Asset Classes for Retirement Investments

Note: this article is also published in AAII Computerized Investing 

When it comes to retirement investments, it’s paramount to construct a portfolio that can deliver a reasonable return with acceptable risk. This is where the asset allocation comes into play. One should carefully choose funds that represent specific asset classes they are targeting within their portfolio. Furthermore, by carefully weighting allocations to each asset class, one can reduce risk by choosing asset classes that have a correlation (meaning they haven’t historically moved in the same direction).

In a word, the criteria to choose asset classes should be

  • Returns: these asset classes should deliver reasonable long term returns.
  • Risk: they are more or less uncorrelated. Ideally, they can hedge each other. Individually, they should pose as little risk as possible for a given level of return.

Asset allocation (weighting in different assets) is the one of the main factors that affect a portfolio’s overall return and risk.  In a study of hundreds of US pension funds by Gary Brinson, Randolph Hood and Gilbert Beebower, it was found that asset allocation is responsible for over 90% of variations in portfolio return. Even though it’s still arguable on how much asset allocation impacts on a portfolio’s return, it’s very intuitive and compelling that asset weighting (allocation) is one of the main determining factors. Meaning, investors should take asset allocation seriously. 

Long Term Asset Class Returns

There are two major asset classes that a balanced asset allocation portfolio should possess: equities or stock ownership and debts or bonds. Other major asset classes worth considering are so-called alternative assets. In the following, we look at these assets in more details. 

Equities

Equities represent fractional stock ownership. Owning stocks means that you become a shareholder that can claim part of the underlying company. A shareholder shares the company’s profit or loss. It’s a direct participation of the business’ success or failure. In a previous article, we stated that equities should deliver extra returns over cash or bonds (also known as the risk premium) in the long term. The main reason is that while stocks have historically given investors (their owners) a better return over the long term, they tend to be more risky than fixed income assets. So while the investor wants the higher return that equity securities provide, he must be compensated for this additional risk. An additional risk to equity securities is if the company goes bankrupt, bond investors would be paid first.

Essentially, higher risk investments have a higher risk premium, and therefore are expected to deliver higher returns over the long term.

In a globally diversified portfolio, there are three main equity assets. 

  • U.S. stocks. U.S. stocks have consistently shown a 5% to 6% extra annualized returns over inflation (the real return, i.e. nominal return minus inflation). In fact, for the past 90 years till 2015, Figure 1 shows US stocks delivered 6.6% annualized real return or 9.5% annualized nominal return. 
  • The second major economic bloc is Europe and Japan, also known as the foreign developed markets. These stock markets have also delivered similar long term returns as the U.S. For example, in Figure 2, for the past 116 years till 2015, U.K. equities (one of the largest economy in this bloc) returned 8.9% annually or 5.0% annualized real return. 
  • The third major economic bloc is the emerging markets. For the past 30 years, emerging markets like India, China, Taiwan, Brazil, eastern European countries and Singapore have grown rapidly. Depending on the definition, the aggregate emerging market economy accounts for around one third of the world GDP. In the table below, one can see that emerging market equity has delivered a reasonable return, though it was hurt recently. 

Figure 1: Long term US stock returns

 

Figure 2: Long term UK stock returns

 

Table 1: Major stock and bond returns (as of 3/3/2017):

Asset Index Fund

1Yr AR

3Yr AR

5Yr AR

10Yr AR

15 Yr AR

Since 12/31/96

VTSMX (Vanguard Total Stock Mkt Idx Inv)

23.0%

10.3%

13.8%

7.9%

7.6%

8.1%

NAESX (Vanguard Small Cap Index Inv)

27.1%

7.6%

13.6%

8.5%

9.6%

9.2%

VGTSX (Vanguard Total Intl Stock Index Inv)

15.2%

1.1%

4.1%

1.6%

6.2%

4.7%

VEIEX (Vanguard Emerging Mkts Stock Idx)

22.3%

3.0%

-0.4%

3.0%

9.1%

5.8%

VGSIX (Vanguard REIT Index Inv)

