Long Term ETF Strategies For Financial Independence
Summary
- A 10+ time period is long and while a 10 Year Investment Plan should be relatively simple it needs to cover certain key asset classes (at least 3-4 different ETFs.
- After assessing your Risk profile you can construct a portfolio quite easily and reduce costs/fees.
- I have presented merits of other Equity and Fixed Income asset classes that can supplement a core Portfolio.
Three Core Portfolio Building Blocks
Key Ingredients for Financial Success
In order to construct solid Long Term Investment Strategies e.g. achieve Financial Independence and Retire Early you need at least each of the following:
- One US Market ETF (#1)
- One or Two International Market ETFs (#2)
- One or Two Fixed Income ETFs (#3)
Example of Asset Allocation for Long Term Investment Strategy
The above allocation is an illustrative example of balanced growth portfolio for someone with some appetite for risk and higher returns:
- 70% is Allocated to Equities
- 30% to Fixed Income
- Assumes no additional asset classes (e.g. investor may already own Real Estate)
- There is slight overweight to Emerging Equities vs. current Market Capitalizations
Here is why you should consider these asset classes for Long Term Investment Strategies
BEFORE YOU START
UNDERSTAND YOUR NEEDS
How much money should I keep in Bonds?
- Remember, knowing yourself and your goals matters most – you should always align your Portfolio with your objectives and that’s why this Portfolio should be individual and tailored to your needs and not benchmarked against other people you know
- Take a questionnaire first to understand what Stocks/Bond allocation you need
- The below Core portfolio is divided into 4 Sections: (i) US Equities (II) International Equities (III) Bonds and (iv) Real Estate
- The allocation to Risky Assets should be the combination of the rest of Core Portfolio (Equity and Real Estate)
- Understand that rebalancing of your portfolio is the key to being successful with any long term investment strategies
#1 Solid Base - US Equities
ETF Benchmark Risk & Annual Returns (2000-2020)
- While there is an argument to just hold S&P 500 in the long term you also want to capture the excess returns from Small Caps and Mid Caps (see the red circle above)
- To that extent the easiest way is to buy a US Total Market Equity Fund
- However, the past two decades have been characterized by an outperformance of the technology Sector – while these are already heavy-weights in the S&P 500 you may think of a small allocation to technology
THE EASY WAY
BUY THE WHOLE US MARKET
One ETF solution – the Total US Market ETF
Total Market ETFs cover all listed securities and thus capture the upper part of the graph that the largest Corporations (S&P 500) may not – over the long term this is the most prudent way of investing
Example of cheap Total Market ETF:
- Vanguard VTI
#2 Capture International Markets' Returns
Annual Equity Returns from US, Developed (ex-US) and Emerging Markets
While there is an argument of just holding US Equities since they represent over 55% of total World Stock Capitalization and derive over 40% of their revenues from abroad there are a couple of arguments to still diversify away:
- There is a tendency of rotation in the markets in different time periods as illustrated above
- The mix of industries is essential – The US is concentrated in biotechnology, computer equipment, IT services, and software but would be underweighted in industries such as electrical equipment, durable household goods, and automobiles. Other example: Europe is skewed towards Value vs. US
- Stocks are strongly correlated to domestic Economy Performance and while the US has done exceptionally well in the past the US Stock market may not always outperform International Markets
- Asian Markets while volatile seem to be something you can’t ignore in the long term. The mix of sectors is also changing with China consumer growing fast and technology being over 33% of the overall MSCI EM Index. US Technology firms have little access to some of these large markets.
THE EASY WAY
BUY AN INTERNATIONAL EQUITY ETF
One ETF solution – International Stocks ETF
This is the easiest way of getting exposure to both Developed and Emerging International Markets
However, it is weighted by the size of the respective Stock Market and thus skewed towards the developed World (Japan, Europe)
Example of cheap International Equity ETF:
- Vanguard VXUS
Bundled International ETF vs. Emerging ETF & Developed ex-US ETF split?
Relative size of Emerging Market Stocks in a typical International Equity ETF
There is however a case of splitting the International ETF Exposure into two:
- Developed Market ETF
- Emerging Market ETF
The problem with typical International Market ETFs is that they are weighted by size of the Market. The chart above shows this trend for a Vanguard ETF as of Q3 2020. You can see how under-represented certain emerging countries are (in red) relative to their size of the Economy and their growth
Annual Equity Returns and Risk from Key Developed and Emerging Market (2000-2020)
You may want to control the exposure to key Emerging Markets and rebalance them manually
This way you have more upside potential from Markets that have outperformed over the past 2 decades and while their risk is higher you will also capture the incremental returns
Over 65% of EM Countries have a good ability to handle COVID-19
What part of the Equity Portfolio should be International?
