Key Points
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When building a portfolio out of just three ETFs, the keys are diversification, fees, and compatibility.
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The core would be built around diversified U.S. and international stock ETFs.
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The third targets a theme that has held up well during past severely adverse bear markets.
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When most people think about investing in stocks right now, they think of the S&P 500 (SNPINDEX: ^GSPC) and tech stocks. These groups have driven stock market returns for several years, and most people’s portfolios are probably heavily concentrated in them right now.
But that doesn’t always work out over the course of decades.
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In the 2000-2009 decade, a pair of generational bear markets resulted in a lost decade for the S&P 500, where it lost 9% over that 10-year period. But some areas of the market didn’t perform nearly as poorly. Financials and tech were clearly the biggest losers, but energy, consumer staples, small-caps, and emerging markets all posted strong returns.
It may not seem like it lately, but diversification still pays off. Investing in multiple areas of the market at once may not maximize your return potential at all times, but it’ll probably smooth out the ride and limit some downside risk along the way.
You don’t need a dozen ETFs to achieve diversification, either. In fact, you can hit almost everything you need with just a few of them. But if you’re going to own just three ETFs to create a full portfolio, you have to make sure these funds are broadly diversified, cheap, and work well together.
Looking back over several decades of history, here’s a three-ETF portfolio that might be your best bet as a long-term holding.
Vanguard Total Stock Market ETF
Any time I talk about portfolio construction, I usually start with the Vanguard Total Stock Market ETF (NYSEMKT: VTI) as my core position. A lot of people will understandably use the Vanguard S&P 500 ETF (NYSEMKT: VOO) for this purpose. But I prefer VTI’s inclusion of mid-caps and small-caps to cover the entire U.S. equity market.
The potential issue with this fund, of course, is its heavy concentration in tech stocks, which currently account for around 43% of the portfolio. That’s clearly on the high side and exposes investors to some extra downside risk right now. If you want an alternative, consider the iShares MSCI USA Equal Weighted ETF (NYSEMKT: EUSA), which has allocations of between 12% and 18% in four different sectors for better diversification.
Vanguard Total International Stock ETF
International equity investing hasn’t been popular for some time. U.S. stocks have outperformed them by a large margin, and the extra risk that comes from less developed markets just hasn’t been paying off. That doesn’t mean that international investing should be written off.
If you go back to the start of the 1970s, you’ll see that U.S. and international leadership has rotated in multi-year cycles. Much of the 1970s and 1980s belonged to international. U.S. stocks outperformed in the 1990s, and international recaptured leadership in the 2000s. Since 2010, U.S. stocks have led in almost uninterrupted fashion.
The point is that international stocks are overdue for an extended stretch of outperformance, and they have a long history of doing that from time to time. The Vanguard Total International Stock ETF (NASDAQ: VXUS) is my pick for this. It invests in nearly 9,000 stocks across both developed and emerging markets, so you’re capturing exposure to everything.
Vanguard Small-Cap Value ETF
I’m guessing that the Vanguard Small-Cap Value ETF (NYSEMKT: VBR) won’t be a popular pick, given how poorly this segment has performed in recent years. But small-caps demonstrated how relatively well they can do in severely adverse markets from 2000-2009. That won’t always be the case, but its potential for diversification and above-average long-term returns makes it worth considering.
This ETF is the way I’d play it. The undervalued nature of the portfolio helps limit some downside risk, and the sector composition offers a nice complement to what you’d get from the Vanguard Total Stock Market ETF. Quality is usually an issue in the small-cap value category, but this portfolio is forecasted to deliver double-digit earnings and free cash flow growth, a good sign that fundamentals are in decent shape.
Together, these three ETFs should be able to deliver in multiple environments moving forward. They pair together well and should be able to provide a smoother ride in particularly volatile periods.
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David Dierking has positions in Vanguard Morningstar Total Stock Market ETF and Vanguard Total International Stock ETF. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
