In recent years, the so-called Yale Model has been extremely popular with investors. The model is an attempt to mimic the investment strategy used by Ivy League endowment funds, which have an outstanding track record of beating the market indexes. David Swensen, the superstar manager of the Yale endowment fund, delivered returns of 10.1% annually from 2002 to 2011, a decade when stocks returned 3.9%. The Harvard endowment returned 9.4% over the same period and has grown 12.9% over the last 20 years.

The Ivy Portfolio, by Mebane Faber and Eric Richardson, describes how Yale and Harvard use an asset allocation model that is broadly similar the Couch Potato strategy. The key difference, however, is that the endowments include a number of asset classes that are not available to retail investors, including private equity, hedge funds, and direct ownership of timber resources and commercial real estate.

The first half of Faber and Richardson’s book is a fascinating look at how individual investors can mimic the Yale Model. The authors quote both Swensen and Jack Meyer (Harvard’s former endowment fund manager), both of whom recommend building diversified portfolios with low-cost index funds. Then they offer three possible “Ivy Portfolios” that anyone can assemble with ETFs: the simplest one allocates 20% each to US stocks, foreign stocks, government bonds, real estate and commodities. Two other chapters explain that private equity and hedge funds can be profitable for institutional investors, but are best ignored by the great unwashed.

It’s all in the timing

So far, so good—but the latter half of The Ivy Portfolio goes a giant step further. Rather than simply encouraging investors to diversify widely and rebalance, Faber explains his strategy for protecting oneself from dramatic drawdowns, or “winning by not losing.” He points out that four of the five asset classes in the Ivy Portfolio have experienced declines of about 50% or more since 1973. (Government bonds were the only exception.) “So, is there a way to avoid these long bear markets and losses?” he asks.

The suggestion Faber offers in the book is based on his paper A Quantitative Approach to Tactical Asset Allocation, first published in 2007 and updated in 2009. It’s still the most downloaded paper on the Social Sciences Research Network, which testifies to its extraordinary popularity.

Faber’s strategy is actually very simple. You just check the price of each asset class on the last day of each month, and if it is greater than its 10-month simple moving average (SMA), you buy (or continue to hold). If the price is less than the 10-month SMA, you sell and move to cash. In other words, it’s straightforward market timing.

If one had employed this timing strategy with U.S. stocks from 1900 through 2008, Faber reports, it would have delivered returns of 10.45%, compared with 9.21% for the S&P 500. More remarkable, it would have protected you from almost all the worst drawdowns: it even earned slightly positive returns in 1931 and 2008, when the market lost 44% and 37%, respectively. Faber’s analysis shows similar results when applied to international stocks, real estate, commodities and even 10-year government bonds. In all cases, the timing strategy produced higher returns with much lower volatility, while avoiding the largest drawdowns.

Backtested from 1973 through 2008, the the Ivy Portfolio with the market timing strategy trounced a buy-and-hold approach and delivered returns that would have made Swensen and Meyer smile:

These are very impressive results, especially when you consider that they came about with an average of just three to four round-trip trades per year.

The Ivy Portfolio is an excellent book that I would highly recommend to index investors (though I would discourage them from building a portfolio that is 40% real estate and commodities). But how about Faber’s timing strategy? Is it a recipe for lowering the volatility and improving the long-term returns on a Couch Potato portfolio? I’ll consider that question later this week.

In a previous post, I looked at some strategies for tax-efficient investing with ETFs. Among the innovative products designed for non-registered accounts are Claymore’s Advantaged ETFs, which hold either bonds or foreign equities. Because interest and foreign dividends are taxed at your full marginal rate, these ETFs use forward contracts to recharacterize all distributions as either return of capital (ROC) or as capital gains. Although there are costs and some added risks, these products may deliver higher after-tax returns than plain vanilla ETFs in the same asset classes.

What was never clear to me was why the distributions came in these two different flavours. In 2010, for example, the Claymore Global Monthly Advantaged Dividend (CYH) paid out $0.67 per share in distributions, virtually all of which was capital gains. Last year, however, the fund’s $0.63 per share distributions were all return of capital. I asked Claymore to clarify and Dan Rubin, vice president of marketing, replied as follows:

“The distributions in any given year will depend on the activity of the flows of the fund and the performance of the Canadian equities held by the ETF as part of the structure.

