The Core Four

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The Core Four

Postby Rick Ferri » Sun Dec 30, 2007 12:46 pm

.
A simple way to construct a portfolio is through core holdings and extended holdings. The core holdings account for a majority of a portfolio’s risk and return characteristics. The extended holdings provide the finishing touches.

This post introduces the “Core Four” funds, and provides a brief framework for selecting extended holdings. Core funds are the cornerstones of a portfolio. They are the base from which the rest of a portfolio sits.

The “Core Four” are:

Vanguard Total Stock Market Index Fund Investor Shares (VTSMX – fee 0.19%)
Vanguard FTSE All-World ex-US Index Fund (VFWIX – fee 0.40%)
Vanguard REIT Index Fund Investor Shares (VGSIX – fee 0.21%)
Vanguard Total Bond Market Index Fund Investor Shares (VBMFX – fee 0.20%)

An example of a 60% stock and 40% bond portfolio with the Core Four is:

36% VTSMX
18% VFWIX
06% VGSIX
40% VBMFX

The above assumes 60% of the equity in VTSMX, 30% in VFWIX, and 10% in VGSIX. Is that optimal? No one knows or can know. And quite frankly, it does not make much difference is you can add a percent here or subtract a percent or two there. It will not make much difference. For example, to keep things simple by using factors of 5%:

35% VTSMX
15% VFWIX
10% VGSIX
40% VBMFX

As Andy Rooney would say, “Close enough”.

The inclusion of extension funds can expand a portfolio beyond the core markets. Extension funds can explore new markets that are not included in the Core Four, or introduce investment strategies into a portfolio that attempt to add “Alpha”. Remember that it is not necessary to add extension funds because the Core Four drive a majority of investment performance. Extending the portfolio may earn you a slightly higher return, or lower the risk, or both. However, nothing is guaranteed.

Extension funds can explore other market that that are not included in the Core Four. For example, Treasury Inflation Protected Securities (TIPS) are not in the Vanguard Total Bond Market Index fund. Adding a TIPS fund hedges a portfolio against an unexpected increase in the inflation rate.

Extension funds are also used to tilt a portfolio to one style or another. For example, the inclusion of a value fund will overweight the style of a portfolio to value stocks in hope that a value premium will be earned for the extra risk taken.

Finally, extension funds may replace a core fund if the strategy behind the extension has the potential for higher risk adjusted returns. For example, rather than using the Vanguard FTSE All-World ex-US Index Fund, I prefer to use a 40% fixed weight in the Vanguard Pacific Stock Index Fund (VPACX – fee 0.22%), 40% in the Vanguard European Stock Index Fund (VEURX - fee 0.22%), and 20% in the Vanguard Emerging Markets Stock Index Fund (VEIEX – fee 0.37%). The slice and dice strategy has returned slightly higher returns than an All-World ex-US without adding more risk.

In summary, the Core Four is your starting point from which to expand. IMO, it can also be an ending point because those four funds explain a vast majority of investor risk and return. For people who want to explore more, you can add markets that are not in the core funds, add strategies such as overweighting value stocks, and create your own strategies by slicing and dicing.

Going into 2008, remember Von Clausewitz' epigram, "The greatest enemy of a good plan is the dream of a perfect plan."

Happy New Year ~ Stay the Course!

Rick Ferri
Last edited by Rick Ferri on Sun Dec 30, 2007 4:25 pm, edited 1 time in total.
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Re: The Core Four

Postby ramsfan » Sun Dec 30, 2007 12:59 pm

Rick Ferri wrote:.
A simple way to construct a portfolio is through core holdings and extended holdings. The core holdings account for a majority of a portfolio’s risk and return characteristics. The extended holdings provide the finishing touches.

This post introduces the “Core Four” funds, and provides a brief framework for selecting extended holdings. Core funds are the cornerstones of a portfolio. They are the base from which the rest of a portfolio sits.

The “Core Four” are:

Vanguard Total Stock Market Index Fund Investor Shares (VTSMX – fee 0.19%)
Vanguard FTSE All-World ex-US Index Fund (VFWIX – fee 0.40%)
Vanguard REIT Index Fund Investor Shares (VGSIX – fee 0.21%)
Vanguard Total Bond Market Index Fund Investor Shares (VBMFX – fee 0.20%)

An example of a 60% stock and 40% bond portfolio with the Core Four is:

36% VTSMX
18% VFWIX
06% VGSIX
40% VBMFX

The above assumes 60% of the equity in VTSMX, 30% in VFWIX, and 10% in VGSIX. Is that optimal? No one knows or can know. And quite frankly, it does not make much difference is you can add a percent here or subtract a percent or two there. It will not make much difference. For example, to keep things simple by using factors of 5%:

30% VTSMX
15% VFWIX
10% VGSIX
40% VBMFX

As Andy Rooney would say, “Close enough”.

