Considering ETF Diversification

By Gregory S. Davis | September 01, 2009 AAA

Investors at the beginning of their journey towards building an investment portfolio are sometimes confused about where and how to begin. While mutual funds are often a good place to start, investors should also consider large exchange-traded funds (ETFs) as an option for building the foundation of their portfolio. Let's take a look at a couple of the largest ETFs, in terms of assets under management, that an investor can use to build their foundation. (For a quick refresher, check out Introduction To Exchange-Traded Funds)
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Why does size matter?
Size and safety are not necessarily synonymous, but ETFs with a large amount of assets offer a level of security for investors. The first benefit is the diversification offered by large ETFs like the SPDRs S&P 500 Index ETF (NYSE:SPY) and the MSCI EAFE Index ETF (NYSE:EFA) with $74 billion and $33 billion in assets respectively. The second benefit is in terms of liquidity, which just means how easily an investor will be able to get in (buy) our get out (sell) of a position in and ETF fund. The third benefit is stability. ETFs with $200 million or more in assets are less likely to close which could otherwise cause investors to reshuffle their portfolio.

What about expenses?
ETF benefits include tax efficiency, the flexibility of trading like a stock and the gift of lower annual expenses. While the average annual expense ratio for a mutual fund is 1.5%, the typical ETF expense ratio tends to be below 1%. Low cost mutual fund providers like the Vanguard Funds offer funds like its Vanguard 500 Index Investor fund with a low expense ratio of 0.16%, in comparison to the SPY ETF with its expense ratio of 0.09%. (For more, see Using ETFs To Build A Cost-Effective Portfolio.)

What about safety?
We have briefly covered a large cap core position using SPY and an international position with EFA. Investors looking for more safety than growth can consider large fixed-income offerings like the iShares TIPS Bond (NYSE:TIP), the iShares Barclays 1-3 Year Treasury Bond (NYSE:SHY) or the iShares iBoxx $ Investment Grade Corporate Bond (NYSE:LQD), which have $15 billion, $7.2 billion and $12.9 billion respectively in assets. Each of these offerings covers a different slice of the fixed income pie. TIP offers inflation protection, SHY offers exposure to treasuries with short terms to maturity, which typically do well during periods of inflation, and LQD offers exposure to the corporate debt of large U.S.-based firms like American Express (NYSE:AXP), IBM (NYSE:IBM) and Wells Fargo (NYSE:WFC).

Final Thoughts
The biggest obstacle investors may have with delving into ETFs is gaining comfort with exactly how the investment vehicles work. Investors have the option of poring over the prospectus of their various ETF investment options in order to gain a level of comfort, or consulting with an investment professional.

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