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In the previous article we weighed in on the debate about the use of tactical asset allocation compared to the venerable strategic asset allocation. Both have benefits and both have weaknesses.

We used the three asset SIB (simpler is better) portfolio -- one index fund in each asset class. We recognized that the SIB has significant limitations in diversification -- if one asset class was underperforming, the other asset classes would not be able to prop it up.

We now introduce an extended SIB or ESIB. An ESIB has multiple funds in each asset class, the purpose being to allow a better opportunity for each asset class to have a better opportunity to offset an underperforming asset class.

In this article, we introduce the ESIB-3 and compare its results with the SIB-3 before we investigate its properties in tactical asset allocation strategies.

The ESIB-3 comprises ten funds. These funds provide access to three major assets: U.S. and foreign equity and fixed income.
Asset Class Ticker Name
LARGE BLEND VTI VanguardTotal StockMarket ETF
MID-CAP BLEND VO VanguardMid-Cap ETF
SMALL BLEND VB VanguardSmall CapETF
Foreign LargeBlend EFA iSharesMSCI EAFEIndex
Foreign Small/MidValue SCZ iSharesMSCI EAFESmall CapIndex
Intermediate-TermBond BND VanguardTotal BondMarket ETF
High Yield Bond HYG iSharesiBoxx $ HighYieldCorporateBd
Inflation-ProtectedBond TIP iSharesBarclaysTIPS Bond
WORLD BOND WIP SPDR DBIntl GovtInfl-ProtectedBond
ROOT CASH CASH

Asset Class Number of funds
REITs 0
Balanced Fund 0
Fixed Income 5
Commodity 0
Sector Fund 0
Foreign Equity 2
Emerging Market Equity 0
US Equity 3
Other 0
Total 10

As of Jan 7, 2011, this plan investment choice is rated as below average based on MyPlanIQ Plan Rating methodology that was designed to measure how effective a plan's available investment funds are. It has the following detailed ratings:

Diversification -- Rated as above average (69%)
Fund Quality -- Rated as poor (7%)
Portfolio Building -- Rated as below average (12%)
Overall Rating -- below average (28%)

This compares favorably with the three ETF SIB's rating of 12%. We then compare the historical results:

Performance chart (as of Jan 7, 2011)

(Click to enlarge)

Performance table (as of Jan 7, 2011)

Portfolio Name 1-yr AR 1-yr Sharpe 3-yr AR 3-yr Sharpe 5-yr AR 5-yr Sharpe
ESIB-3 Tactical Asset Allocation Moderate -0% -2% 2% 24% 5% 44%
ESIB-3 Strategic Asset Allocation Moderate 11% 113% 2% 9% 4% 23%
Three Core Asset ETF Index Funds Tactical Asset Allocation Moderate -3% -28% 2% 17% 4% 30%
Three Core Asset ETF Index Funds Strategic Asset Allocation Moderate 9% 67% 1% 6% 4% 15%

We note that in the short term -- i.e. in a bull market -- an ESIB improves the performance and closes the gap very slightly between SAA and TAA. In the longer term, the additional funds allows the TAA to squeeze out a little more performance.

Takeaways:
  • Adding additional funds to a three asset class portfolio provides additional returns.
  • SAA still comprehensively beats TAA in a bull market.
  • Additional asset classes rather than additional funds should be compared to validate the impact of funds versus asset classes.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Extended 'Simple Is Better' Portfolios: A Better ETF Benchmark for Asset Allocation