10.5%

10.9%

11.1%

5.1%

10.6%

9.6%

VBMFX (Vanguard Total Bond Market Index Inv)

0.7%

2.1%

1.9%

4.0%

4.3%

5.0%

Bonds

Bonds are debt (loan) contracts that allow a lender to get the principal back when the contracts mature, in addition to interest received over the life of the bond. Bonds are thus called fixed income. In general, bonds are more stable than stocks even though they are also subject to the risk of default or missed interest payment. If investors want to sell bonds before they mature in a secondary market, they are also subject to the interest rate risk as bond price can fall or rise depending on the prevailing interest rate at the time of selling. As rates rise, prices decline, and vice versa.

Bonds are an essential asset class that offers stability when stock prices fall. In a falling stock market, demand of “safer” investments such as bonds rises and thus bonds can compensate for the loss of stock investments. Though bonds have been in a secular bull market since early 1980s and many investors fear that once the bull market ends, they will suffer great loss in their fixed income investments, historical evidence indicates that situation is less dire: even in a bond bear market, bonds can still offer positive nominal returns as the interest rates begin to slowly rise, capital losses are compensated by interest payments, and investors periodically repurchase new bonds as the older bonds mature.

Alternative Assets

In the past 10 years, many new investment instruments have become available; other useful asset classes have found a way to help diversify and enhance portfolios. For retirement investments, we believe REITs (Real Estate Investment Trusts) are particularly useful. An REIT invests in real estate or properties that primarily derive income from rental. Furthermore, it can incur capital appreciation or loss if the price of underlying properties increases or decreases at liquidation. By law, an REIT has to distribute at least 90% of its earnings as dividends to its investors. Because of this, REITs have often been attractive investments for income investors. However, even for overall capital growth, REITs have delivered comparable total return (dividend reinvested) in the long term. In the above table, Vanguard REIT index fund VGSIX has had the best total returns in the past 15 and 20+ years. Based on NAREIT, from Dec. 31, 1978, through March 31, 2016—total returns for exchange-traded U.S. Equity REITs have averaged 12.87 percent per year compared to just 11.64 percent per year for stocks. 

However, REITs can be volatile. In fact, Vanguard REIT index fund VGSIX has a 71% maximum drawdown during the financial crisis in 2008-2009, compared with 55% of Vanguard 500 index fund (S&P 500). It also underperformed VFINX in the past 10 years. 

David Swensen, the known Yale endowment manager, and many other well known investors have pointed out that REITs can be a good portfolio diversifier that enhances overall returns. For example, Swensen recommends 20% REIT exposure in an individual portfolio (see P David Swensen Yale Individual Investor Portfolio Annual Rebalancing). 

Another prominent alternative asset class is commodities. However, for average investors, we dont recommend it unless you follow a well defined sound investment strategy. 

Equity Sub Asset Classes

Within the major asset classes, one can invest in sub assets to boost returns. For stocks, investors should consider getting exposure to the following sub asset classes if they are available.

Small Capitalization Stocks

Small companies that have market capitalization less than $2 billion are considered to be small capitalization (sometimes this threshold varies). These companies in general grow faster than larger companies, and tend to offer better returns in the long term. In Table 1, small cap index fund NASEX outperformed large cap index fund VFINX for the past 10, 15 and 20+ years by about 1%. 

Ibbotson has tracked the long term performance of small cap stocks. In the following, it shows that from 1926 to 2015, small cap stocks outperformed large stocks by 2%. 

Dividend Paying Stocks

Another stock sub asset class worth considering is the dividend stocks. In the long term, dividend stocks have had a similar total return compared with broad market stock indexes. But they offer more steady dividend income and have historically had less volatility. In the following table, one can see dividend stocks is very comparable with S&P 500 over a long period. 

