ETFs: An Easy Way to Build a Lifetime Investment Portfolio

In the early days of building my own investment portfolio, I constructed it with individual stocks and the mutual funds that my then-employer offered in my 401(k). Back then, mutual funds were the only option available in retirement programs.

Mutual funds were an easy and effective option for 401(k)s as they pool money from a group of investors and then invest that money in stocks, bonds, and short-term debt (as well as alternative investments like commodities and gold).

Through the years, I’ve invested in many successful funds. And plenty of investors still opt for mutual funds, which now number 7,153 and hold $26.78 trillion in assets.

But when exchange-traded funds (ETFs) arrived in the marketplace in 1993, I was intrigued by the promises of the advantages they offered.

ETFs are constructed a bit differently than mutual funds. An ETF is a basket of investments that track an index, a commodity (or commodities), bonds, or a diverse group of assets. For the most part, ETFs offer the same type of diversity as mutual funds, allowing you to choose different investment strategies and goals, but have several inherent advantages, including:

Transparency and Liquidity. ETFs are required to disclose their holdings every day, while mutual fund managers only have to disclose theirs 60 days after the end of a quarter. That means an investor could purchase a mutual fund today based on data from two months ago. For instance, if you opted to invest in a fund because it appeared that 15% of its assets were in Microsoft (MSFT) and found out later—because of outdated data—that only 3% of the fund’s holdings were actually in MSFT when you purchased it, you’d be a little disappointed to say the least.

Whereas, if you’d bought an ETF holding 15% MSFT, you would know—within a day—if the fund changed its allocation to that stock.

Tax Efficiency. Often, mutual funds need to boost capital for share redemptions or to rebalance their portfolios, which may lead to capital gains—and capital gain taxes for their shareholders.

Alternatively, ETFs redeem blocks called creation units that allow the fund to raise capital without selling its holdings. And the IRS says that redemption does not qualify as a “taxable event.” You would usually incur capital gains and pay capital gains taxes only when you sell shares of the ETF.

Additionally, ETFs generally have lower turnover than mutual funds, so, with less buying and selling, fewer taxable events will occur, lessening your tax bite with an ETF.

Easy to Trade. Mutual funds can only be bought or sold at the close of the market, or 4 p.m. ET. Their Net Asset Value is set at that time, and that time only.

On the other hand, ETFs are—like stocks—sold and bought all day long, so you always know the value of your investment.

And unlike mutual funds, with ETFs, you can use limit orders, you can sell them short, and you can trade options.

Generally, Less Expensive than Mutual Funds. Unlike mutual funds, you buy ETFs through a broker, so you will have to pay a commission (if your broker still charges one). However, the total expenses are, on average, much lower than the expenses of mutual funds in similar asset categories. According to Morningstar, the average index ETF expense ratio in 2023 was 0.48%, and 0.73% for active ETFs, compared with an average expense ratio of 0.81% for index mutual funds and 1.02% for actively managed mutual funds.

No Minimum Investment. Whereas you can purchase one share (or less if your broker offers fractional investing) of an ETF, most funds have a minimum investment, such as $500 to $10,000 or more.

ETFs Make for Great Diversification

I will—foremost and forever—primarily be an investor in individual stocks. The bug caught me early—in college—and I actually won my first stock at an investment conference—five shares of Atmos Energy (ATO)—a natural gas company.

But I like to have a diversified portfolio, one that includes shares or fixed-income investments in a variety of industries and countries. So it makes sense to also buy pooled investments such as ETFs, where your monies are “pooled” with other investors so that you can invest in a basket of stocks, commodities, and bonds, thereby spreading your investments wider while also mitigating the risk of your portfolio by not keeping you’re your eggs in one basket.

Since their inception, ETFs have grown to cover nearly every sector and industry—domestic and international. As of the end of 2023, there were 3,108 ETFs with $8.1 trillion in assets, accounting for 24% of total assets managed by investment companies.

