A trader works on the floor of the New York Stock Exchange (NYSE) in New York, U.S. Photographer: Michael Nagle/Bloomberg© 2019 Bloomberg Finance LP
Exchange Traded Funds (ETFs) have steadily grown assets over decades. ETFs can provide an easy way to own thousands of individual assets, with costs now as low at 0.03% a year. For example, with a single ETF you can effectively own all of the S&P 500 constituents as easily as buying shares in a single stock. Yet, individually, ETFs are pieces of a jigsaw puzzle. Picking the wrong low-cost ETFs may not diversify your portfolio sufficiently. So how can ETFs best be assembled into a portfolio? Here we’ll discuss getting started with just two different low-cost funds.
Look Globally With Stocks
The first thing to consider is having a global stock allocation. ETFs make this simple. Owning a global stock portfolio gives you exposure to stocks around the world, including in the U.S. Having that global allocation, as U.S. investor, may be valuable in the coming years at a time when U.S. stock valuations appear stretched relative to many other markets.
Plus, picking a global allocation doesn’t mean giving up on the U.S. For example, the Vanguard Total World Stock ETF still has over half its assets invested in U.S. companies. That diversified exposure costs 0.10% a year (the expense ratio). If you want to break down your country stock exposure further you can do that too. For example, Russia and Turkey may be among the cheapest global markets today and you could overweight those markets if you wish, but may also be among the more volatile in the coming years. Nonetheless, owning a global stock fund is a robust starting point for however you chose to define your overall allocation with other, potentially more focused, holdings.
Include Bonds For Stability
Then it’s useful to include bonds in your portfolio. Bonds may not be the most glamorous of financial instruments, with steady interest payments the best that can be hoped for in most cases. However, at times of financial distress, high-quality bonds may hold their value, or even rise a little. That’s useful in keeping your portfolio on an even keel, since stocks can move up and down by a lot depending on the emotions of the market, whereas high-quality bonds are often calmer.
Currently the yield curve in the U.S. is extremely flat, and in places starting to invert. This means that you aren’t receiving as much as you might normally would for holding longer-term bonds. Nonetheless, a broadly-diversified bond fund such as the iShares Barclays Aggregate Bond Fund can be a good place to start. It owns over 7,000 bonds and yields approximately 3% a year. The expense ratio is relatively low at 0.05% net.
Diversify Properly
In building out any portfolio it’s important to diversify properly. The portfolio above contains just two funds, but holds approximately 15,000 stocks and bonds. Remember, diversification is not just about holding a large number of different funds, but making sure that they have the potential to smooth portfolio performance. For example, owning seven different funds that all tracked the S&P 500 would provide virtually no diversification benefit. This is because whatever happened, the funds would likely all move essentially in unison.
Consider Costs
Costs really do matter. With ETFs paying less for similar funds tends to result in better performance. This is because there is no skill in tracking an index, and so paying more is unlikely to help your money grow. In fact, it may the opposite. The cost of a fund is simply deducted from performance, so the higher the fee, the less money the investor will receive, all else equal.
The two funds discussed above above have expense ratios of 0.1% for the Vanguard Total World Stock ETF and 0.05% for the iShares Barclays Aggregate Bond Fund, those are at the low end of the ETF cost range. As ETF costs continue to fall, paying over 0.3% (and ideally less) for anything but the most specialist or exotic ETFs makes little sense. It’s also questionable whether specialist and exotic ETFs ever make sense in a long-term portfolio.
Write It Down
Whether you assemble a portfolio based on the two ETFs above or use a different formula, such as one of these expert portfolios, it’s important to write down your investment plan. This can be a simple one-page document, but writing down your plan will help you stick to it, and not make ill-advised trades should the market moves against you.
Extending The Framework
This is a starting point for a portfolio. You then need to consider what stock/bond split might make sense for you, more stock exposure can generally mean improved returns in good markets and over time. Yet stocks also can come with bigger falls in value in bad markets, which can become a permanent loss if you decide to withdraw the money or change strategy.
You may also wish to tilt your portfolio using factors such as momentum. Or vary your bond portfolio depending on the Fed’s potential actions. However, the above should serve as a sn initial building block, providing you with reasonable diversification and relatively low costs.