Roth: Simple ETF Strategies Work

Investors should strive to keep things simple, Allan Roth says.

What sector will outperform in 2014? Will emerging markets regain their lost mojo? Should you shorten bond durations as economists uniformly predict rate increases? As I’ll explain, asking questions such as these leads to lower investor returns.

I’ve long said that a simple three-fund portfolio will beat the vast majority of investors. This simple portfolio can easily be constructed with ETFs from families such as Vanguard, iShares and Schwab. Here, for example, are the funds using the Vanguard ETFs:

• Vanguard Total Stock ETF (VTI | A-100)
• Vanguard Total International Stock ETF (VXUS | B-95)
• Vanguard Total Bond ETF (BND | A)

With these three funds, investors own virtually every publicly traded stock on the planet, as well as all fixed-rate investment-grade bonds in the U.S., with dirt low costs.

This ETF portfolio, also known as the Second Grader portfolio, is one of the MarketWatch Lazy Portfolios Paul Farrell often writes about. It was designed by my son Kevin—with a little help from dad—when he was eight years old.

With so much time on his side, an 8-year-old can be far more aggressive than most adults, As of Jan. 17, 2014, this simple portfolio of 60 percent U.S. stocks, 30 percent international stock and 10 percent bonds has had the following annualized returns:

• One year: 19.93%
• Three years: 10.53%
• Five years: 16.57%
• Ten years: 7.12%

According to MarketWatch, of the eight Lazy Portfolios, the Second Grader portfolio is in either first or second place in all of the time frames.

That’s not bad, considering that the other portfolios were constructed by the likes of passive investing advocate William Bernstein and the Yale University endowment’s David Swensen.

Even more conservative allocations also worked quite well.

Here are the 10-year results through Dec. 31, 2013, for the aggressive, moderate and conservative Second Grader portfolios, which are 90 percent, 60 percent and 30 percent in stocks, respectively.

Why does simple brilliance work?

First, it has the lowest costs, and we all know costs matter.

Second, it uses the broadest index funds. Research demonstrates that narrow index funds have larger gaps between fund and investor returns—geometric versus dollar-weighted—than broad funds. That’s to say we do more performance chasing on narrow funds than broad funds.

Again, the conclusion is that broader is better.

Third, rebalancing resulted in investor returns exceeding the funds’ returns. While simple, it’s not easy to ignore the media, which usually predict the continuation of the past.

Even though it’s human instinct to want to know the future, that instinct gets in the way of maximizing investing returns.

Instead, investors must accept the lonely truth: No one knows the future of markets. No one can predict which sectors will be hot this year.

And before one bails on bonds based on the predictions of economists, one should keep in mind that even the top economists have predicted the direction of interest rates less accurately than a coin flip.

Low cost, broad investing is dull as dishwater, no question about it. But considering the financial advantages of such a strategy, it’s too bad most investors will never dare to be dull.

Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice.

Roth also writes for CBS MoneyWatch.