Best Vanguard ETF Diversifiers, Ranked

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vineviz
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Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Thu Jul 26, 2018 11:04 am

I was curious about which Vanguard ETFs would provide the most diversification benefit to the Vanguard Total Stock Market ETF (VTI), so I analyzed them using Portfolio Visualizer's "Principal Component Analysis" tool. I won't present all 80 or so of them, but I did think others might want to see which ones offered the most diversification.

Refresher on principal component analysis: PCA transforms a set of asset covariances (or correlations) in order to identify the underlying statistical factors that drive the overall variance. The statistical factors are the independent sources of risk, such that the first principal component accounts for the most variance in the data and and each additional component in turn accounts for the next highest variance. This is useful because it allows you to tease out how one asset interacts with multiple other assets simultaneously.

The analysis is obviously sensitive to the universe of assets you are analyzing and somewhat sensitive to the time period you use. I looked at all the broad (i.e. non-sector) Vanguard funds, looking at monthly covariances since July 2013 (the inception date for VWOB).

The list below ranks eight of the ETFs that individually were among the top diversifiers in their fund category (e.g. bond, international equity, US equity) ranked against each other. The list is additive which means that #1 was the single best diversifier of VTI, #2 is the best additional diversifier to VTI+#1, etc.).
  1. Vanguard Long-Term Bond ETF (BLV)
  2. Vanguard FTSE Emerging Markets ETF (VWO)
  3. Vanguard Emerging Mkts Govt Bd ETF (VWOB)
  4. Vanguard FTSE All-Wld ex-US SmCp ETF (VSS)
  5. Vanguard S&P Small-Cap 600 Value ETF (VIOV)
  6. Vanguard S&P Small-Cap 600 Growth ETF (VIOG)
  7. Vanguard Total International Stock ETF (VXUS)
  8. Vanguard Total Bond Market ETF (BND)
The marginal benefit of adding additional ETFs is positive up to and including VIOV. After that, adding the next ETF either provides no additional diversification or (worse yet) reduces diversification.

Interestingly, this approach simultaneously highlights two approaches to international diversification. One, a broad market cap weighted ex-US index like VXUS does NOT add much to a portfolio that already includes a broad market cap weighted US index fund like Vanguard Total Stock Market ETF (VTI). Two, international diversification IS very powerful if you focus on emerging market equities and sovereign debt.

I should also add that this kind of analysis is not influenced by either past returns or future expected returns. The focus is entirely on finding assets that have independent sources of risk. Implicit here is that you are probably holding some allocation to cash OUTSIDE of this risky portfolio, since short-term bonds will almost never show up as a strong enough source of risk to counteract the equities, EMD, or long-term treasury debt that we tend to also hold.

Obviously there are any number of ways you could allocate the "optimal" six-ETF portfolio. One approach would be to weight by the inverse of the volatility of each ETF. That would give you a portfolio like this:

Code: Select all

Allocation	Ticker	Name
15.71%		VTI	Vanguard Total Stock Market ETF
19.63%		BLV	Vanguard Long-Term Bond ETF
10.52%		VWO	Vanguard FTSE Emerging Markets ETF
28.94%		VWOB	Vanguard Emerging Mkts Govt Bd ETF
13.99%		VSS	Vanguard FTSE All-Wld ex-US SmCp ETF
11.20%		VIOV	Vanguard S&P Small-Cap 600 Value ETF
Because of what I said before about returns not being a factor here, you might want to constrain the weights to give you a equity/bond allocation in line with your overall views about expected returns.
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by livesoft » Thu Jul 26, 2018 11:06 am

OK, diversification works both ways: Something that underperforms Total US Stock Market by a large amount will be a nice diversifier.
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Thu Jul 26, 2018 11:44 am

livesoft wrote:
Thu Jul 26, 2018 11:06 am
OK, diversification works both ways: Something that underperforms Total US Stock Market by a large amount will be a nice diversifier.
Just pick the assets that will outperform Total US Stock Market in the future and you'll be fine.
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by whodidntante » Thu Jul 26, 2018 12:07 pm

vineviz wrote:
Thu Jul 26, 2018 11:44 am
livesoft wrote:
Thu Jul 26, 2018 11:06 am
OK, diversification works both ways: Something that underperforms Total US Stock Market by a large amount will be a nice diversifier.
Just pick the assets that will outperform Total US Stock Market in the future and you'll be fine.
Once I pick the assets that outperform, why would I want Total US Market weighing down my portfolio?

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by jhfenton » Thu Jul 26, 2018 12:34 pm

vineviz wrote:
Thu Jul 26, 2018 11:04 am
  1. Vanguard Long-Term Bond ETF (BLV)
  2. Vanguard FTSE Emerging Markets ETF (VWO)
  3. Vanguard Emerging Mkts Govt Bd ETF (VWOB)
  4. Vanguard FTSE All-Wld ex-US SmCp ETF (VSS)
  5. Vanguard S&P Small-Cap 600 Value ETF (VIOV)
  6. Vanguard S&P Small-Cap 600 Growth ETF (VIOG)
  7. Vanguard Total International Stock ETF (VXUS)
  8. Vanguard Total Bond Market ETF (BND)
The marginal benefit of adding additional ETFs is positive up to and including VIOV. After that, adding the next ETF either provides no additional diversification or (worse yet) reduces diversification.

