3. Asset Allocation

This is part three of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part two.

At this point I was feeling pretty good.  I had just discovered an irrefutable truth about investing that not many people knew –  and it was actually going to make me money.  I was going to buy an index fund instead of a mutual fund and ride the market’s performance all the way until retirement.    Except its not quite that easy, because you can’t just buy one index fund.  One of the main points that was pounded in my head through all my research was that you can’t have have all of your retirement money in stocks.  In order to have a safe retirement portfolio, you must have your money in more than just one asset class.  An asset class is a group of securities (things you can buy on an exchange) with similar risk and rate of return characteristics.  For example, investors often refer to stocks, bonds and cash equivalents as the three main asset classes (some might also include Real Estate and Commodities).   Stocks have the highest risk and the highest return, cash equivalents are the lowest risk, but also have the lowest returns.  Bonds are somewhere in the middle.   The main reason to have different assets is to reduce the risk of your portfolio.  If you have a portfolio of all stocks, and the market crashes, you are out of luck.  But if the market crashes and you own bonds as well, your portfolio won’t lose as much value.  That is the very basic explanation of asset allocation.  Another benefit to having different asset classes (also known as diversifying your portfolio) is that when you rebalance your portfolio, you are guaranteeing that you are selling high and buying low.  More on that in Part 6.

How should I divide up my retirement money? As a young investor, the conventional wisdom says that you want 80-90% of your retirement money in stocks and the rest in bonds.  As you get closer to retirement you will want more money in bonds and in cash (the safer investments) so that you can preserve the money you saved.  There is a whole science out there about the best way to allocate your assets which I am only skimming the surface of.  In fact, most of the experts have a much more nuanced view of asset allocation.  It is not just about stocks and bonds, but about certain categories of stocks and certain kinds of bonds.   Richard Ferri’s book, The ETF Book, recommends the following asset allocation for “early savers.”

  • 25% – Total US Stock Market
  • 15% – Small Cap Value Stocks
  • 5% – Micro-Cap Stocks
  • 10% – Real Estate
  • 10% – Pacific Rim Stocks
  • 10% – European Stocks
  • 5% – Emerging Market Stocks
  • 10% – Total US Bond Market
  • 5% – Inflation Protected Bonds
  • 5% – High-Yield Corporate Bonds

That is 10 different asset categories!  More generally, however, it is 80% stocks (55% US, 25% International) and 20% Bonds.  Compare that allocation to Ferri’s suggestions for those who are about to retire.  The generalized allocation is 50% stocks (35% US, 15% International), 45% Bonds and 5% Cash:

  • 23% – Total US Stock Market
  • 7% – Small Cap Value Stocks
  • 0% – Micro-Cap Stocks
  • 5% – Real Estate
  • 6% – Pacific Rim Stocks
  • 6% – European Stocks
  • 3% – Emerging Market Stocks
  • 30% – Total US Bond Market
  • 10% – Inflation Protected Bonds
  • 5% – High-Yield Corporate Bonds
  • 5% – Cash

Can I find a fund for each of these asset categories? When I first looked at this list, I thought it would be impossible to find funds for some of the more interesting categories like “Inflation Protected Bonds.”  Fortunately for us, you can buy an index fund for every one of these asset classes.  It didn’t always used to be this way.  In fact, it wasn’t until 1975 that the first index fund was created by Vanguard as a mutual fund.  And it wasn’t until 1993 and the creation of ETF’s that enabled  you to buy an index just like you would buy a stock. Check out the link for more information of how ETFs work.  Personally, I like to think of ETFs as mutual funds but with ticker symbols.

You’ll notice that index funds can be both mutual funds and ETFs.  There is a great article by the Motley Fool explaining the differences in detail.  While they perform the same function and will generate the same returns (not accounting for any fees), there are differences in their underlying mechanics and the ways in which you can buy mutual funds and ETFs.  With mutual funds, you buy your shares at the end of every day.  There also may be a minimum amount you must invest to enter the fund.  With ETFs you buy a share of the index fund just like you would buy a stock.  For example, to buy the Ishares (a brand) S&P 500 index fund, you would search for ticker symbol “IVV” and place an order, which would be subject to any commissions that you get charged for trading stocks.  Most of the index funds out there today are ETFs and because they have ticker symbols they are often more easily bought and sold than mutual funds that you may only be able to buy if you have a certain company’s brokerage account.

