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3 Ways to Build an All-Index ETF Portfolio

3 Ways to Build an All-Index ETF Portfolio

Key Points
  • An index ETF-only portfolio can be a straightforward yet flexible investment solution.

  • ETFs generally provide excellent diversification at a low ongoing expense, and transparency of investment holdings.

  • We explore three ways to build a portfolio completely out of index ETFs.

Regular readers know that I often talk about the advantages of using exchange-traded funds (ETFs) to fill gaps in an investment portfolio, and lots of investors mix and match ETFs with mutual funds and individual stocks and bonds in their accounts. However, it's equally possible to build a complete portfolio out of nothing but ETFs.

How can you tell if an all-index ETF portfolio makes sense for you? For the most part, it comes down to personal taste. As a rule, ETFs generally provide excellent diversification at a low ongoing expense, and transparency so it's much easier to see what stocks, bonds or other investments the ETF holds each day. If these are top characteristics you look for in your investments, owning nothing but index ETFs may be a straightforward yet flexible solution worth a closer look.

However, an all-index ETF portfolio means giving up actively managed mutual funds, which may outperform index ETFs through professional selection of stocks and bonds. And you'll also leave behind the control of a portfolio comprised solely of individual securities—each stock and bond you own is listed right there in your account. Of course, these approaches have their downsides as well (see the table below).

As for a portfolio of index mutual funds, it would be very similar to an all-index ETF portfolio with two main exceptions: ETFs trade differently than index mutual funds, and for certain niche asset classes you can find ETFs but very few or no index mutual funds.

Pros and cons of four types of portfolios relative to each other

Portfolio Pros Cons
Actively managed mutual funds
  • Professional active management
  • Potential to beat the index
  • Good diversification
  • Commission-free purchase/redemption available
  • Broadest selection of funds
  • Higher ongoing expenses
  • Possible underperformance
  • Least transparent
  • Higher portfolio turnover
Index mutual funds
  • Very good diversification
  • Low ongoing expense
  • Commission-free purchase/redemption available
  • Seeks to match index performance (minus fees and expenses)
  • Limited selection in certain asset classes
  • No active management
  • Limited potential to beat the index
All-Index ETF portfolio
  • Excellent diversification
  • Generally low ongoing expenses
  • Can keep it simple or customize a fine-tuned portfolio
  • Transparency at end of day
  • Trading flexibility
  • Limited commission-free trading generally possible
  • Seeks to match index performance (minus fees and expenses)
  • No active management
  • Trading commissions on most ETFs
  • No potential to beat the index
Individual stocks and bonds
  • No ongoing management expenses
  • Maximum control
  • Complete transparency
  • Higher transaction costs
  • Diversification is more difficult
  • No professional management
  • Generally, low liquidity (for individual bonds)

 

If you think an all-index ETF portfolio might suit you, here are three ways to build one, ranging from ultra-simple to very fine-tuned. The table at the end shows ETFs from the Schwab ETF Select List™ that correspond to the allocation categories and percentages to consider for each approach.

Keeping it simple

If you want a balanced, diversified portfolio of stocks and bonds, you can get it with just two ETFs:

For instance, if you're an investor seeking moderate risk and decide that you want 60% of your portfolio in stocks and 40% in bonds, you could consider purchasing an all-country stock index ETF and then combine it with a bond ETF. Many world stock market ETFs track the Morgan Stanley Capital International All Country World IndexSM (MSCI ACWI), which provides exposure to US stocks, developed-market international stocks and emerging-market international stocks.

Some bond ETFs track the broad Barclays US Aggregate Bond Index, which covers:

  • Treasury bonds
  • Government-agency bonds
  • Mortgage-backed bonds
  • Investment-grade corporate bonds
  • Some dollar-denominated international bonds

The advantage of this type of portfolio is its simplicity: one stock fund, one bond fund. It will be easy to see when you need to rebalance. Plus, because ETFs trade intraday and generally cost you a trading commission every time you buy or sell, a two-ETF portfolio can help keep your trading costs low.

One disadvantage of this portfolio is that it's not very fine-tuned. For instance, as of this writing, MSCI ACWI had about 49% in US stocks and 51% in non-US stocks, according to Morgan Stanley Capital International. If you prefer to have a larger allocation to US stocks than international stocks, you might want two separate stock ETFs.

