Exchange-traded funds have been gaining ground on mutual funds for some time now, especially with the increasing number of investors looking to ditch their pricey portfolio managers and branch out into the DIY realm. Building your portfolio from scratch might seem like a daunting task, but most of the same strategies that work with mutal funds also work for ETF investing. If the prospect of navigating uncharted ETF waters still seems a little overwhelming, don't worry—whether you're just starting out or looking to retire soon, these ETF gurus can help guide the way.
For the younger crowd. With student loans, rent, groceries, and other spending priorities, there's probably not a whole lot of money lying around at the end of the month. But just because you're on a budget doesn't mean you can't start investing for the future. Although there are hundreds of ETFs to choose from, the trick is to keep it simple, says Christine Benz, director of personal finance at investment research firm Morningstar and author of 30-Minute Money Solutions. You don't have to buy and keep track of a hundred ETFs to be well diversified. On the contrary, because many ETFs hold thousands of stocks, diversity is already built in.
Benz recommends putting 70 to 80 percent of your total assets in the Vanguard Total World Stock Index (symbol VT), which provides exposure to almost 2,800 stocks in 47 countries throughout the world. "For people really just getting started, [Vanguard Total World Stock Index] makes it really easy," says Rick Ferri, founder of the investment firm Portfolio Solutions and author of All About Asset Allocation. "You just 'buy the world.' Everything's all bundled together." Keep in mind that the fund's substantial exposure to emerging markets ups the risk, but Morningstar analyst Michael Rawson says higher prospective returns make the extra volatility worthwhile.
For the fixed-income portion of your portfolio, Benz recommends allocating 20 to 30 percent of your assets to the Vanguard Total Bond Market (BND), which holds about 4,500 domestic and foreign bonds and provides exposure to mortgage-backed securities, government bonds, corporate bonds, and bonds from government-sponsored enterprises such as Fannie Mae and Freddie Mac.
Some experts say younger investors can get away with even fewer bonds—sometimes none at all. "There are certainly many intelligent people who say 100 percent stocks because you could shift into safer and safer stocks as you age," says James Early, advisor of the Motley Fool Income Investor newsletter and a former hedge fund analyst. "The risk is that something drastic could happen to the stock market and leave [investors] up a creek, so to speak. That's why I would have a little bit in some other things."
For those "other things," Early recommends throwing in a real estate investment trust (REIT) exchange-traded fund, which would make up about 10 to 20 percent of total assets. Although it might seem like a bad investment now with the unstable housing market, he says that historically, the performance of REITs have been uncorrelated with those of stocks and bonds. "That's really what you want," Early says. "You don't just want raw return. You want investments that 'zig' when the rest of your portfolio 'zags.'" That's also why he recommends a small allocation to precious metals such as the iShares Gold Trust (IAU). "I certainly wouldn't go whole-hog into a certain commodity," Early says. "But if we do have problems with the U.S. dollar or if we have hyper-inflation, investors will be glad they have commodities."
Although a simple ETF portfolio might seem like a "set-it-and-forget-it" plan, it's still important for investors to consistently reevaluate their asset allocations as their lifestyles and investment goals change. As you get closer to retirement age, financial advisors say it's generally a good idea to ratchet down the amount of risk in your portfolio and start thinking about increasing your fixed-income holdings to protect your investments. That means slowly raising your position in an ETF like BND, and even including some inflation protection further down the road with a TIPS ETF such as the iShares Barclays TIPS Bond fund (TIP).
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.