6 Asset Classes Bring Needed Inflation Protection to Vulnerable Retirement Portfolios

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Includes: BND, DBC, VEU, VNQ, VTI, VWO
by: MyPlanIQ

The first baby boomers are getting ready for retirement and with the recent financial meltdown still smoking in our rear view mirrors, there is much about which to be concerned. Even as we climb our way out, inflation appears a near certainty and this is only going to add more stress on already stretched investments.

401K plans have moved from being an adjunct to a pension plan to being the mainstay of retirement income. In a study of over 800 mainly retirement plans, we noted that the majority of plans supported only three asset classes which is going to have a significant impact on the potential returns for the participant.

Asset Classes Number of plans
Three 59
Four 23
Five 14
Six 4
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Sadly, only 4% of the plans we reviewed had the six asset classes to build the sort of portfolios necessary to optimize returns and minimize risk.

In the last article we found reviewed historical simulations from a five asset class plan would, over a decade, put 75% more money in your pocket compared to a three asset plan. In this article, we are going to add commodities as another class to provide diversification protection.

We are going to use a simple benchmark vehicle -- SIB -- simpler is better to show the potential difference in returns between the portfolios with different numbers of asset classes.

Each of the SIBs are built from one ETF per asset class. The ETFs we selected for these portfolios are as follows:

Asset Class Ticker Name
LARGE BLEND VTI Vanguard Total Stock Market ETF
Foreign Large Blend VEU Vanguard FTSE All-World ex-US ETF
DIVERSIFIED EMERGING MKTS 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
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So the three asset SIB has (NYSEARCA:VTI), (NYSEARCA:VEU) and (NYSEARCA:BND). The four asset SIB adds emerging markets (NYSEARCA:VWO). The five asset SIB adds Real Estate (NYSEARCA:VNQ). The six asset SIB adds commodities (NYSEARCA:DBC). Note that these ETFs were chosen arbitrarily. If you want to see a range of alternatives and their relative performance, MyPlanIQ maintains updated information on major ETFs in most asset classes.

Commodities can be volatile and some may have trepidation in owning this type of asset. ETF's which are broadly diversified reduce the volatility and don't rely on fund managers who can be hit or miss. In the coming years, commodities will be important and have already shown their value as inflation is an issue in emerging markets and will shortly start to arise more locally.

If we compare the historical returns between the three asset and six asset SIBs, you can see a wide disparity between the two.

Performance chart (as of Mar 4, 2011)

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Performance table (as of Mar 4, 2011)

Portfolio Name 1Yr AR 1Yr Sharpe 3Yr AR 3Yr Sharpe 5Yr AR 5Yr Sharpe
Three Core Asset ETF Benchmark Tactical Asset Allocation Moderate 2% 17% 3% 29% 4% 37%
Three Core Asset ETF Benchmark Strategic Asset Allocation Moderate 16% 115% 4% 18% 4% 19%
Six Core Asset ETF Benchmark Tactical Asset Allocation Moderate 16% 118% 9% 73% 13% 89%
Six Core Asset ETF Benchmark Strategic Asset Allocation Moderate 18% 143% 5% 21% 7% 33%
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Currently Commodities, US Equity and Real Estate are doing well. Only US Equity is available to Three Core Asset ETF Benchmark participants where as the Six Asset ETF benchmark benefits from all three.

If we ignore the short term difference -- which are not insignificant -- and look at the five year returns we see a clear difference. Note that the different between 4% a year and 13% a year -- over a decade -- puts more than twice the amount of money in your nestegg.

You may not have all the asset classes in your current 401K plan -- but if you have an IRA or the chance to rollover an old 401K into an IRA and assemble a six asset portfolio, you will thank yourself when you retire.

Disclosure: MyPlanIQ does not have any business relationship with the company or companies mentioned in this article. It does not set up their retirement plans. The performance data of portfolios mentioned above are obtained through historical simulation and are hypothetical.

Disclosure: Author is long DBC.