Which Asset Classes Offer True Diversification in Bear Markets?

The financial gurus are always looking for a new “alternative” asset class that both reduces the risk in your portfolio and increases returns. Longboard Funds looked at data from the past 15 years and examined what happened when you added 20% of various asset classes to a traditional 60/40 stock/bond portfolio. Below is a chart of the results based on two factors:

  • Did the asset class have a lower or higher correlation in declining markets? This reduces maximum drawdown.
  • Did the asset class improve overall historical return?


The 6 asset classes that both lowered max drawdown and increased overall return were:

  • Trend Following (SG Trend Index)
  • U.S. Treasuries (Barclays 1-3 Yr US Treasury TR Index)
  • MLPs (Alerian MLP TR Index)
  • Municipal bonds (Barclays Municipal TR Index)
  • Gold (S&P GSCI Gold Index)
  • TIPS (Barclays Gbl Infl Linked US TIPS TR Index)

I would add that your next consideration should be to research each asset class and determine which ones you have strong faith in over the long term. As diversifiers, these asset classes will have long periods of poor performance during bull markets. You must be able to hold onto these asset classes so that they can eventually help you in a bear market.

Personally, I do not have faith in trend-following, I don’t understand the fundamentals of gold (seems heavily based on speculation), and I don’t like the various complexities of Master Limited Partnerships. You may feel differently. That leaves me with the classic high-quality bonds: US Treasury bonds, Municipal bonds, and TIPS (also backed by US Treasury). Munis seem to be the best relative deal right now depending on tax bracket (and perhaps also I Savings Bonds?). None of these offer a ton of yield, but most importantly I’m okay holding them through these lean times.

How To Read Market Commentary and Stay The Course

forecastcloudEvery day, new articles are published telling you to buy this! Sell that! Hedge against this other thing! One of the most underrated skills in investing is the ability to stick to your plan and do nothing.

Some folks argue that that solution is to never listen to any market commentary (or “noise”). Keep your head down, plow your money into index funds and don’t look up until you’re ready to retire. Well, if you can do that, more power to you. However, I’ve been getting more e-mails from people scared to invest due to reports of high stock market valuations and rising interest rates. Here’s an example of how I read market commentary and keep on truckin’ ahead.

The Blackrock Investment Institute recently released their Q4 2016 Global Investment Outlook, which has a lot of carefully-considered statistics, charts, and predictions. The chart below compares the current yields of various asset classes as compared to their pre-crisis averages (2003-2008):


Blackrock’s analysis:

High valuations versus history point to more muted returns across asset classes in the long run. Yet slowing nominal GDP growth and aging populations argue for lower bond yields than in the past — and sustained demand for high-quality bonds. This structural shift changes the prism of assessing today’s valuations. It makes risk assets such as equities, credit, local EM bonds and selected alternatives look attractive on a relative basis.

I choose to take my risk and upside potential with stocks. While stocks have lower earnings yields (higher P/E) than pre-2008, they are still more attractive than high-quality bonds on a long-term basis. They are certainly more attractive than cash. US, European, Japan, Emerging Markets, nothing looks horrible.

I only invest in high-quality bonds because I want bonds to serve as portfolio ballast and help keep the ship steady. Risky bonds are more correlated with stocks, meaning if stocks go down then they are more likely to go down as well. I simply don’t want to own those types of bonds, even if they yield a bit more. Thus, I ignore any recommendation to buy high-yield corporate bonds, high-yield municipal bonds, and emerging markets bonds.

You can see that the high-quality bond yields are all significantly lower in the current environment. This second chart below looks more closely at the current bond picture. If you are in a high tax bracket, you should consider investment-grade municipal bond funds due to their high effective yields. Otherwise, a broad US Corporate bond fund (Investment Grade) is still a pretty good choice, and a a broad Total US Bond fund (US Aggregate) is in the “okay” zone.


If you’re doing the sensible index fund thing, perhaps via Vanguard Target Retirement fund, then I see nothing wrong with staying the course. Nobody knows what will happen in the next 1, 3, or 12 months. Stocks could drop. Rates could rise. But stocks could also keep going up. Rates could also stay flat for a decade. Investing for the long-term requires perseverance. Stocks are still compensating investors for taking risk and are more attractive than bonds in the long-term. I would still add some high-quality bonds to smooth out the ride.

