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7 ETFs for the Perfect Portfolio

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With new exchange-traded funds coming out all the time, ETF providers want you to believe that you can't invest well without the latest gimmick fund. Unless you're looking to make extremely concentrated bets on a narrowly focused group of investments, you can stop poring over every new fund offering. You'll do better with tried and true funds instead.

Chasing performance
Ideally, every new ETF would bring something valuable to the table for investors. But more often than not, new ETFs simply follow a popular trend that has already seen its best days. ETF providers know that most investors chase past performance, so a fund catering to yesterday's top-performing investments will inevitably attract more assets than an ETF that concentrates on an out-of-favor area. Moreover, with huge funds dominating the broad market space, new ETFs have to specialize in ever more narrowly defined areas in order to stand out from the crowd.

While specialized ETFs serve a valuable function, they're not the right ingredients for your core portfolio. Instead, with just a handful of ETFs with long track records, you can put together a well-balanced set of investments that will give you the diversification you want for any market.

By creating the right mix of the following ETFs, you can put together your perfect portfolio:

1. SPDR Trust (NYSE: SPY  )
The original Spyders serve the same function that the index mutual fund has for the past 40 years: an inexpensive and simple vehicle to buy the broad market. As the most well-known broad-market measure, the S&P 500 is the benchmark that many stock investors use to measure their performance. The ETF has done a great job of tracking the index over time, and its rock-bottom 0.09% expense ratio won't hurt your wallet.

2. iShares Russell 2000 (NYSE: IWM  )
The S&P 500 is great, but if it's the only U.S. stock ETF you own, you'll miss out on the up-and-coming small companies that will be tomorrow's leaders. Historically, small caps have outperformed large caps by a substantial margin, even considering how many small caps flare out and fail rather than growing to the next level. With ample liquidity and reasonable fees, the iShares offering is a logical choice for small-cap exposure.

3. iShares MSCI EAFE (NYSE: EFA  )
No portfolio is complete without global exposure. This fund opens its horizons throughout the developed economies of the world, focusing on Europe and Japan for the majority of its holdings. Although the global economy has increased correlations between U.S. and foreign stocks, you can still gain a measure of diversification with an international component to your portfolio.

4. Vanguard Emerging Markets Stock (NYSE: VWO  )
If you only focus on developed countries, though, you'll have a glaring hole in your portfolio. Emerging markets are popular and have seen amazing gains in recent years, but even if valuations are growing pricey, having some emerging market exposure in your portfolio still makes sense. This low-cost fund gives you well-known companies in China, India, Brazil, and other emerging market countries.

5. iShares Barclays TIPS Bond (NYSE: TIP  )
Even with bonds at unprecedented high prices, fixed-income still holds a valuable place in your portfolio. This ETF focuses on inflation-adjusted bonds, which should protect investors in the event of higher inflation more effectively than traditional bond funds and ETFs.

6. Vanguard REIT Index (NYSE: VNQ  )
An alternative to bonds that many have added to the fixed-income side of their portfolios is investing in real estate investment trusts. REITs pay income generated from their real estate holdings, and despite long-held concerns that commercial real estate could follow the plight of the housing market, REITs have performed well since the market meltdown. The Vanguard ETF holds nearly 100 REITs holding investments ranging from mortgages and residential properties to shopping malls and office buildings.

7. Central Fund of Canada (AMEX: CEF  )
Strictly speaking, I'm cheating with this pick, because Central Fund is a closed-end mutual fund rather than an ETF. However, as a closed-end, it trades on exchanges like an ETF. The fund concentrates on precious metals, owning around 1.5 million ounces of gold and more than 75 million ounces of silver. If you believe that precious metals exposure is a necessary insurance policy against financial collapse and the demise of fiat currencies, Central Fund has the bullion backing that smart investors demand.

Set it up
With these seven ETFs and an appropriate asset allocation strategy to help you divide your money among them, you can put together a portfolio that's perfect for your financial needs and goals. Until someone comes up with better all-purpose funds, you can ignore the niche offerings that are taking up everyone else's attention.

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True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger is always searching for the perfect portfolio. He owns shares of iShares Russell 2000 and MSCI EAFE ETFs, as well as Vanguard Emerging Markets Stock and REIT Index ETFs. The Fool owns shares of Vanguard Emerging Markets Stock ETF. Try any of our Foolish newsletters today free for 30 days. The Fool's disclosure policy had to settle for a 9.95 from the East German judge.

Read/Post Comments (5) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 05, 2010, at 4:04 PM, fennecfoxen wrote:

    Emerging markets are nice, but a lot of that's weighted towards oil companies and the like. How about ECON (Emerging Global Shares Dow Jones Emerging Markets Consumer Titans Index Fund), a shiny new offering that might actually be useful?

    Also, if you like a little emerging-markets, how do you feel about a little frontier markets, like FRN (Claymore/BNY Mellon Frontier Markets ETF)?

  • Report this Comment On October 05, 2010, at 4:05 PM, fennecfoxen wrote:

    Emerging markets are nice, but a lot of that's weighted towards oil companies and the like. How about ECON (Emerging Global Shares Dow Jones Emerging Markets Consumer Titans Index Fund), a shiny new offering that might actually be useful?

    Also, if you like a little emerging-markets, how do you feel about a little frontier markets, like FRN (Claymore/BNY Mellon Frontier Markets ETF)?

  • Report this Comment On October 05, 2010, at 4:21 PM, S2000magician wrote:

    Over the last five years, the average correlation of monthly returns for these seven ETFs with each other is +0.5267. That's awfully high. I'd probably look for a mix of ETFs with a lower average correlation of returns: better risk-reducing diversification.

  • Report this Comment On October 05, 2010, at 7:58 PM, shallam1313 wrote:

    This is pretty close to my portfolio but I have added FRN instead of IWM. Frontier market exposure while still collecting a dividend. I still have GSG for commodity exposure but do not like the contango and pre-rolling risk plus high expense ratios, so I'm thinking about nixing that one.

    I'm curious S2000magician, or any other Fool, what other ETFs would produce a lower correlation?

  • Report this Comment On October 05, 2010, at 11:32 PM, predfern wrote:

    What would be the mutual fund equivalent for a retirement account with Fidelity?

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