The One-Decision ETF Portfolio

The goal here is to offer you the best possible investment that requires only a minimal time commitment. I call it the One-Decision Portfolio because after you adopt the asset allocation described here, all that is required from you in the future is a few minutes’ work once each year to maintain the specified program.

A mix of assets that has been far safer than stocks alone and far more profitable than bonds alone is 50 percent in bonds/cash and 50 percent in equity funds.

Let's start with the equity piece. An equity portfolio consisting of 40 percent S&P 500, 40 percent real estate investment trusts (REITs), and 20 percent small-cap value had less drawdown than did any of its individual constituents. These three areas—REITs, small-cap value, and S&P 500—have historically had a relatively low correlation with each other. In contrast, most other broad subsets of the stock market have tended to be more highly correlated. As a result, diversification among these areas has historically been effective at reducing risk, particularly during the volatile 1997–2004 market period.

The income part of the one-decision portfolio is 60 percent cash/40 percent intermediate-term investment grade bonds.

Putting all this together results in the following overall One-Decision investment mix:

• 20 percent S&P 500
• 20 percent REITs
• 10 percent small-cap value
• 20 percent investment-grade bonds
• 30 percent cash (90-day U.S. Treasury bills)

ETFs that most closely match the components of the One-Decision Portfolio and their expense ratios are as follows:

• S&P 500: S&P 500 Depository Receipts (SPY), 0.12%; or iShares S&P 500 Index Fund (IVV) 0.09%
• REIT Mutual Fund Average: iShares Cohen and Steers Realty Majors Index Fund (ICF) 0.35%
• Russell 2000 Value Index: iShares Russell 2000 Value Index Fund (IWN) 0.25%
• Lehman Aggregate Bond Index Index: iShares Lehman Aggregate Bond Fund (AGG) 0.2%

No ETF is available that closely resembles a money market fund. Rather, you should look for the highest yielding money market fund or bank CD for your cash balances.

The One-Decision portfolio suffered only two losing years between 1981 and 2005 (1990 and 2002), and losses during each of these years were small (1.5 percent and 2.3 percent). In contrast, the S&P 500 had five losing years during the same period. The worst year, 2002, saw a loss of more than 22 percent. Only Treasury bills have been safer when judged by the likelihood of having a losing year.

The compounded annual gains for each of the separate components of the one-decision portfolio and for the overall portfolio from 5/31/1980–2/28/2006 (25.75 years) were as follows. The equity components of the portfolio (40 percent S&P 500, 40 percent REITs, and 20 percent small-cap value) gained 13.9 percent per year, whereas the income components (60 percent Treasury bills, 40 percent investmentgrade bonds) gained 7.2 percent per year. The one-decision portfolio generated a compounded annual return of 10.7 percent per year which, as expected, is between the returns generated by its stock and bond components. During this profitable period, the one-decision portfolio returned 3.2 percent per year less than its equity components and 3.5 percent per year more than its income components. (Click on image to enlarge.)

The benefit of the one-decision portfolio becomes apparent when you consider the tremendous reduction in risk that would have occurred historically if you had invested in the one-decision portfolio compared to only its equity components. The drawdown of the onedecision portfolio was 11.2 percent, which is barely worse than the 9 percent drawdown that you would have incurred through investing entirely in investment-grade bonds. The extra 2.2 percent in risk (increase in drawdown from 9.0 percent from bonds alone to 11.2 percent in the one-decision portfolio) is a small price to pay for an increase of 3.5 percent per year in investment return. Figure 7.4 shows the drawdowns of the one-decision portfolio compared to the drawdowns of each of its constituents. The risk-adjusted performance of the one-decision portfolio exceeded that of every one of its constituents, as measured by the Sharpe ratio. This is the best measure of the benefit of diversification. The Figure below shows the risk-adjusted performance (Sharpe ratio) of the entire portfolio compared to that of its components.