Interestingly, this approach simultaneously highlights two approaches to international diversification. One, a broad market cap weighted ex-US index like VXUS does NOT add much to a portfolio that already includes a broad market cap weighted US index fund like Vanguard Total Stock Market ETF (VTI). Two, international diversification IS very powerful if you focus on emerging market equities and sovereign debt.
I don't own BLV, but I essentially own the next four. VSS/VFSVX is our singlest largest position. Emerging markets is our next largest asset class and most of that is VWO/VEMAX. I own VIOV in taxable and a DFA fund in my 401(k). I own VEGBX, Vanguard's active Emerging Market Bond Admiral Shares.

Until recently, we owned no international large-cap developed or total international, but my wife's 401(k) has Vanguard Total International Admiral, so we are using that fund as a best-available option. (My 401(k) has no acceptable international.) But I agree it is less attractive as a diversifier for U.S. equities than our other holdings.

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by ps56k » Sun Sep 30, 2018 11:14 pm

vineviz wrote:
Thu Jul 26, 2018 11:04 am
... Interestingly, this approach simultaneously highlights two approaches to international diversification. One, a broad market cap weighted ex-US index like VXUS does NOT add much to a portfolio that already includes a broad market cap weighted US index fund like Vanguard Total Stock Market ETF (VTI). Two, international diversification IS very powerful if you focus on emerging market equities and sovereign debt....
I've been wrestling with this -
as I've recently added both VWO and VWOB - to my Total US Stock and Total US Bond -
along with - Total Intl Stock and Total Intl Bond
... shotgun approach...

So... may have to revisit the dartboard.

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by HEDGEFUNDIE » Mon Oct 01, 2018 12:14 am

Vineviz, you missed EDV, which is basically a supercharged BLV.

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by JoMoney » Mon Oct 01, 2018 12:17 am

HEDGEFUNDIE wrote:
Mon Oct 01, 2018 12:14 am
Vineviz, you missed EDV, which is basically a supercharged BLV.
I thought the same thing, also I was also surprised not to see a short-term corporate fund on the list. Every time I've played around with one on PV, the short-term investment grade/corporate seems to add a little extra 'something' that short-term treasuries or longer term corporates don't.
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Mon Oct 01, 2018 12:21 am

HEDGEFUNDIE wrote:
Mon Oct 01, 2018 12:14 am
Vineviz, you missed EDV, which is basically a supercharged BLV.
In retrospect it seems weird that isn’t in my list. Even VGLT should have been superior to BLV.

I’ll take a look again tomorrow.

Short term funds in general and corporate bonds in particular are not usually among the best diversification boosters, though.
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by nisiprius » Mon Oct 01, 2018 6:12 am

All this stuff should come with the disclaimer, "past correlations are not indicative of future correlations."
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by columbia » Mon Oct 01, 2018 6:35 am

vineviz wrote:
Mon Oct 01, 2018 12:21 am
HEDGEFUNDIE wrote:
Mon Oct 01, 2018 12:14 am
Vineviz, you missed EDV, which is basically a supercharged BLV.
In retrospect it seems weird that isn’t in my list. Even VGLT should have been superior to BLV.

I’ll take a look again tomorrow.

Short term funds in general and corporate bonds in particular are not usually among the best diversification boosters, though.
I look forward to the updates; very interesting thread.

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Mon Oct 01, 2018 8:57 am

nisiprius wrote:
Mon Oct 01, 2018 6:12 am
All this stuff should come with the disclaimer, "past correlations are not indicative of future correlations."
Why? That disclaimer isn't actually true: past correlations ARE indicative of future correlations.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by Random Walker » Mon Oct 01, 2018 9:05 am

Unfortunately Vanguard doesn’t have any International Small Value offerings. ISV has the potential to be an excellent diversifier. Would be interesting to see how an ISV fund measures in this analysis.

Dave

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by HEDGEFUNDIE » Mon Oct 01, 2018 10:01 am

Random Walker wrote:
Mon Oct 01, 2018 9:05 am
Unfortunately Vanguard doesn’t have any International Small Value offerings. ISV has the potential to be an excellent diversifier. Would be interesting to see how an ISV fund measures in this analysis.

Dave
Not a great diversifier. Over the past 12 years DLS and VTI were 87% correlated.

https://www.portfoliovisualizer.com/ass ... ingDays=60

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Mon Oct 01, 2018 10:18 am

JoMoney wrote:
Mon Oct 01, 2018 12:17 am
HEDGEFUNDIE wrote:
Mon Oct 01, 2018 12:14 am
Vineviz, you missed EDV, which is basically a supercharged BLV.
I thought the same thing, also I was also surprised not to see a short-term corporate fund on the list. Every time I've played around with one on PV, the short-term investment grade/corporate seems to add a little extra 'something' that short-term treasuries or longer term corporates don't.
I took another look this morning, and while I don't have all the data I used initially it does unfortunately look like EDV (Vanguard Extended Duration Treasury) got dropped out inadvertently.

