Exchange-traded funds

have exploded in popularity and so have investment strategies based only on ETFs, but some investors might be wondering whether that could lead to their portfolio being too diversified.

Financial experts say allocating an entire portfolio to ETFs can be a viable strategy, but it is important for investors to know what holdings are in the funds they are buying.

When looking at portfolio

diversification

for ETF-focused investors, Jonathan Rivard, general principal at Edward Jones, said it is important to consider the individual’s time horizon and risk appetite.

“You could absolutely be 100 per cent invested in ETFs. But you want to know what’s in the ETF and what the allocation looks like. Some ETFs will be balanced; they’ll have a mix of stocks and bonds in them. Some will be sector products,” Rivard said.

“The important thing comes down to understanding what does this basket hold? And if I own multiple ETFs, what does it look like across multiple ETFs in terms of asset allocation?”

Prerna Mathews, Mackenzie Investments’ vice-president of ETF product strategy, said there are a few key points to keep in mind regarding diversification; notably, it is important to think beyond just diversifying by geography.

“So (if) you’re starting with the core Canadian, U.S., international exposure, don’t stop there. Think about how fixed income plays a role in your portfolio, real assets, there are thematic products, and there are alternative ETFs. There are a lot of different drivers of return that can be added to a portfolio available in ETF form,” she said.

Another consideration is buying ETFs with different investment styles, she said, which may include combining traditional index ETFs with others that are actively managed or have low volatility.

Time horizon is also an important consideration, where those with a longer investment horizon may want to focus on growth, she said, taking on more risk with higher equity exposure.

Regarding fixed income, Mathews said investors should be aware of the differences between short- and longer-term yields, adding that most will likely not have exposure to every duration of fixed income and should know the relevant trade-offs.

“In some cases, you can get a very attractive yield at the short end of the curve without taking on significant risk as you would on the long end,” she said.

“Really understanding the trade-off there and likely having some short-term fixed income in the portfolio would be viable. But aggregate bonds over a 30-year time period are generally a good place to be.”

Mathews said there is also a growing number of investors opting for an asset allocation ETF. She said this type of ETF is essentially eight to 12 ETFs “all packaged up in one,” and has served as a core holding for those looking for a “set it and forget it” investment.

Despite the benefits of diversification, Mathews said there are dangers to being overly diversified.

This might occur for someone investing in Canadian equities through an ETF but also buying into an asset allocation ETF, Mathews said. In that case, the investor may end up with more Canadian equity exposure than anticipated.

Similarly, with the TSX financials sector representing about 30 per cent of the overall index, an investor with a TSX-focused ETF and a Canadian banks-focused ETF could end up with too much exposure to Canadian bank stocks.

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“There is a risk of having too much product in your portfolio. Sometimes that can creep up on us when we’re not doing a full look through to what each ETF might be investing in,” she said.