The inclusion of extension funds can expand a portfolio beyond the core markets. Extension funds can explore new markets that are not included in the Core Four, or introduce investment strategies into a portfolio that attempt to add “Alpha”. Remember that it is not necessary to add extension funds because the Core Four drive a majority of investment performance. Extending the portfolio may earn you a slightly higher return, or lower the risk, or both. However, nothing is guaranteed.

Extension funds can explore other market that that are not included in the Core Four. For example, Treasury Inflation Protected Securities (TIPS) are not in the Vanguard Total Bond Market Index fund. Adding a TIPS fund hedges a portfolio against an unexpected increase in the inflation rate.

Extension funds are also used to tilt a portfolio to one style or another. For example, the inclusion of a value fund will overweight the style of a portfolio to value stocks in hope that a value premium will be earned for the extra risk taken.

Finally, extension funds may replace a core fund if the strategy behind the extension has the potential for higher risk adjusted returns. For example, rather than using the Vanguard FTSE All-World ex-US Index Fund, I prefer to use a 40% fixed weight in the Vanguard Pacific Stock Index Fund (VPACX – fee 0.22%), 40% in the Vanguard European Stock Index Fund (VEURX - fee 0.22%), and 20% in the Vanguard Emerging Markets Stock Index Fund (VEIEX – fee 0.37%). The slice and dice strategy has returned slightly higher returns than an All-World ex-US without adding more risk.

In summary, the Core Four is your starting point from which to expand. IMO, it can also be an ending point because those four funds explain a vast majority of investor risk and return. For people who want to explore more, you can add markets that are not in the core funds, add strategies such as overweighting value stocks, and create your own strategies by slicing and dicing.

Going into 2008, remember Von Clausewitz' epigram, "The greatest enemy of a good plan is the dream of a perfect plan."

Happy New Year ~ Stay the Course!

Rick Ferri


Great Post Rick, thanks! I only wish I had learned all this stuff 10 years ago, as I slowly and painfully "de-complex" my portfolio.
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Rick's Core Four

Postby Mel Lindauer » Sun Dec 30, 2007 1:00 pm

Hi Rick:

Great post! This will, no doubt, become a reference post that others can point newbies to. Thanks for all you do to help make this the best investing forum on the Internet.

Still reading your new The ETF Book.

Happy New Year to you and yours.

Best regards,

Mel
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Thanks Rick

Postby Bruce » Sun Dec 30, 2007 1:04 pm

Rick, good stuff, just curious, why not use

Vanguard Total International Stock Index Fund
VGTSX

for the international exposure??

happy new years,
Bruce
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Postby Jake46 » Sun Dec 30, 2007 1:07 pm

Rick,

Thank you for the post -- simple but elegant!
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Postby RTR2006 » Sun Dec 30, 2007 1:08 pm

Thank you for posting this.

RTR
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Postby Rick Ferri » Sun Dec 30, 2007 1:09 pm

Why not use Vanguard Total International Stock Index Fund
VGTSX


In a tax-exempt account it is "six of one, half dozen of the other." However, in a taxable account, the Vanguard FTSE All-World ex-US Index Fund is a fund of stocks and has pass through of foreign tax credits. The Vanguard Total International Stock Index fund does not because it is a fund-of-funds. Why not? Ask the IRS.

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Postby livesoft » Sun Dec 30, 2007 1:16 pm

Good stuff which I am migrating to. The 'core four' also have ETF share classes, VTI, VEU, VNQ and BND, right?

I'm wondering about slicing-and-dicing the fixed income portion between 4 funds: TIPS, short-term, intermediate-term and GNMA (tickers: VIPSX, VFSTX, VBIIX, and VFIIX).

Should one slice up fixed income or is total bond gonna do the job?
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Postby RTR2006 » Sun Dec 30, 2007 1:19 pm

Originally I was going to ask how efficient it was to slice and dice your VFWIX into Euro/Pac/Emerging at only slightly different weights than VGTSX. Then you mentioned the issue of taxes in a subsequent post.

How can it be that VGTSX has tax obligations but its components (VEURX, VPACX and VEIEX), which you selected to replace VFWIX, do not?

RTR
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Postby Adrian Nenu » Sun Dec 30, 2007 1:21 pm

This is Scott Burns' Global Couch Potato portfolio with TIPS and REITs added.

I really dislike the use of the word "core" because it reminds me of Schwab's "core and explore" marketing. Each asset class is equally important, like the legs of a table. If they are not and held only in minimal quantities with little effect on portfolio diversification and return, why even bother using them?!



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Postby Trebor » Sun Dec 30, 2007 1:26 pm

Very nice!

