Tag Archives: yahoo

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

MOAT: Have You Considered Using An ETF To Find Companies With Moats?

Summary The sector allocations were a bit surprising to me. Industrials were heavily weighted while utilities and health care were not. The fund has a 15% turnover ratio, which seems within reason for the strategy. The idea of holding attractively priced companies with solid economic moats makes sense, but applying that strategy as an ETF is problematic. The sheer size of the ETF would be a huge problem for acquiring shares in smaller companies with the equal weighting philosophy. Larger companies will receive significantly more coverage and the market should be more efficient. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds that I’m researching is the Market Vectors Wide Moat ETF (NYSEARCA: MOAT ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The net expense ratio for MOAT is .49%. I tend to be very frugal with my expense ratios, so I like to see those low levels. When I’m looking at a simple market cap weighted broad market or total market ETF I would expect to see single digit expense ratios. On the other hand, this portfolio would require analysis on the individual companies so higher expenses would be expected. Sector The following chart breaks down the sector allocations: I don’t love huge allocations to consumer discretionary, but I can believe that they would make sense for a portfolio based on having economic moats since there should be some material differentiation in the products provided by the companies. On the other hand, seeing industrials at almost 25% is quite a surprise to me. Perhaps their concept of a moat is different from mine, but they clearly don’t weight utilities high despite the utilities having regulated monopolies. I would think a monopoly that was protected through regulation would have a fairly solid economic moat. In a similar manner I would have expected stronger allocations to health care because the patent system provides long lasting economic moats. Largest Holdings The following chart shows the largest holdings for the fund from the end of the third quarter: I pulled up the daily list of holdings to verify that they were not materially changed. Since the goal here is to buy companies with durable economic moats, I would expect the allocations to remain similar with some small variations as shares go up and down in value causing them to trade places on the list. (click to enlarge) I had to pull the fund up on Schwab to find the turnover ratio, which was listed at 15%. All in all that suggests the portfolio would be turned over about once every 6 to 7 years. That isn’t too bad. The reason for the turnover seems to be that the portfolio is designed to be allocated as an equal weight portfolio across the “most attractively priced” companies that have been classified as having large moats. If the case is based on most attractively priced, then it starts to seem strange that the companies are not moving up in price enough to force the positions to be turned over the next time the index is updated. Conclusion There is nothing wrong with the concept of selecting stocks based on finding reasonably priced companies that have economic moats to prevent competition from eroding their profits. The strategy makes a great deal of sense and investors selecting individual companies would be wise to consider the influence of future competition on the success of their investment. A challenge for an ETF attempting to follow the same strategy is that it could require some fairly significant capital flows if the ETF becomes larger. The need to completely remove companies and buy up a 5% allocation in another company would risk moving market prices if the ETF were large and their strategy included fairly small companies. While moats may be much more common for established companies that rule their space, that doesn’t mean there won’t be very attractively priced smaller companies that are flying under the radar. The nature of needing to be able to suddenly buy up around $30 million to $40 million would be a difficulty for companies with a market capitalization lower than $1 billion since it could require purchasing at least 3% of the company. This will probably force the ETF to only consider larger companies. The concept makes sense, but execution of the strategy seems like a logistical nightmare unless the investment universe is significantly restricted to limit the list of potential investments to medium and larger companies. Once those restrictions are in place, it seems much more difficult to find and select the best securities because larger capitalization companies attract substantially more analyst attention and should generally be priced be more efficiently.

ITOT: A Solid Core Holding For Building An Efficient Portfolio

Summary This ETF has a low expense ratio and looks like a solid option for a core position. As a total market ETF there is very little opportunity to modify exposures. Due to the sector allocations I believe the fund is best utilized when combining it with a small position in more specialized ETFs to tailor the sector allocations. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds that I’m researching is the iShares Core S&P Total U.S. Stock Market ETF (NYSEARCA: ITOT ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The expense ratio for ITOT is only .07%. I tend to be very frugal with my expense ratios, so I like to see those low levels. There are a couple lower expense ratio ETFs in the categories of broad or total market, but .07% is still pretty good. Depending on where an investor does their brokerage, they may have incentives to use different ETFs to mitigate trading fees. Largest Holdings The following chart shows the largest holdings for the fund: These shouldn’t be a surprise since this is a total market ETF. The holdings across most total market ETFs will be very similar which gives investors a good reason to watch for high expense ratios, bid-ask spreads, and trading commissions to determine their long term costs. These allocations are subject to change, but I wouldn’t expect much in the way of change. Given the presence of such strong dividend champions at the top of the chart, investors might expect a strong dividend yield. Instead, they’ll find the yield is only around 2%. That’s no problem for most investors that would just reinvest their dividends anyway, but it may be less than optimal for investors in retirement seeking stronger yields to provide income without selling shares. Sectors The following chart breaks down the allocation by sector: The only sector I’ve been generally opposed to over the last several months has been telecommunications due to the aggressive price wars being waged. In this case the telecommunications allocation is just over 2.14%. In my view, that is a positive factor because 2.14% is a fairly low allocation for telecommunications among domestic equity ETFs. Using the holdings chart above, we can also determine that AT&T (NYSE: T ) and Verizon (NYSE: VZ ) combined to be about 1.92% of the portfolio, so most of the telecommunications allocation is right there. Energy Energy can be a fairly tricky sector because it can be referring to established champions like Exxon Mobil (NYSE: XOM ) or it can be referring to massively more aggressive plays such as off shore oil drilling. I like the fundamental premise of owning enormous producers of oil. If oil ever becomes irrelevant, it would be a very bullish sign for the rest of the economy pointing towards very low cost transportation and more capital available for spending on other goods and services. In order to hedge that risk, I want to see some of the established oil companies in the ETFs I use in my personal portfolios. I really wouldn’t mind seeing a higher allocation here so long as it was those established champions. They don’t have anywhere near as much upside as buying those drilling operations, but I am happy to sacrifice the upside to have dramatically reduced downside. Information Technology I know this is a growing part of our economy and it may continue to grow dramatically because information technology firms will generally have access to great economies of scale. I want some exposure to this part of the economy, but I wouldn’t mind seeing a slightly lower allocation because with great economies of scale comes the opportunity for earnings to get punished by a large drawdown in the economy or a black swan event. By definition, we won’t be able to predict black swans. However, I do believe we can estimate which industries have more exposure to those events. One Other Note There are 1509 holdings in this fund and it tracks the S&P Composite 1500 index. In my opinion a fund holding 1500 individual securities and tracking an index of 1500 securities is a broad market ETF, not a total market ETF. In my view any domestic ETF with fewer than 2000 holdings looks more like a broad market ETF than a total market ETF. Conclusion Overall this looks like a fairly good ETF. Since the ETF is going for a very low expense ratio and a passive style, there is not much to be done about adjusting the allocations. My preferred way to use an ETF like this would be to combine it with another more specialized ETF that placed a very high emphasis on my preferred sectors. When the investor combines the iShares Core S&P Total U.S. Stock Market ETF with another domestic equity fund they can look at the weighted average of the sector allocations which would be nice for building a very efficient portfolio.