Seeking Alpha

Developing A Low-Risk Vanguard Portfolio For This High-Risk Environment

Charles Bolin
Medium-term horizon, Macro, portfolio strategy, ETF investing
Summary

U.S. equity markets are overvalued based on fundamentals, historical levels, and relative to international funds. Inflation is modest, but starting to rise, adding risk that P/E multiples may decline.

The construction and performance of Vanguard Mixed Asset Funds is looked at Target Retirement funds, LifeStrategy Funds, Traditional Balanced Funds, Managed Payout Funds, and Global Funds.

The February Model Portfolio is a simple, lower risk, globally diversified portfolio created using Vanguard Mixed Asset Funds that should be relatively stable in the current environment.

My appreciation goes out to Exeditior who provided timely articles that I used in support of this one.

Introduction

The global economy continues to improve at a modest rate and I am cautiously optimistic (hopeful), but risks remain elevated and caution is warranted.

This article is divided into four sections and readers can skip to sections of interest to them:

1) The Big Picture shows that U.S. equity markets are overvalued based on fundamentals, historical levels, and relative to international funds. Market returns have been concentrated into just a few funds. Inflation is modest, but starting to rise adding risk that P/E multiples may decline.

2) The Vanguard Philosophy section reviews Vanguard's philosophy of setting goals, establishing an asset allocation based on global diversification, and maintaining a disciplined approach to following the plan.

3) Mixed Asset Mutual Funds reviews the construction and performance of Target Retirement funds, LifeStrategy Funds, Traditional Balanced Funds, Managed Payout Funds, and Global Funds. It reviews these funds and a few others on the basis of diversity, risk, risk-adjusted returns, and yield, among others.

4) February Model Portfolio is intended to be a simple, lower risk, globally diversified portfolio using Vanguard Mixed Asset Funds with a conservative asset allocation.

1) The Big Picture

  • If you start building your portfolio by finding the right mix of asset types, you'll have more control over how risky your portfolio is.
  • There are no "good" or "bad" allocations - you'll need to find the one that's right for you based on your own situation.
  • Extensive research has shown that, if you have a diversified portfolio, a whopping 88% of your experience (the volatility you encounter and the returns you earn) can be traced back to your asset allocation.

- Asset allocation: Key to your investment climate, Vanguard

In this article, I take a look at how to use Vanguard's philosophy and funds to build a conservative, diversified portfolio that is situated for the current environment and the coming decade. In last week's article, I made the case that the U.S. Market is highly valued both historically and relative to international markets, a few stocks have an extreme concentration within the S&P 500, that returns over the next 5 to 10 years will be low due to high starting valuations.

"In Rule #2: Know the Short and Long-Term Investment Environment," I looked at the secular performance of stocks and bonds which varies over long periods of time. Whether stocks return 17% as they did during the 20 years prior to the creation of the Technology Bubble or 7% as they have since the bursting of the bubble is due in large part to starting valuations at the beginning of the period.

Chart #1 is part of the basis of my conservatism. It shows the inflation-adjusted return for the past 20 years including a 4% withdrawal rate of the Vanguard LifeStrategy Conservative Growth (VSCGX), Vanguard LifeStrategy Growth (VASGX), and S&P 500 (SPY) adjusted for inflation and with a 4% annual withdrawal rate. The link to Portfolio Visualizer is provided here. Over the 20-year period there has been little return for taking on additional risk. In particular, with starting periods of high valuations such as 1999 and 2007, 5-year performance favors conservatism. With very high valuations now, there is very little potential reward for having more risk in a portfolio.

Chart #1: 20-Year Return of Conservative Growth, Growth, & S&P 500

Secular Market PerformanceSource: Portfolio Visualizer

Chart #2 illustrates the point that following periods of high valuations, conservative funds outperform aggressive funds because they have lower drawdown to recover from.

Chart #2: 5-Year Performance During Bear Markets

Source: Portfolio Visualizer

Valuation

With the recent run-up in stock prices, the Reported P/E ratio is now 25 and above the historical norm. Cyclically-adjusted price to earnings ratios show an even more extreme valuation, particularly when four or five stocks make up 20% of the market capitalization of the S&P 500. For a deeper look at high valuations, I refer you to Advisor Perspectives.