“For example, when the fund pays distributions it needs to sell a portion of the Canadian equities to raise the cash, and in years when markets have positive performance those positions will be sold at higher prices than they were acquired, and thus trigger capital gains. The opposite is true in years when markets have negative performance.

“Also, in some years, even though the markets can have positive performance, the fund might have accumulated losses from previous years which can be used to offset the losses in the current year.”

In other words, during years when Canadian equities are down, the Advantaged ETFs are likely to pay their distributions as ROC—which is what happened in 2011. When Canadian stocks are up, the ETFs are more likely to distribute capital gains, though these may be partially offset by past losses that have accumulated in the fund.

It’s interesting to note that the Claymore Advantaged Bond (CAB) and the Claymore Advantaged High Yield Bond (CHB) also benefitted from the negative return on Canadian equities in 2011. Although these ETFs track bond indexes, they actually hold Canadian equities as part of the forward structure. (See this post for an explanation.) As a result, the distributions of these funds were ROC last year as well, which means investors in these ETFs would have had zero tax payable in 2011. Call it a silver lining in an otherwise bad year for Canadian equities.

I’m confused by a lot of things in investing, but the enduring influence of market forecasts is the one that stumps me the most. Year after year, expert predictions, estimates, forecasts and projections prove to be profoundly wrong. And yet next year we seek them out again. It’s like repeatedly pounding your thumb with a hammer and expecting that at some point it will stop hurting.

One of the reasons we still listen to forecasts is that the media love to celebrate the few that turn out to be right. Those that are wrong—which are the vast majority—are rarely held accountable.

With that in mind, I thought it would be interesting to look at the 2011 Fearless Forecast, the latest edition of a report published for 20 years by Mercer. The Fearless Forecast compiles the  consensus opinions of Canadian and global investment managers regarding the capital markets and the economy. The 2011 edition included input from 56 investment management firms, including some of the most prestigious asset managers in the world.

The last shall be first, and the first shall be last

The managers were asked to identify which asset classes they believed would be among the top and bottom performers in 2011. The most popular picks in each category are listed below, along with the percentage of managers who predicted that asset class would be among the best three and worst three performers. Where it was available, I’ve also included their average estimate for the returns of that asset class, followed by the actual index return for 2011.

It should be clear from the above table that the forecasts were not merely useless: they were spectacularly harmful to anyone who acted on them. An investor who followed these consensus opinions would have been slaughtered in 2011. They would have been helpful only to the strict contrarian: if you shorted all of the top picks and leveraged all of the bottom picks you would have made out like a bandit.

Dissecting the sectors

Let’s go one level deeper and see how the experts made out when forecasting the performance of  individual sectors of the Canadian economy. After all, active managers know when to get defensive during difficult markets, right?

Below is the percentage of managers who picked each sector as one of the best or worst performers, along with the actual 2011 return for that sector. (I was not able to find index data for the other four sectors—industrials, consumer discretionary, telecom and health care—but none of these make up more than 6% of the economy.)

The message here is not that these investment managers are fools. On the contrary, the participants in this survey are among the smartest folks around. They have a deep understanding of the markets, and access to more data than you and I will ever have. The point is that their superior knowledge and skill give them absolutely zero ability to predict what’s ahead. Their predictions were far worse than you would expect from random chance.

Human beings take comfort in forecasts because we detest uncertainty. But if you’re going to be a long term investor, you need accept that uncertainty is part of the deal. Since we can never be sure of what lies ahead, the most prudent strategy is to diversify.

All of the asset classes in the table above have positive long-term expected returns, but all of them will behave unpredictably over the short term. Rather than engaging in the futile attempt to guess next year’s winners and losers, hold all of them in your portfolio all the time. Rebalance once or twice a year. And make a pact never to listen to market forecasts again.

H&R Block tax software winners

Thanks to everyone who entered the draw for the H&R Block tax software. The five lucky winners are Michel, Mike, CCP Fan, Aziz and Rick. I will contact the winners by email to make arrangements.