Also, in hindsight I think there are possibly ways to construct this list in a more intuitively useful manner. Using PCA to reduce the portfolio one asset at a time produces a rank order that isn't entirely consistent with the way an investor might think about the problem.

For instance, because VGLT an EDV are so highly correlated the PCA indicates that VGLT should be eliminated rather early in the process. This makes sense if the goal is to produce a portfolio with the maximum number of independent sources of risk, but it also means that the short list will contain only one of the two "best" diversifiers.

By way of example, my original "top 8" list included three bond funds: BLV, VWOB, & BND. Taken together, all three of these produce a portfolio that is more diversified than one with just EDV alone. Also, that combination is more diversified than any combination of funds that includes EDV along with the other two. And yet, EDV alone is a better diversifier than any one of the three alone.

I used a slightly different date range to produce the following chart, which shows 12 Vanguard ETFs ranked in their diversification ratio when combined with VTI in a two-fund portfolio. You can see that EDV and VGLT performed far better than any other funds.

Image

Perhaps a more useful way to build a list would be to start with VTI combined with each other ETF alone. Find the combination of two ETFs that produces the most diversified portfolio, then try each remaining fund as a third fund. In other words, my OP list was a top-down list but it might be more sensible to build a bottom-up list. The former approach will result in the most diversification possible (at the expense of holding more funds), but the latter approach would produce the smallest portfolio needed to achieve an optimal level diversity.

Creating a two-fund portfolio of EDV + VTI increased the diversification ratio (higher number = more diversification) from 1.03 to 1.49 as compared to a one-fund portfolio of VTI, improvement of 0.46.

Image

Adding VIOV to make a three-fund portfolio resulted in a further improvement of 0.18.

Adding VSS to make a four-fund portfolio resulted in an additional gain of 0.06.

Adding VWO to make a five-fund portfolio resulted in a minuscule additional gain that rounds to 0.00.
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Mon Oct 01, 2018 10:44 am

HEDGEFUNDIE wrote:
Mon Oct 01, 2018 10:01 am
Random Walker wrote:
Mon Oct 01, 2018 9:05 am
Unfortunately Vanguard doesn’t have any International Small Value offerings. ISV has the potential to be an excellent diversifier. Would be interesting to see how an ISV fund measures in this analysis.

Dave
Not a great diversifier. Over the past 12 years DLS and VTI were 87% correlated.

https://www.portfoliovisualizer.com/ass ... ingDays=60
I tend to agree. Most of the international small value products I've looked at (the ETFs with the longest history are DLS [WisdomTree International SmallCp Dividend] and PDN [Invesco FTSE RAFI Dev Mkts ex-US S/M]) provide virtually no additional diversification benefit over an inexpensive brand small cap ETF (like VSS or SCHC (Schwab International Small-Cap Eq ETF).

I think you could probably make a case that international small value funds MIGHT provide a higher level of expected return but, given how much higher the ERs on the value funds tends to be, they face a headwind IMHO.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by HEDGEFUNDIE » Mon Oct 01, 2018 11:20 am

Vineviz, nice work. So what are the optimal proportions of VTI, EDV, VIOV and VSS in a maximally diversified portfolio?

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by chisey » Mon Oct 01, 2018 11:51 am

vineviz wrote:
Mon Oct 01, 2018 10:18 am
Image

Adding VIOV to make a three-fund portfolio resulted in a further improvement of 0.18.

Adding VSS to make a four-fund portfolio resulted in an additional gain of 0.06.

Adding VWO to make a five-fund portfolio resulted in a minuscule additional gain that rounds to 0.00.
You end up very close to my portfolio, for which I used similar reasoning. A base of US large cap (~8%), to which LTT (~10%) is added, to which US SCV (~12%) is added, to which international small (~10%) is added. Add in additional small slices of Emerging Small (4%) and Emerging Bond (4%) and you have the "risk" side of my portfolio. The "stable" side has shorter duration treasuries and a stable value fund.

I'm quite comfortable with the theory and my available options for constructing this portfolio, though it has been a little painful YTD compared to the broad market approach.

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Mon Oct 01, 2018 2:43 pm

HEDGEFUNDIE wrote:
Mon Oct 01, 2018 11:20 am
Vineviz, nice work. So what are the optimal proportions of VTI, EDV, VIOV and VSS in a maximally diversified portfolio?
Interestingly, VTI itself provides such a small amount of uncorrelated risk relative to the other holdings that a portfolio which maximizes the diversification ratio actually wouldn't hold VTI at all.

