Exchange traded funds (ETFs), or baskets of assets that trade on an exchange like a stock, could be the greatest market invention since its inception. Their tax efficiency, low operating costs and transparency of ownership make ETFs one of the best investment vehicles out there for both institutional and retail investors.
ETFs are designed to track indexes around a "theme", whether it be something simple like small-capitalization companies through the Vanguard Small Cap ETF (NYSE:VB) or complex like solar stocks via the Claymore Global Solar Energy (NYSE:TAN). These funds allow small and large investors the ability to make short- or long-term tactical bets on these themes. However, the recent ETF boom cycle has led to the production of many esoteric and narrowly-focused funds. For every great idea, like giving investors exposure to various emerging markets, there have been plenty of missteps. I'm not sure why anyone would need an index that is designed to track the performance of the 50 securities that are next in line to replace the stocks currently included in the NASDAQ-100, which is what the PowerShares NXQ (NASDAQ: PNXQ) does.
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Keeping It Simple
The truth is that most investors over-complicate their investments. A study by Boston investment firm Dalbar concluded that from 1984 to 2002, when the S&P 500 Index (NYSE:SPY) grew at an annual rate of 12.2%, individual investors in equity mutual funds only saw average returns of 2.6% a year. This is before taxes. Add this to market timing, the failure to diversify and investors buying high and selling low, and you have a recipe for mediocrity. However, it is possible to create a quality portfolio using ETFs as a great core for your portfolio. This will also provide much need asset allocation and diversification.
Creating the Core
Vanguard's Total Stock Market ETF (NYSE:VTI) tracks the Wilshire 5000, the broadest of the U.S.-based stock indexes, covering nearly 6500 different companies made up of large, mid and small caps. Using it in a portfolio is like buying the entire United States stock market in one shot. The fund charges a minuscule expense ratio of 0.09% and currently yields 1.85%.
Adding the Vanguard Europe Pacific ETF (NYSE: VEA) gives the portfolio exposure to the developed nations of Europe, Australia and the Far East. The fund holds 943 different foreign stocks across nearly 25 different nations. This includes mining giant BHP Billiton (NYSE: BHP) and Spanish bank Banco Santander (NYSE: STD). The fund charges 0.16% in expenses.
Diving into Bonds
Vanguard steps up the plate again with Total Bond Market Fund (NYSE: BND). This fund tracks the price and yield performance of the total U.S. investment grade bond market. This includes Treasuries, Corporate and Agency IOUs. The fund has an average yield to maturity of 3.5% and bond duration of 6.5 years for its nearly 3200 different holdings. Credit quality is good at an AA1 average rating and Vanguard again beats iShares on expenses with 0.14%
Adding the Spicy Stuff
One of more important things for investors to have in their portfolios is exposure to commodities. Commodities can provide low correlation and inflation protection versus other assets. However, with recent regulation by the Commodity Futures Trading Commission involving several high profile futures ETFs and their holdings, it may be in investors' best interests to invest in stocks that produce these basic materials. While some of the correlation is lost, these stocks tend to do well in tracking the commodities they produce. The iShares S&P North American Natural Resources (NYSE: IGE) is a good proxy for this market. The fund contains 125 of the largest energy, mining and forestry products companies located within the United States and Canada. The fund charges 0.48% in expenses.
Real estate is typically a low-correlated and high-yielding asset class. Investors can use the Vanguard REIT ETF (NYSE: VNQ), a mirror image of its open-ended sister, to gain access to that sector. The fund holds 97 of the largest domestic real estate investment trusts (REITs). Again, expenses are a low 0.15%.
ETFs have come a long way since their invention in the early '90s. However, the more things change, the more they stay the same. ETFs still provide their best benefits when following a broad-based indexing strategy. The above basic portfolio can provide a good low-cost core that can be used by both beginning investors and experienced ones. (For more on ETFs, see ETFs vs Index Funds: Quantifying The Differences.)
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