Chart #3: Stock Market Valuations

Source: Crestmont Research

Diversifying Globally

The following chart from J. P. Morgan's Guide to the Markets shows that during this bull market, U.S. equities now have P/E valuations more than 25 percent higher than international funds. Over the next 5 to 10 years, performance of international funds are likely to improve relative to the past 10 years.

Chart #4: Domestic Equity Valuation vs. International

JPMorgan's Guide to the Markets

In a CNBC interview, Chief Global Strategist of Morgan Stanley Investment Management, Ruchir Sharma, pointed out that U.S. stocks account for 56% of the world's market value but only 25% of the global economic output. Global Equity Investing: The Benefits of Diversification and Sizing Your Allocation, by Vanguard, shows that the U.S. stock market value as a percent of global markets has ranged from the mid-60s in 1970 to as low as 29% in the mid 1980s. In other words, some of the difference may be due to high valuations but there is a competitive advantage in technology, infrastructure, transportation, and management that will take much longer for the rest of the world to catch up.

Chart #5: Global Equity Markets

Source: Vanguard’s Framework for Constructing Globally Diversified Portfolios and Global Equity Investing: The Benefits of Diversification and Sizing Your Allocation

Inflation

Inflation is modest, but some measures have risen above the Federal Reserve target of 2%. As pointed out by Ed Easterling at Crestmont Research, the P/E ratio is impacted by inflation. A continued rise in inflation would likely lead to rise in interest rates.

Chart #6: Impact of Inflation on Valuation Multiples

Source: Crestmont Research

The key takeaway is that international stocks are going to be more volatile due to currency rate fluctuations, politics, smaller company capitalization, and emerging markets. U.S. stocks are highly valued relative to international stocks which have lagged over the past decade. If the global economy does continue to improve with currently low employment rates, inflation and interest rates are likely to rise over time.

Weakening Dollar?

When the dollar is strong, U.S. stocks tend to outperform international equities. And when the dollar is weak, international stocks tend to outperform. (This is all from the perspective of a U.S.-based investor.)

- How the Dollar Affects the Stock Market

The dollar has been strengthening for most of the past decade which has benefited U.S. stocks. If the global economy strengthens and the U.S. economy continues its slow growth path, international equities may benefit. According to U.S. News, funds that do well when the dollar weakens are inflation protected bonds, U.S. multinational companies, gold, commodities, foreign fixed income, and emerging market equities.

2) The Vanguard Philosophy

Vanguard has the well-deserved reputation of being the leader in low cost index funds. However, eleven of their first funds were actively managed funds, and they now manage $1.4 trillion in active assets out of $6.2T in total assets.

Interesting new mutual funds in the lineup are the 4-year-old Alternative Strategies Fund (VASFX) with $356M in assets (closed to new investors), the 6-year-old Global Minimum Volatility Fund with $4.3B in assets, the brand new Commodity Strategy Fund (VCMDX) with a minimum investment of $50,000, and the 4-year-old Vanguard Emerging Markets Bond Fund (VEMBX), and Vanguard Global ESG Select Stock Fund (VEIGX).

The latest move is that Vanguard is partnering with HarborVest to offer private equity to institutional investors. Eventually, they will be available to individual investors.

Asset Allocation

I reviewed the material at the Vanguard website, such as Vanguard’s Principles for Investing Success which advises to create clear goals, develop a suitable asset allocation with diversified funds, minimize costs, and maintain long-term discipline.

Chart #7 shows the average, minimum, and maximum return of different asset allocations over the past 94 years. An all-bond portfolio would have averaged approximately 5.4% while an all-stock portfolio would have averaged 10.2%.

Chart #7: Portfolio Annual Returns by Allocation

Source: Vanguard

Diversification - No one can see the future

Performance leadership is quick to change, and a portfolio that diversifies across markets is less vulnerable to the impact of significant swings in performance by any one segment. Investments that are concentrated or specialized, such as real estate investment trusts (REITs), commodities, or emerging markets, also tend to be the most volatile. This is why we believe that most investors are best served by significant allocations to investments that represent broad markets such as U.S. stocks, U.S. bonds, international stocks, and international bonds.

- Vanguard

Discipline

Although the asset allocation decision is one of the cornerstones for achieving an objective, it only works if the allocation is adhered to over time and through varying market environments.

