How to build an ETF portfolio

Investors who choose exchange-traded funds (ETFs) often think of themselves as either active or passive investors. But investing in ETFs doesn’t need to be an either/or proposition. A combination of both active and passive strategies can help ETF investors improve their overall returns.

In this article, we’ll look at how an active strategy can complement a passive strategy to enable portfolio alpha when ETF investing (alpha is the part of your portfolio’s returns that’s in excess of the overall market’s returns).

As such, investing in ETFs that strictly track an index, such as the S&P 500, will generate beta (the returns of the overall market) minus fees, but should never be expected to contribute alpha to your portfolio. Yet inexpensive beta can be a good low-cost core holding, which can be complemented by alpha-seeking strategies.

Asset allocation

Attempting to predict which asset class will outperform in any given year is notoriously difficult, but a diversified asset allocation can help reduce overall portfolio risk.

When building your own portfolio, the first steps should include defining your time horizon and your tolerance for risk. Knowing what kind of investor you are will guide your strategic (long-term) asset allocation. This goes beyond striking the right balance between stocks and bonds; it includes understanding what you’re going to hold within these broad asset classes.

If you prefer to take a hands-off approach to asset allocation, asset allocation ETFs are designed as a diversified single-ticket core solution which maintains exposures matching your risk profile.

If you want to take a more active role, ETFs can serve as the building blocks of your custom-built portfolios.

Building a strategic core

The core of your strategic long-term allocation will serve as an anchor for your portfolio. Using ETFs as building blocks allows you to adequately diversify the core asset mix of your portfolio to minimize risk.

A portfolio that includes alpha-seeking strategies holds the potential to outperform portfolios built specifically to capture the returns of the overall market.

For equities, you could start with a strong core of ETFs that track indices made up of large Canadian, US or global companies — which may include many household names. These large cap ETFs have the potential to provide growth and may be less risky than more niche ETFs.

Your approach to fixed income might be similar, with most of this portion invested in investment grade government and corporate bond index ETFs. With their low risk of default, these should provide a measure of stability to your overall portfolio.

Tactical equity

Around this core, you may consider adding ETFs that reflect your shorter-term expectations on the market. These “satellite” ETFs allow you to increase or reduce your exposure to specific asset classes, geographies or investment styles.

These ETFs are designed to provide access to specific market niches and/or deliver returns that are different than the overall market. They may include active management or seek “strategic beta” by following a different set of rules than the major cap-weighted indices.

For example, a core US equity index ETF, such as the Mackenzie US Large Cap Equity Index ETF (QUU), might be complemented by a strategic beta ETF like Mackenzie Global Sustainable Dividend Index ETF (MDVD). Not only will this pairing diversify beyond the US, it also applies a very different strategy.

By focusing on companies that pay sustainable, above average dividends, this kind of ETF will bring income into the portfolio. It may also reduce portfolio risk because it holds more mature, cash-generating companies — and far fewer of the very large companies that dominate the US market cap-weighted indices.

This year’s rally among US tech stocks has made the top 10 holdings in global and US equity indices practically identical. As shown in the table below, MDVD doesn’t currently own any of the US mega cap tech stocks, making it a potentially great complement to existing global or US index holdings in a portfolio.

Source: Morningstar, S&P and MSCI as of July 31, 2023

Tactical fixed income

As mentioned above, investment grade bonds will provide a measure of stability to your portfolio. As is often the case with investing, that stability comes with a trade-off; your core fixed income will likely have a relatively low yield.

One approach to unlocking alpha is through active exposure to specific fixed income assets when market conditions are favourable.

For example, when interest rates are increasing, long-term bonds may underperform, as their interest payments remain stagnant. To mitigate this risk, you may consider a tactical position in an actively managed floating rate loan ETF, such as the Mackenzie Floating Rate Loan ETF (MFT). Floating rate loans offer interest payments that move in tandem with a predetermined benchmark rate, such as the Bank of Canada overnight rate. As interest rates rise, so too will the income you receive from the floating rate loans.

Another approach to alpha is through exposure to a specific market niche, such as high-yield bonds. While these may be included in an aggregate bond index, their allocation within the index would tend to be small relative to government and investment grade corporate issues. A small overweight position to a high-yield ETF, such as the Mackenzie US High Yield Bond Index ETF (CAD-Hedged) (QHY), offers the potential for higher current income.

Rebalancing

Regular rebalancing is important to ensure your portfolio remains aligned to your risk tolerance.

Pairing an index ETF with an alpha-seeking strategy provides a simple and cost-effective way to rebalance your portfolio by using the index ETF as a liquidity sleeve.

Let’s say your US equity allocation has grown beyond your preferred allocation, and your alpha-generating bond allocation has become relatively smaller. You might consider selling a portion of your beta-generating large cap ETF allocation and using the proceeds to shore up your fixed income allocation.

In this example, if you’re going to trim your exposure to US equities, it makes sense to do so from the beta position, rather than walking away from the potential for alpha. The beta-capturing ETF is a larger core holding than the alpha-seeking strategy, and therefore tactical adjustments are less likely to have a major impact on portfolio risk.

Why blend active and passive ETFs?

Combining active and passive ETFs can provide an efficient way to enhance diversification in your portfolio. With a passive core providing relative stability, alpha-seeking ETFs may provide additional returns above the overall market.

Talk to your financial advisor to learn more about ETFs and how they could fit into your portfolio.

Commissions, management fees, brokerage fees and expenses all may be associated with Exchange Traded Funds. Please read the prospectus before investing. Exchange Traded Funds are not guaranteed, their values change frequently and past performance may not be repeated.

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This article may contain forward-looking information which reflect our or third-party current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties and assumptions that could cause actual results to differ materially from those expressed herein. These risks, uncertainties and assumptions include, without limitation, general economic, political and market factors, interest and foreign exchange rates, the volatility of equity and capital markets, business competition, technological change, changes in government regulations, changes in tax laws, unexpected judicial or regulatory proceedings and catastrophic events. Please consider these and other factors carefully and not place undue reliance on forward-looking information. The forward-looking information contained herein is current only as of July 26, 2023. There should be no expectation that such information will in all circumstances be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise.