There comes a time in every Couch Potato’s life when he or she has to answer a nagging question: can I do better? Sure, the three or four plain-vanilla funds in the Global Couch Potato have an excellent track record. But they’re just so dull. Surely you can squeeze out even better performance with a more sophisticated portfolio.
Financial advisor and author Dan Solin hears the question all the time. His previous book, The Smartest Investment Book You’ll Ever Read (Viking, 2006) is one of my recommended reads for new or would-be passive investors. That book, he writes, “spawned tens of thousands of savvy investors. They wanted to know if there was any way to improve the returns of the index fund portfolios I recommended.”
The answer is the basis of Solin’s newest book, The Smartest Portfolio You’ll Ever Own (Perigee/Penguin, 2011). It takes things one step further—actually, it takes things two factors further. The book explains how index investors can use the Fama-French Three-Factor Model to tilt their portfolios to value and small-cap stocks.
A new dimension in ETFs
Solin is an adviser who uses Dimensional Funds, which are built on the Fama-French principles. As he explains, value stocks and small-cap stocks have historically delivered higher returns than the overall market, albeit with correspondingly higher volatility.
Dimensional Funds are available only from a select group of advisors, so Solin’s “SuperSmart Portfolio” is designed for do-it-yourselfers who want to use a similar strategy. His model portfolio is made up of both ETFs and Vanguard mutual funds—but since the latter are not available to Canadians, I’ll substitute the equivalent ETFs. This is his suggestion for an investor with a moderate risk tolerance:
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Solin devotes a lot of space to the historical returns of his SuperSmart Portfolio. Backtestsing always needs to be viewed with some skepticism, but his assumptions here are reasonable. He uses actual fund returns wherever possible (some Vanguard funds go back to the 1990s), and otherwise he uses data from the indexes they track, minus the fund’s current fee. Given that Vanguard and iShares have excellent records of keeping tracking errors low, this is not an unfair comparison. Readers may be surprised to learn that the above portfolio’s annualized return for the 10 years ending in 2010 was 6.54% (in US dollars). So much for the lost decade.
The SuperSmart Canadian
Faithful readers will be aware that I too have designed an ETF portfolio to capture the small and value premiums: the Über-Tuber. It’s the most complex of my model portfolios, but it may be suitable for investors with at least $100,000—preferably more. (Incidentally, Solin suggests the same minimum account size for his SuperSmart Portfolio.) An advisor who uses Dimensional funds recently ran some backtests on the Über-Tuber and found that it would have done a good job of capturing the small and value premiums for Canadian investors over the last 15 years. (Again, the usual caution about backtesting applies.)
One of the main differences between Solin’s portfolio and my own is that he suggests putting half of your fixed income in international bonds, without currency hedging. Many portfolio managers advise against taking currency risk on the bond side: in fact, Solin’s suggestion goes against the opinion of Dimensional Fund Advisors, who recommend using currency hedging as part of their fixed income strategies.
The final section of the book deals with the question of whether index invetsors need an advisor. I’ll discuss Solin’s ideas on this topic in my next post.
I like Solin’s stuff. It’s generally pretty hard-hitting.
I’m looking forward to picking up a copy of your book in November, when I’m in Canada.
Thanks, Andrew. I can a get a book to you before then…
I have become a disciple of index investing and a potato-like strategy over the past couple of years. Of course I am adding money monthly or close to it, and looking at my allocations yearly or so. What are your thoughts on re-balancing and timing? Not the concept of re-balancing – but do you just “do it” the day you decide it needs adjusting or when you add money? For example, often look at my portfolio around year end – I have vacation time and time to think and analyze a bit. Plus my full TFSA contribution goes in ASAP in January. I usually add money around the 15th of each month, once I know my (variable) pay that month.
Do you just execute the trades you need to whenever? Or do you pick a date (January 15th is the day!)? Or do you look at the week and say “too much volatility, I’ll wait a week?”, Or ???
I don’t think I can time the market, but sometimes it seems crazy to buy or sell into a wildly swinging market. But if you wait for “calm”, you could wait a long time! As I move from some high-fee DSC funds (deep shame!) this is an important topic to me!
@Bill: Thanks for your comment. The short answer is that there is no magic formulas for rebalancing. Choosing a date and doing it annually is a perfectly good strategy. As you point out, waiting for “a good time” is futile. Rebalancing anytime you add money is also a great idea with index mutual funds, though with ETFs this will get expensive (too many commissions). Don’t forget that taxes and costs must always be considered when rebalancing.
I’ve done a few posts about rebalancing that may be helpful:
https://canadiancouchpotato.com/2011/02/22/why-rebalance-your-portfolio/
https://canadiancouchpotato.com/2011/02/24/how-often-should-you-rebalance/
https://canadiancouchpotato.com/2011/03/03/how-to-lower-your-rebalancing-costs/
It is interesting that investors always overinvest in their own region or country. For example in the German literature it always more German etc.
If one looks at risk allocation this makes no sense. When I live in a certain country my job and income is already in this country, so I should not invest there. Living in Canada I would no increase the Euro and Emerging Markets part of the portfolio and underinvest in Northern America.
@ Sina
Taxes can be a significant consideration. Overweight allocation within your home country’s markets (equity or bond) allows investors to take advantage of tax credits, no withholding taxes from foreign entities etc.
@Sina: I agree with you that most investors have too much home-country bias, but I think your suggestion goes too far. As Sampson suggests, domestic equities can be taxed more favourably, and they usually have lower investing costs. Currency risk is also an important factor. I think about one-quarter to half of an equity portfolio should be devoted to domestic stocks. My model portfolios suggest one-third.
For American investors, the need for international diversification is somewhat less important. First, US stocks already make up almost half of the world market. Also, the US economy is the most broadly diversified in the world. That’s very different from the situation in Canada, which is about 5% of the global market and highly concentrated in a few sectors.
Wait, is it a difference in taxes if I would just increase the MSCI EAFE part of the portfolio?
Thanks so much for your kind review of my book. I discuss the pluses and minuses of hedging foreign bonds at p. 99. On balance, I opted not to hedge, but I realize there is no right or wrong on this issue. I was persuaded by the fact that the volatility of the SuperSmart portfolio at various risk levels was well within an acceptable range, and I liked the concept of diversifying currency risk. Others may disagree and they would not be incorrect if they did.
I should also note that the US fixed income fund in the SuperSmart Portfolio (SHV) is extremely low risk, with a term of 3-6 months. This permitted me to take more risk with the international fixed income portion of the portfolio.
@Sina: Dividends on Canadian stocks are eligible for the dividend tax credit if they are held in a non-registered account. Foreign stocks are not: their dividends are fully taxable as income. They are also subject to withholding taxes (although this can often be recovered). Even in an RRSP, you will find that the combination of currency hedging, higher MERs, tracking errors and withholding taxes make international investing significantly more expensive. It’s still worth it, of course, but I would not recommend overdoing it.
@Dan Solin: Many thanks for stopping by, and for all your great work. I’m not entirely sold on the benefits of global diversification on the fixed-income side, but part of that is simply the lack of good products available in Canada. Granted, a Canadian investor can use ETFs from Vanguard and SPDR if they’re willing to go unhedged, but the portfolio can get awfully complicated this way. Maybe for a very large portfolio. I’ll be doing a post later this week about your take on whether investors should work with an advisor. I think we’re almost 100% in agreement on this one. :)
Sina,
I think it’s very important to have a home country bias for another reason as well. In what currency will you be paying your future bills? If your investments are largely denominated in that currency, then the swings of other world currencies won’t affect you much. But if you diversify your money equally among other stock markets (thereby other currencies) then you take on a larger risk. If your home currency becomes strong while you’re retired, you’ll be strapped with the albatross of having much of your money invested in currencies that don’t represent the currency in which you pay your bills. So…home country bias, I believe, is essential–with a dash of foreign exposure as well.
I don’t know where I will retire, so I don’t have a home currency bias. But when I find out where I’ll lay roots, I’ll be putting a much larger amount of my portfolio in that market (unless, of course, I retire in a less predictable locale, like Brazil or Thailand).
@Andrew: All good points. But why don’t you want to put all of your money in the Thai stock market? :)
I’ve heard that Vietnam has better growth prospects than Thailand. And you know me: ready to jump an any opportunity that I read about in the papers.
Thanks guys! Very interesting information. It took me a couple of years to figure out the German tax system, now I am starting again with the Canadian. Lets see…so far it seems way simpler.
Does Solin explain in the book why he recommends that the entire bond component be in short term bonds?
@Chris: No , he doesn’t explain the reasoning behind the decision to use only short-term bonds. But this is the usual practice with DFA advisers. Dimensional’s fixed income funds use a strategy designed to find the “sweet spot on the yield curve,” which is described in detail in Larry Swedroe’ s book The Only Guide to a Winning Bond Strategy You’ll Ever Need. In most cases, this means limiting maturities to less than five years.
At p. 180 of the book I explain that “research demonstrates that increases in risk to a portfolio are most efficiently implemented by varying the exposure to stocks and not by varying the term or the credit risk of the bonds in a portfolio.”
@Dan S: Many thanks for clarifying. Readers will notice there are also no corporate bonds in the portfolio: only governments.
Sounds like a great read.
Not a fan of corporate debt either. I’d rather own government debt.
This is kind of off topic, but I’ve never been able to understand why people advise buying bond ETFs. The yeilds are low, and the face value is likely to go down as interest rates rise…Also, the mangement fees on them are higher than on equity ETFs…So how is this a safer investment than simply buying a equity ETF that pays dividends?
I can understand buying bonds — you get your principle back, and it’s guaranteed. But my understanding is that this is not so for bond ETFs…You buy in, just like a stock, and the value of the ETF fluctuates up and down, just as a stock would…and then when you need to sell, you sell at the market price of the ETF. Is this a correct understanding?
I’m sorry if I didn’t get all the terminology right. I’m new to this :-)
@Christina: A portfolio should almost always have a mix of stocks and bonds. You can’t just look at bond yields versus dividends. Stocks can suffer huge losses over short periods, while the downside risk is dramatically lower for bonds. Look at what has happened in the last five months. In 2008, many dividend-paying stocks declined by 30% or more, while bonds went up in value. This is the value of diversification.
As for individual bonds versus bond ETFs, there are many misunderstandings about the differences. It is true that bond funds do not mature on a specific date like individual bonds. But for long-term investors, this is actually preferable. Bond funds also offer diversification and liquidity. This post may help:
https://canadiancouchpotato.com/2010/03/29/bonds-v-bond-funds/
I’ve just finished reading this book, and found it to be a good read. PART ONE is quite critical of the securities industry, and is good affirmation for those contemplating a switch to a passive portfolio. The SuperSmart Portfolio listed on p.82 is composed entirely of U.S. funds/ETFs, and as such is probably not entirely suited for implementation by Canadians. As an investor approaching retirement in 10-15 years, and planning on spending retirement split fairly evenly between the two countries, I am wondering if the Uber-Tuber would be the way to go. Or would the SuperSmart Portfolio with the the equity allocations shifted to make room for the Canadian ETFs in the Uber-Tuber (CRQ & XMD) be better? I know I’m probably splitting hairs, but I have a fair-size portfolio and would like to get it right the first time. Thaks for any feedback from Dan B., Dan S., and any others.
Hi Dan,
Just wondering if there was a reason your Uber Tuber allocated 12% to US total market (VTI) and 6% to US small cap value (VBR) rather than equal amouts to large cap, value, and small cap? Was it because 2 ETF’s are easier to manage than 3 or was there overlap in the exposure?
@Jon: Yes, three funds would result in a lot of overlap. It was also make the portfolio extremely unwieldy and difficult to manage.
I am confused by this question. I’m not sure I ever recall an allocation (one that we built anyway) that would have included exposure to both the VTI and the VBR. The VTI is a total stock market ETF and would, therefore, already incorporate small cap value, so the small cap value ETF would be duplicative.
I’m not sure if I’m making the correct assumptions on behalf of CCP, but the VTI and VBR are in his Uber tuber model portfolio but it’s added to increase the value and size tilt with 2 funds rather than 3 (as Richard Ferri also suggests in his book it’s all about asset allocation). It seems there will be overlap exposure with either suggestion.
I’m in the middle of reading this book (all about asset allocation) now and I’m wondering what the pros and cons would be for dividing EAFE into Europe and Pacific Rim vs EAFE value and size.