Diversifying in the ETF Universe

Most investors have heard that diversification is a good thing. Does that mean you need 20 different funds for your portfolio? As many as 50? If you use exchange-traded funds, the answer could be far less than either of those scenarios. What you don't want is a hodgepodge of funds that overlap -- that's what investors call diworsification.

You need to make sure the pieces of your portfolio fit together harmoniously. To get there, you might consider a core-and-satellite approach. Imagine you're setting up a solar system, with the sun as the core and the various planets as satellites. In a portfolio context, the core portfolio provides the desired equity and bond-market exposure, at a low risk, while the satellites are riskier strategies that you add to increase returns. An investor might use an 80%/20% core-to-satellite asset allocation, for example.

For a core ETF, you might choose a fund like the Vanguard Total Stock Market ETF (AMEX: VTI  ) , which tracks an index that covers all of the U.S. common stocks regularly traded. Slightly less comprehensive, the iShares S&P 1500 Index Fund (NYSE: ISI  ) gives you exposure to roughly 90% of the total U.S. equity market.

For the fixed-income ETF portion of your portfolio, you might add a fund like the iShares Lehman Aggregate Bond Fund (AMEX: AGG  ) , which tracks the investment-grade bond market, as opposed to the more risky junk-bond market. If you're concerned about inflation, here's a tip -- the iShares Lehman TIPS Fund (NYSE: TIP  ) . This one tracks the returns of inflation-protected U.S. Treasuries, which adjust their returns to compensate for inflation.

With the core of the portfolio in the mixer, let's now move to the satellites. Here you can add riskier strategies that branch into real estate, the international scene, small caps, or even currencies. Select ETFs that cover the particular size, style, or sector where you think the next high returns will be. Go ahead and put in a pinch of PowerShares Dynamic Biotech & Genome Portfolio (AMEX: PBE  ) . Splash in a little international flavor with the iShares MSCI Spain Index Fund (NYSE: EWP  ) . Decorate with some Rydex CurrencyShares Mexican Peso, (NYSE: FXM  ) , for dollar diversification.

Now your ETF solar system is set. Your own particular allocation, of course, will depend on your investment horizon and risk tolerance.

Learn all about ETFs in our ETF Center.

For related Foolishness:

Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City.She does not own any of the funds mentioned in this article. The Motley Fool has a disclosure policy.

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