Simplify And Improve Your Investment Results - Set Up A Core ETF Portfolio

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Includes: DBC, IEFA, IEMG, IJH, LQD, PLW, SCHP, VNQ, VOO, VT, VTWO
by: Simply Investing

Summary

A core ETF portfolio is simple to set up and manage.

More importantly, a core ETF should outperform investing alternatives over time.

This article describes the benefits of a core ETF portfolio and the process to set one up.

The Seeking Alpha ETF Investing Guide

I recently reviewed the Seeking Alpha ETF Investing Guide which convinced me that most investors would benefit by following the advice in the guide. I decided to take the advice myself and set up a core ETF portfolio, similar to that suggested in the guide.

I previously wrote an article (links to previous articles are provided in the addendum to this article) which summarized, in four steps, the procedure required to implement the ETF investing guide:

  1. Decide on an asset allocation plan among the ETFs in the core portfolio
  2. Open an online brokerage account with a linked money market bank account
  3. Determine if you will invest everything at once, or over a period of time
  4. Determine which investments to buy in your taxable and tax-deferred accounts

This article focuses on the first of the four steps above, determining an allocation plan among the ETFs in the core ETF portfolio. I, like I believe most Seeking Alpha readers, have already completed the other three steps. For most readers, this first step is likely the only step required to prepare a core ETF portfolio.

Why set up a core ETF portfolio?

Investors should set up a core ETF portfolio because a core ETF portfolio is a simple way to organize your investments that will beat the return of most alternatives over time.

The four steps mentioned above should take as little as four hours to implement, even less time if you have already implemented some of them. Once set up, your core ETF portfolio should take as little as an hour a year to manage. Managing your portfolio requires simply taking tax losses and rebalancing once a year. Many investors will want to spend additional time researching alternatives and monitoring results but once the decision is made to implement the plan, it is quick and easy to set up, monitor and manage.

The core ETF portfolio should improve an investor's results over that of using a full-service broker, asset fee-based investment manager, mutual funds or picking individual stocks. The core ETF portfolio is very well diversified and should beat these other investing methods over time by a significant amount. In general, full-service brokers charge 1.0% of assets and then sell mutual funds that charge another 1.0% and underperform the market by another 1.0%. Asset based investment managers typically charge fees of approximately 1.2%, and under-perform the market by another 1.0%. Picking individual stocks, requires holding stocks long term to delay paying taxes and allowing capital to compound. Even if an investor is able to beat the market on a before-tax basis over some period of time, on an after-tax basis over the same period of time, the same investor could be significantly underperforming the market.

Underperforming the market by 2% may not sound like much but one example will demonstrate the actual cost over time. An investment of $10,000 at the beginning of each year for 40 years with a return of 4.25%, results in a portfolio of $1,051,078 at the end of the 40-year period; increasing the return by 2% to 6.25% a year, results in a portfolio of $1,751,350, an increase of $700,272 or 67%. This increased return should come with less risk and less effort, than other investing methods. The difference for many investors is probably the difference between living a retirement that is, or is not, financially comfortable.

There are investors that beat the market over short periods of time and a few investors that beat the market over long periods of time, but these are the exceptions and no investor can count on this. Since it is unlikely that any specific individual investor will beat the market over the long term using other investing methods, investors should place the majority of their retirement portfolio in a diversified core ETF portfolio, that should, with less effort, result in a better return.

Determining which ETFs to invest in and what percentage to allocate to each ETF

Click to enlarge

Seeking Alpha's core ETF portfolio, shown below, is a good starting point, to determine the sectors and individual ETFs an investor will want to include in a core ETF portfolio.

ETF Ticker

Fund Name

Fund Description

Expense Ratio

VOO

Vanguard S&P 500 ETF

Large cap US stocks

0.05%

IJH

iShares Core S&P Mid Cap ETF

Mid cap US stocks

0.12%

VTWO

Vanguard Russell 2000 ETF

Small cap US stocks

0.15%

IEFA

iShares Core MSCI EAFE ETF

Multi cap foreign developed market stocks

0.12%

IEMG

iShares Core MSCI Emerging Markets ETF

Multi cap emerging market stocks

0.18%

LQD

iShares iBoxx $ Investment Grade Corporate Bond ETF

US investment grade corporate bonds

0.15%

PLW

PowerShares 1-30 Laddered Treasury Portfolio ETF

US Treasuries

0.25%

SCHP

Schwab U.S. TIPS ETF

US TIPS

0.07%

VNQ

Vanguard REIT Index ETF

US REITs

0.10%

DBC

PowerShares DB Commodity Index Tracking ETF

Broad commodities

0.85%

Click to enlarge

After reviewing the sectors and individual ETFs in Seeking Alpha's core ETF portfolio, I picked a subset of Seeking Alpha's core ETF portfolio as my initial core ETF portfolio. My core ETF portfolio consists of the following sectors, ETFs, and allocation percentages.

Sector

Allocation %

ETF Ticker

Fund Name

Expense Ratio

Large cap US stocks

20%

VOO

Vanguard S&P 500 ETF

0.05%

Mid cap US stocks

20%

SCHM

Schwab U.S. Mid-Cap ETF

0.07%

Small cap US stocks

20%

VTWO

Vanguard Russell 2000 ETF

0.15%

Multi cap foreign developed market stocks

20%

IEFA

iShares Core MSCI EAFE ETF

0.12%

Multi cap emerging market stocks

20%

VWO

Vanguard FTSE Emerging Markets ETF

0.15%

Click to enlarge

Reasons for excluding certain sectors and choosing the allocation percentage among the sectors

Every investor is different and will be comfortable with different investments and risks. I eliminated certain sectors from Seeking Alpha's core ETF portfolio either because I generally was not comfortable investing in the sector, felt that the sector was currently overpriced or just did not believe the sector fit in my core ETF portfolio. My reasons for deviating from Seeking Alpha's core ETF portfolio are described below but every investor will have different circumstances, experiences and expectations which will lead to different decisions.

