An ETF Asset Allocation Plan for Everyone

If I have not said it much before, I will certainly say it in the future: the best way to invest is with low-cost index mutual funds or low cost index ETFs. I like Vanguard, but it is even cheaper to get an account at Zecco.com and then invest in low-cost ETFs. They give you a certain number of free trades per month which is more than adequate for a long-term buy-and-hold investor. What I suggest below is not quite as simple as one of Vanguard’s excellent low-cost target date funds (see The Default Investment), but it will give you a portfolio that is more appropriate for your individual circumstances.

In the article on the default investment, I suggested talking to a financial planner if you wanted a tailor-made portfolio. However, the problem with financial planners is that they cost a lot of money relative to investable assets, particularly if you are not rich. A couple hundred dollars an hour or .5% of invested assets adds up quickly if you have a small portfolio. So for those with under a few hundred thousand dollars, it may be best to go it alone. You will need to first determine your risk tolerance. Buy Index Funds: The 12-Step Program for Active Investors; this book will help you think through how much risk you can handle. There are also 20 sample portfolios in the appendix for all different risk profiles. Those portfolios are designed for DFA mutual funds (which can only be accessed through a financial advisor). So I found suitable ETF substitutes for those funds and they are listed below along with their ticker and annual expense ratio. So buy the book, choose an appropriate portfolio for the amount of risk you can handle, get an account with Zecco, and then buy the following ETFs in the proportions recommended for your risk profile in the book. You will pay very few fees, your portfolios will be tax-efficient, and you will not have to think very much about your investments.

US Large Company: Vanguard Large Cap (VV), 0.07%
US Large Cap Value: Vanguard Value (VTV or VIVAX), 0.11%

US Microcap Index: iShares Russell Microcap Index (IWC), 0.60%
US Small Cap Value Index: Rydex S&P Smallcap 600 Pure Value (RZV), 0.35% or Vanguard Smallcap Value (VBR), 0.12%

Real Estate Index: Vanguard REIT ETF (VNQ), 0.12%

International Value Index: iShares MSCI EAFE Value Index (EFV), 0.40%
International Small Company Index: SPDR International Small Cap (GWX), 0.60%
International Small Value Index: WisdomTree Small Cap Dividend Fund (DLS), 0.58%

Emerging Markets Index: Vanguard Emerging Markets Index (VWO), 0.30%
Emerging Markets Value Index: WisdomTree Emerging Markets High-Yielding Equity (DEM), 0.63%
Emerging Markets Small-Cap Index: WisdomTree Emerging Markets Small-Cap Dividend Fund (DGS), 0.63%

One-Year Fixed Income Index: (see below)
Two-Year Global Fixed Income Index:
Five-Year Government Income Index:
Five-Year Global Fixed Income Index:

There are no funds that are very close to the above, but you can use different weights on Vanguard’s bond funds to approximate the average duration of the mix of the above funds. Vanguard Short-Term Bond Index (BSV), 0.11%, has an average maturity of 2.7 years, while Vanguard Intermediate-Term Bond Index (BIV), 0.11%, has an average maturity of 5.7 years. Both are invested primarily in Treasury and government agency securities. For very-short term bonds (or just buying government bonds of any maturity), you could enroll in Treasury Direct and buy 1-year treasuries direct from the US Government. If you hold them to maturity you pay no fees.

I see no great need to invest in foreign bonds, considering the safety of the Vanguard funds. While more diversification is good, there is a limit to how safe something can get–and it doesn’t get much safer than one to five year government and AAA-rated bonds. So if Index Funds says that you should have 10% in each of the four bond categories, your weighted-average maturity would be 3.3 years. So you could put 10% of your investable assets in 1-year bonds through Treasury Direct, 15% in the Vanguard Short-Term Bond Index, and 15% in the Vanguard Intermediate-Term Bond Index. This gives you an average maturity of 3.4 years.