The 2011 performance results are now in for my model Couch Potato portfolios. Many thanks to Justin Bender at PWL Capital in Toronto for providing these data. Complete performance results are available here, and an updated PDF is posted monthly on my Model Portfolios page.

It was a challenging year: the MSCI World Index, which measures the equity markets in all developed countries, was down 3.2% in 2011, and emerging markets plummeted over 16%. But broad diversification once again proved its mettle in 2011, as a multi-asset-class portfolio did much better:

Breaking it down

While equities were down overall, there was a lot of variation. Europe, Japan and emerging markets got clobbered, and Canada was down about 9%. However, US stocks finished in the black for the year. Currency diversification helped too, as the loonie declined against the US dollar, Japanese yen, and British pound.

Real estate went a long way toward offsetting the negative returns in the overall Canadian equity market:

Fixed income once again defied all expectations and delivered outstanding returns, even at the short end:

A portfolio for all seasons

There are a couple of lessons we can take from 2011. The first is that a truly diversified portfolio must include asset classes that have little correlation (or even some negative correlation) with stocks. Real estate helps (so does gold, if you’re so inclined), but the best way to get that diversification is through high-quality bonds. They should be part of just about everyone’s portfolio.

The second lesson is that once again most forecasts proved to be dead wrong. Here’s just one example from a major Canadian bank that predicted: “Equity markets should have another good year,” while “we expect 2011 will be increasingly challenging for bondholders in the developed world.”

Of course, the crystal ball gazing is well under way for 2012. My only prediction for the year is that these forecasts will prove just as unreliable as always. Tune them out, build a porfolio for the long-term, and stick to your plan.

Deciding on the right asset allocation can cause investors a lot of grief—far too much, in fact, since there is no such thing as a perfect mix of stocks and bonds.

In his excellent book Your Money and Your Brain, Jason Zweig reveals that even Nobel laureates are not immune. Zweig tells the story of Harry Markowitz, the creator of Modern Portfolio Theory, who struggled to put his own idea into practice. “I should have computed the historical covariances of the asset classes and drawn an efficient frontier,” Markowitz once said. “But I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.”

There’s something elegantly simple about a 50/50 portfolio. Indeed, when finance writer Scott Burns created the original Couch Potato portfolio way back in 1991, that’s what he recommended: half your money in a bond index fund, and a half in an equity fund.

Of course, investors often equate simplicity with a lack of sophistication. In the last couple of decades, asset allocation experts have strived to create more efficient portfolios designed to squeeze out every last basis point without adding additional risk. And yet, as recent white paper from Vanguard shows, that simple 50/50 portfolio would have served investors extremely well—not just over the last 20 years, but during nine tumultuous decades.

In good times and bad

The Vanguard paper, called Recessions and Balanced Portfolio Returns, looks at the hypothetical returns of a blend of 50% high-quality US bonds and 50% US stocks, going all the way back to 1926. It shouldn’t be surprising that the overall performance would have been excellent: the average nominal return was 8.3%. What was far more interesting was that the real returns—that is, the nominal returns minus inflation—were essentially the same during recessions and periods of prosperity.

The authors classified every period since 1926 as either a recession or expansion, based on the criteria used by the National Bureau of Economic Research. During recessions, the average annual return of the 50/50 portfolio was 7.75%, versus 9.90% during expansions. However, once you adjust for inflation, the real returns were 5.26% and 5.59%, respectively. The small difference is statistically insignificant.

There are a couple observations that explain this result. The first is that inflation tends to be higher during periods of expansion and lower during recessions. But more interesting is the relationship between the two asset classes in the 50/50 portfolio: “First, when a recession is imminent, there is a tendency for bonds to outperform stocks during the initial period of economic weakness (a ‘flight-to-safety’ effect). Second … stock prices tend to decline before a recession officially begins and to rise before it officially ends (a ‘leading indicator’ effect).”

The Vanguard paper is quick to point out that no one is guaranteeing 5% real returns from a balanced portfolio going forward. But there is good reason to believe that the interaction between high-quality bonds and stocks will continue: it is, after all, the very heart of portfolio diversification. Like the yin and yang, stocks and bonds are not opposing forces, but “complementary opposites.”

