Fund Watch
Three Winning Portfolios
These index funds will help you meet your short-, medium- and long-term savings goals.
By Bob Frick, Senior Editor, Kiplinger's Personal Finance
August 28, 2008
As miserably as Standard and Poor's 500-stock index has performed recently, it still has beaten two-thirds of big-company U.S.-stock funds over the past five years. And that, in a nutshell, is why simple portfolios of index mutual funds still make sound financial sense for many investors: They're a dependable way to get better-than-average returns.
Index funds seek to mirror a variety of barometers of the stock and bond markets. Rather than attempt to outpace the markets, these funds aim to match the performance of their indexes -- saving you the time and effort of trying to pick actively managed funds that you hope can consistently outperform the markets. Funds that are actively managed often beat their benchmarks over short periods of time, but few of them outperform over the long haul.
Why do index funds do so well? Mainly, it's because of their low costs. Index funds don't require highly paid managers and analysts to research companies, so they're generally cheap to operate. Vanguard 500 Index (symbol VFINX) carries an annual expense ratio of 0.15%, meaning that for every $1,000 you have in the fund, Vanguard will extract just $1.50 per year for operating costs. That compares with an average expense ratio of 1.4% for all diversified U.S.-stock funds.
Consider the impact of this on a $100,000 portfolio that earns 10% per year before fees. Compared with someone who owns a fund that charges the average expense ratio, an investor in Vanguard 500 Index would earn an additional $28,000 over ten years (not including the impact of taxes).
Because different parts of the stock market often move independently of each other, you can build a portfolio with steadier results by holding funds that focus on different areas. For example, in 2001 the S&P 500 lost 12%. But the Russell 2000, which tracks 2000 small U.S. companies, rose 2.5%.
In reviewing the portfolios of index funds Kiplinger's has recommended over the past ten years, we didn't find any that disappointed. So based on our tried-and-true methodology, we offer three portfolios for different goals:
Long term: 10-plus years away
Here's an all-stock portfolio that covers not just big and small U.S. companies, but foreign stocks and real estate as well. We've chosen Vanguard index funds, but you can just as easily use other low-cost index funds and exchange-traded funds that cover the same territory. The iShares brand of ETFs (iShares S&P 500 for big-company stocks and iShares Russell 2000 for small-company stocks, for example) would work just as well.
This portfolio returned an annualized 6.4% for the past three years through July 31 and 12.4% for the past five. Compare that with 2.9% and 7% for the S&P 500.
35% Vanguard 500 Index (VFINX) -- Large-company U.S. stocks
25% Vanguard Small-Cap (NAESX) -- Small-company U.S. stocks
25% Vanguard Total International Stock (VGTSX) -- Big-company overseas stocks
10% Vanguard REIT (VGSIX) -- Real Estate Investment Trust
5% Vanguard Emerging Markets Stock (VEIEX) -- Emerging-country stocks
Medium term: 5 to 10 years away
You're getting closer to your goal-be it funding retirement, paying for college or fulfilling some other large call on cash-so we've reduced the risk of this portfolio by allocating 30% to a bond fund, which should help your portfolio achieve smoother performance. Less volatile than the long-term portfolio, this collection returned 4.9% and 9.2% annualized over the past three and five years, respectively.
30% Vanguard 500 Index (VFINX) -- Large-company U.S. stocks
30% Vanguard Total Bond Market (VBMFX) -- Broad bond index
15% Vanguard Small-Cap (NAESX) -- Small-company U.S. stocks
15% Vanguard Total International Stock (VGTSX) -- Big-company overseas stocks
10% Vanguard REIT VGSIX) -- Real Estate Investment Trust
Short term: Fewer than 5 years away
You need to think more in terms of preservation of capital and current income, so we've bumped up the weighting in bond funds to 40%. The least volatile of the three portfolios, it returned an annualized 5% and 8.7%, respectively, over the past three and five years.
30% Vanguard Total Bond Market (VBMFX) -- Broad bond index
25% Vanguard 500 Index (VFINX) -- Large-company U.S. stocks
10% Vanguard Short-Term Bond (VBISX) -- Mainly U.S. Treasuries
10% Vanguard Small-Cap (NAESX) -- Small-company U.S. stocks
15%Vanguard Total International Stock (VGTSX) -- Big-company overseas stocks
10% Vanguard REIT (VGSIX) -- Real Estate Investment Trust
Reader Comments (17)
Posted by: Jack at 08/28/2008 03:16:37 PM
Why Total International and Emerging Markets? VGTSX already has what 10-20% in the emerging market area. It would seem we'd be increasing our risk by being in both.
Posted by: john at 08/29/2008 08:12:31 AM
why not the Vanguard GNMA fund?
Posted by: bob at 08/29/2008 11:37:05 AM
...Vanguard - good funds, but in all sectors?
Posted by: Miriam at 08/30/2008 01:44:04 PM
The short-term portfolio looks really practical and simple; I do not index, but if I did, I would not hesitate to follow this allocation; I try to follow a roughly similar strategy with low cost managed funds, including Vanguard Wellington and Wellesley Income
Posted by: Justin at 08/30/2008 05:24:14 PM
Or why not use the Vanguard Extended Market Index which blends small and mid cap stocks? The etf "VXF" could be a good option for that piece of the pie.
Posted by: hockeydad10901 at 08/30/2008 10:09:26 PM
Why not Vanguard Wellington? Well Balanced Fund and incredibly consistent over a long history. 65% stock, 35% bonds and a really solid performer yet i didn't see it anywhere in here. Why not?
Posted by: LuckyDuck at 09/02/2008 12:20:37 PM
I have avoided indexed funds in the past because most indexes reflect the high percentage of financials, some as high as 20%. Not a great place to be given the recent downdraft.
