I have good news, and I have bad news. The bad news, as we all know, is that the market is way down, and there is very little any of us can do to stop this. Worse, most of us probably did not get out in time to avoid it. But, as our former mayor in Chicago, Rahm Emanuel, said “You never let a serious crisis go to waste.” So, the question is what do we do now with our investments?
If you’re sitting on a pile of cash, then God bless you, it’s probably a great time to buy. If your portfolio just got crushed, maybe it it’s a good time to rebalance the portfolio and take advantage of the tax losses for next year (note: I am not a CPA, and do not give tax advice).
Instead of Stock Picking, We Are Going to Analyze What Is the Best Portfolio of ETFs to Hold
To set expectations, if you’re looking for the stock-picking secrets of the illuminati from this article, I am afraid you will be sorely disappointed. I am just smart enough to have learned years ago, that I am not that smart. In fact, I have come to believe there are only certain ways in which one can beat the market:
1. You have illegal information that other people do not have. We call this insider trading, and it will get you thrown in prison and/or heavily fine.
2. You have legal information that other people don’t have. We called this venture capital or private equity. The reason why few people have information on VC/PE investments is because these companies are either too small and/or too private to be covered by a cadre of Wall Street analysts. VC and PE firms are typically purchasing huge chunks of equity directly from the companies in a way that are handled differently by SEC rules than securities on a public exchange.
3. You do not care about whether the securities themselves go up or down because you are making money on people through transaction fees which is quite a bit of what Wall Street does, I am told).
Therefore, the standpoint that we will take in this article is that you can’t beat the market, consistently, over time
. Yes, you can export data on every mutual fund in the world and find the ones that seem to beat the market over every period, but my personal experience with that has been, but the second you buy that fund, it will start to underperformed the indices. That could just be my bad luck or incompetence, but as the linked article above and the famous Warren Buffett Hedge Fund vs. Index Fund charity bet showed
, the pro’s don’t seem to be able to do much better.
Thankfully, there are options that were created with the idea of matching the market in mind: index mutual funds and ETF (exchange traded funds). ETF are affectively the same exact thing as an index fund, except that they trade as a stock, which has a couple of advantages:
2. ETFs can be traded very easily.
(Not that you should be thinking of day trading ETFs, but when you do need to draw out cash, and especially if your online broker gives you free trades, these are very easy to handle from a logistical cash management point of view.)
The question we will answer in this analysis is: How complex does an ETF portfolio need to be, and does complexity add any value?
You may be very surprised at the answers.
Methodology – Let’s Meet Our Competitors
The data set that I used was from MorningStar.com, downloaded on December 19, 2019. It contained data on a large group of index funds from, mostly Vanguard, iShares, two of the major vendors of such funds. There are many other options for ETFs (or mutual funds), such as Fidelity. Most major brokerage houses have their own versions of ETFs that cover major market sectors that can be less expensive from an expense ratio point of view. However, for our purposes iShares and Vanguard had more than enough variety to serve our analysis.
Two of the maxims that most people except are:
With that in mind, I constructed five portfolios.
1. P1: 1 World ETF – Portfolio 1 contains only one stock ETF that covers all stocks worldwide, including US equities (large, mid, small-cap), foreign developed countries, and emerging markets. It is the one stop shop.
2. P2: 1 US ETF – Portfolio 2 uses the same concept, but only for the US market. It has no foreign developed country or emerging market equities.
3. P3: 3 ETFs US, foreign dev., & EM – Portfolio 3 has three equities. The first is an ETF the same one that is used in P2, containing the whole US market. The other two ETF securities are one that covers foreign developed markets and another that covers emerging markets. This allows us to explicitly pin the asset allocation among the three markets, unlike P1, which varies in its allocation by market cap, as the markets vary between the US and foreign markets.
4. P4: 5 ETFs with US market weighting – Portfolio 4 has five securities. It breaks the US market into three segments: large cap, mid-cap, and small cap, assigning an ETF to each one of these, then adding the two foreign ETFs from P3. This allows us to pin of US large, mid, and small-cap exposure.
