A well-diversified investment portfolio does not have to be anything fancy. An investor can build a broad portfolio with just three low-cost, index-based exchange traded funds.
“While it is certainly possible to do better with active managers or style tilts, a portfolio of broad low-cost index funds is not a bad default option for investors who do not have strong conviction about a given active manager or investment strategy,” writes Alex Bryan, fund analyst with Morningstar, “It may be boring, but such a portfolio should do better than most.”
For instance, an investor can build a diversified portfolio of domestic stocks, international stocks and bonds with three ETFs, such as the Vanguard Total Stock Market ETF (NYSEArca: VTI), Vanguard Total International Stock ETF (NYSEArca: VXUS) and Vanguard Total Bond Market ETF (NYSEArca: BND).
VTI provides exposure to the the entire U.S. stock market, tracking 3,629 stocks across large-, mid- and small-cap categories. The ETF has a 0.05% expense ratio. [Diversified Growth ETFs for a Retirement Portfolio]
VXUS tracks 5,504 stocks in global markets outside of the U.S.. The fund’s top country weights include U.K. 15.9%, Japan 15.1%, Canada 7.1%, France 6.6%, Germany 6.5% and Switzerland 6.3%. The ETF has a 0.14% expense ratio.
BND follows 6,342 investment-grade U.S. bonds, including government, agency and corporate debt. The ETF has a 0.10% expense ratio. [Four Fixed-Income ETFs for Your Retirement Portfolio]
In a recent study on index funds, Richard Ferri, founder of Portfolio Solutions, and Alex Benke, a product manager at Betterment, constructed a portfolio that invested in the mutual fund versions of the three respective Vanguard ETFs – Vanguard ETFs are a separate share class of its open-end mutual funds, including 40% in the Vanguard Total Stock market Fund, 20% in the Vanguard Total International Stock Index Fund and 40% in the Vanguard Total Bond Market Index Fund.
Ferri and Benke pitted the index fund portfolio against 5,000 portfolios of actively managed funds that randomly drawn U.S. equity, international equity and U.S. bond funds with the same weights as the index portfolio. The study discovered that the index portfolio outperformed in 82.9% of the simulations, but when they underperformed, the index portfolio only had a median shortfall of 1.25%.
The study found that index portfolios had a higher chance of outperforming actively managed funds over a longer period, partly because of the cost advantage that index funds enjoy.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.