Asset Allocation ETFs: Translating Evidence Into Practice

Editorial Note: Asset allocation ETFs are a very convenient tool for investing. While it may seem too easy, this simple to use vehicle is actually underpinned by portfolio theory and empiric data. Understanding that is important to be able to stick with using them when you are tempted by other strategies that sound more sophisticated and are definitely more complex or expensive to use. We are used to more work yielding better results, but asset allocation ETF providers have essentially done that work for you. At a low cost.

This is a paid sponsor post. You will see relatively few of these on The Loonie Doctor because my mission is the priority of this site. Sponsored posts must align with that and the sponsor provides a service or product that I would use myself or recommend to a family member. One that I like. I retain editorial control, and the articles are written to be educational as the primary objective. It is a win-win because you get deep content written by industry experts, but vetted by me. You can read more about why I decided to collaborate with BMO ETFs as a sponsor, but I think you’ll get it after reading this post.

An Evidence Based Approach to Investing with Asset Allocation ETFs

By: Erin Allen, VP, BMO ETFs, Online Distribution

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Introduction

The importance of asset allocation in investment management should not be understated. Pioneering research by Brinson, Hood, and Beebower (1986, 1991) attributed over 90% of a portfolio’s performance variability to asset allocation decisions, making it the most influential factor in long-term investment outcomes. The proliferation of ETFs has revolutionized asset allocation, offering investors precision, liquidity, and cost efficiency.

This article explores asset allocation in depth, focusing on how Asset Allocation ETFs can serve as an evidence-based approach for building resilient and diversified portfolios.

Theoretical Foundations of Asset Allocation

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Modern Portfolio Theory

Harry Markowitz’s (1952) Modern Portfolio Theory (MPT) laid the groundwork for efficient diversification. According to MPT, an optimal portfolio balances risk and return by combining assets with low or negative correlations¹, thereby reducing overall portfolio volatility. This is the idea of diversification which we are hopefully very familiar with. While some investments go up, others will go down thereby dampening short-term fluctuations while still having the average return in the long run. Assets with low correlation are also impacted by different forces. So, that reduces the unpredictable specific risk of something bad impacting all your investments.

MPT also delves into the relationship between risk and expected return. The finding that higher potential returns generally come with higher risks, is widely accepted.

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Global Diversification Made Easy

BMO’s suite of Asset Allocation ETFs, such as the BMO All Equity ETF (ZEQT), enables investors to achieve broad global diversification—a key principle of MPT—by providing exposure to multiple geographies and sectors within a single vehicle.  They help you align your portfolio with your personal risk profile² and types of assets needed to meet your investment objective.

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Aligning Asset Allocation

Asset allocation decisions must align with an investor’s risk profile and time horizon. Younger investors with longer time horizons may favor equity-heavy allocations, accepting higher short-term risk, but with a longer time horizon. In contrast, retirees may prioritize cash flow and capital preservation through fixed-income or more conservative balanced strategies. Increasing the asset allocation to hold more bonds, not only reduces the expected risk and return. Bonds, particularly government bonds, also have a lower correlation to equity. That makes them powerful for diversification.

The key here is that individual investor needs are unique, and ETFs provide the tools for investors to create the optimal portfolio for their needs, or in the case of asset allocation ETFs, to choose from a pre-set mix ranging from conservative with a high bond allocation up to 100% equity. An investor’s chosen asset allocation may also slowly change over time as their situation and risk profile change.

How Many Holdings to Diversify?

As mentioned, diversification impacts the level of volatility in your portfolio. A paper by S&P Dow Jones Indices research team titled Fooled by Conviction, showed that Between 1991 and May 2016, the average volatility of returns for the S&P 500 was 15%, while the average volatility of the index’s components was 28%. Looking at the variability between one stock and 500 is an extreme example, but it illustrates the important point that if the typical active manager owns 100 stocks now and alters to holding only 20, the volatility of their portfolio will likely increase.