One way to solve the solution would be institute an arbitrary constraint on EDV, limiting it to no more than 20% of the portfolio. That'd give you something like this:

Image
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by JPH » Mon Oct 01, 2018 4:03 pm

This is interesting. It raises this question in my mind. How many components/factors are there in the universe of Vanguard funds? Did you consider permitting the factors to be correlated, as they are in reality, and not restricting how many funds load on each factor?
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Mon Oct 01, 2018 6:42 pm

JPH wrote:
Mon Oct 01, 2018 4:03 pm
This is interesting. It raises this question in my mind. How many components/factors are there in the universe of Vanguard funds? Did you consider permitting the factors to be correlated, as they are in reality, and not restricting how many funds load on each factor?
I estimate that among all the Vanguard ETFs there are roughly three completely uncorrelated factors (aka sources of risk).

If you run all 65 diversified ETFs (i.e. exclude the sector funds, because they muck up the interpretation, through a PCA then the first PC explains 77% of the total variance. The second PC explains 8%, the third PC explains 4%, the fourth explains 3%, the fifth explains 2%, and its down hill from there.

If you use all 65 PCs to compute the Shannon entropy, which you can interpret as the effective number of independent bets in the data set, you get 2.8.

My guess is that the number would rise a little as you remove some highly redundant ETFs, but I don't expect it'd get much above 3.2 or so.
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by columbia » Mon Oct 01, 2018 7:05 pm

What’s the tangible distinction between VIOV and VBR?

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Mon Oct 01, 2018 7:20 pm

columbia wrote:
Mon Oct 01, 2018 7:05 pm
What’s the tangible distinction between VIOV and VBR?
They are based on different underlying indexes, with the result being that VIOV:
  • is significantly more focused on small cap stocks;
  • is slightly more focused on value stocks;
  • contains significantly higher quality stocks;
  • is slightly higher in market beta;
  • is significantly less correlated with US large cap core stocks (e.g. S&P 500);
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by JPH » Tue Oct 02, 2018 7:53 am

vineviz wrote:
Mon Oct 01, 2018 6:42 pm
JPH wrote:
Mon Oct 01, 2018 4:03 pm
This is interesting. It raises this question in my mind. How many components/factors are there in the universe of Vanguard funds? Did you consider permitting the factors to be correlated, as they are in reality, and not restricting how many funds load on each factor?
I estimate that among all the Vanguard ETFs there are roughly three completely uncorrelated factors (aka sources of risk).

If you run all 65 diversified ETFs (i.e. exclude the sector funds, because they muck up the interpretation, through a PCA then the first PC explains 77% of the total variance. The second PC explains 8%, the third PC explains 4%, the fourth explains 3%, the fifth explains 2%, and its down hill from there.

If you use all 65 PCs to compute the Shannon entropy, which you can interpret as the effective number of independent bets in the data set, you get 2.8.

My guess is that the number would rise a little as you remove some highly redundant ETFs, but I don't expect it'd get much above 3.2 or so.
Thank you. Would you be inclined to run it by forcing the ever popular 3-fund portfolio as the first component and permitting other ETFs to compete for the remaining variance?
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by staythecourse » Tue Oct 02, 2018 8:02 am

Great thread. Of course, doesn't mean much since the sample size is a whole 5 years. Correlations will change over time (duh), but the key is to see if there is some logical reason they should persist. The problem with an analysis like this is there may be an underlying reason the correlation was lower for during this 5 year period that won't persist going forward. VTI and EDV make sense to me will persist. As the same person who will be bullish in stocks will not be in long dated treasuries. The others may or may not make sense to persist going forward.

Can anyone do the same work up going back to 1970's to see what that would look like and do rolling 5, 10 year returns? There will be back fill bias, but think the advantages would outweigh the disadvantage of having only 4+ years of data over just one 5 year period.

Good luck.
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Tue Oct 02, 2018 8:39 am

JPH wrote:
Tue Oct 02, 2018 7:53 am
Thank you. Would you be inclined to run it by forcing the ever popular 3-fund portfolio as the first component and permitting other ETFs to compete for the remaining variance?
I've got other projects that I need to attend to, but I took a quick stab at answering your question.

The traditional three fund portfolio ( VTI + BND + VXUS) only contains exposure to about half (i.e. roughly 1.5) of the three total independent risk factors available in the Vanguard ETF universe.

By my estimation, it would take at least four additional funds to add the missing 1.5 factors. The smallest combination of funds that brings you back up to the maximum number of uncorrelated sources of return seems to be:
  • Vanguard Extended Duration Treasruy ETF (EDV)
  • Vanguard US Liquidity Factor ETF (VFLQ)
  • Vanguard US Minimum Volatility ETF (VFMV)
  • Vanguard US Value Factor ETF (VFVA)
These are listed in order of additive power, and you can get most of the way there using just EDV and VFLQ.

Unsurprisingly the list is dominated by funds with relatively "pure" exposure to a single source of risk (EDV is basically a pure play on duration risk). The caveat is that Vanguard's factor funds are relatively new and so they don't have a long history that we can use to evaluate their stability over time. Also, they are pseudo-active unlike other Vanguard ETFs so there is some risk they will change their strategies to make them less useful in the future.
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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Tue Oct 02, 2018 8:45 am

staythecourse wrote:
Tue Oct 02, 2018 8:02 am
The problem with an analysis like this is there may be an underlying reason the correlation was lower for during this 5 year period that won't persist going forward.
I think the main risk would be with EDV. Long term treasury correlations have an interesting history of significant changes. Some researchers expect that periods of high inflation, for instance, might drive the correlation of treasuries and stocks much higher than they have been for the past 20 years or so.