- Vanguard

I believe more in Howard Marks' philosophy below which is to adjust risk tolerance to the business cycle as opposed to Vanguard's which is to pick a personal risk tolerance and asset allocation and adhere to it through full market cycles. Mr. Marks is the chairman and cofounder of Oaktree Capital Management.

In my view, the greatest way to optimize the positioning of a portfolio at a given point in time is through deciding what balance it should strike between aggressiveness/defensiveness. And I believe the aggressiveness/defensiveness should be adjusted over time in response to changes in the state of the investment environment and where a number of elements stand in their cycles.

Mastering the Market Cycle: Getting the Odds on your Side, Howard Marks

Both philosophies have merit and advantages. There is common ground in that the benefit of adhering to a set allocation is that it encourages investors to sell at the top of the market and buy at the bottom of the market to maintain the target asset level. Individual investors tend to underperform the funds that they hold by trying to time the market. This a valid diversified, conservative portfolio suitable for buy and hold for many investors.

3) Mixed Asset Funds

Backtesting portfolios is great for evaluating fund performance over specific time periods. What I have demonstrated is that the next 10 years are not going to be as kind to investors as the past 10 years. For this reason the following five portfolios are constructed based on having a globally diversified, conservative bucket approach.

Vanguard has five groups of balanced funds as described below:

Target Retirement Funds

Target Retirement funds invest globally using low cost index funds. They are best suited for investors that don't spend a lot of time researching investments because they will adjust risk over time while ensuring a diversified portfolio. The date ranges from 2015 to 2065 with Target Retirement Income and Target Retirement 2015 being options for someone already in retirement.

These funds invest in five index funds shown below, giving an investor exposure to international stocks and bonds. The ratio of domestic to international stocks is approximately 60% for the funds with the exception of the Target Retirement Income Fund which is close to 75%. Yields vary, but are about 2.2%.

Vanguard Total Stock Market Index Fund Investor Shares
Vanguard Total Bond Market II Index Fund Investor Shares
Vanguard Total International Stock Index Fund Investor Shares
Vanguard Total International Bond Index Fund Investor Shares
Vanguard Short-Term Inflation-Protected Securities Index Fund

The metrics from Mutual Fund Observer for the past 12 years are shown below. Ulcer Index measures risk and is based on the length and duration of drawdown. Martin Ratio is the Risk-Free return divided by the Ulcer Index and represents the risk-adjusted return. By comparison, the Ulcer Index of the S&P 500 was 11.8 during this time and the 10 year return was 13.9. That the longer dated funds had similar risk to the S&P 500 with lower return is a reflection of the domestic valuations in equities rising faster during this time. It is also noteworthy that beyond 10 years, the funds have similar risk and risk-adjusted return. In other words, there is very little incremental reward for taking on more risk beyond about 70% equity. It is also noteworthy that the Vanguard Target Retirement Fund performed well during the last recession and reasonably well during the past 10 years.

Table #2: Target Retirement Fund Metrics - 12 Years

Symbol Name Ulcer MAXDD % Martin Equity % P/E RTN 10 Years
VTINX Income 3.4 -17.0 1.33 30.1 5.9
VTXVX 2015 7.1 -32.4 0.72 36.4 9.8 7.5
VTWNX 2020 8.2 -35.8 0.68 50.2 13.5 8.3
VTTVX 2025 9.2 -39.1 0.62 60.0 16.1 8.9
VTHRX 2030 10.3 -42.2 0.58 67.4 18.1 9.4
VTTHX 2035 11.0 -44.3 0.56 74.8 20.1 9.9
VFORX 2040 11.0 -44.1 0.59 82.0 22.0 10.2
VTIVX 2045 11.0 -44.2 0.59 88.7 23.8 10.2
VFIFX 2050 11.0 -44.1 0.59 88.7 23.8 10.2

Source: Created by the Author Using Mutual Fund Observer

I created a hypothetical portfolio following a bucket approach with 10% in an intermediate bond fund and 5% in a gold ETF for stability as shown below. I compared it to the LifeStrategy Conservative Growth Income Fund. From July 2006, the Portfolio would have returned 6.5% with a maximum drawdown of 30% during the 2007 recession. The equity exposure is 46% with about 60% is U.S. equities. The portfolio had a similar drawdown to the LifeStrategy Conservative Fund, but with higher upside.

