Best-in-Class ETFs for Ultimate Buy & Hold Portfolio (Updated ...

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´╗┐Best-in-Class ETFs for Ultimate Buy & Hold Portfolio (Updated March, 2019)

What's the best set of ETFs to use to implement Paul's Ultimate Buy and Hold Portfolio? Here are the updated 2019 recommendations that aim to answer that question.

Asset Classes & Funds Old New

Expense Ratios

Factor-Predicted Change in Returns

After Expenses

Other Pros & Cons

US Large Cap Blend VOO VTI

0.04% 0.04%

+0.21%

Increases US number of companies held to ~3,600 at no additional cost

US Large Cap Value VONV RPV

0.11% 0.35%

+1.47%

Only 120 companies, but much better history of getting value premium after expenses -- brings some midcap exposure too

US Small Cap Blend VIOO IJR

0.15% 0.07%

+0.14%

Practically same fund at 0.08% lower expense ratio and much higher trading-volume / liquidity

US Small Cap Value SLYV/IJS/VBR SLYV/IJS

0.07% - 0.25% 0.15% - 0.25%

+0% vs SLYV/IJS + 0.84% vs VBR

Dropping VBR increases the expense ratio and reduces the number of companies held but increases small-value exposure and predicted return premiums significantly

REITs VNQ/VNQI VNQ

0.12%/0.14% 0.12%

NA

Lowers expenses, reduces diversification slightly, simplifies

portfolio back to 10% times 10 funds -- high taxable yield

(4.24%) suggests holding in tax-deferred accounts

Int'l Large Cap Blend VEA

0.07%

0%

Low cost, & high diversification with ~3,900 companies held

Int'l Large Cap Value EFV

0.38%

+0%

Not the cheapest, but consistent exposure to value over time

Int'l Small Cap Blend VSS FNDC

0.13% 0.39%

+1.15%

Fewer holdings, but FNDC represents category better w/ no emerging markets, and related fund SFILX has tracked & beaten benchmark DFISX well in past

Int'l Small Cap Value DLS

0.58%

0%

Tracks benchmark DISVX very well

Emerging Markets VWO/EWX DGS

0.14%/0.65% 0.63%

NA

Decreases holding diversity, but simplifies portfolio for fund that

has long history of tracking & out-performing benchmark DFA

3-Fund EM solution after expenses

These changes lower the average company size and price-to-book for the portfolio thereby increasing long-term expected returns and volatility slightly, but the unit of return per unit of risk stays about the same. Expense ratios increase from 0.20% to 0.28% and the number of companies held decreases from ~12,500 to ~8,000. Here are the Morningstar Style Boxes.

DFA

2018 BIC

2019 BIC

Individual investors should consider whether the advantages of the new recommendations justify trading and tax costs for their particular circumstances before switching.

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Should I switch to the new recommendations? This is something only you can decide. If your funds are in taxable accounts, you should consider the tax implications of selling the old funds vs. the potential benefits of the new ones. If your funds are in tax-deferred accounts, the taxes don't matter, but your confidence in the recommendations does. If you believe the new recommendations will serve you better based on the rationale given and any additional research you do, then go ahead and switch. In the end, it's probably more important that you have an investment strategy you believe in and can stick with than that you have exactly the right funds for that strategy.

What things do I look for when evaluating and selecting the best-in-class ETFs? I start by searching for candidate ETFs for the 10 asset class categories that make up the Ultimate Buy and Hold portfolio. Some of them have been suggested by Paul's listeners. Thank you for that! This year there were over 60 candidate funds. I evaluate each of them individually and as part of a portfolio using Portfolio Visualizer and Morningstar X-Ray. I look at the number of holdings, size of companies, price-to-book ratios, expenses , turnover and taxes, liquidity, weighting methodology, construction and reconstitution rules, and the historical performance of the funds. It's an iterative process that goes back and forth between individual fund and overall portfolio optimization until I'm confident the changes are likely to help investors do better than the previous recommendations.

What's a "factor," and does it matter to Paul's portfolios? Factors in investing are attributes that academics have found which were historically significant indicators of better returns. When we say investing in the market has higher return than fixed income, or that smaller or cheaper companies have done better than large and expensive companies we're talking about the market, size and value factors. Other factors worth considering include momentum (investments which have been going up, tend to continue to go up), profitability/quality, and low-volatility. Though the Ultimate Buy and Hold Portfolio is built to primarily get exposure to the market, small and value factors, I also evaluate every fund for exposure to these other factors as well. As Larry Swedroe points out in his book "Your Complete Guide to Factor-Based Investing," the more broadly a portfolio is diversified across many factors, the less likely it is to underperform.

Do we really need so many funds? Doesn't a global fund get me everything? We only have 10 years of history for the Vanguard Total World Stock Index ETF, but here's a comparison of the past performance of the Ultimate Buy and Hold portfolio using DFA funds. The short answer is that long-term past returns for the Total World Stock Index ETF (portfolio 1 in graph) have been good at 4.95%, but the Ultimate Buy and Hold portfolio (portfolio 2 in graph) has been even better at 5.81%.

Some of you are probably wondering how you can own the whole worldwide market and not get all of the small and value benefits. The reason is that the added returns for these factors only come when a

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portfolio has a bias or tilt towards them that is greater than the overall market. When you own the whole market, you don't have a tilt to value or small. Here's the summary view of VT showing little or no loading on size (-0.02) or value (HML: 0.05) factors.

