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Building portfolios using ETFs

Here's how you can incorporate ETFs for your market outlook.

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We believe that an appropriate way for most individuals to invest is to set a long-term target asset allocation consistent with their investment time horizon, risk tolerance, and financial situation, and then rebalance when needed. Within that context, the ups and downs of the market can offer opportunities for more active investors to over- or underweight market indexes, if they are willing to accept the risk of temporarily moving away from their long-term asset allocation.

Particularly for investors who like to make targeted investment decisions on specific parts of the market, exchange-traded funds (ETFs) can be a convenient, low-cost way to build and manage such a portfolio.

A few things to know about ETFs

Like any investment vehicle, you need to understand how to use ETFs within your investment plan. If you want to invest in the whole U.S. equity market, a convenient proxy is the S&P 1500, which attempts to track the stocks of large, small, and mid-cap companies in the U.S. Of course, you can't invest directly in an index, but certain index mutual funds and ETFs attempt to track the performance of an underlying index, like the S&P 1500, through a variety of techniques.

The S&P 1500 and ETFs that seek to track it, like iShares® Core S&P Total U.S. Stock Market (ITOT), are weighted by the market capitalization of the stocks in the index. The biggest stocks hold a relatively bigger weight, while smaller companies make up a relatively smaller percentage of the index.

Using ETFs to reflect your investing expectations

What if you believe that small caps will outperform? Being that small caps represent a small percentage of the cap-weighted S&P 1500, a surge in small caps would have a very small impact on the overall value of the index.

Fortunately, there are ETFs that can help you invest based on targeted expectations (such as a forecast for small caps to shine). For example, S&P has separate indexes by cap size (small, mid-, and large cap) as well as style (growth and value). The ETFs that track these separate indexes give investors a way to make moves that are more tactical, on narrower slices of the market. One way to search for ETFs that track these and other indexes is to use our ETF Portfolio Builder.

Targeting a specific strategy using ETFs

Let's say you are more bullish on a particular style, cap size, sector, or other segment of the market. With the Portfolio Builder, you can look at the market through seven preset market lenses, or filters, that group the market by sector, cap, or style (or you can create your own). For many of our preset lenses, the cap and style "default" reflects a portfolio of S&P iShares® ETFs constructed to approximate the S&P 1500 index.  In terms of market, the default was 88% large cap, 8% midcap, and 4% small cap stocks as of January 31, 2013.

Then you can adjust the allocation to suit your own situation, with the click of a mouse. And you can consider trading the resulting basket of ETFs online—with access to any of the 70 iShares ETFs that you can purchase commission free online at Fidelity.com.

Let's take a look at how one hypothetical individual investor might use ETFs and the Fidelity ETF Portfolio Builder to construct a portfolio with broad exposure to the global markets, including some tactical investment decisions in areas he feels will perform particularly well as we come out of the economic downturn.

An ETF strategy in action

Assume a hypothetical investor, whom we will call Jim, has an overall asset allocation of 85% stocks (60% U.S. and 25% international) and 15% bonds. Jim measures his investment success relative to benchmarks that represent stocks and bonds in each of his primary asset classes. He uses the S&P 1500 as the benchmark for his U.S. stock exposure, the MSCI® EAFE® Index for his international stocks, and the Barclays Capital U.S. Aggregate Bond Index for fixed income.

Jim has $50,000 in U.S. equities in a taxable brokerage account that he is looking to rebalance and reallocate based on his views of the market and the economy.

Jim has looked at past economic cycles and feels that if the economic recovery in the United States gains momentum midcap and small cap stocks may lead the way. He would like to build a portfolio using ETFs to express this belief.

As you can see in the style and cap illustrations below, Jim first uses the ETF Portfolio Builder to get a sense of where the S&P 1500 is allocated across the different capitalizations (large, mid-, and small cap) and styles (growth and value). Within the Portfolio Builder under "Customize a Model Portfolio," he clicks on “S&P iShares" under "Capitalization Models." He is then served up a model portfolio of iShares that roughly replicates the S&P 1500 Index (see Allocation % below).*

In addition, the "Default Allocation %” initially displays the market weightings of the ETF components of the model portfolio (see Default Allocation % column in chart below).

