The Core Four

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.

Thanks, Rick

Postby Xia » Wed Jan 02, 2008 10:40 am

Rick Ferri wrote:Xia,

If you are in the high tax bracket, REITs and the Total Bond Market Index Fund are not tax savvy investments in a taxable account. They would go into a non-taxable account if you have one.

If you have only taxable money to invest, then I would recommend Taylor's Thrifty Three portfolio as your core and substitute the Vanguard Intermediate-Term Tax-Exempt Fund Admiral Shares (VWIUX - fee 0.08%) for the Total Bond Market Index Fund.

Rick Ferri


Thank you very much for your quick response, and for the advice.

I am in a low tax bracket, since my only income is from my investments. So that income, combined with my (still working) husband's income puts us in the 15% federal tax bracket. My investments are almost all taxable, I only have ~ 6.5% in tax-deferred. I currently hold individual stocks and bonds (in the taxable account) and intend to switch to Vanguard mutual funds at some point over the next month or two. I will look up Taylor's Thrifty Three port.

Thanks again for your assistance!
Xia
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Re: Thanks, Rick

Postby CyberBob » Wed Jan 02, 2008 11:57 am

Xia wrote:I will look up Taylor's Thrifty Three port.

Here is a link.
It's actually a four-fund portfolio if you include the money market fund. ;)

Here is an interesting book on that type of portfolio as well: The Smartest Investment Book You'll Ever Read: The Simple, Stress-Free Way to Reach Your Investment Goals by Daniel R. Solin.

Bob
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Re: Thanks, Rick

Postby Rick Ferri » Wed Jan 02, 2008 12:14 pm

Xia wrote:I am in a low tax bracket, since my only income is from my investments. So that income, combined with my (still working) husband's income puts us in the 15% federal tax bracket.


The Core Four is fine in your taxable account because you are in a low tax bracket.

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Postby Xia » Wed Jan 02, 2008 12:20 pm

Thanks, Bob!

I am so glad I found this forum.

Happy New Year!
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Re: Thanks, Rick

Postby Xia » Wed Jan 02, 2008 12:28 pm

Rick Ferri wrote:
Xia wrote:I am in a low tax bracket, since my only income is from my investments. So that income, combined with my (still working) husband's income puts us in the 15% federal tax bracket.


The Core Four is fine in your taxable account because you are in a low tax bracket.

Rick Ferri


Excellent! Sounds like a good place to start. I also like that 3 of those core four funds are available in admiral shares, too, for even more cost savings.

Thank you so much for taking the time to answer my questions, Rick, it is much appreciated.

Thanks again to you, too, CyberBob.

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Postby baw703916 » Wed Jan 02, 2008 1:07 pm

Just a short comment on Rick's post a while back on the "Mutual Fund vs. ETF" question.

Things end up a little more in favor of the ETF share class in the case of FTSE All World ex-US than in the case of TSM:

-All World ex-US has a slightly larger expense differential between Investor shares and ETF shares (0.15%) than does TSM (0.12).

-All World ex-US doesn´t have Admiral shares, TSM does.

-All World ex-US has an 0.25% charge to buy and sell for the mutual fund (but not the ETF) shares, TSM doesn´t

Depending on one´s brokerage account, fees, and amount invested, the 0.25% might outweigh the commission and buy/sell spread on the ETF shares.

Happy New Year everyone,
Brad
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Postby bonjallon » Wed Jan 02, 2008 5:39 pm

Dear Rick,

I just bought your ALL ABOUT ASSET ALLOCATION book and very much look forward to reading it.

My question is about the pros & cons of ETF vs. traditional index fund investing in light of new COMMISSION-FREE accounts offered by Wells Fargo & B of A. From what I understand, ETFs offer the benefits of higher tax-efficiency and lower costs, but can include add'l trading costs, bid/ask discrepencies, and the possibility of buying shares above NAV. But with the advent of these new COMMISSION-FREE accounts, are the ETF versions of your "Core Four" funds now the superior choice for making regular investments in a taxable account (especially for a high-tax bracket investor)?

Thanks for all your help,

John
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Postby livesoft » Wed Jan 02, 2008 6:20 pm

bonjallon wrote:My question is about the pros & cons of ETF vs. traditional index fund investing in light of new COMMISSION-FREE accounts offered by Wells Fargo & B of A. ....


Rick is getting it from all sides: http://www.diehards.org/forum/viewtopic.php?t=10522
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Postby SmallHi » Wed Jan 02, 2008 6:44 pm

Eric wrote:I do think there's a tension in Fama's position -- he has said that he does not advocate value tilting (generally), yet he is also associated with DFA. But I don't think the tension is as great as you suggest. Certainly, Fama would agree that value-tilting is appropriate for some investors, and if DFA wants to exploit that market niche, why shouldn't he help?


Eric, it is simply not true that Fama has said he generally does not advocate value tilting.