Another drawback to this portfolio is that it lacks any allocation to Treasury Inflation Protected Securities (TIPS), sub-investment grade ("high-yield" or "junk") bonds and non-dollar-denominated international bonds, not to mention other asset classes such as commodities and real estate. Additional asset classes can help further diversify your portfolio. Still, if simplicity is what you seek, the two-ETF portfolio is an alternative worth considering.

Middle of the road

An intermediate approach to an all-index ETF portfolio would consist of about 10 ETFs, choosing commission-free ETFs when possible.

For stocks, you could have:

  • A large-cap US ETF
  • A small-cap US ETF
  • An international developed-market ETF
  • An emerging-market ETF

For bonds, you could start with the same core bond ETF described above and diversify further by including ETFs that invest in:

  • TIPS
  • Sub-investment grade ("high-yield" or "junk") bonds
  • International bonds

The advantage of this portfolio is balance. It has enough ETFs to give you coverage of more asset classes and the ability to adjust your portfolio weights in most areas, but not so many funds that it becomes too challenging to keep track. The disadvantage of this portfolio is that it doesn't offer maximum simplicity, nor maximum customizability.

Fine-tuning

On the other end of the spectrum from an ultra-simple ETF portfolio is a fine-tuned portfolio with 20 or more ETFs. This type of portfolio can make sense for investors who like to allocate their accounts toward exactly the parts of the market they expect to perform best.

This portfolio begins similarly to the middle-of-the-road ETF portfolio but then divides the various parts into thinner slices:

  • US large-cap stocks can be divided into sectors such as financials and health care, or even narrower industries such as banks and biotech.
  • The US stock allocation can further be divided to include mid-cap or micro-cap stocks, or styles such as growth and value.

The international stock allocation can be adjusted to include international small-cap stocks in regions such as Europe and Asia or in individual countries like Germany and China.

The core bond index can be broken into its components:

  • Treasuries
  • Agency-backed bonds
  • Mortgage-backed securities
  • Corporate bonds

The average maturity of the bonds in the portfolio can be fine-tuned to include more long-term bonds or short-term bonds.

Commodity ETFs can be added to the portfolios, and split into fine slices such as:

  • Oil
  • Gold
  • Agricultural Commodities
  • Base metals

Real estate ETFs can be added to the portfolio and could even be split into US and global real estate. With the fine-tuned portfolio, it's unlikely that you would hold every possible ETF at the same time. For instance, rather than holding allocations to all 10 stock sectors and every individual country possible, you would likely have core allocations to certain ETFs, and then add weight to the ETFs representing only those sectors or countries that appear most attractive to you.

The advantage of this portfolio is the ability to get almost exactly the exposure you want to each narrow piece of the market while still enjoying the diversification that ETFs offer over individual stocks and bonds. The disadvantages are complexity and trading costs. With so many ETFs in the portfolio, it's important to be able to keep track of what you own at all times. You could easily lose sight of your total allocation to stocks if you hold 13 different stock ETFs instead of one or even five. In addition, with so many ETFs in the portfolio and relatively more buying and selling, trading commissions could add up quickly. Whether you're looking for super simplicity, extremely fine allocations or something in between, you can build such a portfolio out of ETFs.

Example ETF Portfolios

By Nitin Barve

Here's a list of ETFs worthy of further consideration for each of the three all-index ETF portfolios mentioned. They are funds from Schwab's ETF Select List™ which correspond to the allocation categories, or other low-cost, high-quality ETFs in the case of categories that do not appear on the ETF Select List. Of course, you should carefully review each fund's prospectus to evaluate whether any of these funds or other ETFs are right for your portfolio and investment profile. Also, it's important to monitor and rebalance your portfolio from time to time.

For more allocations built on the "Middle of the Road" framework, consider Schwab ETF Portfolio Builder, a free online tool that provides asset allocation models from Conservative to Aggressive using Select List ETFs.

