How To Build A Portfolio With Four ETFs (2024)

I recently had dinner with a close friend. Our discussion wandered from friends and family to life’s troubles. A pit stop in our conversation was the announcement that this individual didn’t understand how to invest for retirement. Although embarrassing, the situation is all too common. For most people, planning for retirement is just plain overwhelming. This friend was no exception and had taken few steps to invest their money, let alone plan carefully. Paralysis by analysis claimed yet another victim.

When fear meets decision making, a common response is to simply ignore the problem at hand. Sometimes inaction is passable, however not for retirement planning. We must simplify the equation and remove complexities that might be less relevant. Over the course of this conversation, we picked apart the various aspects of working towards retirement and investing money in general.

The conversation showed that retirement planning boils down to two issues.

1. Retirees need consistent delivery of capital

For those retiring without a pension, retirement means the evaporation of an income stream that supported your daily expenditures. The consistency of salaried income is an important aspect of the American economy. An important aspect of the typical American salary is the bimonthly pay structure. Having money delivered to your account twice a month makes financial planning a breeze. Responsible retirement planning should incorporate the same concept, where retirees identify investments that can deliver consistent income in a format that enables budgeting. Interest and dividends delivered monthly or quarterly will be the two most important drivers of this income stream.

2. Retirees need long term growth

While the retirement time horizon is generally shorter than other investors, inflation is still a critical consideration. Income alone is not sufficient to support retirement because inflation causes the cost of living to increase. Pairing an investment strategy with the expectations of long term inflation is critical if you expect to maintain your lifestyle.

A generally accepted assumption for long-term inflation is between 3% and 5%. A portfolio growing at a long-term compound annual growth rate of above 3% should be able to reliably sustain a certain expectation of lifestyle. Bear in mind, this is not a portfolio yield of 3%, but rather a long-term income growth rate of 3%. Many of the highest yielding investments offer attractive income streams in the current term, however they are likely to evaporate over time. Although attractive initially, these investments can leave retirees in difficult situations in which their income has evaporated, and their capital must be drawn down.

These two considerations overshadow most others in terms of importance. While it’s important to analyze your retirement from every angle, most would agree a growing income stream would solve most issues retirees face. At this point in the conversation, we had eased a significant amount of worry because we had narrowed in our goals. We now understood the issue at hand and the next step was tackling this problem. By the check, we had arrived at a simple allocation composed of just four investments which we believed covered these goals. Let's explore these four funds further and finish with the asset allocation.

Criteria

The ETF market is deep with a wide variety of eligible investments to choose from. To narrow the selection, we should establish a set of criteria for investments that we find attractive. These criteria included the following three screens.

1. Each investment is an index fund

The primary advantage is passive management leading to cost efficiency and a consistent, quantitative strategy. The fees on these funds are generally lower because they track an index as opposed to being actively managed. Stock indexes provide an easy way to employ a strategy. By narrowing in and using financial data to assess the health of companies, indexing removes the guesswork from picking investments. Many investors including Warren Buffett have promoted index funds.

2. Each investment holds income producing assets

One of our core retirement tenets is the need for income producing assets. Each fund should produce income on a consistent basis to fund our expenses. This income will form the bedrock of the dividend distributions that will support our income. Income producing assets include stocks and bonds which pay dividends and interest. We have eliminated funds that employ leverage or the significant use of derivatives.

3. Each investment has an expense ratio under 1.00%

Expense efficiency is a critical consideration in investment selection. Over time, fees have a meaningful impact on returns. See the graphic below from the SEC which quantifies the impact of various fee rates over a 20 year period.

Actively managed investments and complex, leveraged investments have elevated expense ratios. While these can be justified, they create a performance drag on your assets. We can avoid these hefty expenses by selecting indexed investments from large managers.

By combining our original two tenets of retirement investing with these three screens, we can reduce the number of worthy investments. Narrowing further to cover a diversified set of industries, we arrive at just four ETFs. Let’s explore each fund in greater detail.

Schwab U.S. Dividend Equity ETF

The Schwab U.S. Dividend Equity ETF (SCHD) is an exchange traded fund managed by Charles Schwab (SCHW) that invests in large, dividend paying stocks. The fund invests in companies operating across sectors including energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, communication services, and utilities. Notably for our portfolio, SCHD excludes REITs. SCHD tracks the Dow Jones U.S. Dividend 100 Index, meaning each stock in the portfolio pays a dividend which is expected to grow.

SCHD is a fan favorite for retirement investors, telling one of the most compelling dividend growth stories of any ETF. Over the past five years, SCHD’s dividend has grown at a rate of 13.1% annually, far outpacing the current rate of inflation. Additionally, based on the current price, SCHD yields 3.45%, checking both of our boxes.

As with all funds managed by Charles Schwab, SCHD is cheap with an expense ratio of just 0.06%. SCHD has outperformed other dividend-oriented competitors through its index, which focuses on underlying financial metrics to drive security selection. More information on the index behind SCHD is available here. SCHD’s top holdings are blue chip, global companies with impressive dividend growth trajectories including Broadcom (AVGO), Merck (MRK), AbbVie (ABBV), and Home Depot (HD).

iShares Core U.S. REIT ETF

The iShares Core U.S. REIT ETF (USRT) is an exchange traded fund that invests in equity real estate investment trusts. USRT tracks the performance of the FTSE Nareit Equity REITs Index, meaning mortgage REITs, infrastructure REITs, and other tangential real estate companies (such as brokerages) are excluded. For investors, this means USRT provides exposure to some of the largest landlords in the United States.

Real estate has faced a tumultuous past year as interest rates continue to trouble the sector. However, as interest rates level and the fed begins to hint at rate cuts in the next year, tailwinds are mounting. If rate cuts arrive, REIT valuations could expand. Until then, investors have an opportunity to buy REITs at a higher yield than recent history afforded.