That data with the S&P500 is also 500 companies that span many sectors, but share exposure to common factors. Like being domiciled in the United States, for example. What impacts a major market will also commonly impact other markets.

Again, correlation comes into play. For example, Surz & Price (2000) estimated that it could take 60 holdings to capture 90% of the diversification benefit. Importantly, that would be for a single market or asset class. If you apply that across multiple sectors and global markets, it would translate to over a thousand holdings.

Fortunately, an ETF is a cost-effective and convenient way to gain exposure to thousands of holdings.

Behavioral Risk & Asset Allocation

Behavioral biases, such as loss aversion, recency bias, or overconfidence, often lead investors to deviate from their optimal asset allocation strategy. Common mistakes include choosing portfolios that may be too conservative to meet their financial needs, panic selling, jumping on the latest meme trend, or failing to rebalance their portfolio over time. The risk of sabotaging your portfolio with those types of behaviors is called behavioral risk.

It’s not about timing the market or stock picking; it’s about time in the broad markets that pays off in the long run. Behavioral biases tempt us to market time or focus on narrower areas of the market.

Choosing the right asset allocation helps us to manage behavioral risk. Higher volatility heightens the emotions that drive us to act on our biases. A mix of asset classes can dampen that volatility as mentioned previously. Morningstar’s annual Mind the Gap Report attempts to quantify that by measuring the gap between what funds return and what investors achieve based on when they buy or sell those funds. In 2024, the higher volatility narrow sector funds had a performance gap of -2.6%/yr over a ten-year period. In contrast, asset allocation funds had the lowest underperformance due to behavior at -0.4%/yr.

Rebalancing to Manage Risk

As time passes, some assets may grow faster than others. Rebalancing is the practice of bringing your asset allocation back to your target. That may mean selling what has done well to buy what is currently lagging. Rebalancing manages risk by ensuring that you stay diversified. Doing it automatically and mechanically helps to combat your human biases leading you astray. For example, recency bias makes it psychologically hard to sell what has recently done well to buy what has recently lagged. However, rebalancing does exactly that.

Buying low and selling high is sometimes touted as an ingredient for investing success. While rebalancing mechanically does that, whether that translates into an increased return is variable. If you are only rebalancing between assets with a similar risk/return, like equity markets, then it may be beneficial through mechanically selling high and buying low.

However, if it is rebalancing between assets with different risk/return, such as stocks vs bonds, then the impact on returns is variable. During periods when stocks and bonds are poorly or negatively correlated, it may help. For example, in a downturn when stocks fall and bonds stay the same or rise in price, you may rebalance by selling bonds to buy stocks, and then ride those stocks back up to a greater degree when the market recovers.

Conversely, if stocks and bonds are moving in similar directions, you would expect to be constantly trimming stocks to buy more bonds (since bonds have a lower expected return rate). That would blunt the overall return. However, it would also keep you from straying from your risk profile. Again, straying from your risk profile could blunt real-life returns due to increasing the behavioral gap.

Automated rebalancing tools, such as those embedded in BMO’s Asset Allocation ETFs, can help mitigate these biases by ensuring portfolios remain aligned to their predetermined asset mix. The scale and structure of ETFs also allow for rebalancing to be more efficient with less loss to taxes or trading frictions.

A More Passive Approach to Investing

Asset allocation ETFs take a strategic approach to asset allocation by using passive index-based investing tools to build the underlying portfolio.  Passive investing brings the benefits of being low-cost, efficient, diversified, and transparent.  That active managers can beat an index beyond the cost of their fees is a common misconception that is easily negated with SPIVA (Standard and Poor’s Index versus Active Funds) research (SPIVA | S&P Dow Jones Indices).  That dataset shows that active managers can add potential alpha² in some circumstances, however in the majority of cases, passive indexes outperform. 

Adding to this, if we look at the persistence of active managers outperforming index-based investing (the likelihood that the same manager who outperformed in any given year will be able to repeat the task), it shows us that it is even rarer statistically. In fact, worse than would be expected by random chance.