As a matter of fact, you are contradicting yourself in the same paragraph. You can not generally advise against value tilting, and then say its fine for some investors? If you think it is fine for some investors, then you don't advise against it, right?

The fact is, Fama is indifferent whether or not investors value tilt or growth tilt, as long as they do so in a diversified manner and understand the implications of their decisions on their level or risk and expected returns.

That, in a nutshell, was my contention with the original post. Building a portfolio out of global beta and REITS without any discussion of the particular risks of such a position flies in the face of a CORE allocation.

Bottom line, size and value tilts are a worthwhile consideration for any investor and should be considered for the CORE of anyone's investment allocation. It is generally unnecessary to include REITS after one has attained their multifactor tilt.

For example...for those with an advisor, there will be plenty of investors who find using DFAs 3 Core Equity portfolios (US/Int'l/EM total market allocations with a moderate size/value tilt) and a ST bond portfolio to be a superior allocation to using US TSM, Int'l TSM, and EM TSM and REITS.

For those same investors without an advisor using ETFs, a TSM/SV/EAFE Value/EAFE Small/EM allocation will be preferable...(assuming they can handle the hastle of adding 1 more fund :lol: )

SH

PS -- for the video interview, click the video tab on dimensional.com and watch the Fama interview. The French one is also time well spent.
Last edited by SmallHi on Wed Jan 02, 2008 6:47 pm, edited 1 time in total.
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Postby Rick Ferri » Wed Jan 02, 2008 6:46 pm

LiveSoft, thanks for posting the link.

I will make just one comment here. Commission free does not mean cost free.

Rick Ferri
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Postby bonjallon » Wed Jan 02, 2008 6:50 pm

LiveSoft, thanks for the link. Rick, thanks for your swift reply. Keep up the great work!
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Postby Rick Ferri » Wed Jan 02, 2008 6:53 pm

SmallHi wrote:

The fact is, Fama is indifferent whether or not investors value tilt or growth tilt, as long as they do so in a diversified manner and understand the implications of their decisions on their level or risk and expected returns.


I would agree with that assessment. The key is understanding, and IMO, the 3-factor model is more sophisticated than you are suggesting. I would venture to guess that less than half of financial advisors including brokers have heard of the 3-factor model and only a small fraction could tell you how it works.

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Postby Eric » Wed Jan 02, 2008 7:15 pm

SmallHi wrote:Eric, it is simply not true that Fama has said he generally does not advocate value tilting.

As a matter of fact, you are contradicting yourself in the same paragraph. You can not generally advise against value tilting, and then say its fine for some investors? If you think it is fine for some investors, then you don't advise against it, right?


I did not say that Fama "generally advise[s] against value tilting." I said, and his statements confirm, that he does not generally advocate value tilting. Those are two very different statements. Based on your latest posts, I think we're actually in agreement on the latter point.

To illustrate a specific case where I think Fama would advocate value tilting, consider an executive at a large growth company. Fama might well encourage that executive to overweight small value stocks. I had an example like this in mind when I used the qualifier "generally."
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Postby SmallHi » Wed Jan 02, 2008 7:22 pm

(to nobody in particular) more on Fama....

The more I think about Fama's position based on everything I have read and studied and heard first hand -- he would probably agree with the fact that multifactor investors using his research and asset pricing models as a guide will need to tilt their equity portfolios to achieve the same level of risk as a TSM/TBM investor.

Consider this...we know Fama has a preference for ST bonds (probably 1YR Fixed), and is also fond of TIPS (lets say a TIPS fund). This fixed income allocation is much less risky v. TBM, and less risky when introduced in a balanced portfolio framework (based on what we know about the interaction between very short term nominal bonds and TIPS with equities).

Therefore, at least a mild global equity tilt (say Core 1 or Core 2) would be required to bring a multifactor investors' portfolio level risk in line with a TSM/TBM investor.

I would imagine Fama would view both of the portfolios below of equal risk and viabliity for the knowledgeable investor depending on their tastes and willingness to "ride it to the beach":

42% US TSM
12% Int'l EAFE
6% EM Index
40% Total Bond Index

AND

42% US Core 2
12% Int'l Core
6% EM Core
20% 1YR Fixed
20% TIPS

For what its worth, I agree (and wouldn't care if Fama disagreed). Just my opinion.

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Postby baw703916 » Thu Jan 03, 2008 11:44 am

bonjallon wrote: From what I understand, ETFs offer the benefits of higher tax-efficiency


Hi John,

A subtle point. The reason that ETFs can be more tax efficient is that redemptions don´t generate a capital gain for the fund, but for traditional mutual fund shares they do.

But all the Vanguard funds being discussed here have both share classes. The tax efficiency of the two will be identical. So for a Vanguard fund with an ETF share class, the choice is only a matter of commissions, expense ratio, price relative to NAV, etc.

Whether the Vanguard funds are going to be as tax-efficient as a fund with only ETF shares is an open question. So far, the Vanguard funds have been very tax efficient. And, in all probability, their tax efficiency has improved since the ETF share class has come into being.