But generally I think the results I got make logical sense and I'd expect them to persist.

BND is likely going to be more correlated with stocks over time than EDV because BND includes corporate bonds (which have equity risk embedded in them) and a much shorter duration.

The stocks in VXUS are (by weight) mostly large cap multinational companies from developed markets so they should be more correlated with large cap US stocks (which dominate VTI) as compared to smaller cap stocks and emerging markets stocks.

And so on.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by Augustus » Tue Oct 02, 2018 9:58 am

Fascinating data work and discussion, especially since I'm early in the accumulating stage and only hold VTI. Because of my limited income (I'm a teacher) and younger age, I'm totally fine buying VTI for another 10-15 years before adding bonds or treasuries. At this point, I'm investing $20-25k per year.

I'd like to keep my portfolio as simple as possible. Would VTI + BND be a better combination than VTI + EDV?

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Tue Oct 02, 2018 10:26 am

Augustus wrote:
Tue Oct 02, 2018 9:58 am
Fascinating data work and discussion, especially since I'm early in the accumulating stage and only hold VTI. Because of my limited income (I'm a teacher) and younger age, I'm totally fine buying VTI for another 10-15 years before adding bonds or treasuries. At this point, I'm investing $20-25k per year.

I'd like to keep my portfolio as simple as possible. Would VTI + BND be a better combination than VTI + EDV?
No, I don't think so.

For one thing, EDV is a far superior diversifier to BND especially when held in small quantities. You'd have to hold twice as much BND as EDV to get the same diversification benefit. As long as your portfolio is more than 60% stocks, EDV will is likely to provide you a higher higher risk-adjusted return than BND.

For another thing, as a general rule the duration of your bond funds should roughly match your investment time horizon. As a long-term bond fund, EDV is IMHO a more appropriate choice fro someone who is 10 years or more from retirement.

I normally recommend that investors hold their age minus twenty in bonds, so if you are 35 years old then you'd hold roughly 15% in bonds.

I also strongly recommend that at least 25-30% of your stocks be international stocks. Being 100% in US stocks is a risky bet at any age, and unnecessarily so since international diversification is easy these days.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by knicknut » Tue Oct 02, 2018 11:01 am

I applaud this analysis, but am also worried about the sample size. One in which stocks have moved close to linearly upwards does not create a range of outcomes that would give us a fuller picture; seeing covariances over full business cycles will give us a better sense, especially if we're looking for diversifiers because we think the performance of the last 5 years is not sustainable in perpetuity.

If the next stock selloff is fueled by burdensome debt ratios (government, sovereign, or corporate), we may not get the bull flattener we'd need for EDV to be an effective hedge for VTI.

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by staythecourse » Tue Oct 02, 2018 11:14 am

vineviz wrote:
Tue Oct 02, 2018 8:45 am
staythecourse wrote:
Tue Oct 02, 2018 8:02 am
The problem with an analysis like this is there may be an underlying reason the correlation was lower for during this 5 year period that won't persist going forward.
I think the main risk would be with EDV. Long term treasury correlations have an interesting history of significant changes. Some researchers expect that periods of high inflation, for instance, might drive the correlation of treasuries and stocks much higher than they have been for the past 20 years or so.

But generally I think the results I got make logical sense and I'd expect them to persist.

BND is likely going to be more correlated with stocks over time than EDV because BND includes corporate bonds (which have equity risk embedded in them) and a much shorter duration.

The stocks in VXUS are (by weight) mostly large cap multinational companies from developed markets so they should be more correlated with large cap US stocks (which dominate VTI) as compared to smaller cap stocks and emerging markets stocks.

And so on.
I do agree EDV is likely to persist. It only makes behavioral sense. When there is stress in the market money will flow to the reserve currency of the world and that is the U.S. dollar. So cash and long dated treasuries usually do well under stress.

I am not sure how you can be confident of everything else though. As I said take the data for the benchmarks of the different asset classes you mention and check them from 2000 at five year intervals and see what happens. Back fill bias is there, but the advantages of seeing if there is a steady correlation (or noncorrelation) would be useful to offset that bias.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Tue Oct 02, 2018 12:31 pm

staythecourse wrote:
Tue Oct 02, 2018 11:14 am
I am not sure how you can be confident of everything else though. As I said take the data for the benchmarks of the different asset classes you mention and check them from 2000 at five year intervals and see what happens. Back fill bias is there, but the advantages of seeing if there is a steady correlation (or noncorrelation) would be useful to offset that bias.
Although it is definite true that the absolute correlation between assets can change over time, it has generally been the case that the relative correlation of assets has been very stable.

