Building a Classic 3-Fund Portfolio with ETFs
The Easy Way to Build a Diversified Portfolio
Three-fund portfolios have become a popular way to invest in the financial markets, given their simplicity and tax-efficiency relative to other all-in-one funds. In general, these portfolios consist of one domestic stock index fund, one international stock index funds, and one bond index fund. The idea is that investors have exposure to all major asset classes in a simple three-security portfolio.
Depending on the investor’s stage of life, different asset allocations can be selected for each of the portfolio segments. Younger investors may devote a greater amount of capital to riskier equities, while older investors may earmark more toward safer bond assets. Over time, these asset allocations can shift in order to effectively ensure that the investor maintains the right level of risk for their age.
In this article, we will take a look at how to choose the right funds when building a portfolio to optimize risk-adjusted returns over the long run.
How to Choose Funds
The three-fund portfolio may seem like an easy concept on the surface, but with thousands of different funds to choose from, it can quickly become an intimidating task for individual investors. Fortunately, there are some easy rules that investors can use to ensure they’re getting the best deal, which makes it easier to narrow down the universe of funds within their target demographic.
The core features to look for in any index fund are:
- Expense Ratio – The amount that the fund’s manager charges as a percentage of assets each year is known as the expense ratio (ideally, this number should be low).
- Liquidity – There should be a sufficient enough number of shares traded each day to mitigate the risk of being unable to sell your shares.
- Tracking Error – The fund should closely mirror the underlying index with very little in the way of tracking errors (especially in international ETFs).
Many investors implementing the three-fund portfolio strategy tend to stick with a single ETF provider when choosing funds. For example, Vanguard and Schwab are two low-cost ETF providers that have a number of great options. The benefit of using the same provider is that it makes it easy to track the funds over time, since prospectuses arrive at the same time and everything.
A great example might be a Vanguard portfolio that consists of the Vanguard S&P 500 Index Fund (NYSE: VOO), the Vanguard FTSE All-World Ex-US ETF (NYSE: VEU), and the Vanguard Total Bond Market ETF (NYSE: BND). These funds all have a very low expense ratio, relatively high liquidity, and low tracking error, which provides investors with well-rounded exposure to the markets.
What Funds to Choose
There are many different types of index ETFs to choose from when constructing a three-fund portfolio. For instance, investors may choose an S&P 500 ETF, such as the SPDR S&P 500 ETF (NYSE: SPY), or a broader market Russell 2000 ETF, such as the Russell 2000 Index ETF (NYSE: IWM).
Both provide exposure to U.S. equities, but in very different ways, which makes it difficult to decide what’s best.
Some tips for choosing fund type include:
- Diversification – Investors should prefer funds that have greater amounts of diversification, both in terms of the number of securities and the spread between various sectors of the economy. In addition, investors may want to consider funds that aren't weighted by market capitalization since that favors the largest companies.
- International Bond ETFs – Investors should consider international bond ETFs, since they provide upside in any interest rate environment, rather than relying on the U.S. economy’s state. However, investors approaching retirement may prefer stability relative to the U.S. dollar, which would make domestic bond ETFs the best option.
- Ex-U.S. International ETFs – Investors should ensure that their international exposure doesn’t include U.S. stocks, since they already have equity exposure to that market in one-third of their portfolio. So, so-called "ex-US" international ETFs often make the most sense.
The Bottom Line
Investors should have a broad market U.S. equity ETF, an ex-U.S. all-world equity ETF, and an international bond ETF. Web portals like ETFdb.com can be helpful in determining the best options in each of these categories, while investors should keep the aforementioned advice in mind when making decisions in order to increase their long-term risk-adjusted returns.