Best wishes,
Brad
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Postby scornovaca » Thu Jan 03, 2008 3:53 pm

Rick,

Do you consider the REIT portion of the 'Core Four' to be US only? Just yesterday my 401(k) added an international REIT index option based on the FTSE EPRA/NAREIT Global Rental ex US Index. Would an equal split between the US and the Internaltional indexes be appropriate for the REIT portion?

Thanks in advance,
_Jeff_
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Re: Thanks, Rick

Postby Sunny Sarkar » Thu Jan 03, 2008 4:57 pm

CyberBob wrote:
Xia wrote:I will look up Taylor's Thrifty Three port.
Here is a link.
It's actually a four-fund portfolio if you include the money market fund. ;)
Bob


Taylor's portfolio is a little different from most other portfolio recommendations we usually see in two important ways:

1) It does not recommend an asset allocation.

2) It acknowledges that no matter how you invest your money, and regardless of whether your asset allocation has some allocation to cash, your portfolio will surely have a cash account at least for cash management. Taylor actually shows in a subsequent post how to smartly use the MMF for performing/recording every transaction in the portfolio.
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Postby Sunny Sarkar » Thu Jan 03, 2008 5:18 pm

Rick Ferri wrote:
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?


Sure, that would work. If you were going to do the "Thrifty Three" portfolio, then Taylor's portfolio is a great choice.

The reason I included REITs in the Core Four is:
1) REITs are a bona fide separate asset class than stocks and bonds...
2) Commercial real estate ... is disproportionally underrepresented in a market index.


Hi Rick,

I understand why REITs is in your Core Four.

My point was that if the argument against including SV is tracking error risk, doesn't including REITs present the exact same problem? On the years when REITs do badly relative to the market, the investor who would be swayed by negative tracking error out of SV, would also be similarly swayed by negative tracking error out of REITs.

I am especially interested in this problem because this is my personal justification to exclude both SV and REITs from my portfolio.

Regards,
Sunny
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Adding Small Value & Reit stocks?

Postby Taylor Larimore » Thu Jan 03, 2008 5:57 pm

Hi Sunny:
I am especially interested in this problem because this is my personal justification to exclude both SV and REITs from my portfolio.


Just a reminder: You are already holding the market's weight of these two funds in your portfolio.

They are in your Total Stock Market Index Fund.

Best wishes.
Taylor
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Re: Adding Small Value & Reit stocks?

Postby Rick Ferri » Thu Jan 03, 2008 7:26 pm

Taylor Larimore wrote:Hi Sunny:
I am especially interested in this problem because this is my personal justification to exclude both SV and REITs from my portfolio.


Just a reminder: You are already holding the market's weight of these two funds in your portfolio.

Taylor


Commercial real estate is a large part of the US economy, but little of it is securitized in REITs. The amount of real estate available to public investors is limited to the financing decisions of companies involved in that industry.

If we want our portfolio to reflect more of the real US "economy" and less the financing decisions of corporate investment boards, we have to overweight REITs in proportion to their weighting in the public markets. You can create a portfolio the mirrors "the market" or "the ecomomy" or a little of both. That decision is up to you.

As Sunny mentions, over-weighting REITs give a US equity portfolio tracking error against the total stock market. Including REITs creates "investment policy risk" for people who do not want tracking error from the shifting correlation between REITs and common stock. If there is tracking error, those investors are prone to switch asset allocations when REITs detract from return, such as in 2007.

Rick Ferri

"Markets may not be efficient, but they are far more efficient than most investors."
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Postby ken » Sat Jan 05, 2008 9:48 pm

Rick Ferri wrote:Xia,

If you are in the high tax bracket, REITs and the Total Bond Market Index Fund are not tax savvy investments in a taxable account. They would go into a non-taxable account if you have one.

If you have only taxable money to invest, then I would recommend Taylor's Thrifty Three portfolio as your core and substitute the Vanguard Intermediate-Term Tax-Exempt Fund Admiral Shares (VWIUX - fee 0.08%) for the Total Bond Market Index Fund.

Rick Ferri


Besides Thrifty Three, Taylor has also recommended Vanguard LifeStrategy Growth for young investors as mentioned inhere.
Knowing this fund is heavily weighted on stocks, but for young investors who don't have a substantial amount to invest in the beginning, would this fund considered a good alternative for Thrifty Three and Core Four?

Btw, thanks for the great post, Rick.
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Postby Rick Ferri » Sat Jan 05, 2008 10:17 pm

The key to investment success is to come up with a logical investment plan that fits your needs and then having the discipline to stick with that plan during all market conditions. There is no point trying to find the perfect asset allocation. We will only know the optimal asset allocation in retrospect.

A Lifestyle fund allocation is fine. It is low cost and well diversified. Whatever works for you.