In other words, during periods when the correlation between long-term Treasuries and US stocks increases it has been much always also been true that the correlation between total bond market and US stocks also increased. As a result, long-term Treasuries have been a better diversifier than total bond market even during periods of increased correlation.

This graph shows trailing 24-month correlations between assets similar to the Vanguard ETFs mentioned here, but selected to produce a longer history.

Image

Long-term treasuries have pretty much always had a lower correlation to US stocks than total bond market, for instance, and emerging markets have almost always had a lower correlation with US stocks than total international stock market.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Tue Oct 02, 2018 12:31 pm

vineviz wrote:
Tue Oct 02, 2018 12:31 pm
staythecourse wrote:
Tue Oct 02, 2018 11:14 am
I am not sure how you can be confident of everything else though. As I said take the data for the benchmarks of the different asset classes you mention and check them from 2000 at five year intervals and see what happens. Back fill bias is there, but the advantages of seeing if there is a steady correlation (or noncorrelation) would be useful to offset that bias.
Although it is definite true that the absolute correlation between assets can change over time, it has generally been the case that the relative correlation of assets has been very stable.

In other words, during periods when the correlation between long-term Treasuries and US stocks increases it has been much always also been true that the correlation between total bond market and US stocks also increased. As a result, long-term Treasuries have been a better diversifier than total bond market even during periods of increased correlation.

This graph shows trailing 24-month correlations between Vanguard Total US Stock Market and assets similar to the Vanguard ETFs mentioned here, but selected to produce a longer history.

Image

Long-term treasuries have pretty much always had a lower correlation to US stocks than total bond market, for instance, and emerging markets have almost always had a lower correlation with US stocks than total international stock market.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by staythecourse » Tue Oct 02, 2018 12:35 pm

vineviz wrote:
Tue Oct 02, 2018 12:31 pm
staythecourse wrote:
Tue Oct 02, 2018 11:14 am
I am not sure how you can be confident of everything else though. As I said take the data for the benchmarks of the different asset classes you mention and check them from 2000 at five year intervals and see what happens. Back fill bias is there, but the advantages of seeing if there is a steady correlation (or noncorrelation) would be useful to offset that bias.
Although it is definite true that the absolute correlation between assets can change over time, it has generally been the case that the relative correlation of assets has been very stable.

In other words, during periods when the correlation between long-term Treasuries and US stocks increases it has been much always also been true that the correlation between total bond market and US stocks also increased. As a result, long-term Treasuries have been a better diversifier than total bond market even during periods of increased correlation.

This graph shows trailing 24-month correlations between assets similar to the Vanguard ETFs mentioned here, but selected to produce a longer history.

Image

Long-term treasuries have pretty much always had a lower correlation to US stocks than total bond market, for instance, and emerging markets have almost always had a lower correlation with US stocks than total international stock market.
Excellent analysis. Much thanks. Great point on relative correlations. For the investor, it is true even if correlations do change over time it is not as important if the relative correlation between the assets are consistent. Great point.

Thanks.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by aristotelian » Tue Oct 02, 2018 12:53 pm

Pet peeve: you mean non-correlation, not diversification.

I am surprised you didn't look at any Treasury Bond funds. I believe they are least correlated.

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Tue Oct 02, 2018 1:59 pm

aristotelian wrote:
Tue Oct 02, 2018 12:53 pm
Pet peeve: you mean non-correlation, not diversification.

I am surprised you didn't look at any Treasury Bond funds. I believe they are least correlated.
No, when I say diversification that’s what I mean.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by jclear » Tue Oct 02, 2018 3:24 pm

vineviz wrote:
Tue Oct 02, 2018 12:31 pm
staythecourse wrote:
Tue Oct 02, 2018 11:14 am
I am not sure how you can be confident of everything else though. As I said take the data for the benchmarks of the different asset classes you mention and check them from 2000 at five year intervals and see what happens. Back fill bias is there, but the advantages of seeing if there is a steady correlation (or noncorrelation) would be useful to offset that bias.
Although it is definite true that the absolute correlation between assets can change over time, it has generally been the case that the relative correlation of assets has been very stable.

In other words, during periods when the correlation between long-term Treasuries and US stocks increases it has been much always also been true that the correlation between total bond market and US stocks also increased. As a result, long-term Treasuries have been a better diversifier than total bond market even during periods of increased correlation.

This graph shows trailing 24-month correlations between assets similar to the Vanguard ETFs mentioned here, but selected to produce a longer history.

Image

Long-term treasuries have pretty much always had a lower correlation to US stocks than total bond market, for instance, and emerging markets have almost always had a lower correlation with US stocks than total international stock market.
Great chart, vineviz. I knew there was a reason the majority of my international equity AA is in EM, and all of my bond AA is in long Treasurys :)
Now if only we could get TIPS to stop being correlated with equities. https://www.portfoliovisualizer.com/ass ... ingDays=60
Last edited by jclear on Tue Oct 02, 2018 3:32 pm, edited 1 time in total.