When investing in these ETFs, you should rebalance every year. You could also choose to put a portion of your funds in one or more of Vanguard’s target date funds and then just add on the extra funds (value, small-cap) to the main target date fund. Then you would not have to rebalance as often.

If you follow the above plan, you should expect to outperform 80% of other investors, because they will incur more taxes and more fees. You will also end up with investments tailored to your unique circumstances. And you will only have to think about your investments once a year. This sounds like a good deal to me.

0 thoughts on “An ETF Asset Allocation Plan for Everyone”

  1. “I see no great need to invest in foreign bonds, considering the safety of the Vanguard funds.”

    I’m not sure that I necessarily agree with this statement. There are often times, where I’ll find foreign bonds that contain identical terms to their domestic counterparts, but they will yield slightly more. These aren’t international companies per se, but rather Eurobonds that are based on the credits of domestic companies. Irregardless of whether domestic or foreign bonds offer a more attractive opportunity though, I would still point out that there is risk in the Vanguard funds.

    Too often investors will use mutual funds to buy treasury bonds, but it really doesn’t make sense. If you want the protection, then buy the bonds directly and avoid paying even a modest fee to a bond manager. If you don’t mind paying a small expense ratio to get a certain amount of expertise, then take advantage of the diversification that mutual funds give, in order to look at high yield bonds or other more aggressive investments. You can lose it all on one company, but it’d be tough to lose 100% from a diversified junk bond portfolio.

    The problem with assuming that a AAA bond fund doesn’t have risk, is that it ignores the interest rate exposure that you are taking. Now in your case, you are talking about pretty short term investments, so this is limited, but wouldn’t it be better to have an exit strategy already built into your investment, instead of hoping that yields stay low, so that you can sell your fund on the open market for what you paid for it? I like the maturity date that an individual bond offers, even if I have to work a little harder in order to find it.

    I’d also like to point out that Zecco is great, but they aren’t the low cost alternative that people think they are. Part of the management fee that you pay on an ETF usually goes towards leverage. Because Zecco makes their money by charging high margin rates and paying out low money market yields, some investors would be better off paying a percent each year, over trying to replicate this on their own. It doesn’t mean that ETF’s don’t have their own set of problems, but it’s important to realize that all those free trades are being subsidized by below average yields on your cash. If you do a lot of stock trading this probably doesn’t matter, but if you use a lot of margin or keep large cash balances, you may be better off paying higher commissions, but then making it up on superior cash investments.

  2. Thanks for the comments Davis. I don’t see a problem with Zecco offering low cash yields and high margin rates because a long-term investor should avoid both cash and margin.

    Of course bonds are not risk-free. And buying bonds directly is good. But for a long-term buy-and-hold investor, interest rate changes will balance out over time. And a bond-fund with an average maturity of 5.7 years will on average have 100% turnover every 5.7 years. And because it is an index fund those bonds will be held to maturity.

    While eurobonds or other foreign bonds would be nice, there are no cheap options for owning them. And an extra .4% in management fees would wipe out any extra yield they might offer.

  3. No. Foreign capital gains are taxed at normal capital gains rates. Dividends are taxed at the normal rate. Unfortunately, there may be some foreign witholding taxes on foreign dividends, but these can generally be taken as a credit on US taxes and end up no more highly taxed than US dividends. Of course, see your CPA to confirm and for specifics.

  4. This was 2007, now it’s 2009, any changes in your thoughts? If one is making regular contributions, why not mutual funds vs. ETF? Thx. Expense control vs. commissions costs (unless it’s Zecco with zero dollar trades 🙂 Zecco doesn’t offer as many as they used to in 2007 🙁

  5. Scott, there is nothing wrong with mutual funds. An investor should compare the total costs (including commissions, bid/ask spread, brokerage maintenance fees, and mutual fund expenses and decide which is cheaper.

    I would probably not recommend Zecco anymore. I would recommend Scottrade–it is cheap, they charge no annoying fees, and they have a large number of mutual funds that can be bought at no cost.

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