Building portfolios

Building the right portfolio can be daunting, so we have provided information on some of the ways ETFs can be used within investment portfolios below. We also discuss how your money can work hard while providing you with some examples how ETFs can be used in investment strategies.

Asset allocation

Asset allocation is the term which refers to how you choose to divide up your investment portfolio among the major asset classes - stocks, bonds, and cash. We can also refer to asset allocation within asset classes - for example, within stocks we have a choice of region (UK, US, Europe etc.), investment style (value or growth) or market capitalisation (large-cap or small cap). Many investors believe that the allocation of investments across asset classes is more important than which securities are owned within that asset class.

The decision of which asset classes to invest in, and in what proportion, will depend on your risk and return objectives and also your time horizon. Investors with longer time horizons will often tilt their portfolios toward ‘riskier’ asset classes with higher historical returns (such as small-cap or alternatives), expecting that the risk of the asset class will average out over time.

A critical component of asset allocation is ensuring appropriate diversification, or making sure that you haven’t ‘put all your eggs in one basket’. iShares range of ETFs help you to ensure your investments are spread over as many asset classes as you feel are appropriate for your investment needs.

The role of correlation

Ice cream sales tend to increase when the weather is warm, but fall when the weather gets colder. This is an example of correlation, which measures the strength of a relationship between two factors.

In financial markets, one example of correlation is that equity markets tend to increase in value when the economic outlook is favourable, but tend to decline when the economic news is less positive. Bonds react in an opposite manner, tending to decline in value during favourable economic conditions, but rising in value when the economy takes a downward turn. This is an example of inverse correlation.

Correlation is a very useful tool when you are establishing your asset allocation (how much you will be investing in stocks, bonds, property or alternative asset classes)

 

Role of Correlation

Correlation values range between +1 and -1. Assets that are perfectly correlated, or move together in the same direction, have a positive correlation of 1. Those that exhibit an inverse relationship (moving in opposite directions) have a correlation of -1. A correlation of zero implies that there is no relationship.

Combining low-correlating assets can help to diversify portfolio risk. Ideally, if an investor holds assets that are negatively correlated (when one goes up the other goes down) the overall volatility of the portfolio would be minimized. Using correlation as a reference point when building portfolios can be a useful tool in managing overall portfolio risk.

 iShares wide range of ETFs offers you different ways of combining low-correlating assets in order to reduce the volatility of your investment portfolio’s performance.

Investment strategies

ETFs can play a key role in portfolio strategies ranging from the simple to the complex.

Their building block nature means they can either be used alone, or in conjunction with other types of investment product or individual securities, to build diversified portfolios.

ETFs can help make your cash work harder

ETFs can be a cost-efficient way of putting idle cash to work in the financial markets, during periods when you are looking to rethink your longer-term investment strategy.

ETFs can also be used to fill gaps in your portfolio or to add diversification to existing portfolios as required.

Sector-based ETFs offer a quick and cost-efficient way of implementing tactical strategies such as sector rotation (switching between sectors as market conditions dictate). After researching market conditions, investors can use ETFs to increase or decrease exposure to chosen sectors. ETFs can also be used to seek relative outperformance from among asset classes, styles or sectors. On the fixed income side, ETFs can be used to increase or reduce duration (interest rate risk) and credit risk among bond portfolios in anticipation of future interest rate movements.

ETFs also offer a cost-efficient way of gaining access to hard-to-reach markets (such as emerging markets).

ETFs can form the centrepiece of your investment strategy

During times of rapid economic and market changes, where the value of traditional portfolios of stocks and bonds can vary wildly, the simple and flexible nature of ETFs means they can now play a more central role in investment portfolios.

A popular investment strategy is known as Core/Satellite, where the core, or centrepiece of the strategy is a low risk fund such as an ETF, which offers low-cost and diversified exposure to an index. The aim of the core is to deliver returns in line with the market’s performance (known in financial markets as beta).

Then, there are satellites, which are typically more specialised investments designed to generate additional returns (known in financial markets as alpha).

Satellites can be either specialist ETFs, actively-managed funds, hedge funds or direct investment in specific securities.

Risks: Keep in mind that the value of an investment may go up or go down. Check in the prospectus for specific risks and tax implications. For example, investing in an ETF with an international focus might expose you to currency risk.

The ‘building block’ nature of ETFs makes them a perfect fit for Core/Satellite investments, as positions can be increased or reduced quickly and cost-effectively.

This is not intended to provide specific investment advice including, without limitation, investment, financial, legal, accounting or tax advice, or to make any recommendations about the suitability of iShares® for the circumstances of any particular investor. If you do require investment advice, please contact your broker or financial adviser. You should take appropriate advice as to any securities, taxation or other legislation affecting you personally prior to investing.