Finally, keep on saving. As Jack Bogle says, “If we’re going to have lower returns, well, the worst thing you can do is reach for more yield. You just have to save more.”

iShares Core ETF Expense Ratios vs. Vanguard ETF Comparison (Updated 2016)


Updated 10/12/16. 18 iShares Core ETFs now trade commission-free at Fidelity. Blackrock announced price cuts to 15 out of its 22 iShares Core ETFs last week. The iShares Core series is their low-cost, index ETF line-up targeted towards buy-and-hold investors. Here are the updated expense ratios, alongside the expense ratios of the closest equivalent ETF from Vanguard for comparison. (Can you tell what their benchmark was?) Numbers are taken from the respective official websites as of 10/8/16.

Category Fund Name Expense Ratio Vanguard Expense Ratio
US Equity iShares Core S&P 500 ETF (IVV) 0.04% 0.05% (VOO)
iShares Core S&P Total U.S. Stock Market ETF (ITOT) 0.03% 0.05% (VTI)
iShares Core S&P Mid-Cap ETF (IJH) 0.07% 0.08% (VO)
iShares Core S&P Small-Cap ETF (IJR) 0.07% 0.08% (VB)
iShares Core Russell U.S. Growth ETF (IUSG) 0.07% 0.08% (VUG)
iShares Core Russell U.S. Value ETF (IUSV) 0.07% 0.08% (VTV)
iShares Core High Dividend ETF (HDV) 0.08% 0.09% (VYM)
iShares Core Dividend Growth ETF (DGRO) 0.08% 0.09% (VIG)
iShares Core MSCI Total International Stock ETF (IXUS) 0.11% 0.13% (VXUS)
iShares Core MSCI EAFE ETF (IEFA) 0.08% 0.09% (VEA)
iShares Core MSCI Emerging Markets ETF (IEMG) 0.14% 0.15% (VWO)
iShares Core MSCI Europe ETF (IEUR) 0.10% 0.12% (VGK)
iShares Core MSCI Pacific ETF (IPAC) 0.10% 0.12% (VPL)
US Bonds iShares Core U.S. Aggregate Bond ETF (AGG) 0.05% 0.06% (BND)
iShares Core Total USD Bond Market ETF (IUSB) 0.08% 0.09% (BIV)
iShares Core 1-5 Year USD Bond ETF (ISTB) 0.08% 0.09% (BSV)
iShares Core 10+ Year USD Bond ETF (ILTB) 0.08% 0.09% (BLV)
iShares Core International Aggregate Bond ETF (IAGG) 0.11% 0.15% (BNDX)
Asset Allocation ETFs iShares Core Conservative Allocation ETF (AOK) 0.24% n/a
iShares Core Moderate Allocation ETF (AOM) 0.23% n/a
iShares Core Growth Allocation ETF (AOR) 0.22% n/a
iShares Core Aggressive Allocation ETF (AOA) 0.20% n/a

* Note: Vanguard does not have ETF versions of their “all-in-one” asset allocation mutual funds.

Commission-free ETF trades. As of 10/12/2016, all 18 of the primary iShares Core ETFs can be traded commission-free in a Fidelity brokerage account (only the 4 Asset Allocation ETFs are excluded out of the 22 total). Here is the full Fidelity commission-free iShares ETFs list. Fidelity also has their own line-up of index fund options. You can trade all 4 of the iShares Asset Allocation ETFs plus 4 other iShares ETFs for free at TD Ameritrade.

You can also use a broker with free trades overall like the Robinhood app (review) and Merrill Edge which gives you 30 free trades per month with $50,000 in assets across your Bank of America and Merrill Edge accounts.

Bottom line. The demand for low-cost, well-run, index ETFs continues to grow. This move by Blackrock is more about professional money managers, as they’ll feel less pressure to move elsewhere due to higher costs due to fiduciary rules. The competition between iShares/Fidelity, Vanguard, and Schwab is making better products at lower prices for consumers. (Side bet: Blackrock will buy Fidelity in the next 5 years.) My personal investments (and lots of unrealized capital gains) are with Vanguard, but new DIY investors can now open an account at any of these three and build their own diversified, low-cost portfolio with no trade commissions.

See also: Schwab Index ETF Expense Ratios vs. Vanguard ETF Comparison

Schwab Index ETF Expense Ratios vs. Vanguard ETF Comparison (Updated 2016)


Schwab also had some reactionary price cuts to some of their Schwab Index ETFs last week. Here are the updated expense ratios, alongside the expense ratios of the closest equivalent ETF from Vanguard. In cases where both Vanguard and iShares compete, Schwab is now 2 basis points cheaper than Vanguard. This is because iShares recently dropped to mostly 1 basis point cheaper than Vanguard, and Schwab wants to keep the title of “cheapest”.

But let’s be clear, Vanguard’s success and mere presence (the “Vanguard effect“) is why these low-cost ETFs exist in the first place. Numbers are taken from the respective official websites as of 10/8/16.

