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.).
- Vanguard Long-Term Bond ETF (BLV)
- Vanguard FTSE Emerging Markets ETF (VWO)
- Vanguard Emerging Mkts Govt Bd ETF (VWOB)
- Vanguard FTSE All-Wld ex-US SmCp ETF (VSS)
- Vanguard S&P Small-Cap 600 Value ETF (VIOV)
- Vanguard S&P Small-Cap 600 Growth ETF (VIOG)
- Vanguard Total International Stock ETF (VXUS)
- Vanguard Total Bond Market ETF (BND)
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