Tag Archives: vanguard

Increase Your Portfolio’s Return By Dropping International Funds

Summary International stocks have underperformed historically – performing even worse in the recent past. Multiple hypothetical portfolios demonstrate the poor returns of international stocks. Short periods of outperformance by international stocks do not make up for their overall performance. Will International Stocks Really Outperform? With emerging markets in the dumps and international funds trailing the returns of domestic funds, analysts everywhere are calling for investment in international stocks, claiming that the chronic underperformance is a sign that they are “due” to outperform. International stocks may very well outperform in the next few years. There is nobody who can know that for sure. I am here to present the facts, and the facts show that international stocks have not been delivering on the promise of outperformance given their higher risk. An investment portfolio built entirely from U.S. stocks can outperform international portfolios while avoiding the political and currency risks of other smaller countries. Hypothetical Portfolios For the sake of this hypothetical situation, let us assume that the owner of this portfolio will be investing in 100% equities and plans to maintain that portfolio for the next decade before moving into some safer bonds. The owner of this portfolio currently has $300,000 invested. Let us see how this portfolio would have performed from 2005 to 2015. First, a control sample: 100% U.S. equities for the entire investment period, invested in the broadest manner possible with the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). In this case, the portfolio would be worth $654,240 at the end of the investment period. Not too shabby, the portfolio has more than doubled with an annualized rate of 8.12% ( Source ). Let’s say the investor wished to broadly diversify his equity portfolio with companies from around the world, putting the U.S. weighting at around 40% with the Vanguard Global Equity Fund (MUTF: VHGEX ). In this case, the portfolio would be worth $533,880 at the end of the investment period. The portfolio has increased at an annualized rate of 5.93%. The investor has missed out on $120,360 ( Source ). Perhaps the investor believed that emerging markets would be a good addition to his U.S. equities. Let’s say the investor allocated 20% to emerging markets with the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) and 80% to Vanguard Total Stock Market ETF. In this case, the portfolio would be worth $625,080 at the end of the investment period. The portfolio has increased at an annualized rate of just over 7.542%. The investor has missed out on $29,160 ( Source ). Let me note that emerging markets are the only international option I would consider. Emerging markets have outperformed U.S. markets from time to time and their current weakness has much to do with the strong U.S. dollar and oil prices. However, emerging markets do not represent all international stocks and therefore I still stand by the statement that international stocks, as a whole, underperform – as seen by the performance of broad international funds such as VHGEX. In all hypothetical portfolios, the investor would have been better off simply investing in the United States market and would have even paid lower fees (and perhaps taxes as well) while doing so. The below table and graph illustrate the results of including international stocks in your portfolio. (click to enlarge) (Excel, using data from Vanguard.com) (click to enlarge) (Excel, using data from Vanguard.com) International Stocks have Underperformed Historically U.S. funds have beaten international funds the past five, 10, 15, 20 and 25 years. Over the past 25 years, large-cap U.S. funds have gained an average 691%, vs. 338% for international funds. The graph below illustrates the difference in performance. (Please note I am not in favor of investments in managed futures. Managed future data is subject to extreme survivorship bias and the results are thus skewed. Survivorship bias is the logical error of concentrating on the people or things that “survived.” inadvertently overlooking those that did not because of their lack of visibility.) (click to enlarge) (AutumnGold) Small Bursts of Outperformance by International Stocks Don’t Make Them a Good Investment Some will argue that there are periods of time when international stocks outperform. This is true. However, these periods of time are often small and they haven’t made up for the underperformance both historically and lately, assuming investors invest gradually over time. For long term investors, a long history of strong performance is needed before an investment can be made. The United States stock market has provided that performance for over a century now. The below chart shows the periods of outperformance for domestic and international equities for roughly the past 20 years. As you can see, in the mid-80s international stocks did very well and mildly outperformed in the mid-2000s. However, in all other years the U.S. stock market outperformed and overall U.S. stocks came out far ahead as mentioned earlier, assuming you didn’t throw all your money into international stocks in 1984. However, most people invest over time and if you had done that, you would have had higher returns with domestic stocks. (Bason Asset Management) For the past 15 years domestic stocks have pulled ahead of international stocks by a fairly wide margin. This is achieved even when the domestic market returns are relatively normal compared to historical averages. International stocks have simply underperformed consistently. You would be very hard pressed to find an international broad market fund that has beaten a U.S. broad fund from inception to date with reasonable fees, assuming the inception dates are relatively similar and that the funds didn’t start around 1984. The Vanguard International Explorer Fund is one exception I have found as it has performed very well since inception in 1996. Unfortunately, over the past 10 years it has returned less than 6% annually. Having a Portfolio of Pure U.S. Stocks Outperforms and Provides International Exposure Investing in U.S. stocks doesn’t mean you lose out on foreign growth potential. In fact, U.S. companies are very savvy and have the luxury of being able to choose which countries to do business in. There is no reason the U.S. equity market can’t benefit from the growth of other nations. Companies in the S&P 500 get 46.2% of their earnings from overseas . If you are looking for diversification to reduce the risk of a drastic drop in your portfolio value, international stocks won’t help you. The 2008 stock market crash showed that all equities fell drastically at the same time. Investing in one country or another made no difference. So do the smart thing: invest in domestic funds and enjoy the decent returns, as boring as they may be.