In this figure, Sharpe ratios are calculated using the 259 months of total return data starting in June 1980 and extending through February 2006. The higher the Sharpe ratio, the better the risk-adjusted performance of an investment. Even though the one-decision portfolio was less profitable than any of its equity components and riskier than either of its income components, the data here shows that the balance between risk and reward is best for the portfolio as a whole.

When maintaining the One-Decision Portfolio, I recommend rebalancing after holding for one year and one day, rather than rebalancing on the same date each year. This way, any gains you realize will be taxed at the more favorable long-term capital gains rate.

Many advisors recommend holding some international equity investments. In particular, emerging market equity funds have enjoyed a low correlation with the U.S. stock market, which could make them candidates for a diversified, static portfolio. I have excluded emerging-market stocks from the analysis in this chapter for two reasons. First, only since early 2003 has the performance of emerging-market stocks been strong enough to warrant attention from individual investors. The period from 1990–2003 was marked by strong gains on three occasions (1993, 1995–1997, and 1998–1999), each of which was wiped out by subsequent declines in the emerging-market area. Indeed, from 1990–2002 (13 years), the average emerging-market equity mutual fund returned only 3 percent per year, compounded. Second, much less historical data is available for broadly diversified emerging-market equity investments than for the better-established asset classes in the one-decision portfolio. Emerging markets represent only a small fraction (11 percent) of the total dollar value of foreign stock markets.

The bulk of international stock market wealth is concentrated in Western Europe (approximately 52 percent of world market total) and Japan (approximately 24 percent of world market total). Stocks from other developed countries, as a group, are best held when their long-term trends are favorable vis-à-vis our own market, rather than at all times.

This article is adapted from an extract from Dr. Appel's new book, Investing with Exchange-Traded Funds Made Easy.

Comments

[Paul Meisel]

This is very useful to those who wish to avoid a lot of research, and cannot follow or invest in many different securities.

Using intuition and heuristics, I recently came up with something similar but slightly different for my children, who are starting Roth IRAs with small investments. Because they are looking at 4 digit investments, it is not practical for them to invest in 5 or 10 different issues, nor do they wish to follow them closely. So I came up with the following:

50%-80% Large cap dividend ETF (FDL);
20%-50% Russell 2000 Index (IWN).

The weightings are approximate; to minimize transaction costs I will purchase for them only one of the two ETF's on most deposit events. I intend to follow this strategy until they have perhaps $10,000, although I will reevaluate the strategy along the way.

I admit to a bias towards equities and away from bonds and REITS -- partly because of a hangover from reading Peter Lynch, and partly due to the age of my children (between 18 and 21).

I find it comforting when rigorous quantitative analysis (which I have the talent, but not the patience, for) arrives at conclusions that match those I reach with intuition and heuristics. This could be "great minds think alike" or "you can tell a person's intelligence by the degree to which his prejudices match your own..."

[NormanGlickman]

A portfolio that omits foreign equities from both developed and developing economies makes little sense to me.

[Panskeptic]

Nice. Are we allowed to substitute enhanced products? I am inclined against putting my own money in SPY, when I can choose from RSP, PWC, PRF, DLN, etc., but these don't have 15 years of numbers.

The absence of international exposure bothers me a lot, too. And what about commodities? I'd rather balance stocks against gold and the rest than against bonds. No room for DBC in this formula.

[Paul Meisel]

I think what is more important than your individual preference is the concept -- buy some things that are not too closely correlated to each other and provide some diversification, and leave them alone for 6 or 12 months at a time. The fact is that many investors do the latter anyway (leave things for months at a time) without enough thought about the choices. This could turn into a long-term contest -- pick your own version and compare with your friends. It would be more entertaining than fantasy football.

On the other hand, people who are sophisticated enough to evaluate the multiplying variety of ETFs for "enhanced products" and make risk/reward distinctions about foreign equity funds don't need a one-decision portfolio. They are re-evaluating their options much more frequently, either because their investments merit the attention or just because they find it to be fun.