Exchange traded funds, aka ETFs, are a remarkably useful investment option. ETFs are a way to buy into a mutual fund without having to make the often hefty minimum purchases that funds tend to require -- you can buy as little as a single share of an ETF. And like mutual funds, ETFs are the perfect way to diversify your portfolio with a minimum of effort. However, with literally thousands of ETFs available for purchase, picking just the right one can be quite a challenge.
For a one-investment stock portfolio
Sometimes simplicity is the way to go, especially if you are a hands-off investor who prefers to spend his time on other pursuits. For a well diversified, general-purpose stock portfolio, you can't go wrong with the Vanguard S&P 500 ETF (NYSEMKT:VOO), widely known to be Warren Buffet's favorite ETF. Boasting an incredibly low 0.04% expense ratio, this ETF will give you a way to track the market at the lowest possible price. Of course, stocks alone are not enough to produce a diversified portfolio, which leads us to...
If you want just one bond ETF in your portfolio, you could do worse than to pick the Schwab U.S. Aggregate Bond ETF (NYSEMKT:SCHZ). Another index ETF that enjoys a low, low expense ratio of 0.04%, this ETF tracks the Bloomberg Barclays U.S. Aggregate Bond Index, which puts most of its holdings in US government bonds, mortgage-backed securities, and corporate bonds. The wide range of bond types represented in this ETF gives its investors excellent diversification in the bond market.
US-based stocks are not the only option these days; there's a whole wide world of investments out there, and an international ETF can give you easy access. For a low cost, broad-based international ETF, consider the Vanguard FTSE All-World ex-US ETF (NYSEMKT:VEU). This ETF tracks the FTSE All-World ex US Index, which (as its name implies) includes stocks from all over the world except the USA. Because of the way that the stocks in this index are weighted, the ETF emphasizes large-cap companies, which makes it a bit less volatile than some international funds. And its expense ratio of 0.11% keeps fees to a minimum.
The REIT way
REITs, or real estate investment trusts, are an excellent option for diversifying away from stocks and bonds. Buying shares in an equity REIT is essentially investing in real estate on a tiny scale, and since real estate tends to react differently from either stocks or bonds to various economic conditions, such an investment can reduce your portfolio's volatility significantly. Once again Vanguard leads the way in this category, with its Vanguard REIT ETF (NYSEMKT:VNQ) which tracks the MSCI US REIT Index. The ETF tracks only equity REITs, not mortgage REITs, which makes it a much less volatile option than many of its competitors. It also emphasizes larger REITs, which gives it a bit more stability (and lower risk). Last but not least, the moderate 0.12% expense ratio gives the ETF's returns a nice boost.
The above ETFs will give you a solid, general-purpose portfolio, but you may want to specialize your portfolio somewhat to meet your own needs and preferences. For example, someone approaching retirement would want to emphasize income and low volatility in her portfolio, so she'd want to replace some or all of the above ETFs with others that specialize in those areas. And many brokers will allow you to buy and sell the broker's own ETFs commission free, so if you have an account at Schwab or Fidelity you can save a lot of money by sticking with that family of ETFs. When choosing an ETF, look for index ETFs if possible to minimize fees. And remember, diversification is the name of the game: don't limit yourself to just one type of investment (say, large-cap stocks) no matter what your focus is, but spread your money out over a wide range of investments. Diversification increases returns, reduces risk, and generally makes for a fat, happy portfolio.