In an ideal world, such a plan would need to be seriously easy to set up and maintain, offer the prospect of strong but steady growth over the ultra-long term and, by avoiding those occasional but potentially devastating bear markets, take full advantage of the remarkable wealth-building power of compound returns.
Such a strategy, we discovered, really does exist. Its historical performance of 11%+ average annual gains over 36 years (with only one negative year: minus 0.59% during the carnage of 2008) would have beaten all but the world's greatest money managers and at astonishingly low levels of risk.
Further tests on historical stock market data right back to 1900 show the plan's ability to match or even exceed returns from a benchmark index during the good years, whilst avoiding disaster in the bad years. More on this critical risk-reduction aspect of the strategy in our final installment, Part 3.
I claim absolutely no credit for creating it: the plan was originally published in a working paper by Mebane Faber in 2006, published in the Journal of Wealth Management in 2007 and then expanded upon in his book 'The Ivy Portfolio' the following year; however, having spent a while studying how I might use it myself, I've come up with one or two tweaks and (dare I say) improvements I'd like to share with you in these posts.
AN INVESTMENT STRATEGY
FOR LIFE
(NOT JUST FOR CHRISTMAS)
So let's get down to brass tacks. If you're a seasoned investor, the following will probably seem yawn-inducingly simple. To which I say: halleluiah! Following a complex strategy may make you feel smart, but since when was being smart any guarantee of making money? Quite the reverse: you'll get plenty of kudos once you're rich but you might as well get there the simplest way you can.
If you aren't seasoned (or even yet an investor) I hope to make this as straightforward as it can possibly be. Jargon-phobic? Gobbledy-gook will be explained (and if I forget something, check here). Mathematical dunce? Fear not: it's as easy as Pi.
By the time this post is through, you'll have chewed and smoothly swallowed the meatiest part of the process: how to set up a small portfolio of investments you can hold, essentially, for life.
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(Everything you ever longed to know about)
DIVERSIFICATION
Huge tomes have been written on this mind-numbingly tedious subject, but essentially all any investor really needs to know is this:
- using a combination of assets which are un-correlated, or inversely correlated, reduces the total amount of risk in your portfolio; factoring in that lower risk, the combined portfolio will outperform any one of those individual investments over time.
Translated into grandma's terms, it's 'don't put all your eggs in one basket'. In fact, grandma, you want one basket made out of steel (in case of fire), one made out of wool (to withstand a cold snap), one made of sponge (in case you drop it), etc.
By combining all these different asset types into one portfolio, each of which should perform well under a different scenario, you will smooth out your overall returns and make it very unlikely you'll suffer the kind of wipeout that, say, many pure stock traders or real-estate investors suffered during the dot-com and housing busts.
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A 'rope' of returns -
individually vulnerable, collectively strong |
It's as if you're trying to weave a rope: a single strand may not be hard to break, but multiple strands intertwined become almost indestructible. Find the right combination of investments and your portfolio should be able to weather almost any storm.
THE IVY SOLUTION
In his paper, Mebane Faber suggests a simple combination of five asset classes, evenly split (20% of available resources invested in each), using low-cost exchange-traded funds covering the following range of investments:
- US STOCKS as represented by an Exchange-Traded Fund (ticker symbol VTI) tracking the MSCI US Broad Market index
- INTERNATIONAL STOCKS as represented by an Exchange-Traded Fund (ticker symbol VEU) tracking the FTSE All-World ex-US index
- US REAL ESTATE as represented by an Exchange-Traded Fund (ticker symbol VNQ) tracking the MSCI US REIT index
- COMMODITIES as represented by an Exchange-Traded Fund (ticker symbol DBC) tracking the Deutshe Bank Commodity Index
- US TREASURY BONDS as represented by an Exchange-Traded Fund (ticker symbol IEF) tracking the index of US 10-year treasuries
Click on the links to see current real-time charts of each ETF (I'll leave these active, but if you don't have a charting package already you might like to set one up free at Stockcharts.com so you can track any US holdings in your own personal portfolio). If you are a non-US based investor, you should generally substitute a local equivalent ETF for each - examples to follow.
