Market Musings 220225: A simple diversified ETF portfolio

Market Musings 220225:
A simple ETF portfolio

Podcast this week:
Is American exceptionalism here to stay? (click link to listen)

Reasons to believe that the US is exceptional.

1. The US economy has grown strongly over the last few years thanks to productivity and population growth.

2. The US is still the largest economy in the world and holds the world’s de facto reserve currency.

3. The US stock market, led by the S&P 500 index, has outperformed consistently over the past few years, while the US dollar has also strengthened.

The consensus view is: why buy any stock market outside the US? In this paper, I challenge this view.

1. US economic growth is set to slow.

2. The level of debt-funded government fiscal stimulus is gigantic and cannot be maintained, given the higher cost of debt.

3. The valuation of the S&P 500 index has become very extended compared to history.

4. Four hyperscalers among the Magnificent 7 plan to invest massive amounts in Artificial Intelligence. But how will this affect the return on investment?

5. The commoditisation of AI will boost economic productivity and accelerate AI adoption in the wider economy.

Conclusion:

1. Look beyond the US stock market and consider other stock markets: Euro area, UK, Japan, China.

2. Diversify away from the US technology sector towards other sectors: Financials, Industrials.

What should a model ETF portfolio look like?

This week, I am going to look at a request I have received from a friend of mine, Tony.

Tony has a relatively substantial amount of cash on deposit earning a good rate of interest at the moment, but is faced with lower interest rates in the near future as deposit rates are falling fast in line with the fall in central bank interest rates in the US, UK and Eurozone.

He is therefore looking to invest this money for the longer term to earn rather more than he will be able to get on cash deposits going forwards, but he wants:

• a simple ETF-based portfolio which he can invest in for capital growth over the longer term, given that

• he is still employed and thus has no immediate need for income from this investment portfolio;

• A diversified portfolio that spreads risk and does not just invest 100% in stocks or bonds;

• A portfolio that can be added to over time in a relatively automatic fashion without the need for sophisticated decision-making or frequent trading, and which keeps overall costs low.

He is very financially literate given that he has worked in finance all of his working career. However, given that he works in high finance and is therefore exposed to a certain level of career risk, he doesn’t want to take too great a financial risk with this investment portfolio.

Of course, we should add that his financial position aside from this cash-based investment portfolio also contains other historic assets, largely property-based.

So where to start with Tony’s request?

1. Keeping it as simple as possible

The good news is that, given the huge expansion of the ETF universe in both the US and Europe over the past few years, there is a huge array of ETFs available covering stocks, bonds, and other asset classes to boot.

But that is increasingly also becoming a key challenge for investors, as the array of potential choices has become simply overwhelming.

So let’s start with the simplest possible portfolio: a single ETF that can cover a number of asset classes in one instrument.

These do exist, in the form of:

• Vanguard ActiveLife Climate Aware 40-50% Equity Fund (VAN45AG) which is a fund, rather than an ETF so needs to be bought from Vanguard directly of via a platform that offers UCITS managed funds; there are also more aggressive (higher exposure to stocks) and more conservative (lower exposure to stocks) funds, but this middle choice gives 45% exposure to stocks and 51% exposure to bonds at present, with an ongoing annual charge of 0.48%.The bond exposure is a mixture of government and corporate bonds, and the geographic exposure has a pronounced skew to the US (59% of assets) as one might expect, given the dominance of US stocks.

• iShares Moderate Portfolio UCITS ETF (MODR in euros, MAMG in pounds) is an ETF of ETFs which has a 48% exposure to stocks, 50% to bonds and 1.5% to alternative assets. The ongoing charge for this ETF is 0.25% per year, but given that it invests in a number of other stock and bond ETFs from iShares, I would imagine that the true annual management charge is somewhat higher than this. The exposure to the US is highest at 49% of assets.

• Wisdomtree Global Efficient Core UCITS ETF (NTSG in euros, WGEC in pounds) which takes a different approach to the first two selections above, in that it adds an element of leverage (i.e. borrowing to increase exposure to stocks and bonds and thus higher potential returns over time). Using leverage, it creates a portfolio with 90% exposure to stocks and 60% to bonds, supposedly thus improving on the risk-return characteristics from a classic 60% stocks:40% bond portfolio. Total expense ratio is 0.25%, it has the highest exposure to the US at over 73%, and has only been in existence since November 2024 so there is little track record to judge this ETF on.

2. Why I am not so convinced of the merits of holding long-term bonds today

For me, there is a major issue with each of these three one-stop shop choices, as they all depend heavily on the expectation that exposure to bonds will diversify the risk from stocks, i.e. that when stocks go down (as they do from time to time), that bonds will in part compensate by increasing in value (typically during recession).

The problem is that this may have been true for the last 30-odd years by and large, but that over these 3 decades we have lived in an era of steadily lower inflation and thus falling bond yields, as they reflected lower and lower inflation expectations over time. In my view, this trend of lower inflation and lower bond yields has come to an end, and we very likely face a future with greater uncertainty of the direction of inflation and thus of bond yields.

In other words, this environment may overstate the likely future returns from the bond universe, and also overstate the diversification benefits of bonds when added to a portfolio containing stocks. As we saw in 2022, when inflation rises sharply and central banks are forced to increase benchmark interest rates, both bonds and stocks can suffer at the same time.

In the long run, the best predictor of bond returns is simply the current bond yield - in the case of the Bloomberg global aggregate bond index, the current yield is just over 3%. Even if you were to take just US or UK government bonds, this would only improve to 4%-4.5%.

