A Few Good ETFs

A handful of exchange-traded funds can provide a great degree of diversification

The number of exchange-traded funds (ETFs) in operation is tiny compared to the number of mutual funds available to investors. Still, it's possible to put together a diversified portfolio using only a handful of ETFs.

An ETF that tracks the S&P 500 index alone would provide broad exposure to the equity market, said David Braverman, a vice president with the company's portfolio services unit. Investors could then add one fund that tracks an index of small-cap stocks, and another that does the same for mid-caps, he said.

There are very few ETFs that invest in fixed-income securities, "but I think you can put together an adequate portfolio with what's out there," Braverman said.

Of the 187 ETFs in operation as of the end of October, only six tracked bond indexes, according to the Investment Company Institute, the fund industry's trade organization. Of the remainder, 132 invested in domestic stocks, and 49 bought shares of foreign companies. By comparison, there were over 8,000 mutual funds on the market, excluding money market funds.

Standard & Poor's has put together a suggested portfolio of nine ETFs that invest in domestic and foreign stocks and U.S. bonds. The list of funds and the percentage of assets Standard & Poor's recommends keeping in them appears in The Outlook, a weekly newsletter. The latest asset breakdown, which appeared in the November 2 issue, appears below.

For exposure to the S&P 500, the model portfolio includes S&P Depositary Receipts (SPY), or SPDRs. Mid-cap and small-cap stocks are represented by S&P MidCap Depositary Receipts (MDY) and iShares S&P SmallCap 600 Index Fund (IJR). The iShares fund is a product of Barclays Global Investors.

The list includes four Barclays ETFs that invest overseas: the iShares MSCI EAFE Index Fund (EFA), the iShares MSCI EAFE Index Fund (EFA), the iShares MSCI Emerging Market Index Fund (EEM), and the iShares MSCI Japan Index Fund (EWJ).

Bonds in the portfolio are represented by two other Barclays ETFs, the iShares Lehman Aggregate Bond Fund (AGG) and the iShares Lehman 1-3 Year Treasury Bond Fund (SHY).

These ETFs are aimed providing adequate diversification, Braverman said.

In addition to the S&P 500 SPDR, Rosanne Pane, a mutual fund strategist at Standard & Poor's, suggested that investors seeking broad exposure to domestic stocks could also consider the iShares S&P 1500 Index Fund (ISI), or the iShares Russell 3000 Index Fund (IWV).

Investors can supplement core ETF holdings with sector funds that focus on selected groups of businesses or industries, Braverman and Pane said.

These funds can take off when a sector gets hot, as energy companies have been recently and technology companies were in the late 90s. But they can cool just as rapidly as they heat up.

Because of their potential volatility and risks, Pane said investors should limit their investments in sector funds to 5%-10% of their total assets.

"It would be sort of a cardinal error to make a sector ETF the centerpiece of your portfolio, or the only holding in your portfolio," said Braverman. "By nature, they're not intended to be diversified."

A MODEL ETF PORTFOLIO

InvestmentAdvisor.com has more mutual fund news from Standard & Poor's available here.

Allocation

Asset Class/Investment Style

ETF/Ticker

Expense Ratio

*One-Year Total Return

45%

U.S. STOCKS

35

Large-Cap Blend S&P Dep Receipts (SPY)

0.12

12.1

6

Mid-Cap Blend S&P MidCap Dep Receipts (MDY)

0.25

21.8

4

Small-Cap Blend iShares S&P SmallCap 600 Index Tr (IJR)

0.20

21.0

20%

FOREIGN STOCKS

9

International iShares MSCI EAFE Index Tr (EFA)

0.35

25.4

4

Japan iShares MSCI Japan Index Fd (EWJ)

0.84

26.0

4

Pacific iShares MSCI Pac Index Fd (EPP)

1.50

33.6

3

Emerging Markets iShares MSCI Emerg Mkt Index Fd (EEM)

0.78

49.7

20%

BONDS

10

U.S. Debt iShares Lehman Aggregate Bond Fd (AGG)

0.20

2.5

10

U.S. Short-Term Debt iShares Lehman 1-3Yr Treas Bond Fd (SHY)

0.15

0.8

15%

CASH U.S. 6-Month Treasury Bills

Total = 100

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