Category Fund Name Expense Ratio Vanguard Expense Ratio
US Equity Schwab US Broad Market ETF (SCHB) 0.03% 0.05% (VTI)
Schwab US Large-Cap ETF (SCHX) 0.03% 0.08% (VV)
Schwab US Mid Cap ETF (SCHM)* 0.06% 0.08% (VO)
Schwab US Small-Cap ETF (SCHA)* 0.06% 0.08% (VB)
Schwab US Large-Cap Growth ETF (SCHG) 0.06% 0.08% (VUG)
Schwab US Large-Cap Value ETF (SCHV) 0.06% 0.08% (VTV)
Schwab U.S. Dividend Equity ETF (SCHD) 0.07% 0.09% (VYM)
Schwab U.S. REIT ETF (SCHH) 0.07% 0.12% (VNQ)
Schwab International Equity ETF (SCHF)* 0.07% 0.09% (VEA)
Schwab International Small-Cap Equity ETF (SCHC) 0.16% 0.17% (VSS)
Schwab Emerging Markets Equity ETF (SCHE)* 0.13% 0.15% (VWO)
US Bonds Schwab U.S. Aggregate Bond ETF (SCHZ)* 0.04% 0.06% (BND)
Schwab U.S. TIPS ETF (SCHP) 0.07% 0.08% (VTIP)
Schwab Short-Term U.S. Treasury ETF (SCHO) 0.08% n/a
Schwab Intermediate-Term U.S. Treasury ETF (SCHR) 0.08% n/a

* indicates ETFs that had a price cut 10/7/16.

Where should self-directed investors buy these ETFs? You can trade all Schwab Index ETFs commission-free in a Schwab brokerage account. Here is the full of over 200 commission-free ETFs at Schwab OneSource.

You can also use a broker with free trades like the Robinhood app (review) and Merrill Edge which gives you 30 free trades per month with $50,000 in assets across your Bank of America and Merrill Edge accounts.

Bottom line. Schwab has shown a willingness to sacrifice profits in the short-term in order to keep the title of “cheapest index funds”. I think this is brave move with long-term vision, and hopefully they can keep it up. The competition between iShares/Fidelity, Vanguard, and Schwab continues to lead to better products at lower prices for consumers. My personal investments (and lots of unrealized capital gains) are with Vanguard, but new DIY investors can now open an account at any of these three and build their own diversified, low-cost portfolio with no trade commissions.

See also: iShares Core ETF Expense Ratios vs. Vanguard ETF Comparison

More Charts: Withdrawal Rates and Portfolio Longevity

Here’s another pair of tidy charts about safe withdrawal rates, or the amount you can safely withdraw from your retirement portfolio without running out. They are taken from this Blackrock page, specifically their “one-pager” 2-page PDF.

First up, this chart shows how a $1 million portfolio would have done over a 30-year period, given withdrawal rates between 4% and 8%. They specifically chose a start date of December 31, 1972 because it was right before a large drop in the stock market. Click to enlarge.


No matter what the withdrawal rate, the total balance dropped from $1,000,000 down to roughly $600,000 in the first three years. The hypothetical portfolio was 50% stocks and 50% bonds. That must have been quite stressful. The chart gives you a feel of how a lower withdrawal rate can extend the longevity of your portfolio.

The second chart uses Monte Carlo probabilistic modeling to show you the percent chance that your assets will last for retirement, given several variables. You can adjust the time period (20 to 30 years), the portfolio asset allocation (from 20% to 100% stocks) and your withdrawal rate (1% to 10%). Click to enlarge.


I wouldn’t use these as definitive numbers, and there are other similar scenario generators out there. Just consider them another data point to add to the collection. Note that all the scenarios above assumed a fixed withdrawal strategy as opposed to a more flexible dynamic withdrawal strategy.

Robinhood Gold Review: $10 a Month For Extended Trading and Interest-Free Margin

rhgold0The Robinhood app became well-known for their free stock trades and sleek app-only interface. People wondered, how will they make money? Well, they just announced one way – Robinhood Gold, a premium plan starting at $10 per month with the following highlights.

  • Extended hours trading. In addition to standard trading hours, you can start trading a half-hour earlier (pre-market) and two hours later (after-market).
  • Additional buying power. The equivalent of a margin account, or a line of credit for the stock market. You get up to 2x your buying power so you can invest more, and keep any profits. You pay no interest, just the flat monthly fee.
  • Bigger instant deposits. Instant Reinvesting lets you access proceeds from a stock sale immediately, instead of having to wait for it to settle. Instant Deposit eliminates the three-day wait period for funds to transfer from your bank into Robinhood.

Let’s look at these features more closely.

