How to Choose an Index ETF Portfolio?

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How to Choose an Index ETF Portfolio?

Deciding on an entire portfolio index portfolio from scratch is no easy problem. But it is an essential thing. If you decide to choose your index portfolio, you will need to be very careful about what you are going to invest in. Once you have chosen it, you will need to stick with your portfolio. If you plan to invest for the long-term, you may have to invest in your new portfolio for more than ten years.

Therefore, it is crucial to do this carefully. You will have to decide on your asset allocation and your international exposure. From there, you will have to find the indexes you want to invest in. And finally, for each index, you will have to find an Exchange Traded Fund (ETF) to invest in it.

Nevertheless, choosing your index portfolio from scratch may not be necessary. And it may not even be a good idea! In most cases, you should invest a simple, broad portfolio. Making too many choices in your portfolio is market timing and is unlikely to pay off in the long-term. But I still believe it is an interesting exercise. And you can design a simple three-fund portfolio from scratch and have something quite sound.

So, in this post, we are going to cover in detail all the different steps involved in choosing your index ETF portfolio.

Asset allocation

The first thing that is necessary to decide is the asset allocation of your portfolio.

Two main investment assets interest us: stocks and bonds. I have already talked about these two assets. But it is crucial to understand their differences to design a good portfolio.

Stocks are there for the returns part of your portfolio. They are more aggressive investments than bonds, by far. They are quite volatile, meaning that they can move several percents in a single day. And over a year, they can have substantial increases or substantial decreases.

On the other hand, bonds are the safest part of your portfolio. They are here to stabilize it. In bad financial times, your bonds should perform better, or not as bad, than stocks. So, if you have to leave your portfolio, you can sell some bonds when times are bad and let your stocks recover. Contrary to what some people believe, they are not exempt from risks at all. It is not unlikely for bonds to go down a lot, either! They are just less likely to go down as much as stocks.

In your portfolio, you can have both. But you have to decide on how much of each. How much of each asset is your asset allocation. If you are conservative and risk-averse, you should have a high allocation of bonds. If you want aggressive investing for the long-term, you want more stocks. One rule of thumb is to hold your age in bonds. However, I do not believe this rule of thumb makes sense. Your asset allocation is something quite fundamental, and you should not take it lightly.

One thing you should not forget is that you should consider your allocation on your entire net worth. For instance, I am considering my second pillar as bonds due to its very conservative investment. Therefore, I am not investing in bonds in my investment portfolio. In my broker account, my allocation is 100% to stocks.

There is another crucial thing. You should hold bonds in your home currency, ideally bonds from your own country. These bonds are supposed to stabilize your portfolio. Therefore, you do not want to have currency risk with them. Moreover, bonds are very different from one country to another. In the United States, treasury bonds are quality bonds and have nice yield. However, here in Switzerland, bonds have negative yields. And in some countries, bonds are riskier. Therefore, you need to consider the bonds available in your country to decide your asset allocation.

International Allocation

Once you have decided on asset allocation, you need to determine the international allocation of your portfolio.

Although you could, you should probably not hold only stocks of your own country. Your international allocation is the percentage of foreign stocks in your portfolio. You could also have international bonds and then decide on your international bonds allocation. But I do not think that international bonds should be in a standard portfolio. So, we should focus on international stock allocation.

Your international allocation will highly depend on your country. Generally, the smaller your country is, the more you should have foreign stocks. You want to profit from returns in the world, not only in your little country.

However, for people in the United States, the international allocation can be quite small. Some people in the U.S. do not have any international stocks in their portfolios. The United States stock market is around 50% of the entire world stocks. Therefore, there is less interest in having a large international allocation. On the other hand, for a small country, you are losing out on a lot of stocks if you only invest in the local stock market.

Personally, my international allocation is 80%. I only hold 20% of Swiss stocks. The rest are stocks from the entire world.

Choosing the indices

Together, your asset allocation and your international allocation will tell you what will be part of your portfolio. For instance, if your bond allocation is 20% and your international allocation is 50%, your portfolio should be made of these assets:

  • 20% Local Bonds
  • 40% Local Stocks
  • 40% International Stocks

Now, you need to find indices to invest in for each for your assets. For some assets, this is pretty easy because there is only one index for this asset. However, for some popular assets, there are many indices that you can choose from. Another thing you have to decide is whether you want to use a World index or several smaller indexes. In most cases, you want to use a world stocks index for your international stock allocation. But that is also something you can choose for yourself.

I wrote a full article on how to choose between stock market indexes if you want all the information. Here are a few points you would need to consider to choose an index:

  1. The country of the stocks in the index. Usually, you should know that before. However, be aware that, for instance, not all European indexes invest in the same countries.
  2. The size of the index. This size is the number of companies in the index. Generally, a higher number indicates that the index will more closely follow the performance of the market. However, once it is very large, adding new companies does not make a large difference since most indexes are market-capitalization-weighted.
  3. The size of the companies. Most indexes are following the stocks of companies of given market capitalization. For instance, one index could be following only Large-Cap companies. It is up to you to decide what kind of companies you want to invest in.
  4. The style of investing. Some indexes are tracking only in value stocks or growth stocks. Some indexes are tracking all of them together.

