ETFs, All-Weather Portfolios and Managing FX Currency Risk

Exchange-traded funds are a common way to hold a broad basket of assets in a single trade. Understanding how they follow an index, what they cost, and how currency can change the result helps with choosing between them and with building a portfolio that does not rely on one outcome.

How an ETF tracks an index

An index ETF aims to match the return of a published index, such as a broad share index or a government bond index. Buyers purchase ETF shares on an exchange during the trading day at the market price. Large institutions known as authorised participants create and redeem ETF shares by exchanging baskets of the underlying assets with the fund, which keeps the ETF's market price close to the value of what it holds.

• Full replication: the fund holds every constituent of the index in index weights. It is simple and works well for large, liquid indices.
• Sampling: the fund holds a representative subset, which is cheaper for indices with thousands of securities, at the cost of a small tracking error.
• Synthetic: the fund holds other assets and uses a swap with a bank to deliver the index return, which adds counterparty risk. Some ETFs in Europe use this approach.
• Futures-based: commodity and some volatility funds hold futures, so roll costs and the shape of the futures curve affect them, as explained in the crude oil article.

Costs: expense ratio and tracking difference

The expense ratio, also called the total expense ratio (TER) or ongoing charge, is the annual fee as a percentage of assets, taken from the fund's value. On 10,000 in a fund charging 0.20% a year, the fee is 20 per year, and at 0.75% it is 75.

Tracking difference is the gap between the fund's return and the index's return over a period. It is usually negative and close to the fee, though it can differ because of trading costs, taxes on dividends and income earned by lending securities. Tracking error is a different measure: it describes how much that gap varies over time.

The 0.55 point difference in fees costs about 3,100 over 20 years in this simple illustration, since the fee compounds along with the return. The figure assumes a constant return, and real returns vary. Fees are one of the few parts of investing that you know in advance, which is why they are worth comparing. Other points to check are the ETF's size and trading spread, the index it follows, where it is domiciled, and whether it pays out or reinvests income.

The All-Weather idea

The All Weather strategy is associated with Bridgewater Associates and its founder Ray Dalio. Bridgewater describes it as an approach designed to hold up across different economic environments rather than to forecast them. The reasoning starts from the observation that asset prices respond mainly to surprises in growth and inflation, which can each come in higher or lower than expected, giving four broad conditions. Different assets tend to do better in different conditions: shares when growth beats expectations, government bonds when growth and inflation fall, and commodities and inflation-linked bonds when inflation rises.

The distinctive step is how the portfolio is weighted. Rather than splitting money equally or holding mostly shares, the approach tries to balance the risk each part of the portfolio contributes, which is why it is described as risk parity. Because bonds are less volatile than shares, a risk-balanced mix usually needs far more money in bonds, and versions of the strategy can use leverage to bring the expected return up. That is where it differs from a plain unleveraged mix.

You will find simplified retail versions online that give fixed percentages for shares, long-term bonds, intermediate bonds, gold and commodities. Those are popular adaptations. A fixed allocation could not be confirmed from Bridgewater's own material, so this article does not present one as the official portfolio. Treat any specific mix as an illustration of the idea, not as a recommendation or as the actual Bridgewater fund.

The trade-offs are worth knowing. A portfolio built to avoid large losses in any one environment will usually lag a share-only portfolio in a long bull market. A large bond allocation is exposed when interest rates rise sharply, and in 2022 shares and bonds fell together, which hurt many diversified portfolios that relied on bonds as the cushion. Commodity exposure through futures carries roll costs. Holding the pieces in separate ETFs also means rebalancing, which has transaction costs and possible taxes.

60/40 and core-satellite

A 60/40 portfolio holds 60% in shares and 40% in bonds. It is a long-standing benchmark for balanced investors. Shares provide growth and bonds are intended to dampen swings, an arrangement that works best when bonds do not fall at the same time as shares, as happened in 2022. Moving the split changes the risk: 80/20 has higher expected growth and bigger drawdowns, and 40/60 the reverse.

A core-satellite portfolio puts most of the money, say 80%, in a low-cost, diversified core made of broad index ETFs. The remaining 20% goes to smaller satellite positions: a sector, a theme, a commodity or a single idea. The core keeps costs and effort low, and the satellites limit the damage if an idea fails. The satellite share is the part where a single bad decision costs the most, so it is worth fixing its size in advance.

Currency risk

If an ETF holds assets in a foreign currency, your return in your home currency depends on both the assets and the exchange rate. The currency the ETF is listed in is not what matters. A UK-listed ETF priced in pounds that holds US shares still carries dollar exposure, because the shares are priced in dollars.

Take a UK investor buying an ETF that holds US shares, priced at 100 dollars. Assume 1 dollar is worth 0.80 pounds, so the purchase costs 80 pounds. The ETF then rises 10% to 110 dollars. The result depends on the exchange rate at the sale:

A weaker dollar removed most of the gain, and a stronger dollar added to it. Currency moves are not a reliable source of gains, since exchange rates are hard to forecast and can move in either direction. The forex fundamentals series explains what drives them.

Hedged and unhedged ETFs

Some ETFs offer a currency-hedged share class, which uses forward contracts to offset the exchange-rate effect, typically resetting monthly. A hedge removes most of the currency swing, so the result is closer to the asset's own return in the local currency. It is not free: the cost of hedging reflects the difference in interest rates between the two currencies, plus fees and small tracking differences. Hedging also removes the cushion that foreign currency sometimes gives. Many investors hold the dollar partly because it has often strengthened in market stress, though that is a tendency and not a rule.

There is no single right choice. The longer the holding period, the less currency tends to matter for shares relative to the assets' own returns, while for bonds, where returns are smaller, a currency swing can dominate the result, which is why bond investors hedge more often. Costs, tax treatment and your own spending currency decide the question.

ETFs and CFDs

Buying an ETF makes you the owner of fund shares, and you receive any income the fund pays. A CFD on an ETF is a contract with a broker that follows the price. You do not own the fund, financing is charged on positions held overnight, and distributions are handled through adjustments set by the broker. Leverage magnifies gains and losses. CFDs fit short holding periods, and the financing makes them a poor match for the long holding periods that most of this article is about.

This article is educational and is not personal advice. Portfolios can lose value, and diversification reduces risk without removing it.

Sources: Bridgewater Associates (The All Weather Story and fund descriptions); fund prospectuses and key information documents published by ETF providers (replication, fees and tracking difference definitions and currency-hedged share classes). This article is the last in the series.