Dividend stocks vs. S&P 500 (as of 3/3/2017)

Index fund

1Yr AR

3Yr AR

5Yr AR

10Yr AR

15Yr AR

Since 3/31/93 AR

VFINX (Vanguard 500 Index Investor)

22.0%

11.1%

14.0%

7.7%

7.0%

9.2%

VDIGX (Vanguard Dividend Growth Inv)

15.3%

9.8%

12.6%

8.7%

7.8%

8.2%

 

 

 

 

 

 

 

Dividends are considered to be “sticky” – meaning management is very hesistant to decrease the dividend once it has been implemented. Management knows that investors rely on the steady stream of income, and historically, if a dividend is decreased the company’s stock has been severely punished. 

Dividend-paying companies tend to be more mature, sustainable firms, which is a primary reason why dividend paying stocks are less volatile than their non-dividend-paying counterparts.

Fixed Income Sub Asset Classes

Many investors overlook the importance of sub asset classes in bonds. Some sub asset classes of bonds can be very effective to help enhance returns or hedge losses from stock positions. MyPlanIQ believes it’s possible to actively manage exposures to these sub asset classes to deliver returns above the market. 

There are two main risk spectrums in bond investment: interest risk and credit risk. Interest risk is related to the maturity length of a bond; the longer the maturity, the higher the interest rate risk. Interest rates and bond prices have an inverse relationship; as interest rates rise, bond prices fall and vice versa.

Bonds are generally divided into 3 maturity groupings: short term, intermediate term and long term bonds. They are also often categorized based on what type of entity issues the bond: typical categories include government bonds or corporate bonds.

Credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. Credit risk is often measured by the bond credit ratings from Moody’s or Standard and Poors and typically applies to corporate bonds (government bonds are considered more “safe” and therefore have higher credit quality). U.S. Treasury bonds are considered to be of highest credit quality and thus they belong to a separate class, different from investment grade corporate bonds. 

In general, when referencing credit quality, one can divide bonds into investment grade and high yield. High yield bonds offer higher returns but also possess higher risk. For example, Vanguard High Yield Bond Index Fund (VWEHX) had a 6.3% annualized return for the past 10 years, better than the total bond market index fund’s (VBMFX) 4%, but it lost 21% in 2008, compared with VBMFX’s 5.1 gain in that year.

Other important bond asset classes include inflation-protected bonds, emerging market bonds, foreign bonds and municipal bonds.  

Because of the wide spectrum of bonds to select from, we believe a good active bond investment strategy can be used to outperform a bond index fund. For more details, see September 26, 2016: Fixed Income Investing: Actively Managed Funds vs. Index Funds 

Asset Allocation: Putting It Together

Once the asset classes are identified, the next step is to decide asset allocation (or weights to the asset classes) based on investors’ risk profile. A simple way to decide asset allocation is to first decide how much should be invested in ‘safe’ bond sub assets that exclude more risky sub classes such as high yield bonds, emerging market bonds and long term bonds. Once the ‘safe’ allocation is decided, the rest is allocated to ‘risk’ assets including stocks, alternative assets and risky bonds.

Factors like investors’ age, income and risk tolerance are important to help decide the risk allocation, in addition to long term stock and bond performance and expected returns. MyPlanIQ.com first asks a user a series of simple questions and then uses Mean Variance Optimization (MVO) type technique to decide the risk and ‘safe’ allocations. Other robo advisors also feature questionnaire to evaluate and decide such allocations.

Allocations among risk asset classes (US stocks, international stocks, emerging market stocks, REITs etc.) and bonds can be determined in the above step or subsequently. Again, many online services including MyPlanIQ.com can help investors in this process.

Notice if there are sub asset classes such as US small cap stocks in the (401k) plan, their allocations will be also decided based on their historical and expected behavior and returns.

Asset allocation can be strategic or tactical. A strategic allocation does not change the asset allocations often and will only rebalances back to the target (or predetermined) allocations periodically. On the other hand, a tactical allocation is a dynamic allocation that can change reduce risk allocation from time to time, depending on market and other factors. It can reduce investment loss when markets are distressed.

There are pros and cons for both strategic and tactical asset allocation strategies. A hybrid so called core satellite approach is to adopt both strategies in one’s overall investments so that the two portions can complement with each other. You can find  more asset allocation information here.

