The Core Approach to Building an Effective ETF Portfolio

    by Maria Crawford Scott

    The Core Approach To Building An Effective ETF Portfolio Splash image

    Do you really need to sort through 700-plus ETFs to build an effective portfolio?

    As investment products increase in number, complexity and expense, many individuals are plaintively searching for an investment approach that keeps it simple and low-cost.

    Exchange-traded funds (ETFs) offer a useful starting point for such an approach. But the sheer number of funds to choose among may appear as an insurmountable hurdle and stop many investors in their tracks.

    In reality, this hurdle is rather easily bypassed. You can in fact narrow down your options relatively quickly if you build your portfolio around a core of exchange-traded funds that track broad-based, well-known indexes. These funds are passively managed portfolios that do not require you to evaluate the skill of a portfolio manager, provide you with complete diversification within the market the index covers, are low maintenance, and have rock-bottom costs.

    Using the core index portfolio approach, you can build effective portfolios that range from the basic, bare-minimum portfolio to one that is more complex, depending on your interest, the amount of time you want to spend managing it, your investment knowledge, and the total amount of dollars you’ll be investing.

    There are, of course, several investment constraints that any investment portfolio must follow:

    First, it must meet your financial goals and match your risk tolerance. Your asset allocation—how much you put into the various asset categories—addresses these financial concerns and is driven by your investor profile.

    Second, it must be broadly diversified among major market segments.

    Exchange-traded funds provide you with all the tools you need to accomplish this approach.

    The Core Portfolio

    As Table 1 shows, your core portfolio should contain four main asset classes: U.S. stocks, international stocks, U.S. government bonds, and a liquidity account. That means that, at a bare minimum, your core portfolio would contain at least four ETFs.

    Table 1. Building a Core Portfolio of ETFs
    Core Holdings Non-Core Holdings
    U.S. Stocks
    Holdings should focus on ETFs that track well-known, broad-based, strategy-neutral U.S. stock indexes, with exposure to all cap sizes.

    A Basic Core:
    Total U.S. Stock ETF

    More Complex Examples:
    Large-Cap Stock ETF and an Extended Stock Market ETF
    Large-Cap Stock ETF, plus a Mid-Cap Stock ETF, plus a Small-Cap Stock ETF, and a Micro-Cap Stock ETF

    Strategy ETFs
    Sector ETFs
    Enhanced Index ETFs
    Actively Managed ETFs
    International Stocks
    Holdings should focus on ETFs that track well-known, broad-based, strategy-neutral international stock indexes, with exposure to all foreign markets.

    A Basic Core:
    Total International Stock ETF

    More Complex Examples:
    European Stock ETF, Pacific Stock ETF and an Emerging Markets Stock ETF

    Specific Country ETFs
    Regional ETFs
    Global Sector ETFs
    Holdings should focus on ETFs that track a U.S. government bond index; holdings should have an intermediate-term average maturity.

    A Basic Core:
    Intermediate-Term U.S. Gov’t (or Muni) Bond ETF

    More Complex Examples:
    Short-Term Gov’t Bond ETF and a Long-Term Government Bond ETF

    Corporate High-Yield ETFs
    Foreign Bond ETFs
    Currency ETFs
    Liquid Account
    Very short-term (less than one-year maturity) no-default-risk fixed-income ETFs, money market funds or bank accounts

    U.S. Stocks
    For the U.S. stock portion of your portfolio, the most basic approach would be to hold a total U.S. stock market ETF that tracks a broad-based index of U.S. common stocks of all capitalization sizes—large cap, mid cap and small cap.

    While these ETFs hold thousands of stocks, the key is not the number but the weightings. Most indexes are capitalization-weighted, meaning that stocks with large capitalizations (number of common stock shares outstanding times the market price per share) tend to dominate any total stock index fund.

    While holding one total domestic stock index ETF is a bare minimum, if it tracks a capitalization-weighted index it will be dominated by large-cap stocks. You could supplement it with a mid-cap and/or a small-cap index ETF so that these segments of the market are not overpowered by the largest stocks, although you will have some overlapping duplications.

    An ETF that tracks an equal-weighted total market index—one that holds equal proportions of each stock in the index—is another option that prevents the larger stocks from dominating your holdings, although there is no one ETF that currently fits this bill.