Extended hours trading.. Traditionally, the markets are open from 9:30 am EST to 4:00 am EST during normal business days. With extended hours trading, every market day you’ll be able to trade an extra two and a half hours:

Pre-Market opens 30 minutes earlier starting at 9:00 am EST
After-Hours continues for 120 minutes (2 hours) until 6:00 am EST

Do you really need these hours? If you don’t have a specific reason, then you may want to steer clear. Liquidity is limited, price volatility is high, and you’ll be trading against mostly professionals and/or computers. It’s also not that special… Most other brokerage firms also allow extended hours trading.

Additional buying power. Robinhood Gold upgrades you to a “full” margin account. For one, this means that you can get immediate access to funds after selling stock. That means you can reinvest those funds without waiting three days for settlement. This also means that they are required by law to have a minimum balance of $2,000.

Margin is essentially borrowing money from Robinhood and using your cash and stocks as collateral. The amount of extra “Gold Buying Power” you get is based on how much you pay, up to 2X your normal buying power. If you invest in high volatility stocks like penny stocks or leveraged ETFs, they may also limit your buying power to less than 2X.

  • $2,000 of extra buying power is $10 a month, with 0% interest
  • $4,000 of extra buying power is $20 a month, with 0% interest
  • $6,000 of extra buying power is $30 a month, with 0% interest
  • $10,000 of extra buying power is $50 a month, with 0% interest
  • Additional buying power over $50,000.00 has a yearly interest rate of 5.0%.

For example, if you have $2000 in your account, you can get at most $2000 in Gold Buying Power. But if you increase your account value to $3000 by depositing $1000, you can get at most $3000 in Gold Buying Power (if you are on the appropriate tier).

Now, if you really cared about margin, you’d probably use a broker with cheap margin rates like Interactive Brokers. IB’s current margin rates for a $2,000 balance is 1.9%, which would amount to $38 a year in interest if you carried a $2,000 balance for an entire year. (IB also requires you to spend at least $10 a month in commissions and fees if you hold less than $100,000 in assets.) On the other hand, TD Ameritrade will charge you 9.25% on a $2,000 balance, or $185 a year. Compare with Robinhood Gold at $10 a month would be $120 a year.

Bigger instant deposits. Another way that Robinhood lets you borrow some short-term money is with Instant Deposits. When you initiate an ACH deposit at most brokerages, you have to wait 3 business days for the money to actually show up. With Instant Deposits, you can use the money to buy stocks instantly. Your maximum instant deposit amount is the same as your extra buying power tier above ($2,000 for $10/month, $4,000 for $20/month) etc.

Instant deposits let you act on a stock idea quickly without having a bunch of idle cash sitting around all the time. You can keep it in an online savings account earning 1% instead of nothing at Robinhood.

What about Robinhood Instant? Robinhood Instant is a free middle tier that has been around for a while. Priority access is given based on the number of referrals you send to them. Your mileage may vary, but I referred two other people to Robinhood and was given access to Robinhood Instant. There is no hard number, that’s just my data point. This is a “limited” margin account that has the following features:

  • Get immediate access to funds from selling stock. That means you can reinvest those funds without waiting three days for settlement. (Again, any brokerage margin account offers this.)
  • Limited instant deposits. Use up to $1,000 of your pending bank deposits right away.

How do I get Robinhood Gold? They are rolling it out gradually. Preferred clients, including those that have referred other new users, will have priority. They will e-mail you, or you can see it in your app. Some people got access to it immediately upon launch.

Bottom line. Robinhood has been doing a nice job of meeting their basic promise of free stock trades. Robinhood Instant is a useful upgrade, although you’ll have to convince a couple friends to join. At the same time, they don’t let you use leverage, which magnifies both gains and losses.

Robinhood Gold takes off the training wheels and gives you a full margin account, for a fee. You are moving from credit as a temporary convenience to enabling riskier trading with long-term leverage and extended trading hours. This may be appealing to a newer trader that eventually wants a bit more buying flexibility. For a serious trader that uses a lot of margin, it may be cheaper to go with another broker with low margin rates.

Vanguard Advice on Dynamic Retirement Spending Rules

eggosThere is a lot of focus on how to accumulate a big nest egg, but possibly even more complicated is how to spend it down. Vanguard Research has released a new whitepaper called From assets to income: A goals-based approach to retirement spending [pdf] (companion article). The three major topics covered are (1) spending rules, (2) portfolio construction, and (3) tax-efficient withdrawal ordering in retirement. This is a long, dense paper covering a lot of ground, so here are my highlights of just the dynamic spending rules.