Quicken giveaway and more

• Intuit Canada, makers of Quicken money management software, have offered to give away a copy of Quicken Home & Business 2012 to one lucky reader. This program, which retails for $110, allows you to track your cash flow and monitor your investments. To enter the draw, Tweet this post (include @cdncouchpotato so I can track you) or leave a comment below. Contest ends at midnight on Sunday, December 18, and I will announce the winner on Monday.

• I would like to welcome the first Vancouver-based firm to my Find an Advisor directory. Macdonald, Shymko and Company pioneered the concept of fee-only financial planning 30 years ago. Their team can help index investors set up passive portfolio with ETFs and Dimensional Fund Advisors mutual funds, and they also offer planning services to clients who manage their own portfolios.

• A huge thank you to readers who responded to the charitable initiative of Justin Bender and PWL Capital in Toronto. About half a dozen DIY investors contacted Justin to get advice in exchange for a donation to the Centre for Addiction and Mental Health (CAMH). Thanks to you, Justin has raised close to $10,000 for this worthy cause. Nice work, everyone!

Here’s the second part of my interview with Craig Rowland, the blogger behind Crawling Road and a champion of Harry Browne’s Permanent Portfolio.

Any index investor who has studied diversification would agree with your overall idea, which is that a portfolio should be built to withstand a variety of risks and economic conditions. But what surprises a lot of people about the Permanent Portfolio is that it has equal buckets for each of the four asset classes. I can see using a portfolio that was 30% bonds, 10% cash, 10% gold and 50% stocks, or something similar. Why use a 25% allocation for all four?

I hear this from people all the time: “You should own less gold,” or “You should own fewer long-term bonds.” And this is something that Harry Browne got asked many times over the years. The original Permanent Portfolio concept did have a more elaborate split, but my understanding is that over the years Browne basically discovered that it is simpler to just keep it even. He didn’t notice any significant advantage to the other methods.

The other problem with splitting the assets in a disproportionate way is that you are making an assumption that you know what’s going to happen in the future. A lot of the market data that people use is only about 85 years’ worth. Prior to that there isn’t really much good data. And it’s really shocking when you think about it, that people draw from just 85 years of history. People said a couple of years ago that there is no way deflation is going to happen, because the Fed isn’t going to let it. But the Fed is just one player in the market: they don’t control everything, and now we are operating under deflation. Look at Japan: they have been in a deflationary funk for 20 years. So for me to say we should hold more of this asset and less of that one—that assumes that I know what is best going forward.

For instance, it was “obvious” to everyone in 1999 that any portfolio that didn’t have a heavy emphasis on stocks was going to suffer. And I’m sure now, in 2011, there are people who say that it is “obvious” that a portfolio should be 80% gold.

Just by having the four-way split, it seems to work well enough and I don’t want to tamper with it. When you look at the results, you have to agree with Harry Browne. I like simplicity, and the 25% split is not only simple, but it also works.

Well, I would argue that it’s reasonable to assume that stocks, because they are riskier than cash or short-term bonds, must have a higher long-term expected return if markets work at all. That doesn’t mean they will perform over the next two, three or even 10 years. But it should mean they will outperform over the next 30.

But you are using some weasel words here. You are saying expected and should. Japanese investors in 1989 expected the Nikkei index to continue to go up, and now here they are 20 years later with not so good performance. So I just don’t know.

I hear you, and I understand, and I tend to agree with your position. And my response is, if you can hang on for the ride, then go for it. But I would also say that life gets in the way, and sometimes you might need the money earlier, and you might not be able to wait things out. I would also say that, based on history, you don’t want to rely too heavily on stocks.

Rather than holding 25% cash and 25% long-term bonds, why not just hold 50% of the portfolio in a diversified bond fund that holds all maturities? Why the barbell approach?

First of all, I don’t recommend any total-market bond fund. You should only own the bonds of your own government: so in the case of Canada, you should only own Canadian government bonds. The reason is that the government can always pay their obligations by taxing people, or by printing more money as a last resort. It’s not going to default: at least, that’s a very small risk. Whereas if you include corporate bonds, or agency bonds, you never know. And that’s what happened in 2008: people got socked. So I don’t recommend blended funds.

