Radical Guide to Investing: Understanding the Core Portfolio

OK, now the rationale for the core portfolio.

First, we cover the US stock market. You could do this by buying a single “total market” ETF index fund, such as the Barclays i-Shares Dow Jones US Total Market Index Fund (ticker: IYY), or the Barclays i-Shares Russell 3000 Index (ticker: IWV). Alternatively, you could buy three separate funds that split the US market into large company stocks, mid-cap stocks and small cap stocks. Standard & Poor splits the US market into the S&P 500 (large cap), S&P Mid-cap 400, and the S&P Small-cap 600. Barclays iShares offers ETFs that track these indexes; the tickers respectively are IVV, IJH, and IJR. Russell splits the US market into the Russell 1000 (large and mid-cap) and the Russell Russell 2000 Index (small cap). Barclays offers ETFs that track these indexes; the tickers respectively are IWB and IWM.

There are three advantages to buying funds that split the US stock market into market cap groupings versus buying a single total market index fund:
    1     The US stock market, when weighted by company size, is dominated by large companies. So a total market fund is dominated by large cap companies. By splitting the market into two or three, you can increase your exposure to small and medium sized companies. Why might you want to do this? Historical data suggest that small company stocks, while riskier, appreciate more over time. If you divide your US stock allocation into one third large cap, one third mid cap, and one third small cap companies - effectively over-weighting small and medium companies relative to their actual share of the market by value - you may reasonably expect greater long term appreciation than if you buy a total market fund.
    2     Building greater granularity into your portfolio provides more opportunities for rebalancing. Portfolio rebalancing is discussed in the next chapter, “Managing Your Portfolio”.
    3     Your will lower the overall expense ratio of your portfolio if you opt for the S&P split of the market. All the ETFs mentioned (including the total market ETFs) have annual expense ratios of 0.2%, with the exception of IVV, the Barclays i-Shares S&P 500 Index fund, which has an annual expense ratio of 0.09%. So if you cover the market with three ETFs including IVV as opposed to a single total market ETF, you’ll lower the annual expense ratio of your portfolio.

Which split of the market - the S&P split or the Russell split - should you adopt? Both have advantages. The Russell split has the advantage that it offers greater diversification by covering more stocks: 1000 large and mid-cap stocks (the Russell 1000) and 2000 small cap stocks (the Russell 2000) versus S&P’s 900 large and mid-cap stocks (the S&P 500 and the S&P Mid-cap 400) and 600 small cap stocks (the S&P Small-cap 600). Also, the Russell split may be better for taxable accounts, as the Russell 1000 fund doesn’t need to sell stocks (and realize capital gains) if they graduate from mid-cap to large cap status, whereas the S&P Mid-cap 400 index fund will sell stocks if they are promoted to the S&P 500 (large cap) index. On the other hand, you’ll pay slightly lower expenses with the S&P split due to the lower expense ratio on the S&P 500 Index fund. And the S&P split allows you to chose different weightings for large, medium and small stocks, whereas the Russell split only allows you to chose two weightings: large plus medium stocks, and small stocks.

My personal preference is to mix the two: buy the S&P 500 and Mid-cap 400 to cover large and mid-caps, and the Russell 2000 to cover small caps. That way you get the flexibility of choosing your weighting for large, mid- and small-cap stocks (which you can’t do with the Russell 1000), but also the greater breadth of the Russell 2000 versus the S&P Small-cap 600. And you also get the lower expense ratio of the S&P 500 index ETF. The downside to this is that 100 companies included in the Russell 1000 are excluded from the S&P 500 and 400, so you don’t get the same total market coverage as you do with just the Russell indexes.

So your US stock exposure will consist of two or three index ETFs: two funds that track the Russell indexes (IWB and IWM), three that track the S&P indexes (IVV, IJH and IJR), or two S&P indexes (IVV and IJH) and the small cap Russell index (IWM).

If you’re used to owning many mutual funds, you may be concerned by the small number of US stock funds in this portfolio. Don’t be. Between them, the three funds cover the entire US stock market and provide better diversification than any set of actively managed US stock mutual funds. And the fact that you can purchase the entire US stock market with only two or three trades (remember that you have to pay to buy and sell ETFs) keeps your costs down.

Next, we add two foreign stock funds: the the Barclays i-Shares Europe, Australasia and Far East (EAFE) Index (ticker: EFA), and the the Barclays i-Shares MSCI Emerging Markets Index (ticker EEM). These foreign index funds have higher expenses than the US funds (0.35% and 0.75% respectively). If you want significant exposure to emerging markets, the 0.75% annual expense ratio on the MSCI Emerging Markets Index fund is problematic; I’ll discuss using closed end funds as an alternative in the section on Emerging Markets & Closed-end Funds.

Next, we add bond index funds. Bond index ETFs are relatively new, and the choice is somewhat limited. (One important omission: there are currently no municipal bond index funds. Investors generally buy municipal bonds for their tax benefits, which are greatest with bonds issued in the investor's own State. There are numerous State-specific closed-end and open-ended bond funds.) You can cover corporate and government bonds with four funds: LQD, the iShares GS $ Investop Corporate Bond Fund; SHY, the iShares Lehman 1 to 3 Year Treasury Bond Fund; IEF, the iShares Lehman 7 to 10 Year Treasury Bond Fund; and TIP, the Lehman Treasury Inflation-Protected Bond Fund. These funds are broad bond indexes with low annual expense ratios (0.15%). If you want to, you can add another bond index fund with even longer duration: TLT, the iShares Lehman 20+ Year Treasury Bond Fund.

Two quick notes on bonds. First, the cheapest way to buy individual US Treasury bonds (no fees at all!) is at Treasury Direct from the US Treasury. The disadvantages of buying bonds direct through the US Treasury are (a) you buy individual bonds, and need to replace them when they reach maturity (more work); and (b) you need to set up a separate account with Treasury Direct, which makes asset allocation and rebalancing harder. Second, I mentioned that municipal bond index ETFs are not yet available. So investors wishing to avoid Federal and State taxes on their bond income will be forced to buy regular municipal bond mutual funds, closed-end bond funds, or individual municipal bonds. For ease of asset allocation and portfolio rebalancing, the best option is to buy closed-end funds (as you can keep them in the same account as the ETFs). However, many closed-end bond funds are leveraged (ie. borrow money to buy bonds), so you need to be careful.

Finally, we add real estate. ETFs that track real estate investment trust indexes include the iShares Cohen & Steers Realty Majors Index Fund (ticker: ICF; expense ratio: 0.35%); the iShares Dow Jones US Real Estate Index Fund (ticker: IYR; expense ratio 0.6%), and the streetTRACKS Wilshire REIT Index Fund (ticker: RWR; expense ratio: 0.25%). We’ll simply chose the index fund with the lowest expense ratio: RWR.

That’s it! You have a list of about ten index fund ETFs from which to construct an ultra-low cost, diversified portfolio. Three index funds cover the US stock market, two funds cover non-US stocks, four index funds cover the bond market, and one the real estate market via a real estate investment trust index. And if 10 ETFs are too much for you, don't despair: in the next chapter, you'll find a portfolio for low-maintenance investors.

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