William J. Bernstein
The One-Fund Holy Grail
Wouldnít if be ducky if the average small investor could get an inexpensive, efficient asset allocation from just one fund? While this might put me out of a job, it would be great news for the overwhelming mass of investors who view managing their retirement assets with the same enthusiasm as a trip to the colonoscopist.
Well, Iím not out of work yet, but Iím starting to sweat a bit. Within the past several months, both Vanguard and Dimensional Fund Advisors have made available several one-size-fits-all portfolios, and while not perfect, theyíre not badónot bad at all.
Letís begin with Vanguardís Target Retirement funds, whose compositions are tabulated below:
Fund Target Date
Total Stock Market
For the first four funds, the Bond portion is the Total Bond Portfolio, with a tad of cash; for some strange reason, the 2005 fund splits the bond portion between Total Bond and the TIPS fund.
The idea is, you buy the fund that corresponds to your retirement date and, as you and the fund managers grow older, the stock allocations gradually fall. (The stock-bond formula is interestingóMr. Bogle makes a good case for the bond allocation equal to your age; the 2045 and 2035 funds use age minus fifteen, and the 2025 and 2015 funds use age minus five. Only the 2005 fund uses the Bogle recommendation.) The Target Retirement funds are completely indexed, and at a rock-bottom 21-23 basis-point expense ratio, itís hard not to like these funds. Theoretically, you can set up your account and not even have to adjust the allocations as you age.
There are several minor flaws in this strategy, though. The bond duration is just a tad longer than necessaryóabout four years. And why did they drop the foreign allocation from the 2005? If international diversification is a good idea at high and medium stock exposures, itís just as good at a low one. But the overarching flaw, in my opinion, is the underweighting of REITs, small, and value stocks, particularly abroad.
If you believe that there is indeed a risk premium attached to small and value stocks and that REITs provide diversification benefit, then itís worth considering Dimensionalís model equity allocation:
U.S. Large Cap Value
U.S. Small Cap Value
International Large Cap Value
International Small Cap
International Small Cap Value
Emerging Markets Large Cap Value
Emerging Markets Small Cap
This model portfolio, which can be diluted with the desired amount of bonds, provides more than adequate exposure to the various factors and is used as a starting point by many advisors. The only problem, of course, is that you have to hire an advisor to use this type of strategy, which is not practical for the average small investor.
Many small investors do, however, have access to DFA through their 401(k) plans, and the good news for them is that they now have available a one-size-fits-all approach: DFAís new family of global funds. The global funds come in three flavors: 100% equity, 60/40 and, for some inexplicable reason, 25/75. Alas, the composition of the global equity component (and fund) is rather different from the above model allocation:
U.S. Large Value
U.S. Small Cap
International Large Cap
International Small Cap
Emerging Markets Value
Emerging Markets Small
Note how there is no direct small-cap value exposure either in the U.S. or abroad, the REIT and emerging-markets components are relatively small, and the global-equity component uses small cap instead of microcap. DFAís reasons for these deviations from the model portfolio are, respectively, that it is cheaper to obtain exposure to the value factor with large caps than with small caps, that most investors already are exposed to real estate through home ownership, and that emerging markets and microcaps are both too expensive and too volatile for the average investor with minimal advisor exposure.
Again, not perfect, but very good. Below, Iíve plotted how these three approaches have done over the past 16 years. In order for the comparisons between the three strategies to be apples-to-apples, Iíve used the Lehman Brothers Aggregate Bond Index, the strategy employed in the Vanguard Target Retirement funds, as the diluting asset in all three cases. All three strategies assume annual rebalancing. The top curve is the return from the full-bore DFA model equity strategy, the middle curve is the new DFA global equity fund and the bottom curve, the Vanguard Target strategy:
A few words of warning. First, the value and small strategies have had salutary returns during this period. Although this is consistent with theory, thereís no guarantee that it will be true going forward; thatís why theyíre called "risk premia." Second, thereís very little chance of equity returns being as high in the future as they have been in the past 16 years, and thereís no chance that the Lehman Aggregate will return 8% going forward. Caveat emptor.
That said, my clear preference, obviously, is the DFA global family. If you have a 401(k) plan, do not have exposure to these vehicles, and plan to stay a while with your current employer, itís definitely worthwhile to pester your HR administrator to get them included. The 60/40 portfolio is a good one-step allocation, but with a 55 basis-point expense ratio, youíre better off using the 100% equity fund in combination with one of the low-cost Vanguard short-term bond funds. (Make sure your company uses the DFA I-class funds; the R-class funds carry an extra 25 basis-point expense ratio for advisory/administrative expenses.)
If you donít have access to the DFA funds, then you can juice up the Vanguard Target strategies with a tad of their small value, large value, and REIT index funds. Obviously, there is a tradeoff between complexity and efficiency; this is true even with the DFA strategies, where lower cost can be obtained by using a cheaper separate bond fund instead of the stone-simple 60/40 fund. And, in the same vein, you can also juice up the DFA global-equity strategy to closely mimic the DFA "model portfolio" by adding their international and U.S. small-value funds, which some 401(k) plans also carry.
No doubt Vanguard and DFA will expand their retirement offerings, and other firms may choose to follow suit. But for now, both companies offer excellent low-cost fire-and-forget portfolio management for those adverse to pulling a bunch of asset-class strings in their retirement accounts
Copyright © 2004, William J. Bernstein. All rights reserved.
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The right to download, store and/or output any material on this Web site is granted for viewing use only. Material may not be reproduced in any form without the express written permission of William J. Bernstein. Reproduction or editing by any means, mechanical or electronic, in whole or in part, without the express written permission of William J. Bernstein is strictly prohibited. Please read the disclaimer.