It is important to note that not all index funds are benchmark indexes – or indexes that are meant to track the performance of a market.  Generally, when speaking about index funds – as I have in previous sections – investors are referring to benchmark indexes.  Strategy indexes are index funds that use analysis or strategy to pick stocks in their index and are not meant to track the market.  For example, there could be a strategy index ETF that uses a screen so that only stocks of socially responsible companies are in the index.  Another strategy index may use a complex mathematical formula to constantly buy stocks that exhibit certain price trend characteristics.

Strategy index ETFs like these outnumber benchmark indexes by 2 to 1 in ETF market (according to Ferri’s The ETF Book), but from my point of view they are not something that you want in your retirement portfolio.  Because strategy indexes are attempts to beat the market, they should be treated the same way as actively managed mutual funds and should have their performance compared to the market’s performance.  While there have been no studies (that I have seen) measuring performance of strategy indexes against the market, I am willing to bet that their performance is about the same as mutual fund performances – which as you will recall from part 2, is not very good. Furthermore, if you agree that having proper asset allocation in your retirement portfolio is important, then strategy index funds will not work for you.  It will be impossible to tell if your strategy index (that is based on some computer model with stocks that change every day) will have the proper ratio of micro cap to small cap to emerging market stocks.

How do I actually buy these different asset categories? At this point, I knew I didn’t have all the specifics, but I had a general plan for how I was going to actually fund my retirement account.  As I saw it, the first step was to find an ETF benchmark index that matches the asset categories I was looking for.  Once I found an ETF for each of the 10 categories listed above (for a young investor), I would buy each of the 10 ETFs every time I put money into my retirement portfolio.  I would make sure that the amount of money I had in each ETF was equal to the percent that recommended in the preffered asset allocation.  Lets say each ETF cost $1 a share (in reality the Bond Index ETF might cost $21.63 a share and the Emerging market Stock Index might cost $84.16 a share) and I had $100 to put in my retirement portfolio.  I would buy 25 shares of the Total Stock Market ETF, 15 Shares of the Small Cap Stock ETF, 5 shares of the Micro Cap stock index and so on…  In a case where all the shares were $1, except for the Total Stock Market ETF which was $25, I would buy just 1 share of the Total Stock Market ETF.  Its not the number of shares that count, but the amount of money in each category.

My retirement plan was finally starting to come together – that was until I realized that there was more than 1 ETF for every index I was looking for.

To continue reading, follow the link to Part 4 – Expense Ratios.

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4. Expense Ratios

This is part four of seven in my attempt to explain how you should invest in your retirement portfolio.  Click here for part three.

As I began google searching for the first ETF I would buy, I quickly realized that there was more than one ETF for each type of index fund that I was looking for. In fact, for most of the index funds, there were at least three ETFs I could choose from. From my research, it appears that there are three main players in the ETF benchmark index world: Vanguard, Schwab, and iShares. These are three companies that actually “make” their own ETFs. Take the Total Stock Market Index, for example. I saw at the very least that I could buy Vanguard’s ETF (VTI), Schwab’s ETF (SCHB), or iShares’ ETF (IWV). Each of the ETFs were created for the same purpose – to track the performance of the broad (as in not just large companies) US stock market. Each ETF used a slightly different benchmark to track the broad market. IWV uses the Russel 3000 index, SCHB uses the 2,500 stock Dow Jones US Broad Stock Market Index, and VTI uses the MSCI US Broad Market index.  Despite the small differences, each index would be acceptable to use for the 25% of my portfolio that was to track the “Total US Market.” Knowing that each of the three ETFs were essentially the same, I was left with one question:

How do I know which ETF to choose? Since I had at least 3 options in front of me, I had to find a reason to choose one over the other. and I didn’t want that to be based on something silly – like which fund had the coolest ticker symbol. This is where expense ratios come in. Expense ratios are the amount by which your annual return will be decreased as a result of fees from the company that makes your index fund. So for example, IWV, the S&P 500 index fund from iShares has an expense ratio of 0.21%. That means if IWV’s annual return is 10%, the actual return reflected in your bank account would be 9.79%.  As of March 2011, these were the expense ratios for each of the three funds mentioned above:

