I've written about many exchange-traded funds, and I thought it would be worthwhile to see how these ETFs coordinate to create the equity portion of a diversified portfolio, or at least my idea of one. The following is an actual account, recently implemented, that shows a blend of ETFs, common stocks and even a closed-end fund.

I'm not a fan of all-ETF portfolios, but I'm a big believer in using the best tool to capture a given effect. For some people, the best tool might be an ETF, and for others, it might be a stock. The following represents one person's best way to capture a diversified portfolio. For purposes of this article, I'll go sector by sector, but focus on the funds.

Financial

In the financial sector, the client has 3% in a domestic large-cap bank stock, 3% in an Irish bank stock and 9% in the WisdomTree Pacific ex-Japan High-Yielding Equity Fund ( DNH), which I wrote about a few months ago. It's less volatile than the S&P 500 and has a 6% yield.

DNH has 87% of its assets in Australia, which is known for mining, but 50% of the fund is in Australian bank stocks. The chart shows that DNH is really a proxy for Australian financials, as it correlates almost exactly with National Australia Bank ( NAB) and much less so with BHP Billiton ( BHP). Therefore, its total weight in the banking sector is 15%, compared to 21% for the S&P 500.

Health Care

In the health-care sector, a large-cap domestic drug company makes up 3% of the client's portfolio, a big biotech company at 2% of the portfolio and the WisdomTree International Health Care Sector Fund ( DBR). The fund is heavy in the U.K. and Switzerland (both countries I want exposure to) and yields 2%, which is more than any other sector ETF I'm aware of. The client's exposure to health care is 14% vs. 12% for the S&P 500.

Technology and Telecom

Tech is not my favorite part of the market for ETF exposure, but this particular client is not a candidate for any single-stock risk in this sector. Therefore, she owns 6% in iShares Dow Jones Technology ( IYW), 2% in iShares Goldman Sachs Semiconductor ( IGW) and 2% in First Trust Dow Jones Internet Fund ( FDN).

I would rather have domestic exposure only in this part of the market. For now, I think that the cap-weighted nature of IYW is the way to go, as mega-caps Cisco ( CSCO) and Microsoft ( MSFT) have done quite well in this latest rally.

A fund that equal-weights -- for now, that's just the Rydex Equal Weight S&P Technology Fund ( RYT) -- seems like a good replacement in nine to 12 months if, as is usually the case, smaller companies rotate back into favor. I don't use Semiconductors HOLDRs ( SMH) because it's so concentrated in just a couple of stocks.

Telecom is a small component of the market, and this portfolio just uses Vanguard Telecom ETF ( VOX) with a 4% weight. I prefer it over iShares Dow Jones Telecom ( IYZ) because it is less concentrated in mega-caps Verizon ( VZ) and AT&T ( T).

Industrial

For the industrial sector, the client has 8% in the Rydex Equal Weight S&P Industrial Fund ( RGI) and 3% in the PowerShares Water Portfolio ( PHO), which results in an equal weight.

I like RGI because many of the sector funds have huge positions in General Electric ( GE), which I don't want to own. With PHO, I believe in the water theme as a powerful long-term investment thesis.

Energy

Energy is a sector where I want a lot of foreign exposure. As chronicled earlier , most clients own WisdomTree International Energy Sector Fund ( DKA). This particular client has an 8% weight in DKA and 2% in one of the Chinese oil majors for an equal weight in the sector.

Consumer

For the consumer sector, the one ETF I use is iShares Dow Jones U.S. Consumer Goods Sector Index Fund ( IYK). For this client, it represents 10% of the portfolio, and the rest of the sector is made up of individual stocks.

In this sector, I want mostly domestic exposure, as I feel the brand names are worth owning. While the fund is not perfect, I like the heavier weighting to Altria ( MO). While its 15% weighting in Procter & Gamble ( PG) may not be ideal, the concentration is nowhere near as heavy as a lot of other cap-weighted funds. However, its 1.7% yield is only fair compared to other ETFs in this sector.

Materials

The materials sector is usually a good place to add foreign exposure and assets that have a low correlation to the market. In pursuit of these goals, the client's portfolio has a 3% weight in the streetTRACKS Gold Trust ( GLD) and a 2% weight in iShares S&P Global Material Index Fund ( MXI).

According to PortfolioScience.com, GLD has a -0.12 correlation to the S&P 500, while MXI has a 0.34 correlation. MXI has heavy exposure to large-cap diversified mining companies like BHP Billiton, Anglo American ( AAUK) and Rio Tinto ( RTP).

Utilities

In the utility sector, I prefer a common stock with a 4% weight for its yield over any ETF. This sector is a way to add yield and reduce volatility, and an individual stock often captures this better than a fund.

One last holding to round out the portfolio is a 4% weight in the Blackrock Global Opportunities Equity Trust ( BOE). This is a closed-end fund that buys foreign stocks and sells options in an attempt to offer high yield and capital appreciation with less volatility than the overall market. BOE yields 8.4% and trades at a 1.8% premium to NAV.

The portfolio yields about 2.5%, although dividend information is not available for every fund because some of them are so new. It has a 0.77 correlation to the S&P 500, a beta of 0.64 and a cash position just under 10%, which, after such a big move up for the market, seems prudent. The portfolio is intentionally light on emerging markets as a function of tolerance for volatility.

The point of this is to show how mixing different types of products can create what is hopefully a diversified portfolio. This particular portfolio is probably not ideal for you, but the willingness to explore different themes and different products probably is.
At the time of publication, clients of Nusbaum were long DNH, DBR, IYW, IGW, FDN, RGI, PHO, GLD, MXI, VOX and BOE, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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