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Exchange-traded funds, or ETFs, have made retirement investing simpler for many people. They combine the diversification and hands-off investing of mutual funds with the lower minimum investments and liquid trading of the stock market. If you're looking to get started in ETF investing, here are five that you can use to build a complete and diversified retirement portfolio.
For U.S. stock market exposure
Warren Buffett has said several times that the best investment most people can make is a low-cost S&P 500 index fund, and with a low 0.05% expense ratio, the Vanguard S&P 500 ETF (VOO +0.55%) is an excellent example.
The fund essentially invests in all 500 companies that make up the index and in the same proportions, so you're investing in the long-term success of American industry, not any single company or business. And by making periodic investments over time, you'll end up buying more when the market is cheap and less when it's expensive -- a concept known as dollar-cost averaging.
To invest in small caps
The S&P 500 index fund is great, but it's also nice to have some exposure to small-cap stocks, which can be more volatile but also tend to have more upside potential.
One good ETF to get small-cap exposure is the iShares Russell 2000 ETF (IWM +1.22%), which tracks the 2,000 stocks in the index that shares its name. The fund has an expense ratio of 0.20% and its largest stock holding, Advanced Micro Devices, makes up just 0.26% of the fund's asset value. So when compared with the S&P 500, whose largest holding, Apple, makes up more than 3% of the index, this index is a much more diverse collection of stocks.
2 ETFs to spread your money out internationally
Why invest in foreign stocks? Well, just to name a few reasons:
- It can protect your portfolio from currency fluctuations.
- It adds diversification.
- Some economies are growing faster than ours and have the potential for higher returns.
While there are a number of ways you can classify international stocks, two main categories are developed markets, which refers to countries such as Great Britain and Germany, and emerging markets such as China, Brazil, and India. Developed markets tend to be less volatile and can be a nice component of a diverse portfolio. Emerging markets can be quite volatile but have the potential to produce monster returns when things are going well -- in fact, during the 20-year period from 1988 through 2007, the leading emerging markets index averaged an annual gain of 17%.
For developed markets, the iShares Core MSCI EAFE ETF (IEFA +1.53%) is a good choice. The fund invests in a mix of stocks from developed markets all over the world – excluding the U.S. and Canada. As an example, some of the fund's biggest holdings include Nestle, Novartis, Roche, and Toyota. Its 0.12% expense ratio is among the lowest you'll find for foreign stock funds of any kind.
To invest in emerging markets, the Schwab Emerging Markets Equity ETF (SCHE +2.06%) is my top choice. Its 0.14% expense ratio is lowest among diversified emerging markets ETFs, and the fund holds a diverse blend of 794 stocks from markets such as China, Taiwan, India, South Africa, Brazil, and Mexico.
Don't forget about bonds
All investors should have some exposure to bonds, which are also known as fixed-income securities. However, it's generally not a great idea for most investors to buy individual bonds, or even to invest in a fund that specializes in a single type of bond.
A broad bond fund, composed of bonds of varying types and maturities, will do the trick. And, the Vanguard Total Bond Market ETF (BND +0.38%) is a good choice. The fund has a rock-bottom 0.06% expense ratio and invests in a mix of government and investment-grade corporate bonds. The fund's dividend yield is currently 1.88%, but this figure can rise considerably if interest rates start to normalize.
How much of each? It depends
We have a thorough introduction to asset allocation here, but in general, younger investors should have most of their money in stocks, while older investors should have more of their investments in bonds. One rule of thumb states that if you subtract your age from 110, you can determine how much of your money should be in stocks. For example, I'm 35, so I should have roughly 75% of my money in stocks. You can adjust this figure to meet your own risk tolerance – I actually have closer to 90% in stocks to capture more long-term growth potential.
Within the "stocks" category, I'd suggest about half of your stock allocation in an S&P 500 index fund, with about one-fourth in small or mid-caps. The remaining can be invested in international stocks of either developed or emerging markets. For example, an ETF portfolio for a 30-year-old investor might look like this:
- 40% in the Vanguard S&P 500 ETF
- 20% in the iShares Russell 2000 ETF
- 10% in the iShares Core MSCI EAFE ETF.
- 10% in the Schwab Emerging Markets Equity ETF.
- 20% in the Vanguard Total Bond Market ETF.
As a final point, it's important to mention that there are many other good ETFs than the five mentioned here. These are just some good examples that fit together nicely to form a diverse portfolio. The main takeaway here is the diversification and exposure to different types of asset classes, and low expense ratios, the combination of which can allow you to build an excellent retirement nest egg over time, while still allowing you to sleep soundly at night.