For the most part, ETFs offer the same type of diversity as mutual funds, allowing you to choose different investment strategies and goals.

An Investment Style to Fit Almost Every Investor

Investors can help themselves to market-, dividend-, earnings- and sales-weighted ETFs. You can also find plenty of commodity, country, and sector exchange-traded funds. Actively managed ETFs are growing in popularity, and during the economic woes of the recession—with sectors like housing and financials under fire—short ETFs grew considerably.

Here are some of the most common ETF styles:

Active vs. Index ETFs

The goal of an index ETF, or “passive” fund, is to replicate the performance of an underlying index, such as the S&P 500, which tracks the overall large-cap market. But you can also invest in more targeted subsets of the overall market, including small-cap growth stocks or large-cap value stocks. Or you may choose to buy an ETF that replicates a bond, commodity, or currency index.

Most ETFs track an index, so trading is fairly minimal. And with that lower investment turnover, you won’t be realizing a lot of gains as the prices of your funds rise, so your capital gains taxes should be minimal.

Alternatively, the goal of “active” ETFs is to outperform a specific index, or some other target, such as maximizing dividend income. And because the manager of an active fund must monitor the investments and trade more often, expenses will be higher than with a passive ETF.

Equity ETFs

These ETFs invest in baskets of individual stocks. They may invest in companies in specific sectors, such as technology, real estate, healthcare, consumer goods, utilities, or energy; international stocks, including regional or country-specific shares. And each of these can be subdivided into even smaller sectors. For example, technology ETFs could be further focused on companies generating their income from the cloud, software, internet, or mobile communications.

You will even find ETFs that focus on a particular investing style, like value, growth, dividends, or momentum. In my opinion, Equity ETFs should be in every investor’s portfolio, to add diversification and exposure to areas in which you may not be comfortable investing directly.

Bond ETFs

These are fixed-income ETFs, in which investors can potentially buy into thousands of bonds using just one ETF. These ETFs—like equity ETFs—trade on exchanges, which gives investors more transparency and liquidity. And bond ETF investors can also diversify by purchasing municipal issues, U.S. debt instruments, corporate or mortgage bonds, foreign debt, and investment-grade or high-yield bonds. It’s an easy way to buy a bond without shelling out thousands of dollars on just one issue.

Commodity ETFs

These ETFs track the price of physical assets such as gold, silver, rare earth metals, oil, livestock, sugar, coffee, and wheat. Commodities generally rise with inflation, so investors may buy or sell them, depending on their view of the economy. And they generally have a low correlation with stocks and bonds, and even other commodities.

Additionally, you can’t beat the convenience. Instead of lugging around and storing a bar of gold, you can invest in ETFs that own physical gold or a varied group of gold-related companies, including the miners who take it out of the ground, or the businesses trading in gold futures.

Currency ETFs

If you want to invest in a particular currency or basket of different currencies, I’m sure you can find one. However, know that these ETFs are extremely volatile and depend on their relationship with the U.S. dollar. If the index declines relative to the dollar, you will lose money. These ETFs are meant to be mostly shorter-term holdings.

Cryptocurrency ETFs

You knew it would happen! I counted 33 new cryptocurrency ETFs. But that has probably changed since I typed this!

These ETFs allow you to invest in crypto without holding the digital asset yourself. And since I’m no crypto expert, I’m going to leave it there. Risky; buyer beware.

International ETFs

International ETFs can give you exposure to stocks and bonds from individual countries—India, China, Ireland, France, Italy, etc., as well as regions and subregions, like Asia-Pacific and Latin America. They also offer an entrée into different types of economies, including developed (Europe, U.S.); emerging (China, India); and frontier (Kenya, Croatia, Latvia, Malta, for example). Like the U.S.-focused ETFs, international ETFs also provide choices of specific sectors, investing strategies, factors and styles.

