ETFs are comprised of individual securities. Unlike mutual funds, the fund can be freely traded like stocks. Expense ratios are lower than mutual funds since may are passively managed vehicles linked to an underlying index or market sector. ETFs can be used to create entire portfolios and are normally well diversified.

Here are the three basic steps in creating a portfolio with ETFs.

  • Set the Right Allocation - Check objective(s) for the portfolio, return, and risk projections, as well as time horizon, distribution needs, legal and tax situations, and personal situation.
  • Implement Strategy - Evaluate the available funds and find the best ones that meet allocation targets
  • Track and Assess - Review performance and allocations annually based on your circumstances

Consider the following when knowing the right allocation:

  • Objective or purpose
  • Risk/return objectives
  • TImetable
  • Distribution needs
  • Legal or tax issues (if any)
  • Suitability of portfolio in overall plans and conditions

Aside from the above-mentioned factors, study market returns. Research by Eugene Fama and Kenneth French led to the conception of the three-factor model in assessing market returns, which indicates the following: 1) market risk explains portion of a stock’s return; 2) value stocks surpass growth stocks because these are inherently riskier; and 3) small cap stocks outmatch large cap stocks over time because of having more undiversifiable risk. For investors with high risk tolerance, they can and should include smaller cap, value-centered equities in their portfolios. Remember, over 90% of a portfolio’s return is shaped by allocation.

Make that strategy work once you have figured out the right allocation. Good thing about ETFs is you can choose an ETF for every sector or index where you want exposure. Look for funds that offer the most reasonable expense ratios and most closely meet allocation needs for each index or sector. ETFs trade during market hours. Based on Stock Trader's Almanac data, equity markets are firmest from November to April, and weakest between May and October.

Now that your strategy is in place, make it a point to trail and assess your portfolio yearly. Depending on tax conditions, the ideal timing is at the start or end of a calendar year. Assimilate each fund’s performance and its corresponding benchmark index. Bear in mind tracking error should be low. Otherwise, ditch the fund which causes the difference.

Market fluctuations are inevitable; do not be impaired by it. So, it is imperative to balance ETF weightings for any imbalances. But never overtrade. Also, stick to your original allocations and keep a long-term perspective.