I would consider Tips to be a "core" holding since it is not covered at all in your top four. Likewise, I would move Reits to "extended" since they are already part of the total market index. All in all this is great stuff. It is just the way I like to think about it.

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Postby Rick Ferri » Sun Dec 30, 2007 1:30 pm

How can it be that VGTSX has tax obligations but its components (VEURX, VPACX and VEIEX), which you selected to replace VFWIX, do not?


Foreign governments withhold parts of dividend's paid to US shareholders. That is a foreign withholding tax. You can claim that tax as a tax credit on your taxes if your international stock (or stock index fund) is in a taxable account. However, the IRS says that you cannot claim the tax credit on VGTSX because it is a fund of funds.

As such, in a taxable account, it is better to own fund that own stocks rather than own funds that own other funds.

Hope that helps.

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Postby Levett » Sun Dec 30, 2007 1:33 pm

Let's see. Do I second, third, fourth, fifth, or what?

Ah, hell. It's essentially where I've ended up (TIPS in the mix) with non-annuitized portfolio thanks to Rick. Bob U.
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Postby il_gancio » Sun Dec 30, 2007 1:38 pm

Hi Rick,
I am long-time lurker whose AA is largely influenced from having read your All About Asset Allocation book. From your "Building Your Portfolio" chapter, I understood your suggestions for Early Savers and Mid-Life Accumulators to have a 10% of your total portfolio allocated to REITs. In your post here, you describe it as 10% of your stock allocation. I realize that you may be rounding numbers for simplification, but I have enough experience that I am interested in your more precise suggestion.

So for a 70% stock, 30% bond portfolio, do you recommend 10% allocation to REIT or 7% (10% of 70% stock)?

Thanks so much for your great books and contributions to this forum!!!

-Il Gancio
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Postby foodnerd » Sun Dec 30, 2007 1:41 pm

Rick, my question to you (and to the forum) is that won't the cost difference between All World Index versus the Total International index also make some of the difference in tax deferred accounts (.4 for All World vs .27 for Total Int). Will the tax credit make up that difference in the taxable account?

FN
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Postby bolt » Sun Dec 30, 2007 2:03 pm

[removed at request of poster]
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Postby Paulo » Sun Dec 30, 2007 2:06 pm

With regards to international diversification of fixed income allocations, a very nice resource is at Everbank which is available online. This is a US based bank, with FDIC insured accounts. I use there foreign currency combination 3 month CDs.
There is a Commodity exporting index CD that is a combination of Australian $, New Zealand $, Canadian $, and South African Rand and yields 5.40 %.
Hard to beat that. There is also a Prudent Central Bank "index" CD comprised of Brittish pound, Euros, Australian $ and New Zealand $. There are several others: World energy, non-Opec oil countries, and others. Go to the everbank website and navigate to the "World Currency Index CD"s. The CD's roll over every term unless you request otherwise. They provide excellent service with advanced e-mail and snail mail notification. Great way to hedge the dollar and diversify fixed-income in my opinion.
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Postby DaveTH » Sun Dec 30, 2007 2:32 pm

Paulo wrote:With regards to international diversification of fixed income allocations, a very nice resource is at Everbank which is available online.

You probably don't want to be doing this in a taxable account. Aren't gains from currencies taxed at the 28% rate? I would definitely recommend exploring the tax implications before perusing this investment option.
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Re: The Core Four

Postby DA » Sun Dec 30, 2007 3:09 pm

Rick Ferri wrote:Extension funds can explore other market that that are not included in the Core Four. For example, Treasury Inflation Protected Securities (TIPS) are not in the Vanguard Total Bond Market Index fund. Adding a TIPS fund hedges a portfolio against an unexpected increase in the inflation rate.

Rick Ferri


Rick,

Thanks for a great post. I enjoy reading your commentary here and I've also read All About Asset Allocation.

I understand the diversification and protection from unexpected inflation that TIPS bring to a portfolio.

What I can't wrap my arms around is how much of the portfolio is best allocated to TIPS (Vanguard's VIPSX, in my case).

Some folks here allocate 50% or more of their fixed income to TIPS. Others allocate less. Some choose not to include TIPS in their portfolio.

In All About Asset Allocation you recommend 10% of the portfolio for retirees. I don't have the book in front of me, but I believe you also recommend the 10% for an accumulation investor.

Would you share with us your thinking behind the 10% recommendation?

Thanks

Dan
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Postby RTR2006 » Sun Dec 30, 2007 3:13 pm

Thanks for the clarification...I'll take this to heart as I do some re-balancing early in the new year.

Kind regards,

RTR

Happy New Year to all!!

:D
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Postby Munir » Sun Dec 30, 2007 3:24 pm

Would you recommend the same percentages for a retiree in the distribution phase? If not, what percentages would you suggest?

