The Penny-Pincher's All-ETF Portfolio

By Murray Coleman

A lot of pundits are telling you to start bottom-fishing for stocks. That might be true since many blue-chip companies are trading at ridiculously low valuations.

But such short-term moves can be difficult to turn into long-term gains. Instead of focusing on trying to time markets, another strategy might be to put your portfolio's fee schedule under the same microscope as its returns.

The average mutual fund's expense ratio now is 1.24%, according to Morningstar. That means for every $100,000 you've set aside, you're forking over $1,240 a year in administrative-related fees.

So let's do some penny-pinching. You can easily set up a portfolio of exchange-traded funds that would come with a total expense ratio of 0.12% to own. Such a miserly basket of 60% stocks and 40% bonds would set you back $120 per every $100,000 invested. And it'd be widely diversified with plenty of room to grow through nine different funds.

The Penny-Pincher's All-ETF Portfolio

ETF	Symbol	ER %	Category	Weight %	YTD Return %
Vanguard Total Stock Market	VTI	0.07	U.S. Large-Cap	10	-6.91
Vanguard Value	VTV	0.10	U.S. Large Value	10	-10.79
Vanguard Small Cap Value	VBR	0.11	U.S. SC Value	10	-11.75
iShares EAFE Small Cap	SCZ	0.40	Int'l Dev. SC	5	-10.07
Vanguard European Stock	VGK	0.11	Int'l Dev. LC	10	-11.89
Vanguard Pacific Stock	VPL	0.11	Int'l Dev. LC	10	-10.93
Vanguard Emerging Markets	VWO	0.25	Int'l Emerging	5	-6.92
Vanguard Total Bond Market	BND	0.11	U.S. Bonds	30	-3.13
Vanguard Short-Term Bond	BSV	0.11	U.S. Bonds	10	-1.58

But it's important to realize what such a portfolio doesn't include. As a confirmed penny-pincher, you've got to just say no to high-priced funds.

For example, it certainly might be advantageous in the long term to include an international small-cap value ETF. And since the iShares EAFE Small Cap Index (NYSE: SCZ) provides only developed markets exposure, it might be nice to have a bit of emerging markets coverage to juice returns down the road.

But you're going to start really paying up for those types of features. (In an earlier Long Road column, we studied low-cost foreign small-cap alternatives. See the story here.)

It's like buying a car—you've got to walk into the showroom knowing how much is enough. Stick with the basic features needed and stick to a set allocation plan, which is what will drive a majority of your returns over time.

(A side note: Vanguard has a new FTSE All-World ex-US Small-Cap Index ETF set to launch soon. It will provide exposure for both emerging and developed markets and come slightly cheaper than SCZ. See related story here.)

With pure small-cap value ETFs starting at around 0.60%, a more cost-conscious strategy might be to get most of your exposure to that style of stock in the U.S. The price differences are startling. The Vanguard Small Cap Value ETF (NYSE: VBR) comes with a much easier-to-swallow 0.11% expense ratio—a fifth the cost of its closest foreign rivals. In order to remain diversified, a true penny-pincher would dabble in small-cap stocks overseas without going overboard.

A Globally Diversified Approach

Still, you'll notice the Penny-Pincher's Portfolio is equally split in its stock allocations between domestic and international weightings. Although there are some bargain-basement ETFs that fold coverage of non-U.S. developed markets under one umbrella, you're still paying more for such conveniences. By splitting your large-cap international exposure into a pair of separate ETFs, you can actually shave expenses.

Another nice result of going with two instead of one in developed foreign markets is that you have some added flexibility. Funds tracking the widely followed MSCI EAFE index had 65.7% devoted to Europe and 34.3% to Pacific markets heading into 2009. In the Penny-Pincher's Portfolio, half of the amount allocated to international large-cap developed markets goes to the Vanguard European Stock ETF (NYSE: VGK). The rest goes to its sister Pacific Stock ETF (NYSE: VPL).

The result is that Asia is overweighted in this model portfolio. But since both VGK and VPL cost the same, you can easily tweak weightings to more closely track broad market-cap-sized indexes such as the EAFE.

The portfolio also doesn't hold specific funds focusing on mid-cap stocks. That's due to the fact that the Vanguard Total Stock Market ETF (NYSE: VTI) covers the entire U.S. spectrum. Although it's mainly weighted in large-caps, it holds a notable contingent (about 20%) of mid-caps as well. Small-caps are also provided, although at levels (around 10%) some might feel could be spruced up a bit.

And as a so-called blend fund, VTI's smaller names are spiced liberally with more growth-oriented small-cap stocks. Allocating another 10% to VBR creates a nice style mix that also tilts the entire portfolio to the value side, which over the long term has shown a tendency to help improve overall returns.

Other Slicing & Dicing Options

Along those lines, you can also add some Vanguard Value ETF (NYSE: VTV). In the downturn of 2000-2002, it didn't fall quite as hard as VTI, which holds both growth and value stocks.

