Build a Great ETF Portfolio

The Motley Fool, By Zoe Van Schyndel, CFA October 17, 2007

While it's tempting to chase performance, buying highfliers after they've already jumped will usually prove hazardous to your investing health.

For many months, the best-performing ETFs have invested in developing markets and natural resources. These markets may seem appealing, but they've had pretty good runs already, and it's not clear how long this performance will continue.

To avoid getting hit in a downturn, it's best to diversify your portfolio across a broad spectrum of investments. There are many different ways to structure your portfolio, and while the following four steps aren't the only way to go, they're a simple approach to get you started.

Step 1: Shop at home
Building a diversified portfolio should start with U.S. equities as a base. Exposure to the world's largest market is important, and an investment in the U.S. should be the most significant holding in your portfolio. The SPDR S&P 500 ETF (AMEX: SPY) can get you cheap and easy exposure to U.S. assets. If you want to further segment the markets, your equity exposure can be spread across various market capitalizations or styles.

Step 2: Add some bonds
A domestic fixed-income fund adds safety and income to your portfolio. The iShares Lehman 1-3 Year Treasury Bond ETF (AMEX: SHY) can be a solid base upon which to build your portfolio. As its name suggests, it holds short-term U.S. Treasury securities and tracks the Lehman 1-3 Year Treasury Bond Index.

Step 3: Go global
It's hard to imagine the world retreating from our ever-more-integrated and growing global economy. Although the U.S. is a huge part of that picture, it's increasingly important to look beyond our own borders when investing.

Broadly diversified equity funds that invest across a wide spectrum of countries can serve you well. The WisdomTree DEFA Fund (NYSE: DWM) invests in 20 different countries in Europe and the Pacific Rim. In addition, non-U.S. fixed-income securities give you some currency exposure, letting you take advantage of higher interest rates in some other countries. The SPDR Lehman International Treasury Bond ETF (AMEX: BWX) is an easy way to get bonds from countries including Italy, South Africa, and Taiwan.

Step 4: Specialize
Once you've placed most of your assets in a handful of broad-based domestic and global holdings, you might want to complete your portfolio with a few select and specialized funds. Such narrowly focused funds are risky, but also potentially offer high returns. You might add an emerging-market fund like the Vanguard Emerging Markets ETF (AMEX: VWO), or get some exposure to international real estate with a fund like the WisdomTree International Real Estate Fund (AMEX: DRW). If commodities interest you, the iPath Dow Jones AIG Commodity Index ETN (NYSE: DJP) may be what you need. Specific country funds like the iPath MSCI India ETN also let you focus in on areas of particular interest.

Best of all ...
The four-step process above won't cost you an arm and a leg. None of the funds mentioned has an expense ratio greater than 1%. That means you'll keep more of your money working for you.

With hundreds of ETFs to choose from, it's easy to diversify. Just make sure you cover the basics first, with investments in stocks and bonds, before placing your bets on more exotic assets such as precious metals. The optimal portfolio will be different for every investor -- but these ideas should help you create the portfolio that's right for you.