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Using exchange traded funds to instantly diversify your portfolio

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It’s a truth universally acknowledged that diversifying your portfolio among different asset classes is a No Brainer.

Sure, just as with brushing your teeth or the merits of jogging, you’ll find a few backwoods men howling at the wisdom of asset allocation. But the general consensus is you can likely reduce the volatility and thus the uncertainty of the returns from your portfolio by spreading your bets between different kinds of investments, without reducing returns too badly.

In the old days, such financial black magic would have been done by a pension fund manager or a kindly broker, who would have charged you heavily for the privilege. These days though many investors are managing at least a portion of their funds for themselves. For too many of us, that means big equity portfolios and not a lot else.

I’ve been looking to address this problem in my own investing pot. While I’ve currently got a fair amount of cash (about 25 per cent of the total fund value, earning around 5% a year), elsewhere I’ve ridden the bull market in shares since 2004 at the expense of wider asset allocation. With markets looking shakier, I don’t want to push my luck.

Buying ETFs gives you quick, broadly spread exposure

From my research, I believe Exchange Traded Funds (ETFs) offer the potential for a rough-and-ready overhaul of my asset allocation strategy. Below I’ll go through the ones I’m looking at and in some cases have already invested in. You can decide for yourself if they have a place in your own portfolio.

Today’s ETFs offer you instant diversification benefits from assets as diverse as:

  • Government
  • Corporate bonds
  • Commodities like gold, cotton and timber
  • Foreign stock markets
  • Commercial property.

ETFs are cheap – you can buy them through an online share broker in the usual way you’d buy any share, with no initial charge beyond the dealing fee. They simply track indexes so the annual charges are low, too. With an ETF you’ll never outperform any asset market, but you won’t underperform it by more than the annual charge either.

Now, I’m not claiming that ETFs are a perfect solution for all asset allocation issues. For instance, UK investors sometimes buy various Gilts (the age-old name for UK government bonds) to create timed income streams to meet future liabilities.

Buying a Gilt fund won’t do that – instead you’re simply tracking an index of various gilts, as determined by the ETF provider. It’s a one-time buy-and-forget strategy. But for my part, that’s all I currently need Gilt exposure to do. Same deal with timber and oil. I don’t want to become an expert on the cotton crop or the diseases afflicting cocoa beans, and I don’t want to be trading into some in spring and out of others come December. I just want my portfolio to have exposure to the results of those who do, primarily to diversify my equity portfolio.

ETFs are perfect for such quick diversification in my opinion, especially given their low charges, so let’s consider a few to get started. (I look at using exchange-traded funds to get direct exposure to commodities in a different post about these so-called ETCs.)

(The ETFs below are all UK issues; other countries have their own ETFs – investors in the US in particular are blessed with thousands to choose from. The principles for US and other investors are exactly the same, though. You just need to find domestic ETFs that match your desired asset class).

ETF Name: iShares £ Corporate Bond

Symbol: SLXX
Asset class: Corporate bonds
Expense ratio: 0.20%
What you get: Exposure to a range of investment grade bonds from companies around the world, denominated in Pounds Sterling. This means you won’t suffer (or benefit from) currency fluctuations, assuming you’re a UK investor.
Why it’s good: Bonds typically move the opposite way to equities, so they’re perfect for diversifying your portfolio. Traditionally, you were advised to hold a percentage equal to 100 – (your age) in equities, and the balance in bonds. You get a regular income from corporate bonds (around 6% as I write), but your capital isn’t guaranteed – it will rise or fall as bonds fluctuate in popularity. Personally I’m buying bonds for the regular income, and plan to ignore the capital fluctuations unless they become really extreme, when I’ll top-up if they seem very cheap or sell down if they seem very expensive, relative to equities.
Other notes: The income is tax-free if held in an ISA. There’s a danger to your income if the underlying bonds default; that risk is mitigated by the ETF holding such a range of bonds from across the world.
Similar ETFs: A Euro-denominated iShares Corporate Bond ETF (IBCX) and a dollar-denominated one (LQDE) track bond indexes with the added risk/opportunity that comes from holding your money in another currency. Good for extra diversification, but I’d concentrate on SLXX first if you’re a UK investor.
Learn more: On the SLXX iShares page.

ETF Name: iShares FTSE UK All Stocks Gilt

Symbol: IGLT
Asset class: UK Government debt
Expense ratio: 0.20%
What you get: A fixed income fund giving you exposure to a basket of UK Government securities, across all maturities. (If you think the UK Government is spending too much money, here’s one way to benefit…)
Why it’s good: You get a regular income, fixed when you buy the fund. For instance, as I type the fund is yielding around 4.7%. That’s less than cash currently, but if Bank of England base rates are slashed, you’ll still get that return. An element of fixed interest can therefore help your portfolio in times of deflation. Still, the low fixed returns mean you’ll typically only want a modest portion of your portfolio in Gilts, unless you’re feeling very bearish. Like bonds, the capital value of Gilts fluctuate as their interest payments become more or less attractive.
Other notes: The income is tax-free if held in an ISA. The UK Government has never defaulted on a Gilt payment. (It is allowed to print money, after all, so it’d be odd if it did).
Similar ETFs: A range of Euro denominated and dollar denominated Government Bonds are available. For instance, the iShares $ Treasury Bond 1-3 (IBTS) tracks a basket of short-term US Treasures, while the iShares Euro Government Bond 7-10 (IBGM) offers exposure to a range of long-term bonds issued by a variety of European governments. Buying them you’ll get further diversification benefits, along with currency risks.
Learn more: On the iShares IGLT page.

