The proliferation of exchange traded funds has helped investors and advisors create low-cost and tax-efficient ways to access various market segments.
With ETFs, investors are able to diversify risk-exposure, or maximize a portfolio’s Sharpe ratio, the return per unit of risk, according to BlackRock.
The Sharpe ratio is the average return earned in excess of the risk-free rate per unite of volatility or total risk. Higher Sharpe ratio readings typically correspond with better risk-adjusted returns.
One “can combine different investments together in such a way that the overall risk of the portfolio is substantially less than the sum of its parts,” BlackRock analysts said. “Such diversification is the cornerstone of good portfolio construction.”
Specifically, investors should consider major risks, including credit risk, interest rate risk and equity risk, for a risk-managed portfolio. For instance, in a stock-heavy portfolio, rate-sensitive bonds can diminish overall risk more than credit-sensitive fixed-income assets because rate-sensitive assets help offset equity market shocks.
“Although long-term Treasuries have higher volatility than high-yield bonds, a mostly equity portfolio can achieve more risk reduction by incorporating long-term Treasuries than by incorporating high-yield,” according to BlackRock.
Moreover, looking at interest-rate risk, bonds react differently to changes in various term interest rates. For instance, from 2012 to 2014, some of the greatest changes in the standard deviation, or volatility, were seen across bonds in the middle of the yield curve.