Of course, value has been slammed during the current credit crunch. So you could nix VTV and just go with VTI, which would save even more in expenses. And if you wanted to go more middle-of-the-road with small-caps, the Vanguard Small-Cap ETF (NYSE: VB) offers a blended approach with an expense ratio of 0.10%.

The Penny-Pincher's Portfolio won't be for everyone. It requires a level of comfort with using a total markets approach to gain broad coverage to niches such as mining, real estate investment trusts and companies exposed to commodities. Buying specialized funds to overweight sectors isn't in the game plan.

It's certainly not something to be taken carte blanche without consulting an adviser or some other knowledgeable investor you know and trust. The Penny-Pincher's Portfolio is being presented here as a building block to show what's possible.

And remember that in past Long Road columns, we've explored discount brokerages now offering transaction-free trading in ETFs. We've also written about several others now charging pennies on the dollar in commissions to buy ETFs.

The bottom line is that no matter how you choose to do it, pinching pennies in these tough economic times should be a no-brainer.

Comments

[Larry House:]

"Low valuations"--give me a break! You have to have a good idea of what a company IS GOING to earn to know if the valuation is low! We have no idea what earnings will be over the next year and further out. Is the action in blue-chip GE what your are talking about? "Valuation" is not nearly as clear as you make it sound.

Feb 05 04:15 PM

[Stephen Webb:]

True that strategies providing low expense ratios are appealing in tough economic times. But given the current high levels of correlation between securities, both across the market and within asset classes, I'm not sure I'd be pouring money into a diversified basket of stocks that track an index at the moment.

Don't get me wrong, I'm an advocate for frugality minded investing, but is now the time to be trumpeting strategic allocations because of their expenses?

Feb 05 04:50 PM

[Owen:]

The one constant common to both bull and bear markets are the frictional costs. They seem insignificant when the market shoots up, and meaningless when the market crashes. But over time, these costs can make a larger impact on overall returns than, say, choosing value versus growth or US equity versus European.

Unless you can see the future, minimizing costs is the best general advice. Good article!

Feb 05 05:26 PM

[dieuwer:]

Buy physical gold and store it under your pillow. Expense ratio: 0%.

Feb 05 08:51 PM

[PROXIMO:]

Penny-pinching is a moot point if you are on the wrong side of this market. Overwhelming evidence indicates that it is the worst in many years with much more trouble likely ahead.

Feb 05 11:50 PM

[Hedged In:]

This is a useful article -- well written, good data, interesting thesis. Thank you, Murray -- it's appreciated.

The issue for investors is whether the indexing matra -- low costs, asset allocation, don't try to time the market -- works. Not in the sense that you'd do better picking individual stocks or expensive mutual funds, but in the sense that you might have done a lot better staying out of the market.

For that reason, an investor needs to combine a low cost portfolio with rigorous work on asset class pricing or some other approach to market timing. I'm not sure your assertion that some asset classes are "bargains" is convincing -- your expertise (which I admire) is clearly in index fund selection more than asset class pricing.

More rigorous work on asset class pricing would give investors an indicator of when to enter the market with this sort of portfolio.

Feb 06 07:29 AM

[AndrewBaker:]

I agree that costs of some investments hurt the return a lot: mutual funds, especially the specialist ones, do reduce the real return from that of the underlying; but it is just as important to select your holdings appropriately, and I don't think that right now index tracking ETF - unless short, lol - are the ones to hold. Good point though made on charges: all investors need to keep these in mind.

Feb 06 01:37 PM

[donzelion:]

For a pure penny pincher, buying one ETF instead of two wherever possible makes sense. Hence, I prefer Vanguard Europe + Asia (VEA) to VGK + VPL. If Asia starts pulling away from Europe, then the MSCI index itself will start to rebalance, right?

And why buy both VTI + VTV? Unless you want to double up on value stocks (in which case, I'd prefer VTI + a handful of choice purchases of direct equities).

As for Stephen Webb - why buy index funds now? Well, unless you're convinced the market is heading for Armageddon, now seems like a much better time to buy than 2006 or 2007.

Feb 07 07:19 AM

[Scott's Inv...:]

Wow, IndexUniverse doesn't let us down again! The only two things they are capable of discussing are expenses (important) and diversification (very important). But those two things combined do not maximize a portfolios risk adjusted returns. Increasing research (and of course the experience of 2008) has shown that we cannot rely on traditional diversification and low expenses, especially when all correlations between asset classes go to one. IndexUniverse seems to have selective amnesia when it comes to 'black swan' years like 2008. I for one think momentum based moving average strategies are a third element critical to reducing risk while not sacrificing nominal returns (for more research on the topic checkout Mebane Faber, Tom Lydon, etc.)

Feb 11 08:58 AM