5. P5: 5 ETF w/US LC equal weighting
– Portfolio 5 is the same as Portfolio 4 with one twist. Most index funds or ETFs allocate the distribution of funds among the securities they hold by the market capitalization of each security. That means that the larger companies (and therefore, the industrial sectors) dominate more of the assets. However, there are several studies
that show in general it’s very hard to predict which segment of the market industry segment of the market will perform the best and, therefore, equal weighted funds perform better. In P5, we use an ETF for the large cap segment of the US market that enforces equal industry allocations, instead of a market-cap weighted S&P 500 ETF.
A note on how I chose specific ETF securities: Within each of the asset classes (for example emerging markets or mid-cap US equities) I looked at all the ETF options for that category that I had downloaded. I selected the fund that I thought had consistently performed best over the one, three, five, and ten-year periods, typically waiting my judgment toward longer periods. However, because we are using the same securities in many of the portfolios, our specific selection of a better or worse fund will not make a lot of difference.
Asset allocation was done by the first allocating a between foreign and US exposure, as shown on Figure 1 and then allocating within foreign markets and US markets among asset classes as shown in Figure 2. For foreign market allocation, VT, Vanguard Total World Stock ETF
was used as the benchmark. Within it, approximately 10% of its assets are allocated to emerging markets (EM) and the rest to developed markets foreign companies. Therefore, this equated to approximately 15% of total portfolio been assigned to emerging markets for which are proxy ETF was VWO, Vanguard FTSE Emerging Market ETF, and 30% of total portfolio been allocated to our proxy for the vault foreign markets, which is VEA, Vanguard FTSE Developed Markets ETF.
Within the US, asset allocation was benchmarked off of VTI, Vanguard Total Stock Market ETF
, which holds 74% of its assets are in large cap stocks, 14% in mid-cap stocks, and the balance in small, micro, and other. The appropriate amounts were allocated across the large-cap proxy ETF VOO, Vanguard S&P 500 ETF for market waited portfolios or RSP, Invesco S&P 500 Equal Weight ETF for the equal-weighted industry sector portfolio. Mid-cap allocations were placed into JKG, iShares Morningstar MidCap ETF, and small-cap allocations were placed into VB, Vanguard Small-Cap ETF.
Average Annual Returns Over One, Three, Five and Ten Year Time Periods
The MorningStar.com data provided performance over of the five different portfolios over one, three, five, and ten-year periods. These returns for each portfolio are shown on Figure 3.
It is clear that over the ten-year period analyzed, P2 (US-only companies) significantly outperformed foreign portfolios in all the time periods analyzed. However, investors should not confuse having no foreign companies in the portfolio with having no foreign exposure. Over 40% of revenues of the S&P 500
came from foreign in 2018. Therefore, even if you only held US only securities, you are still getting a lot of exposure to foreign markets (just not to foreign companies). There may be ETFs out there that focus on companies with maximum exposure to US sales, but that is beyond the scope of this article.
It is interesting that over the last ten years, the longer the time period, the worse the P1 (1 world ETF) portfolio performs, not only versus the US-only portfolio, but also versus the synthesized world portfolios P3, P4, and P5. We do not know the reason for this. Perhaps, it is related to the fact that in the synthesized portfolios, the allocation between the US and foreign securities was pinned in our analysis at the percentages shown on Figure, whereas in P1, VT is market-weighted like most index funds, meaning that the foreign versus US exposure will fluctuate over time.
Considering the portfolios with foreign company exposure (P1, P3, P4, P5), P3 is the best performing overall average time periods.
As discussed above, the investment hypothesis of equal- weighted industry segment index funds is that nobody can predict which industry segment will perform best in any year. People holding to this hypothesis believe it is better to hold enforced equal weightings of industry sectors than to let the allocations fluctuate according to market cap, which is inherently more of a momentum strategy. According to our analysis, this hypothesis does not hold true over the one, three, five, or ten-year period in the ten years ending December 19, 2091. However, it does seem that the strategy does better over longer periods of time in our data.
