Are two mutual funds enough?
Reprinted courtesy of MarketWatch.com
Published: May 2, 2019
To read the original article click here
When I interviewed the late John Bogle two years ago, he emphasized his belief that most investors are often best served by a simple plan they will stick with for the long term, even though a more complex and challenging plan may be likely to make them more money.
Bogle wove that point of view into the fabric of The Vanguard Group, of which he was the founder and longtime chief executive.
Though Vanguard investors can build complicated portfolios, the company offers simple options that do a fine job of getting good results with relatively little effort.
That Bogle interview inspired me to search for a simpler way to implement an asset allocation strategy I’ve been recommending for the past quarter of a century.
Read: The legacy and luck of Vanguard’s Jack Bogle
Unfortunately, there’s never been a way to implement my Ultimate Buy and Hold Strategy in just one mutual fund, and there may never be one.
That’s a shame, because this strategy, which makes up the bulk of my own retirement investments, has a long-term track record of producing significantly higher returns than the S&P 500 index SPX,
Read: The reason Jack Bogle doesn’t fly first class says everything about his investing legacy
But could investors get the major benefits of this portfolio with only two funds?
I think the answer is yes. My two-fund solution comes from research and analysis done by my friend and colleague Chris Pedersen, who is devoting a good part of his life these days to helping investors.
Leaving out some important details, here’s the broad outline of my two-fund strategy, in three bullet points:
• Use a target-date retirement fund as the “base” of your portfolio for controlling risk and producing reasonably good long-term expected returns.
• Use a “booster” fund that invests in value stocks to improve your long-term return.
• The booster fund should make up the majority of the portfolio for young people, then gradually give way to the target-date fund as retirement approaches.
Chris did lots of research on ways this two-fund combination could be put into practice. He and I have come up with two variations.
Protocol 1: For maximum simplicity, you can make a single lifetime decision and let the results play out. For example, a 25-year-old with presumably 40 years until retirement could allocate 90% of his retirement savings to a target-date fund and the other 10% to a small-cap value fund.
That’s it, an asset allocation that doesn’t need to be rebalanced, ever. Based on the historical data we have, that is likely to produce 30% more money after 40 years than the target-date fund alone.
Protocol 2: To take much fuller advantage of the long-term premium expected return of value stocks, here’s a more aggressive variation.
Multiply your age by 1.5. That tells you what percentage of your portfolio should be in the target-date fund. Keep the rest in a value fund. Adjust this allocation periodically as you age, and your portfolio will automatically shift more and more to the target-date fund.
For your “booster” fund you can choose small-cap blend (conservative), large-cap value (moderate), or small-cap value (aggressive).
Recently I’ve been talking to lots of investors about this strategy, and I have had lots of questions.
Here are a few of them:
Question: My 401(k) plan doesn’t offer small-cap value but they do have target-date funds and a small-cap fund that is balanced between growth and value companies. What should I do?
Answer: You have described a small-cap blend fund, and it certainly can work as a “booster” to complement a target-date fund.
Studies of 40-year periods in the past suggest that if you use a small-cap blend fund in what I described above as Protocol 1, you could wind up with 20% more money than if you used only the target-date fund. If you used a small-cap value fund instead, the additional return could be 45%.
Either way, you can expect the booster fund to produce a very significant improvement. But I think the difference between 20% and 45% is worth the extra trouble of adding small-cap value.
If you can’t get small-cap value in your 401(k), you certainly can get it in an IRA.
My advice: First, contribute enough to your 401(k) to get the maximum employer match. Then, use an IRA to gain access to a small-cap value fund. If you include a target-date fund in your IRA, you’ll be able to rebalance when you need to.
Question: How can you be so confident that small-cap value stocks will keep producing higher returns?
Answer: Obviously, I cannot know the future. But I can know the past, and I can know what academic researchers believe. That knowledge gives me confidence (although not assurance) that small-cap value investing will continue to be very worthwhile for long-term investors.
One study tracked the performance of various asset classes in all 40-year periods since 1927. In 94% of those periods, small-cap value had the highest return of all the asset classes under study.
The S&P 500 index, which is equivalent to the major equity holding of target-date funds, was the top performer in only 4% of the 40-year periods.
Many people have found this statistic equally interesting: The worst 40-year return for small-cap value was almost as good as the best 40-year return for the S&P 500.
The academics generally agree on these two points:
• Over the 51 40-year periods since 1927, small-cap value has produced about 5 additional percentage points of compound return compared with the S&P 500.
• Though nobody can know the specifics in advance, small-cap value is likely to significantly outperform the S&P 500 in the future. That in turn can make a big difference in the size of withdrawals in retirement.
Question: I’m young, and not interested in owning bond funds or international stock funds, two asset classes that are usually found in target-date funds. Can I skip the target-date fund and substitute a U.S. total market fund or an S&P 500 Index fund?
Answer: Of course. As a young investor, you are right in not wanting bonds in your portfolio; and the additional return you might get from international stock funds isn’t likely to change your life.
However, at some point as you get older, you should add a bond fund to your portfolio in order to gradually reduce your overall risk level. That will give you three funds for life instead of two, and the addition won’t be very hard to manage.
Question: You say young investors they shouldn’t have any bonds in their retirement portfolio, yet you recommend Vanguard target-date funds, which keep 10% of their portfolio in bonds even for investors who are many, many years from retirement. Why do you recommend a fund that isn’t built for what you believe investors should own?
Answer: That’s an excellent question. If I were designing a target-date fund, it would not include bonds for investors in their 20s. Some fund families have target-date funds without bonds for such young investors, and I think that’s good.
In choosing a target-date fund, there are other important factors to consider, including expenses, portfolio turnover, and equity asset classes.
The two-funds-for-life strategy should improve the returns of all target-date funds, and later this year I will compare and contrast these funds from the largest major fund companies.
For more on this strategy, check out the video and two podcasts here.
Richard Buck contributed to this article.
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