The Young Investor's Model Portfolio: Getting Started With ETFs

by: Morningstar

By Abby Woodham

Investing can be a daunting prospect for a novice, but it doesn't have to be. Exchange-traded funds are straightforward, comprehensive products that can help simplify the investing process for the uninitiated, particularly those in their twenties who have aftertax investable assets for the first time, perhaps from diligent savings or from a year-end bonus. While retirement accounts (401(k), Roth IRA) have their merits, we recommend young investors hold some money in a taxable brokerage account to keep it accessible for potential large expenses, like buying a house or going to grad school. This article explores how new investors can use ETFs to create a balanced portfolio without stress or confusion. We'll discuss what a target asset allocation should be, and how it can be implemented using ETFs on various trading platforms.

Laying the Groundwork
When starting out, new investors should follow two important rules of thumb: keep it cheap, and keep it simple. With a relatively small amount of money to invest, every penny you keep after expenses counts. There's no need to pay a high expense ratio and no reason to rack up costly commissions from your broker by frequently trading stocks. Multiple studies by Morningstar have shown that a fund's expense ratio is a reliable predictor of future success. For the cost-conscious investor, ETFs are the perfect vehicle: on average, ETFs charge a lower expense ratio than mutual funds, and none of the ETFs recommended in our model portfolio cost more than 0.20% a year. At that price, a $5,000 investment would incur $9 in annual fees.

Our model portfolios for young investors involve just four or five ETFs, and all are index products. The basic argument for index investing is that the average person is not a masterful stock picker and unlikely to beat the market. Instead of trying to pick winners, investors can purchase funds that track indexes covering a broad range of companies within an asset class--such as domestic equities, international equities, or bonds. Most ETFs fall into this "passive" indexing category, allowing investors to buy comprehensive and diversified swaths of the market in a single package.

The Model Portfolio
Appropriate asset allocation is another important component of good investment practices. Investors allocate a specific percentage of their portfolio to each asset class and maintain that percentage through regular rebalancing--this helps prevent investors from selling positions during a down period. Regular rebalancing moves capital from asset classes that have done well into asset classes that have done poorly--in other words, buying low and selling high. Asset diversification also reduces the risk of a large loss by spreading capital across different sectors.

These portfolios are appropriate for a holding period of at least 10 years. Research by Morningstar indicates that investors with an expected 50 or more years until retirement should allocate aggressively to equity: 95% stock and no more than 5% in bonds. As investors come closer to retirement age, their portfolio should incorporate more fixed income and inflation hedges. Young investors can take on more risk because they have time to ride out market volatility and downswings.

We selected three different brokerage accounts and created a model portfolio for each that executes the target asset allocation as cheaply as possible. The portfolios below are extremely simple and inexpensive, but powerful. Forty-five percent has been allocated to a core United States equity ETF: Vanguard Total Stock Market ETF (NYSEARCA:VTI), Schwab U.S. Broad Market ETF (NYSEARCA:SCHB), or iShares Russell 3000 Index (NYSEARCA:IWV). These ETFs replicate the entire U.S. stock market and offer broad coverage by owning over 2,000 stocks, about 20% of which are mid-cap stocks and 9% small- and micro-cap firms. Historically, these ETFs have been slightly more volatile than the S&P 500 but outperformed by about 0.5% a year. We've also allocated 10% to U.S. dividend funds: Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) or Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD). VIG buys stocks that have increased their dividends in each of the last 10 years, and its index also uses a variety of proprietary screens to weed out less-desirable companies. SCHD is a younger and smaller fund that uses a similar methodology. We've included these dividend-focused ETFs because the rationale behind dividend investing is rigorously supported by research. From 1900 to 2010, almost 70% of the U.S. stock market's real growth came from dividends, and there's a strong correlation between high dividend payouts and future earnings growth. VIG and SCHD allow investors to buy quality companies at a very low cost.

International equity's 40% allocation is represented by Vanguard FTSE All-World ex-US ETF (NYSEARCA:VEU), or a combination of Schwab International Equity ETF (NYSEARCA:SCHF) and Schwab Emerging Markets Equity ETF (NYSEARCA:SCHE). VEU tracks stocks from 46 countries in the developed world (excluding the U.S.) and emerging markets. SCHF only includes the developed world, so we've added SCHE.

Rounding out the portfolios is a 5% allocation to the aggregate U.S. bond market. Vanguard Total Bond Market ETF (NYSEARCA:BND), Schwab US Aggregate Bond ETF (NYSEARCA:SCHZ), and iShares Core Total US Bond Market ETF (NYSEARCA:AGG) have performed almost identically over time.

Keeping costs low also means picking your broker carefully. Many brokers offer commission-free trades of some ETFs, but not all. Every ETF we've selected trades commission-free on its respective platform.

Vanguard offers over 60 ETFs, and investors with Vanguard brokerage accounts can trade them all commission-free. For any other securities, the commission is $7 for the first 25 trades, and $20 after. Vanguard's brokerage account is not appropriate for investors who plan to frequently trade outside the firm's family of funds.

Schwab offers its 15 proprietary ETFs commission-free, as well as over 100 ETFs from other providers. Other trades cost $8.95. Because Schwab's ETFs are newer, they haven't had years to grow in size like their competitors. The Schwab portfolio's weighted annual cost is the cheapest, at a rock-bottom 0.079%.

TD Ameritrade lets investors buy 101 ETFs from various providers without commission. All other trades cost $9.99, which is the most expensive fee of the group. If you expect to branch out beyond the model portfolio, particularly to buy individual equities, this account may prove expensive.

Because your ETFs will trade commission-free, you can rebalance quarterly without incurring additional charges. Remember to not sell out of your position if the market enters a down period--you have ample time to wait out the volatility. Happy investing!

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.