    Perhaps a better approach, particularly if you want to be able to control asset allocation and diversification more precisely, is to break the total U.S. stock market index into several components—for example, using an ETF that tracks a major large-cap index plus an ETF that tracks an extended-market index (these indexes include both mid-cap and small-cap stocks), or a large-cap index ETF fund plus an ETF that tracks a mid-cap index, one that tracks a small-cap index and possibly even an ETF that tracks a micro-cap index. By pairing a large-cap ETF with ETFs that cover these other market segments, you can fine-tune the ratio of smaller to larger companies to meet your objectives.

    Note, however, that these suggested breakdowns relate only to the size of the stock market segments; the ETFs chosen for these segments should track indexes that cover all stocks within the market segment, and should not tilt toward any particular strategy or style.

    International Stocks
    Foreign stocks add to overall diversification and risk reduction, even if the allocation is small. For that reason, your core portfolio should include, at a bare minimum, an all-in-one total international stock ETF that tracks a major index covering the primary regional economic zones: Europe, Asia/Pacific, and Latin America. This covers both developed and emerging international economies, but developed economies dominate the index, as does Europe, since capitalization weighting determines exposure and diversification.

    If you want to more precisely control the allocation among the more developed markets and the emerging markets of the Pacific Rim and Eastern Europe, you could break down the total international stock index into an ETF that tracks a major European stock index, one that tracks a major Pacific stock index and one that tracks an emerging markets index.

    Intermediate-term maturities (average maturity of seven to 10 years) capture most of the yield and total return of a long-term bond fund with substantially less fund volatility caused by changing market interest rates. At a bare minimum, your core portfolio should consist of at least one ETF that tracks the total return of an intermediate-term U.S. government bond index.

    If your bond holding is in a non-tax-sheltered environment and your tax exposure is significant, you may want to consider an intermediate-term municipal bond ETF.

    You could also create your own maturity level by combining a short-term government (or muni) bond ETF and a long-term government (or muni) bond ETF. A long-term government bond ETF can provide a higher return, although with more volatility; combining it with a more stable, although lower-yielding, short-term government bond ETF allows you to control how much extra risk you are willing to take on for added yield.

    Liquidity Accounts
    The fourth element of your core portfolio should consist of a liquidity account—assets that you can easily access to cover your short-term needs. Any short-term (less than one-year maturity), liquid fixed-income investment with absolutely no default risk can be used for this purpose. Several ETFs fit this description, but money market funds and bank accounts fit the bill as well.

    Non-Core Holdings

    If you are intrigued by certain market sectors or strategies that you feel you would like to emphasize, a safe and efficient approach is to do it through non-core holdings. This allows you to “tilt” your portfolio toward those areas, while remaining in a solid core of diversified holdings.

    For the U.S. stock portfolio, sector ETFs, specialty ETFs that focus on particular stock strategies, or ETFs that track “enhanced” semi-active indexes can be added, but should be considered non-core holdings—they should not dominate the total domestic stock portfolio.

    Similarly, specific country, regional, global sector, corporate high-yield bond, foreign bond, and currency ETFs could be added as non-core holdings as your risk level dictates—and again not dominating that asset class holding.

    Make sure when adding a sector or strategy ETF that you understand the added risks that you are taking on.

    Sector funds concentrate on one industry or a few closely related industries, and as such they are not well diversified. Similarly, style funds focus on stocks with either growth or value characteristics; they also tend to be concentrated in certain industries and not well diversified.

    “Enhanced” ETFs track indexes that follow rules-based approaches, which add a semi-active element to the decision-making process, requiring higher maintenance (you need to monitor how the index behaves in different market environments), as well as the risk they will tilt toward certain market segments.

    Beyond any additional risk that is added by these non-core holdings, the trick to master is just which sector, style or strategy to invest in—adding to the complexity of the analysis.

    Remember, too, that when you invest in one of these ETFs, you are most likely decreasing your diversification in that asset class, even though you are adding more funds. For instance, if you add a value-focused stock fund to your U.S. stock holdings, you are moving from a portfolio that is totally diversified among all U.S. stocks to a portfolio that includes all U.S. stocks but also adds in duplicates of only the value stocks—you have more funds, but less diversification and, therefore, more risk.

