The exchange-traded fund industry has exploded over the past couple of decades. But when investors comb through the vast number of fund choices, they often find it a bit confusing. Let's quickly break down the ETF industry. Then we'll look at two simple methods for constructing a well-diversified ETF portfolio.
Exchange-traded funds are investments that attempt to mirror the return of a particular index, like the S&P 500, Russell 3000, or the MSCI World Index. That is an ETF fund manager's sole objective -- no more, no less. Therefore, buying and selling decisions are based purely on the contents of the underlying index, rather than research.
Although actively managed ETFs are gaining popularity, most ETFs are passively managed. Because passive ETF managers make no active decisions, this results in less trading, increased tax efficiency, and reduced fund expenses. And as more and more dollars funnel into the ETF market, economies of scale kick in, which makes these funds even cheaper for us to own.
But, as rapidly as the 20-year old, $1.3 trillion ETF market has grown, only 3% of U.S. households own an ETF. ETFs will likely gain further popularity due to their hands-off approach, which allows you to spend more time traveling, gardening, or whatever you like. If you're a hands-on investor, you may favor ETFs because they allow you more time to research individual stocks.
Building an ETF portfolio
You can construct a well-diversified ETF portfolio in a couple of ways, with the real differentiator being the level of ease or sophistication you want.
You can get an incredibly simple portfolio that's balanced and diversified with just two ETFs: a total world stock market ETF and a total bond market ETF. For example, Vanguard Total World Stock Index ETF (NYSEMKT:VT) possesses global stock-market exposure, and Vanguard Total Bond Market ETF (NASDAQ:BND) adds plain-vanilla bond exposure to your portfolio. So if you're an investor who wants moderate risk, you can simply invest 60% in the stock ETF and 40% in the bond ETF.
Some benefits of this type of portfolio are its simplicity and ease of knowing when to rebalance. And because ETFs typically cost you a commission every time you place a buy or sell trade, a two-ETF portfolio helps to keep costs super low. But one disadvantage of this portfolio is that it's not very fine-tuned. For example, if you prefer to have a larger allocation of international stocks than domestic stocks, you may want two separate stock ETFs.
A more sophisticated approach to an all-ETF portfolio would consist of more stock and bond ETFs. For stocks, you could have a large-cap domestic ETF, mid- and small-cap domestic ETFs, an international developed-market ETF, and an emerging-market ETF. For large-cap domestic exposure, consider Vanguard Large-Cap ETF, and for your mid- and small-cap domestic ETF, think about iShares Core S&P MidCap 400 and iShares Core S&P Small-Cap ETF. For your international developed-market and emerging-market exposure, consider iShares MSCI World ETF and Vanguard Emerging Markets ETF (NYSEMKT:VWO), respectively.
For bonds, start with the same core bond ETF mentioned above and diversify a bit more by including ETFs that invest in Treasury inflation-protected securities like Schwab U.S. TIPS ETF (NYSEMKT:SCHP) or international bonds such as SPDR Barclays International Treasury Bond ETF (NYSEMKT:BWX).
The advantage of this portfolio is that it gives you coverage of several more asset classes and the ability to fine-tune your portfolio weightings. But the downside is that it doesn't offer maximum simplicity. And, because you'll be doing more rebalancing, choose commission-free ETFs when possible.
Foolish bottom line
Don't let the ETF world scare you. It's really quite simple to craft a balanced all-ETF portfolio. As an added bonus, it has never been cheaper to own them. Consider building your own all-ETF portfolio using one of these methods.