Making sure the ETF you buy is the one you need

Exchange-traded funds have long been touted as a simple, liquid, transparent and tax-efficient solution to gain access to a particular asset class, geography or sector. While this can be true, the myriad of options now available in the market makes choosing the right ETFs a challenge, particularly for complex portfolios.
These layers of complexity aren’t necessarily immediately obvious, just as when searching for a home. When people describe their perfect house, they use multiple criteria. The size, floor plan, yard, number of floors, neighborhood and cost are all good places to start. On paper, it’s easy to try and create a simple list of wants and some buyers treat these criteria as wholly separate. They aren’t. For instance, it is much cheaper to get loads of square footage by having multiple floors than it is to build one really big ranch. The devil is in the details and, if you aren’t careful, you can end up with tons of square feet in a crowded house when what you really wanted was a broad, quiet expanse of land. The same is true with ETFs — you need to understand the goals within a portfolio to avoid risk of overexposure in an area you hadn’t intended.
INDIRECT EXPOSURES
When you purchase an ETF, you might end up with more or less than you bargained for due to the variety of factors that comprise the fund. Your portfolio can become overexposed in a manner you didn’t intend because the type of ETFs you purchased brought additional exposures along with them. Exposures we see popping up in portfolios are larger allocations to consumer staples and health care stocks. These two sectors are defensive in nature, and defensive stocks have performed well in recent years. While each sector can offer opportunity, these gains are unlikely to be replicated.
(More: Liquidity in bond ETFs: The real story)
In recent research projects we conducted, our goal was to identify the types of ETFs that indirectly provide extra exposure to these two sectors, and we found several that invested heavily in them. This was especially true when we compared the ETFs to the S&P 500, which allocates about 24.3% to these two sectors. (As of June 8, health care made up about 15% of the S&P 500, and consumer staples made up about 9.3%.)
We’ve put together a quick cheat sheet as a guide to help you avoid these most common overexposures:
• Dividend Growth ETFs – Health care and consumers staples companies (e.g., food and beverage producers, detergent makers and drug stores) tend to be steadier businesses. That’s why more firms in those sectors regularly increase dividends, as opposed to more cyclical industries such as technology or finance. Screening for stocks with steadily growing dividends tilts the portfolio toward steadier sectors.
• Momentum – The aforementioned excellent performance makes these sectors popular in strategies that emphasize solid performance over the intermediate term.
• European Mega Caps – Health care and consumer staples companies are often large and global in nature. The largest holding in the iShares MSCI Europe Index is Nestle, a consumer staples firm based in Switzerland. The rest of the top 10 includes five health care companies.
• Select Countries – Switzerland (health care) and Belgium (beer) bring some pronounced sector tilts to portfolios. These tilts can change rapidly. When Inbev bought Anheuser Busch, the merged company became a very large company in a small country.
• Minimum Volatility – ETFs designed to reduce risk tilt toward stocks that are less volatile. Lower volatility sectors like consumer staples and health care get extra emphasis in ETFs designed to reduce risk.
Additional exposure to consumer staples and health care together is just one example. Emphasizing value tends to mean you will be buying extra banks. Investing in Japan’s market can include a large allocation to auto companies.
BUILDING THE PORTFOLIO
So how should investors make sure their portfolios emphasize the desired exposures? The most important step is to evaluate the whole portfolio from multiple perspectives rather than just reviewing each individual position. For example, examine ETF portfolios from the perspective of sector, region, country, style and capitalization.
Often, a combined portfolio doesn’t need to be adjusted. But when it does, the easiest step is to buy targeted ETFs to increase allocations to particular sectors. For example, if the strategies above are favorites, then you can purchase sector ETFs to cover gaps in the portfolio. Buying a technology or financial sector ETF may offset the extra emphasis to consumer staples and health care. Inverse ETFs offer another way to control exposures, but these can be more difficult to manage for the average investor.
If none of these options work, then it may make sense to lessen the emphasis on the ETFs above. The best investors focus on getting a portfolio’s risk and allocation managed first and then figuring out the combination of holdings that works best together.
Just as when looking for a house, it pays to look at portfolios from all angles.
Scott Kubie is chief strategy officer at CLS Investments.