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How Many U.S. Equity ETFs Do You Need In Your Portfolio?

June 22, 2017

An important question to consider as an investor is how many ETFs you should really have in your portfolio to fulfill your investment objectives. This number can certainly vary widely depending on the size of your portfolio and where you are in life as an investor - what your goals are. The truth is that with most issues trending in more or less the same direction, you may need fewer ETFs in your portfolio than you think.

Currently many U.S. equity-based ETFs are highly correlated in trend one with another. This is primarily due to extremely accommodative Fed policies that encourage risk taking, given the low returns available from savings and other alternatives. These high levels of correlation allow only for minor differences in performance from one equity sector to another. It's true that some sectors exhibit greater beta (volatility) than others, occasionally making for some significant variation in performance. For example, small cap sectors have a higher beta and may outperform or underperform other sectors like large cap value. Nevertheless the overall trends remain relatively the same. Given this fact, it's important to remember that less is more when it comes to assembling a portfolio of U.S. equity ETFs.

 

Another interesting development in the U.S. equity ETF space has been the demand for income. This trend has two basic components. First, baby boomers are either retiring or rapidly nearing retirement age. As a general rule investors in this category are usually advised to be more conservative with their equity allocations, and income-oriented ETFs fit the bill. Secondly, the two bear markets in the preceding 10 year period, various trading scandals involving insider trading at large hedge funds, Ponzi Schemes and trading accidents involving HFTs (High Frequency Trading) have all lead to a generally distrustful attitude towards equity markets.

To meet the income needs of this large pool of investors, ETF sponsors have been issuing income and dividend oriented ETFs at a furious pace. These have clearly proven to be very popular with investors, with fixed income ETFs registering net inflows of $4.2 billion in August, leading all ETF asset categories. The problem is that many of these ETFs are repetitive in structure, which makes differentiating among them difficult. Investors must really focus on fee structure and liquidity among several different asset classes. These might include large cap, small cap, real estate and high yield. In other words, you can count the number of dividend oriented ETFs you need on one hand to satisfy the demands of building a diverse, income-oriented portfolio.

 

The risk with these issues and other equity issues is that if and when the economy starts to take off again, monetary authorities will almost certainly raise interest rates, and this will make these income-oriented issues' yields comparatively much less competitive. The dividend from income-oriented ETFs becomes less attractive when the level of return from riskless savings rises. This is to say that you should not expect low interest rates to last forever. They are cyclical in nature along with the economy. Should monetary policies change allowing interest rates to rise substantially from current levels, this would almost certainly decimate income ETFs.

Some argue that given the unique nature of current economic conditions and monetary policies that further inflation in the future is a certainty. If so, investors seeking income may wish to think outside the box, remaining invested in higher-growth assets to keep up with declining purchasing power.

One pitfall that dividend-oriented investors should be aware of are preferred stock ETFs. Current yields are higher overall but they're primarily weighted by bank issues. The high yields here are a result of the financial crisis, fear related to creditworthiness, and the reliability of payments. The other issue often not discussed is that preferred stocks are "callable" meaning as banks recover, their borrowing costs decline and they will likely call away these issues as soon as possible. Once these issues are "called," their high yields evaporate.

As long as these policies remain in place, with many equity related ETFs in a portfolio the correlations will remain high. This means you need fewer ETFs in your portfolio than you otherwise might expect. For many investors only one or two ETFs in this category will suffice for primary investment objectives, absent other considerations. Should different asset classes become less correlated than current market conditions have been permitting, it may not be a bad idea to add a few uncorrelated issues to your portfolio.

 

There is one caveat and this involves beta or volatility differences among equity choices. For example, small cap issues have a higher level of volatility than large cap or defensive sectors like consumer staples. When markets rise, and with the aforementioned policies in place, small caps will outperform within the same rising trend. When markets are declining the opposite will be true, which is to say that small caps will decline more dramatically as well. Overseas issues, particularly from Emerging Markets have seductively higher yields, but they are also the most volatile.

With all of this in mind, investors should keep an eye on monetary policies, specifically those enacted by the Federal Reserve, as it is these policies that have caused traditionally uncorrelated issues to become correlated, with all of the excess liquidity that it has injected into the financial system. Should the Fed change its Zero Interest Rate Policies (ZIRP), a very different market climate with more widely varying correlations among asset classes is likely to develop. Remaining aware of these monetary policies is one of the best ways for investors to remain agile through changing market conditions.

 

In my latest book "The Best ETFs: US Equities" I draw on my 40 years of experience in the investment industry to pinpoint the best ETFs in the US Equities space. Thinking first as a strategist and secondarily as a technician, I use my methodology to hand-pick ETFs in 26 subcategories, ranging from different market capitalizations and approaches, to sector and subsector-specific ETFs, to dividend and high yield dividend ETFs. The book offers a detailed look at my ETF picking methodology, a bird's eye view of the evolving ETF landscape, as well as a look ahead at what the markets may have in store for us.

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