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Target Retirement Funds

Postby Taylor Larimore » Sat Jan 05, 2008 10:25 pm

Hi Ken:
Besides Thrifty Three, Taylor has also recommended Vanguard LifeStrategy Growth for young investors as mentioned in here.


When I wrote that letter, Vanguard had not yet introduced the Target Retirement Funds which I think are an improvement over their older Life Strategy Funds for these reasons:

1. Eleven choices instead of four.

2. No market timing fund (Asset Allocation Fund in LS). You never know your stock/bond/cash allocation.

3. Better diversification within each TR Fund (up to 7 sub-funds).

4. Inclusion of TIPS & Emerging Market sub-funds.

5. Automatic decrease in stocks (risk) with age.

I continue to believe that a fund-of-funds in a Roth is ideal for most first time investors.

Best wishes.
Taylor
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Postby plake15 » Sat Jan 05, 2008 11:06 pm

BigD53 wrote: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.


I love the Vanguard retirement income fund as core holding in retirement..but I think( my own opinion) that 70% fixed,30% equites is too conservative in retirement.I do want to beat inflation

I would do something like a 3 fund retirement..portoflio.simple if I was retired

TSM 20%
FTSE all world 20%
Vanguard retirement income.. 60%

mixed that way you get around 55% to 60% equities..and a 40% to 45% fixed,little bit of diversification in the fixed area..you get Total bond fund,TIPS and a little bit of Prime MM.

most experts say optimal retirement portofolio should hold more equities than fixed..around 50% to 60% equities most say.depending on level of risk you can take.50% equites if risk tolerance is low...60% is you can stand a little more.
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Postby Gekko » Sun Jan 06, 2008 11:11 am

since when is a REIT fund a core holding?

i disagree.
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Postby Rick Ferri » Sun Jan 06, 2008 11:41 am

Gekko wrote:since when is a REIT fund a core holding?

i disagree.


Most people consider REITS are a core holding because they represent an asset class that is different than stocks and bonds in many ways including their underlying collateral, tax treatment, and historic low correlation.

However, if you don't believe REITs should be a core holding in your portfolio, then don't include them. Taylor's Thrifty Three portfolio mentioned earlier in this conversation is an ideal alternative for people who do not want REITS.

Rick Ferri
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Postby plake15 » Mon Jan 07, 2008 8:31 am

If your holding TSM..your getting REIT and SV exposure..

TSM contains 2.5% REITS and 9% small caps..broken down 3-3-3..so your getting 3% SV.

one small cavet...9% of TSM is in Small caps..2% of that 9% falls under the defination of "Microcaps".So your getting Microcap exposure also in TSM.
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Re: Adding Small Value & Reit stocks?

Postby jar2574 » Mon Jan 07, 2008 8:56 am

Rick Ferri wrote:
Taylor Larimore wrote:Hi Sunny:
I am especially interested in this problem because this is my personal justification to exclude both SV and REITs from my portfolio.


Just a reminder: You are already holding the market's weight of these two funds in your portfolio.

Taylor


Commercial real estate is a large part of the US economy, but little of it is securitized in REITs. The amount of real estate available to public investors is limited to the financing decisions of companies involved in that industry.


I would be nervous that the securitized portion of US commercial real estate is not representative of the entire US commercial real estate market. In that case, overweighting REITs would not make your portfolio representative of the US economy.

How does one address this concern?
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Postby Rick Ferri » Mon Jan 07, 2008 11:36 am

I would be nervous that the securitized portion of US commercial real estate is not representative of the entire US commercial real estate market.


While the Vanguard REIT ETF is not representative of the entire commercial real estate market, it is a large enough sample to provide adequate diversification within the sector. [/i]
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Postby Sunny Sarkar » Mon Jan 07, 2008 11:51 am

Rick Ferri wrote:IMO, the 3-factor model is more sophisticated than you are suggesting. I would venture to guess that less than half of financial advisors including brokers have heard of the 3-factor model and only a small fraction could tell you how it works.


Hi Rick,

When you have some time, could you please give us a little tutorial about how the 3-factor model works.

Regards,
Sunny
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Postby SmallHi » Mon Jan 07, 2008 12:26 pm

Sunny,

This newsletter is about as good as it gets for just 2 pages:

http://www.equiuspartners.com/pdf/asset ... v04ac2.pdf

This one puts more emphasis on the "why"

http://www.equiuspartners.com/pdf/asset ... r98ac2.pdf

SH
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Postby plake15 » Mon Jan 07, 2008 12:36 pm

Well nowadays you can hold only 3 funds..but within each single they are just so diversifed you can get everything in just 3 funds or even less if really want a hands off mentality.

For instance look at Vanguard Retirement income.It's one single fund..
but within the fixed portion alone..you get some great fixed diversification.
You get Total Bond fund..which is about as diverse as you get in terms of a bond holding,you get a nice helping of TIPS also..and you get a small spattering of Prime Money market.Then throw in the equity side with TSM and European,emerging markets and Pacific funds inside TR income and it's got about everything.