Together with the timing component of the strategy, which I'll detail in Part 3, this portfolio was able to generate the following yearly returns in backtests from 1973-2005, then in real time through 2008:
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The yearly return, on average, from following a Buy & Hold strategy (buy all five indexes in 1973 and sleep 'til 2008) compared to the complete Ivy Portfolio strategy, right. A higher overall return was achieved, with a less than 10% loss occuring at any stage. |
SETTING UP YOUR PORTFOLIO
So let's assume we like this original range of asset classes (we'll look at some alternatives later). The vehicles we're best off using to invest are, as a rule, low-cost Exchange-traded Funds as shown above. ETFs behave just like an ordinary stock, can be easily bought and sold anytime for a small fee and are designed to closely track a particular index.
There are only a handful of mutual funds or unit trusts (the traditional vehicle for ordinary investors) which are able to outperform their benchmark indexes on a consistent long term basis, but those that do almost always depend on star fund managers who are unfortunately human, have the occasional bad run and have an infuriating tendency to retire or move on.
If you have a current favourite by all means substitute it into your portfolio, but be aware that what's needed for the purposes of the strategy is consistent, low-cost performance over the ultra-long term which can be tracked on a chart - that's what ETFs provide.
In the US, companies like Vanguard, ishares, Powershares and Proshares offer a vast range of ETFs, while in the UK, ishares and db-x trackers (a division of Deutsche Bank) are the top providers.
Your broker (you'll need one if you don't already have one) will provide a list of every ETF available on their platform. Unless you're after personalized advice, all you require from your chosen broker is fast, reliable service over the phone or online and cheap dealing costs (you pay a fee each time you buy or sell; even though you'll generally need to do so only a handful of times per year, some firms' fees can add up, so it's worth shopping around).
Important:
Now, here's the equivalent mix of asset classes from a British perspective, substituting UK ETFs trading on the London Stock Exchange for their American counterparts:
- UK STOCKS as represented by an Exchange-Traded Fund from db x-trackers (Yahoo chart symbol XUKX.L)* tracking the UK FTSE 100 index
- INTERNATIONAL STOCKS as represented by an Exchange-Traded Fund from db x-trackers (Yahoo chart symbol XWXU.L) tracking the FTSE All-World ex-UK index
- UK & EUROPEAN REAL ESTATE as represented by an Exchange-Traded Fund from db x-trackers (Yahoo chart symbol XDER.L) tracking the FTSE EPRA/NAREIT Developed Europe Property index
- COMMODITIES as represented by an Exchange-Traded Fund from ETF Securities (I.I. chart symbol AGCP) tracking the Dow Jones/UBS Commodity Index
- UK GOVERNMENT BONDS (GILTS) as represented by an Exchange-Traded Fund from db x-trackers (Yahoo chart symbol XBUT.L) tracking the iboxx £ Gilts Total Return index
* A note on the chart symbols: I have linked you to charts from Yahoo Finance and Interactive Investor websites which run a free bare-bones service (all that's needed for our purposes). The links to Yahoo in particular can be temperamental, so if the prepared chart doesn't appear try switching to their 'basic' chart for now. I'll show you how to set up and follow your own charts in Part 3 (if you're new to all this, relax, it's child's play).
ON THE MONEY'S
PERSONAL SELECTION
The strategy's success argues rather strongly against meddling, particularly as it has been achieved under a wide variety of conditions. So having devoted a good deal of thought to how the original mix might be improved I decided, on the principle of ain't broke, don't fix, to stick to the same broad sweep of assets which have proven their value over such a long period of time - with one major exception.
The most obvious change to hit markets since the financial crisis is the phenomenon which has come to be known as 'risk-on / risk-off'.