Posted by: Drew Horter at 09/05/2008 09:42:09 AM
For the lay person who does not have a quality fee based advisor this may make sense....Active mgt does work.
Posted by: Bob Frick at 09/10/2008 08:23:39 AM
Hey, this is Bob Frick, Kiplinger Personal Finance Senior Editor and author of this story. I wanted to respond to some of the comments here, in order to clarify, where possible.
The idea here is simplicity without sacrificing performance. The premise is based on the low cost advantages and predictability of index funds. If you're not convinced of that premise, and prefer actively managed funds, well ... that's a huge debate that I will gladly have, but this isn't the forum.
On adding emerging markets, I believe they deserve extra weight given the relatively higher performance. The additional volatility is minimal given the added return.
Why all Vanguard? Why not? You can argue for other index funds or ETFs, but additional gains are incremental and debatable. Vanguard Extended Market doesn't give a high enough weighting of small cap, in my opinion. Small cap outperforms large cap over time.
Index funds have high percentage of financials? Maybe, but when you get into underweighting or overweighting sectors you've just gotten into market timing and/or fundamental analysis, which is precisely what index funds avoid. A year from now (or two or three) when financials have come roaring back, you'll be singing a different tune. Will you have called that correctly? Only if you're lucky. I hope this helps.
Here is what I know, when it comes to individual investors and their portfolios: Most do not earn the market return. Study after study has proven this. Why? It is very hard not to invest emotionally, so we tend to buy high and sell low. So simply earning the market return is a victory for most. Well-diversified portfolios of index funds do this cheaply and dependably.
Can you beat the market if you think logically (not emotionally) about investments and have a well-diversified portfolio of top actively managed funds? I think so, but it takes time, knowledge and dedication. One of our missions at Kiplinger's to provide the knowledge and shorten the time needed. But I believe research shows many people don't have the time or understand what it takes to manage a portfolio properly. For these people, index fund portfolios are an excellent choice.
Posted by: Mehmet at 10/28/2008 07:10:49 PM
Market returns are superior returns. Even those who think they have the skills and time to do the research and beat the market have failed over time. Bill Miller was the only fund manager who beat the market consistently (15 years back to back), and even his fund's performance collapsed last year. These are excellent choices, but investors should also consider that international market indexes have slightly higher expense ratios (0.3 versus 0.15). If you read Bogle's common sense investing, he even advises against ETFs.
Posted by: Rhun at 11/30/2008 10:42:17 AM
Good starting points, but my main beef with these portfolios is that there is too little fixed income. I think if someone is less than 5 years away from retirement, at least 60% of the portfolio should be in bonds, preferrably short-term bonds. An example would be VBISX.
Posted by: DeConnick at 05/07/2009 05:30:56 PM
To Mehmet: Bogle cautions against ETF's, but opines if you go that route, treat them as long-term investments, and not as trading vehicles.
Posted by: Rimaye at 05/17/2009 01:23:31 AM
If "preservation of capital" is important in the short term, why is over 50% of the portfolio allocated to stocks? The events of the past year should have convinced everyone that holding a large portion of one's portfolio in stocks is a risky strategy if your horizon is short.
Posted by: Josh at 05/20/2009 04:04:58 PM
Bob, thanks for the article. I'm 25 and have a Roth IRA with Vanguard. Since the minimum investments for Vanguard funds are $3,000, it is not possible for me to have smaller percentage allocations yet. What advice do you have? Also, is Vanguard Total Stock Market Index an acceptable substitute for the two US stock funds?
Posted by: Bob Frick at 05/21/2009 09:02:00 AM
Hey Josh, Bob Frick here. Good question. There is no substitute for diversification, so we recommend people buy ETFs instead of index funds if they haven't yet accumulated enough money to diversify with index funds. You can buy ETFs for a fraction of what you pay for funds because they trade like stocks. Vanguard, for example, has enough ETFs (39 at last count) that you can build a diversified portfolio with them alone. While the Vanguard extended market index fund has a minimum in the thousands, you can buy a single share of the extended market ETF for $33. You have to be careful about fees, though. Since ETFs trade like stocks, you'll be paying a commission everytime you buy and sell. So once you've settled on a portfolio, don't do a lot of trading -- buy and hold is the ticket. I hope this helps. If you have any more questions, feel free to email me at rfrick@kiplinger.com.
Posted by: Carroll at 06/23/2009 02:03:34 PM
Bob, In the June 2009 issue of Kiplinger's, "An Investor's Manifesto" by Knight Kiplinger (p. 17) reads "My share of bonds equals my age." Suze Orman also recommends a percentage of bonds equal to age. However, in the article posted here and others in the magazine, it is regularly recommended to have most of my holdings in stocks if I have more than 15 years before retirement. I'm 40 and don't plan to retire until 65 - so which is it...40% in bonds (equals my age) or 0-10% in bonds because I have 25 years until retirement? Thanks.
Posted by: Bob Frick at 06/23/2009 04:25:57 PM
Carroll, Bob Frick here, author of this article. You've asked a great question, and one that unfortunately does not have one great answer, though the bond percentage=age rule-of-thumb certainly comes closest. It may be too conservative for someone in your situation, some might argue, because given in the 25 years you have until retirement, stocks will almost certainly outperform bonds. This is why our favorite target date funds (whole portfolios in a single fund) would be 90% stocks for someone in your position. The historical outperformance of stocks over bonds, over long periods, is also why our advice is often along the same lines. But many people's risk tolerance is such that they need more bonds in their portfolios for stability -- if their portfolios are too volatile, they'll often make bad investment decisions based on fear. A portfolio that you're comfortable with cannot be underestimated. There are other factors as well, which I'd be happy to discuss with you. Feel free to email me at rfrick@kiplinger.com.