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Dan’s new book for millennials, Wealthier: The Investing Field Guide for Millennials, is now available on Amazon.
Here’s a quote attributed to P. J. O’Rourke, an American author, journalist and political satirist: “There is a simple rule here, a rule of legislation, a rule of business, a rule of life: beyond a certain point, complexity is fraud.”
As a Registered Investment Advisor, you are legally obligated to act in your client’s best interests and provide them with the most effective strategies to achieve their financial goals. Yet, on two recent occasions, advisors have told me they recommended basic portfolios for new clients, but their firm required them to use more complex ones.
A policy that prevents advisors from recommending an uncomplicated portfolio to any investor is unconscionable.
A simple, two-ETF portfolio – combining a total stock market fund like the Vanguard Total World Stock ETF (VT) with a short-term bond fund like the iShares 1-3 Year Treasury Bond ETF (SHY) or the Dimensional’s Ultrashort Fixed Income ETF (DUSB) – could be more than adequate for most investors.
You could also consider Vanguard’s Short-Term Bond Index Fund ETF (BSV) and its Ultra-Short Bond ETF (VUSB) for the bond portion.
I know of one advisor at a multi-billion dollar firm who takes simplicity further. He puts most of his clients in a core fund, in an appropriate asset allocation.
He told me, “Their account statement is one line. They love it.”
He has compared the core fund’s performance to a more complicated portfolio and reports that it consistently has higher returns.
When complex portfolios are justified
Clients with substantial assets may require a more complex portfolio to address specific tax optimization strategies, risk management, diversification, and estate planning issues.
What about tax loss harvesting?
Tax-loss harvesting allows investors to offset capital gains by realizing losses, reducing their overall tax burden, and improving after-tax returns. This strategy can be particularly effective in portfolios with multiple funds, with more opportunities to harvest losses across different asset classes and sectors.
Continuous or systematic tax-loss harvesting may be beneficial, especially in volatile markets or during market declines. However, the benefits of tax loss harvesting may be overestimated because the future tax impact of harvested losses must be considered. Harvesting losses now could result in higher taxes later, when gains are realized.
In an extensive review of the benefits of tax loss harvesting, Michael Kitces concluded: “Tax loss harvesting (TLH) does have some economic benefit over time, although it’s driven not by the outright savings (typically measured by “tax alpha”), but instead by the economic value of tax deferral, which leads to modest but non-trivial economic benefits over time.”
Another justification often offered is that, in some instances, traditional investments are insufficient to meet an investor’s objectives, requiring alternative assets (like private equity, hedge funds, or real estate).
I’m skeptical of the benefits of publicly traded alternatives. They often seem to benefit the fund sponsors and those who recommend them more than the clients who buy them.
John Rekenthaler at Morningstar analyzed publicly traded alternatives with a minimum 15-year track record. All the alternatives he analyzed performed worse than an Intermediate Core Bond Fund, except for real estate, which was significantly more volatile than the bond fund.
The much-touted diversification benefits were also illusory. Rekenthaler reviewed the correlation between each alternative fund category and a traditional balanced fund that holds 60 percent of its assets in large-blend U.S. stock funds and 40 percent in intermediate core bond funds. He found that the returns of all alternative categories positively correlated with the bond fund, with seven of the 10 categories posting a high correlation.
Large institutional investors, like pension funds or endowments, often employ complex portfolios to achieve stable, long-term returns while managing liquidity, risk, and diversification across various time horizons and economic scenarios. These circumstances may justify the added complexity. However, for most other investors, a simple portfolio often trumps a complex one.
The appeal of a simple two-ETF portfolio
A portfolio consisting of VT, and SHY or DUSB (which I recommend in my latest book, Wealthier: The Investing Field Guide for Millennials), offers broad diversification with minimal management. VT provides exposure to the entire global stock market, covering over 9,000 stocks across all sectors and geographies. This single fund covers the portfolio’s equity side, making it incredibly efficient and comprehensive. Meanwhile, the addition of SHY or DUSB stabilizes the portfolio with short-term bonds, which are less sensitive to interest rate changes and provide a safety net during market downturns.
