Low Cost Diversification With Vanguard Total World Stock ETF (VT)?

In this Ask The Expert With Larry Swedroe article, the reader, Murali, is wondering if she could use the Vanguard Total World Stock ETF (VT) to simplify and diversify her investment portfolio.  Vanguard is known for its high quality and low cost investment products, and the Total World Stock ETF should provide most of the needed diversification all in one shot.  Should she invest as much as 50% in one equity fund? What should she do?  Here’s the question from Murali:

What is your opinion about having Vanguard Total World Stock ETF (VT) as much as 50% of ones equity portfolio? It seem to provide the needed diversification with low cost. At present the US equity accounts for about 45% in this ETF.

Answer From Larry Swedroe

There are a few important points here.

EFTs Should Be More Tax Efficient Than A Similar Open-Ended Fund

The first is that in general, for taxable accounts ETFs are a very good choice because, all else equal, they should be more tax efficient than a similar open-ended fund based on the same index. However, ETFs are not a very good choice for the small investor doing dollar cost averaging because of the high transactions costs.

Core Funds Are Better Than Component Funds

The second is that core funds are better than component funds. By core I mean a fund that represents several asset classes instead of the single asset class that a component fund would have exposure to. For example, owning a 50/50 allocation to the S&P 500 value and S&P 500 growth makes no sense because you can own the same thing by simply owning the S&P 500 itself. This is a common error I have seen many investors and even professional advisors make. The core S&P 500 fund will avoid the turnover that the component funds have caused by the “migration” of stocks from value to growth and vice versa. In addition, a core fund eliminates the need to rebalance between the funds, saving taxes and possibly transactions costs.

Core Funds Can Be Used As A Starting Point

The third point is that the core funds can be used as a starting point and then you can “tilt” your portfolio towards your preferred asset allocation, but then you only need to use a small amount of the components. Using our same example of the S&P 500 and the component value and growth funds, let’s assume you have $100,000 and you want to be allocated $75,000 to value and $25,000 to growth. Using the component approach you would have that allocation. But using the more tax efficient core approach you can hold $50,000 of the S&P 500 and (which is $25,000 value and $25,000 growth) and then add $50,000 of the S&P 500 value fund. That would give you the 75/25 allocation you want but do so in more efficient manner.

Most Investors Have Too Low an Allocation to International Assets

The fourth point is that, in my opinion, most investors have too low an allocation to international assets. They make this error because they confuse the familiar with the safe. I discuss this, and why international stocks should play a significant role in the portfolio, in The Only Guide to Alternative Investments You’ll Ever Need. I believe U.S. investors should have at least a 30% allocation to international stocks and preferably closer to 50%. Further, as “The Only Guide” discusses, the best diversifiers of U.S. risks are international small and emerging market stocks. They are better diversifiers of U.S. risks than international large caps of the developed markets as they have low correlations. The book provides the logic and the evidence, showing you how their inclusion makes for more efficient portfolios. So you might want to consider adding a fund that represents that asset class. There are now ETFs that do so.

By using the VT fund you can minimize the need to rebalance between domestic and international as the fund will use its cash flows and dividends to rebalance internally. Rebalancing, while important to control the risk of your portfolio, often leads to tax inefficiencies (a cost worth incurring) because you are typically selling appreciated assets to generate proceeds to rebalance.

So the question for you is: Does this fund give you the asset allocation you desire? Does it have the right mix of domestic to international? If it does not, you can simply add more U.S. or more international by using Vanguard’s Total Market Funds (domestic and international) or ETFs to achieve your objective. It does not have to be black or white. You can combine the core and component funds to achieve your objective.

Finally, if you don’t yet have a written investment policy statement I urge you to write one down, including an asset allocation table, including rebalancing targets. Then make sure you check for rebalancing, and tax loss harvesting, on a quarterly basis. And always use new cash flows to rebalance, as that cuts down on transactions costs and can improve tax efficiency (as it reduces need to sell winners).

Disclaimer: Mr. Swedroe’s opinions and comments expressed are his own, and may not accurately reflect those of the firm, nor Moolanomy and its owner.

Larry Swedroe

Larry Swedroe is a principal and director of research at Buckingham Asset Management, LLC, an SEC Registered Investment Advisor firm in St. Louis, Missouri. He is also principal of BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.

Before joining Buckingham in 1996, Larry served as senior vice president and regional treasurer at Citicorp and vice chairman of Prudential Home Mortgage. Larry is author of The Only Guide to a Winning Investment Strategy You’ll Ever Need (updated and re-released in 2005), as well as six other books. Most recently, he authored The Only Guide to Alternative Investments You’ll Ever Need (2008).

Larry has started his own blog called Wise Investing at CBS Money Watch. Please check it out!