Fund Selection: Index Funds or Actively Managed Funds

The next question for retirement investing is how to choose funds that represent the asset classes. Based on our extensive studies, we believe for average retirement investors, low cost index funds should be used for stock (equity) assets while if it is possible, good actively managed total return bond funds (intermediate term bond funds) can be used for bonds to enhance returns. Here is a more detailed explanation. 

Index Funds for Stock Assets

The following are the two main reasons why we believe low cost index funds should be the first choice for stock asset classes:

  • Active stock funds rarely outperform index funds consistently

Though it’s been a popular and hotly debated topic on the value of active stock funds, the very first common sense and experience tell us that there have been way too many great stock funds that suffered from sudden downward performance. SEQUX (Sequoia) is one of the recent examples. The following table shows some of recent ‘disgraceful’ funds: 

Performance of some well known actively managed value funds (as of 9/16/2016):

Fund Name

YTD

Return**

1Yr AR

3Yr AR

5Yr AR

10Yr AR

10Yr Sharpe

SEQUX (Sequoia)

-10.8%

-26.3%

-0.8%

8.1%

5.9%

0.29

LMVTX (Legg Mason Cap Mgmt Value C)

4.1%

6.1%

7.1%

12.9%

1.7%

0.05

FAIRX (Fairholme)

-1.0%

-12.2%

-3.7%

6.9%

4.7%

0.18

LLPFX (Longleaf Partners)

15.3%

11.6%

2.4%

8.6%

3.8%

0.14

TAVFX (Third Avenue Value Instl)

5.8%

4.9%

1.7%

7.3%

2.1%

0.07

DODGX (Dodge & Cox Stock)

7.4%

6.8%

8.1%

14.9%

5.5%

0.22

VFINX (Vanguard 500 Index Investor)

5.8%

9.0%

10.0%

14.1%

7.1%

0.31

See detailed year by year comparison >>

The first two funds are well covered. Fairholme’s Bruce Berkowitz was named as the manager of the year by Morningstar. He was a rising value investing star before 2008. The next three funds are all managed by well known value investors and have been recognized for a long period of time. Not only these funds underperformed Vanguard S&P 500 (VFINX), they underperformed by a big margin: as high as 5.4% difference!

We also took a task to look at the performance of the domestic (U.S.) stock funds whose managers won at least once the covet Morningstar’s manager of the year award. The following table shows the funds whose managers won the award before year 2000. 

Performance Comparison of Funds That Won Morningstar’s Manager of The Year (as of 9/16/2016):

Fund Name

1Yr AR

3Yr AR

5Yr AR

10Yr AR

10Yr Sharpe

FKACX (Franklin Growth Opportunities C)

-3.4%

7.2%

10.8%

7.7%

0.3

VIGRX (Vanguard Growth Index Inv)

6.4%

10.7%

14.0%

8.6%

0.39

FMAGX (Fidelity Magellan)

4.3%

10.0%

13.5%

5.6%

0.22

TAVFX (Third Avenue Value Instl)

4.9%

1.7%

7.3%

2.1%

0.07

PRNHX (T. Rowe Price New Horizons)

5.8%

9.4%

16.7%

11.4%

0.47

FPPTX (FPA Capital)

-0.1%

-2.1%

3.7%

5.0%

0.21

SKSEX (Skyline Special Equities)

-0.7%

5.3%

15.3%

7.4%

0.27

NAESX (Vanguard Small Cap Index Inv)

5.7%

7.3%

13.6%

8.0%

0.3

NYVTX (Davis NY Venture A)

5.7%

7.7%

12.2%

5.3%

0.21

GABAX (Gabelli Asset AAA)

4.9%

4.7%

10.8%

7.2%

0.32

YACKX (Yacktman Svc)

10.8%

5.7%

10.7%

9.6%

0.5

CFIMX (Clipper)

9.6%

10.0%

13.3%

5.2%

0.21

VFINX (Vanguard 500 Index Investor)

9.0%

10.0%

14.1%

7.1%

0.31

See detailed year by year comparison >>

Notice that some funds have different styles and should be compared with their respective benchmarks (highlighted). For example, PRNHX (T. Rowe Price New Horizons) is a small cap stock fund and it should be compared with Vanguard Small Cap Index (NAESX). 

