ETFs Made Easy: 2 Simple Portfolios

Sometimes we assume around here that everyone comes to ETF.com trying to answer one simple question: “What’s the best _________ ETF? “ And we’ve gotten pretty good at answering that question.

Wanna know what the best all-around U.S. small-cap ETF is? You head to our segment report on small-caps and look for the blue ribbon, which signals our “analyst pick” in almost any market segment.

While there are lots of good funds in the list, if you’re just looking for cheap, tradable exposure, you’ll be hard pressed to do better than the Vanguard Small Cap (VB | A-99).

But what if you’re approaching ETF investing—or investing at all—for the first time? You’re middle aged, have a little money to get to work and don’t even know how to get started?

Traditionally, this would be where I write 1,500 words on asset allocation. I’d tell you to assess your risk tolerance and time horizon and educate you about different asset classes. But in a stroke of what I can only imagine is bureaucratic oversight, the SEC actually maintains one of the clearest guides to all of that in its investor education website.

And once you’ve read the basics, there are quite literally thousands of places on the Internet that will offer up presliced portfolios for you.

You could follow one of the portfolios at Bogleheads (a long running Vanguard-centric community). You could buy one of Rick Ferri’s books (or just hire him as your manager), or you could just head over to Wealthfront, go through its questionnaire and steal the resulting portfolio. You could even just use Matt Hougan’s Cheapskate Portfolio from ETF.com.

But let’s imagine you’ve already got a brokerage account and $100,000 to invest, and you’ve already decided you’re a pretty average investor, who’s looking for something like 60 percent risky assets (generally equities) and 40 percent less risky assets (generally bonds). How do you approach the process of building a portfolio of ETFs to match that allocation?

Question No. 1: Where Is Your Money?

If you’re like most people (or like me at least), you made a choice a long time ago about where you were going to park your money. Maybe you got a rollover from a 401(k) in the ’90s and stuck it in Fidelity. Maybe you scraped together $10,000 in college and opened a Charles Schwab account. Maybe you’ve been a longtime Vanguard investor because that’s what your father did.

Most financial writers ignore this, but I’d argue it’s one of the more critical contributors to answering the question “which ETFs?” With the rise of commission-free trading, for a smaller account like $100,000, oftentimes the lack of commissions will be more important than a decent amount of expense ratio on the funds you choose.

If you’re making six trades a year in your account (not unreasonable with perhaps two rebalancing trades in three funds), and you’re paying $10 a trade, you’re automatically out 0.06 percent a year just in trading costs.

Question 2: How Many ETFs?

This is where it gets tricky, and ultimately, the answer is going to come down to how lazy you are. If you’re really, truly lazy, you can implement your 60/40 portfolio with just two funds. By limiting yourself to two funds, you minimize complexity, but you put a higher emphasis on getting the “right” two funds.

For your equity fund, you’ll likely want a fund that has stocks from all over the world, and from up and down the capitalization spectrum. There’s a whole segment of 10 funds competing for those dollars called “Global Total Market Equity.”

Our analyst pick in that segment, the Vanguard Total World Stock ETF (VT | A-100), gets you 6,775 stocks covering 98 percent of the world’s markets. While it has 1.67 percent of its money in Apple, it also has a 2.5 percent allocation to Australian stocks, and even includes a 1 percent allocation to micro-cap stocks, all for just 0.18 percent a year.

On the bond side of the portfolio, things are less obvious. There’s no equivalent to VT for bonds, so if you’re limiting yourself to a single fund, you’re likely going to be stuck with U.S. bonds.

The traditional choice here is an ETF tracking the Barclays Aggregate index, which covers nearly 9,000 bonds from governments, companies and agencies. It includes mortgage-backed securities, and bonds rated down to about BBB, or the bottom of the investment grade scale.

There are three ETFs tracking that index, all good, but our analyst pick there is the iShares Core U.S. Aggregate Bond ETF (AGG | A-98), at a skinny 0.08 percent a year.