The two major competing goals of spending strategies are:

  1. You want your nest egg last for the rest of your life. Well… yeah. If your portfolio drops 25%, your stress level goes way up.
  2. You want a consistent level of income. Everyone likes a reliable stream of income, especially if you’re used to a reliable paycheck during your working years. Having income drop by 25% on year can also be quite painful.

One major consideration is your initial, or target portfolio withdrawal rate. Here’s a figure showing how four primary factors can affect this choice: time horizon, asset allocation, flexibility in annual spending, and how certain you want to be that your portfolio won’t be depleted.


Another major consideration is how to adjust your withdrawal each subsequent year. Vanguard supports a hybrid solution called “dynamic spending” that is a compromise between someone who completely ignores market performance (reliable income most important) and someone who is completely dependent on market performance (portfolio lasting forever most important).


Here’s how dynamic spending works.

  1. Once a year, multiply your current portfolio balance by your (initial) target portfolio withdrawal rate. This is your unadjusted target spending for the year. For example, $1 million times 5% = $50,000.
  2. Determine your ceiling (maximum) and floor (minimum) based on last year‘s spending number. For example, you may say that it can only increase by 5% or decrease by 2.5%. If this is your first year, just stick with your existing number.
  3. Compare the two numbers. If your unadjusted number exceeds the ceiling amount, spend the ceiling. If your unadjusted number is below the floor amount, spend the floor. If unadjusted number is in between, the unadjusted amount becomes your final number.

For example, if last year’s spending was $50,000, then your upper and lower “bumpers” for this year will be $48,750 and $52,500. No matter what the market does, you’ll stay in between these two numbers. You can see a worked-out example using actual numbers in this previous WSJ article.

Your flexibility is rewarded with better portfolio survival odds. Here’s the results of an analysis with the following assumptions: moderate asset allocation of 50% stocks (60% U.S. equity, 40% non-U.S. equity) and 50% bonds (70% U.S. bonds, 30% non-U.S. bonds), a time horizon of 35 years, and initial portfolio withdrawal rate of 5%.


You can see that your portfolio success is improved significantly, even with a relatively high target withdrawal rate of 5%. You can see here that Vanguard picked the 5% ceiling and the 2.5% floor because it provided a portfolio survival rate of 85% over a 35-year time horizon.

Being flexible during periods of poor performance is most important. Vanguard found that a retirees’ ability to accept changes in their floor helps their portfolio more than increasing their ceiling hurts it. Here’s a modified chart from the paper that shows how your portfolio survival rate improves with a lower floor percentage.


You have to be careful, as having your withdrawals drop 5% a year for 5 straight years might be more than you can handle. You should carefully examine how much flexbility you have in your spending, taking into account other income sources like Social Security. In general, the numbers support Vanguard’s suggestion of a 5% ceiling and 2.5% floor as a good starting point.

Finally, here are some initial/target withdrawals that will get you 85% survival certainty for various time horizons and asset allocations. Click to enlarge. I’d prefer to see some numbers with a 95% survival certainty.


Since my time horizon is (hopefully) closer to 50 years and I want a significantly higher survival certainty, I am personally thinking about a 3% target withdrawal rate combined with a 5% ceiling and 2.5% floor.

Warren Buffett’s Ground Rules: Do-It-Yourself Investing Guidelines


Okay, so you probably aren’t reading a book titled Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor if you are perfectly happy owning solely index funds forever. While the shared concepts with low-cost, passive investing still apply, here are things to consider if you want to do some of your own picking and choosing between individual stocks and bonds.

Given how much energy an 86-year-old Buffett seems to have, it must have been very interesting to invest with him as a hungry young man. On the other hand, reading through the partnership letters also shows how mature he was in his late 20s and early 30s.

Be honest with yourself. Pick a yardstick ahead of time. You need to pick a proper benchmark against which to measure your performance, not just having positive or negative years. Back in 1966, it was the Dow over the last 3 years. Note that it wasn’t just an index, but also a timeframe of at least 3-5 years.

If you’re going to invest a portion of your portfolio on your own, always keep track of your performance. You need to be honest about your results and whether they beat the rest of your portfolio, or even a simple target-date fund.

Investing modest amounts is an advantage. Use it. Warren Buffett had a lot more flexibility with a smaller asset base. There are many deals out there that on a percentage basis are attractive, but if you have to deploy billions, it won’t even move the needle. For example, there might a 12-month CD that earns you 8% APY, but only on $10,000. If you only have $20,000 to invest, putting a big chunk of your portfolio in a risk-free 8% would be much smarter than stocks over the next year. However, if you have $100 million to invest, such a deal would be a rounding error. Some other transactions like odd-lot tenders are also ideal for smaller investors.