This simple structure is appealing because it is:
- Cost-effective: The two-ETF portfolio is cost-effective. VT has an expense ratio of 0.07 percent. The expense ratios of SHY and DUSB are both 0.15 percent.
- Easy to understand: Clients can quickly grasp how their money is invested, building trust and confidence.
- Efficient: Rebalancing is straightforward, requiring minimal intervention.
Is complex better?
Proponents of more complex portfolios argue that they allow factor-based investing.
If advisors want to tilt portfolios towards certain factors (e.g., value, small-cap, momentum), ETFs are now specifically designed to capture these factors. One such ETF is the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC), which “ tracks an index that selects stocks based on four distinct attributes associated with long-term performance: good value, strong momentum, high quality, and low volatility.” Its expense ratio is only 0.09 percent.
Another recent option is Dimensional’s World Equity ETF (DFAW) which tracks the MSCI All Country World IMI Index and offers “broadly diversified, total market exposure and aims to add value with integrated emphasis on securities with higher expected returns.” Its net expense ratio is 0.25 percent.
The downsides of factor-based investing are often poorly understood. They include higher risk and “decade-long periods of underperformance.”
For patient investors, factor-based investing “has the potential to improve a portfolio’s long-term risk-adjusted return, especially when strategies used are transparent, use sufficiently researched factors, and have low management fees and good implementation characteristics.”
Performance data
Ultimately, the issue for advisors and investors is performance. Do complex portfolios outperform simple ones?
Wealthier:
The Investing Field Guide for Millennials.
Why have so many financial advisors agreed to review an advance copy of Wealthier: The Investing Field Guide for Millennials. It empowers millennials to be responsible DIY investors and financial planners. You can see some of their reviews here.
Dan’s new book for millennials, Wealthier: The Investing Field Guide for Millennials, is now available on Amazon.
Here’s what one advisor said: "Saplings grow into trees. We need to help the next generation of investors get to where they need our services."
For more information, visit the website for Wealthier:
To review Wealthier send an e-mail to: [email protected]
Ben Carlson, the author of the insightful blog A Wealth of Common Sense, compared the performance of endowments reported in the NACUBO 2020 Endowment Study to a simple three-index fund Vanguard portfolio using different asset allocations.
The Vanguard index funds were the same ones I recommended in my 2006 New York Times bestselling book, The Smartest Investment Book You’ll Ever Read (which is probably why I continue to receive e-mails from investors who followed that advice and are comfortably retired).
Here’s a summary of his findings: “Not only did the simple Vanguard 3-fund portfolio beat the average endowment over 3, 5, and 10 years, but it also finished in the top quartile over those same periods.”
Reflect on that for a moment.
A “dumb” three-index portfolio beat the returns of the average endowment with enormous resources, including access to the best investment consultants money can buy.
A June 18, 2024 paper by the Center for Retirement Research confirmed Carlson’s findings.
The authors investigated pension plan performance over various periods since 2000. These plans typically used external managers and allocated a significant portion of their portfolios to alternative assets like private equities, hedge funds, real estate, and commodities.
Surely, the performance of these plans would demonstrate the benefit of the high fees paid to the sponsors of alternatives and the sophisticated managers advising the plans.
Unfortunately not.
It found that, since 2000, “pension funds’ annualized aggregate returns since 2000 have been virtually identical to a simple 60-40 index portfolio.”
The authors concluded: “If public plans cannot reasonably anticipate higher long-term returns from a complex active approach, they should stick with a simple and transparent strategy.”
Why isn’t this conclusion the same for RIAs advising individual investors?
Final thoughts
A fiduciary duty aims to ensure that clients receive advice that benefits them.
If a simpler, cheaper, and more effective portfolio would better serve the client, recommending anything else could be considered a breach of this duty.
Dan coaches evidence-based financial advisors on how to convert more prospects into clients. His digital marketing firm is a leading provider of SEO, website design, branding, content marketing, and video production services to financial advisors worldwide.
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