Additionally, investing in a foreign-focused ETF gives investors “boots on the ground”— analysts who live and work in that region or country, and who understand the economics, geopolitics, and accounting of that country or region.

Lastly, international stocks and bonds can help investors reduce portfolio risk and find additional growth opportunities.

Buying foreign investments—if you are unfamiliar with the economic and accounting practices of the company’s home country—is simply a crapshoot. If you want to invest internationally, I would highly recommend an ETF that is professionally managed by folks who are immersed in that country or region.

How to Evaluate an ETF

Just as with your decision to buy a stock, ETFs also require evaluation. For ETFs, that means reviewing performance, expenses, capital gains distributions, and risk.

As with mutual funds, Morningstar rates ETFs with their 1 – 5-star system, based on the fund’s past performance, the fund manager’s skill, risk- and cost-adjusted returns, and performance consistency. The ETFs are evaluated for up to three time periods: three, five and 10 years, and then combined to create an overall rating for the fund.

Here are some tips to assist you in reviewing each category:

Performance. Of course, you want to make sure that the ETF you select will appreciate. But it is important to look beyond short-term numbers. Almost any investment can do well in the short run. But you’ll want to track its performance over a period of time, such as three and five years, to ascertain how the ETF stacks up against its competitors.

Expenses. Not all ETFs are created equal. As I said earlier, active ETFs will have higher expenses than their passive brethren. But here’s where you need to get picky. Don’t assume, for instance, that all Technology ETFs will have similar expense ratios. They don’t. You’ll need to ferret that out and then balance that expense against the ETF’s return to see if it makes sense. If the expense ratio is a bit higher, but the gains of the ETF are double that of its competitor, it may be worth your while to buy the more expensive ETF.

Another important factor—you may want to review the ETF’s efficiency, by weighing the fee the fund charges against how well it “tracks”—or replicates the performance of—its index. If an ETF has low expenses and tracks its indexes in step, it’s considered to be highly efficient.

To understand if an ETF is tracking its index well, just look at its performance. Did it perform the same way the index did? If the index rose in value, so should the ETF.

Capital Gains Distributions. Since one of the reasons investors buy ETFs is for lower taxes, you should also consider the ETF’s rate of capital gains distributions. You can calculate this by taking the average capital gains paid out to shareholders over a recent period divided by the Net Asset Value (NAV) at the time. The lower, the better; that means the ETF is maximizing its tax efficiency.

Risks. Some ETFs are riskier than others. Here, from Fidelity, are some risks you may not have considered that are associated with ETFs:

Market risk. If the market takes a dive, so too will your ETF.

“Judge a book by its cover” risk. Just because the biotech or energy market is “hot,” that doesn’t mean every associated ETF will have the same performance. The range in gains or losses can be pretty wide. So, just like individual stocks, it’s imperative for investors to evaluate each ETF as you would a stock—performance, holdings, expenses, etc.

Exotic-exposure risk. Your ETF choices are vast, but some are also complex. And the more complicated an investment gets, the riskier it may also be. Currencies, commodities, cryptocurrencies, short ETFs, leveraged ETFs, options, bonds—each of these can create huge exposure to risk. So, again, do your homework.

Tax risk can come into play with commodities and currencies. The IRS can tax gains as ordinary income, because the capital gains holding period may not apply, such as in the case of buying an ETF that holds gold bars. In that example, even if you hold the ETF for a year, the IRS doesn’t charge you at the long-term capital gains rate but instead makes you pay 28% (the “collectibles” rate) on that gain. The key here is that the ETF holds gold bars, not gold stocks (which would be subject to the lower capital gains rate in this case). Good to know, right?

Counterparty risk is generally confined to exchange-traded notes (ETNs), not ETFs. ETNs are unsecured debt notes backed by an underlying bank. The risk is, that if the bank folds, you’ll have to get in line with everyone else to recoup your money.

