Portfolio Weighting with U.S., Developed Market and Emerging Market Equities

The major indices for developed and emerging markets were created in 1994. This post presents 10-year price charts for the S&P 500 index versus the MSCI EAFE (developed) markets index and versus the MSCI emerging markets index.

These discreet fixed length periods may be helpful as you evaluate portfolio weights for US [proxies SPY (SPY) and iShares Russell 3000 Index (IWV)], developed market [proxies iShares MSCI EAFE Index (EFA) and Vanguard Europe Pacific ETF (VEA)] and emerging market [proxies iShares MSCI Emerging Markets Index (EEM) and Vanguard Emerging Markets Stock VIPERs (VWO)] equities.

Most performance representations are for X years in the past to the present. These charts are each 10 years in length beginning January 1st of 1994, 1995, 1996, 1997, 1998 and 1999.

Ten years is often referred to as the period over which everything usually works out (that is not always the case, but it is a good observation period). We think sequential 10-year periods provide helpful perspective when thinking about allocation between US, other developed and emerging market stocks.

There are only six 10-year intervals to consider, but what titanic shifts they show.

The EAFE index began in 1994. The Emerging Market index began in 1996. Here are the available 10-year intervals displayed graphically.

This kind of fluctuating and shifting relative performance provides some visual support for the concepts of rebalancing within an asset allocated portfolio, and perhaps for tactical asset allocation within a range of weights around a target weight for each class.

Rebalancing involves periodically taking money off the table (harvesting) from better performing classes, while adding money to lesser performing classes (planting). That approach is important to help maintain total portfolio risk level at acceptable and planned levels.

Rebalancing prevents riding bubbles all the way up and then back down. It also cost averages down for declining classes.

Note: While we subscribe to asset allocation and rebalancing, we took almost all money off the table in July when an unprecedented train wreck for all asset classes appeared to be coming our way. We now think staging back into ultimate asset allocation positions makes sense. We’ve been going back into bonds for a couple of months and have recently cautiously put our toe into equities. All of our positions have persistent trailing percentage stop loss orders. — Note also that many investors have discovered that their risk tolerance is lower than they thought, and will be holding a more balanced mix of stocks and bonds than before 2008.

The shifting relative performance of asset classes may also be the basis for active tactical allocation weight adjustments to capture opportunities, as persistent shifting patterns become obvious.

We think there is a persistent shift of economic growth and wealth from the developed countries to Asia which tactical allocation help might capture.

The way we suggest to most prudently attempt to capture shifting growth and wealth is to allocate core equities in the same proportion that they represent world market-cap, and to adjust those core weights each year as world market weights change.

Note: the world market-cap weighting approach will increase exposure to bubble countries, compared to fixed allocations between countries, but the world has changed much and will change much, making permanent fixed weights obsolete in our view. Possible bubbles within world market-cap should be examined logically as situations progress. Rebalancing between equities and fixed income helps reduce the bubble risk.

Core world market-cap can be easily achieved with one, two or three funds - for example:

• One fund: Vanguard Total World Stock ETF (VT) (all world)
• Two funds: Vanguard Total Stock Market Vipers (VTI) (US) plus Vanguard FTSE All-World ex-US ETF (VEU) (all world ex US)
• Three funds: VTI (US) plus VEA (developed) plus VWO (emerging)

Note: oddly enough, Canada is missing from the three fund model, but is present in the one and two fund model — MSCI EAFE (non-US developed) excludes Canada.

A more aggressive tactical approach would be to market weight core equity positions, and then tactically add positions to the core that bias the overall weights in the direction of those investment styles, market-cap sizes, regions or countries that you expect to outperform.

Comments

[donzelion:]

A word on asset location might be helpful. Doesn't it make sense to place a US-based ETF like VTI in a tax advantaged account (IRA, 401k, etc.) and foreign equity ETFs (like VWO, VEU, and VEA) in a normal, taxable account?

In theory, the taxes on foreign equities in a normal account should be recoverable come tax time, but the taxes on foreign equities in a tax advantaged account would not be.

The difference in tax treatment - if it outweighs the fees - suggests avoiding the 1-ETF model, and focusing on a 2 or 3 ETF model.

And, if the difference in fees between VEA and VWO outweighs the costs of buying 3 securities rather than just 2, then the 3 ETF model would win out. Hence, for an investor putting in large quantities of money for long-term holdings, the 3-ETF model is likely to be the ideal core holding (in terms of tax advantage and ETF fee advantages, though with Vanguard, the low fees in general make this less of an issue).

Jan 08 05:06 AM