Simplest 2-Fund Portfolio

A few notes about this approach. In any given year, one of these two funds is going to do better than the other. Over the last year, VT was up 7.7 percent and AGG was up 5.47 percent, meaning that right now, you’d be 60.5 percent in equities.

That’s not much of a drift, but a key part of any portfolio strategy is monitoring this allocation and rebalancing, generally when the portfolio crosses a threshold. A 5-10 percent tolerance is very common. With a 10 percent threshold, you’d wait until your VT position was 70 percent of your holdings, and then sell a bunch (buying AGG with the proceeds).

Question 3: Do You Want More Complexity?

There are plenty of things wrong with the simplistic two-ETF portfolio above. Off the bat, it’s not actually the very cheapest you could do.

If you’re a Schwab customer, you could replace AGG with the Schwab U.S. Aggregate Bond ETF (SCHZ | A-99) and save 0.02 percent and not pay to trade, at the expense of a little long term tracking difference.

If you’re a Vanguard customer, you could pay the same fee to get the Vanguard Bond ETF (BND | A-94) to get free trades at the expense of a little long-term tracking difference. Those are legitimate concerns, but if we’re being honest, that's fairly fine hair-splitting.

The biggest issue with this two-ETF portfolio is precisely its simplicity.

There are, for instance, no international bonds in it. If we were going for maximum diversification, we’d reach for some international exposure, either by replacing the venerable AGG with the newly launched iShares Core Total USD Bond Market ETF (IUSB | C), which adds dollar-denominated international bonds to a U.S. base, or by splitting the bond bucket in two to wedge in an international bond ETF like the Vanguard Total International Bond (BNDX | B-57). That would get us broad international exposure without taking on currency risk.

And we could do the same thing with our equity position. VT is a fine, fine fund, but because it’s market cap weighted, it’s still 51 percent in U.S. stocks, and overall, its 93 percent in developed markets. Less than 8 percent of the fund is in small or microcap stocks.

There’s nothing wrong with those allocations—it’s the market weight. But if this is the “risky” part of our portfolio, we could certainly split the exposures into U.S. equities, developed international equity (without euro and yen risk) and emerging markets.

And all of the sudden, our “simple” portfolio looks like something like this:

Again, there are easy tweaks to make here depending on where you hold your assets and your sensitivity to fees and commissions.

As a Schwab customer, you might swap out the equity positions for the nearest Schwab equivalents, the Schwab US Broad Market ETF (SCHB | A-100), the Schwab International Equity ETF (SCHF | A-95) and the Schwab Emerging Markets Equity ETF (SCHE | B-82).

As a Vanguard customer, you might reach for the Vanguard Emerging Markets (VWO | C-82) over the iShares offering. Heck, if you’re a believer in active management, you could just swap the whole bond position for Fidelity’s new Fidelity Total Bond ETF (FBND).

Regardless, it’s easy to see how a simple idea can get complicated pretty quickly. We’re still in the simplest of ideas here—we haven’t added any new asset classes. We’re not looking at REITs or gold or commodities or liquid alternatives. We’re not even trying to make any guesses about growth or value or small-caps or individual sectors or countries. And this portfolio of just five ETFs will require more frequent rebalancing, as something in it will always be the winner, while something else is the loser.

Keeping It Simple

Part of the joy in investing is actually embracing complexity—it’s what makes investing actually fun for some people. But that doesn’t mean it’s smart. Most investors—myself included—are better off the simpler we keep things.

With more than 1,600 ETFs to choose from, it can be a bit overwhelming trying to choose the best ETF for any given purpose. But by keeping the exposures broad and looking at a few key quality measures (such as ETF.com’s scores and analysts picks), you can make informed decisions without having to crack open your MBA textbooks.

At the time this article was written, the author held positions in SCHE, SCHB, SCHF and DBEF. You can reach Dave Nadig at [email protected], or on Twitter @DaveNadig.