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| click to enlarge |
This, courtesy of a recent study by HSBC, is a heat-map of asset classes as they stood pre-crisis, showing their correlations to each other by colour. To see how strongly, weakly or negatively two assets are correlated, match an asset on the vertical axis with another on the horizontal axis. Dark red colours where they meet mean the assets walk in lock-step; dark blue colours suggest they move in opposite directions; washy yellows, blues and greens mean either little or no correlation.
In 2006 there was plenty of yellow, blue and green on this chart, which is as it should be. This is how diversification works: to be effective it needs assets to move in natural winding cross-currents. Then, when the shinola hit in 2008, everything changed - and stayed changed.
See how the dark red areas expanded, showing lock-step moves among large numbers of previously un-correlated assets? This was what made the crisis so intense. Either everything remotely speculative went up together, or went down together. It was risk on, or risk off. And that, unfortunately, is how it remains.
Had you been running the Ivy portfolio in late 2008 when markets crashed, the single asset class which would have saved you suffering the financial enema of a lifetime was US bonds - everything else went down the sluice.
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That one little red strand would have saved your bacon |
Luckily you would have survived 2008 with only a tiny loss (0.59%) and made plenty of profit since, which shows the essential robustness of the asset mix and overall strategy. Still, I think this is a potential weakness which could be tested in coming years if US bonds (and their highly correlated UK cousins) begin to sell off severely, something we've had a taste of just in recent weeks.
My answer?
BUY UNCLE SAM...
The one other asset which not only survived but thrived during the financial crisis was the king of currencies, the US dollar. As money panicked out of other assets and cash was suddenly needed to pay debts, investors rushed back into the world's reserve currency. They did so again last summer, when Greece threw Europe into a tailspin.
Now, if a full-scale European sovereign debt crisis were to take hold - something still firmly on the agenda - I'd expect a similarly dramatic dynamic to play out. The same would be true of a crisis in Asia, possibly precipitated by a property collapse in China. That's why I would be smart to buy 'king dollar'. But wait! Doesn't the opposite argument make equal sense?
...SELL UNCLE SAM
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For a century the US dollar, adjusted for inflation, has had a powerful 'negative expectation' |
What we need in a portfolio are assets with 'positive expectation', ones which, by generating income or cash-flows, rise in value naturally over time.
Sadly, adjusted for inflation, the inexorable trend for the greenback over the past 90 years is DOWN. In fact plenty of shrewd judges see the current actions of the Federal Reserve as creating the longer term risk of a dollar collapse.
Worse still, UK and European investors have a major problem making money in dollar-based investments (which are ubiquitous) because the persistent downward drift of the buck comes at the expense of a relatively higher pound and Euro, making dollar-denominated assets lose value for Brits and Europeans as the greenback falls. So what to do - buy the king or sell the king? Fortunately, we don't have to choose.
We can play the dollar both ways, long and short, insuring our portfolio whichever scenario plays out.
