Ready for an All-ETF Portfolio? Here Are Some Models

PENNY MARLIN HAS over two decades' worth of experience as a financial advisor. Two years ago she decided to open her own shop in Delray Beach, Fla., a coastal town about an hour north of Miami that's popular with retiring baby boomers. She oversees $12 million that's invested in index and actively run mutual funds. However, she has been increasingly favoring exchange-traded funds as a cheap and easy way to get exposure to every part of the stock market. "I'm constantly making comparisons," she says.

One thousand miles away is Clark Capital Management, a $1.2 billion advisory headquartered in a sprawling steel and glass tower that dominates Philadelphia's skyline. The company's experts can pump their clients' money into a variety of sophisticated investments, including hedge-fund products. But this firm, too, has been using ETFs to play the market. "They've become more and more the mainstream," says Sean Clark, the firm's chief investment officer. "We've never had an issue with liquidity."

Exchange-traded funds are at the center of one of the biggest transformations in the indexing world, a no-frills fund category that was launched by Vanguard in 1976. As ETFs have spread to every corner of the stock market, both here and abroad, financial advisors small and large have been turning to these products for their flexibility, tax efficiency, low cost and, in some cases, market-beating returns. A decade ago 19 ETFs held a measly $6.7 billion. Now there are 545, according to State Street, that hold $505 billion. That's still a small sliver of the $10 trillion sitting in mutual funds, but the impact has been swift and dramatic.

With the ETF universe growing at warp speed, we wondered: Could you now create an all-ETF portfolio? More specifically, would you want to? All-ETF portfolios come with their own set of risks and rewards — and not every investor can pull one off successfully. That's why we interviewed financial advisors from across the country to see how they would put together portfolios that would fit not only an investor heading toward retirement but also one who can stand a little more risk.

To do so, we made some assumptions about who would be ideally suited for such an exercise. For example, if you invest for retirement solely in a 401(k) then the following models won't make much sense, since you can't dollar-cost average into an ETF like you can a mutual fund. The trading commissions are prohibitive. That's one of the reasons why you won't see an ETF in your 401(k) — at least not yet. And if you are a buy-and-hold type you may be able to do just as well by sticking with the tried and true index mutual funds at shops like Vanguard. But if you have some extra cash and can invest it in one big lump sum or if you want to diversify outside the funds in your 401(k), then an all-ETF portfolio might be an intriguing option.

That's because ETFs offer some attractive advantages over other investments. For one, you don't have to worry about finding the best pharmaceutical or retail stock, for example. Just buy the industry ETF. In addition, since ETFs constantly change hands you can jump in and out of the market quickly, a huge selling point for active traders. In most cases, they can also be shorted. And for the most part they charge cheap fees and have better tax efficiency than mutual funds since their low turnover doesn't typically lead to big capital-gains hits. A new generation of ETFs is even allowing small-time investors to get access to some sophisticated strategies that in the past were reserved for a select few. That puts Marlin on a level playing field with her bigger competitor in Philly.

In the wrong hands, though, those benefits can actually cause problems. After all, the original idea behind index funds was to give investors access to the entire market through a product that shunned sales and marketing charges while eliminating turnover. Being able to trade index funds throughout the day — in addition to shorting them, too — is anathema to John Bogle, Vanguard's founder. "If long-term investing was the paradigm for the classic index fund," he said in a Wall Street Journal opinion piece last week, "trading ETFs can only be described as short-term speculation." He has a point. Most of the newer products are untested and designed with institutional or hedge-fund clients in mind. Today, many ETFs track benchmarks that didn't exist just two years ago. Finally, there's also a profit motive at play here: ETFs generate about $1 billion in management fees. That doesn't include the trading commissions that fall into the pockets of brokerages and wire houses.

But even Bogle had his doubters at the beginning. We're about to see one of the largest chunks of ETFs celebrate their third birthday, an important starting point for studying long-term performance. And while there are clunkers on the market, there are also just as many ETFs that have proven their mettle. That doesn't mean your favorite fund manager will be out of a job any time soon. Many advisors still prefer putting their money with an expert whose skills have been honed over decades dealing with the market. However, it should serve as a reminder to all those high-priced laggards out there that better returns at lower costs are an easily obtainable option for every type of smart investor.