A couple of people have asked if a TIPS fund can replace REITS since TSM already has REITS. What do you think?

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Postby Amishman » Sun Dec 30, 2007 3:32 pm

So much for the simplicity of the "Core Four" :D
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The "Core Four" Fund Portfolio !

Postby Taylor Larimore » Sun Dec 30, 2007 3:41 pm

Hi Rick:

Few investors have more experience and knowledge about portfolio construction than you do. Your simple and elegant "Core Four" portfolio is one of the very best I have seen. It has the virtues of:

Very low cost
Very diversified
Very tax-efficient
Very simple to understand, rebalance and maintain


It is not often we see simple portfolios from the investment industry. They want us to believe that investing is too complicated for investors to do themselves.

Thank you and Happy New Year!
Taylor
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Postby DRiP Guy » Sun Dec 30, 2007 3:44 pm

Amishman wrote:So much for the simplicity of the "Core Four" :D


he he he

You knew it would not stay unmarred for long, with so many tinkerers around!

I think most of us (I hope :shock: ) are just doing the mental 'what-ifs' not really jumping from "allocation scheme of the day"...
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no to tinkering!

Postby Murray Boyd » Sun Dec 30, 2007 3:48 pm

I like it. Just say no to tinkering!

However, I do think every portfolio should add up to 100%. :)
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"Tinkering"? YES !

Postby Munir » Sun Dec 30, 2007 4:00 pm

What is being called "tinkering" I would describe as adjusting Rick's recommendations to one's individual situation such as age, retiree, distribution phase etc..I doubt if Rick means his recommendations to be cast in stone in the exact percentages he lists. After all, he does call it "core" and allows extenders.

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Re: no to tinkering!

Postby stan1 » Sun Dec 30, 2007 4:14 pm

Murray Boyd wrote:However, I do think every portfolio should add up to 100%. :)


I'm amazed 23 posts before you didn't catch that! The Diehard INTJs must be on a holiday slump!
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Postby Rick Ferri » Sun Dec 30, 2007 4:25 pm

Ooops! Your are right, Stan!

30% VTSMX
15% VFWIX
10% VGSIX
40% VBMFX

Does not add up to 100%

:oops:

So, let's go with:

35% VTSMX
15% VFWIX
10% VGSIX
40% VBMFX

BTW, with the edit feature of this forum I took the liberty to change my original post to the above allocation.

Rick Ferri
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Postby BigD53 » Sun Dec 30, 2007 4:25 pm

Thank you Rick. I like the simplicity of your core four (with extensions) portfolio. It reminds me of my Vanguard Target Retirement Income fund.

VTINX
Allocation To Underlying Funds as of 11/30/2007

Vanguard Total Bond Market Index Fund 45.1%
Vanguard Total Stock Market Index Fund 24.4%
Vanguard Inflation-Protected Securities Fund 19.9%
Vanguard Prime Money Market Fund 4.5%
Vanguard European Stock Index Fund 3.4%
Vanguard Pacific Stock Index Fund 1.5%
Vanguard Emerging Markets Stock Index Fund 1.2%

After I retire, I would like to trim my portfolio to include this one simple fund. I want to enjoy my retirement and not worry about my investments. I intend to keep 25% to 30% in equities at all times. The Vanguard Target Retirement Income fund fit my needs very nicely.
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Postby Murray Boyd » Sun Dec 30, 2007 4:29 pm

And it took an ENTP to do it!

I think when someone is worried about if they should invest 1.5% of their portfolio in Emerging Market Small Value or Emerging Market REIT, that's tinkering.
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Postby ramsfan » Sun Dec 30, 2007 4:51 pm

foodnerd wrote:Rick, my question to you (and to the forum) is that won't the cost difference between All World Index versus the Total International index also make some of the difference in tax deferred accounts (.4 for All World vs .27 for Total Int). Will the tax credit make up that difference in the taxable account?

FN


foodnerd, see my post in this thread.
http://www.diehards.org/forum/viewtopic.php?t=10424
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Postby bottlecap » Sun Dec 30, 2007 5:22 pm

Thank you very much, Rick. It is a good and timely ('tis the New Year, after all) post. Thanks to those involved in the discussion about the FTSE ETF v. the Total Int'l as well.

JT
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Postby SmallHi » Sun Dec 30, 2007 6:02 pm

I am all for simplicity. When I see 12 to 15 asset class portfolios, I just scratch my head...

That being said, I think it is a huge mistake to ignore the Fama/French 5 Factor model (Equity, Size, Price, Credit and Term risk) when developing an asset allocation. One should at least consider a multifactor investing as the CORE part of their portfolio.