The FTSE Russell Index factsheet has the market capitalization of Developed and Emerging countries. You could broadly align the Equity part of your portfolio to market capitalization where:
- US is 55%
- Developed Markets ex-US 35%
- Emerging Markets 10%
It’s up to you to make any tweaks by investing in two ETFs instead of one International ETF – I personally feel that Emerging Markets should have a higher allocation, perhaps at the expense of Developed Markets ex-US. As an example I have tweaked the illustrative portfolio from 10% to 15% in Emerging and 30% down from 35% for non-US Equity (given 70% of allocation to Stocks it is 10.5% and 21% of the overall Portfolio)
READ Gold vs. Treasuries for a 5 Year Portfolio
Examples of cheap ETFs to obtain exposure to Developed and Emerging Markets include:
#3 Bonds - Choose your Protection
Bond ETF Portfolio Protection Properties
Key Fixed Income ETFs to consider:
- US Blend Bond Funds
- Global Blend Bond Funds – These are much larger than the first category but incremental benefits are generally marginal – on a currency hedged basis there is little difference to US Bond Funds
- Treasuries
- Inflation Protected Bond ETFs
- Gold
Diversify
As an example 75% of the Bond allocation was assigned to Blend Bond ETF & 25% of the Bond allocation to the following: Inflation Linked Bond ETF and/or Gold
- Bonds are robust and provide you with Income – unless you are very risk averse and want to reduce volatility to a minimum (and thus have more Treasuries) holding a Blend Bond ETF is a good compromise of downside protection and (OTCPK:SOME) income
- Inflation Bonds and/or Gold hedge against a change of environment and since you invest for the Long Term you need to have inflation protection in your portfolio that regular Bonds don’t provide
Examples of cheap Blend Bond Funds:
Examples of Inflation Linked and Gold ETFs:
If you want a deep dive into Fixed Income here is all you need to know about Bond ETFs
Treasuries, Bonds and Gold - the long term view
- Lengthening your time horizon increases your odds of positive returns – any of the below portfolios didn’t experience any losses since 1976 if kept for 10 years while 20 year annual returns were at a minimum 5%
- Historically, Long Term Treasuries were the best bet for hedging downside risk and return – these have very low yields now
- On average Gold produced a inferior returns than Bonds and such small differences add up to a substantial absolute amount over long periods of time
- However while Gold is volatile on its own in a portfolio context it provided for a smoother overall ride (see next sections)
Annual Returns and Ranges for different Time Horizons (1976-2019) - 60% Equity 40% other Asset
Treasuries vs. Blend Bonds
Protection vs. Income Trade-Off in the Short Term
- For the same maturity/duration profile Treasuries have lower yield than Blend Bond Funds that include higher yielding securities like high quality MBS, too
- However, Treasuries will react better in a crisis and allow you to (i) lower the overall volatility of your portfolio and (II) rebalance quickly into cheaper Equities should you wish so
- Ultimately it’s a trade off but I think that investing in a Blend Fund (which includes over 50% of Treasuries) is a good balance
Inflation Protection
Gold - Uncorrelated to other Assets and provides incremental benefit
Rolling Annual Returns over 10 Year Period - 60% Equity 40% Other Asset Portfolio (1976-2020)
- Adding a small allocation to Gold makes sense even though it doesn’t produce income
- The below graph shows average annual returns over the prior 10-year period (i.e. one dot is an the average annual return that was generated at the time of exit e.g. 14% in 1987 after having invested 10 years before i.e. in 1977)
- Gold had inferior overall returns but provided better downside protection in case of severe stress period (GFC)
- Read how Gold reacts to different macro environments
Inflation Protected Bonds
- Another option are Inflation Protected Bonds
- For Inflation Protected Bonds, both Bond Face Value and coupon are adjusted to inflation so you get inflation protection
- For Treasury Inflation Protected Securities (OTCPK:TIPS) the real yield may be the same as for Treasuries but they won’t react the same way to inflation / deflation
- TIPS will protect you against inflation but will under-perform relative to Tresuries if inflation turns out lower than expected
- TIPS have a relatively short history and first issued in 1997. The Market is relatively small compared to Treasuries and may be more illiquid impacting prices in times of stress
Additional Asset Classes - Real Estate
REITs
Real estate Investment Trusts (REITs) are part of wider Real Estate Markets. You should always consider it in conjunction with the Real Estate you already own (e.g.limited benefit of over-allocating if you already own and rent out Real Estate). Real Estate:
- Produces consistent cash flows and pays high dividends
- Makes great use of conservative leverage (LTV below 50%)
- Serves as a strong defense against inflation
A cheap way to get exposure to REITs is:
- Vanguard Real Estate ETF (VNQ)
BONUS - Recent Trends
Annual ETF Returns/Returns (2010 to 2020)
- Incredibly strong decade with S&P annual return of 13.4% – we should prepare for low returns in the years ahead
- Yields are at their lowest and Bond ETFs will be impacted on the short to medium term
- While perceived as safe heaven, Gold is a very volatile asset – it it benefiting from tailwinds currently but may underperform in the years ahead (akin to 2013)
- In a nutshell, this is one of the most difficult investment environments
Read more about last decade Asset Class returns
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