Keeping Portfolios Simple

Different strokes for different folks. Some investors, prefer individual stocks and bonds. Others prefer funds. Some have a combination. All too often, investors have an eclectic collection of stocks, bonds, funds and annuities that they have accumulated over a lifetime with no clear rationale or plan.

Greater simplicity is most often the obvious need. At the extreme of simplicity is the use of a handful of broad, passive index funds.

We frankly prefer an intermediate portfolio composition — less than complex, but more than simple — let’s call it “simplexity”. However, for those seeking great simplicity in their portfolios, here are some very basic ideas.

A small group of funds could be used as a the core of a portfolio or as the entire portfolio (examples shown in the image above).

Once allocation weights are established for each broad asset category, if you have a large cash position, you would step into the market for each category in stages based on the fundamental logic and/or market conditions applicable to each category.

To the extent that you wish now or later to have exposures that differ from the core funds, you could “tilt” the exposures by:

• Supplementation (such as by adding a China fund to increase that country’s overall weight in the emerging markets category, or by adding an investment grade corporate bond fund to increase the weight of that form of debt in the US taxable bonds category), or by

• Complementation (such as by adding an foreign currency denominated international Treasury fund to expand the fixed income exposure beyond US only bonds; or by adding a commodity or real estate fund to expand into those categories).

There are all sorts of ways to supplement or complement core exposures with regional or country funds, sector or industry funds, market-cap and/or style funds, thematic funds, bond funds with different credit quality or duration, and other subclasses and categories; but selectivity is important to avoid recreating a complex mass of holdings, or inadvertently recreating a virtual broad index with many funds.

Tilting the few simple core positions remains an option when and if appropriate or desired to expose you to various risks/opportunities in a tactically targeted way.

Here are charts for seven of the funds identified in the image above as candidates for a simple portfolio:

Even if you don’t chose simplicity, or even “simplexity” for your portfolio, a simple portfolio concept may be useful as a benchmark against which to compare your actual results in yoru real portfolio.

Securities named or implied in this article: VT, ACWI, BND, AGG, VTI, IWV, VEU, MUB, VWITX, VEA, EFA, VWO, EEM, FXI, LQD, BWX, DBC, VNQ.

Disclosure: we own most, but not all, of these funds in managed accounts.

Comments

[Emerald:]

Excellent article and a great idea for the average investor.

Jun 25 10:00 AM

[Wirsbo:]

Richard, I agree this is a sound beta strategy. I'd like to get your thoughts on the allocation weighting technique suggested below. The aim is to double the portfolio's Sharpe ratio from about .36 to .76 providing a more return for less risk exposure.

First, formalize and broaden the asset classes to gain economic diversification and provide the option to reduce correlation between assets in the portfolio. Applying the simplexity principle, assets react to growth and inflation, either can be either rising or falling. Define 4 economic environments in these terms. Assign asset classes to 1 or more of the 4 buckets based when they historically out perform.

Secondly, define capital and risk allocation percentages to maximize Sharpe ratio within and across the buckets. Due to expansion of the global economy and a transfer of relative growth rate to the BRIIC countries, I believe EM assets are uncorrelated to their developed counterparts and need to be considered separate classes. Here is the grid based on historical risk (volatility) and rates of return:

1. Rising Growth - 31%
- Equities - 48%
- Nominal Bonds - 12%
- Commodities - 34%
- Emerging Market Bonds - 6%
2. Rising Inflation - 24%
- IL Bonds - 34%
- Commodities - 43%
- Real Estate - 9%
- Emerging Market Bonds - 14%
3. Growth / Falling - 19%
- Nominal Bonds - 57%
- IL Bonds - 43%
4. Inflation / Falling - 26%
- Equities - 58%
- Nominal Bonds - 42%
Finally, select instruments that provide the desired exposure. I like the ETF approach you suggest due to low fees and liquidity. For a beta strategy, the low fees are especially important.

Thank you for sharing this and other thought provoking articles.

Jun 25 11:00 AM