The Role of ETFs in Multi-Asset Investing

How to build a multi-asset portfolio using ETFs

An effective way to deal with randomness in the markets is to follow a disciplined approach in investing. One such integral element in disciplined investing is asset allocation. Investing in a portfolio of varied asset classes with low or no correlation with each other can effectively reduce risk for the investor.

A carefully determined asset allocation can be used to construct a portfolio across asset classes and rebalance the portfolio from time to time. Exchange traded funds (ETF) can come in handy for this purpose.

Exchange traded funds invest in stocks, bonds, and commodities such as gold and silver. In case of stocks and bonds, they try to mimic the performance of an underlying index; and gold as well as silver ETFs buy physical commodities to achieve asset class exposure. This gives wide choices to investors who want exposure to specific asset allocation. Using ETFs makes it cost-efficient and it is relatively easy to transact in them. Let us understand this with an example.

An aggressive investor looking to invest for the long term can invest around 70% of the money in equities, 20% in bonds and rest in commodities. This can be well achieved using ETFs. She can invest her 70% of the money in the following manner: 40% in the Nifty 50 ETF, 15% in the Nifty Midcap 150 ETF, 10% in the Nifty Smallcap 250 ETF and 5% in the Nifty200 Momentum30 ETF.

Bond allocation can be achieved using ETFs tracking short, medium or long term bond indices depending on the view of investor. If an investor is of the view that interest rates may fall, then she can invest in ETFs tracking long-term bond indices such as the Nifty 8-13 year G-Sec Index. Investors who do not have a view about interest rates are better-off investing in units of ETFs investing in short-term bond indices or medium term constant maturity ETFs like Nifty 5 Year benchmark G-Sec. An aggressive investor can allocate around 5% each in units of gold and silver ETFs. Here is a table of possible portfolios using ETFs for three different profiles of investors.

Invest in a staggered manner in the units of ETF to reduce the timing risk while investing in risky asset classes such as equities and commodities.

While investing across asset classes, savvy investors can also consider allocating money to foreign equities. As of now, investments in overseas equities by Indian mutual funds are restricted and hence the investors have to be careful while investing in ETFs tracking an index such as the Nasdaq100. While placing orders for units of ETFs investors must check the i-NAV or indicative net asset value. A trade closer to an i-NAV should help investor transact at the fair value.

After the portfolio is built investors need to keep track of their portfolios. When asset prices change, asset allocation of portfolios also changes. For example, when there is a bull phase in equities, allocation to equities tends to go up. And in the case of a fall in stock prices, allocation to stocks comes down.

That calls for rebalancing of the asset allocation. It can either be done at regular interval – say once in a year or after big changes in asset allocation. Rebalancing of asset allocation help investors book profits from time to time in a disciplined manner and stay on the path to achieve their financial goals. If the allocation to equities have gone up at the cost of allocation to bonds, then investor should sell some amount of units of equity ETF and using the proceeds buy the units of ETFs investing in bonds. That should revert the asset allocation to the one with which the investment journey started.

In the long-term, say once in five years, even asset allocation needs to be reassessed. Changes in risk profile, income and financial goals of the investor, may warrant a change in the asset allocation. Such changes can be carried out by selling and buying units of ETFs on stock exchanges.  On the whole, regular investments in units of ETFs using asset allocation approach can help investors accumulate wealth over a period of time. Investors must note here that investments in units of ETFs can be used as margin for trading purpose.

Article is published in Economic Times – Click here