These days, I'm all about simplicity. Between juggling the kids, work and those obligatory social events (another birthday party?!), I'm generally too tired to deal with complications. That's exactly why creating a portfolio consisting solely of exchange-traded funds has a lot of appeal. With just a few of these funds, you can have total market coverage with very low expenses, very few tax issues and very little complications. So are exchange-traded funds the simpler way to go to create a well-rounded portfolio? It depends.
Ups and Downs of ETFsWhen you buy an ETF, you are essentially buying a single security that represents a basket of stocks that track an index. And since the S&P 500 generally beats its actively managed brethren, holding a product that mirrors an index can be a good thing. But we all know that looks can be deceiving. While ETFs may look like index funds, they actually trade like stocks. So that means you can do a bit more market-timing with your buys and sells since you can trade these things throughout the day. Even better, you can short ETFs, or, if you're audacious enough, buy them on margin. You can't do any of that with your mutual fund shares. ETFs' annual expenses are generally very low since the managers don't have a whole lot to do except watch an index all day (how's that for simple?). "Expense ratios are all mostly under 75 basis points," says Michael Iachini, senior research analyst for the Schwab Center for Investment Research. Some are even as low as 10 or 20 points. And with the average actively managed mutual fund hovering at 150 points, or 1.5%, that's a pretty good deal. And since there's very little change in the indices, ETFs are very tax efficient, as well.
But there is a catch. Because ETFs trade like stocks, you have to pay a commission fee every time you buy or sell a piece of these things -- just like you would a regular stock trade. So if you're planning on making monthly contributions to your portfolio, ETFs might not hold an advantage over regular funds. In addition, if you're looking to beat the market as opposed to just keeping pace with it, you'll probably want to go with individual stocks or actively traded mutual funds, says Iachini.
Who Can Benefit From ETFs?If you came into a big chunk of change and are just planning on dumping it into a taxable account, with no real intention of trading that money, these things could work for you, says Dan Culloton, a senior fund analyst at Morningstar. In short, you want to buy 'em and hold 'em. But ETFs can also be a great way to add some sector exposure to your portfolio, says John Sweeney, senior vice president, Fidelity Personal Investments. Let's say you don't have enough health care exposure in your portfolio. You could consider the Health Care Select Sector SPDR ( XLV), which tracks the S&P 500 health care sector, and be covered with one purchase. You could also try using ETFs the way the pros do -- as a parking lot for excess cash. ETF shares can easily be converted back to cash and don't have short-term redemption fees like many funds do. So you won't have to pay an early withdrawal charge because you withdrew the money before a specified time. You will be hit with commissions on the buy and sell, though, so make sure the amount is large enough to justify those fees.
Build an ETF PortfolioSo let's presume ETFs could work for you. What should go in your ETF portfolio?
Start with a basic diversification that would give you broad U.S. and international exposure, including some emerging markets plays, as well as some fixed income, depending on your risk tolerance, says Culloton. If you're a risk taker and have time on your side, you probably could afford to go all-equities. If not, Culloton recommends that 10% to 30% be in fixed income. For your U.S. exposure, the Vanguard Total Stock Market VIPERs ( VTI) and the iShares S&P 500 Index ( IVV) are relatively cheap. The iShares Russell 3000 Index ( IWV) is also worth checking out, since its expense ratio is just 0.20%. On the international front, consider the iShares MSCI EAFE Index Fund ( EFA), suggests Culloton. This ETF mirrors the Morgan Stanley Capital International Europe, Australia and Far East Index (MSCI EAFE) index and is composed of about 1,000 companies that trade on 20 stock exchanges around the world (not including the USA, Canada, and Latin America). Can't get much more international than that. For emerging markets, there's the Vanguard Emerging Markets Stock VIPERs ( VWO), which is cheaper than its iShares counterpart. If your ulcer (or common sense) requires some fixed income in your portfolio, check out the iShares Lehman 1-3 year Treasury bond ( SHY). Especially with the interest rate uncertainty out there, fixed income could be a wise choice.
tool . It allows you to pick different ETFs and adjust the weightings in your hypothetical portfolio. Also, be sure to check out TheStreet.com's ETF section for new developments in the ETF industry, including new ETF offerings. Many of us long for simplification -- like my poor mother, who can't seem to figure out how use the TV in my house -- but it has to make financial sense. So do some investigation before you decide if simpler really is better.