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by aristotelian » Tue Oct 02, 2018 3:29 pm

vineviz wrote:
Tue Oct 02, 2018 1:59 pm
aristotelian wrote:
Tue Oct 02, 2018 12:53 pm
Pet peeve: you mean non-correlation, not diversification.

I am surprised you didn't look at any Treasury Bond funds. I believe they are least correlated.
No, when I say diversification that’s what I mean.
What is your definition of diversification? I don't see how picking specific components of total stock market can be considered diversification in any coherent sense.

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by vineviz » Tue Oct 02, 2018 4:41 pm

aristotelian wrote:
Tue Oct 02, 2018 3:29 pm
vineviz wrote:
Tue Oct 02, 2018 1:59 pm
aristotelian wrote:
Tue Oct 02, 2018 12:53 pm
Pet peeve: you mean non-correlation, not diversification.

I am surprised you didn't look at any Treasury Bond funds. I believe they are least correlated.
No, when I say diversification that’s what I mean.
What is your definition of diversification? I don't see how picking specific components of total stock market can be considered diversification in any coherent sense.
I define "diversification" as the process of spreading a portfolio's risk across correlated sources.

There are a number of modern measures of diversification, but the two I refer to the most are the diversification ratio and Shannon entropy (aka "effective number of bets"). There are other measures, but these are relatively robust and easy to compute.

The field has generally moved on from relying on older, more simplistic concepts of diversification (e.g. the number of assets, or assumptions that the market portfolio is inherently maximally diverse).

Recent threads on the topic of diversification:

viewtopic.php?t=252099

viewtopic.php?t=251043
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by aristotelian » Tue Oct 02, 2018 7:28 pm

vineviz wrote:
Tue Oct 02, 2018 4:41 pm

I define "diversification" as the process of spreading a portfolio's risk across correlated sources.

There are a number of modern measures of diversification, but the two I refer to the most are the diversification ratio and Shannon entropy (aka "effective number of bets"). There are other measures, but these are relatively robust and easy to compute.

The field has generally moved on from relying on older, more simplistic concepts of diversification (e.g. the number of assets, or assumptions that the market portfolio is inherently maximally diverse).

Recent threads on the topic of diversification:

viewtopic.php?t=252099

viewtopic.php?t=251043
I am familiar with the arguments. I do not believe there is a consensus in the field. Other than that, I have no wish to get into a semantic argument as long as you are clear about what you mean.

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by Taylor Larimore » Tue Oct 02, 2018 8:07 pm

I'd like to keep my portfolio as simple as possible. Would VTI + BND be a better combination than VTI + EDV?
Augustus:

VTI (Vanguard Extended Duration Treasury Index Fund ETF) is an excellent diversifier in many conditions. We have had a long period of interest rate declines which favor long-duration bonds. However, if interest rates rise, long duration bonds can be expected to suffer. In other words, don't depend on past returns to forecast future returns.

Diversification is great and EDV certainly adds that. However, bond fund declines must also be considered. EDV lost -36% in 2009. BNDs (Vanguard Total Bond Market) worst annual loss was -3% in 1994.

Vanguard Total Bond Market Index Fund is the largest bond fund in the world -- for good reasons , primarily its good quality bonds and its broad diversification (the only "free lunch" in investing).

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by bondsr4me » Wed Oct 03, 2018 11:56 am

are there any other websites than have a similar tool like Portfolio Visualizer?

I would like to go back more years.

thanks,

don

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by HEDGEFUNDIE » Wed Oct 03, 2018 12:16 pm

bondsr4me wrote:
Wed Oct 03, 2018 11:56 am
are there any other websites than have a similar tool like Portfolio Visualizer?

I would like to go back more years.

thanks,

don
EDV only goes back 10 years, but I was able to pull Treasury STRIPS data for the last 30 years (PM me if you'd like the dataset).

Here is a backtest for the last 30 years.
Portfolio 1 is 80% S&P 500, 20% EDV (25-year Treasury STRIP data before 2008)
Portfolio 2 is 80% S&P 500, 20% Total Bond Market
Portfolio 3 is 100% S&P 500

Image

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by bondsr4me » Wed Oct 03, 2018 12:24 pm

HEDGEFUNDIE wrote:
Wed Oct 03, 2018 12:16 pm
bondsr4me wrote:
Wed Oct 03, 2018 11:56 am
are there any other websites than have a similar tool like Portfolio Visualizer?

I would like to go back more years.

thanks,

don
EDV only goes back 10 years, but I was able to pull Treasury STRIPS data for the last 30 years (PM me if you'd like the dataset).

Here is a backtest for the last 30 years.
Portfolio 1 is 80% S&P 500, 20% EDV (25-year Treasury STRIP data before 2008)
Portfolio 2 is 80% S&P 500, 20% Total Bond Market
Portfolio 3 is 100% S&P 500

Image
Thanks HEDGEFUNDIE....much appreciate the data

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by bondsr4me » Wed Oct 03, 2018 12:36 pm

Taylor Larimore wrote:
Tue Oct 02, 2018 8:07 pm
I'd like to keep my portfolio as simple as possible. Would VTI + BND be a better combination than VTI + EDV?
Augustus:

VTI (Vanguard Extended Duration Treasury Index Fund ETF) is an excellent diversifier in many conditions. We have had a long period of interest rate declines which favor long-duration bonds. However, if interest rates rise, long duration bonds can be expected to suffer. In other words, don't depend on past returns to forecast future returns.