VFINX/VBLTX Power-Up: Replace VFINX With UPRO Or SPXL

Summary I recently wrote about VFINX/VBLTX portfolios, and how to choose an asset allocation to maximize returns for the level of volatility you can tolerate. Swapping VFINX for a leveraged S&P 500 ETF makes the maximization game much more profitable. You can achieve a greater expected return for any particular level of volatility. You lose the benefit of completely free trades in a Vanguard account, but the improvement in expected returns is definitely worth it. Mathematically, using a leveraged version of VFINX allows you to increase your allocation to VBLTX, capturing a greater percentage of its alpha. I believe UPRO/VBLTX (or SPXL/VBLTX) can be an excellent core portfolio for many investors. VFINX and VBLTX In a recent article, I looked at the performance of various two-fund “stocks and bonds” portfolios comprised of Vanguard mutual funds. I paired the Vanguard 500 Index Fund Investor Shares (MUTF: VFINX ) with Vanguard bond funds of various durations, and found that the long-term bond fund, the Vanguard Long-Term Bond Index Fund (MUTF: VBLTX ), was generally the best choice in terms of maximizing expected returns for a particular level of volatility. Here is a slightly modified version of a graph from that article (curves for the other bond funds removed): (click to enlarge) To get you up to speed, the upper-right point on the curve shows that for a portfolio comprised of 100% VFINX, and 0% VBLTX, the mean and standard deviation of daily gains going back to 1994 are 0.042% and 1.192%, respectively. The next point, which represents 90% VFINX and 10% VBLTX, results in a slightly lower mean (0.041%) and considerably lower standard deviation (1.061%), making it arguably the better portfolio. You can see how mean and standard deviation vary as VFINX allocation increases in 10% increments all the way to 0% VFINX, 100% VBLTX. Notably, standard deviation is minimized for 25.8% VFINX, 74.2% VBLTX. So if you were a relatively conservative investor who wanted to take on no more than 75% of the S&P 500’s volatility, you would look at the second-from-the-right vertical line, and see that to maximize expected return you would need to be just below the 3rd data point from the right, or a VFINX allocation slightly below 80%. A nice aspect of a two-fund strategy based on Vanguard mutual funds is that trading costs are very low. The mutual funds have very low expense ratios and can be traded commission-free in a Vanguard account. 3x VFINX and VBLTX Something magical happens when you swap VFINX for a hypothetical 3x daily version of it: you get a drastically better expected returns for any given level of volatility. Take a look: (click to enlarge) (Note: Data points represent 10% allocation steps for VFINX/VBLTX, and 5% allocation steps for 3x VFINX/VBLTX. Also, daily gains for the hypothetical 3x VFINX fund were calculated by simply multiply VFINX gains by 3 and then subtracting a fixed value corresponding to a 1% annual expense ratio.) You can see that the blue curve offers drastically better mean returns than the red curve. For example, 90% VFINX/10% VBLTX (second point from the right on the red curve) has a standard deviation of 1.061% and a mean of 0.042%; 30% 3x VFINX/70% VBLTX (7th point from the bottom on the blue curve) has a very similar standard deviation of 1.064, with a much greater mean of 0.058%. In addition, with 3x VFINX/VBLTX you have the option of taking on more volatility than the S&P 500, and getting an excellent additional return. For example, if you can tolerate up to 50% more volatility than the S&P 500, you can achieve an 84.3% greater mean return (51.2% 3x VFINX/48.8% VBLTX: standard deviation 1.788%, mean 0.077%). CAGR vs. MDD I think the mean vs. SD plot best describes the performance of various VFINX/VBLTX portfolios. But CAGR vs. MDD is also very interesting, and highlights the huge improvement you get with 3x VFINX. (click to enlarge) You see drastically better raw returns for various maximum drawdowns with 3x VFINX/VBLTX compared to VFINX/VBLTX. One interesting special case, 35% 3x VFINX/65% VBLTX has about the same