Shutdown risk. If an ETF is liquidated, the shareholders are paid in cash. Bloomberg reports that about 110 ETFs close every year. This could result in capital gains to you, which may or may not be taxed at higher rates. You can also expect to pay transaction costs, too. With new ETFs popping up daily, I’d recommend you stay—for the majority of your ETF portfolio—with those that have been around a while.

ETF trading risk may occur as the price spread can change from pennies to dollars from day to day. Additionally, Fidelity warns that “an ETF’s liquidity can be superficial: The ETF may trade one penny wide for the first 100 shares, but to sell 10,000 shares quickly, you might have to pay a quarter spread.”

These spreads can increase your costs and reduce your gains over time. To mitigate the risk, you may want to “use limit orders and avoid trading around the open and close of the market.”

Broken ETF risk can be a factor, particularly with international ETFs, if an exchange closes for some reason (such as the summer 2015 closing of the Athens Stock Exchange). In that instance, the Global X MSCI Greek ETF (GREK) traded at significant premiums to net asset value. ETF.com noted, “If investors wanted to get out, they would expect to lose money when they sold. Market prices of the underlying securities were not available while the market was closed, so the ETF had to be priced with the information available, which was limited.”

This can also occur with commodity ETFs if the product decides to no longer issue new shares.

Hot new thing risk. Just like with “hot” new stocks, new ETFs can also be risky. Here, I would err on the side of caution and wait awhile to see a real track record before investing my hard-earned money.

Crowded trade risk. That hot new thing or emerging market debt or high-yield stock may attract a lot of investors, initially. But the newness may wear off, and liquidity may eventually diminish or disappear.

Bottom line: I would be very conservative in chasing the unusual. That isn’t to say that you can’t have a “speculative” portion of your portfolio devoted to riskier ideas—just don’t make them your core investments.

How to Find the ETFs with the Most Potential

I was disappointed when Morningstar turned their ETF screener into a paid-only version. But don’t worry; there are other free screeners, including:

VettaFi (Formerly ETFdb)
WisdomTree
Pensions&Investments
Yahoo! Finance

Most of the screeners will allow you to compare several ETFs. Just make sure you really look under the hood and verify that the composition of the portfolio is attractive to you, the expenses are reasonable, and the returns are stellar!

The Highest-Rated Brokerages for Buying ETFs

You may already have a brokerage that you use to place your trades. But if you don’t, here are the top online brokers for ETFs, according to NerdWallet.com:

Why NerdWallet likes it:
“Robinhood provides free stock, options, ETF and cryptocurrency trades (but no bonds or mutual funds), and its account minimum is $0, too. Robinhood Gold offers a high interest rate on uninvested cash and low margin rates.”

Pros

• Commission-free stock, options and ETF trades.
• Streamlined interface.
• Cryptocurrency trading.
• High interest rate on uninvested cash.

Cons

• No mutual funds.
• Limited customer support.

Why NerdWallet likes it:
“Charles Schwab has earned its strong reputation: The broker offers high-quality customer service, four free trading platforms, a wide selection of no-transaction-fee mutual funds and $0 commissions for stocks, ETFs and options.”

Pros

• Commission-free stock, options and ETF trades.
• Four trading platforms with no minimums or fees.
• Above-average mobile app.
• Extensive research offerings.
• Large fund selection.

Cons

• Low interest rate on uninvested cash.

Why NerdWallet likes it
“IBKR Pro offers advanced traders a variety of features to up their investing game, including some of the lowest margin rates in the business, discounted contract fees on large-volume options trades, and a high cash interest rate for balances above $10,000. In exchange, users pay very low trade commissions.”

Pros

• Per-share pricing.
• Volume discounts.
• Large investment selection.
• Extensive tools for active traders.
• Powerful trading platform.

Cons

• Complex pricing on some investments.

Why NerdWallet likes it:
“E*TRADE has long been one of the most popular online brokers. The company’s $0 commissions and strong trading platforms appeal to active traders, while beginner investors benefit from a large library of educational resources.”

