Asset Allocation ETFs: Highly Diversified, Secure, and Low Maintenance
How can investing in them lead to higher returns?
Updated 
6 min. read
A seemingly simple solution that could benefit many novice and sophisticated investors alike is an asset allocation ETF. It may be one of the greater investment product innovations in a generation because they are amongst the lowest cost investment funds you can buy and they provide a complete portfolio solution that can help you achieve greater diversification with little maintenance required.
In this article, we'll go through a hypothetical case study to show you how an asset allocation ETF could help an investor reach their retirement savings goal five whole years earlier. An asset allocation ETF is really a "fund of funds". It is one ETF that in turn holds multiple other ETFs. Each of these underlying ETFs are low-cost index funds that represent different asset classes and the overall asset allocation is determined by professional investment managers. These managers also handle the rebalancing of these asset classes on a periodic basis which helps keep the overall asset allocation in line with the overall ETF's mandate. For example, if we look at BMO Asset Allocation ETFs, we see they offer a conservative, balanced, and growth asset allocation ETF. Each of these asset allocation ETFs have a target mix between stocks and bonds that are maintained over time through periodic rebalancing. Other ETF issuers, such as Vanguard and iShares, also offer a range of asset allocation ETFs.
One of the benefits of asset allocation ETFs is their cost. Using the BMO Growth ETF as an example, the MER (or management expense ratio) is just 0.20%. Generally, lower costs translate into higher returns due to less drag on the portfolio returns over time, all other things being equal. And as time goes on, the cost saving benefit compounds. Let's use a hypothetical case study to explain just how powerful this can be.
Assumptions
Imagine we have an investor who starts investing at age 25 when they are earning $45,000 per year. They diligently put away 10% of their gross earnings every year until age 65. Our analysis assumes their income grows an average of 4% per year, which means that during the final year of their career (at age 64) they'll be earning just under $96,000 in today's dollars (adjusted for 2% inflation). We'll assume they are more aggressive when they are working and contributing to their portfolio (6% growth rate before costs) and that during the withdrawal phase they are more conservative (4% growth rate before costs). We'll now compare annual costs of 1.5% per year (which could be from actively trading stocks or using higher cost investment funds) versus 0.2% per year.
Results
By age 65, the lower cost scenario would leave our investor with almost $140,000 more in their portfolio ($565,923 vs $425,711). And yes, these numbers are adjusted for inflation. Further, if we assume that our investor made equal annual withdrawals from age 65 until age 90 to completely spend down their portfolio, the lower cost scenario would allow for approximately 54% larger annual withdrawals from the portfolio ($27,680 vs $17,946 per year).
But another way of looking at the impact of costs is in terms of time. If we assume that our investor would indeed be happy with $17,946 of annual withdrawals, then in the lower cost scenario they would actually be able to achieve this five years earlier, at age 60. And this would still allow for making equal withdrawals until 90. That means they would have 30 years of withdrawals versus 25 – again, all because of the impact of being cost-sensitive about long term investments.
Diversification
It's often been said that diversification is the only free lunch in investing. But while holding 50 stocks from one market is more diversified than holding just five, many investors would benefit greatly by diversifying more globally as well. Different asset classes and sub-asset classes (Canadian stocks, Canadian fixed income, emerging markets' stocks, developed markets' stocks, etc.) tend to have their own investment cycles. An asset allocation ETF not only holds hundreds of stocks, it holds hundreds of stocks from multiple countries and economies from around the world. This may help increase the risk-adjusted returns in your portfolio. In other words, for every unit of return your portfolio gets, you're likely experiencing less risk than an under-diversified portfolio on average.
Low maintenance
Another benefit of asset allocation ETFs mentioned was their low maintenance. With the automatic rebalancing that asset allocation ETFs provide, you don't have to monitor your portfolio to see if, and when, you want to rebalance. Automatic rebalancing also helps take some of the emotions out of those decisions as well. Rebalancing involves selling some of your recent winning asset class holdings to buy some your recent losing asset class holdings. It's easy to second guess ourselves if we were to do this process manually. By automating your rebalancing with an asset allocation ETF, it just happens like clockwork. Not only do you avoid having to constantly monitor the portfolio yourself, you won't fall into the trap of second guessing your rebalancing strategy.
Where can an asset allocation fit into your portfolio?
Some investors have embraced asset allocation ETFs as a one-stop solution for their entire portfolio. They follow all the guidelines for a prudently constructed and managed portfolio: low cost, diversification, automatic rebalancing. Really the only piece of the puzzle to solve for is matching the right asset allocation ETF to your risk tolerance and risk need for your given portfolio.
Other investors may choose to use asset allocation ETFs as a core component of their portfolios. For example, they may use the BMO Balanced ETF as the bulk of their portfolio. Maybe 80% of their portfolio is in this asset allocation ETF. The remaining 20% might be allocated to individual stock picks. Since the BMO Balanced ETF has a target asset allocation of roughly 60% equities and 40% fixed income, adding in the all-equity allocation of the remainder 20% of the portfolio effectively gives this investor an overall asset allocation of 68% equity and 32% fixed income. This is a moderately aggressive overall mix, anchored with a solid core of an asset allocation ETF that is completely hands-off and a satellite allocation to individual stocks picks that are more hands-on.
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