Diversification is great and EDV certainly adds that. However, bond fund declines must also be considered. EDV lost -36% in 2009. BNDs (Vanguard Total Bond Market) worst annual loss was -3% in 1994.

Vanguard Total Bond Market Index Fund is the largest bond fund in the world -- for good reasons , primarily its good quality bonds and its broad diversification (the only "free lunch" in investing).

Best wishes.
Taylor
Hi Taylor....

At the risk of sounding really foolish, where did you get BND 1994 loss of 3%?

VG's website says the fund inception is 4/3/2007.

Are you referring to VBLTX?

Thanks

Don

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by Taylor Larimore » Wed Oct 03, 2018 3:01 pm

bondsr4me wrote:
Wed Oct 03, 2018 12:36 pm
Taylor Larimore wrote:
Tue Oct 02, 2018 8:07 pm
I'd like to keep my portfolio as simple as possible. Would VTI + BND be a better combination than VTI + EDV?
Augustus:

VTI (Vanguard Extended Duration Treasury Index Fund ETF) is an excellent diversifier in many conditions. We have had a long period of interest rate declines which favor long-duration bonds. However, if interest rates rise, long duration bonds can be expected to suffer. In other words, don't depend on past returns to forecast future returns.

Diversification is great and EDV certainly adds that. However, bond fund declines must also be considered. EDV lost -36% in 2009. BNDs (Vanguard Total Bond Market) worst annual loss was -3% in 1994.

Vanguard Total Bond Market Index Fund is the largest bond fund in the world -- for good reasons , primarily its good quality bonds and its broad diversification (the only "free lunch" in investing).

Best wishes.
Taylor
Hi Taylor....

At the risk of sounding really foolish, where did you get BND 1994 loss of 3%?

VG's website says the fund inception is 4/3/2007.

Are you referring to VBLTX?

Thanks

Don
Don:

I am the one who sounds "really foolish." I should have realized that BND only goes back to 2007.

I purchased our Total Bond Market Index Fund (VBMFX) in 1986 after considerable investigation. I learned (rom Morningstar) that it's worst annual loss was -2.66% in 1994. I also went back to the inception in 1976 of its benchmark, Aggregate Total Bond Market Index, and learned it also never had a loss more than -2.66%.

Of course, anything can happen plus the fact that past-performance does not forecast future returns. Nevertheless, 42 years should be a reasonable time to estimate a bond fund's downside protection and its non-correlation with stocks.

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Best Vanguard ETF Diversifiers, Ranked

Post by bondsr4me » Tue Oct 09, 2018 7:20 am

Taylor Larimore wrote:
Wed Oct 03, 2018 3:01 pm
bondsr4me wrote:
Wed Oct 03, 2018 12:36 pm
Taylor Larimore wrote:
Tue Oct 02, 2018 8:07 pm
I'd like to keep my portfolio as simple as possible. Would VTI + BND be a better combination than VTI + EDV?
Augustus:

VTI (Vanguard Extended Duration Treasury Index Fund ETF) is an excellent diversifier in many conditions. We have had a long period of interest rate declines which favor long-duration bonds. However, if interest rates rise, long duration bonds can be expected to suffer. In other words, don't depend on past returns to forecast future returns.

Diversification is great and EDV certainly adds that. However, bond fund declines must also be considered. EDV lost -36% in 2009. BNDs (Vanguard Total Bond Market) worst annual loss was -3% in 1994.

Vanguard Total Bond Market Index Fund is the largest bond fund in the world -- for good reasons , primarily its good quality bonds and its broad diversification (the only "free lunch" in investing).

Best wishes.
Taylor
Hi Taylor....

At the risk of sounding really foolish, where did you get BND 1994 loss of 3%?

VG's website says the fund inception is 4/3/2007.

Are you referring to VBLTX?

Thanks

Don
Don:

I am the one who sounds "really foolish." I should have realized that BND only goes back to 2007.

I purchased our Total Bond Market Index Fund (VBMFX) in 1986 after considerable investigation. I learned (rom Morningstar) that it's worst annual loss was -2.66% in 1994. I also went back to the inception in 1976 of its benchmark, Aggregate Total Bond Market Index, and learned it also never had a loss more than -2.66%.

Of course, anything can happen plus the fact that past-performance does not forecast future returns. Nevertheless, 42 years should be a reasonable time to estimate a bond fund's downside protection and its non-correlation with stocks.

Best wishes.
Taylor
Hi Taylor,

Thank you for your reply.
I kinda thought maybe that was the case.
I have recently taken a small position in BND, building towards my AA.
I still like to buy (at least for now anyway) short term Treasuries thru our VG account.

Again, "Thanks" for all you do here at the forum...appreciated VERY much!

Have a great week,

Don

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