Pros

• Commission-free stock, options and ETF trades.
• Easy-to-use tools.
• Strong customer support.
• Advanced mobile app.

Cons

• Website can be difficult to navigate.
• Low interest rate on uninvested cash.
• No fractional shares.

Why NerdWallet likes it:
“J.P. Morgan Self-Directed Investing is a clear-cut investment platform that is great for beginners looking to learn how to buy and sell investments. More advanced investors, however, may find it lacking in terms of available assets, tools and research…”

Pros

• Commission-free stock, options and ETF trades.
• Easy-to-use platform.
• App connects all Chase accounts.
• In-person customer support at Chase branches.

Cons

• Limited tools and research.
• Portfolio Builder tool requires $2,500 balance.
• Low interest rate on uninvested cash.

Portfolio Construction

Many investors favor a “strategic” or “tactical” portfolio allocation. Here’s what I mean:

A strategic portfolio is designed around an investor’s long-term goals—returns, risks, liquidity, time horizon, and taxes, for the most part. You would then mix your assets and the weight of those assets in your portfolio, based on your most important goals.

Here’s an example of a strategic portfolio’s asset allocation:

Cash = 10%
Bonds = 35%
Stocks = 45%
Commodities = 10%

In comparison, a tactical portfolio is simply taking your strategic allocation and adjusting it over a short period of time, according to market and economic factors, to maximize returns. By its nature, a tactical portfolio is not really a trading portfolio, but a nudge in the assets to take advantage of shorter-term changes—basically shifting percentages of the current holdings while keeping the original asset mix.

In a tactical portfolio, the asset mix and weights would change, depending on what you thought the economy or markets might do in the near future. For example, if you think a bull market is on the horizon, you may shift to a higher percentage of stocks. And if you thought small-cap stocks were on the rise (which looks to be the case currently), you may allocate a higher percentage to small-cap stocks.

Sample Stock/ETF Portfolios

Most financial planners recommend that investors tailor their portfolios around their age and risk tolerance, such as the ones I included in my recent Cabot Stock of the Month newsletter:

By Age:

By Personal Risk Tolerance:

If you don’t know whether you are a Conservative, Moderate, or Aggressive investor, I invite you to take this quiz I created to help you determine just that.

I hope you’ll run your own searches for ETFs that will fit into your investing strategy and risk tolerance. But, if you’d like to get started by looking at some constructed portfolios, I’d like to refer you back to some of the stocks and ETFs in the Cabot Stock of the Month portfolio and propose some portfolio mixes, according to age and risk tolerance.

Here are the stocks and ETFs I am using to construct the sample portfolio ideas:

STOCKS:

*Aggressive (A), Moderate (M), Conservative (C)

ETFs

*Aggressive (A), Moderate (M), Conservative (C)

And here are some sample portfolios, according to age and risk tolerance:

Age 0-40

Aggressive Portfolio

Moderate Portfolio

Conservative Portfolio

Ages 41-60

Aggressive Portfolio

Moderate Portfolio

Conservative Portfolio

Ages 60+

Aggressive Portfolio

Moderate Portfolio

Conservative Portfolio

You’ll notice that I didn’t include any bond funds in these sample portfolios. We don’t currently own any bond funds in Cabot Money Club but, especially for the conservative portion of your portfolio, you may want to consider some bond funds.

Here are a few of the highest-rated at this time that you may want to consider:

• Long-Term Corp Bond Vanguard (VCLT)
• Tax-Exempt Bond Vanguard (VTEB)
• Pimco Enhanced Short Maturity Active ESG ETF (EMNT)

I hope these ideas will help you design the portfolio that will work best for you. Of course, the specific stock and ETF recommendations will change with the market and sector outlooks.

And if you are only building an ETF portfolio, you can do the same construction, allocating aggressive, moderate, and conservative ETFs according to your age and risk tolerance.

Happy building!