Investors regularly mix and match exchange-traded funds (or ETFs) with mutual funds and individual stocks and bonds in their accounts. But it's possible to build a well-diversified portfolio completely from ETFs.
While the trading costs associated with ETFs can be a drawback, compared to mutual funds, especially for smaller investments, ETFs offer their own benefits.
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.
On the simple side, if you want a balanced, diversified portfolio of stocks and bonds, you can get it with just two ETFs: a total world stock market ETF and a total bond market ETF.
For instance, if you're seeking a moderate level of risk, you could consider putting 60% of your portfolio in an all-world stock index ETF and 40% in a core bond ETF.
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, using just two ETFs can help keep your trading costs low.
One disadvantage of this portfolio is that you can’t really dial in on specific segments of the markets. For instance, many global stock ETFs are evenly balanced between U.S. equities and the rest of the world.
If you prefer to have a larger allocation to U.S. stocks than international stocks, you might want two separate stock ETFs. The two-ETF approach also lacks any allocation to certain parts of the bond market, not to mention other asset classes, such as commodities and real estate. Still, if simplicity is what you seek, the two-ETF portfolio is worth considering.
A middle-of-the-road approach to an all-index ETF portfolio would consist of about eight to 10 ETFs. For stocks, you would include a large-cap U.S. ETF, a small-cap U.S. ETF, an international developed-market ETF and an emerging-market ETF.
For bonds, you might start with a core bond ETF and then add ETFs for TIPS, below-investment-grade bonds and international bonds.
The advantage of this portfolio is balance. It has enough ETFs to give you coverage of more asset classes, 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.
On the other end of the spectrum from an ultra-simple ETF portfolio is a fine-tuned portfolio with 20 or more ETFs. This could 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 further divides the various parts into thinner slices: U.S. stocks can be divided into sectors and industries, growth and value, or size categories including mid-cap and micro-cap.
International stocks can be expanded to include foreign small-cap stocks or individual countries.
The core bond index can be divided into Treasuries, agencies, mortgage-backed securities and corporate bonds, and the portfolio can be tilted toward long-term bonds or short-term bonds.
Commodity ETFs can be added and split into fine slices such as oil, gold, agriculture and base metals.
Real estate ETFs can be added and could even be split into U.S. and global.
The advantage of this portfolio is the ability to get almost exactly the exposure you want while still enjoying the diversification that ETFs offer. The disadvantages are more complexity, more trading costs, more tax issues, and more work for you to keep track of it all.
The key takeaway is that whether you're looking for super simplicity, extremely fine allocations or something in between, you can build just the portfolio you want out of ETFs.