There are two approaches to asset allocation, and ETFs' characteristics make them suited for use in both methods. In this article, we will discuss the two approaches to asset allocation, the advantages of ETFs for each approach, and because this is Ideas Week at Morningstar, we will highlight three tactical trade ideas.
The first approach is called strategic asset allocation. After establishing an investment objective and exploring one's tolerance for risk, a portfolio is constructed with exposures to different asset classes. It relies on the efficient market hypothesis, and, while its proponents may not agree that the market is always efficient, they at least believe that it is difficult to consistently beat the market net of fees. This approach seeks to maximize the benefits of the only free lunch in investing: diversification. ETFs are ideal for strategic asset allocation because they are offered in a variety of different asset classes, they track broad indexes (so you do not have to worry about style drift or management turnover), and, most importantly, they have low fees.
The second approach to asset allocation is more tactical and tends to be more aggressive. It also requires a more active view of the markets and tends to be riskier. This approach can begin with the strategic asset-allocation plan but will take larger deviations based on some investment process or idea. This can also be called a core-satellite approach, where the core, or bulk of the portfolio, is made up of the strategic portfolio and the satellite represents small shifts in allocation based on investment ideas. For those willing to do their homework, ETFs are useful in tactical asset-allocation plans for several reasons. They allow the investor to focus on investment research rather than researching fund managers. They trade likes stocks, so they can be traded throughout the day and used in combination with options or limit orders. Despite the fact that they tend to follow passive indexes, they can be used actively by varying the timing or amount of exposure.