Worry about risk and return, not about the name of the product. It doesn’t matter if it’s a laundromat, rental unit, shares of a public company, or bonds. When Buffett was winding down his partnership, municipal bonds were yielding 6.5% on a tax-free basis. In his mind, it was a better investment to buy the municipal bonds rather than stocks given the near-term prospects. So that’s what he recommended.

Ignore the crowd. Think rationally and independently. If you’re going to “beat the market”, then you have to think differently than the market. You’re looking for some area where the market price is much lower than the intrinsic value. By definition, that means a lot of people will be disagreeing with your opinion.

Develop your best ideas, and then bet big on it. Buffett is not a big fan of owning 100+ stocks in the name of diversification. If you have your 5-10 best ideas, why also invest in the other 90 that are worse? If you’re going to actively manage your portfolio, you must have the conviction to bet big on your opinions.

Self-confidence is required, as you will have periods of bad performance. For me, keeping my conviction during times of underperformance is the primary reason most of my portfolio is indexed. Here a stat from the book credited to Joel Greenblatt: Of the top 25% of managers who had outperformed the market over the decade: 97% spent at least 3 years in the bottom half of performance and 47% spent at least 3 years in the bottom 10%.

If you are hiring an outside manager, look at integrity first. Buffett on the types of managers he seeks for Berkshire:

We look for three things: intelligence, energy, and integrity. If they don’t have the latter, then you should hope they don’t have the first two either. If someone doesn’t have integrity, then you want them to be dumb and lazy.

As a side example, here is how Buffett organized his own fee structure for the partnership. If the fund did not accumulate anything past a 6% annual gain every year, he would not take any fees at all. Above the 6% annual rate, he would take 25% of gains as his fee. While some hedge funds also employ a “high water mark” system, they usually still have some form of flat fee that they take, no matter way. If Buffett didn’t reach his 6%, he got nothing. In addition, he had nearly all his own net worth in the partnership as well. He “ate his own cooking”.

Warren Buffett’s Ground Rules: Shared Concepts with Low-Cost Index Funds

groundrules0If you get in a debate about owning index funds, Warren Buffett will likely be invoked as an example of successful stock-picking. A recent book called Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor covers a period when Buffett was arguably at his peak of active stock trading. However, even during this time, Buffett’s rules and wisdom still shared a lot in common with low-cost index investing.

From 1956 to 1970, Buffett managed a relatively modest amount of money through the Buffett Partnership Limited (BPL), mostly from family and close friends. Already a good teacher, he wrote his partners a series of transparent, frank, and educational letters. While he does write a lot about his outperformance goals and successful trades, but here are examples of how you can be both a Buffett fan and an index fund fan.

You are buying fractional ownership of a real business. Too often, stock trading is treating like playing a game with numbers that zip up and down. Even if you just buy index funds, you should always realize that you are still buying a piece of a business and all its future earnings. These businesses employ hard-working people and provide tangible value and useful services to customers.

In the long-term, the market is efficient. Value investing tries to take advantage of times when the quoted prices of shares vary from “intrinsic value”. Market quotes will vary in the short-term, and you can’t predict them. You can only choose whether to buy, sell, or do nothing. However, value investing also relies on the price eventually returning towards intrinsic value in the long run.

If you buy index funds, you do not spend your time and energy determining intrinsic value. However, you also believe that the markets will work themselves out over the long run.

In the short-term, be ready for big drops in prices. Even though index funds give up the search for intrinsic value, all stockholders are subject to the same short-term swings. From a 1965 BPL letter:

If a 20% or 30% drop in the market value of your equity holdings is going to produce emotional or financial distress, you should simply avoid common stock type investments. In the words of the poet Harry Truman – “If you can’t stand the heat, stay out of the kitchen.” It is preferable, of course, to consider the problem before you enter the “kitchen”.

Beating a diversified index of companies is hard. From a 1962 BPL letter. Buffett made these observations more than a decade before a single person owned an index fund… because they didn’t exist yet.

The Dow as an investment competitor is no pushover and the great bulk of investment funds in the country are going to have difficulty in bettering, or perhaps even matching, its performance.

You may feel I have established an unduly short yardstick in that it perhaps appears quite simple to do better than an unmanaged index of 30 leading common stocks. Actually, this index has generally proven to be a reasonably tough competitor.

Consider after-tax results. Buffett offers good advice in that you should always keep track of your portfolio on an after-tax basis. If you are creating a lot of short-term capital gains, your outperformance has to be rather significant in order to counteract the additional tax drag. This doesn’t mean that Buffett never traded – he did a lot of transaction in the partnership years – but he also had many years of awesome returns.