ETF Name: iShares £ Index-Linked Gilts

Symbol: INXG
Asset class: UK Government debt
Expense ratio: 0.25%
What you get: A fixed income fund giving you exposure to a basket of UK Government inflation-linked securities, across all maturities.
Why it’s good: You get a regular real income, fixed when you buy the fund. In addition, both the capital value of index-linked gilts and the income they pay are structured to increase payments in line with UK inflation. As such, money put into the index-linked gilt fund is guaranteed to give you a ‘real’ return. That’s all good stuff. The bad news is the fixed rate above inflation paid is very small – currently just a shade over 1% – largely due to massive buying by UK pension funds. But it’s also the price of off-setting inflation risk, and guaranteeing a definite real return. Inflation has been deemed a done deal since the mid-1990s, but beware it has a habit of rearing up when you least expect it!
Other notes: The income is tax-free if held in an ISA. The UK Government has never defaulted on a Gilt payment. (It is allowed to print money, after all, so it’d be odd if it did).
Similar ETFs: You can get the same inflation-protected funds in dollars (code: ITPS) and Euros (code: IBCI). You may get a better return in these funds, particularly depending on the inflation rate in the US or the Eurozone, but as usual that will come with currency risk. The other thing to consider is National Savings inflation-linked certificates. (I covered National Savings’ in my massive UK savings guide), which may be a cheaper and simpler way to get the same inflation protection.
Learn more: On the iShares INXG page.

ETF Name: iShares FTSE EPRA/NAREIT UK Property Fund

Symbol: IUKP
Asset class: UK stock market listed property companies and REITS
Expense ratio: 0.4%
What you get: A basket of UK property companies and real estate investment trusts (REITS). For instance, the five largest holdings as I write are Land Securities, British Land, Liberty International, Hammerson and Segro.
Why it’s good: Property is a diversifier away from equities, as well as a good long-term investment in its own right. With changes in 2006 to UK legislation having enabled UK companies to become REITS, this fund should also benefit from a decent yield, giving you a reasonable though fluctuating income. Note that buying property companies via an ETF is not as good a diversifier as holding property directly via a suitable Unit Trust (or even buying a couple of shops or offices yourself!) Listed property companies are likely to move in the short-term in sympathy with broader markets, although in the medium-term their valuation should largely reflect their underlying property holdings.
Other notes: As I write (in January 2008), listed property shares have been hammered by the credit crunch, in some cases falling by over 50%. That’s a huge move for what’s usually deemed a rather stable asset class (although see the note about listed property companies above) and I believe represents the bursting of what had become a bubble. As such, I’ve dipped my toe into this ETF, with a view to building up a decent holding over a couple of years.
Similar ETFs: iShares also provides similar index funds tracking US (code: IUSP) and Euro (code: IPRP) listed property companies. There’s even an unusual Asian property ETF (code: IASP), which long-term should provide really good diversification benefits for Western investors. As usual, these foreign funds come with currency risk (the risk being the value of dollars or euros fluctuates against the pound, changing the underlying value of the investments for a UK holder).
Learn more: On the iShares IUKP page.

ETF Name: iShares S&P Global and Timber Forestry

Symbol: WOOD
Asset class: Stock market listed timber-related companies
Expense ratio: 0.65%
What you get: A basket of companies from around the world operating in the timber sector. Most of these companies have large amounts of forestry under management.
Why it’s good: Timber has historically been a good long-term investment (with the usual ups and downs on the way). It’s also uncorrelated with equities. This fund however is a halfway house. You’re investing in listed timber companies, and they’re sure to oscillate with stock markets. However similar to other commodity companies like oil explorers and miners, their valuation should also be greatly influenced in the medium term by the value of their underlying forestry.
Other notes: Dollar-denominated, so there’s currency risk for UK investors. The companies held are primarily US listed but not exclusively, which should help reduce the overall currency gyrations.
Similar ETFs: iShares provides a couple of other ETFs with potential for diversifying a portfolio, such as a water fund (code: IH2O), a clean energy fund (code: INRG), and a listed private equity fund (code: IPRV). These are likely to be riskier investments in my view than WOOD, with the corresponding potential for greater rewards. Furthermore, how much diversification they provide from the wider equity markets is open to debate.
Learn more: On the iShares WOOD page.

Next I’ll cover Exchange Traded Commodities – a quick way to access some of the hottest sectors in the market in recent years, such as gold, wheat and precious metals, although our aims are more long-term diversification, of course.

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