Building A Basic 2-Fund Stocks And Bonds Portfolio With Vanguard Mutual Funds
Summary Adding bonds to a portfolio of stocks generally improves risk-adjusted returns, and in some cases also improves raw returns. Implementing a stocks and bonds portfolio using Vanguard mutual funds is a great way to minimize trading costs (low expense ratios, free trades). Here I look at properties of two-fund portfolios comprised of VFINX paired with various bond funds: VBISX, VBIIX, VBLTX, and VBMFX. I provide a graph that lets you pick a bond fund and asset allocation that maximizes your expected return for the level of volatility you can tolerate. Stocks and Bonds It is well-known that stocks generally provide greater expected returns, but also greater volatility, compared to bonds. Conventional wisdom dictates that individual investors should increase exposure to bonds as they get closer to retirement, sacrificing raw returns for less susceptibility to major drawdowns. Adding bonds to a portfolio of stocks generally improves risk-adjusted returns (i.e. Sharpe ratio). This is primarily because bond funds generate positive alpha, thanks to maturing bonds. In fact it would be senseless to knowingly add a bond fund to your portfolio that doesn’t increase risk-adjusted returns. (You would be much better off using cash to decrease risk while locking in your current Sharpe ratio.) In some cases, adding a high-alpha bond fund can actually increase a portfolio’s raw returns. We will see one such example in this article. Vanguard Funds Vanguard is a great trading platform for individual investors. They offer a wide variety of mutual funds and ETFs with extremely low expense ratios, and they have zero-commission trades for Vanguard mutual funds and ETFs. When it comes to portfolio building, simpler is often better. In particular, I think when you start considering specialty funds (e.g. sector-specific; lesser-known indexes or subsets thereof) you can transition to speculative investing pretty fast. So in this article I’ll consider only the following six mutual funds. Table 1. Vanguard mutual funds included in analysis. Fund Ticker Expense Ratio Average Effective Maturity (years) SEC Yield Vanguard 500 Index Fund Investor Shares VFINX 0.17% – 2.09% Vanguard Total Stock Market Index Fund Investor Shares VTSMX 0.17% – 1.96% Vanguard Short-Term Bond Index Fund Investor Shares VBISX 0.20% 2.8 1.01% Vanguard Intermediate-Term Bond Index Fund Investor Shares VBIIX 0.20% 7.2 2.40% Vanguard Long-Term Bond Index Fund VBLTX 0.20% 24.1 3.94% Vanguard Total Bond Market Index Fund Investor Shares VBMFX 0.20% 7.9 2.03% VFINX and VTSMX are natural choices for the “stocks” part of a stocks and bonds portfolio, and the four bond funds cover bonds of various durations, including a blend in VBMFX. To allow for direct comparisons, all analyses here are based on performance of these funds over their mutual lifetimes: March 1, 1994, to Oct. 26, 2015. Historical Performance of Each Fund Let’s take a look at historical performance metrics for the six individual funds. Table 2. Performance metrics for six Vanguard mutual funds. 1 Ticker CAGR (%) MDD (%) Mean SD Sharpe Alpha (%) Alpha p-value Beta VFINX 9.08 55.3 0.042 1.193 0.035 0.0014 0.67 0.961 VTSMX 9.03 55.4 0.042 1.198 0.035 0.0014 0.71 0.959 VBISX 4.38 2.7 0.017 0.167 0.103 0.0182