MDD as VFINX (55.4% vs. 55.3%), but with a much greater CAGR (14.7% vs. 9.1%). Also noteworthy, the CAGR for 3x VFINX/VBLTX portfolios starts to decrease once the allocation to 3x VFINX reaches about 70%. How to Invest in 3x VFINX Vanguard does not offer a leveraged version of VFINX (or any leveraged funds for that matter), but there are several 3x daily S&P 500 ETFs to choose from. The ProShares UltraPro S&P 500 ETF (NYSEARCA: UPRO ) and the Direxion Daily S&P 500 Bull 3x Shares ETF (NYSEARCA: SPXL ) are two options. They both have expense ratios right around 1%, and both have done an excellent job tracking 3x daily S&P 500 gains over their 6-7 year lifetimes. I know some readers will take issue with the fact that my results are based on sort of “fake” data, as I just multiplied daily VFINX gains by 3 to simulate a leveraged version of the fund (or, equivalently, the performance of UPRO or SPXL before they were around). I wouldn’t worry about this too much. All signs indicate that daily leveraged ETFs like UPRO and SPXL have very minimal tracking error. Mathematical Basis Intuitively, the reason 3x VFINX/VBLTX provides better mean returns for a given level of volatility is that it allows for a greater allocation to the alpha-generating VBLTX. Suppose you can achieve a volatility of 1% with either 90% VFINX/10% VBLTX or 40% 3x VFINX/60% VBLTX. Which will have greater expected returns? The second, because it retains 40% of VBLTX’s alpha rather than only 10%. Now for a more mathematical approach (feel free to skip). Consider a VFINX/VBLTX portfolio where C represents the proportion allocated to VFINX, and (1-C) the allocation to VBLTX; and a 3x VFINX/VBLTX portfolio where D represents the proportion allocated to 3x VFINX, and (1-D) the allocation to VBLTX. Suppose we start at the top-right part of the first figure (i.e. C = D = 1) and decrease both C and D to the point where both portfolios have the same volatility. It is easy to see that D will be less than C, i.e. you will have to allocate less to 3x VFINX than to VFINX to achieve a certain portfolio volatility. So the two portfolios have the same volatility, and D < C. Let's compare their expected returns. Let X = daily VFINX return and Y = daily VBLTX return. The first portfolio's daily return, say Z 1 , is given by Z 1 = C X + (1-C) Y. The second portfolio's daily return, say Z 2 , is given by Z 2 = 3D X + (1-D) Y. How do Z 1 and Z 2 compare? Let's subtract their expected values, and see if we can figure out if the difference favors one or the other. E(Z 2 ) - E(Z 1 ) = [3D E(X) + (1-D) E(Y)] - [C E(X) + (1-C) E(Y)] = [3D - C] E(X) + [(1-D) - (1-C)] E(Y) We know E(X) and E(Y) are both positive (otherwise we wouldn't invest in stocks or bonds). The coefficient [(1-D) - (1-C)] is also positive since D < C. Thus the entire expression will be positive as long as 3D > C, or equivalently D is greater than one-third of C. I’m sure there’s some way to prove this is true under certain circumstances. But it’s good enough to just look at a plot of C and D vs. volatility, and observe that indeed 3D > C (i.e. dotted black line is above blue line), except at the very left side of the graph. (click to enlarge) Conclusions The more I think about leveraged ETFs, the more valuable I realize they are. Here, I show that you can drastically improve performance of a S&P 500/long-term bonds portfolio by simply replacing the S&P 500 fund with a 3x version. Whatever level of volatility you are willing to tolerate, you can achieve higher expected returns by simply using a leveraged S&P 500 fund. The reason is positive alpha. Using a leveraged stocks fund lets you achieve a particular level of volatility while allocating a greater percentage of your assets to an alpha-generating bond fund. More capital generating more alpha means greater returns. The results here are shown for VBLTX, but the main points should also hold for other long-term bond mutual funds or ETFs. Additionally, for those wary of investing in long-term bonds given that interest rates are about to rise, I would suggest considering a similar approach with a short or intermediate-term bond funds.