First of all...multifactor investing isn't really all that complicated. If you've taken the time to register on this forum or read a decent books, I'm sure you can figure it out.

Secondly, in many periods, your equity tilt is as important, or more important than your equity to fixed income ratio.

Thirdly, if you can cut through all the noise, there are a number of high quality, low cost smaller and more value oriented options now available for the retail investor, and Dimensional has made "tiltiing" just as easy, and almost as tax efficient as TSM investing with the advent of their Core strategies.

Fourth, a multifactor tilted portfolio's expected returns can be easily estimated based on risk exposure and estimate of risk premiums (with the aid of 80 years worth of historical data).

Fifth, an investor with multifactor intensions is more able to customize their asset allocation to account for their unique personal situation (concerns about volatility, tracking error, human capital risk, concerns about portfolio losses and the timing of those losses)

Sixth, investors who choose to tilt are able to achieve necessary diversification without incorporating sector-like specific portfolios (REITS) with industry specific risk.

Seventh, multifactor investors are able to spread their equity risks across market dimensions. Size and Value exposure does increase timing and volatility risks, but can serve to offset long periods where beta risk does not produce a return premium. Every few decades, beta has gone 10 to 15 years without producing a return premium. Bettiing all of your risky "growth" $ on beta is unnecessarily concentrated. Furthermore, it is well documented that Beta only explains approximately 65% of equity portfolio returns, while size and value factors increase that number to almost 95%. If we understand how markets work and where returns come from, it is not prudent to ignore those options as part of your CORE allocation.

Eighth, looking at "beta" exposure as the CORE of a portfoliio, and size/value tilts as an EXTENSION will likely result in an investor timing in and out of value and small dimensions as popularity waxes and wanes. This will promote performance chasing behavior in the vast majority of investors, likely causing them to underperform the allocation they've chose

Nineth, its been pretty well documented that investors are better off taking their risks on the equity side of the portfolio (the payoffs are larger and more persistent for a given level of risk), and ratcheting down the fixed income risk (call risk, credit risk, and significantly longer term bonds add uneeded and unrewarded risk, complexity, and agency issues). A TSM/TBM portfolio is completely agnostic to this.

Finally, you'll be less likely to chase higher cost active management strategies whose recent returns appear to be "positive alpha", but in reality are just multifactor (value or small tilted) strategies.

Bottom line, not everyone should tilt away from the market, but everyone probably should consider multifactor investing. There is no reason to expect a positive global equity risk premium, as Rick has apparently done with his original post, without also expecting positive expected returns to size and price dimensions of the worldwide equity markets.

SH
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more tinkering, er, i mean fine-tuning

Postby 1210sda » Sun Dec 30, 2007 6:10 pm

If you don't like 60/40, then try this

VTSMX 35%
VFWIX 15%
VGSIX 10%
Tot Equities 60%

Therefore,
VTSMX is 35%/60% or 58.33% of equities (round off to 60%)
VFWIX is 15%/60% or 25.00% of equities
VGSIX is 10%/60% or 16.67% of equities. (round off to 15%)

Choose the percent you want for equities and multiply by the above
percents (60%, 25%, & 15%). For example a desired 80% allocation to equities would work out to 48% VTSMX; 20% VFWIX & 12% VGSIX. The remaining 20% to reach 100% would go to VBMFX

Hope this works for you

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Postby Rick Ferri » Sun Dec 30, 2007 6:45 pm

SmallHi

As you say, there are many ways to 'tilt' away from a portfolio of market risk, and I am not against any of those ways if an investor fully understands what that means. That does not change the fact that pure market risk is where every investor should begin. That is the way Fama/French envisioned their three-factor model to work, i.e. start with market risk and add value and size risk to it if you want too.

IMO, a portfolio of market risks is where many investors should end. I agree that value and size risks are not too difficult to comprehend for experienced investors, but three-factor investing is an advanced strategy. Unfortunately, for less experienced or disciplined investors, when value and small stocks are out of favor, good intentions typically go by the way-side and emotions take over. And we all know what happens when emotions rule investment decisions! As such, many investors would be better off not doing a three-factor portfolio.

Again, I have no issue with experienced and disciplined investors doing a three-factor portfolio. But I cannot recommend that everyone do it. To assume that everyone is sophisticated is just no reality. And it takes a deep understanding of the strategy to stick with it during long periods of under-performance.

Rick Ferri
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Postby Robert T » Sun Dec 30, 2007 8:20 pm

.
Rick,

Thanks for the post – very useful. I agree that the total market is often a useful endpoint for many investors and for some a useful starting point from which to tilt (reasons often cited for tilting include to diversify human capital risk with higher international allocations and to achieve higher needed expected return with a greater small and value tilt).