You’re probably asking why I don’t just use an intermediate-term government bond fund. But I like the barbell: I like having that slug of cash, because it is very stable. It gives you the peace of mind when you look at the portfolio and see these other parts moving around. You know that you have this cash to cover living expenses, emergencies, whatever.

For investors who do want to put a portion of their portfolio in gold, is a gold ETF acceptable, or do you believe that people should actually hold physical gold?

When Harry Browne passed away, gold ETFs had not become that popular, although he was aware of them. Generally, gold is there for inflation protection, but it also guards against catastrophic situations. So the ideal in Harry Browne’s world was having some physical bullion under your immediate control, whether it is in a safe deposit box, or someplace secure near you, and also another slug of it overseas in a country like Switzerland. So he wanted geographic diversification, too. That is relatively painless to do for non-US residents, though it is now almost impossible to do here in the US—no Swiss bank is going to want to deal with you.

On Monday I introduced the Permanent Portfolio, an investment strategy created in the early 1980s by Harry Browne. It calls for investors to hold equal amounts of stocks, long-term government bonds, gold and cash. I recently spoke to Craig Rowland, the blogger behind Crawling Road, to learn more about the ideas behind the Permanent Portfolio.

What attracted you to the Permanent Portfolio?

My background is computer security, so when I test something I always start by trying to break it. And when I looked at traditional index fund portfolios, I noticed there were periods of time where they basically broke. By that I mean they either had significant declines, or they had extended periods where they didn’t have real returns after inflation. I noticed, for instance, that during the entire decade of the 1970s, a stock/bond portfolio didn’t even beat inflation. And I noticed that in other countries that type of portfolio failed over protracted periods of time. So I became convinced that the traditional idea of asset-class correlations was incorrect.

So I started looking at Harry Browne’s Permanent Portfolio, and honestly, at first I thought the guy was nuts. This idea of holding 25% of your portfolio in gold—I almost ignored everything he had to say. But I when I looked at the results and the economic underpinning of it, I said, “This guy is right.” What I mean is that he didn’t pick asset classes because they had some past correlations between each other. He picked the asset classes based on economic cycles, and that is really the secret.

Harry Browne broke up the cycles this way: inflation, deflation, prosperity, recession. Then it was a matter of figuring out which asset classes were going to do best during those conditions: gold for inflation, long-term bonds for deflation,  stocks for prosperity, and cash for periods of recession. And it doesn’t matter what caused the condition to occur: all that matters is that you hold an asset class that protects you from it.

I think one of the biggest wastes of space in financial books are pages and pages of asset class correlation tables. It is such a complete waste of information, because they don’t mean anything. People are puzzled as to why asset class correlations change over time. Well, they’re looking at the wrong pieces of information: the only correlation that matters is how that asset responds to what is going on in the economy. That is the only conclusion you can possibly reach.

So the idea is not that long-term bonds go up because stocks go down. It’s more correct to say that the economic conditions that cause stocks go down have some overlap with the economic conditions that cause long-term bonds to go up.

Exactly. And it’s not black and white: there are periods when economies are transitioning from one cycle to another and there is this murky area where the markets try to figure out what the heck is going on. In the fall of 2008, this is what happened. The stock market was collapsing and the long-term bonds didn’t pick up immediately: it took some time before the markets collectively realized that deflation was in progress. At that point, the long-term bonds went up over 30% by the end of the year. It wasn’t instantaneous—there is always this lag time.

That’s why I tell people not to look at their portfolio every day. I don’t look at mine very often: people would be very surprised at how rarely I look at my portfolio. The more you look at it, the more pain you are going to experience. Just let the asset classes do what they do.

The remarkable thing about the Permanent Portfolio is not so much its average annual return, but its low volatility. According to the historical returns on your website, it would have had negative returns only twice in 40 years.

You’re right, the volatility is very low, and this is something that Harry Browne noticed as well. He worked in the financial industry and he knew that volatility scares people off their investment plan. If you can have a portfolio that has lower volatility, even if it might have lower returns, you’re more likely to stick with it. And if you stick with it, those lower annual returns are probably going to deliver better long-term results than a very volatile portfolio, because when people experience big swings up and down, they’re probably going to quit. Or they are going to sell out at the wrong time and miss the recovery.