Myself I like to feel I have some control,so I don't buy Target retiremnet funds..but my holdings are very similar to them and really I follow very closely to what they do.I like once a year when I rebalance to control my bond/fixed allocation and international allocations.I don't like complete autopilot,I kinda like cruise control with manual control once a year :)
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Postby Rick Ferri » Mon Jan 07, 2008 12:50 pm

Sunny,

Here is an abbreviated version of investing using the FF Three-Factor Model:

THE THREE FACTOR MODEL

Fama/French quantified the idea that three difference risk "factors" that explain about 95% the long-term variability of any diversified stock portfolio.

The three factors are BETA, which is the return of all stocks by cap weighting, ie, the market: SIZE, which is the difference between the return of small stocks verses large stocks; and BtM, which is the difference in return between low price-to-book (value) stocks and high price-to-books (growth) stocks.

1) The most important factor is market risk, also called BETA. This simply means that most portfolios go and down with the entire universe of stocks. About 70% of a broadly diversified stock portfolio's return is attributed to BETA. Fama/French tested thousands of randomly selected portfolios holding 100 stocks to come up with the 70% number.

2) The second factor is SIZE. This means the weighted average size of the companies in a portfolio affect the return. Portfolios with mostly big companies acted differently than portfolios of small companies. The average weighted size of companies have an effect on annual return. On average small companies have more risk than large companies, so SIZE is a risk factor with its own expected risk premium (excess return expectation over the market return).

Note: the SIZE premium varies and has had low correlation with BETA, thus the potential diversification benefit.

3) The third is BtM, or style. Whether a portfolio is mainly growth stocks or value stocks has an effect on performance. There are lots of different ways to define growth and value, but Fama/French wanted to find one simple number that make the decision easy. They tried lots of different methods, and finally settled on the Book to Market ratio (BtM), which is basically the inverse of price-to-book.

Value companies have more long-term risk than growth companies because of the old line cyclical industries and businesses they tend to be (a very general statement). As such VALUE investing means adding an extra risk factor with its own expected risk premium (excess return expectation for value stocks over a total market return).

Note: the VALUE premium varies and has had low correlation with BETA, thus the potential diversification benefit.

BTW, there are lots of ways to define value and growth, but only FF use only book value because it is the most stable factor. But they will also say any methodology used by the popular index vendors like S&P/Citi, Russell, Dow Jones, Morningstar, Wilshire et. will all work just fine.

HOW TO BUILD A THREE FACTOR PORTFOLIO USING VANGUARD

Vanguard has a Total Market Index Fund, small cap index funds, and value index funds. You start with the Vanguard Total Stock Market fund. That is your BETA exposure. If you choose to add more risks than market risk, then you “blend” in small cap exposure and value as you desire. Hence, the Three-Factor Model portfolio.

Some people prefer just market risk, and that is perfectly fine. Others prefer to take more risk in a attempt to achieve higher returns. They can do that by adding small stocks and value stocks to their portfolio. It is completely up to you.

Whatever you do, DISCIPLINE is the key. You must maintain the strategy for many years for it to work. Don't try to tilt toward value one year and then pull out of it did not work. That will get you nowhere. Come up with a plan, execute the plan, stick to the plan. THAT works.

Rick Ferri
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Postby SmallHi » Mon Jan 07, 2008 1:46 pm

Sunny,

This may actually be the best paper (under 10 pages) written on the subject.

http://www.ifa.com/Media/Images/ThreeFactorsFamaJr.pdf

One point of clarification on what Rick said:

The most important factor is market risk, also called BETA. This simply means that most portfolios go and down with the entire universe of stocks. About 70% of a broadly diversified stock portfolio's return is attributed to BETA.


Directly from one of Fama's research colleagues Jim Davis:

Fama and French (1992) brought together size, leverage, E/P, BtM, and beta in a single cross-sectional study. Their results were controversial. First, they showed that the previously documented positive relation between beta and average return was an artifact of the negative correlation between firm size and beta. When this correlation is accounted for, the relation between beta and return disappears. Figures 3 and 4 show this result. Figure 3 plots beta and average return for twelve portfolios formed by ranking stocks on firm size. The positive relation between return and beta is highly linear, as predicted by the CAPM. Based on this evidence, it appears that the CAPM nicely explains the higher returns that small firms have earned. Figure 4 plots average return and beta for portfolios formed by ranking on both firm size and beta, so that each portfolio contains stocks that are similar in both their betas and their market values. This chart shows that when beta is allowed to vary in a manner unrelated to size, the positive, linear beta-return relation disappears. This result contradicts the central prediction of the single-period CAPM....The Fama/French (1992) results dealt a severe blow to the view that the single-period CAPM is the way securities are actually priced. The model that has been taught more than any other in business school doesn't seem to work.


