An all-passive portfolio for investors with very long time horizons.
By Christine Benz | 11-09-14 | 06:00 AM | Email Article

Investors often look to Morningstar for a definitive answer on whether they should employ actively managed mutual funds or simple low-cost index funds and exchange-traded funds.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

The answer, alas, isn't black and white. Assuming an investor focuses on low-cost funds (whether active or index), creates a sound asset-allocation plan, and doesn't undermine his or her results by buying high and selling low, it's possible to create a successful portfolio plan using an all index funds, all actively managed products, or some of both.

For the past three weeks, I've rolled out model portfolios consisting of actively managed funds. These portfolios--an Aggressive, Moderate, and Conservative version--are geared toward still-working investors at various life stages. I used Morningstar's Lifetime Allocation Indexes to help guide the portfolios' asset allocations and populated them with actively managed funds that earn "Medalist" ratings from Morningstar analysts.

Beginning this week, I'll feature portfolios with similar allocations--Aggressive, Moderate, and Conservative--that are instead composed of passively managed products. As with the actively managed portfolios, I'm using Morningstar's Lifetime Allocation Indexes to guide the ETF portfolios' stock and bond mixes, and I relied on our passive fund researchers to help select the holdings.

The Portfolio Details
This portfolio uses the aggressive version of the Morningstar Lifetime Allocation Index geared toward investors retiring in 2055. Such an investor could reasonably use a total U.S. stock market index fund and a total international stock market index fund--and perhaps a dash of bond exposure via a Barclays Aggregate tracker--and call it a day. Employing broadly diversified funds is the best way to keep a portfolio's costs down. And by limiting the number of moving parts in a portfolio, an investor might also squelch his or her impulse to make unnecessary trades.

I used a total U.S. and total international index fund as the anchors for the portfolio, but supplemented them with dedicated exposure to domestic small-cap value and emerging-markets stocks. Of course, a total market tracker will also supply a dose of small-value stocks--roughly 3% of total assets--but I added additional exposure in recognition of the fact that value stocks--and small-value, in particular, have historically delivered a slight performance edge relative to large. (Note that the small-value index has enjoyed a strong run so far in 2014, so investors initiating a position right now might consider moving in via a dollar-cost averaging program.)

I also employed separate developed- and developing-markets exposure on the recommendation of Morningstar ETF strategist Sam Lee. He pointed out that holding discrete developing and developed components can help facilitate rebalancing when mature markets outpace developing--and vice versa. And perhaps even more importantly, the developed-markets index fund is cheaper than a total stock market index fund, so holding the two funds is actually cheaper than holding  Vanguard FTSE All-World ex-US ETF .

50%:  Vanguard Total Stock Market Index ETF
10%:  Vanguard Small-Cap Value ETF
30%:  Vanguard FTSE Developed Markets ETF
5%:  Vanguard FTSE Emerging Markets ETF
5%:  Greenhaven Continuous Commodity ETF

How to Use
Note that these portfolios aren't designed to shoot out the lights over short time frames. Rather, the goal is to depict sensible asset-allocation mixes for investors at varying life stages and to show how to put Morningstar's best ETF ideas into action.

I'll employ a long-term, hands-off approach to portfolio maintenance and will only make changes if something has fundamentally changed with one of the holdings. Because index products almost never undergo any substantive changes, I would expect to make even fewer alterations to the ETF portfolios than I will to the actively managed ones.

It's also worth noting that investors can employ similar traditional index mutual funds in place of the exchange-traded funds featured in these portfolios. Equity exchange-traded funds will generally be more tax-efficient over time than comparable index mutual funds, but both types of products are extremely tax-efficient. And while this portfolio tilts heavily toward Vanguard's ETF lineup, investors might reasonably employ a similar basket of ETFs from other providers.

Finally, investors who wish to hold the portfolios inside of a taxable account should consider foregoing the commodities-tracking ETF, which, like most commodities-focused investments, will tend to have poor tax efficiency.

Note: We're currently having some issues with our Comments field; many readers have not been able to post comments below articles. We're working to get this fixed, but in the meantime, I welcome any questions or feedback you have on the model 'saver' portfolios that I've posted the past few weeks. You can post here, and I'll check in with this thread periodically.  

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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