As you can see, even choosing a stock market index is not that easy. Even though you have a lot of choices, you should avoid being too refined. Try to have the broader index as possible. If you select only a few countries to invest in, this is market timing, and you have no idea how it will end. If you choose only small-cap companies, this is also market timing! Be careful of not optimizing too much. In the long-term, over-optimization never pays off.

Choosing the ETFs

You should now have a portfolio of indexes. For instance, if you are in the United States, your portfolio could look like this at this stage:

(Note that this is only an example, I do not advice this portfolio, it is too conservative for most people)

Unfortunately, you cannot invest in an index. You need to find a mutual fund or an Exchange Traded Fund (ETF) that follows this index. And once again, there are often several funds following the same index. Therefore, you will need to choose between different index funds.

I wrote a complete article about how to choose between different index funds if you want all the details.

Shortly, here are the main things you need to consider when making this choice:

  • The Total Expense Ratio (TER). How much the fund is charging on your assets is very important. You want to limit the fees to a minimum.
  • The Assets Under Management (AUM). The size of a fund is an essential indicator of how well it is going. And larger funds are generally replicating the index better.
  • The number of stocks. Even though several funds follow the same index, they may have a different number of stocks. For instance, they may too small to replicate the index correctly.
  • The dividend distribution. Some funds are distributing the dividends directly to you while other funds are accumulating and reinvesting them directly. Depending on the taxation laws in your country, one may be better than the other.
  • Currency Hedging. To protect yourself against currency volatility, you can opt-out for a fund that is hedged against your base currency. However, you will pay a premium for that.

These are only the main things you should look at when you compare two index funds tracking the same index. But there are other points that you may want to look at if you are serious about it, such as the trading volume.

Finalizing our example portfolio

We can finish the small example we started with actual ETF chosen for each of the indexes:

  • 20% iShares U.S. Treasury Bond ETF (GOVT)
  • 40% Vanguard S&P 500 ETF (VOO)
  • 40% Vanguard FTSE All-World ex-US ETF (VEU)

Once again, this is only an example for the sake of the article. But starting from the asset allocation and the international allocation of a fictional investor, we have been able to design a simple portfolio of three good ETFs. By now, we have convered the entire process of choosing an index portfolio.

Conclusion

As you can see, choosing your passive ETF portfolio is not necessarily. First, you need to choose an asset allocation for your situation. Then, you need to decide how much international exposure do you want. From these two percentages, you can start to choose stock market indexes to invest in. Finally, for each index, you can choose an index fund.

This process is much easier if you choose an existing portfolio, such as the popular three-fund portfolio. The biggest problem with designing a portfolio is that it highly depends on where you live and on your situation. The three-fund portfolio is excellent, but it will look quite different if you are living in Switzerland or the United States.

Indeed, the Swiss stock market is tiny, so a large allocation to this market may be a bit risky. Moreover, Swiss bonds have negative yields and, therefore, should be avoided. So, even if you decide on the three-fund portfolio, you still need to take local information into account.

Even though you may not have to choose a portfolio yourself, it is essential to know what you are investing in. You do not have to do all the choices yourself. But you should know what you are investing in and you should understand why you are investing in each of your assets.

Did you ever choose an entire portfolio? What is your current investment portfolio?

Mr. The Poor Swiss

Mr. The Poor Swiss is the author behind thepoorswiss.com. In 2017, he realized that he was falling into the trap of lifestyle inflation. He decided to cut on his expenses and increase his income. This blog is relating his story and findings. In 2019, he is saving more than 50% of his income. He made it a goal to reach Financial Independence. You can send Mr. The Poor Swiss a message here.

18 thoughts on “How to Choose an Index ETF Portfolio?”

  1. Hi,
    Living in Europe, what bonds portfolio would you suggest? I know that Vanguard has a global bond (BNDW), but I don’t know how to find it at European markets

    1. Hi K,

      Personally, I do not invest in bonds. If you want to invest in bonds due to your risk allocation, I would advice first to take bonds of your own country if they are any good.
      I do not think BNDV is in the Europea Markets. iShares have some global bonds ETFs. You could even invest in only USD bonds if you would like.

      Thanks for stopping by.

  2. Very interesting post, thank you. Would you recommend the Vanguard ETF versus investing in the Vanguard index fund directly? There is a 100k minimum to invest in the fund directly, but supposing that weren´t an issue which one would you go for and why?

    1. Hi Dimitry,

      First, it will depend if you have access to the fund itself or not. In Switzerland, we have no access to Vanguard funds, only ETFs.
      If you have access, you can invest in any of them. It will be almost exactly the same thing. Some of the ETFs are slightly lower fees. But it is almost irrelevant.
      Then, as you said, index funds have a higher minimum. But I never heard of such a minimum for Vanguard funds. I thought they were in the ballpark of 3K, no?

      Thanks for stopping by:)

  3. Good article, but I would suggest bonds are riskier than stocks for (young) investors. I see risk also as the chance my investments don’t yield enough, which is the case for bonds vs. stocks over longer time frames.
    Therefore just like you I don’t invest in bonds at the moment.