As new investment products are continuously becoming available, as witnessed by the rapid rise in ETFs, I find a more constant framework is to have targets for exposure to the four core risks, the four core markets, and caps for the four core costs (as listed below – at least this has been helpful for me). Fund selection may change overtime as new, cheaper, more tax efficient, better structured etc. products become available (as with the recent Vanguard FTSE All-world ex-US Index fund) but the targets in the areas listed below should remain more constant thus forming a firmer bedrock/foundation for portfolio decisions. Fund selection within this framework is then to minimize costs per unit of desired (and consistent) risk exposure across the four core markets.

The ‘Core Four’ risks which drive portfolio returns

    Market (stocks vs bonds)
    Size (small cap vs large cap stocks)
    Value (value vs growth stocks)
    Term (longer term versus short term fixed income)
The ‘Core Four’ markets, which when combined, reduce the volatility of portfolio returns
    US Equities
    Non-US Developed Market Equities
    Emerging Market Equities
    US Treasuries
The ‘Core Four’ costs which when reduced (or minimized) can enhance portfolio returns
    Expense ratios
    Taxes
    Trade costs
    Advisor fees (and wrap account fees)
And perhaps to add importantly:- The ‘Core Four’ emotions which if not kept in check can devastate returns:
    Tracking error regret (with the market and ‘hot’ sectors or asset classes)
    Myopic loss aversion
    Overconfidence
    Impatience
An IPS can help keep emotions in check (it has been personally helpful, at least so far:).

Just a few additional thoughts.

Happy New Year!

Robert
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Rick --

Postby SmallHi » Sun Dec 30, 2007 8:59 pm

...pure market risk is where every investor should begin. That is the way Fama/French envisioned their three-factor model to work, i.e. start with market risk and add value and size risk to it if you want too.


Actually, I look at it the exact opposite way. The FF 5 Factor Model explains over 95% of the returns to a diversified portfolio of stocks and bonds. FF5F has displaced CAPM as the asset pricing model of choice for most investors/analysts based on its significantly improved level of explainability. When making stock & bond investments, ideally we want to use the asset pricing model with the greatest explainatory power as our roadmap.

With that in mind, multifactor investors have a multitude of investment options, none of which necessarily predates or supercedes any other. As a matter of fact, I could make the argument that an investor's chief goal is to determine the level of size and price exposure within the context of their equity portfolio, and then determine how much equity they are comfortable holding relative to fixed income.

For many investors, their relative size and value tilts are as or more important than their equity/fixed ratio for a number of reasons:

a) over some periods, the relative payoffs to size and (more typically) price are larger than the equity v fixed payoff

b) for many investors, the equity/fixed decision is a moving target...starting off favoring equities, and gradually becoming more conservative with age

The relative size/price decision, on the other hand, is likely a "one and done" decision. If you want to give yourself the greatest likelyhood of capturing the premiums, you probably need to establish a permanent tilt and (as Fama says...) "ride it to the beach".

IMO, a portfolio of market risks is where many investors should end.


US investors who have lived through the 66-82 or 00-07 markets may disagree with you. All Japanese investors of this generation may also have a bone to pick with this contention...

Direct risks (the equity/fixed decision) and dimensional risks (size, price, term, and default) both have and will continue to have random periods where investors don't earn a return commensurate with their assumed risk. But they have very low and in some case negative correlations, so assembling a portfolio that contains a greater number of mutifactor dimensions for a given level of risk should hedge an investor better than just chosing one (beta) and keeping their fingers crossed.

It is very important that all investors understand this (new and seasoned). Those that don't learn history are doomed to repeat it!

I agree that value and size risks are not too difficult to comprehend for experienced investors, but three-factor investing is an advanced strategy.


I guess I just don't see how diversifying internationally or diversifying into an industry specific fund like REITS is LESS advanced than a decision to tilt to smaller or more value oriented shares? Advanced or not, flat out ignoring 2 key variables in the most widely accepted asset pricing model we have seems a bit imprudent.

Unfortunately, for less experienced or disciplined investors, when value and small stocks are out of favor, good intentions typically go by the way-side and emotions take over. And we all know what happens when emotions rule investment decisions! As such, many investors would be better off not doing a three-factor portfolio.


The tracking error that stems from international diversification or REIT investing is greater than that of domestic small and value decisions. Consider the notorious 95-99:

Code: Select all
ASSET CLASS          Ann RET

S&P 500              +28.6%
US LV                +21.9%
US Small             +20.5%
EAFE                 +12.8%
REITS                 +8.3%
EM Markets            +2.0%


When you are out of favor, you're out of favor. Sometimes EAFE, EM, and REIT markets tank, and you seriously question your allocation there. Other times, small and/or value stocks languish. Either way, you are going to feel left in the cold. This isn't a basic v. sophisticated thing, its a way of life for investors who maintain strategic asset allocations.

