How many funds do you need in your portfolio? A fairly radical view is that
you need just two: a share fund and a bond fund. What's wonderful about that is that
it's so simple. Asset allocation simply becomes a matter of how much money you
put into fund A and into fund B but if you do it in sterling there are some
considerations that you have to take into account and a lot of the proponents
of the two fund model are US dollar based investors so let's see how we
could do that in a bit more detail. This is not a recommendation if you want
advice tailored to your specific circumstances seek independent financial
advice. The question is can we build a portfolio using just two funds? Warren
Buffett certainly seems to think so. In his will he says he'd put 10% of the
money into short-term government bonds and 90% into an S&P 500 index fund and
he likes Vanguard because its fees are very low so here's the best active fund
manager in the world putting his money into two funds and passive funds at that
and he thinks the performance of those funds will be better than that from
active fund managers particularly the ones which charge high fees so let's see
why having just one fund that tracks equity might make sense here's a
selection of Vanguard equity funds notice how they all seem to jiggle up
and down together they're not exactly the same but they are certainly very
correlated and if they behave the same then perhaps it makes sense just to own
one of them if we look at the returns of a selection of Vanguard funds and here
I've included both share funds and bond funds the size of the blue dot tells you
how closely correlated two of these funds is so if we look down this column which
is VMID which is the FTSE 250 tracker for UK stocks you can see that
it's highly correlated with almost all of the other equity funds and if we look
at VUSA which is the U.S. S&P 500 tracker again it's highly correlated
with the other equity funds but the correlation with the bond funds is very
low or even negative in some cases those are the red dots
so all of the share funds form one big block of highly correlated asset returns
in other words their price behavior makes them very similar bond funds
aren't as correlated with one another as stocks are but importantly their
correlation with equity which is this block here is very low so if you have
both stocks and bonds then you're going to have a diversified portfolio the
question is how many stocks do you need and how many bonds do you need to be
diversified? In the video where I showed how I invested my own portfolio I showed
this tree and what this illustrates is how assets behave if they're highly
correlated with one another like the S&P 500 and the VNRT which is the FTSE
North America fund which includes Canada though they sit close together in the
tree so my approach was to cut the tree and then choose the fund which I thought
would give the best returns from every branch and I named the characteristics
of each branch according to characters in scooby-doo so all of the action and
excitement comes from the ex-UK shares branch that's global shares which don't
include the UK and for my portfolio in this branch I chose the VVAL fund
that's the global value factor fund I'm afraid I chose Scrappy-Doo to
characterize European shares and in that branch I chose the FTSE Developed
Europe excluding the UK in the Shaggy branch I chose the UK FTSE 250
mid-cap tracker and then when we get to the dollar bonds which is Fred
I chose dollar emerging market government bonds because they gave me a
bit of yield for my European bonds characterized by Daphne
I chose European corporate bonds and then my safety play characterized by
Velma who's the brains of the operation and the safe one I chose UK government
bonds so in total I had six funds but why make it so complicated do I really
need all six funds here's another tree which includes more
assets and that means I've had to restrict the time period but what this
shows up quite nicely is that I could slice it neatly into two branches with
Velma's bonds up at the top and that would provide safety
and income for my portfolio and Scooby-Doo would be the other half of
the tree and that would provide the excitement and the unlimited upside for
my portfolio now the challenge for UK investors is to choose one of those
funds from each of the branches I need one stock fund and one bond fund
ideally I'd choose funds which are already diversified and that would mean
choosing a global stock fund and a global bond fund because now that's
really easy with exchange-traded funds and it's also very cheap so the share
and bond funds I choose will be global and I'll choose funds which are very low
cost because although you can't control markets you can control the fees you pay
and unlike Warren Buffett I have to think in terms of stirling because I'm a
UK investor and as we'll see that affects your choices so now let's choose
our stock fund there are several global equity funds
that you could choose but here I've shown three of the cheapest and remember
this isn't a recommendation Vanguard's VWRL fund tracks the FTSE All-World
index it's not hedged which means it's denominated in u.s. dollars and the fee
you'll pay for that is 0.25 percent so for every 100 pound investment you'd pay
just 25 pence per year the company Blackrock which manages the huge
selection of iShares funds has a whole family of global equity trackers
and these track the MSCI World Index IWDG is sterling hedged which means that
you have a hugely reduced risk of currency movements of sterling versus
the US dollar and the fee for that fund is 0.3 percent per year a little bit
more than VWRL another version of that iShares tracker is not hedged and that's
a little bit cheaper that's point 2 percent per year but it still tracks the
MSCI World Index and for that fund you'll also be taking the sterling
versus US dollar currency risk whenever you're thinking of buying some of these
funds you should always look at the detail in other words look at the fund
fact sheet look at the contents of the fund to see exactly what it is you're
buying we can see that VWRL contains over 3,000 stocks which isn't all of the
stocks in the World but it's a fair proportion of them and we're
particularly interested in the fee or the ongoing charge figure which is 0.25
percent per year at the top of each of these fact sheets you'll see the
description of the fund's objective it's always worth reading that to see if it's
aligned with your investment goals and here we can see that the fund contains
global equities from both developed and emerging markets and it's only gone for