A passive approach with low costs is able to closely track indices for the relevant markets and beat the vast majority of actively managed funds. An asset allocation ETF uses passive index-based ETFs to do that for markets around the world. One fund to rule them all.

Strategic Portfolio Construction in One ETF

So far, we’ve covered why asset allocation matters, how diversification and mechanical rebalancing help in mitigating risk, and the advantage of a low-cost passive approach, An asset allocation ETF should tick off those boxes. The ETF structure has advantages. However, implementation also matters.

BMO’s Asset Allocation ETFs are set to specific strategic asset allocation based on risk profiles from conservative, to balanced, to growth, to all-equity solutions. These funds provide a blend of global equities and fixed income, rebalanced quarterly to maintain the desired allocation. They are constructed to invest in that asset allocation conveniently and effectively. The underlying ETFs used are also designed to be efficient. For example, the ETFs used to cover foreign markets hold foreign stocks directly to avoid extra layers of foreign withholding tax.

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Advantages of Asset Allocation ETF Structure

Cost Efficiency: ETFs generally have lower expense ratios compared to mutual funds. BMO ETFs maintain this advantage, allowing investors to keep more of their returns. In fact, the Management fees on BMO’s flagship asset allocation ETFs were just lowered to 0.15%/yr!

Transparency: ETFs disclose holdings daily, enabling investors to understand their exposures and make informed decisions.

Liquidity & Flexibility: ETFs have multiple layers of liquidity. They trade on major exchanges, offering intraday liquidity and the ability to implement strategies quickly.

Instant Diversification: Asset Allocation ETFs are comprised of 6-8 underlying ETFs³, meaning you have exposure to thousands of individual securities.

Whole Portfolio or Core Position?

Asset allocation ETFs can be used as a complete portfolio for those who want a simple approach to investing.  Choosing the ETF that matches your risk profile and objective is a one-ticket solution that makes investing easy. Even though it is a simple-to-use instrument, it has a complex evidence-base underpinning it.

For those looking for a more complex strategy, an Asset Allocation ETF could still be used to build the core of your portfolio. making up the bulk of it to keep you disciplined and to benefit from the evidence and rationale that we discussed in this article.  From there investors can add satellite positions to explore areas of the market where they have particular conviction.  They can add sector or thematic ETFs they expect to add value to their portfolios, or even individual stocks. That may help to “scratch the itch” for those who enjoy that more active approach to investing while still keeping a strong anchor.

[Editor Note: For those looking to stay simple, but want more tax planning options later, adding more than one asset allocation ETF over time is an option]

Conclusion

Asset allocation is the bedrock of portfolio success, influencing both the risk and return characteristics of investments. By leveraging the principles of diversification, risk management, and systematic rebalancing, investors can build portfolios that align with their investment objective while simultaneously limiting the impacts of emotional biases.  BMO’s Asset Allocation ETFs provide a robust suite of tools for implementing asset allocation strategies, offering low-cost, transparent, and diversified solutions for both novice and experienced investors.

Learn more here: Asset Allocation ETFs | BMO Global Asset Management

Related Video

This is a short video, and asset allocation ETFs are an elegant tool. Surprisingly, to most people, the impact could be profound, like a third of your portfolio profound, or more than doubling your money over your investing horizon. Watch and find out why.

Footnotes

1. Correlation: A statistical measure of how two securities move in relation to one another. Positive correlation indicates similar movements, up or down together, while negative correlation indicates opposite movements (when one rises, the other falls). ↩︎
2. Alpha: A measure of performance often considered the active return on an investment. It gauges the performance of an investment against a market index or benchmark which is considered to represent the market’s movement as a whole. The excess return of an investment relative to the return of a benchmark index is the investment’s alpha. ↩︎
3. Portfolio holdings are subject to change without notice. ↩︎

Disclaimers

Sponsored by BMO Exchange Traded Funds, published June 2025.

This article is for information purposes only. The information contained herein is not, and should not be construed as investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated and professional advice should be obtained with respect to any circumstance.

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