Risk Versus Return
Figure 4 shows us a 2×2 scatter plot of return on the y-axis versus the risk of each portfolio on the x-axis. Unfortunately, I was not able to obtain the 10-year standard deviation as a proxy for risk, only the three-year standard deviation. Even though P2 is less diversified in that it does not have foreign companies, it is the clear winner in risk versus reward. Only P1 (one ETF world portfolio) has less risk. However, it is not that much less risk and comes with a significant decrease in return.
On the other hand, looking at our three more complex synthesized portfolios, it seems like P3 is the winner, both in terms of a slight return advantage, and a slight advantage in less risk. However, all three are fairly close together.
We also should note, that at least over the three-year standard deviation, the equal-weighted industry hypothesis does not seem to hold true; it is the riskiest of all portfolios.
What Portfolio Actually Will Make You the Most Money?
We know from Figure 3 already that the best return is from P2 (US-only companies). However, looking at the metric most beloved of the index fund mutual fund industry, “the growth of $10,000 over 10 years,” we can see how much that performance advantage is worth. Underneath the graph in Figure 5, the orange footballs show the under-performance to the category winner, first considering only the four portfolios with foreign company exposure, and in the second row all five portfolios.
P2 (US only portfolio) is the clear winner and would have made the investor about $10,000 more (between 27% and 32% more) than any of the other four portfolios over the ten-year period. The three synthesized world coverage portfolios (P3, P4, P5) have very similar returns after the ten-year period, but the simple one world ETF portfolio had meaningful underperformance.
Returns are shown net of the expense ratio, so the user may not care too much about expense ratio. However, giving fan service to all the Bogleheads
who are reading this article, one will note that all of these portfolios have very low expense ratios, which is one of the big advantages of using ETF securities and index mutual funds. Another advantage of index funds and ETFs securities in general, is their lucrative tax effects, which are low for all portfolios.
Which Portfolio You Invest in Is Very Much Dependent on Your Goals
By now, especially if you’re not a big data fiend like I am, you’re asking “OK so what does this all mean?! Which portfolio should I invest in?” I hate being equivocal, but it really does depend on your goal. However, I’ve tried to make it as simple as possible in Figure 6. It shows four different goals and the portfolio from our analysis that best suits that goal. Remember, we are not saying in this article that other portfolios of index funds, ETFs, individual stocks, or whatever other securities do not exist that might have beaten our portfolios over the time period analyzed. We are operating on the premise set forth in the beginning that it is very hard to beat the market over a long period of time.
Whichever of the strategies you choose, you probably will be doing well compared to many of your peers. Lots of people like to brag over the water cooler about how much return they got on a given stock. Maybe they did, although one might ask: if they are that good at picking these hot stocks, why are they standing at the water cooler and working at your company anyway? It is far more likely that they are bragging about a singular win and not talking about the losses. It is my belief that overtime a simple ETF portfolio will win out, but I am not offering professional investment advice here.
All these portfolios, even the more complex ones, are very simple compared to most investment strategies. They are very easy to execute with any online broker with extremely low expenses. If you want an even simpler experience, you could sign up with one of the auto-rebalancing services, such as personalcapital.com or betterment.com, but you will pay a price for this. Furthermore, there may be other good reasons to use a financial advisor, but if your only goal is to execute of these portfolios as your investing strategy, it is probably unnecessary to pay the standard 1% fee to have someone else buy these portfolio and re-balance them once or twice a year.
What *IS* important, is the following:
1. Get started! If you have the cash, get started today. It’s probably a good time to invest, just because the market is down, you will likely get a little advantage by investing now. On the other hand, if you want to minimize risk, you can dollar cost average your money into the market over the next 3 to 6 months. But whatever you do, don’t sit around and do nothing.
2. Be disciplined. Once you invest your money in any of these portfolios, the worst thing you could do would be to pull it out during a market correction or crash, such as we have seen in the last few weeks.
Now get out there and invest, and I hope when we talk ten years from now, one of these strategies has made you a boatload of money!