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How to Build a Diversified ETF Portfolio

Byline profile imageEdited by Marie White, CEPF®
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Byline profile imageEdited by Arturo Conde, CEPF®
Byline profile imageReviewed by Brandon Renfro, CFP®, RICP, EA
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If you want a resilient portfolio, you’ll need diversification. Allocating assets across different classes, sectors, market capitalizations, and geographic regions helps you weather economic downturns. For those wondering how to build such a portfolio, consider ETFs. They are a popular choice for diversification due to their numerous benefits, with some investors even choosing portfolios made entirely out of ETFs. Here’s how they work.

A financial advisor can help with the process of building a diversified ETF portfolio that meets your long-term financial goals.

Why Build a Portfolio With ETFs

Exchange-traded funds (ETFs) are investment funds that trade on stock exchanges, similar to individual stocks. They’re designed to track the performance of a specific index, sector, commodity, or asset class. Because ETFs offer investors a way to gain exposure to a broad range of securities within a single fund, provide diversification, and reduce risk, they’re a popular choice for investors looking to build a diversified portfolio.

ETFs are also highly liquid, meaning they can easily be bought and sold throughout the trading day at market prices. Transparency is another key advantage, as ETFs regularly disclose their holdings, giving investors clear insight into their investments.

How to Build a Diversified ETF Portfolio Step by Step

Step 1: Determine Investment Goals and Risk Tolerance

You can start by asking yourself questions such as whether you’re investing for long-term growth, income, or a specific financial goal such as retirement or buying a home. Understanding your risk tolerance is equally important, as it will influence your asset allocation. Those with a higher risk tolerance might allocate more towards emerging market ETFs, while conservative investors might favor bond ETFs.

Step 2: Choose Asset Classes

A well-diversified ETF portfolio typically includes ETFs that cover a variety of assets such as stocks, bonds, and even real estate. Within each asset class, investors can further diversify by selecting ETFs that cover different market sectors, geographic regions, and market capitalizations.

Step 3: Select Your ETFs

When building a diversified ETF portfolio, it can be helpful to start by looking for ETFs with good expense ratios, as these costs can erode your returns over time. It’s also important to consider the liquidity of the ETFs and their tracking accuracy relative to their benchmarks. Within each asset class, look for ETFs that cover different sectors, regions, and market capitalizations. For example, within the equity portion of your diversified ETF portfolio, you might include a U.S. large-cap ETF, an international ETF, and an emerging markets ETF.

Step 4: Allocate Your Assets

This involves deciding what percentage of your total investment will go into each ETF. Your asset allocation should reflect your investment goals and risk tolerance. For example, a more aggressive investor might allocate a larger portion to equity ETFs, while a conservative investor might allocate more to bond ETFs.

Step 5: Regularly Rebalance Your Portfolio

Over time, the performance of different ETFs will cause your asset allocation to drift from your original plan. Rebalancing your portfolio involves periodically buying or selling ETFs to return to your target asset allocation. This ensures that your portfolio remains aligned with your risk tolerance and investment goals.

Types of ETFs to Consider

A client and advisor, discussing ETF portfolio diversification.

When building a diversified ETF portfolio, it’s important to understand the broad spectrum of ETF categories available. Different types of ETFs provide different forms of exposure, allowing you to tailor your portfolio to your specific goals, risk tolerance and investment timeline.

  • Equity ETFs give exposure to stocks and can be categorized by market cap (e.g., large-cap vs. small-cap), sector (e.g., healthcare, technology), or geography (e.g., international or emerging markets).
  • Bond ETFs cover a range of fixed-income investments, including government bonds, corporate bonds, high-yield (junk) bonds, and short- or long-duration bond strategies.
  • Real Asset ETFs invest in tangible assets like real estate (via REIT ETFs), commodities (like gold or oil), or infrastructure projects. These ETFs may help hedge against inflation.
  • Thematic ETFs target niche areas of growth or innovation, such as clean energy, artificial intelligence (AI), ESG (environmental, social and governance), or blockchain technologies.
  • Dividend ETFs are designed for income generation and typically include companies with a strong history of paying dividends. These can appeal to retirees or income-focused investors.
  • Multi-Asset ETFs combine multiple asset classes, such as stocks, bonds and real assets, into a single fund, offering built-in diversification and simplified asset allocation.

Tax Considerations for ETF Investors

While ETFs are known for their tax efficiency, there are still key considerations that can affect your overall investment strategy.

  • ETFs vs. Mutual Funds: ETFs generally trigger fewer taxable events than mutual funds due to their unique structure and in-kind creation/redemption process, making them more tax-efficient over time.
  • Capital Gains Distributions: Although rare, ETFs can still distribute capital gains. You can reduce the impact by choosing tax-efficient funds and avoiding buying shortly before ex-dividend dates.
  • Tax-Loss Harvesting: ETFs offer ample opportunity for tax-loss harvesting, selling a fund at a loss to offset capital gains, thanks to the wide variety of similar funds that can be used as replacements while avoiding wash-sale rules.
  • Taxable vs. Tax-Advantaged Accounts: Consider placing ETFs that generate income (like dividend or bond ETFs) in tax-advantaged accounts such as IRAs or 401(k)s, while using ETFs with lower distributions in taxable accounts to reduce your overall tax bill.

A tax-smart ETF strategy can make a big difference in your long-term performance, especially when combined with smart portfolio construction and rebalancing.

Bottom Line

ETF portfolio diversification can help investors manage risk.

Building a diversified ETF portfolio involves a thoughtful and strategic approach that begins with understanding your investment objectives and risk tolerance. By selecting a mix of asset classes, choosing low-cost and liquid ETFs, and carefully allocating your assets, you can create a robust portfolio that balances risk and return. Regular rebalancing is essential to staying on track with your financial objectives, too. This systematic process not only helps manage risk but also positions you for long-term growth. A financial advisor can help to fine-tune your strategy so you can navigate these markets with confidence.

Portfolio Management Tips

  • Having trouble deciding the best way to approach your investments? A financial advisor can help you create an investment plan for your needs and goals. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • If your investments pay off, you may owe taxes on the returns you earn. In the eyes of the IRS, this tax is called the capital gains tax. Figure out how much you’ll pay when you sell your investments with SmartAsset’s capital gains tax calculator.

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