the large companies which are generally safer but also some of the mid cap
companies which would hopefully boost the capital growth and we can also see
that it's a passive tracker which is simply tracking the FTSE All-World
index at the bottom the bar plot shows you how closely the fund tracks its
benchmark so in this year the benchmark rose by eleven point four percent and
the fund grew by eleven point four percent as well because that's the goal
of a tracker it simply has to match its index the SWDA fund which is offered by
Blackrock under the iShares brand is an accumulating fund you can see that here
and you can also see that it's denominated in US dollars which means
you'll be taking that sterling versus US dollar currency risk if we look at the
key facts for the fund you'll see the fee is 0.2 percent per year and it's
also eligible to go in an ISA or a SIPP which are both tax efficient ways of
investing if you don't want to take the currency risk then IWDG provides a
sterling hedged version of the fund in other words it's got exactly the same
assets inside the fund but Blackrock uses currency derivatives to get rid of
that risk and if you look at the ongoing charges figure for the fund it's higher
than it was for the non hedged version of the fund and this version of the fund is
also eligible for your ISA and your SIPP now let's consider the bonds again
there's a big selection of these funds you could choose from here I've just
shown four but I've chosen them because they're some of the cheapest ones out
there the Vanguard VIGBBD fund is the cheapest and that tracks the
unpronounceable Bloomberg Barclays Global Aggregate Bond Index its dollar
denominated so you're taking that sterling versus US dollar currency risk but the
fee is just point one five percent per year the three iShares funds which
all track the same index the FTSE G7 Government Bond index but they're all
slightly different IGLA is an accumulation fund IGLO is a US dollar
denominated income fund and IGLA and IGLO both charge point two percent per year
and the third version of the fund is IGLH which is sterling hedged so as you'd
expect the fee is a little bit higher for that one but there you're not taking
the currency risk if we look at the VIGBBD fund it contains almost 10,000 bonds
and there's that extremely attractive 15 basis points or point one five percent
ongoing charge figure and if we look at the objective you can see that it
contains a real mishmash of different bond types and although it doesn't buy
all of the bonds and the index it buys at least 90% of them and it does a
pretty good job of tracking its benchmark and looking at the contents of
the fund at the top you can see that there's a very high market allocation to
the United States US bonds make up 40% of the index because the US bond market
is simply so big just like the US equity market if we compare those three iShares
global bond index trackers you'll see that IGLA is accumulating in other words
any coupon payments on its bonds are reinvested automatically back into the
fund and you aren't paid a cash dividend whereas for IGLO and IGLH they're income
funds which means that any coupon will be aggregated and passed through to you
as a cash payment and the two funds at the top aren't sterling hedged so
they're dollar denominated whereas IGLH at the bottom is hedged into sterling
here's the breakdown of the contents of that fund by currency and again you can
see the very strong domination of US dollars then there's about a quarter
each in the euro and Japanese yen and if you look about geographically you can
see that global isn't really very global at all the geographic exposure is
focused on rich countries which have big bond markets once we've chosen our two
funds we to choose how much to put into the share
fund and how much to put into the bond fund and that choice is called asset
allocation and it's a very important driver of risk and return for this
example I use VWRL and for the bond component I've chosen VIGBBD again a
Vanguard fund but don't take my word for it do your own research into which fund
is best for you here I've shown what would have happened to the cumulative
returns based on your asset allocation the line at the bottom in purple is the
hundred percent bond portfolio and the red line at the top is the hundred
percent equity portfolio and this period of time remember was very unusual
because it had a blistering equity rally so although it seems like a no-brainer
that you'd put a hundred percent of your money into equity that's not such a good
idea after all it makes sense to consider alternative
allocations what most people do is to choose an allocation which is somewhere
between those two extremes based on their risk capacity which is your
ability to take risk so that if you do lose money you wouldn't affect your
lifestyle and your risk appetite which is how much risk you're comfortable with
to see what can go wrong if you have a hundred percent equity let's focus on
this period around 2015 and 2016 during this period there was a market
correction from a hundred percent equity component fell by almost 20 percent
whereas the 100 percent bond portfolio lost only three percent so if you want
to protect your money or if you have a very short investment horizon and you
can't stomach that kind of loss say you need the money in one year then you want
to dial up your bond allocation and that reduces the risk of your portfolio but
it also reduces the potential upside over the long term if we look at the
annualized returns for each of those portfolios the 100 percent equity
portfolio would have got you about 13 percent per year and that's unusually
high a more reasonable expectation over many decades would be around 6% per year
and 100 percent bond portfolio would have earned just 2.5 percent per year
and again that's uncharacteristically low
because rates since the global financial crisis have been extremely low and if we
plot the two together so we have risk along the bottom with low risk on the
left and high risk on the right and return along the left axis with low
returns at the bottom and high returns at the top the pure equity portfolio at
the top right is extremely high risk but also extremely high return and as we
dial down the risk we also dial down the return so that for the one hundred percent
bond portfolio at the bottom the returns are the lowest of all but it also has
the lowest risk so a two fund portfolio isn't as crazy as it seems and it
embodies Jack Bogle's principle of the "majesty of simplicity" we rely
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