A Simple But Winning Strategy: Permanent Asset Allocations In Extremely Volatile Markets

by: O. Young Kwon

Summary

Two long-term (5-7 years) portfolios with Vanguard Funds and TIAA Funds were set up two years ago. The fund allocation is permanent.

For more than two years, no changes in allocation or no trade or no re-balancing has been made, even amid the market rout in summer of the last year and the market turmoil in the recent weeks.

The TIAA Intelligent Annuity outperforms the DOW, the S&P 500, and the Vanguard Mutual Fund Portfolio (VMF), and the VMF underperforms the markets and its peer.

Market perspectives in a near term, in a short term, and in a long term are bullish, bullish, and bullish.

Four recommendations are made to younger investor because the article focuses on retired investors.

As a retiree in mid-70s, a safer investing strategy is need for me: The investment goal is not to make a significant growth by taking more risk as before, rather this time just to keep our savings grow at least 2% after inflation in an investment horizon between five to seven years. In 2014, as a result, by employing all wisdom and investment knowledge accumulated during over more than three decades, a sort of an "endgame" dual portfolio strategy was set up, following my article (A Dual-Portfolio Strategy With 2 Controls Has Worked Out. Can It Weather Any Looming Storm?).

Until then a major portion (about 90%) of our retirement savings had been solely at Vanguard (The Vanguard Group), making a good performance year after year. When more money have been piled up in the Vanguard Index Mutual Funds and Exchange-Traded Funds (ETFs), a diversification of investment organization would be prudent. Therefore, about 45% of capital moved into an Intelligent Variable Annuity at TIAA (or TIAA-CREF: The Teachers Insurance Annuity Association and the College Retirement Equity Fund). The Vanguard Portfolio and the TIAA Annuity have six and seven Fund/Portfolios, respectively. Even though TIAA has a number of Vanguard products which were not selected to avoid over-weights, combining two portfolios.

A permanent fund/portfolio allocation was made for both. Re-balancing is not made because it requires market timing. Also a long-term portfolio would have less benefits form re-balancing. The original allocation and the current weights as of July 8, 2016 are shown in Table 1 & 2.

Table 1: Vanguard Mutual Fund Portfolio

Allocation

Mutual Fund

Target

7/8/2016

Extended Market Index Fund (MUTF:VEXAX) (NYSEARCA:VXF)

30%

29.2%

Total Stock Market Index Fund (MUTF:VTSAX) (NYSEARCA:VTI)

30%

30.5%

Intermediate-Term Corporate Index Fund (MUTF:VICSX) (NASDAQ:VCIT)

10%

13.3%

Short-Term Inflation Protected Security Index Fund (MUTF:VTAPX) (NASDAQ:VTIP)

10%

6.3%

Total Bond Market Index Fund (MUTF:VBTLX) (NYSEARCA:BND)

10%

7.5%

Total International Bond Index Fund (MUTF:VTABX) (NASDAQ:BNDX)

10%

13.1%

TOTAL

100%

100.0%

Note: The over-weighted components are highlighted.

Click to enlarge

Table 2: TIAA-CREF Intelligent Variable Annuity

Allocation

Account (Portfolio or Fund)

Target

7/8/2016

T. Rowe Price Limited-Term Bond Portfolio

16%

15.8%

Templeton Developing Markets VIP Fund

8%

7.4%

Newberger Berman AMT Mid Cap Intrinsic Value Portfolio Class I

16%

15.5%

ewberger Berman AMT Large Cap Intrinsic Value Portfolio Class I

16%

15.4%

TIAA-CREFT Life Stock Index

20%

21.3%

Western Asset Variable Global High Yield Bond Portfolio Class I

8%

8.6%

DFA VA Global Bond Portfolio

16%

16.0%

TOTAL

100%

100.0%

Note: The over-weighted components are highlighted..

Click to enlarge

In Table 1, VTI and VXF cover the major stocks. For bonds, BND and BNDX are enough for the global bond market, but VTIP and VCIT are added to mitigate the impact of the future Fed policy on interest rates. The allocation of Table 2 follows the Vanguard's allocation, by picking available TIAA Portfolios which are most similar to the counterparts of Vanuard's funds.

The main features of the setup are: (1) The primary selection criterion is cost. (2) The asset allocation is 60/40 of stocks and bonds. (3) The second-tier portfolios are two discount-brokerage accounts at Charles Schwab and TD Ameritrade (where only commission-free ETFs are traded with about 10% of our capital.) (4) Cash for emergency and some idle money in brokerage accounts is parking in two savings accounts at GS (Goldman Sachs) Bank to earn ten times more than money-market funds.