Portfolio Holdings

Morningstar Style Boxes

Morningstar X-Ray

Factor Loads & CAGR

WW Total Mkt: VT (100%)

Expense Ratio: 0.10% Price-to-Book: 2.03 Avg. Mkt Cap: $39.55B

Yield: 2.54% Proj. EPS Growth: 10.85%

Market: 1.07 Size: -0.02 HML: 0.05

Momentum: 0.04 Quality: 0.14

Ann. Alpha: -2.01% Adj R2: 98.6%

12/10 to 12/18 CAGR: 7.38%

How have the 2019 BIC ETFs performed vs. all-DFA and all-Vanguard portfolios in the past? Here's a backtest from the Portfolio Visualizer website. I've substituted similar funds (VTRIX for VYMI in Vanguard and SFILX for FNDC in 2019 BIC) to get a longer history. The compound annual growth rates were 7.18% for all Vanguard, 7.46% for all DFA, 7.71% for the 2018 BIC ETFs and 8.08% for the 2019 BIC ETF Recommendations.

Backtest of Ultimate Buy and Hold Portfolios implemented with DFA, all-Vanguard (Portfolio 1), 2018 BIC ETFs (Portfolio 2) and 2019 BIC ETFs (Portfolio 3)

When is it worth it to pay more for funds with smaller and cheaper companies? Also, what are factor-predicted return premiums? This is the most difficult question I grapple with each time I update the Best-in-Class ETF recommendations. One of the tools I use to try and answer the question is the Portfolio Visualizer fund factor regression analysis, and historical factor statistics. Using them, it's possible to calculate expected return premiums (above risk-free investments) based on past fund and market behavior. Here's an example showing expected return premiums for several US large-cap-value funds going back to 2010. The total expected premium including expenses is the number on the right of each stack of bars.

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The highest expected return premium (7.69%) in this chart is for the Invesco S&P 500 Pure Value ETF (RPV) which has an expense ratio of 0.35%. This is one of the main reasons RPV made it into our recommendations this year. The fund with the lowest expense ratio is SCHV at 0.04%, but it has has a much lower expected return premium (6.10%). The second choice based on this analysis would have been the DFA fund, and the second choice ETF would be VTV at an expected premium of 6.98% and expense ratio of 0.05%. It's impossible to predict with certainty which fund will do best in the future, but the factor analysis seems like a useful indicator. It's also reassuring to see that RPV has outperformed both DFLVX and VTV on average by about 0.75% per year over the last 11 years.

Why aren't there factor-predicted return premiums for REITs and Emerging Markets? As far as I know, there is no historical factor performance data for REITs and Emerging Markets. Without those data, it's impossible to calculate a factor-predicted return with any confidence.

What's a fundamentally-weighted fund and aren't they actively-managed? Fundamentally-weighted funds use non-price measures of company size (e.g. sales, cash flow and dividends plus buybacks) to select and weight securities in a broad-market index. Though this implies some trading activity, the fact that the trading is done based on transparent rules and a public index means this is a passive approach. The Schwab fundamentally-weighted fund FNDC included in this year's recommendations has historically delivered well on the value and size premiums after expenses. Though the average company size and discount can vary over time, it has historically had more exposure to small and value than VSS which is the fund it replaces. VSS has also lagged in overall return -- likely due to the emerging markets part of the VSS holdings.

Are all of the BIC ETFs available for commission-free trading at Vanguard and M1 Finance? Yes!

If the BIC ETFs are available commission-free at Vanguard, why do you still have the all-Vanguard portfolio? I've left it in this year for two reasons. First, there may be people who are brand loyal or want to stick with Vanguard for their low costs. Second, people may want to see the comparison. The all-Vanguard portfolio has a much smaller percentage of its holdings in the small-value corner of the Morningstar style boxes, and a much larger average company size and price-to-book which should lead to lower returns over the long-term.

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Why aren't the expected return premiums higher? The asset classes with the highest expected premiums are some of the hardest to get cost-effectively. Here are some US Small-Cap-Value charts that help illustrate the point.

Factor-predicted return premiums vs. expense ratios for US Small-Cap Value ETFs 10/2006-12/2018

VBR

SLYV

PXSV

DFSVX

VBR is the cheapest fund by far with an ER of 0.07%, but it also has the largest average company size and price-to-book ratio. For a small step up in cost (to 0.15%), SLYV provides smaller companies and lower price-to-book ratios, but it's still on the high-end of the Morningstar definition of value. If we reach further to get a true small and value, fund like PXSV, the expected returns from small and value go up, but they are offset by higher (0.39%) expenses, a substantial negative alpha for this historical timeframe and a 0.39% average bid-ask-spread due to the funds small daily trading volume. Yes, DFA's DFSVX mutual fund has the highest predicted premium, but it's only 0.06% per year higher than SLYV, and this analysis doesn't include management fees. Add it all up, and I think you can see the law of diminishing returns at work. This doesn't mean we shouldn't try to get the small and value premiums the academics say are there, but it does suggest we should temper our expectations regarding how much of them we'll be able to get.

The expense ratio for the portfolios is going up by a lot (0.08%) -- is it worth it? Time will tell. Historically, the small and value factors we're seeking to get are worth more than 1% per year, so increasing exposure to them should be worth and increase of 0.08% per year to a total of 0.28% to 0.38% for the various portfolios.

When will Paul's Motifs, M1 Pies and calculators be updated to the new ETFs? They will all be updated by the end of March.

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