At a stroke, this offers the investor a whole slew of advantages -
- Protection from significant dollar/sterling or dollar/euro currency fluctuations (for non-US investors)
- Protection in the event of a 'flight to quality' from Europe or Asia
- Protection in an inflationary scenario (falling dollar)
- Protection in a deflationary scenario (rising dollar)
- The dollar is negatively or un-correlated with most other assets, making it a true diversifier
- The long-term trend for the dollar is down - it clearly has a 'negative expectation' - and as long as that continues (but even if it doesn't) this strategy will benefit
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Just add dollars |
To accomodate my inclusion of the dollar I've tweaked allocations elsewhere, expanding the total number of ETFs to six from the original five:
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THE
ON THE MONEY
LONG-TERM INVESTMENT
PORTFOLIO
- 20% UK STOCKS
through an ETF from db x-trackers (Yahoo chart symbol XMCX.L) tracking the FTSE 250 Mid-Cap index
- 20% INTERNATIONAL STOCKS
through an ETF from db x-trackers (Yahoo chart symbol XWXU.L) tracking the FTSE All-World ex-UK index
- 15% COMMODITIES (inc. GOLD)
through an ETF from ETF Securities (MSNMoney chart symbol AGCP) tracking the Dow Jones/UBS Commodity Index
- 15% GLOBAL REAL ESTATE
through an ETF from ishares (Yahoo chart symbol IWDP.L) tracking the FTSE ESPRA/NAREIT Developed Dividend+ index
- 10% US DOLLAR LONG / SHORT
through two leveraged ETFs from Proshares:
(Stockcharts ticker symbols: long dollar EUO; short dollar ULE; however, timing signals are to be taken from Stockcharts ticker symbol $USD tracking the broad US dollar index)
- 20% UK GOVERNMENT BONDS (GILTS)
through an ETF from db x-trackers (Yahoo chart symbol XBUT.L) tracking the broad iboxx £ Gilts Total Return index
Important:
Those ETFs not labelled 'Total Return' must be bought with an instruction to have income or dividends automatically reinvested; you will likely be given an option either to have income 'distributed' to you, or 'capitalized / accumulated'. You want it capitalized - ie. reinvested automatically into your ETF to accumulate compound gains at the earliest opportunity - not sitting in a separate account at your broker earning miserly interest. If for any reason automatic reinvestment is not an available option, you can easily do it yourself. Reinvested dividends and income are a major part of compound returns.
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In the end, I have to admit my portfolio is rather boringly similar to the original. Having cogitated over it for so long I'm slightly disappointed (though secretly quite relieved) not to have come up with anything more racy. Still, for the curious among you, here is the rationale behind it.
1. BALANCING THE BUCK
With only 40% of the portfolio in purely UK assets (it's 2011 folks, there's nothing to be gained from being parochial) I've pushed the dollar play as far as I dare to mitigate currency risk and take advantage of its qualities as yin to everything else's yang. And so, to create a 10% holding, I filched a 5% slice from the two other asset classes most exposed to risk from dollar movements - commodities and global real estate.
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| In the 'risk on/risk off' world in which we now live, a strong push higher by the dollar means trouble for those with investments in...well, virtually everything else |
My own preference is for switching between a long & short leveraged ETF which multiplies the daily percentage moves of the Euro/Dollar currency index by x2* (exactly how you switch between long and short ETFs you'll see in Part 3. Newbie hint: it's easy).
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| US dollar (white) v euro (blue) and sterling (green) Notice how the euro plunge in summer 2010 was relatively deeper than the pound's fall, as euro investors fled for the safety of the greenback |
Doing this will accentuate gains from the dollar-denominated assets in our portfolio during periods when the US currency is rising and limit losses we sustain when it's falling. As you can see, the moves made by sterling against the dollar are, on the whole, merely a more exaggerated version of those made by the euro. But we particularly want to benefit from any further disruption in the eurozone - which is highly probable - so a dollar/euro ETF is the better proposition.
When the dollar falls, it will beef up our returns from those dollar-slaves the commodities, eg. oil, gold and copper, and when it rises it will cushion any resulting drop in commodity prices. International stocks from Sao Paulo to Singapore are also benefitting from a weakened dollar and will suffer too if it rises: our dollar play also has that angle covered.
Current UK practice does not allow leveraged ETFs to be used within a tax-free ISA, which is extremely irritating. Still, the multiple positives of tracking the US dollar in my view outweigh the tax disadvantages, so you'll need to open an ordinary stocks & shares account with your broker if you don't have one already.
* Leveraged ETFs are generally a bad idea for long term investment purposes, because the peculiar effects of compounding and volatility can work heavily against you. In our case however, two things make these factors less significant:
- We will be switching between long and short ETFs at major turning points, maximizing the positive effects of compounding
- The dollar is more 'trendy' than most other asset classes, ie. it has a greater tendency to make sustained moves over long periods rather than chop back and forth as stock indexes do; using leveraged ETFs, this trendiness works in our favour.