Today, some people criticize Berkshire for not distributing a dividend, but in fact Berkshire does a great job deferring taxes so that the growth can keep compounding and keep your after-tax returns higher. If cash is needed, a Berkshire shareholder can always sell some shares.

A market-cap-weighted index fund usually has very low turnover and thus minimized tax drag. An actively-trading mutual fund that has the same pre-tax performance numbers as a passive mutual fund will often have lower after-tax performance.

More assets makes it much more difficult to create outperformance. More assets doesn’t always translate into lower returns, but as Buffett states you must have enough ideas to put that money to good use. From a 1964 letter:

Our idea inventory has always seemed 10% ahead of our bank account. If that should change, you can count on hearing from me.

Buffett stopped accepting new partners when asset levels reached $43 million. He decided to unwind the partnership completely in 1969, for a variety of reasons. He eventually found a better way to align his interests by all becoming shareholders of Berkshire Hathaway (and only taking a small salary as CEO).

A mutual fund with high performance will naturally attract a lot of assets. The good ones will stop accepting funds if the asset levels outrun their supply of great ideas. The bad ones will keep accepting funds because it means higher management fees. However, with Vanguard index funds the problem goes the other way. As the asset levels rise, the costs go down and the performance is unaffected. Here’s an interesting profile of the little-known manager of the Vanguard Total Market Index Fund, which now holds nearly a trillion dollars in assets.

Vanguard Complacency Check

vanguard_logo_snoozeVanguard recently celebrated the 40th anniversary of the Vanguard 500 Index Fund, the first index fund available to individual investors. If you are like me and have a significant portion of your net worth in Vanguard products and services, you should read this Morningstar article No Signs of Complacency at Vanguard which includes excerpts from interviews with Vanguard executives. Here are highly-condensed highlights:

  • Vanguard is huge and getting bigger.
  • Vanguard is still the only place where the firm is owned by the fundholders.
  • Vanguard costs are low, but it will be hard to get much lower.
  • Competitors can sell their products at a loss. Vanguard can’t, so they may not be the cheapest.
  • So far, there are no signs of complacency, wasted money, or ego-driven moves.
  • Vanguard’s next move will be focusing on better service for clients.

My thoughts. Vanguard has focused primarily on asset growth. This was okay, as bigger assets meant lower costs for fundholders. Now that costs really can’t go that much lower, I agree their next move should be to focus on customer service, both in terms of human interactions and online user experience.

Compared to Fidelity and Schwab, it has been in my experience more difficult to get specific, custom requests accomplished with Vanguard. This includes estate paperwork and large transactions. That means it is harder to get someone on the phone, the person on the phone is less responsive and/or knowledgeable, and overall it takes longer for the action to get done (if it is even allowed). These limitations are probably reflective of their focus on cost savings, but hopefully they can find a better balance. (I’d rather they spend money on this, than more advertising.) I do feel that Vanguard has been improving their technology, so I hope they keep that up.

Jack Bogle WSJ Interview Highlights (September 2016)

wsj_bogleWhen Jack Bogle grants an interview, I sit down and take notes in case he drops something significant. Here is a link to his WSJ interview dated 9/2/2016 (paywall, use Google redirection if needed).

  • Bogle estimates 2% annualized returns over the next decade (he does not forecast past that).
  • Stay invested in a diversified portfolio of stocks and bonds at very low cost.
  • Don’t reach for yield. You just have to save more.
  • Don’t go to cash.
  • He’s fine with 5% of your portfolio in gold, if you like that.
  • He’s still sees no need for international stocks.
  • He’s not worried about too much money flowing into index funds.
  • Bogle predicts that in five years, Fidelity will be sold.

The interview is rather vague in a few areas. I am assuming that the 2% annual returns forecast applies to after-inflation returns of a 50% stock and 50% bond portfolio. This is based on Bogle’s October 2015 presentation which predicted 3% after-inflation returns for a 50/50 portfolio. Since then, stock markets are up and bond yields are down, so future expected returns are now even lower.

Another little nugget is a link to a previous WSJ interview from exactly 10 years ago – 9/2/2006. It provides some additional background to the initial creation of the first index fund for individual investors.

Schwab Target Date Index Funds Review


Charles Schwab has announced Schwab Target Index Funds, a new series of “all-in-one” target date mutual funds that are made up entirely of in-house Schwab Index ETFs and a Schwab cash mutual fund. Their existing offering Schwab Target Funds differs in being significantly more expensive and including a mix of passive and actively-managed funds. Each fund will have a target date between 2010 and 2060, spaced in 5-year increments. Let’s take a closer look.

What’s inside? The portfolio for any given target year is composed of 9 different asset classes. Here is a graphical illustration of their “glide path”, or how the asset allocation changes relative to the target retirement date. (Source. Click image to enlarge.)