On July 8, 2016 (Friday), the S&P 500 stock index reached the intraday all-time high, and closed at 2109.90 which was just 0.92 shy of the previous record closing at 2,130.82 on May 21, 2015. The Dow Jones Industrial Average climbed to 18,146.74 which was just 166 points short of its record high, 18,213.99, made on May 19,2015. Tech-heavy Nasdaq Index also surged to 4,946.76 that is just 5.3% away from its record 5,218.86 on July 20, 2015.

In the same day, Bond also rallied, showing the yield of the 10-year Treasury downed by 0.021%. The bond prices advanced as the yields declined so that BND (Vanguard Total Bond Index ETF) and SCHZ (Charles Schwab Total Bond Index ETF) went up to 84.89 and 54.01 from 84.67 and 53.95 or 0.26% and 0.11%, respectively.

Typically, bonds and stocks have been de-coupled, in other words, one is up when the other is down. In an extremely stressed market, they couple, by dropping sharply due to sell-off of both toward to money-market funds which are cash, as shown in the financial crisis in 2007-08. A de-coupling case for both to move in the opposite direction (to upward), however, is quite rare.

Both Dow and S&P 500 were closed to their records with a less than 2% of the yield of the 10-year Treasury in 2013: That was the first time in the last 40 years. The coupling of bonds and stocks on July 8, 2016 was the second case. For both cases investors favors both bonds and stocks because they expect economic growth without fearing Fed's tightening policy for a significant period.

The DOW notched another record Friday (July 15, 2016), showing the rally's resilience. Major stock indexes posted their third consecutive weekly advances, rebounding after the wave of the U.K exit vote on June 23. Now, intensified is a tug of war between optimists and pessimists: The former believe a new potent upswing leg of the aging bull has a strong sustainable momentum while the latter claim that the current equity prices are extremely overpriced, judging by their traditional valuation matrix such as price-earnings (-sales) ratio.

The rare market action on July 8, 2016 of pushing both stocks and bonds up significantly would be a starting point of the so-called the TINO or there is no alternatives. Last week the markets seem to pave the TINO road, but one week is too short to prove a new trend in the coming years. Is this a real or simply a mirage? In a couple of week, a verdict would be delivered.

Two facts are primarily responsible for this Goldilocks environment: The first one is a big change in valuations of equities. The other is that the valuation of bonds, in particular Treasuries, has been influenced by the actions of the Fed with its rate hikes, not fully reflecting the trend of global Treasuries and the relationship between bonds and stocks (which areas an alternative for income).

The value of stocks is determined by discounting the future of their earnings (capital gains and dividends). The discount factor plays a crucial role. Historically the yield of bonds (or Treasuries) is excluded because bonds are traded by mostly institutional investors such as insurance companies and banks.. But a prolong near-zero interest period since the Great Recession, bonds are demanded by individual investors.

As a result, the discount factor of equity valuation should change from equity risk premium to risk premium and the 10-year Treasury yield as a proxy of the bond yield, The Treasury yield has been lowered in the recent years as we witness. This trend is going to be extended for the coming years. If the discounting factor is getting lower, The value of stocks is higher, very much higher!

On the other hand, bonds have been undervalued. In other words the yields of bonds have been too high in the recent years even though most think they are too low. The U.K. exit vote on June 23 affected bonds to correct their mispricing. Therefore, bonds also rallied as stocks did. Some argue that risk premium would offset lowering bond yield (in the discount factor) when a global risk due mainly to slow/declining economic growth. But considering a smooth settlement in the U.K. politics last week: It took about two weeks rather than three months or longer as expected and recent upbeat the U.S. economic data, the risk factor would be stable.

The market perspective in a near term (in several weeks), in a short term (in several months), and in a long term (in several years) is bullish, more bullish , and much more bullish, respectively, because the rebounds would be expected from the British and emerging markets in a near term, from the U.S. equity market fueled by a significant change in the valuations of stocks in a short term, and from the world markets to catch up the mediocre performance over the past two years. Bull Markets rarely die on a moderate economic growth and a low inflation pressure. The current one is likely not an exception.

The Table 3 summarizes the extremely turbulent stock markets for the past three weeks, starting June 17 (Friday) before the Brexit on June 23 (reflected on markets on June 24). The DOW, the S&P 500, the VXF (Vanguard Mutual Fund Portfolio) and the TVA (TIAA Intelligent Variable Annuity) are depicted. Remarkable are the Brexit-induced reactions of the markets and y portfolios: the sharp jumps on June 20, June 21, and June23 (with one-day brief pause on June 22) and the deep plunge on June 24 and June 25. (See the Daily Percentage Change in Table 3) The TVA (+4.66%) outperformed The DOW (+4.54%), the S&P 500 (+4.28), and the VMF (+3.09). The VMF turned out to underperform the markets as well as its peer. (See Cumulative Percentage Change in Table 3)

Note that the percentage change formula (2*(B-A)/(B+A)) differs the traditional formula ((B-A)/A). The former is symmetrical upward or downward while the latter is not. For example, when the maket downs 1%, a1% gain is needed to make up. But the latter case, a 1% down requires a more-than-1% gain.

