ETF Investing Guide: Understanding The Core Portfolio

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 |  Includes: DBC, IEFA, IEMG, IJH, LQD, PLW, SCHP, VNQ, VOO, VTWO
by: David Jackson

Important note: As the ETF space continues to expand and expense ratios continue to fall, it is necessary to revise which funds belong in the Core ETF Portfolio. This portfolio was most recently revised on December 17, 2014.

OK, now the rationale for the core portfolio.

First, we cover the US stock market. You could do this by buying a single “total market” ETF index fund, such as the iShares Dow Jones U.S. ETF (NYSEARCA:IYY), or the iShares Russell 3000 ETF (NYSEARCA:IWV). Alternatively, you could buy three separate funds that split the US market into large company stocks, mid-cap stocks and small cap stocks. Standard & Poor splits the US market into the S&P 500 (large cap), S&P Mid-cap 400, and the S&P Small-cap 600. iShares, SSgA and Vanguard each offer ETFs that track these indexes separately. Russell splits the US market into the Russell 1000 (large and mid-cap) and the Russell Russell 2000 Index (small cap). iShares, SSgA and Vanguard each offer ETFs that track these indexes.

There are two major advantages to buying funds that split the US stock market into market cap groupings versus buying a single total market index fund:

  1. The US stock market, when weighted by company size, is dominated by large companies. So a total market fund is dominated by large cap companies. By splitting the market into two or three, you can increase your exposure to small and medium sized companies. Why might you want to do this? Historical data suggest that small company stocks, while riskier, appreciate more over time. If you divide your US stock allocation into one third large cap, one third mid cap, and one third small cap companies - effectively over-weighting small and medium companies relative to their actual share of the market by value - you may reasonably expect greater long term appreciation than if you buy a total market fund.
  2. Building greater granularity into your portfolio provides more opportunities for rebalancing. Portfolio rebalancing is discussed in the next chapter, The Low-Maintenance ETF Portfolio.

Which split of the market - the S&P split or the Russell split - should you adopt? Both have advantages. The Russell split has the advantage that it offers greater diversification by covering more stocks: 1000 large and mid-cap stocks (the Russell 1000) and 2000 small cap stocks (the Russell 2000) versus S&P’s 900 large and mid-cap stocks (the S&P 500 and the S&P Mid-cap 400) and 600 small cap stocks (the S&P Small-cap 600). Also, the Russell split may be better for taxable accounts, as the Russell 1000 fund doesn’t need to sell stocks (and realize capital gains) if they graduate from mid-cap to large cap status, whereas the S&P Mid-cap 400 index fund will sell stocks if they are promoted to the S&P 500 (large cap) index. On the other hand, you’ll pay slightly lower expenses with the S&P split due to the lower expense ratio on the S&P 500 Index fund. And the S&P split allows you to chose different weightings for large, medium and small stocks, whereas the Russell split only allows you to chose two weightings: large plus medium stocks, and small stocks.

My personal preference is to mix the two: buy the S&P 500 and Mid-cap 400 to cover large and mid-caps, and the Russell 2000 to cover small caps. That way you get the flexibility of choosing your weighting for large, mid- and small-cap stocks (which you can’t do with the Russell 1000), but also the greater breadth of the Russell 2000 versus the S&P Small-cap 600. And you also get the lower expense ratio of the Vanguard S&P 500 ETF (NYSEARCA:VOO) at just 0.05%. The downside to this is that 100 companies included in the Russell 1000 are excluded from the S&P 500 and 400, so you don’t get the same total market coverage as you do with just the Russell indexes.

So your US stock exposure will consist of three index ETFs: two S&P indexes ((VOO) and (NYSEARCA:IJH)) and the Russell 2000 index (NASDAQ:VTWO).

If you’re used to owning many mutual funds, you may be concerned by the small number of US stock funds in this portfolio. Don’t be. Between them, the three funds cover the entire US stock market and provide better diversification than any set of actively managed US stock mutual funds. And the fact that you can purchase the entire US stock market with only three trades - many of which are offered commission-free via your deep-discount broker - keeps your costs down.

Next, we add two foreign stock funds: the iShares Core MSCI EAFE ETF (NYSEARCA:IEFA), and the iShares Core MSCI Emerging Markets ETF (NYSEARCA:IEMG). These foreign index funds now have expense ratios on par with U.S. equity funds (0.12% and 0.18% respectively). And they provide excellent diversification across foreign large, mid and small cap stocks with more than 4,300 holdings between them.

Next, we add bond index funds. You can cover corporate and government bonds with just three funds: iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD), the PowerShares 1-30 Laddered Treasury Portfolio ETF (NYSEARCA:PLW) and the Schwab U.S. TIPS ETF (NYSEARCA:SCHP). These funds are broad bond indexes with low annual expense ratios.

A quick note on bonds. The cheapest way to buy individual US Treasury bonds (no fees at all!) is at Treasury Direct from the US Treasury. The disadvantages of buying bonds direct through the US Treasury are (a) you buy individual bonds, and need to replace them when they reach maturity (more work); and (b) you need to set up a separate account with Treasury Direct, which makes asset allocation and rebalancing harder.

Next, we add real estate. There are multiple broad U.S. REIT ETFs currently available. We’ll chose the index fund with the combination of the lowest expense ratio and the most holdings: Vanguard REIT Index ETF (NYSEARCA:VNQ).

Finally, we add some broad commodities exposure via PowerShares DB Commodity Index Tracking ETF (NYSEARCA:DBC). While not the cheapest broad commodities ETF available, DBC offers three distinct advantages over competing funds: 1) It is roll-yield optimized meaning its underlying index isn't limited to front-month contracts and is designed to roll into the cheapest available futures contract 2) DBC is the most liquid of all the broad commodities funds meaning it trades with the tightest spreads 3) DBC caps its energy allocation at 60%, ensuring a more diversified approach.

That’s it! You have a list of 10 index ETFs from which to construct an ultra-low cost, diversified portfolio. Three index funds cover the US stock market, two funds cover non-US stocks, three index funds cover the bond market, and one each cover the real estate market (via REITs) and commodities. And if 10 ETFs are too much for you, don't despair: in the next chapter, you'll find a portfolio for low-maintenance investors.

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