5 ETFs for a Diversified Portfolio
Learn some great ETFs to start building your own portfolio
[Disclaimer: I am not a financial advisor and not qualified to do so. I’m a non-professional investor and everything described in this post is based on my experience alone]
Have you ever wondered how to get started into investing in Exchange Traded Funds (ETFs)?
With hundreds of ETFs to choose, most first-time investors find it hard to understand the advantages of choosing one ETF over others. After learning what an ETF is and knowing which features matter when buying these types of financial instruments (asset class, strategy, expense ratio, etc.) the next logical step for beginner investors is to build a diversified portfolio with different asset classes.
This post will give you some recommendations with a shortlist of straightforward ETFs you can buy, relating them with asset classes. These ETFs were chosen for this list for several factors, namely:
- Low Expense Ratio;
- Accumulating Dividends;
- Diversity of Assets;
In this post, we’ll also take a look into portfolio allocation, another important component to consider when building your nest egg. We’ll use Portfolio Visualizer, a backtesting tool that enable us to do some portfolio simulations and understand the expected return and risk of different allocations through stocks, bonds, commodities and gold.
Stocks — Vanguard Total Market
Ticker Symbol: VTI
This ETF is one of the most famous stock ETFs in the world. It follows the total value of the USA stock market, investing in stocks like Google, Microsoft, Amazon, Johnson and Johnson, Coca-Cola, among many others. It has one of lowest expense ratios available in the market (just 0.03%) and it’s the best one to approximate USA stock returns at a very low price. Additionally, it doesn’t distribute dividends, reinvesting them all into the fund.
In terms of average return, it achieved an average of 7.71% since 2002, the inception date of the fund. In a nutshell, this fund is appropriate for investors that:
- Want to invest in USA stocks.
- Have a long time horizon (over 10 years).
- Are looking for capital appreciation, first.
Find all details on the fund’s page.
Stocks — Vanguard All-World
Ticker Symbol: VWRL
One of the downsides of the VTI is that it only invests in stocks based in the United States. If you don’t want to become entirely dependent on the US market, the Vanguard All-World ETF is a good choice!
This ETF has an expense ratio of 0.22 and an average return of around 10% since inception (May 2012). It has the advantage of having stocks outside of the United States, making you exposed to the entire world economy. Although 63% of the fund consists of US stocks, the fact that the fund invests in equities outside US, including Europe and the Pacific region, is a good reason to add this ETF to your portfolio. Compared with the VTI, this fund is able to invest in companies that are not based in the US like Roche, Samsung, Tencent or Nintendo.
This ETF is a good choice for:
- Want to invest in world equities (stocks);
- Have a long-term time horizon (over 10 years)
- Are looking for capital appreciation, first.
- Want some exposure outside of the US stock market.
Find all the details on the fund’s page.
Bonds — iShares 7–10 Bond
Ticker Symbol: IEF
The iShares 3–7 Year Treasury Bond ETF gives you an exposure to US treasury bonds with mid range maturities. Bonds are a good way to diversify your portfolio and are normally considered a good way to diversify outside of more riskier equities such as stocks.
To balance your risk, an all-weather portfolio considers investing in bonds of different maturities from mid range maturities (7–10) to longer time frames (bonds with over 20+ maturity). Bond trading is a really hard game with a lot of variables involved when it comes to pricing a specific bond. If you want to have an exposure to this type of asset, you will be better off investing in a Fund that manages the buying and selling of the asset for you and the IEF does exactly that.
This ETF is appropriate for investors that want:
- Investors that want to diversify outside equitities;
- Investors looking for exposure to bonds that will mature in 10 years, at most.
If you want to know more about bonds, check this incredible BlackRock guide.
Note: If you are based in Europe, you will be better off investing in bonds from governments from the EuroZone instead of the IEF to avoid currency risk.
Bonds — United States 20+ Bonds
Ticker Symbol: TLT
Using the same logic as the ETF above, this instrument will give you exposure bonds. The difference is that, in this case, the maturity of the bonds negotiated by the fund are longer (20+ years).
This ETF also only invests in bonds of the United State Government and it is suited for investors with really long time horizons that are able to weather the storm of uncertainty on the bond market and getting rewarded with higher yields because of that.