Target Date Funds As Aid In Retirement Portfolio Design

Summary Investors in or near retirement should be aware of portfolio design that leading fund sponsors suggest as appropriate. Leading target date funds appear to generally have less severe drawdowns than a US 60/40 balanced fund. The funds have slightly higher yields than a US 60/40 balanced fund. Target date funds have underperformed a US 60/40 balanced fund in part due to a cash reserve component and non-US stocks. Non-US stocks drag on historical performance could become future boost to performance. INTENDED AUDIENCE This article is suitable for investors who are in retirement or nearly so, and who are or will rely heavily on their portfolio to support lifestyle. It is not suitable for those with many years to retirement, or those with a lot more money in their portfolio than they will need to support their lifestyle. SHORT-TERM and LONG-TERM We have been writing about the short-term recently ( here and here and here ), because we are in a Correction, that may become a severe Correction, and possibly a Bear. For our clients who fit the profile of being in or near retirement and heavily dependent of their portfolio to support lifestyle in retirement, we have tactically increased cash in the build-up to and within this Correction, as breadth and other technical have deteriorated. However, we don’t want to lose sight of long-term strategic investment. This article is about asset allocation for investors that fit that retirement, pre-retirement, portfolio dependence profile. WHERE TO BEGIN ALLOCATION THINKING We think it is a good idea to begin thinking about allocation by: reviewing the history of simple risk levels ( see our homepage ) from very conservative to very aggressive to get a sense of where you would have been comfortable reviewing what respected teams of professionals at leading fund families believe is appropriate based on years to retirement (they assume generic investor without differentiated circumstances). This article is about the second of those two important review – basically looking at what are called “target date” funds. Generally, portfolios should have a long-term strategic core, and may have an additional tactical component. We think some combination of risk level portfolio selection and/or target date portfolio selection can make a suitable portfolio for many investors. You may or may not want to follow target date allocations, but you would be well advised to be aware of the portfolio models as you develop your own. In effect, we would suggest using risk level models and target date models as a starting point from which you may decide to build and deviate according to your needs and preferences, but with the assumption that the target date models are based on informed attempts at long-term balance of return and risk appropriate for each stage of financial life. For example, an investor might deviate one way or the other from more aggressive to less aggressive based on the size of their portfolio relative to what they need to support their lifestyle, and the size of non-portfolio related income sources; or merely their emotional comfort level with portfolio volatility. There no precise allocation that is certain to be best, which is revealed by the variation in models among leading target date fund sponsors. Their allocations are different, but similar in most respects. FUND FAMILY SELECTION For this article, we identified the 7 fund families with high Morningstar analyst ratings for future performance (those ranked Gold and Silver, excluding those ranked Bronze, Neutral or Not Rated). Those 7 families are: Fidelity Vanguard T. Rowe Price American Funds Black Rock JP Morgan MFS Fidelity, Vanguard and T. Rowe Price have about 75% of the assets in all target date funds from all sponsoring families combined. ASSET CATEGORIES CONSIDERED We then used Morningstar’s consolidated summary of their detailed holdings to present and compare the target date funds from each family. The holdings were summarized into: Net Cash Net US Stocks Net Non-US Stocks Net Bonds Other While we have gathered that data for retirement target dates out 30 years. This article is just about target date funds for those now in retirement or within 5 years of retirement. PROXY INVESTMENT FUNDS USED We simulated the hypothetical past performance of those target date funds using these Vanguard funds: Admittedly, this is a gross proxy summary of the holdings of the subject target date funds The funds may hold individual stocks or bonds, may hold international bonds, may use some derivatives, and may have some short cash or short equities. Nonetheless, we think these Vanguard funds are good enough to serve as a proxy for the average target date funds, and as a baseline model for you to examine target date funds and to plan your own allocation. THE BENCHMARK As a benchmark for each allocation, we chose the Vanguard Balanced fund (MUTF: VBIAX ) nwhich is 60% US stocks/40% US bonds index fund. Figure 1 shows the best and worst periods over the last 10 years for that fund, as well as its current trailing yield. FIGURE 1: So, let’s