Simple All-Index ETF Portfolio (Moderate Risk Allocation)

Allocation Ticker Name Morningstar category Expense ratio1
60% VT Vanguard Total World Stock Index ETF World Stock 0.19%
35% SCHZ Schwab U.S. Aggregate Bond ETF Intermediate-Term Bond 0.05%
5% NA Cash NA NA

Middle-of-the-Road All-Index ETF Portfolio (Moderate Risk Allocation)

Allocation Ticker Name Morningstar category Expense ratio1
35% SCHX Schwab U.S. Large-Cap ETF Large Blend 0.04%
10% SCHA Schwab U.S. Small-Cap ETF Small Blend 0.08%
12% SCHF Schwab International Equity ETF Foreign Large Blend 0.09%
3% SCHE Schwab Emerging Markets Equity ETF Diversified Emerging Mkts 0.14%
23% SCHZ Schwab U.S. Aggregate Bond ETF Intermediate-Term Bond 0.05%
6% SCHP Schwab U.S. TIPS ETF Inflation-Protected Bond 0.07%
3% PHB PowerShares Fundamental High Yield Corporate Bond High Yield Bond 0.50%
3% BWX SPDR Barclays International Treasury Bond ETF World Bond 0.50%
5% NA Cash NA NA

Fine-Tuned All-Index ETF Portfolio (Moderate Risk Allocation)

Allocation Ticker Name Morningstar category Expense ratio1
22% SCHX Schwab U.S. Large-Cap ETF  Large Blend 0.04%
6% SCHA Schwab U.S. Small-Cap ETF  Small Blend 0.08%
1% IWC* iShares Russell Microcap Index Fund*  Small Blend 0.72%
17% SCHF Schwab International Equity ETF  Foreign Large Blend 0.09% 
3% VSS Vanguard FTSE All World ex-US Small Cap  Foreign Small/Mid Blend 0.25%
5% SCHE Schwab Emerging Markets Equity ETF  Diversified Emerging Mkts 0.14%
9% SCHR Schwab Intermediate-Term U.S. Treasury ETF  Intermediate Government 0.10%
2% AGZ* iShares Barclays Agency Bond Fund*  Intermediate Government 0.20%
4% VCIT Vanguard Intermediate-Term Corporate Bond Index ETF Intermediate-Term Bond  0.12% 
11% VMBS* Vanguard Mortgage-Backed Securities Index ETF*  Intermediate-Term Bond 0.12%
2% SCHP Schwab U.S. TIPS ETF  Inflation-Protected Bond 0.07%
1% PHB PowerShares Fundamental High Yield Corporate Bond High Yield Bond  0.50%
1% BWX SPDR Barclays International Treasury Bond ETF  World Bond 0.50% 
5% SCHH Schwab U.S. REIT ETF  Real Estate 0.07%
2% USL United States 12 Month Oil  Commodities Energy 0.84%
2% DBA PowerShares DB Agriculture Fund  Commodities Agriculture 0.85% 
1% SGOL ETFS Physical Swiss Gold Shares  Commodities Precious Metals 0.39%
1% DBB PowerShares DB Base Metals Fund  Commodities Industrial Metals 0.75%
5% NA Cash NA NA

 

1. Net expense ratios may reflect a cap on or a contractual waiver of fund expenses. This waiver could be discontinued. Please read the fund prospectus for details on limits or expiration dates for such waivers.

*Funds not from the Schwab ETF Select List.

Source: Charles Schwab Investment Advisory, Inc., as of February 28, 2014.

While participation in the Schwab ETF OneSource program is not a requirement for consideration for the ETF Select List™, cost of ownership is a significant component of the evaluation of ETFs for the ETF Select List. Therefore, ETFs in the Schwab ETF OneSource program will have an advantage over non-participating ETFs in making the ETF Select List, because the calculation used to evaluate ETFs for inclusion on the ETF Select List includes the cost of two online commissions (a buy and a sell). Commissions can add significantly to the cost of ownership, particularly for transactions in smaller amounts. Learn more about the selection criteria for Schwab OneSource ETFs™.

These portfolios are intended as examples only, not as specific recommendations.

No mention of particular funds or fund families here should be construed as a recommendation or considered an offer to sell or a solicitation of an offer to buy any securities. This information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The securities listed may not be suitable for everyone. Each investor needs to review a securities transaction for his or her own particular situation.

The funds for a category were selected based on total cost of ownership for a client who trades on schwab.com and invests $5,000 per ETF with a one-year holding period on each fund. The allocations are long-term, strategic allocations.

Next Steps

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