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Building portfolios

From managing risk, generating income and exploring core satellite investment strategies, there's plenty to consider when building investment portfolios. Discover how ETFs can be used throughout this process below.

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Risk

Risk is an inherent part of investing. Every investment portfolio carries some degree of risk and by better understanding the types of investment risk, investors can manage portfolios’ risk/return balances through market cycles.

What is more, the elevated risk associated with higher volatility can present opportunities for investors aiming to enhance portfolio returns.

How ETFs can help manage risk

ETFs can help investors diversify across asset classes and risk exposures, customise active risk, and adjust expected portfolio volatility.

With over 500 iShares ETFs to choose from investors can use ETFs to manage almost any type of risk. For example if an investor is looking to manage inflation, iShares offers inflation linked bonds across a variety of currency and exposures. Equally there is a range of Term ETFs to facilitate duration management.

The unique benefits of iShares ETFs offers a transparent and a cost-effective way of managing almost any type of investment risk.

Asset allocation

Asset allocation refers to how an investor divides up an investment portfolio among the major asset classes—for example, stocks, bonds, and cash—and within those asset classes, looking at regional, style and market capitalization categories. Many investors believe that the allocation of investments across asset classes is more important than which securities are owned within that asset class.

The decision of which asset classes to invest in, and in what proportion, will depend on an investor's risk and return objectives and the time horizon. Investors with longer time horizons will often tilt their portfolios toward "riskier" asset classes with higher historical returns (such as small-cap or alternatives), expecting that the risk of the asset class will average out over time.

A critical component of asset allocation is ensuring appropriate diversification. Akin to "not putting all your eggs in one basket," diversification refers not only to the number of investments in a portfolio, but also to the relationships among those investments, often expressed in terms of their correlations. (Adding one more technology stock to a portfolio of 15 technology stocks, for example, is not true diversification).

                   

Income

During times of increased market volatility, income investing can serve as a defensive strategy and positively contribute to a portfolio’s total return. iShares income ETFs can provide investors with a cost-efficient and flexible way to use income. Specifically, iShares income ETFs can provide a regular income stream that mirrors those of a specific index or a group of securities while enhancing overall portfolio risk-adjusted return.

For example, by increasing the proportion of income in the total return, investors can:

1) Enhance risk-adjusted return
2) Lower the portfolio’s volatility with periodic income cash flows
3) Provide downside price protection

Fixed income instruments have traditionally formed the core of income strategies. Bonds generate higher yields required by income investors, but they also produce lower risk-adjusted returns than equities. iShares ETFs offer a good balance by providing investors not only with strong risk-adjusted returns associated with equity investment, but they also distribute substantial dividends, thus supplying the income levels approaching those associated with investment in bonds. Therefore, although it is possible to increase portfolio yield and risk-adjusted return within a single asset class portfolio, combining equity and fixed income instruments also improves diversification thus further lowering portfolio volatility.

A wide range of iShares ETFs allows the implementation of income-enhancement strategies across equity and fixed income segments.
The figure below illustrates the iShares Income ETF opportunity set.

income-diagram
  • Select dividend ETFs provide a combination of current dividend income and capital appreciation.
  • Property, sector and style ETFs track companies that historically have paid high levels of income due to the nature of their business.
  • Fixed income ETFs provide an income stream that mirrors the weighted average coupon payments of a particular bond index.

Core satellite

Core satellite portfolio construction combines the most effective characteristics of index and alpha-generating strategies offering flexibility and lower costs than more conventional approaches. The broad range of market exposures offered by exchange traded funds allows for a significant role in the implementation of core/ satellite strategies, used both as efficient core investments as well as satellites.

Core satellite investing is based on the simple concept of splitting a portfolio into two segments.

The first is the core (see diagram below). This forms the foundation of the strategy and provides the axis around which the more specialised satellite investments can be added. The core usually takes the form of a low risk, pooled investment vehicle. This is typically an index tracking fund, such as an ETF, that offers low cost, broadly diversified exposure to a market or index. The aim is to deliver a return in line with the market’s performance – this is often referred to as the beta return.

Core Satellite

The second segment of the portfolio is made up of the satellites. These are typically more specialised investments that are designed to generate additional returns (alpha). This can be achieved through exposure to specific markets, specialist ETFs, actively managed funds, investment themes and individual securities. Satellite investments typically carry higher risk and fees than core investments.

Many different types of professional investors are now using core satellite strategies including pension fund managers, wealth managers and asset managers. The building block nature of ETFs makes them ideal for use as a core element of a portfolio, or as satellite investments in specialist areas such as emerging markets or clean energy.