These funds are the who’s who in mutual fund industry in the last 20 to 30 years, long enough for a generation of investors to have patience in them. However, the majority of them have vanquished or underperformed significantly. 

Again, this table shows it’s hard to maintain consistent outperformance. 

Larry Swedroe has written a series of articles on the persistence of outperformance of actively managed stock funds by looking at many well known funds’ performance. Interested readers can read his latest one Are the Returns of Jeremy Siegel’s “Superstar” Funds Likely to Persist?

  • Risk (stock) funds are heavily influenced by sectors and styles

The other problem with active stock funds is so called ‘disappearing alpha’: their performance is mostly influenced by their so called factor weights instead of individual stock picking ability. In academic study, Fama and French’s 4 factor model is the most famous. Basically, it states that the performance of a stock fund can be mostly explained (or decided) by the following factors: 

  • Beta or market exposure: how much correlated with a broad based market index (such as S&P 500)
  • Size: large capitalization or mid cap or small cap of a stock
  • Value: how expensive a stock is (value stocks vs. growth stocks)
  • Momentum: the recent price performance 

A famous example is CGMFX (CGM Focus). The fund had a fantastic run before 2008, averaging 23.5% annually since its inception in 1997. It outperformed S&P 500 by a large margin (see the following picture). At times, investors were attracted by the fund’s stock picking ability. But a more elaborate analysis reveals that the outperformance was mostly due to its timely and outsized bets on various sectors. To some extent, it was more a sector rotation fund. 

 

Unfortunately, just like other popular stock funds, this fund has lagged since then: 

Performance Comparison (as of 8/31/2016):

Ticker/Portfolio Name

YTD

Return**

1Yr AR

3Yr AR

5Yr AR

10Yr AR

10Yr Sharpe

CGMFX (CGM Focus)

-7.8%

-12.1%

1.3%

5.1%

2.4%

0.05

VFINX (Vanguard 500 Index Investor)

7.7%

13.7%

12.0%

14.6%

7.4%

0.33

Actively Managed Total Return Bond Funds for Fixed Income

Unlike in stock investing, in principle, we prefer using a selected list of actively managed fixed income bond funds instead of bond index funds. However, that does not mean we like any actively managed bond funds. In fact, there are only handful of bond funds that qualify as our candidate funds. 

There are three main reasons to support the above claim 

  • Capitalization weighting in a bond index fund is questionable

The very first objection to invest in a bond index fund is that it does not present an intuitive sense to use market value (capitalization) to decide how much an index fund should invest. For example, if a company borrows more, its bonds will have bigger capitalization, thus, it will have bigger weight in an index fund. Similarly, if government issues more debts, its bonds get more weight. This is exactly what has happened lately as the prices of U.S. Treasury bonds have risen so much. Even John Bogle, the champion of indexing, has voiced concerns on this. 

The other surprising fact for the most popular bond index Barclays U.S. Aggregate bond index (the index the biggest bond fund Vanguard Total Bond Index Fund (VBMFX), ETFs AGG and BND are based upon) is that it has no or very little (less than 1%) exposure in high yield bonds as shown in this Morningstar’s article:

It’s also true that the total aggregate bond index has no exposure to municipal bonds or foreign bonds. Municipal bonds, though mostly used for taxable accounts, actually can outperform even taxable funds from time to time (even before tax). They deserve to have a place in your portfolio. See April 25, 2016: Tax Free Municipal Bond Funds & Portfolios on municipal bond funds based portfolios. 

Notice the criticism of less exposure in high yields and other sectors can be remedied by investing in index funds in those sectors. However, the capitalization weighting is certainly something hard to be corrected in a normal index fund. 