Having low volatility in a portfolio should not be underestimated. It’s very important, if only for your own sanity. You want to be able to control your emotions, and the Permanent Portfolio with its low volatility, I think helps control investor emotions. That is just as important as overall returns. It is easy to look at a spreadsheet and get excited, but when you are living through that market where you have 20%, 30%, 40% losses, but spreadsheet is not going to help you much.

The asset mix in the Permanent Portfolio really is a remarkable example of Modern Portfolio Theory in action, because you’ve achieved this very low volatility in the overall portfolio by using three extremely volatile asset classes.

I think Harry Browne really captured the essence of Modern Portfolio Theory. It’s like in chemistry—I can take very volatile elements like sodium and chlorine. By themselves, sodium is quite explosive and chlorine is toxic, but if you mix them together you get salt, which is benign. It’s kind of the same thing with this portfolio. You take different components that by themselves are extremely volatile, but when you put them together the result is actually low volatility.

A lot of people don’t understand that. They want to look at each asset in isolation, and I was guilty of that initially, too. When I first read about the 25% gold, I thought Browne was nuts, and then I read about 25% long-term bonds and I thought he was really nuts. But I have looked at it every way, and I’ve looked into every criticism, because my own money is at stake. But what I have decided over the years is that I sleep like a baby following this strategy.

This whole idea about the US and the debt crisis—everybody is writing me about it, and I’m telling them to just ignore it. You can’t do anything about it, and you’ve got a 25% slug of gold, so you’re going to be OK. And if everything gets fixed, and the gold goes down, well, you’ve got 25% in long-term bonds that are probably going to do well. So don’t worry about it. That has always been my attitude.

We’ll continue the discussion with Craig Rowland on Friday.

When Scott Burns created the original Couch Potato portfolio back in 1982, he suggested that investors put half their money in an S&P 500 index fund, and the other half in a bond index fund. At the time, that was a revolutionary approach to investing. It was based on the idea that picking stocks and forecasting the economy are futile, and that investors would be better off simply buying entire asset classes in equal amounts, and holding them at all times.

But the Couch Potato wasn’t entirely original. The year before, an American investment analyst and libertarian named Harry Browne co-authored a book called Inflation-Proofing Your Investments, in which he laid out his own passive strategy based purely on asset allocation. Browne suggested dividing your money equally among stocks, long-term government bonds, gold and cash. He called it the Permanent Portfolio.

When Browne created the Permanent Portfolio in the 1980s, it wasn’t particularly easy to manage on your own. (A mutual fund version of the of the Permanent Portfolio was launched in California in 1982 and is still going strong, albeit with a more complex asset mix that includes silver, Swiss francs and real estate.) There were a few equity index funds, but you would have had to buy individual Treasury bonds and gold coins.

Today, the strategy has gained a following among do-it-yourself investors, since it’s easy to build and maintain a Permanent Portfolio with ETFs. For Canadians, it might look like this:

A child of the 1970s

It’s not surprising that Browne’s idea arose when it did. The bear market of 1973–74 was horrendous, and sky-high inflation meant that real returns on both equities and bonds were negligible during the decade (remember The Death of Equities?). President Nixon also took the US off the gold standard in 1971—before that, an ounce of bullion was fixed at $35. As soon as it was allowed to float, the price of gold skyrocketed: 49% in 1972, over 70% in both 1973 and 1974, and 136% in 1979 (all figures in US dollars). During a period like that, it’s easy to see the appeal of moving beyond traditional portfolios of stocks and fixed-income.

But not long after Browne introduced the Permanent Portfolio, stocks began a charging bull market that would last for some 18 years, until the dot-com bubble burst in 2000. Gold performed horrendously during this period, and the Permanent Portfolio lost its shine as investors fell in love with equities again.