    Adding non-core holdings increases the complexity of your ETF portfolio, requiring significant selection and monitoring effort to earn the chance for above-index-fund returns. Non-core holdings would also be impractical to add to a core portfolio if your total investment portfolio is modest in size, due to the number of ETFs required.

    Populating the Core

    If you are sticking with simply a core portfolio, how do you know which ETFs to put into your portfolio?

    Although there are over 700 ETFs to choose from, most ETFs cover specific market sectors, are strategy-specific (for instance, growth or value) or are specialty or enhanced indexes that focus on specific investment strategies. The core approach relegates these funds to the non-core segment, which significantly narrows down your choices.

    The ETFs listed in Table 2 are all based on widely followed indexes that offer the most complete coverage of the core portfolio segments.

    Remember when looking at the list, you only need to pick one fund from each market segment. Index funds, including ETFs, are by nature fully diversified. For example, you do not need to own two different mid-cap ETFs.

    Table 2. Core Portfolio ETFs
    U.S. Stocks

    Total U.S. Stock ETFs
    iShares Dow Jones U.S. Index (IYY)
    iShares Russell 3000 Index (IWV)
    SPDR DJ Wilshire Total Market (TMW)
    Vanguard Total Stock Market (VTI)

    Large-Cap Stock ETFs
    iShares Russell 1000 Index (IWB)
    iShares S&P 500 Index (IVV)
    Rydex S&P Equal Weight (RSP)
    SPDR DJ Wilshire Large Cap (ELR)
    SPDR S&P 500 (SPY)
    Vanguard Large-Cap (VV)

    Extended Market ETFs
    Vanguard Extended Market (VXF)

    Mid-Cap Stock ETFs
    iShares Russell MidCap Index (IWR)
    iShares S&P MidCap 400 (IJH)
    SPDR DJ Wilshire Mid Cap (EMM)
    SPDR Mid Cap (MDY)
    Vanguard Mid-Cap (VO)

    Small-Cap Stock ETFs
    iShares Russell 2000 Index (IWM)
    iShares S&P SmallCap 600 Index (IJR)
    SPDR DJ Wilshire Small Cap (DSC)
    Vanguard Small-Cap (VB)

    Micro-Cap Stock ETFs
    iShares Russell Microcap Index (IWC)

    International Stocks

    Total Market International Stock ETFs
    iShares MSCI-EAFE (EFA)
    Vanguard FTSE All-World ex-US (VEU)

    European, Pacific and Emerging Market ETFs
    Vanguard European (VGK)
    Vanguard Pacific (VPL)
    Vanguard Emerging Market (VWO)


    Interm-Term U.S. Gov’t Bond ETF
    iShares Lehman 7-10 Year Treasury Bond (IEF)
    SPDR Lehman Intermediate Term Treasury (ITE)
    Vanguard Intermediate-Term Bond (BIV)

    Short-Term U.S. Gov’t Bond ETFs
    iShares Lehman 1-3 Year Treasury Bond (SHY)
    iShares Lehman 3-7 Year Treasury Bond (IEI)
    Vanguard Short-Term Bond (BSV)

    Long-Term U.S. Gov’t Bond ETFs
    iShares Lehman 10-20 Year Treasury (TLH)
    iShares Lehman 20+ Year Treasury Bond (TLT)
    SPDR Lehman Long Term Treasury (TLO)
    Vanguard Long-Term Bond (BLV)

    Municipal Bond ETFs
    iShares S&P National Municipal Bond (MUB)
    SPDR Lehman Municipal Bond (TFI)

    Keeping It Simple

    Despite the large number of ETFs available, it is possible to quickly narrow down your choices and build an effective, low-cost portfolio of exchange-traded funds. The core approach illustrated here allows you to build a portfolio that requires very little time and energy to manage, is relatively low cost, and yet provides substantial diversification.

    It can be used with portfolios of any size, from the very modest to the largest.

    And the core provides you with the flexibility to add to it if a fund, approach or sector strikes your fancy, without putting your portfolio at substantial risk should your “fancy” turn into a “flop.”

→ Maria Crawford Scott