Chart #8: Hypothetical Target Retirement Fund Allocation

Source: Created by the Author Using Portfolio Visualizer

Chart #9: Hypothetical Target Retirement Portfolio Results

Source: Created by the Author Using Portfolio Visualizer

LifeStrategy Funds

The LifeStrategy Funds invest in all of the same index funds as the Target Retirement Funds, but without the Inflation Protected Bond Fund. They are best suited for investors who have a defined risk tolerance. The advantage is that an investor can select his/or target risk while maintaining a diversified portfolio that is automatically rebalanced. Allocation to domestic equities is about 60% of each stock allocation for each of the funds with the exception of the income fund which is closer to 70% domestic.

Table #3: LifeStrategy Fund Metrics - 12 Years

Symbol Name Ulcer MAXDD% Martin %Equity P/E 10 Years
VASIX Income 3.0 -15.3 1.28 20.2 5.3
VSCGX Conservative Growth 5.6 -26.2 0.83 39.6 10.6 6.8
VSMGX Moderate Growth 8.1 -35.0 0.66 59.4 15.9 8.3
VASGX Growth 11.1 -43.8 0.53 79.3 21.3 9.6

Source: Created by the Author Using Mutual Fund Observer

I again created a similar portfolio with 10% in an intermediate bond fund and 5% in a gold ETF. The equity exposure is 44% with about 60 in U.S. equities. From July 2006, the Portfolio would have returned 6.1% with a maximum drawdown of 29% during the 2007 recession. The portfolio had a similar drawdown as the LifeStrategy Conservative Fund with higher upside.

Chart #10: LifeStrategy Portfolio Allocation

Source: Created by the Author Using Portfolio Visualizer

Chart #11: LifeStrategy Portfolio Results

Source: Created by the Author Using Portfolio Visualizer

Managed Payout Funds

Vanguard Managed Payout (VPGDX) is designed to provide investors with regular monthly income of roughly a 4% distribution rate. In my opinion, this fund is most suited for an investor who understands broad risks and wants a managed portfolio with steady income. It has a 10-year existence so the metrics below are not directly comparable to the Target Retirement and LifeStrategy Funds above which are based on 12 years.

The fund invests in the same four funds as the LifeStrategy Funds, but also includes seven other funds including the Alternative Strategies Fund, Global Minimum Volatility Fund, Commodity Strategy Fund, Market Neutral Fund, and Emerging Markets Stock. Because the fund uses a long/short fund, the allocation to international equities is more ambiguous, but foreign stocks are currently equal to or higher than US equities. The current yield is about 6.5%. This is the most diversified mixed asset fund.

According to Vanguard:

Vanguard Managed Payout Fund is designed to give you regular monthly payouts that, over time, keep pace with inflation to help you cover your expenses in retirement.

To accomplish this, the fund aims to strike a balance between how much income it will generate and how much principal growth it will pursue.

Table #4: Managed Payout Fund Metrics - 10 Years

Symbol Name Ulcer MAXDD% Martin %Equity P/E 10 Years
VPGDX Managed Payout 2.8 -12.6 2.53 59 17.6 7.7

Source: Created by the Author Using Mutual Fund Observer

Table #5: Managed Payout Fund Composition

Source: Vanguard

From May 2008, the Portfolio would have returned 5.2% with a maximum drawdown of 32%. The portfolio had a slightly higher draw down compared to the LifeStrategy Conservative Growth Fund.

Chart #12: Managed Payout Fund Allocation and Results

Source: Created by the Author Using Portfolio Visualizer

I like the fund because it takes into account inflation (commodities), market volatility (bonds, Alternative Strategies, Global Minimum Volatility, and Market Neutral Fund), and the slow growth environment (emerging markets). It has performed reasonably well in the 10-year bull market, but is designed for stability.

Traditional balanced funds

The Vanguard actively managed Wellesley Income Fund (VWINX) is 40/60 stock to bond fund, the actively Tax-Managed Balanced Find (VTMFX) is roughly 50/50 stocks and bonds and the remaining three are more traditional 60/40 stock to bond funds. The STAR Fund is a fund of funds which invests in the same four funds as LifeStrategy plus six others. The Traditional Balanced Portfolios with the exception of the STAR Fund are best suited for investors who have a home bias for domestic investments.

