A Simple 3-ETF Portfolio

If you are asked to build a portfolio with the least number of funds but broad enough to provide the diversification you need, how many funds do you need?

Essentially, I think I will need only two funds: a total stock market fund that covers the entire equity market, US and foreign, and a total bond fund that tracks fixed income securities, domestic and international. As Mr. John Bogel points out in his latest book, The Little Book of Common Sense Investing [Affiliate link], the long-term winning strategy of investing is “simply buy all the stocks in the U.S. stock market and hold them forever.” In this way, you take whatever the stock market has to offer instead of trying to find stocks/funds to beat the market.

Back to the original question. With Mr. Bogel’s principle in mind and the fact that though the US still has the world’s largest economy, its GDP accounts only about 20% of the world’s overall GDP, it makes sense to look beyond the national border for investment opportunities. Therefore, I want to own not just the entire US stock markets, but the stock markets in the world as well, if that’s possible. The same for fixed income investments.

Now that I know what I want, next is how to get there with ETFs. Looking at the complete list of available ETFs at Morningstar.com, I found that there’s no way I can build the portfolio I want with only two funds. They are just not there yet, especially the bond ETF. Instead, I will have to split the funds into two parts, domestic and international. For domestic funds, I can use:

• Vanguard Total Stock Market ETF (VTI): tracks the MSCI US Broad Market Index, which represents 99.5% or more of the total market capitalization of all of the US common stocks.
• Vanguard Total Bond Market ETF (BND): tracks the Lehman Brothers Aggregate Bond Index, including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities.

For the international part, currently there’s no bond ETF that has the broad coverage of the world debt markets. As for the equity funds, however, there are two choices with similar coverage:

• SPDR MSCI ACWI (ex-US) (CWI): tracks The MSCI ACWI ex USA Index, which include 2,126 securities from 47 countries, but developed and developing.
• Vanguard FTSE All-World ex-US ETF (VEU): tracks the FTSE All-World ex US Index, which includes approximately 2,200 stocks of companies in 47 countries, from both developed and emerging markets around the world.

So before I can get the two-fund portfolio I can want, I can use three ETFs, VTI, VEU/CWI, and BND, to build a passive portfolio that gives me the broadest exposure to both the equity and fixed income markets. And this portfolio is cheap to own. The expense ratios of these four funds are:

• VTI: 0.07%
• VEU: 0.25%
• CWI: 0.35%
• BND: 0.11%

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