Here’s a 2016 snapshot of what every fund is holding by target date (Source. Click image to enlarge.):


Overall, the glide path conforms to industry norms, with high equity at younger ages and lower equity as you reach and pass retirement. Here are the ETFs and mutual funds that represent each asset class.

  • US Large Cap Equity – Schwab U.S. Large-Cap ETF (SCHX)
  • US Small Cap Equity – Schwab U.S. Small-Cap ETF (SCHA)
  • International Developed Equity – Schwab International Equity ETF (SCHF)
  • Emerging Markets Equity – Schwab Emerging Markets Equity ETF (SCHE)
  • Real Estate – Schwab U.S. REIT ETF (SCHH)
  • Short-Term Bond – Schwab Short-Term U.S. Treasury ETF (SCHO)
  • Intermediate-Term Bond – Schwab U.S. Aggregate Bond ETF (SCHZ)
  • Inflation-Protected Bond – Schwab U.S. TIPS ETF (SCHP)
  • Cash – Schwab Variable Share Price Money Fund — Ultra Shares (SVUXX)

How much do they cost? What are the investment minimums?

  • Individuals can buy Investor Shares with an expense ratio of 0.13%. The minimum initial investment is $100.
  • Employer-sponsored retirement plans can access the Institutional Shares with an expense ratio of 0.08%. There is no minimum initial investment.

An interesting thing to note is that the mutual funds technically have an extra layer of management fees and “other fees” on top of the expenses from the underlying ETFs and mutual funds. However, Schwab has agreed to cap the expenses at 0.13% for Investor Shares and 0.08% for Institutional Shares. This is supposed to stay in place “for so long as the investment adviser serves as the adviser to the fund”… they might want to re-word that.

In any case, even with the cap, the Investor Shares still cost more than the expenses from the underlying investments. You are basically paying 0.05% to 0.08% for some simple asset allocation. That means you could build your own portfolio using the same Schwab ETFs at a lower cost. You could also get rid of the (unnecessary in my opinion) cash component, which currently only yields 0.43% with another temporary fee waiver as of 8/26/2016. Personally, that’s what I would rather do, but I will admit that some folks will do better with an automated asset allocation.

How does it compare with Vanguard Target Retirement Funds? This is the natural comparison, as Vanguard’s target funds have the most assets and they used to be the cheapest before Schwab came along. Across the series, the expense ratio for their retail fund varies between 0.14% and 0.16%. You can now see why Schwab has priced their funds just below that at the “sale price” of 0.13%. Schwab loves to be cheaper by a basis point or two.

In terms of asset allocation and glide path, here are some side-by-side comparisons:

  • Vanguard has a equity split of 60% domestic and 40% international. Schwab has a equity split of 67% domestic and 33% international (if you consider the 4% US REITs as US stock).
  • Vanguard starts at 90% equity max and reaches 50% equity at retirement age. Schwab starts at 95% equity max and reaches 40% equity at retirement age.
  • Asset classes that Schwab includes specifically, which Vanguard does not: REITs, inflation-protected bonds (TIPS), and cash.
  • Asset classes that Vanguard includes specifically, which Schwab does not: International bonds.

Commentary. Schwab is definitely serious about index funds. They’ve built their own set of low-cost index mutual funds and index ETFs to compete with Vanguard and iShares. They already have an automated portfolio “robo-advisor” called Intelligent Portfolios, which uses these index funds as well as some “smart beta” funds. They’ve added these Target Index funds to grab the 401(k) and individual markets including IRAs. Put another way, they sell flour and butter, and they also sell pre-made pies and cakes.

This is a long-term play for Schwab, as they’ve all but admitted that the index ETFs themselves are currently losing money, while hoping to either make up the difference in other fees, services, or products somewhere down the line (like when interest rates rise again). Schwab will surely grab much more assets from employer retirement plans as a result of this move. In my limited experience with them, I have found Schwab to have solid customer service, at times in fact better than Vanguard. If they can leverage their customer service and human component, I think this is a smart move on their part.

However, if given the choice, I’d recommend my family to buy Vanguard Target Retirement funds first because Vanguard is not a for-profit company and I trust Vanguard more to keep customer interests first over the long run. (I believe that Schwab includes cash where it isn’t necessary in order to increase their future fees from money market funds, which are an important contributor to profits. This isn’t as significant here as in their robo-advisor product, but it will matter more as interest rates rise. More importantly, Vanguard doesn’t play such games.) However, big-picture-wise they are very similar. I’d gladly recommend that they buy a Schwab Target Index fund in their 401(k) or 403(b) plan as they are likely the best options if available. This is a positive development overall for individual investors.