  • Some actively managed bond funds can outperform index funds more consistently

What’s more important, is that, unlike in stock investing, there are only a small amount of actively managed bond funds that have outperformed general bond index funds over a long period of time. The following table shows the 15 year performance of the list of candidate funds used in our fixed income portfolios listed on Brokerage Investors page. 

Total Return Bond Funds Performance Comparison (as of 9/26/2016):

Ticker/Portfolio Name

YTD

Return**

1Yr AR

3Yr AR

5Yr AR

10Yr AR

15 Yr AR

TGMNX (TCW Total Return Bond N)

4.4%

4.1%

4.1%

4.6%

6.5%

6.1%

DLTNX (DoubleLine Total Return Bond N)

3.7%

3.4%

4.1%

4.2%

 

 

WABRX (Western Asset Core Bond R)

6.4%

6.0%

4.7%

 

 

 

LSBRX (Loomis Sayles Bond Retail)

9.4%

7.8%

2.8%

5.5%

5.9%

8.4%

DODIX (Dodge & Cox Income)

6.8%

6.6%

4.3%

4.2%

5.4%

5.5%

MWTRX (Metropolitan West Total Return Bond M)

5.1%

4.9%

3.9%

4.5%

6.3%

5.6%

PTTDX (PIMCO Total Return D)

4.5%

4.8%

3.2%

3.7%

5.7%

5.5%

VBMFX (Vanguard Total Bond Market Index Inv)

5.6%

5.3%

3.9%

2.8%

4.7%

4.6%

See detailed year by year comparison >>

Unlike stock funds, these bond funds have consistently outperformed bond market index fund such as Vanguard Total Bond Market Index Fund (VBMFX). In fact, not only they have done better for the past 15 years (for those that have data), each of them has outperformed VBMFX since its inception respectively. 

Take PIMCO total return bond fund (PTTDX) as an example, this fund was a consistent winner before 2014.  After its star manager Bill Gross left PIMCO, the fund suffered and thus it has worse 1 and 3 year returns than VBMFX. However, it still betters VBMFX by 1% in its 10 year annualized return. Another example is LSBRX (Loomis Sayles Bond Retail) that is the most aggressive one among this set of total return bond funds. It tends to take over sized high yield bond exposure to boost its return. That has helped its performance, though it was badly hurt in both 2008 and 2015 when low quality bonds (high yield bonds) had difficulty. However, this fund has a long outstanding performance record. Since its inception from 1997, its annualized return 7.6% is 2.2% higher than VBMFX’s 5.4%!

A similar but more conservative fund is DODIX (Dodge & Cox Income). It takes opportunistic bets on corporate bonds. It outperformed VBMFX by a smaller margin but with much smaller risk.

In general, we believe that because of the relatively stable trends in bond market, it’s easier for a manager to take advantage of the intermediate term strength of bond segments (such as high yield, long corporate bonds etc.) 

  • More importantly it’s possible to pick a winning total return bond fund periodically

At MyPlanIQ, we have shown that a portfolio that periodically picks the best total return bond fund from a set of funds with solid long term record can outperform the bond index fund by a wide margin. We recommend readers the following articles on these portfolios: 

The representative portfolios listed on Advanced Strategies serve as the benchmarks (brokerage specific portfolios can be found on  Brokerage Investors page): 

Portfolio Performance Comparison

Ticker/Portfolio Name

YTD

Return**

1Yr AR

3Yr AR

5Yr AR

10Yr AR

Since 7/30/2000

P Bond Funds Momentum Based on Upgrading Fixed Income Managers of the Year`s Funds Monthly

8.2%

8.5%

5.8%

6.5%

7.8%

9.4%

P Bond Funds Momentum Based on Upgrading Fixed Income Managers of the Year Quarterly

8.1%

7.8%

4.8%

6.2%

7.5%

8.9%

VBMFX (Vanguard Total Bond Market Index Inv)

5.6%

5.3%

3.9%

2.8%

4.7%

5.2%

The two portfolios have had a more than 3.7% extra annualized return over VBMFX in the last 16 years. The outstanding performance (and ongoing) is the best testimony to our claim that it’s possible to utilize actively managed bond funds to achieve very reasonable return without much risk. 