- For those who prefer not to use leverage, Powershares offer standard long and short Dollar ETFs.
2. BEST OF BRITISH
The UK market is stuffed with mining and oil giants which are affected by the price of oil and metals and therefore by the value of the dollar - making our holding of the greenback look even smarter. Most such companies, (eg. BP) are in the FTSE 100 index, but the FTSE 250 does have some dollar exposure. The 250 is however more diverse, dynamic and far better-performing than the stodgy 100 over the long term and that's why I've chosen it.
3. COMMODITIES ON NOTICE
EMERGING MARKETS ON STANDBY |
| Booms have been followed by long bouts of stagnation |
There will come a point, perhaps sooner than anyone thinks, when the commodities boom as we've known it joins that great hall-of-fame of ex-bubbles, a gallery featuring such recent luminaries as the 'dot-com bubble' and the 'housing boom'.
As the above chart suggests, commodity prices have tended to move in 30-year cycles, the latest of which is set to peak by 2010. We saw a monster spike and crash in prices in 2008 so it seems unlikely we'll get that again, but an 'echo' boom does seems to be unfolding. Can it blow one final bubble?
Whether or not a final blow-off occurs in 2011, historical patterns show that once a peak has passed, commodities subsequently fall or move sideways for years. Not great timing for us, then.
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Commodities (black), as useful in a portfolio as they are, do not have a 'positive expectation' over the very long term |
Of course, many emerging economies will require basic materials, metals and energy sources to expand and grow for decades to come. But long term demand is not the issue - price is. As I've fog-horned in these columns numerous times, speculation has bloated commodity prices for years; now, finally, some major developments are conspiring to bring that to an end:
- Speculative 'hot money' conjured up in the Federal Reserve's quantitative easing experiment is forcing up the price of oil, wheat, corn and other essentials to a level the market can no longer stand...
- ...a level which has sparked serious inflation in emerging economies, leading to interest rate hikes and a likely major slowdown in demand from China which alone would provoke a commodity price bust...
- ...the pain of which would lead, in its aftermath, to the final long term draining of speculation from commodities.
Although this is my preferred scenario, a bust could play out in various ways; bottom line is, though, that increasing commodity prices are not sustainable in a fragile, debt-laden western economy nor in an inflation-prone, bubble-plagued eastern economy. At some point, they'll give.
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| Commodity index approaching another blow-off peak? |
If historical norms apply, once the bust has occured there will be little if any growth in commodity prices for some years. So, while we'd be foolish to remove them from our portfolio altogether (they'll serve to diversify against our other assets), we can sensibly reduce their share whilst they languish so we can deploy the funds more productively elsewhere.
EMERGING INTO THE LIGHT
In the long run, therefore, we will want to be less exposed to pure commodities and more exposed to these countries' diverse stock markets, which should enjoy spectacular growth over the next several decades. Which is why, after the coming bust, I would buy a focused Emerging Markets ETF to replace my current broader holding of international stocks. Here's how the whole portfolio would look:
THE
ON THE MONEY
POST-BUST
LONG-TERM INVESTMENT
PORTFOLIO
- 20% UK STOCKS *
- 20% EMERGING MARKET STOCKS
through an ETF from db x-trackers (Yahoo chart symbol XMEM.L) tracking the MSCI Emerging Markets index
- 17.5% GLOBAL REAL ESTATE
- 12.5% COMMODITIES (inc. GOLD)
- 10% US DOLLAR LONG / SHORT
- 20% UK GOVERNMENT BONDS (GILTS)
THE
ON THE MONEY
THIRD-AGE
INVESTMENT PORTFOLIO
With that in mind, I offer a final variation of the OntheMoney portfolio which is much more conservative, focusing on bonds (it's rather UK-centric too, so please tweak as necessary).
There is still opportunity for capital growth via stocks and commodities, but the emphasis is on inflation protection and steady if unspectacular growth from reliable income payers - the UK government and top-quality UK, european and US companies via corporate bonds.
