July 31, 2017: Asset Classes And Fund Choices: A Primer

Re-balance Cycle Reminder All MyPlanIQ’s newsletters are archived here.

For regular SAA and TAA portfolios, the next re-balance will be on Tuesday, September 5, 2017. You can also find the re-balance calendar for 2017 on ‘Dashboard‘ page once you log in.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Please note that we now list the next re-balance date on every portfolio page.

Asset Classes And Fund Choices: A Primer

Recently, AAII published our article “Selecting Asset Classes for Retirement Investments“. It discusses our view on how to select essential asset classes for retirement investments. Furthermore, we also discuss our position on what kinds of mutual funds and/or ETFs we favor to represent the asset classes. The article is based on several newsletters we published in the past. Since it is a bit long, this newsletter will summarize some of the key points in the article. You can also find the article on our site here. We encourage readers to read the entirety of the article.

Key Asset Classes

We view there are three asset class groups: equities (stocks), fixed income (bonds) and alternative assets. We further pick the following core asset classes in each group:

Stocks

US stocks
Foreign developed country stocks
Emerging market stocks

Bonds: Unlike many others, we believe all major bond segments are important.

Interest rate spectrum (or maturity spectrum): short, intermediate and long term bonds
Credit quality spectrum: US Treasuries, investment grade corporate bonds and high yield (or low quality) corporate bonds
Municipal bonds (can have both interest rate and credit quality representation)
Inflation protected bonds
Foreign bonds and emerging market bonds

Alternative assets: for retirement investments, we believe commodities are too volatile for average investors, thus it should be ignored. Furthermore, hedged equity or bond funds are also hard to predict. They, like commodity funds, are seldom available in a retirement plan. They too can be ignored. This leaves only

Real Estate Investment Trusts (REITs): in a future article we will discuss why REITs is deserved to be considered as a stand alone major asset class.

Sub asset classes in stocks

For US stocks, we believe the following two sub asset classes can be very useful to enhance returns and reduce risk:

Small cap stocks: this asset has better long term returns than large or mid cap stocks.
Dividend paying stocks: this asset has similar or better long term returns than general stock market indices but their returns are more steady and less volatile.

Though one can venture into foreign small cap stocks, since they are not as popular as US stocks in many retirement plans, we do not classify them as essential sub asset classes.

Asset Allocation

MyPlanIQ generally classifies assets into ‘risk’ and ‘safe’ asset groups. In general, ‘safe’ assets are short term and intermediate term investment grade or higher quality (i.e. US government) bonds. Notice that even though we use the term ‘safe’ here, by no means these assets are absolutely safe. The percentage of ‘safe’ assets in an investor’s overall investments is called ‘risk profile’. To decide this risk profile, MyPlanIQ.com first asks a user a series of simple questions to derive the risk profile. It then uses Mean Variance Optimization (MVO) type technique to decide the risk and ‘safe’ allocations (it is also based on assets historical returns and risks data).

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. MyPlanIQ advocates a hybrid core satellite approach that adopts 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 selections

For Equities and REITs, we advocate using low cost index mutual funds or ETFs.

For fixed income (bonds), when it’s possible, we favor actively managed funds, especially total return bond funds (that can invest in any bond sectors but still keep overall interest rate risk close to intermediate and credit risk close to high quality bonds). These candidate funds are managed by excellent fixed income managers. On the other hand, we don’t advocate just simply holding such a bond fund forever. Instead, one should adopt a bond fund rotation/upgrade algorithm just like the one in our total return bond portfolios (see, for example, Schwab Total Return Bond).

401k or IRA

Other practical considerations include whether investors should roll over their 401k accounts from their previous work places to brokerage IRAs, and what strategies should be carried out in a 401k, IRA or a taxable brokerage account. We refer readers to read the full article or newsletter March 27, 2017: Practical Consideration For IRAs And 401k Accounts for more details

Market Overview

According to Factset, more than half of S&P 500 companies have reported last quarter’s earnings so far. The blended earnings growth is 9.1%, higher than the expected 6.5%. As July is ending, we are in the midst of summer. Investors have been complacent: markets are calm and volatility is again at its lowest level. In addition to the usual ‘overvalued’ stocks, high yield bonds have the lowest yields now since they had data. We again emphasize that investors should stay the course and manage portfolios accordingly based on a sound plan.

For more detailed asset trend scores, please refer to 360° Market Overview.

Now that the Trump administration has been in the office for more than half a year, it has stumbled and encountered many difficulties to implement its promised changes in terms of tax cuts, job stimulation and infrastructure spending. On the other hand, stocks continued to ascend, regardless of the progress. Looking ahead, however, we remain convinced that markets will experience more volatilities at some point when reality finally sets in.

In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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