keep the 2.10% yield in mind as we look at the models, and also the 19.7% 3-month worst drawdown, the 27.6% worst annual drawdown, and 7.3% worst 3-year drawdown. FOR THOSE CURRENTLY RETIRED Figure 2 shows the allocation from each of the fund families for those currently in retirement. It also averages their allocations for all 7 and for the top three (Fidelity, Vanguard, T. Rowe Price). ( click image to enlarge ) (click to enlarge) You will note substantial ranges for allocations from fund family to fund family. For example, MFS using about 19% US stocks while Fidelity uses about 38%; and MFS uses about 64% bonds and Fidelity uses about 36%. The average bond allocation for the 7 families is about 54%, but the top three by assets average about 42%; and their average cash allocation is about 9% versus the top 3 average of 5%. Figure 3 shows how a portfolio using Vanguard index funds would have performed over the past 10 years with monthly rebalancing if it was based on the average of the top 3 families. We recalculated the allocations to exclude “Other” which is undefined, but which is relatively minor in size in each fund. We also note that the Vanguard index funds have a small cash component, so that the effective cash allocation is higher than the model. FIGURE 3 – Backtest Performance: (retired now: average of top 3 families) Observations: Yield is somewhat higher (2.28% versus 2.10%). Worst 3 months were somewhat better (-18.4% versus – 19.7%) Worst 1 year was somewhat better (-26.2% versus -27.6%) Worst 3 year drawdown was better (-5.7% versus -7.3%) Underperformed benchmark over 10, 5, 3 and 1 year and 3 months (10 years underperformed by annualized 1.05%). Reasons For Underperformance: Inclusion of non-US equities may be the biggest contributor to underperformance versus the balanced fund with 100% US securities. Another part of the underperformance is maintenance of a cash reserve position that is over and above any cash position within the benchmark balanced fund. Part is also due to a higher bond allocation. Those factors probably account most of the performance difference. We did not try to determine the exact contributions of each attribute to performance differences. The historical underperformance due to non-US stocks could possibly turn out to be a long-term reason for future outperformance. FIGURE 4 – Backtest Performance: (retired now: average of top 7 families) Observations: Yield is somewhat higher (2.19% versus 2.10%). Worst 3 months were significantly better (-12.6% versus – 19.7%) Worst 1 year was somewhat better (-17.7% versus -27.6%) Worst 3 year drawdown was a lot better (-2.3% versus -7.3%) Underperformed benchmark over 10, 5, 3 and 1 year & outperformed over the last 3 months (10 years underperformed by annualized 1.32%). Incurred less drawdown in exchange for lower cumulative return. FOR THOSE EXPECTING TO RETIRE WITHIN 5 YEARS FIGURE 5 – Allocation: (expected retirement within 5 years) ( click image to enlarge ) (click to enlarge) Again, we see substantial variation between fund families, and also between the averages for the top 3 by assets and for all 7 of the Gold or Silver rated target date families. The average bond allocation for the 7 families is about 44%, but for the top 3 it is only about 34%. For the 7 families the average non-US stocks are about 15%, but for the top 3 families it is about 21%. FIGURE 6 – Backtest Performance: (up to 5 years to retirement: average of top 3 families) Observations: Yield is higher (2.30% versus 2.10%). Worst 3 months were somewhat worse (-21.1% versus – 19.7%) Worst 1 year was somewhat worse (-30.1% versus -27.6%) Worst 3 year drawdown was the same (-7.3% versus -7.3%) Underperformed benchmark over 10, 5, 3 and 1 year and 3 months (10 years underperformed by annualized 0.95%). FIGURE 7 – BacktestPerformance: (up to 5 years to retirement: average of top 7 families) Observations: Yield is somewhat higher (2.19% versus 2.10%). Worst 3 months were better (-16.2% versus – 19.7%) Worst 1 year was better (-22.9% versus -27.6%) Worst 3 year drawdown was better (-4.4% versus -7.3%) Underperformed benchmark over 10, 5, 3 and 1 year & slightly outperformed over the last 3 months (10 years underperformed by annualized 1.19%). PERFORMANCE OF INDIVIDUAL PROXY FUNDS Figure 8 presents the current yield and rolling returns of the five individual proxy funds used in this review. FIGURE 8: (click image to enlarge) (click to enlarge) PERFORMANCE OF THE TARGET DATE FUNDS FIGURE 9: (click image to enlarge) (click to enlarge) Symbols for funds mentioned in this article are: VMMXX, VTSAX, VGTSX, VBTLX, VBIAX, TRRGX , AABTX , JSFSX , LFTDX , VTXVX , FLIFX, BAPBX , TRRUX , AACFX , JTTAX , MFLAX, VTWNX , FPIFX , BAPCX Disclosure: QVM has no positions in any mentioned fund as of the creation date of this article (October 4, 2015). We certify that except as cited herein, this is our work product. We received no compensation or other inducement from any party to produce this article, and are not compensated by Seeking Alpha in any way relating to this article. General Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here .