A Balanced Passive Strategy: Global Stocks, Bonds, And TIPS

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Includes: AGG, BND, VGIT, VT, VTEB, VTI, VTIP, VXUS
by: Movement Capital
Summary

My overall investing strategy is a blend of active and passive approaches.

Passive stock exposure comes from total market-cap U.S. and international funds.

Passive bond exposure comes from intermediate-term Treasuries, munis, and TIPS.

Investment managers tend to group themselves into either the active or passive camp. Active managers think they have an edge, so they typically allocate most client assets to active strategies. Passive managers do the opposite and buy and hold index funds.

I've never personally agreed with going all-in on either active or passive. For that reason, the overall strategy I run is roughly 50% active and 50% passive. Earlier this week I wrote about the active trend and macro strategies I use. This article details the passive stock and bond allocations.

Passive Stocks

Investing 100% in the S&P 500 is not a passive approach. It's both concentrated in one country and concentrated in large-cap stocks. Passive equity exposure needs to be global and avoid market-cap tilts. U.S. stocks currently represent approximately 50% of the global stock market.

Vanguard graph of historical mix of global equity market capitalization

Source: Vanguard

The average U.S. investor has 79% of their stock exposure in U.S. stocks. People tend to invest more in their own local markets because it's the comfortable thing to do. This is called home country bias. Staying close to home and ignoring the rest of the world is the wrong decision to make in today's globalized markets.

Equity market home bias by country

Source: Vanguard

Research shows that portfolio volatility is most reduced when a U.S. investor's allocation to international stocks is 40-50%. Another benefit of owning international stocks is that they've historically been a better inflation hedge than domestic stocks.

My passive stock exposure comes from VTI and VXUS, the same U.S. and international total market-cap index funds I use in the trend and macro strategies. A 50/50 split between VTI and VXUS achieves truly passive global stock exposure. I use these same funds as opposed to using the combined global VT fund to simplify the number of holdings in client accounts.

Passive Bonds

My passive bond allocations are built with intermediate-term Treasuries, municipal bonds, and inflation-protected Treasuries (TIPS). TIPS are used in both tax deferred and taxable accounts. Treasuries are only used in tax deferred accounts, and municipal bonds are only used in taxable accounts.

Intermediate-term bonds are the most passive way to get bond exposure. A tilt to either short-term or long-term bonds is an implicit bet on which way interest rates will go. You feel like a genius if you shift to short-term bonds (which are less sensitive to rising rates) right before rates spike and bond prices fall. Then you're likely to get frustrated if you tilt to short-term bonds before the economy enters a recession, when interest rates typically fall and bond values rise.

The graph below shows that economist and investor forecasts (dashed lines) for the 10-year Treasury yield have consistently been off the mark. Nobody can predict where interest rates are going, and this is why I allocate to intermediate-term bonds. Additionally, intermediate-term bonds have historically provided the highest return for their level of interest rate risk (The Bond Book, page 407).

Interest rate forecasts from economists and investors, from The New York Times Source: The New York Times

I don't use bond funds (like AGG or BND) that track the popular Bloomberg Barclays Aggregate Bond index. The purpose of bonds in growth-oriented portfolios is to diversify equity risk and to (hopefully) not go down as much in a recession. Corporate bonds represent a quarter of the Bloomberg Barclays Aggregate Bond index. U.S. Treasury, municipal, and TIPS bonds are less correlated to the ebbs and flows of the business cycle, hence why they've historically been better portfolio diversifiers during periods of stock market volatility.

Bloomberg Barclays Aggregate Bond fund composition Source: Vanguard

The chart below shows the drawdown during 2008 of two example allocations: one 50% in U.S. stocks and 50% in a blended bond fund, and another 50% in U.S. stocks and 50% in a fund that only invests in intermediate-term U.S. Treasuries.

2008 max drawdown of two different simulated hypothetical portfolios, one 50/50 in VTI and VBMFX and one 50/50 in VTI and VFITX

There are two main types of Treasury bonds: regular bonds that pay a nominal rate of interest and TIPS that pay an inflation-adjusted rate of interest. TIPS were introduced in 1997 as a way for U.S. bond investors to protect against inflation. Twice a year, the U.S. Treasury raises the face value of a TIPS bond by the realized inflation over the prior six months. So if you buy a $1,000 TIPS bond on January 1, and inflation during the entire year rises 3%, the face value of that bond will be adjusted higher to $1,030. TIPS also have a rarely discussed deflation floor, preventing their face value from dropping below $1,000 at maturity.

My passive bond allocation uses a 50/50 split between intermediate-term regular bonds and TIPS. Anything other than a 50/50 split is an implicit bet on whether current market inflation expectations are high or low. The graph below shows a measure of inflation expectations called the breakeven rate. The 10-year breakeven rate is the difference in yield between a regular 10-year U.S. Treasury and a 10-year TIPS bond.

10-year breakeven inflation rate from the St. Louis Federal Reserve Economic Database Source: FRED

For example, if a regular 10-year Treasury yielded 3.0% and a 10-year TIPS yielded 1.0%, the 10-year breakeven rate would be 2.0%. This is the level of average inflation over the next 10 years that would result in identical total returns between regular Treasuries and TIPS.

If an investor were to only use regular bonds, they'd be vulnerable to future inflation that's higher than what the market currently expects. On the other hand, an investor that were to only use TIPS would lose out if we were to enter a deflationary environment and future inflation ends up being less than current expectations.

Passive Allocation Summary

Client passive stock and bond allocation percentages are a function of their individual time horizon and risk tolerance, but each segment can be summarized by:

  • Passive Stocks: 50% VTI and 50% VXUS
  • Passive Bonds: 50% VGIT and 50% VTIP (in tax-deferred accounts) or 50% VTEB and 50% VTIP (in taxable accounts)

I hope this article was helpful; do let me know if you have any questions in the comments below.

Disclosure: I am/we are long VTI, VXUS, VGIT, VTEB, VTIP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: In the fifth graph, U.S. stock data is historical dividend adjusted data for VTI. Intermediate-term Treasury data is historical dividend adjusted data for VFITX. Bloomberg Barclays Aggregate data is historical dividend adjusted data for VBMFX. Returns shown are total returns net of fund expense ratios but do not reflect management or trading fees. The results are hypothetical simulated results, were not realized in an actual account, and are not an indicator of future results.

Movement Capital (MVMT Capital LLC) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Movement Capital is properly licensed or exempt from licensure. This article is solely for informational purposes. Investments involve risk and are not guaranteed. Movement Capital is not responsible for the accuracy, suitability, or completeness of any information on this website prepared by any unaffiliated third party. No advice may be rendered by Movement Capital unless a client agreement is in place.