The big picture
I’m sometimes asked about investing with exchange traded funds (ETFs), one of the most popular investing formats. ETFs, for all intents and purposes, are just collections of individual assets bundled together under one ticker. They can be almost anything you might want to invest in – stocks, bonds, commodities, real estate or other things – but as the name suggests, in a format you can trade on an exchange just like a stock. This makes it easy to build a broadly diversified portfolio with just a handful of positions. In this post I’ll focus on ETFs available in the United States appropriate for American investors.
For example a US investor can build a virtually complete and balanced portfolio using only three funds. It can be used by itself or as a template for a more detailed portfolio. The three funds are VT, GOVT and IAU.
VT is the Vanguard Total World Stock fund. It’s the single most complete and diversified stock fund I know of. It currently holds over nine thousand stocks from around the world, all of them except the smallest and least liquid microcaps. Almost every other common stock ETF is effectively a subset of VT.
GOVT is the iShares US Treasury Bond fund. This fund is iShare’s broadest such offering, covering the range of maturities from one to thirty years.
IAU is the iShares Gold fund. It invests in gold bullion.
It’s remarkable that building a complete and balanced portfolio can be this easy. The only serious thought most investors following this template need give to their portfolios is what proportions or weights to give to each asset class. This is discussed more fully elsewhere, but is a combination of individual circumstances and goals as well as long term market expectations, and in my case, the medium term outlook from our Market Analysis section.
A more selective approach to stocks
At this point in financial history there are good reasons to consider something more nuanced. Financial assets are historically overvalued and unlikely to provide future returns resembling the past. US stocks are more overvalued than the rest of the world, near their highest levels ever. Fortunately some are less so than others, raising the possibility that a somewhat more selective approach can improve the risk-return proposition.
So as a first step we divide the field covered by VT into its US and non-US parts. This can be done with Vanguard’s VTI and VXUS. Then we replace VTI with three more specialized ETFs, so that some or all of VT has been replaced by the following:
DTD – WisdomTree US Total Dividend Fund
VFQY – Vanguard Quality Factor Fund
VFVA – Vanguard Value Factor Fund
VXUS – Vanguard World exUS Stock Fund
DTD is essentially the entire US stock market, except instead of weighting by market cap (size), it weighs by total dividends. Not to be confused dividend yield – instead it’s the total dollar volume of dividends – a sort of hybrid of market cap and yield.
VFQY and VFVA help broaden this out with a large selection of smaller names and a quality and value orientation. I like that the quality fund has a bit of a value tilt and the value fund a bit of a quality tilt. They’re actively managed, yet sport Vanguard’s trademark ultralow expenses.
Half of the stock allocation is divided among the above three US stock funds, with the other ex-US half covered by the appropriately tickered VXUS. To maintain a market-like balance of large, medium and small cap stocks, DTD should have at least the weighting of VFQY and VFVA combined.
Some or all of the VT allocation of our original three fund template is replaced by these four ETFs. What this does is maintain very broad diversification while reducing exposure to non-dividend-paying giants and low quality or overvalued stocks.
We can extend the same principle to further refine the non-US part of the stock allocation. Unfortunately there are no exUS analogs of VFQY and VFVA, but working within that limitation, here we replace part of the VXUS allocation with the following:
IQDF – FlexShares International Quality Dividend Fund
DNL – WisdomTree International Dividend Growth Fund
VSS – Vanguard FTSE All World exUS Small Cap Stock Fund
What about proportions? There is room for personal preference on this front, but to maintain as much of the benefit of broad coverage and market cap weighted correlation while underweighting the most overvalued stocks, the following can be used as a guide. We also add the US analog of IQDF. Note these are not portions of the entire portfolio but portions of the stock allocation you’ve already chosen, less any amount allocated to VT.
DTD – 48
DNL – 12
QDF – 12
IQDF – 48
VFQY – 18
VFVA – 18
VSS – 4
VXUS – 32
These proportions allocate half to US stocks and half to the rest of the world, and also maintain a market-like capitalization distribution.
Treasuries, commodities and real estate
Next, let’s take a closer look at the Treasury allocation. GOVT allocates the entire Treasury market over one year in maturity according to market weight. Some investors may want to allocate across the yield curve differently. For this purpose USD (cash) can be used in conjunction with four Vanguard Treasury ETFs.
USD – Cash
VGSH – Vanguard Short Term Treasury Fund
VGIT – Vanguard Intermediate Treasury Fund
VGLT – Vanguard Long Term Treasury Fund
EDV – Vanguard Extended Duration Treasury Fund
By adjusting the weightings of these five assets, duration can be allocated anywhere from zero (cash) to decades (EDV). Synthetic Systems forecasts come in handy for this.
The commodities allocation can be further refined by replacing IAU with a combination of four ETFs.
CPER – United States Copper Fund
IAU – iShares Gold Fund
SLV – iShares Silver Fund
PLTM – GraniteShares Platinum Fund
Before substantially diversifying metals beyond gold, however, investors should review my earlier post The Impermanent Portfolio, where we statistically analyzed how the asset classes interact. Because in a portfolio with stocks and bonds non-gold metals have historically provided little to no additional diversification benefit, in most cases I suggest positions in these other metals be kept small in comparison to gold.
The stock funds listed above include publicly listed real estate. Investors who own their own homes usually need no further realty exposure. Those who don’t should consider adding some through realty funds such as Vanguard’s VNQ and VNQI or through more specialized realty funds or individual real estate securities.
Finally, to maintain target asset class allocations, the amount allocated to funds should be adjusted to account for any corresponding individual positions.