KISS Retirement Portfolio: Frank Armstrong's 'Ideal Index' Portfolio

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Includes: BSV, IEFA, IJR, IVE, IWN, NAESX, RWR, SCHA, SCHF, SCHH, SCHO, SCHV, SHY, SPY, SWPPX, VB, VBISX, VBR, VFINX, VFITX, VGSIX, VGTSX, VISVX, VIVAX, VNQ, VOO, VTV, VXUS
by: Robert Mattei

Summary

Today we look at Frank Armstrong's Ideal Index Portfolio.

The Ideal Index Portfolio has more international stocks and less bonds than most of KISS portfolios we’ve reviewed so far.

Let’s see how it stacks up.

In this series of articles, we will present simple index fund based portfolios. Each KISS (Keep It Simple Stupid) portfolio is backtested and we compare both the Compound Annual Growth Rate and risk-adjusted returns against the S&P 500 index.

The portfolios are rebalanced once per year and dividends and distributions are reinvested.

For each portfolio we will examine:

  • How large a $10,000 initial investment would have grown between 1972-2014
  • How our $10,000 investment did during bear markets.
  • How our portfolio did if we started with $10,000 and made contributions every year starting at $5,000 and adjusting the contribution for inflation every year.
  • How our portfolio did if we started with $100,000 and made a withdrawal every year starting at $4,000 and adjusting the withdrawal for inflation every year.

As with the previous articles, this article is intended to start a conversation. I consider this a group effort. The primary benefit of SA, in my view, is it gives us an opportunity to discuss investment ideas. I encourage you to participate in the conversation.

The Portfolio

Frank Armstrong is probably best known for writing "The Informed Investor" in 2003. He runs a fee-only investment advisory service. The portfolio we are looking at today, is one he suggested in an MSN Money article. The portfolio:

  • US large blend stocks : 6.75%
  • US large value stocks : 9.25%
  • US small growth stocks: 6.75%
  • US small value stocks : 9.25%
  • US REITs : 8.00%
  • International stocks: 31.00%
  • US short-term bonds: 30.00%

I made a slight adjustment to the portfolio using 15% 5-year T-Bills and 15% Short-term T-bills instead of 30% short-term bonds; this change allowed me to test back to 1972. This does change the performance slightly, but does not change the overall characteristics of the portfolio.

The backtesting was done at PortfolioVisualizer.com. The data used by Portfolio Visualizer:

Portfolio 1

Large Cap Blend

  • S&P 500: Standard & Poor's 1972-1976
  • Vanguard 500 Index Fund (MUTF:VFINX) 1977-2014

Large Value

  • Fama and French 1972-1978
  • Russell 1000 Value Index 1979-1992
  • Vanguard Value Index Fund (MUTF:VIVAX) 1993-2014

Small Cap Blend

  • Ibbotson 1972-1978
  • Russell 2000 Index 1979-1991
  • Vanguard Small Cap Index Fund (MUTF:NAESX) 1992-2014

Small Cap Value

  • Ibbotson 1972-1978
  • Russell 2000 Value Index 1979-1998
  • Vanguard Small Cap Value Index Fund (MUTF:VISVX) 1999-2014

REITs

  • National Association of Real Estate Investment Trusts 1972-1996
  • Vanguard REIT Index Fund (MUTF:VGSIX) 1997-2014

International Stock Market

  • MSCI EAFE Index 1972-1987 (Developed Only)
  • 85% EAFE Index/15% EM 1988-1996
  • Vanguard Total International Index Fund (MUTF:VGTSX) 1997-2014

Intermediate Term Treasuries (5-year T-bills)

  • TAM Asset Management Spreadsheet 1972-1991
  • Vanguard InterTerm Treasury Fund (MUTF:VFITX) 1992-2014

15% T-Bills - Risk Free Return Benchmark

  • T-Bills (federalreserve.gov) 1972-1983
  • Vanguard Treasury Money Market Fund (VMPXX, VUSXX) 1984-2014

Portfolio 2 (for comparison)

  • S&P 500: Standard & Poor's 1972-1976
  • Vanguard 500 Index Fund 1977-2014

If you read my article on the Coffeehouse Portfolio, you will notice this portfolio is similar. The big differences are: this portfolio has a much larger international stock allocation and a smaller allocation to bonds.

