As I commented before, the exchange traded fund (ETF) industry is replicating the development of the mutual fund industry: fee creep, new players and increasingly exotic products. If history does repeat itself, and the industry engages in similar sales and marketing strategies as mutual funds, an uneducated investor may merely be going back to the future: a portfolio of numerous high fee ETFs that may overlap each other with no coherent or long-term strategy.

Thus, in an industry pushing more and more product, how many ETFs is too many ETFs in your portfolio?

Let’s look at the “why” question first. Why are you investing in an ETF based portfolio? Primarily, an ETF portfolio allows the investor low cost, diversification and an ability to re-balance from time to time. The question of “what” or “how many” should always be answered by referring back to the answers to the question why.

I am going to answer the “what” and “how many” without specifics to a product. Product is product. The primacy of strategy should always be top of mind rather than on product. More practically, Canadian Capitalist does a superior job commenting on ETF product and reference should be made to his blog.

Instead, my post addresses whether you may be committing mutual fund-itis by buying too many ETFs by analyzing each asset class.

CASH

An ideal ETF portfolio should not be a fully invested portfolio. After all, one of the reasons why you build an ETF portfolio is to re-balance periodically to capitalize on market weaknesses and to prevent a drift away from diversification. Always keep cash around to utilize this advantage fully (good advice no matter what your investing strategy). How much? This is subject to some debate. I like keeping 5-10% of my portfolio  in normal times and between 10-15% in volatile markets.

FIXED INCOME

One could achieve significant fix income diversity by 3 fixed income ETFs although 2 is probably a better number. If you want full coverage without too much duplication, consider: (i) a government bond ETF (short term for greater predictability); (iii) corporate bond ETF; and (iii) real return (aka TIPS) ETF for inflation protection.

If you opt for two fixed income ETFs, and assuming you want some margin of safety, consider looking at a short-term government ETF and real return ETF. If you want to be more aggressive, then substitute the government ETF with a laddered corporate bond ETF (bond laddering is a fixed income strategy where one purchases bonds that mature at regularly internals- for example, a portion of the portfolio matures every year) and a real return ETF.

What about preferred shares ETFs? As a hybrid debt-equity instrument, it can be classified as fixed income given it pays set distributions. However, preferred shares are typically issued by financials and utilities which constitute large portions of mature equity indexes. Thus, if a financial or utility hits a rough patch, it could adversely impact your equity and fixed income holdings if you hold both preferred share ETFs and a board based equity ETF. Since one of the advantages of an ideal ETF portfolio is diversification, it is arguable that loading up on preferred shares ETFs is defeating this purpose if there is a large equity holding in a ETF portfolio.

EQUITY

The portion of equity in your portfolio depends on your risk tolerance and investing horizon. The larger your risk tolerance and the longer your horizon, the larger portion of your portfolio should be in equities (typically, the formula is 120- your age should be your holdings in equities but a safer formula is 100- your age).

Depending on where you live, you may want to consider 3-4 EFTs: (i) and (ii) 2 ETF’s tracking the major North American equity index (typically S&P 500) and a major European/Asian equity index (typically the MSCI EAFE Index); (iii) an ETF tracking a LARGE emerging market index (as opposed to country specific); (iv) Canadians like purchasing ETFs tracking the TSX (which is really a financials, energy, materials index) OR, if you do not like the TSX, an ETF tracking a mid-cap or small-cap index (if you have the stomach for it).

It is in this portion of a ETF portfolio that mutual fund-itis usually occurs. People buy dividend paying ETFs, BRIC ETFs, ETF’s tracking specific countries or industries (I am still giggling about the ETF that tracks airline stock; might as well buy a distressed debt ETF to hedge against your loss now). Since dividend-paying stocks constitute large portions of large equity indexes and stocks issued in BRIC countries may also constitute holdings an in emerging market indexes, duplication is occurring and, again, the goal of diversification is being defeated. Having said that…

FUN MONEY

ETF investing can arguable be boring: it is quite passive and you aren’t rooting for one company in general, you are rooting for the indexes. Thus, if one has a long investing horizon and wants some excitement, one could take 2-5% of their portfolio and basically take a risk on something high-risk, high reward ETF (bio-tech, wind power etc.) keeping in mind: (i) the ETF could lose a lot of its value; and (ii) fun money should be kept a very small portion of your portfolio.

In summary, one should consider:

1. Cash
2. 2-3 Fixed Income ETF’s
3. 3-4 equity ETF’s
4. Fun money ETF (if you can handle the downside risk).

But the key is that each of the ETFs are tracking broad based indexes rather than narrow indexes.

Anyone have any thoughts on how much is too much in ETF investing?