So I am not convinced that it is today worth the extra risk of buying long-term bonds instead of short-term bonds, as the extra (inflation-related) risk is not well paid in terms of extra yield. In the US, you receive a 4.2% yield on a 2-year Treasury bond, and only 4.4% (i.e. +0.2% extra) for holding a much riskier 10-year bond. Similarly in the UK, you only get a 0.3% higher yield for buying a 10-year gilt (UK government bond) as opposed to a 2-year gilt.

The average historic premium for holding a US 10-year bond over a 2-year bond has averaged 1.1% over the last 30 years, giving some indication of why it has historically been better to hold longer-term bonds simply from an income perspective.

Over the last 5 years, global bonds have lost money (even including coupons paid)

Source: amundietf.com. Note:in euros

This can be seen in the 2022 performance of the Vanguard fund (-5.4% in pounds) and the iShares ETF (-15.5% in euros).

iShares Moderate Portfolio ETF: performance in euros

Source: ishares.com

I would argue that a true multi-asset ETF that delivers reasonable long-term performance and diversifies risk effectively needs to contain more than just exposure to stocks and bonds.

3. One multi-asset portfolio example: The Permanent Portfolio

The Permanent Portfolio is a portfolio evenly split between stocks, bonds, gold, and cash. Harry Browne introduced the concept in his book, Inflation-Proofing Your Investments, in 1981.

Mr. Browne designed the portfolio to weather all economic conditions, and historically, it has performed well. It is suited for risk-averse investors wanting to minimize losses while still receiving modest returns (because people hate the thought of losing more than gaining).

Harry Browne said a “portfolio split evenly between growth stocks, government bonds, precious metals, and Treasury bills would be an ideal mixture for investors seeking safety and growth.”

Each of these 4 components should perform well under differing economic conditions: long-term bonds perform best in deflation when stocks suffer and central banks cut interest rates; gold performs well at times of geopolitical crisis or high inflation; cash does well in times of recession; and stocks do well in times of positive economic growth.

Performance of this Permanent Portfolio has been pretty robust over the long term: over the last 30 years since start-1995, a US-based version of this strategy has delivered a 6.9% compound annual growth rate. It can be implemented with the following 4 ETFs in equal measure:

• A short-term government bond ETF or money market ETF for the cash component;

• A long-term government bond ETF;

• A physical gold ETF; and

• A stock ETF.

4. Permanent Portfolio, excluding cash

In Tony’s case, given falling cash deposit rates and the fact that he continues to earn a relatively high salary, I would argue that he does not need to put 25% into cash or short-term bonds.

So a simplification of this strategy that would earn higher returns at a modestly higher level of risk would be ⅓ in each of :

• A medium-term government bond ETF;

• A physical gold ETF; and

• A stock ETF.

A US-based version of this modified Permanent Portfolio (PP) returned 8.2% on average from 1992 to 2024, while suffering an 18% drawdown from peak to trough in 2007-09 (versus a 13% drawdown for the original PP), but the time to recover from bottom to previous pre-recession highs was the same in both cases at 11 months (trough in October 2008; recovery to new high by September 2009). Compare this to 35 months for US stocks to recover to their pre-crisis high hit in October 2007. It took 35 months (nearly 3 years) to return to pre-crisis highs, i.e. only by August 2012…

Note: returns in US dollars

5. Tweaking the Permanent Portfolio to improve risk-adjusted returns

We can also make small modifications to the choice of these 3 ETFs to modestly improve the risk-adjusted performance going forwards:

• I would be tempted to use a US inflation-protected (TIPS) bond ETF instead of a US or global government bond ETF as the performance of TIPS has been substantially better over time, and provides better protection in case of higher inflation over time.

• I would not invest 100% in a US- or MSCI World-based stock ETF as this is not sufficiently diversified and ends up being over-concentrated in mega-cap US tech stocks today; I would rather split the stock exposure into 2 ETFs - using an equal-weight US S&P 500 ETF for the US portion (as the equal-weight S&P 500 has beaten the traditional capitalisation-weighted S&P 500 significantly over time, and is better diversified).
  
  I would also use a MSCI Europe Quality ETF for European exposure (as this has significantly beaten the standard MSCI Europe index over time both in up and down-trending stock market phases).

Examples of UCITS ETFs for a euro-based investor to build this modified portfolio might thus be:

• ⅓ in TPSA (listed on Euronext Amsterdam) iShares USD TIPS UCITS ETF, denominated in euros. Yes you do take US dollar risk in this ETF, but I think that this should not be a big worry for a long-term investor.

• ⅓ in EGLN (listed on the London Stock Exchange) iShares Physical Gold ETC, denominated in euros.

• ⅙ in XDEW (listed on the German XETRA) Xtrackers S&P 500 Equal Weight UCITS ETF, denominated in euros. Again there is US dollar risk, but I avoid the currency-hedged versions as this adds cost over time.

• ⅙ in EQUA (listed on Euronext Paris) BNP Paribas Easy ESG Quality Europe UCITS ETF.

Similar versions of these ETFs denominated in pounds or US dollars are easily available for GBP and USD-based investors.

Next week, I will continue the possible ETF-based portfolio solutions, looking at the application of simple trend-following techniques to improve risk-adjusted performance over the long term, which are relatively simple and thus don’t require much work over time to put into practice.

Have a great week,

Edmund