The article focuses on the retired investors. What offers to the younger? Well, several suggestions and a warning are offered. First, a warning: Don't jump in annuities that are sticky contracts with insurance companies. They are tax-advantaged, but there would have pitfalls.

Second, some recommendations: (1) The VMF would be mimicked for your investments to target a goal such as buying a home, funding educational or medical expenses or to start a new business. (2) The Vanguard Index products (Mutual Funds and ETFs) are so popular that they are almost everywhere. You cab set up your portfolios at TD Ameritrade or Charles Schwab with no/low commissions.

(3) If you prefer a permanent Fund allocation idea, you can select VTI (Vanguard Total Stock Market Index ETF) and BND (Vanguard Total Bond Index ETF) or SCHB (Schwab Broad Stock Market Index ETF) and SCHZ (Schwab Total Bond Market Index ETF). You may allocate your capital 80/40 or 50/50 without changing and without re-balancing year after year.

(4) If you don't want to keep paying your attention on your portfolios for some reasons, you may select balance funds such as Vanguard Balance Fund or Vanguard Star Fund, which Vanguard takes care of for you.

Table 3: Performance Comparison: Portfolio vs. S&P 500 Stock Index

Daily Percent Change

Cumulative Percent Change

DATE

DOW

S&P

DOW

S&P

VMF

TVA

DOW

S&P

VMF

TVA

17-Jun

17,695.16

2,071.22

*

*

*

*

*

*

*

*

20-Jun

17,804.80

2,082.25

-0.62%

-0.53%

0.45%

2.17%

-0.62%

-0.53%

0.45%

2.17%

21-Jun

17,829.73

2,088.90

-0.14%

-0.32%

-0.08%

0.12%

-0.76%

-0.85%

0.37%

2.29%

22-Jun

17,780.83

2,085.45

0.27%

0.17%

-0.04%

-0.01%

-0.48%

-0.68%

0.32%

2.28%

23-Jun

18,011.09

2,113.32

-1.29%

-1.33%

0.90%

0.90%

-1.77%

-2.01%

1.22%

3.18%

24-Jun

17,400.00

2,037.30

3.45%

3.66%

-2.11%

-2.56%

1.68%

1.65%

-0.89%

0.61%

27-Jun

17,140.24

2,000.54

1.50%

1.82%

-1.34%

-1.51%

3.19%

3.47%

-2.23%

-0.89%

28-Jun

17,409.45

2,036.08

-1.56%

-1.76%

8.19%

1.19%

1.63%

1.71%

5.97%

0.30%

29-Jun

17,694.68

2,070.77

-1.63%

-1.69%

-5.94%

1.11%

0.00%

0.02%

0.02%

1.41%

30-Jun

17,929.99

2,098.85

-1.32%

-1.35%

0.94%

0.97%

-1.32%

-1.33%

0.96%

2.38%

1-Jul

17,949.30

2,102.95

-0.11%

-0.20%

0.30%

0.26%

-1.43%

-1.52%

1.26%

2.64%

5-Jul

17,840.62

2,088.55

0.61%

0.69%

-0.94%

-0.74%

-0.82%

-0.83%

0.31%

1.90%

6-Jul

17,918.62

2,099.73

-0.44%

-0.53%

0.82%

0.26%

-1.26%

-1.37%

1.13%

2.16%

7-Jul

17,895.88

2,097.90

0.13%

0.09%

0.06%

0.11%

-1.13%

-1.28%

1.19%

2.27%

8-Jul

18,146.74

2,129.90

-1.39%

-1.51%

1.12%

1.04%

-2.52%

-2.79%

2.31%

3.31%

11-Jul

18,226.93

2,137.16

-0.44%

-0.34%

0.28%

0.39%

-2.96%

-3.13%

2.59%

3.71%

12-Jul

18,347.67

2,152.14

-0.66%

-0.70%

0.45%

0.76%

-3.62%

-3.83%

3.04%

4.47%

13-Jul

18,372.12

2,152.43

-0.13%

-0.01%

0.00%

-0.02%

-3.75%

-3.85%

3.04%

4.45%

14-Jul

18,506.41

2,162.75

-0.73%

-0.48%

0.12%

0.30%

-4.48%

-4.32%

3.16%

4.75%

15-Jul

18,516.55

2,161.74

-0.05%

0.05%

-0.07%

-0.09%

-4.54%

-4.28%

3.09%

4.66%

Note: 1: The percent change formula: 200*(B-A)/(B+A)

Note: 2: VMT: Vanguard Mutual Fund Portfolio TVA: TIAA Intelligent Variable Annuity

Click to enlarge

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.