Finally,

My point (which may have been lost in all my long winded posts) is that, even if exposure to BETA and the market accounts for about 70% of the explainability of results, the added historical risk premiums as you move to a Small Value portfolio (combining small and value risk in one package) from a TSM portfolio are in the same ball park as the risk premiums when moving from 5YR T-Notes to a TSM allocation (which isolates beta). (1)

Simply put, moving from 5YR T-Notes to a TSM allocation has provided about 5% a year in higher returns (and higher risk) since 1927. Moving from TSM to FF SV xUtilities has provided about 4% a year in higher returns (and higher risk) since 1927.

For reasons I am yet unable to grasp, some folks seem to put considerable faith in the ability of a TSM portfolio to continue to outstrip T-Notes by a similar degree and by similar magnitude...yet the "SV premium" is highly suspect and not generally recommended for investors lacking significant sophistication (2). I can assure you, this was not the conclusion of the FF research, or any of the studies that came post 1992 that confirmed the findings

SH

(1) in 2 sentences, I basically outlined all the decisions a mutifactor investor should be concerned with: how much fixed income relative to equity one will hold, and how much size/value risk within the equity markets one is willing to target...pretty tough stuff! :D

(2) this despite the fact that you can basically learn as much about multifactor investing as you can total market investing reading just the 14 pages of research I linked above (approximately 2 hours of study?)
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Explanation of 3-Factor Model with Conclusions

Postby Taylor Larimore » Mon Jan 07, 2008 2:49 pm

Hi Rick:

Here is an abbreviated version of investing using the FF Three-Factor Model:

Your abbreviated version is the best I've seen and one that even I can understand.

Your conclusions deserve repeating:

1. "Some people prefer just market risk, and that is perfectly fine. Others prefer to take more risk in a attempt to achieve higher returns. They can do that by adding small stocks and value stocks to their portfolio. It is completely up to you."

2. "Whatever you do, DISCIPLINE is the key. You must maintain the strategy for many years for it to work. Don't try to tilt toward value one year and then pull out if it did not work. That will get you nowhere. Come up with a plan, execute the plan, stick to the plan. THAT works."

Thank you and best wishes.
Taylor
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Postby Eric » Mon Jan 07, 2008 2:59 pm

SmallHi wrote:This may actually be the best paper (under 10 pages) written on the subject.

http://www.ifa.com/Media/Images/ThreeFactorsFamaJr.pdf


Just to clarify, the article is by "the" Fama's son, Fama Jr. I know you know this, but not everyone may notice that at first.

SmallHi wrote:For reasons I am yet unable to grasp, some folks seem to put considerable faith in the ability of a TSM portfolio to continue to outstrip T-Notes by a similar degree and by similar magnitude...yet the "SV premium" is highly suspect and not generally recommended for investors lacking significant sophistication (2).


It's possible some folks feel that way, but I don't think that's the primary objection to value-tilting as a prescription for investors generally. I accept (or least don't dispute) your assumption that the probability of value outstripping growth may be similar to the probability of the total stock market outstripping T-Notes. We draw very different conclusions from that, however. I believe that the average investor should own the market weight of stocks and bonds (which is currently about 60% stocks and 40% bonds) and, likewise, should own the market weight of value stocks and growth stocks (i.e., TSM). I assume you wouldn't argue that the average investor should own more than the market weight of stocks.

(By "average investor," I mean average in the sense of personal characteristics like income, job status, family status, etc., not "average" in intelligence or sophistication. An investor whose personal characteristics differ significantly from the average probably should deviate from a total market portfolio.)
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VFWIX over VGTSX

Postby MrsDoverSharp » Mon Jan 07, 2008 3:50 pm

[quote="Rick Ferri"][quote]Why not use Vanguard Total International Stock Index Fund
VGTSX [/quote]

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.

Rick Ferri[/quote]

Thanks for the tip, I had no idea. VWFIX is less than a year old. Do you know about how much the pass through amounts to per year?

Tangential topic... if I exchange the VGTSX in my taxable account, is Vanguard very clever about avoiding capital gains by sort of repackaging those stocks I hold in VGTSX into VWFIX? Or is it a total sell off with capital gains?
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Eric --

Postby SmallHi » Mon Jan 07, 2008 3:51 pm

...I believe that the average investor should own the market weight of stocks and bonds (which is currently about 60% stocks and 40% bonds) and, likewise, should own the market weight of value stocks and growth stocks (i.e., TSM). I assume you wouldn't argue that the average investor should own more than the market weight of stocks.

(By "average investor," I mean average in the sense of personal characteristics like income, job status, family status, etc., not "average" in intelligence or sophistication. An investor whose personal characteristics differ significantly from the average probably should deviate from a total market portfolio.)


I don't think its worthwhile for someone to invest based on where they perceive themselves in the population based on lifestyle demographics of some sort. As a matter of fact, I think this would be a huge mistake. I believe each investor should invest according to their own unique situation and give very little consideration to what the average investor does.

