too many ETFs because trading costs would start to accumulate and the portfolio would become harder to manage.

‘A range of 10 to 15 ETFs is probably the very maximum that is practical to run while still providing diversification,’ he adds.

SHOULD I ADD ACTIVE FUNDS TO MY PORTFOLIO?

Whether you choose to focus solely on ETFs or combine ETFs with active funds is a matter of personal preference.

Some experts think there are situations when active funds could provide a better outcome. There’s a chance that active managers will outperform the market, whereas ETFs can’t by virtue of the fact they’re index-tracking investments.

The difficulty is trying to identify the active fund managers who will outperform.

Will Dickson, head of portfolio management at P1 Investment Management, says there are markets where active managers can add value over and above the additional fees they charge, both in absolute and risk-adjusted return terms.

For example, some European and UK equity active funds have been able to outperform consistently over long time periods and in different market conditions.

They include Royal London UK Equity Income (GB00B8Y4ZB91), which has a 10-year annualised return of 9.9%, and Jupiter European (GB00B5STJW84), with a 10-year annualised return of 13.8%.

Dickson says there are also more opportunities for niche investments within the active management space, which can add significant diversification to portfolios.

If you’re adding actively-managed funds to your portfolio keep an eye on the cost of ownership, as this is often higher than with ETFs.

AJ Bell’s Russ Mould says some experienced investors like to use a ‘core-satellite’ approach where their core holdings are in active funds and their shorter-term, more tactical asset allocation decisions are made through ETFs. This is because ETFs are more liquid and so are easier to trade.

IS THERE AN EASY WAY TO INVEST?

If you don’t want to choose investments yourself, it’s worth considering a ready-made portfolio, where the holdings are selected by an investment expert.

There is a wide range of ready-made options on the market. For example, AJ Bell Youinvest offers five passive funds, which are designed to cater for different risk profiles. They each contain around 14 ETFs and index-linked funds, tracking a wide range of indices and assets. (EP)

HOW TO PICK AN ETF

Decide how much risk you’re willing and able to take – this will determine your asset allocation strategy.
Within each asset class identify the most appropriate index to follow.
Compare the costs of similar products.
Look at the tracking error – the higher the figure, the more likely it is that the ETF will outperform or underperform its benchmark.
Look at the ‘replication method’ – physically replicating ETFs hold all or a sample of the underlying assets that make up the index; synthetic ETFs replicate the performance of the index via swap agreements with a counterparty.

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Important information:

These articles are provided by Shares magazine which is published by AJ Bell Media, a part of AJ Bell. Shares is not written by AJ Bell Youinvest.

Shares is provided for your general information and use and is not a personal recommendation to invest. It is not intended to be relied upon by you in making or not making any investment decisions. The investments referred to in these articles will not be suitable for all investors. If in doubt please seek appropriate independent financial advice.

Investors acting on the information in these articles do so at their own risk and AJ Bell Media and its staff do not accept liability for losses suffered by investors as a result of their investment decisions.

The Shares team
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