Fund Selection: Putting It Together

To summarize, we advocate low cost index funds for stock assets and good total return bond funds for fixed income bond asset. This section discusses the way to select funds.

If you are using a robo advisor or an online service like MyPlanIQ.com, it usually chooses funds for you. MyPlanIQ.com selects funds based on funds’ historical performance, expense and management. In an IRA account where investors can select funds from a wide range of funds, we further pre-select some excellent funds as candidate funds. For example, for the fixed income portfolios for an IRA or taxable account, MyPlanIQ only selects total return bond funds from a very limited pool of candidate funds. After the candidate funds are selected, algorithms will decide fund selection at a rebalance time.

Researching Funds Online

If you decide to do it yourself completely, there are several websites that allow you to research mutual funds and ETFs online.

AAII’s Computerized Investing outlines which websites you could use to search for mutual funds and ETFs online. They also break it down in terms of mutual fund and ETF data, mutual fund and ETF ratings and recommendations, and mutual fund and ETF screeners.

You also will likely have access to fund and ETF research through your brokerage account. If you are interested in looking up which funds or ETFs a particular brokerage offers with low commission, most of the brokerages allow you to view this list without having an account. For a 401k type retirement plan, you can research funds in the investment options and decide to choose which at a rebalance time.

For example, Vanguard lets you browse through mutual funds on their website.

Practical Considerations For IRAs and 401k Accounts

It’s very common for many users to have several accounts – some of them are 401k or employer sponsored retirement accounts, some of them are IRAs and some of them are taxable accounts. In this article, we look at IRAs and 401k type accounts in more details and offer some observations. For a related topic on how to allocate overall capital across multiple accounts, please refer to December 16, 2013: Tax Efficient Portfolio Planning

Brokerages for IRAs

Many major brokerages still target active traders instead of portfolio builders. To the extent we have investigated, we are really not satisfied with what’s provided for retail investors who just want to construct a balanced asset allocation portfolio instead of trading ETFs and stocks.  For example, so far, no brokerages other than FolioInvesting provide a basket portfolio rebalance feature that allow investors to rebalance a portfolio at once, not being forced to issue many sell and buy orders. The good news is that such a feature exists in many 401k accounts. However, if you limit yourself to only finding a brokerage that’s good for portfolio construction, here are some of our observations: 

ETFs

You want to find a brokerage that provides ETFs commission free or low commission. If you consider Vanguard’s ETFs are good enough for your portfolio construction, you might as well open an account in Vanguard brokerage. The other choice is TD Ameritrade, that provides most of Vanguard ETFs commission free. If you still want to get some exposure to other ETFs, the other choice is Merrill Edge, which allows you to have 30 commission free trades in each month if you have over $50,000 in your combined Bank of America bank accounts and brokerage accounts. Other firms provides commission free ETFs that are either very illiquid (such as Schwab’s many commission free ETFs) or incomplete. Fidelity offers half baked commission free ETF trades that are only buy commission free, but not sell commission free. We think you can be better off in other brokerages that offer real commission free trades. 

For this purpose, we found that Vanguard brokerage is probably the best that provides all Vanguard funds without transaction fees. Fidelity and Schwab also provide some good low cost index funds (though they are not as complete as Vanguard’s). Other than these, many firms have limited low cost index funds and thus making it very hard to construct a low cost portfolio. Furthermore, many brokerages put a minimum 3 month holding period for a mutual fund, otherwise, they will charge transaction fee. In TD Ameritrade’s case, it has an unusual 6 month requirement, rendering itself almost not useful. 

Here is the summary :

  •  Vanguard brokerage: commission free Vanguard ETFs which are relatively complete and extremely low cost. 
  • TD Ameritrade: provides most Vanguard ETFs commission free. 
  • Merrill Edge: if you have over $50,000 in combined accounts, you are entitled to 30 commission free ETF trades. 

