By Michael Iachini, Vice President, Head of Manager Research for Charles Schwab Investment Advisory.

Three ways to build an all ETF portfolio

There are plenty of advantages in using 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.

But it’s equally possible to build a complete portfolio out of nothing but ETFs, which in most cases track indexes.

How can you tell if an all-ETF portfolio makes sense for you? For the most part, it comes down to what your goals are—and your preferences.

As a rule, ETFs generally provide excellent diversification at a low ongoing expense since they’re passive index funds that track a certain benchmark. Because of this, they also offer good transparency—it’s easy 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 ETFs may be a straightforward yet flexible solution worth a closer look.

There are some trade-offs to think through. An all-ETF portfolio means giving up actively managed mutual funds, which have the potential to outperform index ETFs through professional selection of stocks and bonds.

And you’ll also leave behind the control that comes with a portfolio composed solely of individual securities you have selected. Some people won’t want to give these things up, even though these approaches have specific disadvantages as well.

A portfolio of index mutual funds, meanwhile, would be very similar to an all-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.

If you think an all-ETF portfolio might suit you, here are three ways to build one, ranging from ultra-simple to very fine-tuned.

Keeping it simple

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
• A total bond market ETF

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 Index (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, and 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 April 30, 2019, MSCI ACWI had about 55% in US stocks and 45% in non-US stocks, according to Morgan Stanley Capital International. If you prefer to have a larger allocation to US stocks, for example, 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 bonds (also known as 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-ETF portfolio would consist of about ten 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, and 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, and 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 offers neither 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, and 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, and base metals.

Real estate ETFs can be added to the portfolio and could even be split into US and global.

With the fine-tuned portfolio, it’s unlikely that you would want to hold every possible ETF at the same time. For instance, rather than holding allocations to all 11 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.

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.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)