These ETFs offer protection against whatever volatility 2023 has in store.
A common definition of diversification is “not keeping all your eggs in one basket.” However, there are different levels to this. For instance, the investor who bets their portfolio on a single software company is less diversified than an investor who invests in the entire tech sector. That being said, the tech sector investor is also less diversified than someone who invests in the entire U.S. stock market. From there, increasing diversification can mean investing in international stocks, bonds, cash, commodities or even alternative investments. By doing so, investors can spread the risk in their portfolios across many different asset classes. Each asset class has its own strengths and weaknesses, and investors can mix and match them to construct their ideal portfolio. As Nobel Prize laureate Harry Markowitz put it: “Diversification is the only free lunch in investing.” Here are 10 exchange-traded funds, or ETFs, that investors can use to build a diversified portfolio.
Vanguard Total Stock Market ETF (ticker: VTI)
A core holding in many portfolios should be a healthy allocation to domestic U.S. stocks. For maximum diversification, investors should try and capture stocks from all market-cap sizes and all 11 stock market sectors. A great option for this approach is VTI, which tracks the CRSP U.S. Total Market Index. This index holds over 4,000 U.S. stocks, with around 80% comprising the large-cap stocks represented in the S&P 500. For a very cheap 0.03% expense ratio, or $3 a year for every $10,000 invested, investors can buy and hold VTI to capture the returns of the U.S. stock market.
Vanguard Total International Stock ETF (VXUS)
A great way to diversify a portfolio of U.S. stocks is via an allocation to international stocks. These are shares of companies not listed on U.S. exchanges. The main benefit here is hedging against the possibility of the U.S. market stagnating. This occurred from 2000 to 2009, when the U.S. market’s performance was essentially flat. A good all-in-one pick here is VXUS, which tracks the FTSE Global All Cap Index. VXUS currently holds more than 7,000 stocks from international-developed and international-emerging markets weighted according to their market cap. The ETF charges an expense ratio of 0.07%.
Vanguard FTSE Developed Markets ETF (VEA)
Investors looking to fine-tune their international stock allocation can break VXUS down further into developed and emerging markets. For developed-market stocks, investors can use VEA, which tracks the FTSE Developed All Cap ex US Index. VEA holds stocks from markets like Japan, the U.K., Canada, France, Switzerland, Australia, Germany and Korea to name a few. Like VXUS, the ETF is market-cap weighted and diversified across all 11 stock market sectors. VEA costs an expense ratio of 0.05%.
Vanguard FTSE Emerging Markets ETF (VWO)
The smaller portion of VXUS is held in emerging-market equities, which are shares of companies listed in developing nations. This includes countries like Russia, China, India, Brazil, South Africa and Mexico. Historically, emerging-market equities have posted strong performance when U.S. stocks faltered, with a notable example being 2000 to 2003 following the dot-com bubble. To buy over 5,000 emerging-market stocks in a single ticker, investors can opt for VWO, which tracks the FTSE Emerging Markets All Cap China A Inclusion Index. VWO costs an expense ratio of 0.08%.
iShares Core U.S. Aggregate Bond ETF (AGG)
Not all investors have the risk tolerance for a 100%-stock portfolio. A heavy stock allocation may help boost expected returns but can also sharply increase volatility. Thus, a sensible allocation to high-quality fixed-income assets can help greatly. A popular option here is AGG, which tracks the Bloomberg US Aggregate Bond Index. This index primarily holds both U.S. Treasurys and investment-grade corporate bonds. A great way to think about AGG is as the bond market counterpart to VTI. The ETF charges an expense ratio of 0.03%.
Vanguard Tax-Exempt Bond ETF (VTEB)
Bond investing can be tricky in a taxable brokerage account thanks to the higher rate of taxation on the income generated. A good alternative to AGG for tax-conscious investors is VTEB, which invests in over 6,000 municipal bonds by tracking the Standard & Poor’s National AMT-Free Municipal Bond Index. Income from municipal bonds is exempt from federal taxes and can be exempt from state taxes as well if the investor lives in the state that issued the bond. Buying an ETF like VTEB saves investors the need to purchase and manage a ladder of individual bond issues. VTEB charges an expense ratio of 0.05%.
iShares TIPS Bond ETF (TIP)
2022 showed many investors just how harmful the effects of inflation could be for their portfolio. A potential way to mitigate inflation is via an allocation to Treasury Inflation-Protected Securities, or TIPS bonds. The value of TIPS is indexed to inflation. If inflation suddenly spikes, TIPS can grow in value and pay out higher coupons, potentially offsetting some of the effects of inflation. A great way to access a portfolio of TIPS of all maturities is via TIP, which tracks the Bloomberg U.S. Treasury Inflation Protected Securities (TIPS) Index. TIP costs an expense ratio of 0.19%.
iShares 0-3 Month Treasury Bond ETF (SGOV)
Bonds may be less volatile than stocks in the aggregate, but they can still lose value. When interest rates rise aggressively like they did in 2022, bonds can see sharp losses due to the inverse relationship between bond prices and yields. A way to mitigate this is via an allocation to cash-like assets with minimal duration, with duration being one measure of interest rate sensitivity. A good example here is SGOV, which holds U.S. Treasury bonds with maturities less than or equal to three months. With an effective duration of 0.1 year, SGOV can be expected to lose just 0.1% if interest rates rose by 1%, all else being equal. The ETF is a great way to hold a safe cash allocation while still earning a decent yield. SGOV costs an expense ratio of 0.05%.
SPDR Gold Shares (GLD)
The three core asset classes are stocks, bonds and cash. Beyond these three are alternative investments, which can provide unique risk/return profiles. A common alternative investment is gold, desirable worldwide as a store of value, inflation hedge, manufacturing input and currency reserve. Although gold’s price can be volatile and subject to supply and demand, the metal has a historically low correlation with stocks and bonds. A small allocation to gold can therefore help portfolios during situations when stocks and bonds fall together, such as occurred in the late 1970s. A great way to invest in gold without buying physical bullion is via an ETF like GLD. GLD costs an expense ratio of 0.4% and has tracked the spot price of gold closely since its inception.
Real Estate Select Sector SPDR Fund (XLRE)
Real estate investment trusts, or REITs, are another popular alternative asset class. REITs are publicly traded companies that invest in or operate real assets. Investors often purchase REITs for their high passive income potential and exposure to real estate prices. As a result, REITs can be a good substitute for a rental property. In lieu of picking individual REITs, investors can buy ETFs like XLRE, which holds 31 large-cap U.S. REITs and real estate development companies represented in the S&P 500. XLRE is a great way to instantly obtain a market-cap-weighted portfolio of the most notable REITs in the U.S. market. The ETF costs an expense ratio of 0.1%.
10 ETFs to build a diversified portfolio:
— Vanguard Total Stock Market ETF (VTI)
— Vanguard Total International Stock ETF (VXUS)
— Vanguard FTSE Developed Markets ETF (VEA)
— Vanguard FTSE Emerging Markets ETF (VWO)
— iShares Core U.S. Aggregate Bond ETF (AGG)
— Vanguard Tax-Exempt Bond ETF (VTEB)
— iShares TIPS Bond ETF (TIP)
— iShares 0-3 Month Treasury Bond ETF (SGOV)
— SPDR Gold Shares (GLD)
— Real Estate Select Sector SPDR Fund (XLRE)
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Update 01/05/23: This story was published at an earlier date and has been updated with new information.