  • Vanguard’s VTI 0.07%
  • Schwab’s SCHB 0.06%
  • iShares’ IWV 0.21%

The expense ratios are not even one whole percent!  The good news is that this is typical for funds that track the major indexes.  ETFs that track more nuanced indexes, like the emerging markets index, have slightly higher expense ratios.  Here are three examples of Emerging Market ETFs:

  • Vanguard’s VWO  0.27%
  • Schwab’s SCHE  0.25%
  • iShares’ EEM  0.69%

Clearly in the two examples above Schwab and Vanguard funds have the lowest expense ratios.  They are in fact almost identical, leading me to question whether the small percentage differences is a valid reason for choosing one fund over the other.

Is one tenth of one percent really that important?  I found a great website that had an article on how expense ratios affect long term performance.  Using the author’s work as a template, I made a spreadsheet of my own so that I could look at the specific examples I started above.  Lets take the first example – the three ETFs measuring the Total US Stock market:

This is a screenshot from the excel file I was using.  Here I am assuming that each fund will return 8% each year after an initial $10,000 investment.  After 10 years, if you put your money into SCHB which has an an effective annual return of 7.96% (8.0% – .06% expense ratio) you would have $120 less than you would have if you did not have to pay an expense ratio.  After 30 years, you would have $1,664 less in your retirement account because of SCHB’s expense ratio.    Lets say you chose to go with VTI over SCHB.  Over 10 years that choice would have cost you $20 ($140 – $120), and over 30 years that choice would have cost you $274 ($1,938-$1,664).  Now in the grand scheme of things, this is not a whole lot of money, especially over 30 years.  Now if you chose  the iShares IWV fund, I really can’t defend that decision.  After just 10 years you would be giving up $296, and after 30 years you would be giving up $4,043!  This is all money that you could have saved if you chose the SCHB fund.

With such low expense ratios – less than .1% –  the difference between competing ETFs is not as noticeable.  If we take a look at the Emerging Market ETFs, however, the differences become even more real:

In this case, choosing the Vanguard fund over the Schwab fund will cost you $39 in 10 years and $522 in 30 years.  Don’t even get me started on what you would loose if you chose the iShares fund.  That decision would cost you over $10,000 ($17,602 – $6,758) in 30 years!  If you are like me, you might be thinking “Expense Ratios really suck” and might ask yourself why you are buying funds that have them in the first place.

Do other assets have expense ratios? Any type of investment that requires a pooling together of different individual stocks or commodities is likely to have an expense ratio.  Consider it the price you have to pay to organize a number of different assets into one fund.  So while individual stocks don’t have an expense ratio, they are assets that are not relevant in this discussion since we are interested in index funds for our retirement portfolio.  If the lack of expense ratios in stocks make you want to buy them for your retirement, just think of the percent of your (likely) underperformance relative to the market as your expense ratio for buying individual stocks.

As far as mutual funds go, they have expense ratios and much more.  Typical expense ratios for actively managed mutual funds are around 1.5% according to Fool.com.  Not only do mutual funds have expense ratios, but many of them also have sales charges called loads.  A front-end load, for example, is a fee that takes a percentage of your money (around 5%) the moment you buy the mutual fund.  So if you wanted to put $10,000 into a mutual fund with a 5% front end load, you transfer $10,000 into the fund, but only  $9,500 makes it into your portfolio.  Then, after they are done stealing your money up front, the fund will still have an expense ratio further reducing your return that wouldn’t have beat the market anyway.  Now just in case I haven’t proved my point on how important expense ratios are, I want to include some examples of higher expense ratios, like those you might find in a mutual fund.  I haven’t bothered to calculate what loads do to your real return, but i didn’t see the point. Hopefully this spreadsheet scares you enough to never want to buy a mutual fund with a high expense ratio, much less one that charges load fees.

Armed with a new understanding of how to chose each ETF that I would buy, I quickly selected the 10 ETFs with the lowest expense ratios.  I logged onto to my Scottrade Account (my online broker at the time) to make my first trade when it hit me:  At $7 a trade, I would be spending $70 every time I put money into my retirement account.

To continue reading, follow the link to Part 5 – Account Fees and Commissions.