Again, I have no issue with experienced and disciplined investors doing a three-factor portfolio. But I cannot recommend that everyone do it. To assume that everyone is sophisticated is just not reality. And it takes a deep understanding of the strategy to stick with it during long periods of under-performance.


For investors with any reasonable degree of net worth, they owe it to themselves to spend the time educating theirselves on how markets work, and how they can be their own worst enemies when it comes to investing. There is a enormous potential payoff to getting this stuff right over the course of ones lifetime...I just cannot see advocating REIT and Global investing, but yet ingorning the various dimensions of equity markets for fear of complication? Your books are as good as they get, but Swedroe, W. Bernstein, Armstrong and Schuelthesis have also done great work. To completely ignore a major aspect of global markets (small stocks and high Btm shares) just doesn't seem reasonable in even the most basic of investment plans.

Look at DFAs Global Equity funds, for example. Likely designed for the small 401k investor, they offer a tremendous amount of global diversification and reasonable size/value exposure for even those committing $25/month (the same investor I assume your 4 fund portfolio is designed for). I see no reason DFA Global investors should have all the fun!

Thats all.... :D

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Postby Rick Ferri » Sun Dec 30, 2007 9:36 pm

Rober T

Thank you for that fine post.


SmallHi,

I agree with what you are saying, although I think you are overstating the importance of using the three factor model in portfolio management. Using it is just not that critical. Developing a plan and staying consistent is the most critical factor of any investment plan.

FF research shows that CAPM explains 70% of diversified portfolio's return. CAPM is based on a function of beta, or market risk. The three factor model explains 95% of a diversified portfolio's return, with beta being the dominant of the three factors!.

Any way you slice the data, it comes back to the basic fact that market risk (beta) is the dominant factor driving portfolio returns. And I believe Fama and French would agree.

That being said, if people want to diversify beyond market risk (or beta), that is fine with me as long as they fully understand the risk. Investing in any strategy without understanding risks eventually leads to breakdown.

Rick Ferri
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Postby Michael Weiss » Sun Dec 30, 2007 9:41 pm

Rick Ferri wrote:
Unfortunately, for less experienced or disciplined investors, when value and small stocks are out of favor, good intentions typically go by the way-side and emotions take over. And we all know what happens when emotions rule investment decisions!



Rick,

I can appreciate you trying to make investing as simple and realistic for the average investor. However, the argument above regarding bailing out of value strategies could be applied to any strategy. Plenty of experienced and inexperienced investors bail out of core and growth stretegies when those strategies fall out of favor as well. I don't think there is anything unique about how investors view value or small strategies when they are of favor.

I guess your argument is based on the long term volatility of these strategies...Not all value strategies are aggressive and if you look at the data from 1969, value stocks are actually less volatile than growth stocks.

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Postby Rick Ferri » Sun Dec 30, 2007 10:38 pm

the argument above regarding bailing out of value strategies could be applied to any strategy....I don't think there is anything unique about how investors view value or small strategies when they are of favor.


MW,

You are absolutely correct. We just got on the topic of three factor investing in the general course of the conversation.

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Don't mess with The Core Four

Postby cfs » Sun Dec 30, 2007 10:55 pm

Just when I had all the answers they changed the questions on me ...

I like this!!!

35% VTSMX
15% VFWIX
10% VGSIX
40% VBMFX
~ Muchas gracias for reading - Señor Fig | | Semper Fortis ~
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Postby stepjone » Sun Dec 30, 2007 11:12 pm

Rick:

Great Post!

Just one question: Does this "Core Four" allocation apply to those in thier younger years as well.....say 25-35 yrs of age? I am so new at the investing that I thought I would ask.

Stephen
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Rick, a question

Postby CountryBoy » Sun Dec 30, 2007 11:16 pm

Rick, I bought your ETF Book and am continuing to study it. I am wondering if it could be more efficient for some people to buy some of the Core funds in ETFs.

For example if one knows that they are a DH and are going to put money in 'for the long haul' and not trade ETTs then couldn't it be more efficient to buy say VTSMX in the ETF equivalent?

Thanks.

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Postby Sunny Sarkar » Sun Dec 30, 2007 11:21 pm

Rick Ferri wrote:The three factor model explains 95% of a diversified portfolio's return, with beta being the dominant of the three factors!.

Any way you slice the data, it comes back to the basic fact that market risk (beta) is the dominant factor driving portfolio returns.


Hi Rick,

If that is the case, why not stay with market risk - why then the 10% REITs? Why not simply stay with Taylor's 3 musketeers: Total US/Intl/Bond Index?

I guess I'm not understanding the logic behind adding 10% REITs yet not adding SV to the total market portfolio. If the goal is to keep it simple and avoid tracking error risk for the unsophisticated investor, doesn't the total market portfolio looks even better?