Notes on Portfolio Visualizer

Because many readers may not have used PortfolioVisualizer.com, I list here some notes about results as specified on the site:

  • Past performance is not a guarantee of future returns and data and other errors may exist. See Disclaimer and Terms of Use
  • CAGR = Compound Annual Growth Rate
  • StdDev = Standard Deviation based on annual portfolio returns
  • Sharpe and Sortino ratios are calculated from annual portfolio returns over risk free rate (1-month t-bills)
  • Stock market correlation is calculated from the correlation of annual returns
  • Maximum drawdown for asset class allocations is calculated based on annual returns due to historical data availability.
  • The backtested results include annual rebalancing of portfolio assets to match the specified allocation.

Performance from 1972-2014

As expected due to its high allocation to international stocks, this portfolio had a strong correlation with international markets.

Over this time period the Ideal Index Portfolio provided better CAGR than the S&P 500 and did better on a risk-adjusted basis as shown by both the Sharpe and Sortino Ratios.

For those that are not familiar with the Sharpe Ratio and the Sortino Ratio, both are attempts to relate portfolio performance to risk. In Modern Portfolio Theory, risk is measured by volatility and the theory is that taking on more risk will enhance the upside potential of a portfolio. However, it will also enhance the downside risk of a portfolio. Both the Sharpe Ration and the Sortino Ratio attempt to even the playing field by measuring the portfolios on a risk-adjusted basis. For a better understanding of these ratios follow the links earlier in this paragraph.

During Bear Markets

Many investors believe that markets always bounce back and that they will patiently wait through any bear market, holding their positions until they recover. I believe both beliefs are incorrect. Most investors given a long enough bear market will panic; in fact bear markets can only occur when there are more sellers than buyers causing prices to drop until the demand matches the supply. As far as waiting out a bear market, I believe investors are biased by the fact that recent bear markets have had quick recoveries. It can take decades for markets to recover, as shown by the great depression and the fact that the Nikkei (Japan's Nikkei 225 Stock Average) is still less the 50% of its 1989 high. Given a long enough bear-market most investors will panic or simply not be able to afford to wait it out, especially those who are in the withdrawal phase, using their portfolio to fund their retirements. This is one reason it is important to look at how portfolios have performed during Bear markets.

1973 - 1978

During this period the Ideal Index Portfolio has a smaller Max Drawdown and a quicker recovery than the S&P 500.

Below we break out the performance of the Small Cap Value allocation (Portfolio 1), Small Cap Blend allocation (Portfolio 2) and the Bond allocation (Portfolio 3) to show how diversification helped the Ideal Index Portfolio. The Bonds limited the draw down while the small caps lead the recovery:

2000 - 2005

The tech wreck provides another good time frame to assess how the portfolio did in bear markets.

During this period the Ideal Index portfolio outperformed the S&P across the board. Diversification again provides big benefits. Below we show how REITs performed during this time period, so well, even a small allocation provided big benefits.

2008 - 2011

Finally, we look at the "Great Recession".

The Ideal Portfolio outperforms the S&P 500, but the margin is small. In this case the Bond allocation (Portfolio 2) helps a great deal, but the international stocks (Portfolio 1) slow the recovery:

In Accumulation Phase

In the accumulation phase, market downturns, especially early on, can work to an investor's advantage allowing them to buy low. In this case the bear market of the early 1970s benefits both the Portfolios.