This ETF is suitable for:
- Investors that want to diversify outside equitities;
- Investors looking for exposure to bonds that will mature in 10 years, at most.
- Investors with a longer time horizon than 5 or 10 years — meaning that they do not expect to sell the bonds in the short term.
Gold — SPDR Gold Shares
Ticker Symbol: GLD
Gold, one of the assets that is, arguably, a protector when inflation is high, may also be a relevant asset class to have on your portfolio.
There are multiple ETFs out there that follow gold price — one of the best ones is GLD. This ETF tracks Gold Prices and gives you an exposure to this type of asset without having to buy physical gold (with all the storage issues that that brings). Many people are questioning if gold is really a good investment (as it doesn’t produce much “value”) — nevertheless, it’s still considered that an allocation of less than 10% is relevant for diversification reasons in most portfolios.
If you have a really long time horizon, I would argue that this asset doesn’t belong in your portfolio as it tends to have a minimum impact on your returns and risk in the long run. If your time horizon is very long, then, probably, gold doesn’t make much in the risk of your portfolio and if you are able to stomach big “drawdowns” without hitting the sell button then this ETF may not be a fit for you.
This ETF is suitable for:
- Defensive investors that want to be protected against economic downturns;
- Investors that want to be protected against big “potential drawdowns”.
- Investors that want to invest in precious metals;
Finally, let’s do some simulations using Portfolio Visualizer. As some ETFs have inceptions dates that are more recent, I’ll use the underlying asset classes to simulate our returns.
For this simulation, we’ll consider that we’ve invested 10.000$ in 1982 and we add 5.000$ to the portfolio each year. Additionally, we’ll also rebalance our portfolio annually to match the allocation we are targeting.
Starting with a portfolio consisting of:
- 50% Stocks
- 15% 7–10 year Bonds
- 27.5% +20 year Bonds
- 7.5% Gold
Our portfolio evolution would be:
And the details about our portfolio 30-year return:
- Our final balance would be almost 3 million dollars.
- Our average return (we’ll use TWRR as a proxy) is 9.89%.
- Our standard deviation (represents risk) is 8.85%.
- In our worst year, we would lose 17.06%.
- Our max drawdown (the amount our portfolio will shrink from a previous high) was 20%.
Very good! Max drawdown and worst year are the better columns to match with the psychological factor of investing. Everytime you look at this data you should think: “Am I able to endure this drawdown without getting nervous and selling my assets?”.
Let’s see more portfolios! For instance, let’s increase the gold percentage and reduce the stock allocation:
- 40% Stocks
- 15% 7–10 year Bonds
- 27.5% +20 year Bonds
- 17.5% Gold
I’ve left both portfolios on the plot so that we can compare them easily. Let’s see the data for both portfolios:
Notice the differences between Portfolio 1 and 2 data. The most important things to highlight are:
- Portfolio 2 ends up with less 400k dollars.
- Portfolio 2 has a lower average return (9.18%).
- Portfolio 2 has a smoother max drawdown and worst year.
What we’ve done when adding gold to our portfolio was protecting ourselves from the maximum drawdowns. In this way, we would have to endure through lower potential “losses” during our investiment period.
The major setback is that that will impact our expected return by a few points and that will end up costing us 400k at the end of our time horizon.
In another scenario, let’s tweak our portfolio to become really aggressive in terms of expected return:
- 70% Stocks
- 10% 7–10 year Bonds
- 20% +20 year Bonds
- 0% Gold
I’ve taken all the gold of our portfolio and put our “stock allocation” in the 70%. Let’s see what will happen in our simulation by adding this new portfolio to the mix:
With this portfolio, we end up with 3.5 million dollars with an average return of 10.71%. But, as there’s not free lunch in the market, look at the Drawdown and Worst Year data! We would have to endure through a maximum drawdown of 33.1%.
An important point: These numbers are indicative of the past 30 years in the market — it doesn’t mean that the next 30 will also be the same as the macro scenario will be completely different so always take these estimations as a grain of salt. The major assumption on the last 50 or 70 years of public markets is that stocks are riskier in the short term but bring a much bigger reward after 30–40 years. If you believe in that assumption, have a long time horizon and can deal with a 30% “potential” drawdown then, probably, you want to maximize the amount of stocks in our portfolio for better returns.