Regards,
Sunny
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Re: Rick, a question

Postby Sunny Sarkar » Sun Dec 30, 2007 11:29 pm

CountryBoy wrote:For example if one knows that they are a DH and are going to put money in 'for the long haul' and not trade ETTs then couldn't it be more efficient to buy say VTSMX in the ETF equivalent?


I always thought that buying ETFs is more efficient for a one time purchase buy&hold strategy, while the fund is better for those like me who accumulate little by little every paycheck.
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Re: The Core Four

Postby sgr000 » Sun Dec 30, 2007 11:30 pm

Rick Ferri wrote:Going into 2008, remember Von Clausewitz' epigram, "The greatest enemy of a good plan is the dream of a perfect plan."

When alluding to von Clausewitz, it's good to remember the countervailing opinion from the Graf von Moltke: "No battle plan survives contact with the enemy."
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Small Cap and Value Stock performance?

Postby Taylor Larimore » Sun Dec 30, 2007 11:33 pm

Hi Bogleheads:

"Recency" has made value and small-cap stocks popular (and maybe rightly so). However, it is helpful to go back and look at SCV domestic stock performance reported by Morningstar for various periods ending 6-30-00:

Style.......1 Yr.....3 Yr......5Yr....10 Yr....15 Yr.
LCG......27.19...27.04...24.98..17.85....17.15
LCB........8.93...17.29...20.35..15.60....15.23
LCV.......-5.21.....8.74...15.16..13.36....13.45

MCG.....57.24...31.09...24.81..18.14....16.82
MCB.....11.87...12.36...16.09..14.12....14.23
MCV......-2.56.....7.23...13.20..12.77....12.64

SCG......55.14...24.42...20.86..17.12....15.64
SCB......17.77...10.08...15.30..13.03....12.02
SCV........3.29.....3.55...12.58..11.80....11.34

Best wishes and Happy New Year!
Taylor
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Re: The Core Four

Postby kiki » Mon Dec 31, 2007 12:39 am

Rick Ferri wrote:Finally, extension funds may replace a core fund if the strategy behind the extension has the potential for higher risk adjusted returns. For example, rather than using the Vanguard FTSE All-World ex-US Index Fund, I prefer to use a 40% fixed weight in the Vanguard Pacific Stock Index Fund (VPACX – fee 0.22%), 40% in the Vanguard European Stock Index Fund (VEURX - fee 0.22%), and 20% in the Vanguard Emerging Markets Stock Index Fund (VEIEX – fee 0.37%). The slice and dice strategy has returned slightly higher returns than an All-World ex-US without adding more risk.


Rick, thank you for the post. I'm curious on the above comment, since I'm in the process of deciding to slice and dice these funds or buy a single fund. Would you recommend doing this in a taxable account? It's been mentioned that these fund's dividends won't fully quality for the foreign tax credit, but I'm wondering if the slightly higher return would offset the loss of the tax credit. Thanks again!
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Postby DaveTH » Mon Dec 31, 2007 5:56 am

kiki wrote:It's been mentioned that these fund's dividends won't fully quality for the foreign tax credit

Actually I believe what was mentioned in a previous post is that the 3 individual funds did not have 100% qualified dividends whereas the All-World ex/US fund did.
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Postby SmallHi » Mon Dec 31, 2007 8:56 am

Taylor,

"Recency" has made value and small-cap stocks popular (and maybe rightly so). However, it is helpful to go back and look at SCV domestic stock performance reported by Morningstar for various periods ending 6-30-00:


To the extent that your post helps investors realize that SV doesn't always outperform the S&P 500, it is helpful. Beyond that, its a questionable comment...

I know its one of your favorite charts, might you consider adding the following (*)s the next time you use it so first time investors can see the whole story?

(*) From wikipedia: Data mining is the principle of sorting through large amounts of data and picking out relevant information

(*) Morningstar calculates style returns using the performance of the surviving funds in each category over the given period. No serious investor considers the performance of surviving funds as an actual performance barometer. (thats why indexes were invented)

(*) For all calendar 15 year rolling periods since July of 1927, US SV has underperformed the S&P 500 8 times out of 67. Over this same period, the S&P 500 has underperformed 5YR T-Notes 7 times out of 67. The persistence of USSV over the S&P 500 is equal to the persistence of the S&P 500 over Treasury Notes and not unique to the last few years.

(*) For all calendar 15 year rolling periods since July of 1927, US SV has outperformed the S&P 500 by 4.7%. Over this same period, the S&P 500 has outperformed 5YR T-Notes by 5.7%. The stock/bond decision has been only marginally more profitable than the S&P 500/USSV decision and not unique to the last few years.

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