    1. Thanks, B :)

      I would not say they are riskier, because their negative years are less strong than negative years for stocks.

      On the other hand, I completely agree that they are a risk of slowing down the progress for young investors! I never put it like that before, but it does make a lot of sense to express it like this!

      Thanks for stopping by :)

  4. Are you familiar with the impact investing or ESG investing? It seems this is becoming a trend recently and it will grow in the future. They forecast that millennials (23-39 years old) will transfer 40 trillion dollars of assets to ESG investing in the next 20 years.

    Are you taking ethical impacts into the account when building your portfolio?
    Do you know if there are already any ETFs that are focusing on these aspects already?

    1. Hi Vale,

      I am not really familiar with it but I know what it is. I have never seen such a forecast, but I would not really be surprised if this started getting bigger.

      So far, I am not taking ethical impacts into account when building my portfolio.
      There are many ETFs that take this into account. You can search for ESG ETF, Socially Responsible ETF, Sustainable ETF. They all do the same things.
      The problem is that many of them are fairly small and have higher TER. But if they become bigger and cheaper, I will consider investing.

      Thanks for stopping by!

  5. If one has a good amount of cash parked, returning 0% with constant threat of negative interest rates, what and where would you suggest to invest, as stocks and real estate are in bubble territory already?

    1. Hi D. Oesch,

      Honestly, I do not know. If you do not want to invest in the stock market or real estate, you could try to invest in P2P Lending or P2P investing. You could consider creditgate24 or cashare for instance in Switzerland. I do not have any better option than the stock market.

      Thanks for stopping by!

  6. Hello Mr The Poor Swiss,

    It would be great if your example is more Europe centric not US centric, for example what kind of portfolio profile would you advise a Swiss person?

    Thanks in advanced! :)

  7. hi there,

    Popping by to ask a question related to ETF. Why do you choose VT instead of VWRL?
    And what do you think of UVSA?

    There are options to have CHF hedged ETF instead of in USD, what do you think of that? I noticed that people I know in Switzerland chose the USD ETF but not CHF hedged ones. I am curious why so. Thanks!

    1. Hi Yasi,

      VWRL is an ETF from Europe (UCITS) while VT is an ETF from the U.S.
      Both are good ETFs. But ETFs from the United States are more efficient from Switzerland since they will withhold fewer dividends (you will save 15% of the dividends).
      And VT is more global since it contains both developed and emerging markets.

      VUSA is good but will only invest in the USA, so it’s less diversified.

      CHF hedged is good but only for the short-term. For the long-term, it will be too expensive (eat too much of your profits). If you have a few months to a year investment time frame, you may want hedged ETFs but otherwise, it’s not that interesting.

      Thanks for stopping by!

      1. Hi the poor swiss guy

        Thanks for your answers. I thought ETFs from Ireland are subjected to the 15% withholding tax instead of 30%. But VT is from US, how is it more efficient from Switzerland?

        my second question is that when you say for long term investment, USD ETF is better, and CHF hedged will eat up the profits, how so? Isn’t it exposing my investment to FX risks? So I put CHF into IB, and convert CHF to USD each month. Like this?

        Thanks for your answers.

        yasi

        1. Hi Yasi,

          Yes, you are right, with Ireland ETFs, you will lose 15% tax and you cannot get back this tax. On top of that, 15% will be withheld too and you can get that back.
          However, 15% dividends from U.S. stocks are removed from the U.S. government. This is not recoverable and you will never see it on your Ireland ETF.
          On the other hand, we have a treaty with the United States where this 15% are canceled but only if the fund is U.S.
          So, with a U.S. ETF, you will get 15% withheld (counted as paid taxes).
          And with an Ireland ETF, you will lose 15% of U.S. dividends without any way of getting it back.

          So, if your fund had U.S. stock, a U.S. ETF is better. If it has no U.S. stock, it’s the same efficiency.

          Of course, USD ETF will have currency risk. CHF Hedged will reduce this risk. But this will strongly increase the costs of the ETF.

          It’s up to you to choose whether you want currency risk or hedging costs.

          Thanks for stopping by!

          1. Hi the poor swiss guy,

            Thanks for your clarification. It is indeed quite complicated to understand at first glance. I think what you mean is the L1TW and L2TW tax. If I buy Ireland based ETF, the L1TW 15% tax is gone. but if I buy US based ETF, thanks to the swiss/us treaty, we can claim the L1TW 15% tax when we file annual tax and it is counted as paid tax. Is it so?

            But I think Ireland doesn’t withhold any tax to foreign investors. the L2TW (level 2 tax) is 0%. So we lose 15% tax which US charged to the Irish ETF.

            Have you read the new? since 1 Jan 202, pillar 3a all US based investment withholding tax to swiss residents will be 0%.

            thanks again for the info.

            yasi

          2. Hi Yasi,

            You synthesized it very well!
            The problem is only with U.S. Dividends indeed. For dividends from other counties, we would not have this issue.

            Yes, I have read the news, this is good for third pillar accounts.

            Thanks for stopping by!

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