First, the average investor is not the one who has the most impact on securities prices worldwide, institutions are. It takes a lot of average investors to have as much price control as CALPERS, for example.

Second, no matter how average you think you are/aren't (1)...you may have very unique goals, objectives, and concerns. When you account for risk tolerance, timeframe, longetivity concerns, sensitivity to various economic scenerios, charitable aspirations, inheritance assumptions, and a slew of likely behavioral issues -- you have to realize a 60% Stock (world mkt cap weighted), 40% TBM allocation is only going to be the proper allocation for a small handful of investors. Despite the world market portfolio being somewhat of a moving target, however, I remain confident that the average of all investors will conform. We don't all have to own the world portfolio for the average of all of us to be the world portfolio.

This, in a nutshell, is one of the primary benefits of a multifactor investment framework. Investors are able to customize their investment portfolios to more closely reflect their unique circumstances in life.

SH

(1) there is very little evidence that people in general could even identify themselves as average, above average, or below average if they tried. Regardless of zipcode, we all tend to vacation in Lake Wobegon more than we should! :lol:
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Re: Eric --

Postby Eric » Mon Jan 07, 2008 5:13 pm

SmallHi wrote:I believe each investor should invest according to their own unique situation and give very little consideration to what the average investor does. . . . This, in a nutshell, is one of the primary benefits of a multifactor investment framework. Investors are able to customize their investment portfolios to more closely reflect their unique circumstances in life.


Yet we see very few "customized" portfolios on this forum. Somehow large numbers of posters, considering their "unique situations" and their "unique circumstances in life," all come to the same conclusion -- that they need a more generous helping of small and value stocks. Isn't it curious that none of these unique individuals seek a more generous helping of growth stocks?

I don't have a problem with people saying that investors should tilt to value because the market's inefficient and that sector of the market is, well, undervalued. I may disagree with that position, but it's reasonable. However, I do choke on the argument (not necessarily made by you) that "the market is efficient but we've all independently decided, based on our own unique circumstances, that we personally happen to be better off owning more value stocks."
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Postby SmallHi » Mon Jan 07, 2008 5:38 pm

I don't have a problem with people saying that investors should tilt to value because the market's inefficient and that sector of the market is, well, undervalued. I may disagree with that position, but it's reasonable. However, I do choke on the argument (not necessarily made by you) that "the market is efficient but we've all independently decided, based on our own unique circumstances, that we personally happen to be better off owning more value stocks."


Well, we seem to be moving farther and farther apart. For one, I don't generally advocate anyone invest attempting to profit from anomolies or inefficiencies. Over time, that is not a very valid investing strategy. Too many apparent anamolies either disappear after we learn about them, are too costly to impliment, or never existed in the first place upon closer scrutiny.

I do think investors should consider the implications of tilting towards smaller and more value oriented stocks, however...even if they are entirely based on risk based premiums. (they should also consider what role fixed income plays in their portfolio, and consider the lower overall payoffs to fixed income risk and allocate accordingly)

Lets face it, its a big market out there. What a few thousand investors (who inhabit Diehards.org) do with their money is not even a drop in the bucket relative to the market. Pool all of our money together, we probably don't have as much as an Ivy League endowment portfolio. There is some divergence in portfolios here that I have seen...some are TSM based, others are small/value tilted, so that is happening to an extent.

Where are all the growth investors? Well, last time I checked, the largest mutual fund in the US is a US LG stragegy (with the large and growth heavy S&P 500 not far behind), so I would say us tilters haven't overturned the boat just yet.

The bottom line, whether or not sufficient consideration are being given to multifactor portfolio decisions and their accompanying risks, its still worthwhile to suggest they should.

SH
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Postby Eric » Mon Jan 07, 2008 5:55 pm

SmallHi wrote:Well, last time I checked, the largest mutual fund in the US is a US LG stragegy (with the large and growth heavy S&P 500 not far behind), so I would say us tilters haven't overturned the boat just yet.


My concern isn't about you value tilters overturning the boat. Yes, there are other investors in the world who can load up on growth. I just wonder why it is that Fama-French afficionados, in particular, seem overwhelmingly to be value tilters. Logically, some of you should be growth-tilters.
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Postby zhiwiller » Mon Jan 07, 2008 6:37 pm

Rick Ferri wrote:While the Vanguard REIT ETF is not representative of the entire commercial real estate market, it is a large enough sample to provide adequate diversification within the sector. [/i]


This is assuming that private real estate holdings act exactly the way public REITs do. I don't buy it. Why not overweight YUM stock because most pizza shops are privately owned? If you want to overweight REIT because of its history of acting different than stocks and bonds, that's fine. Just be honest. You can't receive the returns of private companies by overweighting public companies.

Otherwise, great post. :D
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Postby Eric » Mon Jan 07, 2008 6:53 pm

SmallHi wrote:There is some divergence in portfolios here that I have seen...some are TSM based, others are small/value tilted, so that is happening to an extent.