What’s gold is new again

Now we’ve come full circle. Despite another bull market from 2003 through 2006, the returns on stocks over the last dozen years have been dismal, while gold has regained its lustre. The Permanent Portfolio mutual fund posted an annualized return of 11.8% over the 10 years ending June 30, and even managed to eke out a small positive gain in 2008, when just about everyone else took a bath. With stocks in the toilet again this summer—and gold up about 30% year to date—I expect it will begin attracting interest once again.

With this in mind, I wrote about the Permanent Portfolio in my most recent column in MoneySense, and interviewed Craig Rowland to get his insights. Craig, a DIY investor in Portland, Oregon, has kept Browne’s ideas alive on his website Crawling Road. He writes a blog about the Permanent Portfolio’s ongoing relevance, hosts a discussion forum about the strategy, and has even archived episodes of Harry Browne’s radio show, recorded in 2004 and 2005, shortly before Browne’s death. They’re well worth a listen if you’re interested in learning more.

Later this week, I’ll share some highlights from our chat. While I’m not ready to adopt the Permanent Portfolio myself, I do find it a fascinating idea, and index investors can learn a lot from what Craig has to say. Stay tuned to see what Browne can do for you.

Broad diversification is one of the pillars of the Couch Potato strategy. But getting exposure to thousands of stocks and bonds doesn’t mean you have to hold a dozen funds in your portfolio.

I recently received an email from a reader named Thomas who was concerned that his investments were getting unwieldy: “I am concerned I have ETFs with too much duplication and am not keeping it simple.” He agreed to let me use his situation as an example of how investors can make their portfolios more efficient and easy to manage.

Thomas has a pension and adequate RRSP savings, so he’s not worried about covering his retirement expenses. However, he also has about $115,000 in a taxable account and another $15,000 or so in a TFSA. “I have been looking at the taxable account and the TFSA as one overall portfolio,” he says. “I plan to use this money in one of two ways. The first option is to dip into it to renovate our home, perhaps to add a pool. Or I can just let the investments grow until I retire and fund the renovations with a line of credit, paid off in a reasonable time.”

Based on his risk tolerance and goals, Thomas is aiming for an asset allocation of 60% stocks and 40% bonds, with the equity holdings more or less evenly split among Canadian, U.S. and international. Here are his current holdings:

The diagnosis

Thomas’s portfolio is certainly diversified, but it needs some serious decluttering:

Too many ETFs. With 14 different ETFs, Thomas’s portfolio is far more complicated than it needs to be. For starters, since he is planning to use both accounts for the same purpose, he doesn’t need to hold multiple funds for each asset class. The three equity funds in his TFSA, for example, overlap with others in his taxable account. He can dramatically reduce the number of ETFs without significantly changing his overall allocation. (Unfortunately, if he sells ETFs that have gone up in price in his non-registered account, he’ll trigger capital gains taxes.)

Too many small holdings. Several of the portfolio’s holdings are random items that don’t fit into any thoughtful plan. The Claymore Balanced Income CorePortfolio (CBD), for example, holds 14 ETFs in many asset classes. It’s meant to stand on its own, not make up a tiny sliver of a larger portfolio. The 1% allocation to a natural gas ETF and the preferred shares are also misfits. “I have been inclined to add bits and pieces from time to time,” Thomas admits.

Too much tax-inefficiency. By holding equities in his TFSA, Thomas is not taking maximum advantage of the tax shelter. Canadian stocks are best held in a non-registered account, where they benefit from the dividend tax credit. Dividends from the US and international equity ETFs are fully taxable, but the yields on these funds are relatively low, and any capital gains would be taxed favourably. Thomas would save more in taxes by using the TFSA to hold the corporate bonds, which have a higher yield and limited potential for price gains.

The makeover

Before rebuilding his portfolio, Thomas will need to decide how he wants to fund his reno projects. If he chooses to use his investments to pay for the pool, he should set aside this portion in cash—the remainder can then be used for long-term growth (Option 1). If he decides to use his line of credit for the home improvements, then the whole portfolio can be considered part of his long-term strategy (Option 2).

Here’s how Thomas might rejig his holdings. Without giving up any diversification benefit, he can reduce his portfolio from 14 ETFs to just six:

.
I imagine that many investors, like Thomas, have portfolios filled with too many ingredients, many of which play no meaningful role in their overall plan. By streamlining your holdings you can reduce costs, complexity and taxes, and stay focused on your larger investing goals.

