For the young-at-heart. Although exchange-traded funds are marketed as no-fuss investments, they are not one-size-fits-all products. While a broad global stock ETF might be suitable for younger investors who can take on more risk, Benz steers investors approaching retirement away from the Vanguard Total World Stock Index (VT) because of its sizeable allocation to foreign stocks. "There's nothing inherently wrong with that," Benz said in an E-mail. "But I worry that it courts too much currency risk for a retiree."
For those nearing or in retirement, Benz favors separate ETFs for U.S. and foreign stocks: Vanguard Total Stock Market (VTI) and Vanguard FTSE All-World Ex-US (VEU). Vanguard Total Stock Market holds some 3,300 different stocks—nearly all of the publicly traded domestic stocks available—and according to Morningstar, it provides more diversification than most broad-market ETFs. Another boon for retirees, this fund's stake in riskier mid-, small-, and micro-cap stocks helps it generate more income while giant-cap multinational corporations anchor the portfolio and somewhat offset the risk of the smaller-cap names.
Vanguard FTSE All-World Ex-US (VEU) is a good complement to VTI because it has no direct exposure to U.S. markets, which helps prevent overlap among stock holdings. The focus on large- and mid-cap foreign companies keeps a lid on volatility and according to Morningstar, this fund's position in emerging markets—about 27 percent of total assets—helps boost returns. Says Morningstar's Michael Rawson, "no matter what region or industries succeed in the coming years, this ETF's broad coverage ensures that it will own them."
For the bond portion of the portfolio, Benz recommends investing in a few inflation-hedging funds as well as ETFs with shorter-term horizons. She recommends allocating 15 percent of assets to the iShares Barclays TIPS Bond (TIP), which only owns U.S. Treasury-issued inflation-protected bonds and helps diminish the effect of inflation. Another 10 percent of the portfolio should be in a short-term bond ETF such as the Vanguard Short-Term Bond (BSV). Short-term bonds provide greater liquidity for retirees and tend to weather inflationary periods better than longer-duration bonds.
Plan for pitfalls. ETFs are fairly simple investing tools, but it's still easy to fall prey to some common pitfalls. They usually beat out most investment products when it comes to tax efficiency and expense ratios, but the brokerage fees you pay to buy and sell ETFs affect your bottom line. "The expense ratios of most ETFs are typically lower than similar mutual funds," says John Gannon, senior vice president of Investor Education at the Financial Industry Regulatory Authority (FINRA). "But if you're a dollar-cost averager or a trader, you're going to have a lot of expenses because of the commissions you're going to get charged." A $7 commission might sound cheap at first, but frequent trading—or frequent contributions—can take a substantial bite out of your investment and returns. It's a good idea to compare trading fees among discount brokerages before choosing one. Brokerage Charles Schwab even offers commission-free trades with no minimum balance for its ETF offerings.
Gannon says investors can make sure they're getting the best deal by comparing the expense ratios for ETFs that track the same index. FINRA has a tool, Fund Analyzer, that allows users to compare ETFs based on a number of criteria, including operating expenses.
Finally, if you're new to ETF investing, don't get bogged down in the nuances and niche nature of these products. Over the past five years, ETF offerings have become increasingly granular and more complicated, Gannon says. Many times, sticking to broad-based ETFs that track more common indexes is the smartest—and simplest—way to go about building your ETF portfolio.