The Simple 2 Vanguard ETF Portfolio That Gives You (Almost) Everything You Need

Many investors believe you need a dozen or more ETFs to achieve diversity, but you can get nearly the whole package with just two.
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When it comes to portfolio building, I'm a big believer that simpler is better. If you have the time and the interest, there's certainly nothing wrong with a little more complexity by adding individual dividend, sector and thematic ETFs to the mix, but for most of the people who don't follow the financial markets on a regular basis, it can be a bit overwhelming. With more than 2,500 different funds to choose from today, the ETF marketplace makes it simple to build a portfolio as simple or as complex as you'd prefer.

Today, we're going to focus on simplicity.

The idea of a "complete" portfolio can be a challenging idea if you want to keep things as simple as possible. Most investors today think of "the market" as a handful of mega-cap growth and tech stocks since those are the ones that get 90% of the financial markets' attention. You might think that the S&P 500 should be your proxy for stocks, but that too leaves out a number of asset classes that should be included in a portfolio.

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While your specific allocations may vary, you should be including U.S. stocks of all sizes (large-, mid- and small-caps), international stocks (developed and emerging markets), government bonds, corporate bonds and real estate. Those are the basics of what would be considered a diversified portfolio, but you could add things, such as cryptocurrencies, gold or high yielders if you want a little extra oomph. For the purposes of what we're doing here, I'm going to omit those for the time being and stick to the basic portfolio framework.

Now, you could certainly go about adding individual ETFs to cover each of these asset classes, but that could turn unwieldy in a hurry and, frankly, it's unnecessary. There are ETFs out there already that cover the "total" market, whether it's stocks or bonds, and they do so at rock bottom prices.

That's the pond we're going to go fishing in today.

6_Vanguard_ETFs_That_Fit_In_Any_Retireme-600e354efb74df5fefe8ada9_1_Jan_25_2021_3_56_41_poster

Vanguard, as most of you are already well aware, is the industry's low cost leader. If you want an ETF that costs next to nothing to own, this is the place you want to go. Vanguard's lineup is mostly plain vanilla index funds and sector ETFs with a sprinkle of dividend and thematic products. But I want to narrow in on two ETFs specifically, a pair in which when put together can provide you a fully diversified portfolio (well, almost, but we'll get into that in a bit) that's about as simple as it gets.

Let's examine those two ETFs.

Vanguard Total World Stock ETF (VT)

source: ETF Action

source: ETF Action

Most investors are aware of the Vanguard Total Stock Market ETF (VTI). It's currently the 3rd largest ETF in the industry, but focuses solely on the U.S. equity market. The Vanguard FTSE Developed Markets ETF (VEA) and the Vanguard FTSE Emerging Markets ETF (VWO) manage nearly $200 billion between and do a good job of covering the international markets.

VT is essentially a combination of the three all in one ETF that charges just 0.08% annually (just a couple years ago, the fee was 0.10%, so it's actually gotten cheaper over time).

In terms of the breakdown, VT is roughly 60% North America (which consists of 58% United States and 2% Canada), 30% developed foreign markets and 10% emerging markets.

source: Morningstar

source: Morningstar

I know that many U.S. investors tend to have a home country bias and would prefer to see their U.S. equity allocation closer to the 80-90% range, if not 100% altogether. I can appreciate that given how equity market returns how played out over the past decade, but I think the 60/30/10 allocation actually makes a lot of sense.

On a pure looking forward basis, both developed and emerging markets are expected to grow faster over the coming decade than the United States and both areas are roughly 20-30% cheaper than the S&P 500 today. That kind of above average growth/below average valuation combination is something you want to keep in your portfolio. Given its position as a global economic leader, it still makes sense to keep the majority of your equity holdings in U.S. stocks, but I don't have any issues with the 40% allocation to overseas investments.

The international presence also helps balance out some of the tech sector overweight we're currently seeing in the United States.

source: Morningstar

source: Morningstar

Tech is still the largest sector in the fund, but only at around 20% of total assets (compared to around 28% in the S&P 500). A total of five different sectors have allocations of at least 10%, including a nice mix of cyclicals and defensive sectors. As the world economy evolves into the 2020s and we begin to eventually move past the current period of COVID impacts and central bank easy money policies, the more diversified nature of VT will be important to reducing portfolio risk.

It's worth noting that while VT is an all-cap portfolio, it's still heavily skewed towards large-caps. According to Morningstar, the fund has 17% of assets in mid-caps and just 4% in small-caps. Of course, you can use any of the more targeted Vanguard ETFs to tilt your equity allocation one way or the other (e.g. less international, more small-cap, etc.), but VT is still well-constructed as a one-stop long-term core portfolio holding.

