Exchange traded funds can make creating a simple portfolio for younger investors cheap and straightforward. Younger investors usually have less capital to work with, emphasizing the need the make every penny count.
“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,” Abby Woodham wrote for Morningstar.
Morningstar’s model portfolio for younger investors is a guideline that should help take the guesswork out of creating an investment strategy. It includes about 4-5 ETFs and is based on ETFs rather than mutual funds. The idea of investing in ETFs is so that investors can purchase large areas of the market in one transaction while paying lower fees because there is not an active stock-picking manager. ETFs passively track a benchmark consisting of sectors, bonds or asset classes. [Creating ETF Portfolios with Folio Investing]
Here is one model portfolio from Morningstar, with an intended holding period of about 10 years:
- About 45% should be allocated to a broad-based U.S. stock ETF such as the Vanguard Total Stock Market ETF (NYSEArca: VTI). This ETF replicates the entire U.S. stock market and offers broad coverage of large-caps, mid-caps and small-caps. About 10% can be allocated to a dividend ETF such as the Schwab U.S. Dividend Equity ETF (NYSEArca: SCHD). From 1900 to 2010, about 70% of the U.S. stock market’s real growth came from dividends, with a strong correlation between high dividend payouts and future earnings growth, reports Woodham. Around 40% should be allocated to international stocks, such as the Vanguard FTSE All-World ex-US ETF (NYSEArca: VEU). Lastly, about 5% goes to the bond market through a fund such as the iShares Core Total US Bond Market ETF (NYSEArca: AGG). [How Financial Advisors are Using ETFs]
Another important consideration when creating a portfolio is to have proper asset allocation. By allocating a certain percentage of a portfolio to certain sectors or asset classes, portfolio re-balancing is not needed as much and good diversification benefits will be embedded. [The Rise of ETF Managed Portfolios]
Keeping costs as low as possible is another target of a simple portfolio. What is saved in costs is actually retained in principal, helping younger investors build a good base. Many of the brokerage houses now offer commission-free trades or offer rock-bottom prices for a high quality ETF.
Tisha Guerrero contributed to this article.