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There is an easy to understand strategy that can lead to high returns with low risk. If you have a portfolio with the correct asset classes represented, over the long term, you will get better results at a lower risk than picking the latest and greatest fund or stock. This is not the bleeding edge of new ideas. This is proven and widely used – being the basis of most money manager’s strategies.

MyPlanIQ created SIB portfolios (Simpler Is Better) – market index funds from key asset classes that can be used to measure historical returns to show the impact of asset class selection rather than fund or stock selection. SIB portfolios for different numbers of asset classes are built and used to benchmark returns. From this, conclusions can be drawn as to what is an effective investment strategy for today.

The following funds were used:

Index Funds Asset Class

Ticker

Name

Large Blend

VTSMX

Vanguard Total Stock Mkt Idx

Foreign Large Blend

VGTSX

Vanguard Total Intl Stock Index

Diversified Emerging Markets

VEIEX

Vanguard Emerging Mkts Stock Idx

Real Estate

VGSIX

Vanguard REIT Index

Commodities Broad Basket

DBC

PowerShares DB Commodity Idx Trking Fund

Intermediate-Term Bond

VBMFX

Vanguard Total Bond Market Index

ETF Asset Classes

Ticker

Description

LARGE BLEND

VTI

Vanguard Total Stock Market ETF

Foreign Large Blend

VEU

Vanguard FTSE All-World ex-US ETF

Diversified Emerging Markets

VWO

Vanguard Emerging Markets Stock ETF

Real Estate

VNQ

Vanguard REIT Index ETF

Commodities Broad Basket

DBC

PowerShares DB Commodity Idx Trking Fund

Intermediate-Term Bond

BND

Vanguard Total Bond Market ETF

Three Asset Class SIB: The three core assets are U.S. and international equities and fixed income. This represents what used to be conventional wisdom: Heavy dependence on the U.S. and the rest of the developed world. With a conservative strategic asset allocation strategy, the portfolio would consist of 60% fixed income and 20% each for U.S. and international equities. With a tactical asset allocation strategy, the fixed income would never be less than 60% but the split of the three asset classes would move based on asset price movement.

Three Core Asset Portfolios

1 year AR

3 year AR

5 year AR

SAA Index

11%

1%

4%

SAA ETF Index

15%

1%

3%

TAA Index

7%

4%

6%

TAA ETF Index

9%

4%

5%

The SAA (buy and hold) strategy represents what many people may end up with. There is little thought put into which asset classes are represented but these are the most likely ones to be covered. The TAA strategy gives a little higher long term performance because of the ability to move to other asset classes when one aspect of the economy is slowing.

It’s clear that world economics has changed; becoming smaller, more interlinked and complex. It’s no longer possible to ignore the impact of emerging markets and we are very aware that real estate has an impact on the economy.

If you are just using three asset classes, you should look to upgrade your portfolio immediately.

Four Asset Class SIB: There are two variants for the four asset class SIB. Either add emerging markets or real estate trusts to the three asset class SIB. Note that the international asset class means established nations such as those in Europe and emerging asset classes are represented by developing nations. With a conservative strategic asset allocation strategy, the portfolio would consist of 60% fixed income and 13.33% each for U.S., international and REIT or emerging market equities. With a tactical asset allocation strategy, the fixed income would never be less than 60% but the split of the three asset classes would move based on asset price movement.

Four Core Asset Portfolios

1 year AR

3 year AR

5 year AR

SAA Em Index

12%

2%

6%

SAA REIT Index

17%

2%

5%

SAA ETF Em

16%

2%

6%

TAA Emerging

11%

7%

10%

TAA REIT

15%

6%

8%

TAA ETF Em

15%

7%

11%

Adding another asset class improves the performance as it balances risk. TAA is also able to increase its long term benefit over SAA as there are more asset classes to move into when one of the asset classes is not performing properly. Choosing between REIT and emerging markets is hard and further diversification is of long term value.

If you are using a four asset class portfolio, you could be doing better. Making the choice between emerging markets and real estate is a tough one.

Five Asset Class SIB: Has been covered in a previous article and the results are included for completeness. The five class SIB takes both REIT and Emerging markets so is a fusion of the two four asset class SIBs.

Five Core Asset Portfolios

1 year AR

3 year AR

5 year AR

SAA Index

15%

3%

5%

SAA ETF

20%

3%

7%

TAA Index

15%

8%

10%

TAA ETF

19%

8%

12%

The five asset class SIB is a strong platform for portfolio creation. It has broad diversification and, with tactical asset allocation, good returns.

If you are using a five asset class portfolio, you are in good shape – but take a look at the six asset class portfolio because it will be increasingly important in the current macro economic climate.

Six Asset Class SIB: The last asset class adds commodities to the portfolio. This gives another type of asset class and will further help diversification

Adding another asset class does not significantly improve the result within the 5 year time frame. It may be asked whether the extra effort of building and managing a six asset class portfolio is worth it. Broader diversification is good, but is it really necessary? In our view, the addition of commodities will be increasingly important as commodities will protect against inflation as the recovery slowly continues and there is increasing inflationary pressure.

Click to enlarge:

Figure 1 5 Year Annualized Returns for the different SIBs with SAA and TAA strategies

What conclusions can be drawn from this?

  • It’s time to leave a three asset class portfolio in the past. The world is more connected and complex and higher returns require more sophistication

  • Four and five asset class portfolios have fared well and show solid returns but everybody should consider adding commodities in the light of the current economic realities

  • This is not rocket science and you should be able to increase your returns and be in control of improving your returns

  • ETF’s are a very effective vehicle for implementing a SIB strategy and deliver excellent returns compared to the other funds selected

In a future article, we will look at the impact of the actual fund selection to increase the return still further.

Click here for a detailed view of the six asset portfolio

Disclosure: Long IYR,LQD,TLT
Source: 11 ETFs for Simpler-Is-Better Portfolios