by Maria Crawford Scott

You can still keep it simple, even if you make it complex.

There are many different “levels” of portfolios, ranging from a basic, bare-minimum portfolio to one that is very complex. By following an all-index approach to portfolio building, your portfolio can be barebones minimalist or highly intricate—yet still be relatively easy-to-build as well as low cost.

The simplicity or intricacy of your portfolio really comes down to the amount of time and interest you want to spend managing it, your investment knowledge, and the total amount of dollars you’ll be investing.

There are, however, several investment constraints that any investment portfolio must follow:

• First, it must meet your financial goals and match your risk tolerance. Your asset allocation—how much you put into the various asset categories—addresses these financial concerns and is driven by your investor profile.
• Second, it must be broadly diversified among major market segments.

With those constraints in mind, the easiest and most cost-effective approach is to build your entire portfolio around index funds. These are passively managed portfolios that do not require you to evaluate the skill of a portfolio manager, provide you with complete diversification within the market the index covers, are low maintenance and have rock-bottom costs.

And exchange-traded funds provide you with all the tools you need to do it.

Table 1 illustrates three basic ETF portfolio levels, from the simple, realistic minimum to the complex. The holdings in each portfolio are generic descriptions rather than specific ETFs.

The Bare Necessities

Level I contains only three ETFs, but covers substantial investment ground.

The total U.S. stock market ETF should be just that: an ETF that tracks a broad-based index, with U.S. common stocks of all capitalization sizes—large, mid and small cap.

While these ETFs hold thousands of stocks, the key is not the number but the weightings. Most indexes are capitalization-weighted, meaning that stocks with large capitalizations (number of common stock shares outstanding times the market price per share) tend to dominate any total stock index fund. Holding one total domestic stock index fund is a bare minimum holding, but you may want to augment it with a Level II mid-cap index or small-cap index ETF so that these segments of the market are not overpowered by the largest stocks.

While the total domestic market index ETF covers the U.S. markets, your portfolio needs to be global in scope. Foreign stocks add to overall diversification and risk reduction, even if the allocation is small. For that reason, the Level I portfolio includes an all-in-one total international stock ETF that should track a major index covering the primary regional economic zones: Europe, Asia/Pacific, and Latin America. This covers both developed and emerging international economies, but developed economies dominate the index, as does Europe, since capitalization weighting determines exposure and diversification.

The third component in the Level I portfolio is an intermediate-term government bond ETF. Intermediate-term maturities (average maturity of seven to 10 years) capture most of the yield and total return of a long-term bond fund with substantially less fund volatility caused by changing market interest rates. If your bond holding is in a non-tax-sheltered environment and your tax exposure is significant, you may want to consider an intermediate-term municipal bond ETF.

The liquidity account is the same for all three levels. Any short-term (less than one-year maturity), liquid fixed-income investment with absolutely no default risk can be used for this purpose. Several brand-new ETFs fit this description, but money market funds and bank accounts fit the bill as well.

Table 1. Exchange-Traded Fund Portfolio Levels: From Basic to Complex