The suggestions in this post are presented as general information and should not be considered investment or tax advice aimed at any individual.

Last September, I wrote a piece for Canadian MoneySaver called An ETF Portfolio With Added Dimension. The article looked at the strategies used by Dimensional Fund Advisors, “the best money management firm that most people have never heard of.” The portfolio I put together for that article became the Über-Tuber — as in “the ultimate Couch Potato” — which you’ll find on my page of Model Portfolios.

If you’re not familiar with Dimensional Fund Advisors, that’s not surprising: the firm keeps a low profile, and its funds are offered only through a select group of advisors who must first undergo extensive training. DFA’s investing strategies are based on the academic work of Eugene Fama and Kenneth French, whose research demonstrated that value stocks and small-cap stocks have historically delivered higher returns than the overall market. (For more details, see the DFA website and my own post, Where Do Returns Come From?) The point of my article was to suggest a way for do-it-yourself investors to use Dimensional’s passive strategies with ETFs.

I later learned that the article made the rounds among DFA advisors, who gave it a mostly positive review, though with some criticisms. I recently spoke about this with Justin Bender, an advisor with PWL Capital in Toronto who uses both DFA funds and ETFs with his clients. Using Morningstar’s PALTtrak research tool, Justin drilled into the Über-Tuber to compare its asset class exposure to what you would get in an actual Dimensional portfolio like this one:

Then he made a number of suggestions to bring the ETF portfolio much closer to being a DFA clone. Here’s what he came up with:

Peeling back the Potato

Justin provided some commentary to explain the changes:

• “The original Über -Tuber had 40% of its Canadian equity allocation in small cap stocks, but the DFA Canadian Core Equity Fund has just 15% to 20% in small cap stocks. I reduced the small-cap allocation to reduce risk in the portfolio. The original portfolio also had an underweight in energy and materials stocks and an overweight to financial stocks. I reduced exposure to CRQ and added XIC to better mimic the DFA fund and also to lower the overall MER.”

• “I found that 11% PRF combined with 5% VXF [a fund of US mid- and small-cap stocks] gave the appropriate small-cap and value tilts relative to the DFA US Core Equity Fund.”

• “The original Über -Tuber had too much international large cap and not a sufficient amount of small cap, relative to the DFA International Core Equity Fund. I replaced the Vanguard All World ex-US Small-Cap (VSS) with PDN to gain more value exposure while also increasing the exposure to mid and small-cap companies. I replaced the iShares MSCI EAFE Value (EFV) with VEA, which helped reduce costs as well as remove the overallocation to large value and spread it more evenly across the other size and style categories. The sector allocations also aligned more closely to the DFA fund after these changes.”

• “Using equal amounts of the two DFA fixed-income funds results in an allocation of approximately 25% to US bonds (with currency hedging). We can get a similar exposure by allocating 10%  to XIG and the other 30% to XSB. The approximate maturities, as well as the mix of government and corporate bonds, also mirror the DFA model portfolio more accurately than a single position in XSB.”

Too many moving parts?

The Über-Tuber started off as an intellectual exercise more than anything else. As a couple of DFA advisors have told me, it has a lot of moving parts, which will make it difficult and potentially expensive to maintain: the original was already a behemoth with 11 ETFs, and the above version uses an even dozen. Is it too unwieldy?

If you’re going to build a portfolio like this, a low-cost brokerage is a must. Your account would have to be quite large before you even consider it: $100,000 is the bare minimum, and unless you’re investing at least $300,000 or so there is probably no meaningful benefit over the Complete Couch Potato. Rebalancing could be something of a nightmare — I would suggest doing so only when the allocations are way out whack.

In fact, the more I speak with experienced advisors who understand investor behaviour, the more I have come to value simplicity. The urge to tinker with a complex portfolio is just too great. I’m not going to make any changes to the Über-Tuber on the Model Portfolios page for now, and I’ll be giving some thought to how it might be streamlined without losing too much of its small-cap and value tilt.

In the meantime, I’d love to hear from readers who are currently using the Über–Tuber or something like it — I know you’re out there. How are you managing?