Vanguard Total World Bond ETF (BNDW)

source: ETF Action

source: ETF Action

If we've got the Total World Stock ETF for our equity position, it's probably not surprising that we've got the Total World Bond ETF for fixed income.

BNDW covers the entire global investment-grade bond market and owns more than 16,000 bonds in total. You will find some U.S. fixed income ETFs with slightly cheaper expense ratios than BNDW's 0.06%, but in terms of the global fixed income ETF market, nothing else even comes close. The fund only has about $600 million in assets, so it's not quite as large and liquid as some other ETFs. Trading costs are a bit higher here, but nothing I'd consider egregious.

BNDW is actually just a fund of Vanguard funds. It consists of 50% allocations to the Vanguard Total International Bond ETF (BNDX) and the Vanguard Total Bond Market Index ETF (BND).

Screen Shot 2021-09-22 at 11.10.12 AM

This structure presents some interesting considerations. There's no expense ratio advantage to buying BND and BNDX individually, but they are both much larger and much more tradeable than BNDW. If you're a more frequent trader, there's a case to be made that going with the pair of bond ETFs over BNDW is more cost effective. If you're looking for a simple, diversified portfolio, however, this probably isn't you, which is why I still think BNDW is the preferred method for targeting all-in-one fixed income exposure.

If we return to the home bias argument in this fund, you could argue that it's the U.S. bond side that comes with more risk at the moment. With interest rates still at historic lows, there's not much capital growth upside remaining and some significant downside potential should interest rates move back up and you're out on the long end of the yield curve. Granted the yield situation isn't much better in foreign bond markets, but I do see some better risk/yield tradeoffs in places, such as emerging markets, right now.

Focusing on the portfolio itself, it's split between roughly 2/3 government and sovereign debt and 1/3 corporates and other notes.

Screen Shot 2021-09-22 at 11.00.46 AM

I would argue that perhaps I'd prefer a little less exposure to government-issued debt and more to corporate bonds than what BNDW currently offers, but for a core long-term holding, I still think it's acceptable. It's certainly not going to help in terms of the yield being generated by the portfolio, but its geographic diversity helps balance out some of that yield shortfall.

That heavy focus on government bonds does help on the credit quality side as well.

Screen Shot 2021-09-22 at 11.00.55 AM

Given what's happening globally with the COVID pandemic and many economies being artificially propped up by mountains of central bank stimulus, I think having a bond position that's dominated by notes in that A-rated to AAA-rated range is a good thing. Again, the yield being generated by such a portfolio probably won't be pleasing to income seekers, but in terms of pure risk reduction, I like it.

What's Missing?

I mentioned in the title that this 2 ETF combination gives you almost everything you need. If you look in the credit quality graphic in the section we just covered, you'll see what it is.

There's no high yield bond exposure in this portfolio.

I've discussed several times in recent articles that I'm not a fan of the risk/reward tradeoff in junk bonds right now. Still, in terms of building diversified portfolios, at least some exposure to junk bonds is warranted. 10-20% of an overall fixed income allocation seems like a reasonable range.

I've offered up the Fidelity Total Bond ETF (FBND) before as an option for the fixed income spot in a portfolio such as this. It has about 10% of its portfolio dedicated to high yield bonds and has a better balance between government and corporate bonds. There are two problems though. The fund is nearly 90% invested in U.S.-issued bonds, so there's almost no international exposure at all. Second, the fund's expense ratio is 0.36%. With yields on fixed income ETFs already minimal, giving up 28 basis points on fees is a dealbreaker for me.

Conclusion

If you're an investor looking to keep things absolutely as simple as you can get, the combination of VT and BNDW may be about as close as you can get to ideal. Getting a fully diversified portfolio that contains stocks of all sizes from all regions of the world along with a mix of both government and corporate bonds for just 8 basis points in annualized fees is a terrific option, especially in retirement portfolios, for a "set it and forget it" investing style.

It's not perfect, of course. It's a little light on real estate and there are no junk bonds to speak of. You can stay within Vanguard and target the Vanguard Real Estate ETF (VNQ) if you want to up your allocation to this sector. You'll probably have to go outside of Vanguard to something like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) if you're interested in adding junk bonds.

Tweak the allocations to your liking, but this 2 ETF combination from Vanguard is a great way to set yourself up for long-term success.

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