Equity ETF Portfolio Decision Tree

ETFs are the gift that keeps on giving and continue to gain in popularity around the globe for their endless efficiencies. In Canada, there are over 350 equity ETFs, dwarfing that number in the US there are over 1300 equity ETFs.¹ If you have an exposure in mind, chances are you can find an ETF to meet your desired outcome with products covering the spectrum of broad beta, factors and sectors. Additionally, recent innovation has led some investors to consider adopting active ETFs to enhance alpha in a portfolio.

Portfolio construction is as much an art as it is a science. ETFs can simplify the portfolio construction process because they offer greater transparency. It may be helpful to review a simple framework for building an equity portfolio and the considerations that help determine what mix is right for you. For the purposes of this framework we have divided the equity ETF universe into three simple groups.

The challenge is deciding how to combine these products to build a strong equity portfolio

Approaches to portfolio construction

A further approach would be to adopt a blend of these approaches. Sounds simple enough but deciding how to align your portfolio weights with your economic views, level of conviction, and considering how factors and sectors intersect entails greater deliberation.

Decision Framework:

1. a) Conviction Level: How heavy in the core?

Using a core and satellite approach, higher conviction leads to higher weights in the satellites, whereas more uncertainty leads higher weight in the core. Investors with confidence in global leadership and the further expansion of coordinated global growth will put higher weights in satellites; including more cyclical factors, and less defensive sectors. Investors with limited confidence will do the opposite. Those in between, are best off with broad beta exposures.

1. b) Active, Index or Blend?

With the launch of Active Equity ETFs, investors will typically follow three paths: passive portfolios for confident investors or efficient market believers, mixed active and passive portfolios for less confident investors, and active portfolios for unsure investors, and enhanced global exposure.

2. Economic View:

Not all factors and sectors have the same macroeconomic drivers, and therefore some factors/​sectors will outperform others based on inflation, the interest rate environment, and the economic cycle. Using a rotation strategy can be profitable as a satellite to your core broad beta exposures.

3. Sector/​Factor convergence - what are the biases?

Being aware of how Factors intersect with sectors and how Factors have consistent sector concentrations is an important consideration. While concentration of sectors in factors such as Momentum and Quality would change over time and tend to be more diverse, Factors such as Low Volatility have more consistent sector biases (Utilities, REITs, Consumer Staples) consider.

Other Considerations

Currency – While over the longer term there is purchasing power parity (PPP) between two currencies, to which they will revert over time, over the shorter-term currencies can trade beyond their PPP for significant periods of time. If an investor believes the U.S. Dollar will appreciate against the Canadian Dollar and are looking to invest in U.S. equities, an unhedged U.S. equity ETF may be more suitable as an example.

Geography – Political regimes, tax laws, monetary policy and business cycles are rarely the same across the globe, and these variables have an impact on the performance of your portfolio. Therefore an investor should be aware of a region’s macro-economic landscape as these variables will impact performance. 

Income Needs – investors needing extra income can consider a higher allocation to higher income sectors such as financials and utilities, as well as higher exposure to yield based factor indices.

Sectors: Rotating for Success

Early Recovery

Mid-Cycle

Late-Cycle

Recession

Smart Investing with a Factor Based Approach

Quality

Value

Low Volatility

Dividend

¹Source: ETFGI, June 2023.

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