IRA or 401k Accounts

If you have a 401k plan from your current employer, you don’t have much choice as you can’t abandon your 401k and just invest your 401k in a new IRA  or add to an existing IRA. Note, some 401k plans allow participants to choose a brokerage window to invest., but sometimes, there are many restrictions in the brokerage window. However, if you have a 401lk/403B or other retirement accounts, you do have a choice whether you should retain your old 401k account or just roll over to an IRA or to your current 401k account. Things to consider:

  1. 401k accounts might have some ultra low cost funds, especially index funds. Sometimes, for a large plan, your administrator can manage to negotiate extremely low fees for some funds (mainly for Collective Investment Trust funds or CITs). However, considering today’s rock bottom expenses of index ETF or index mutual funds, this has become less attractive. 
  2. 401k might allow you to access to some good funds that are not available to retail investors in a discount brokerage (in which your IRA is most likely to reside). Examples include DFA (Dimensional Fund Advisors) funds that can be only purchased through financial advisors in a retail brokerage account or some load waived share classes (such as institutional or class A) of funds. 
  3. As stated above, 401k has a one click feature to allow you to rebalance your account based on the percentage allocation. That makes your rebalance trades much easier. 
  4. If your employer offers to match your contributions into your 401k, you should definitely take advantage of that (it’s free money!).

In general, even if the above does exist, to simplify your life and consolidate your financial accounts (lots of people are really bogged down by too many accounts), it’s still a good practice to just pick a good low cost brokerage for your IRA and move your old 401ks there. There many also be advantages to rolling your assets over into a Roth IRA account – an interesting topic, but not covered in this article.

How to allocate among IRAs and 401k accounts

If you have both IRA and 401k accounts, you need to decide what asset classes or styles of portfolios to be held in what accounts. You must consider your entire portfolio together – meaning, when determining your overall asset allocation do not view each account separately. For general allocation between taxable and tax deferred accounts, we outlined some suggestions in  December 16, 2013: Tax Efficient Portfolio Planning.  But among tax deferred IRA and 401k accounts, there are more to consider:

  • IRAs can allow access to a relatively complete list of total return bond funds (see June 3, 2013: Total Return Bond Fund Portfolios For Major Brokerages on using these funds to construct a fixed income portfolio) that are generally not available in a 401k plan. In fact, we have observed that many plans actually ignore or overlook the importance of having good choices of fixed income funds. Most plans only feature a few fixed income funds and leave investors not many choices to enhance the fixed income side returns. For example, the following table shows the fixed income funds available in DEUTSCHE BANK MATCHED SAVINGS PLAN. In this case, a major investment bank has decided to only offer a bond market index fund, an active intermediate bond fund and a high yield bond fund for all of its fixed income lineup. 
  • IRAs in general have more asset class choices. If you choose a brokerage right, you can also choose funds with low expense. 

In general, we would suggest that first allocate your fixed income portion as much as possible in an IRA if your 401k plan lacks of good fixed income funds (which is usually the case). You then try to leave the active or tactical portion as much as possible in IRAs if the active or tactical portion uses index mutual funds or commission free ETFs.

Often, you might have both strategic and tactical portfolios in your overall retirement investments as stated above. In this case, your strategic portfolio will have to be implemented in your 401k account(s). 

Unfortunately, the above suggestion seems to under utilize the good portfolio level basket rebalance feature available in 401k plans as the more active (tactical) portfolios would need this feature most. But investors just have to make the tradeoff in this situation . 

To summarize, even among retirement accounts, investors should make an effort to consider how to allocate funds and assets by looking at the pros and cons in these types of accounts. From the above discussion, one can see both discount brokerage based IRAs and employer sponsored (401k) accounts have weakness to avoid. 

Summary

Choosing asset classes in your retirement investment portfolios is one of the most important steps. Exposure to both risk assets and fixed income bonds is the key to construct a balanced portfolio. Global assets can further increase diversification and even possibly boost returns. Investors should not underestimate the importance of fixed income investing. A sound and active fixed income strategy can enhance returns without incurring much risk.