Will We Learn From Japan's Triple Tragedy?
04/07/2011 0 comments
While the disaster in Japan will take many years to be put right, there is a very important lesson that can easily be overlooked in the rush to stop radioactive leaks and repair the damage. Like New Orleans where the levies were known to be a problem area, Japan's nuclear reactors were living on borrowed time, having had their life extended -- just another year. The temptation to delay until next time is very seductive until disaster strikes and the cost to repair dwarfs the cost to prevent.
For many years we have put off focusing on our retirement investment for -- just another year. Many are facing the repair crisis as their portfolios have been blighted by the recent financial melt-down and they are left with a hole that they have to fill somehow. The good news is that there are actions you can and must take to repair the damage and make the most of the time you have left.
In a series of articles, we are going back to basics. Asset allocation is critical in determining the risk adjusted returns from your portfolio.To make this clear, we are going to use a simple benchmark vehicle -- SIB -- Simpler Is Better to show the potential difference in returns between the portfolios with different numbers of asset classes.
Each of the SIBs are built from one ETF per asset class. The ETFs we selected for these portfolios are as follows:
| Asset Class | Ticker | Name |
|---|---|---|
| LARGE BLEND | VTI | Vanguard Total Stock Market ETF |
| Foreign Large Blend | VEU | Vanguard FTSE All-World ex-US ETF |
| DIVERSIFIED EMERGING MKTS | VWO | Vanguard Emerging Markets Stock ETF |
| REAL ESTATE | VNQ | Vanguard REIT Index ETF |
| COMMODITIES BROAD BASKET | DBC | PowerShares DB Commodity Idx Trking Fund |
| Intermediate-Term Bond | BND | Vanguard Total Bond Market ETF |
So the three asset SIB has (VTI), or (SPY), (VEU) or (EFA) and (BND) or (AGG). The four asset SIB adds emerging markets (EEM) or (VWO). The five asset SIB adds Real Estate (RWR) or (VNQ). The six asset SIB adds commodities (DBC) or (GCC). These are index funds, we are not attempting to pick the best fund for each asset class but to make sure we have each asset class covered.
The three asset portfolio is old school. The world comprises the US and the rest. US equities are enough of a microcosm that I can find enough diversification to give me protection against certain segments of the markets declining. Even if that does happen, I have fixed income and international equities to bail me out. We know that this is no longer the case. We can see on our browsers how the DOW, FTSE and NIKKEI act as if they are the same index, just on a different timezone. With a three asset portfolio, you really have very limited diversification.
Unfortunately, most of the portfolios in retirement plans only support three asset classes. In a study of over 800 mainly retirement plans, we noted that the majority of plans supported only three asset classes which is going to have a significant impact on the potential returns for the participant.
We use Strategic Asset and Tactical Asset allocation investment strategies to compare returns.
| Portfolio Name | 1Yr AR | 1Yr Sharpe | 3Yr AR | 3Yr Sharpe | 5Yr AR | 5Yr Sharpe |
|---|---|---|---|---|---|---|
| Three Core Asset ETF Benchmark Tactical Asset Allocation Moderate | 1% | 30% | 2% | 31% | 4% | 35% |
| Three Core Asset ETF Benchmark Strategic Asset Allocation Moderate | 15% | 129% | 3% | 15% | 4% | 18% |
Over a five year period, you will see five year returns are 4% for either strategy. This is what you might be getting from your retirement portfolio, and you can do better.
Adding emerging markets does give you a completely different asset
| The list of minor asset classes covered by Three Core Asset ETF Benchmark | The list of minor asset classes covered by Four Core Asset ETF (EM) Benchmark |
|---|---|
| Foreign Large Blend: VEU Intermediate-term Bond: BND Large Blend: VTI |
Diversified Emerging Mkts: VWO Foreign Large Blend: VEU Intermediate-term Bond: BND Large Blend: VTI |
| Asset Class | Three Core Asset ETF Benchmark | Four Core Asset ETF (EM) Benchmark |
|---|---|---|
| Fixed Income | 1 | 1 |
| Foreign Equity | 1 | 1 |
| Emerging Market Equity | 0 | 1 |
| US Equity | 1 | 1 |
| Total | 3 | 4 |
As of Apr 6, 2011, Three Core Asset ETF Benchmark investment choice is rated as below average and Four Core Asset ETF (EM) Benchmark investment choice is rated as below average based on MyPlanIQ Plan Rating methodology that was designed to measure how effective a plan's available investment funds are . It has the following detailed ratings:
| Attribute | Three Core Asset ETF Benchmark | Four Core Asset ETF (EM) Benchmark |
|---|---|---|
| Diversification | poor (2%) | poor (8%) |
| Fund Quality | below average (23%) | average (39%) |
| Portfolio Building | poor (6%) | below average (16%) |
| Overall Rating | below average (10%) | below average (20%) |
Performance chart (as of Apr 6, 2011)
Performance table (as of Apr 6, 2011)
| Portfolio Name | 1Yr AR | 1Yr Sharpe | 3Yr AR | 3Yr Sharpe | 5Yr AR | 5Yr Sharpe |
|---|---|---|---|---|---|---|
| Three Core Asset ETF Benchmark Tactical Asset Allocation Moderate | -1% | -10% | 3% | 31% | 4% | 36% |
| Three Core Asset ETF Benchmark Strategic Asset Allocation Moderate | 12% | 88% | 3% | 16% | 4% | 19% |
| Four Core Asset ETF (EM) Benchmark Tactical Asset Allocation Moderate | -0% | -2% | 6% | 57% | 8% | 56% |
| Four Core Asset ETF (EM) Benchmark Strategic Asset Allocation Moderate | 13% | 88% | 4% | 15% | 5% | 22% |
We note that applying a tactical asset allocation strategy with three asset classes and funds is of limited value. Tactical asset allocation relies on having other asset classes that are not correlated so that when one asset class is under performing, another one becomes a hedge and rises to compensate. However, with an additional asset class, you are able to double returns over the longer time horizon. Note that an extra 1% a year over a decade puts 10% more money in your portfolio (SAA to SAA) and 4% a year over a decade puts 50% more money in your portfolios (TAA to TAA)
Emerging markets are going to play a larger and larger part in our lives as countries such as China and India are increasingly powerful. We have already seen how these nations have sprung back from the great recession and are leading the recovery. This is an important part of any portfolio and if you want to know how to better your chances of a better retirement, now you know.
How can you do this if your plan only supports three asset classes? If you have an IRA, overweight the missing asset class (or two) in the IRA to compensate and create a more balanced portfolio that can deliver higher returns and lower risk.
Prevention is better than cure, which we all know. Just don't leave it -- one more year -- until you get started.
Disclosure:
MyPlanIQ does not have any business relationship with the company or companies mentioned in this article. It does not set up their retirement plans. The performance data of portfolios mentioned above are obtained through historical simulation and are hypothetical.
Symbols: SPY, VTI, EFA, VEU, AGG, BND, CIU, BIV, GWL, PFA, IVV, IYY, IWV, VV, DLN, RSP, SCHX, EEM, VWO, GMM, PXH, DEM, SCHE
Exchange Tickers: (SPY), (VTI), (EFA), (VEU), (AGG), (BND), (CIU), (BIV), (GWL), (PFA), (IVV), (IYY), (IWV), (VV), (DLN), (RSP), (SCHX), (EEM), (VWO), (GMM), (PXH), (DEM), (SCHE)
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