- 15% UK STOCKS
- 15% US CORPORATE BONDS
through an ETF from ishares (Yahoo chart symbol LQDE.L) tracking the iboxx $ Liquid Investment Grade Top 30 index
- 15% UK INFLATION-PROTECTED BONDS
through an ETF from db x-trackers (Yahoo chart symbol XBUI.L) tracking the iboxx UK Gilt Inflation-linked Total Return index
- 15% UK & EUROPEAN CORPORATE BONDS
through an ETF from ishares (Yahoo chart symbol ISXF.L) tracking the Markit iboxx £ non-financials index (featuring top-quality corporate bonds excluding banks and financial services)
- 15% UK GOVERNMENT BONDS (GILTS) *
- 15% COMMODITIES (inc. GOLD)
- 10% US DOLLAR LONG/SHORT
through two un-leveraged ETFs from Powershares:
long dollar & short dollar (Stockcharts ticker symbols: long dollar UUP; short dollar UDN; however timing signals are to be taken from Stockcharts ticker symbol $USD tracking the broad US dollar index)
* The UK gilts and commodity ETFs I recommend here are the same as those suggested in my original OntheMoney Long-term Investment Strategy.
AND FINALLY:
STAYING IN BALANCE
Just as hard-working human beings need occasional R&R, investment portfolios sometimes need to re-adjust and rebalance.
Rebalancing takes advantage of a universal trait of markets, reversion to the mean. So occasionally you want to trim those positions which have become over-extended and add to those which have lagged because next year, the chances are that this year's star performers will poop out while the laggards will outperform. You don't want to be caught short when that happens.
Fortunately, the process is dead easy. It's like pruning. You only need do it annually, or whenever you have new money to invest.
PRUNING AND REPLANTING
YOUR PORTFOLIO
After you've been going a year, say, calculate what percentage of your total portfolio now lies in each ETF. To take a simple example, you might find that UK stocks have done well and ballooned to 25% of your total holdings while the dollar has plunged to 7%. The bond fund may have dropped to 15% while international stocks storm to 25%. That's unbalanced.
At a date of your choosing (it's not too important exactly when you do it, only that you do it), calculate the total amounts that should be in each ETF according to the percentages you started out with originally.
In this case, to bring the original OntheMoney portfolio back into balance I would sell enough of my UK and international stocks ETFs to bring them down to 20% of total assets each and redistribute that money into the bond and dollar ETFs, boosting them back up to the 20% and 10% levels they began with.
This method is perfectly fine; you could also rebalance 'as you go', redistributing when you buy and sell according to the timing signals I'll describe in Part 3.
This will ensure you're always funnelling profits from those assets which have recently peaked into those which are about to move meaningfully higher.
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CONCLUSION
OK, so we've had to plough through a fair amount of detail and it's not exactly been a barrel of laughs, but the process of setting up your portfolio isn't rocket science, boiling down essentially to three parts.
- Decide on your asset classes (based on the length of time you have remaining until retirement and your tolerance for risk) and select ETFs which best represent those asset classes
- Spread your available funds as evenly as practicable between them and buy your ETFs within the most tax-efficient investment account you can
- Occasionally prune your out-performers and redistribute to your under-performers to rebalance the portfolio
I've set out the simple yet highly successful mix of five asset classes described in the original Ivy Portfolio (plus a broadly equivalent UK version); and I've revealed my own twist, which keeps the essence of the original but craftily drops the US dollar into the mix to add greater firepower on the upside and greater protection on the downside.
In Part 3, (the final installment of The Compleat Investor, coming early in the new year) I'll describe the strategy's pièce de résistance, a risk-reduction timing technique so simple - yet so effective - you'll be embarrassed to admit using it.
Until then, let me go all gooey for a moment and wish you, my gentle reader, a happy, healthy and profoundly prosperous 2011.