While I believe most investors should have a cash and fixed income allocation, I believe that now is not a good time to invest in any fixed income instruments that do not mature in the very short term. After peaking in 1981, US ten-year treasury bond interest rates have fallen steadily to their current rate around 1.75%. I am not comfortable investing in ETFs made up of medium or long-term bonds at current interest rates. I expect to keep funds I have allocated for this portion of my core ETF portfolio, invested in bank accounts and shorter-term certificates of deposit that offer similar interest rates with far less risk of capital loss. I expect to review this periodically and consider investing in Seeking Alpha's fixed income sectors and ETFs when long-term interest rates increase from current levels.

I did not include a real estate investment trust (REIT) in my core ETF portfolio. Since bottoming in 2009, REIT's have performed very well. Since I am not very familiar with the real estate sector, I would like to do more research to better understand where real estate is in its cycle, and believe it is a good time to invest in it, before making an initial investment in this sector.

I question whether commodities are necessary for most investor's core portfolio. Commodities are down approximately 50% over the last 10 years and much further from their peak in 2008. The expense ratio for commodity ETFs is also much higher than for any other asset class in the core portfolio. I will research long-term commodity cycles further, but at this point, I do not expect to add commodities to my core ETF portfolio.

Finally, for the five sectors that I did choose, I allocated an even 20% of my core portfolio to each sector. In three of the five sectors, I invested in the ETF recommended in Seeking Alpha's core portfolio, but I went with a very similar ETF in the other two sectors. Most investors might be more comfortable with a higher percentage allocated to US stocks and US large cap stocks in particular. I have always had a higher than typical allocation to foreign stocks and emerging market stocks. Over the years, this allocation to foreign developed and emerging markets has been very favorable for me; however, the last five years, it has not.

Actual implementation

The implementation of a core ETF portfolio will be different for a new investor in the markets and an investor transitioning from a current portfolio to a core ETF portfolio. Once an investor has determined the sectors, ETFs and allocation percentages for their core ETF portfolio, a new investor must decide whether to invest all at once, dollar cost average in over some period of time, or use some other method to buy in. An investor transitioning from a different style of investing, must determine which current investments to sell to fund the core ETF portfolio and which current investments to hold outside their core ETF portfolio.

This step proved to be more difficult than I had expected. Over the years, I had accumulated a number of investments in my portfolio, some of which were difficult to sell for various reasons. An important consideration for most investors when selling current investments is to try to offset capital gains with capital losses to minimize any tax payment. Although my plan was to transition approximately 80% of my stock investments into the five ETFs I had selected, I found that I could sell only about 40% of my current investments easily. These were stocks, ETFs and mutual funds that were similar to my chosen core ETFs but many of these had been purchased in the past when expense ratios had been higher or they were investments that had not gone according to my investment thesis. While I would have liked to make the transition of 80% of my investments into the ETFs selected in my core ETF portfolio all in one move, and this would have minimized trading commissions, this would have resulted in capital gains taxes and in many cases been psychologically difficult. I decided that moving 40% of my investments at this point was a good start and I could take some time to look more closely at the rest of my investments to determine when, and which investments, I would transition next.

Conclusion

A core ETF portfolio is likely the best investment option for most investors. Over time, it should require less effort and provide better investment results than other investment options. As with any investments, an investor can spend as much time as they want researching and implementing a core ETF portfolio, but most investors can set up or transition their current portfolio with relatively little effort.

Seeking Alpha's core ETF portfolio may be right for many investors. After reviewing it, I determined that based on my experience and expectations, I would be more comfortable with a modified version for my core ETF portfolio. Although many Seeking Alpha readers are experienced investors and likely enjoy the investment research process, I still believe a core ETF portfolio is the best option for most investors. Those that enjoy the investment research process can always add a speculative portfolio to their core ETF portfolio.

Addendum

Further reading on the subject:

Simply Investing - Philosophy

Establishing a core portfolio in well-diversified, low expense ETFs, held for the long term, is a good idea for most all investors. The core of a small portfolio can start off as simple as one well diversified global ETF with a low expense ratio, like Vanguard Total World Stock ETF (NYSEARCA:VT). Typically, as the portfolio grows, the core of the portfolio would include some exposure to the ten asset classes listed above.

There are four steps needed to set up an efficient investment plan. The decisions and actions required to set up the plan and purchase the ETFs can be done in about 4 hours (see the further reading section below for more details):

  1. Decide on an asset allocation plan among the ETFs in the core portfolio
  2. Open an online brokerage account with a linked online bank account
  3. Determine if you will invest all your investment funds at once or over a period of time
  4. Determine which investments to buy in your taxable and tax-deferred accounts

The core ETF portfolio outlined above, after tax, should significantly outperform either individual stock picking or a portfolio managed by a financial advisor. Over the typical investors time horizon of 40+years, the expected advantage of this core ETF portfolio is staggering.

Investors that enjoy the investment analysis process and are willing to spend the time to analyze and invest in individual stocks or sectors can still do this. I believe, the majority of these investors should still set up a core ETF portfolio, but can allocate a small, fixed percentage of their portfolio to "edge" positions, which offer additional risk and opportunity.

Disclosure: I am/we are long VOO, SCHM, VTWO, IEFA, VWO, VT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.