USRT invests in some of the largest and most qualified landlords in the world. The fund’s top three holdings are Prologis (PLD), Equinix (EQIX), and Welltower (WELL). PLD is the largest industrial landlord, owning a meaningful portion of the global supply chain. The firm has a fortress balance sheet and continues to grow through acquisitions, development, and providing asset management services. EQIX is the largest data center landlord, owning, developing, and operating a portfolio of data centers. WELL is the largest public senior housing landlord, owning, developing, and operating nursing care and senior living facilities.

USRT invests in a total of 135 domestic REITs, providing diversified investment in the real estate sector. As is consistent with the iShares line of ETFs, USRT is inexpensive, charging an expense ratio of just 0.08%.

iShares 0-3 Month Treasury Bond ETF

The iShares 0-3 Month Treasury Bond ETF (SGOV) is an exchange traded fund that invests in U.S. dollar denominated treasuries with less than three months to maturity. The ETF is designed to be a cash substitute with intraday liquidity. The most important differentiator for the ETF and a money market, is that SGOV is not “dollar in, dollar out” as with a money market mutual fund.

However, SGOV holds securities with less than three months to maturity, meaning there is little sensitivity to interest rates. Additionally, interest generated by the short-term treasuries is distributed as monthly income. As interest rates have increased, so have the dividends distributed by SGOV.

Note, the choppiness in share price is the result of SGOV trading ex-dividend during the month. As rates have climbed, so has SGOV’s monthly distribution. As the dividend increases, the impact of SGOV trading ex-dividend on a specific day becomes more pronounced.

Based on current share prices, SGOV yields 4.93%, which is commensurate with current money market rates. Rising rates have been a key tailwind for the dividend. Should rate cuts arrive, shareholders can expect the dividend to quickly evaporate. That said, SGOV is a stabilizer in our portfolio. SGOV is also cheaper than many money market competitors, charging an expense ratio of just 0.07%. This fund could easily be replaced with a money market alternative, which would accomplish the same goal in the portfolio.

VanEck BDC Income ETF

The VanEck BDC Income ETF (BIZD) is an exchange traded fund that tracks the MVIS US Business Development Companies Index. BIZD invests in publicly traded business development companies or BDCs. Business development companies are specialty finance providers who lend to middle market companies. The middle market makes up most of the American economy but cannot use investment banks to get capital due to their size. BDCs fill the gap, offering debt and equity buyout financing to smaller, but strong businesses across the country. These companies are often private equity buyout targets during the growth or recapitalization phases.

BIZD is popular because it diversifies exposure to a sector often perceived as high risk. The BDC sector is also heavily concentrated. Nearly half of BIZD’s assets are invested in just three firms. However, the three largest holdings are worthy investments of their own. Each BDC is heavily diversified with thousands of individual loans. By investing across the sector, we spread our risk while still participating in the impressive yield. Currently, BIZD yields over 10%.

BIZD’s management fee comes into question as Seeking Alpha estimates the expense ratio at a whopping 11.2%. Looking deeper, we can understand the expense ratio is complex. BIZD charges an effective management fee of 0.40%. See below for a portion of BIZD’s annual report quantifying the fund’s expenses.

Allocation

Having selected the four investments that will compose our retirement portfolio, we have concluded a critical step in the process. Next, we must decide how we're going to allocate our initial capital. The 80/20 rule has guided investors for generations, and I suggest following similarly.

In our case, we built a portfolio called “4-3-2-1”. The investments will be allocated on a 40%, 30%, 20%, 10% basis, totaling to 100%.

The portfolio has a weighted average trailing twelve month yield of 4.5% with a three year compound annual growth rate of 5.9%. For retirees, this means the portfolio produces sufficient income to cover a four percent annual drawdown, while growing that income at a sufficient rate to beat inflation. Additionally, the portfolio is sufficiently diversified with 80% invested capital and 20% cash equivalents. Again, a money market or high yield savings account would suffice as a substitute for SGOV in our hypothetical. The weighted average expense ratio of the investments is also just 0.10%.

SCHD has received the largest allocation in the portfolio at 40%. SCHD’s diverse portfolio of large capitalization equities makes it the ideal choice for a core position in a retirement portfolio. The yield combined with the index’s impressive dividend growth model means the ETF generates sufficient income that grows faster than inflation.

USRT receives the next largest allocation at 30% of the portfolio. USRT’s large portfolio of domestic REITs provides diverse exposure to core properties across the globe. Public real estate investments provide a unique combination of income and growth that retirees may find attractive.

SGOV received a 20% allocation, acting as an interest-bearing stabilizer to the portfolio. While earning monthly interest, SGOV provides a cash reserve that can be drawn down in the event of market volatility or a near term reduction in income. At 20% of the portfolio, the allocation for the average retiree should be sufficient to cover expenses for a moderate time frame.

Finally, we have BIZD earning a 10% allocation. According to the barbell strategy, high risk investments can provide strong upside potential with relatively small allocation. In this case, BIZD generously increases the yield of the portfolio, despite receiving a small allocation. Like hot sauce, a little BIZD goes a long way.

Conclusion

It took a few hours, but by the end of the conversation we had arrived at a dramatically different location. We had quelled concerns around security selection, diversified a portfolio, and charted a path forward. More importantly, we showed that people tend to overcomplicate issues. Slowing down, taking some deep breaths, and assessing the situation piece by piece can make an otherwise overwhelming situation feel more manageable.

Take the trouble out of investing. Choose simple investments with established track records. Stick to what you know and don’t overcomplicate your investment strategy. Plan ahead and chart a retirement that affords you the relaxation you deserve.

REITer's Digest