If Jim clicks on the "Style" tab to the right of the adjusted portfolio in the screener, he can view its "Equity Style Profile" (see below). The first box shows the cap/style makeup of the adjusted portfolio, which is Large Blend, according to Morningstar's cap and style definitions. The second box shows the actual index by capitalization and style, as a comparison.

The S&P 1500: cap and style breakdown

Given Jim's short-term views on the market, he decides to overweight U.S. small- and midcap growth stocks within his taxable account. So, under "Allocation%," he boosts his midcap allocation from 8% to 35%, and his small-cap allocation from roughly 4% to nearly 25%, as you can see in the illustrations below.

Again, hitting the "Style Map" tab gives him a snapshot of how his choices will change his portfolio allocation by cap and style (see below).

Jim's new equity style profile

Jim is comfortable with the additional risk this small- and midcap exposure may present in his portfolio as it represents only a small portion of his overall investments. He's decided on the allocation of his taxable account. The Portfolio Builder helped him identify a series of iShares S&P ETFs that were mapped against the S&P 1500. Now he can choose to trade the above list of ETFs all at once.

What you can do

Just like Jim, you can use the ETF Portfolio Builder to help you to construct your portfolio of ETFs to implement your investment strategy. If you have a strong conviction about the market, you can easily tweak your allocation to reflect your views. We believe you should not veer too far from your strategic asset allocation. Consider using tactical overweights and underweights as relative tweaks to a long-term investment plan. Beware of "betting the farm" on any one belief, no matter how strongly held.

Learn more

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Free commission offer applies to online purchases of select iShares ETFs in a Fidelity account. Fidelity accounts may require minimum balances. The sale of ETFs is subject to an activity assessment fee (of between $0.01 and $0.03 per $1,000 of principal) and, subject to a short-term trading fee by Fidelity if held less than 30 days.
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
For iShares ETFs, Fidelity receives compensation from the ETF sponsor and/or its affiliates in connection with an exclusive, long-term marketing program that includes promotion of iShares ETFs and inclusion of iShares funds in certain FBS platforms and investment programs. Additional information about the sources, amounts, and terms of compensation is described in the ETF's prospectus and related documents. Fidelity may add or waive commissions on ETFs without prior notice. BlackRock and iShares are registered trademarks of BlackRock, Inc. and its affiliates.
The Morgan Stanley Capital International Europe, Australasia, Far East Index (MSCI® EAFE® Index) is an unmanaged market capitalization–weighted index of equity securities of companies domiciled in various countries. The index is designed to represent the performance of developed stock markets outside the United States and Canada, and excludes certain market segments unavailable to U.S.-based investors. The Net version of the MSCI EAFE adjusts for withholding taxes applicable to Massachusetts Business Trusts.
Additional information about the sources, amounts, and terms of compensation is described in the ETF's prospectus and related documents. Fidelity may add or waive commissions on ETFs without prior notice.
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
The S&P 1500 is a market-weighted index that combines three leading indices, the large-cap S&P 500®, the S&P MidCap 400, and the S&P SmallCap 600 to cover approximately 90% of the U.S. market capitalization. It is designed for investors seeking to replicate the performance of the U.S. equity market or benchmark against a representative universe of tradable stocks.
The Barclays U.S. Aggregate Bond Index is an unmanaged market value–weighted index for U.S. dollar–denominated investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities with maturities of at least one year.
The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy, any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transaction costs, which may significantly affect the economic consequences of a given strategy.
The Fidelity ETF Portfolio Builder tool has been provided to help self-directed investors evaluate ETFs based on their own particular needs and circumstances. Any information obtained from its use should not be considered investment advice or a recommendation of any particular security or portfolio. While this research tool may be of use to investors in evaluating certain information on exchange-traded funds, it should not be considered to include every factor that may be necessary for an investor to make a decision to invest in an exchange-traded fund. A decision to invest in a particular exchange-traded fund may be based on a number of factors, including an investor’s needs, goals, and comfort with risk.
The Fidelity ETF Portfolio Builder is an educational tool offered for use by Fidelity Brokerage Services LLC, member NYSE, SIPC.
Before investing, consider the ETF’s investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus containing this information. Read it carefully.
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Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917
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