Wellesley, Wellington, and STAR have a more value-oriented approach. Wellesley and the Tax-Managed Fund do better during downturns. Wellesley is the least risky of the funds. Wellesley and Wellington are about 85% domestic equity and 15% international. The Balanced Fund and Tax-Managed Fund are predominantly domestically invested while the STAR Fund is 65% domestic.

Table #6: Traditional Balanced Fund Metrics - 10 Years

Symbol Name Ulcer MAXDD % Martin Equity % P/E RTN 10 Year
VWINX Wellesley Income 3.4 -17.8 1.9 37 22 8.2
VTMFX Tax-Managed Balanced 5.1 -23.7 1.3 48 30 8.9
VBINX Balanced Index 6.5 -30.2 1.1 60 29 9.8
VWELX Wellington 6.8 -30.9 1.1 65 22 10.1
VGSTX STAR 7.2 -32.4 0.9 60 17 9.2

Source: Created by the Author Using Mutual Fund Observer

Table #7: STAR Fund Composition

From May 2008, the Portfolio would have returned 7.1% with a maximum drawdown of 28%. The portfolio had a higher drawdown compared to the LifeStrategy Conservative Fund with higher upside.

Chart #13: Managed Payout Portfolio Allocation

Chart #14: Managed Payout Portfolio Results

Source: Created by the Author Using Portfolio Visualizer

Global Balanced Funds

The Global Wellesley and Wellington funds are both 2 years old so the metrics are not comparable to the previous funds. In my opinion, Global Balanced Funds are best suited for investors that want a global managed portfolio that is tilted toward value and large companies. They are shown with their domestic counterparts for comparison. A general observation is that the global versions are slightly more risky. Due to the outperformance of domestic equities, the global funds have also underperformed over the past 2 years. The two Global Funds are about 35% to 45% domestic equities.

Table #8: Target Retirement Fund Metrics - 2 Years

Symbol Name Ulcer MAXDD% Martin %Equity P/E APR%
VWINX Wellesley Income 1.6 -3.5 3.0 36.7 22.0 6.9
VGYAX Global Wellesley Inc 2.0 -5.3 1.0 37.2 22.9 4.0
VWELX Wellington 2.6 -6.8 2.1 65.0 22.0 7.4
VGWAX Global Wellington 2.8 -7.7 1.3 63.9 19.5 5.7

Source: Created by the Author Using Mutual Fund Observer

Yield

I extracted data on the funds with a yield higher than 3% and excluded those with higher Ulcer Index (Risk). One observation is that international funds have higher yields.

Table #9: Funds with High Yields - 2 Years

Symbol Name Yield% /yr Yield /Ulcer Ulcer Down Cap %SP500 Martin Rtn 2Yrs
VWAHX High-Yield Tax-Ex 3.3 8.3 0.4 -14 11.3 6.8
VTABX Total Intern Bond 3.3 6.6 0.5 -20 9.24 6.7
VEMBX Em Markets Bond 4.1 3.7 1.1 4.3 5.99 8.6
VPGDX Managed Payout 6.5 2.1 3.1 48 0.13 2.4
VGSIX Real Estate Index 3.2 1.1 2.9 39 3.75 13.0
VWESX Lng-Trm Invest-Grd 3.4 1.1 3.2 -25 2.59 10.2
VTMGX Developed Markets 3.1 0.3 9.0 89 -0.4 -1.6
VEURX European Stock 3.2 0.3 9.6 88 -0.35 -1.3
VGTSX Total Intern Stock 3.1 0.3 10 90 -0.45 -2.5
VEIEX Emerging Markets Stock Index 3.2 0.2 13.7 89 -0.53 -5.3

Source: Created by the Author Using Mutual Fund Observer

Lower Risk

I also extracted data on funds with lower risk (Ulcer Index) and higher risk-adjusted returns shown below. Of particular note is the Global Minimum Volatility Fund (VMNVX) because it is all equity. "Disciplined Systematic Global Macro Views" is an interesting article that discusses the sustainability of global low volatility funds.