Some are TSM based, others are small/value tilted relative to TSM, but none are large/growth tilted relative to TSM.

By way of analogy, suppose posters here were all either Independents or Republicans. You could say "there is some divergence in politics here," but wouldn't you think it odd that there were no Democrats?
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Jack Bogle on TSM vs S&D

Postby Sunny Sarkar » Mon Jan 07, 2008 7:19 pm

Since we are diverging into a mini S&D discussion, I thought I'd add this excerpt I read on Jack Bogle's website...

Jack Bogle wrote:I'm a firm believer in all-market indexing, owning the entire U.S. stock and/or bond market, overweighting or under weighting no particular style or sector, and holding it forever. This strategy, executed at minimal cost, will guarantee that you earn your fair share of whatever returns our financial markets are generous enough to provide. The DFA approach is, in some respects, different. DFA has, I suppose, been a pioneer in offering index funds that cover niche benchmarks that it regards as providing excess returns (i.e. value, small-cap, etc.).

Some financial advisors whom I respect greatly utilize DFA funds, and they believe that overweighting small and value stocks will continue to boost your returns as it has in the past. But I know that we all can't do so. And wiser heads than mine will have to determine how much exposure US investors need to something like small Japanese or international value stocks.

Minimal cost is an important part of any investment strategy, and all-market index funds can be acquired with no sales loads and minimal annual operating expenses (as low as less than 0.10 percent). Most DFA funds cost considerably more, with expense ratios in the 0.50 percent range, plus a fee of perhaps 1 percent to the advisor who sells the funds. Will their funds' performance be able to overcome this cost handicap in the years ahead? Well, time will tell.


What I find interesting about the cost argument is that implementation costs as described above does not exceed the small-value premium as we know it. Of course the premium may go down since "we all can't" keep doing it, but if it is a risk premium, shouldn't it hold it's own even if we all keep doing it?
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Postby Easy Rhino » Mon Jan 07, 2008 8:27 pm

Eric wrote:I just wonder why it is that Fama-French afficionados, in particular, seem overwhelmingly to be value tilters. Logically, some of you should be growth-tilters.

I belive those famafrenchers who are looking for lower risk and lower expected returns gravitate towards bonds, instead.
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Postby mithrandir » Mon Jan 07, 2008 11:39 pm

Rick Ferri wrote:Whatever you do, DISCIPLINE is the key. You must maintain the strategy for many years for it to work. Don't try to tilt toward value one year and then pull out of it did not work. That will get you nowhere. Come up with a plan, execute the plan, stick to the plan. THAT works.

This is extremely important advice. Don't dive into a plan that will feature tracking error until you determine your tolerance for tracking error. Many novice and even experienced investors will jettison investments that lag the market even if these investments are performing as they "should".
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Re: Jack Bogle on TSM vs S&D

Postby mithrandir » Mon Jan 07, 2008 11:51 pm

Sunny wrote:What I find interesting about the cost argument is that implementation costs as described above does not exceed the small-value premium as we know it. Of course the premium may go down since "we all can't" keep doing it, but if it is a risk premium, shouldn't it hold it's own even if we all keep doing it?

Aren't costs the biggest determinant of long-term individual investment performance? (AA is the biggest for portfolio performance.)

No one can say to what extent the small/value premium will be in the future. Will it shrink because of growing knowledge about FF 3-factor model? Therefore there is a pretty strong argument for just buying the market portfolio especially since it can be bought so cheaply.
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Core Four: What are 1-3-5-10 year results?

Postby Retired2 » Thu Jan 31, 2008 3:21 pm

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

Maybe my answer is already somewhere in this long thread, if so, I apologize for asking again.

I like the simplicity of this concept.

What was the performance of the Core Four over the previous time periods? I'd like to use the past results to make comparisons with other investing choices.

I need to simplify my portfolio and this may be it!



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Past performance

Postby Taylor Larimore » Thu Jan 31, 2008 7:29 pm

Hi
Welcome to the Vanguard Diehard Forum!

What was the performance of the Core Four over the previous time periods? I'd like to use the past results to make comparisons with other investing choices.


You will find the information you are looking for on the Vanguard website. Here is a link:

https://personal.vanguard.com/us/funds/vanguard/byname

You should know that past performance is almost useless as a predictor of future performance. It is such a bad predictor, that even the government requires a warning on all mutual fund advertising and past performance figures.

Read a good book on mutual fund investing and you will understand. This is a link to a carefully selected list:

http://www.diehards.org/readbooks.htm


Best wishes.
Taylor
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Bad wording

Postby Taylor Larimore » Thu Jan 31, 2008 10:22 pm

Hi again, Real1:

I read my post again, and this line struck me in the face:

You should know that past performance is almost useless as a predictor of future performance.


I did not mean it the way it sounds. I should have written:

Past performance is almost useless as a predictor of future performance.


Thanks for your understanding.

Best wishes.
Taylor
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