During the accumulation phase the S&P 500 does slightly better, but at the cost of much more volatility. Because PortfolioVisualizer uses yearly return numbers the Max Drawdown shown here for the S&P 500 of 37.45% is less than the actual Max Drawdown using daily prices, on Oct 12 2007 the S&P 500 stood at 1561 before dropping to 638 on March 6 2009. That kind of drawdown makes it hard to stick you your investment plan. I would much prefer the smoother ride provided by the Ideal Index Portfolio.

In The Withdrawal Phase

A market downturn during the withdrawal phase is particularly painful, as investors are losing money in the market and compounding the problem by withdrawing living expenses. The negative effect is made worse when it occurs early in the withdrawal phase.

During the withdrawal phase, we can really see how important smoothing out returns is. The less volatile Ideal Index Portfolio handily outperformed the S&P 500 over this timeframe.

Portfolio Components

There are many funds that can be used to create or approximate the Ideal Index portfolio, including those listed below.

Large Cap Blend

  • Vanguard 500 Index Fund
  • Vanguard S&P 500 ETF (NYSEARCA:VOO)
  • Schwab S&P 500 Index (MUTF:SWPPX)
  • SPDR S&P 500 ETF (NYSEARCA:SPY)

Large Value

  • Vanguard Value Index Fund
  • Vanguard Value ETF (NYSEARCA:VTV)
  • iShares S&P 500 Value ETF (NYSEARCA:IVE)
  • Schwab U.S. Large-Cap Value ETF (NYSEARCA:SCHV)

Small Cap Value

  • Vanguard Small Cap Value Index Fund (MUTF:)
  • Vanguard Small Cap Value ETF (NYSEARCA:VBR)
  • iShares Russell 2000 Value Index (NYSEARCA:IWN)

Small Cap Blend

  • Vanguard Small Cap Index Fund (MUTF:)
  • Vanguard Small Cap ETF (NYSEARCA:VB)
  • Schwab U.S. Small-Cap ETF (NYSEARCA:SCHA)
  • iShares S&P small cap FUND (NYSEARCA:IJR)

REITs

  • Vanguard REIT ETF (NYSEARCA:VNQ)
  • Vanguard REIT Index Fund (MUTF:)
  • Schwab U.S. REIT ETF (NYSEARCA:SCHH)
  • SPDR Dow Jones REIT ETF (NYSEARCA:RWR)

International Stock Market

  • Vanguard Total International Index Fund (MUTF:)
  • iShares Core MSCI EAFE ETF (BATS:IEFA)
  • Schwab International ETF (NYSEARCA:SCHF)
  • Vanguard Total International Stock ETF (NASDAQ:VXUS)

Short-term Treasuries:

  • Vanguard Short-Term Bond Index (MUTF:VBISX)
  • Schwab Short-Term U.S. Treasury ETF (NYSEARCA:SCHO)
  • Vanguard Short-Term Bond fund (NYSEARCA:BSV)
  • iShares 1-3 Year Treasury Bond fund (NYSEARCA:SHY)

Conclusions

The past can be used to give us some insight into the future, but the insights must be used with some caution. Market situations now and in the future will never exactly match what has occurred in the past. Backtesting provides some useful information, but its ability to predict the future performance is far from perfect.

Comments about previous KISS Portfolio articles have often mentioned a fear of holding bonds because of today's low bond rates. This portfolio may hold more appeal for those worried about rates, as it has a lower allocation to bonds and the bonds it holds are short duration bonds.

I also am also worried about today's low rates - but I'm equally worried about today's stock valuations. For me the appeal of this portfolio is its diversification. It is never clear looking into the future, when the next downturn will occur, or what asset classes will suffer the largest losses. As shown in this and previous articles on KISS portfolios, diversity limits downside risk and volatility, which is especially important for retired investors.

What do you think?

I am not a professional advisor or researcher. I am an individual investor who studies investing and shares my thoughts. I encourage all investors do their own due diligence and please share your findings. I strongly feel the best thing about Seeking Alpha is the sharing of ideas. Please comment; I value your input. Divergent opinions are welcome.

Disclosure: The author is long IEFA, SCHO.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.