Table #10: Mixed Asset and Equity Funds with Lower Risk

Symbol Name Yield% /yr Yield /Ulcer Ulcer Down Cap % SP500 Martin 2 Years
VMNVX Global Min Vol 2.7 1.4 1.9 50 4.64 9.4
VWINX Wellesley Inc 2.8 2.2 1.3 24 4.34 6.9
VWELX Wellington 2.5 1.1 2.2 60 3.61 7.4
VGSTX STAR 2 0.7 2.8 69 2.46 5.8
VPGDX Managed Payout 6.5 2.4 2.7 52 1.67 2.4

Source: Created by the Author Using Mutual Fund Observer

4) February Model Portfolio

After reviewing the above funds, I selected nine funds to be in the February Model Portfolio based on risk, diversification, 5-year potential, and yield. The funds in Table #11 are the ones that I am willing to hold until after the next bear market in which case, I will probably want to increase my target allocation to equities. The Model Portfolio includes the intermediate term bond fund for liquidity, the Wellesley Income Fund for performance during bear markets, Global Wellington for international exposure to value funds, Managed Payout Investor and STAR for its international diversity, Total International Bond fund for diversity and yield, Global Minimum Volatility for its global mid-cap exposure, Emerging Markets Stock fund for growth potential, and Gold for its protection to uncertainty and inflation.

Table #11: Hypothetical February Model Portfolio

The portfolio has 41% allocated to stocks with almost equal allocations to domestic and international equity and with 16% in international bonds.

Chart #15: Hypothetical February Model Exposure

Source: Created by the Author Using Portfolio Visualizer

The portfolio has almost identically matched the LifeStrategy Conservative Growth in performance and risk for the past 3 years. The yield of the portfolio is 3.1% compared to 2.6% for the Conservative Growth Fund.

Chart #16: Hypothetical February Model Results

Source: Created by the Author Using Portfolio Visualizer

I like to use the Mutual Fund Observer Portfolio Tool to measure the Risk and Risk-Adjusted Return of a portfolio instead of relying on a stock to bond ratio. Table #12 shows that the Model Portfolio is conservative (Risk - 2). The Ulcer Index is low, only 45% of the S&P 500 and the Martin Ratio (Risk-Adjusted Return) is 1.8.

Table #12: February Model Portfolio Metric - 2 years

Symbol Name Weight APR MAXDD Ulcer MFO Risk Martin MFO Rating
VTABX Total Intern Bond 10 6.7 -1.7 0.5 2 9.2 5
VBILX Intrmdt-Term Bond 15 7.1 -1.5 0.6 2 8.6 5
VWIAX Wellesley Income 20 6.9 -3.5 1.6 2 3.1 5
VMVFX Global Min Vol 5 9.3 -8.2 2.3 3 3.1 5
VGWAX Global Wellington 15 5.7 -7.7 2.8 3 1.3 4
VGSTX STAR 10 5.8 -9.2 3.0 3 1.3 4
VPGDX Managed Payout 15 2.4 -8.4 3.1 3 0.1 1
IAU Gold Shares 5 8.2 -12.0 5.6 4 1.1 3
VEMAX Emer Mrkts Stock 5 -5.1 -22.3 13.6 4 -0.5 3
Portfolio 100 5.5 -4.8 2.0 2 1.8 -

Source: Created by the Author Using Mutual Fund Observer

Closing

As I near retirement, I evaluate simpler approaches to investing including managed accounts and a portfolio such as constructed in this article. I have been investing according to the business cycle, and have only a small exposure to international equities. I have concerns about high central bank assets (quantitative easing) and low interest rates giving few traditional tools to fight the next recession, high federal budget deficits during a long economic expansion, high federal debt, corporate leverage, high valuations, and the list goes on.

I already own four of the nine funds in the Model Portfolio. It is now the target allocation that I will be moving towards in one portfolio. As pointed out, investors can simplify from this portfolio, and many will have good performance over time as long as they stick to their allocations.

Disclosure: I am/we are long VWIAX, VWELX, VASIX, VTWNX, VEMBX, VMNVX, VTABX, IAU, VBILX. 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.

Additional disclosure: I am an engineer with an MBA nearing retirement and not an economist nor an investment professional. The information provided is for educational purposes and should not be considered as advice. Investors should do their due diligence research and/or use an investment professional. In September 2019, I began contributing to the Mutual Fund Observer monthly newsletter.