Note: This article is part of Morningstar's 2018 Portfolio Tuneup week. A version of this article appeared on May 1, 2017.
Investors who started their investment careers 20 years ago--which is the group that our Moderate ETF Saver portfolio is created for--have endured one heck of a ride.
They witnessed blue-chip mania in the mid-1990s, just as they were funding their 401(k)s. They've seen the dot-coms rise and fall, and a different set of dot-coms grow up in their place. They've invested through 9/11, more than a decade's worth of U.S. involvement in wars in the Middle East, and the global financial crisis from 2007-09. Most recently, they've lived through the fourth-longest-running equity rally in market history.
Having gone through numerous stress tests, many midcareer savers are probably getting a sense of their investment dispositions, and that should be informing how they invest. Nerves of steel? Even though they're getting older, such investors should harness their still-long time horizons by holding portfolios that are primarily equity. But they should also bear in mind that long-running bull markets have a tendency to make us feel more risk-tolerant than we actually are.
Meanwhile, investors with a track record of buying and selling at the worst possible times might do well to maintain a slightly more conservative mix. And if they're still not confident they'll keep their mitts off their portfolios when things get rocky, they should also consider outsourcing their investment management to a professional financial advisor--or at a minimum, to a good-quality target-date fund--to help provide behavior management on an ongoing basis.
My Moderate ETF Saver Portfolio aims to strike a reasonable balance for both types of investors. It harnesses the 40-something's 20-plus-year time horizon by holding primarily stock ETFs. But in contrast with the Aggressive Saver ETF Portfolio, which is all equity with the exception of a bond commodities component, the Moderate Saver holds a complement of high-quality bonds, a stake that will ramp up over the next 20 years. The basic idea is that, as retirement draws close, the investor mitigates the portfolio's vulnerability to sequencing risk by holding bonds and cash at the front end of the portfolio. Should the new retiree encounter a bum market early on, he or she can spend the portfolio's cash and bonds while leaving the equity portfolio in place to recover.
The Portfolio Details
This portfolio uses the moderate version of the Morningstar Lifetime Allocation Index, geared toward investors retiring in 2035, to guide its allocations. Thus, it's appropriate for an investor in his or her mid-40s or thereabouts. Its baseline asset allocation is roughly 55% U.S. stock, 25% foreign stock, and 20% bond.
I employed the same equity holdings, albeit in slightly reduced allocations, that appeared in the Aggressive ETF Saver Portfolio. I used a total U.S. market index fund as the anchor equity holding; with just a 0.05% expense ratio, it keeps the total portfolio's costs way down. I augmented it with a small position in a small-cap value index to harness that asset class' historic performance edge relative to U.S. blue chips and to facilitate periodic intra-asset-class rebalancing. (Indeed, investors who have small-value exposure in their portfolios and haven't rebalanced recently may want to do so; small-value stocks have dramatically underperformed the S&P 500 and especially large-growth stocks recently.)
On the international side, I employed discrete developed- and emerging-markets index funds. Not only are both funds cheaper than a total international-stock index ETF, but holding the two funds also facilitates rebalancing, as developed and developing markets haven't always moved in lockstep.
Of course, employing total U.S. and international-stock ETFs or index funds would be a perfectly reasonable way to go, too. By limiting the number of moving parts in a portfolio, an investor might also squelch his or her impulse to make unnecessary trades.
47%: Vanguard Total Stock Market Index ETF (VTI)
8%: Vanguard Small-Cap Value ETF (VBR)
20%: Vanguard FTSE Developed Markets ETF (VEA)
5%: Vanguard FTSE Emerging Markets ETF (VWO)
20%: iShares Core Total USD Bond Market (IUSB)
The biggest change with this portfolio (and all of the Retirement Bucket and Saver portfolios) is that I've jettisoned the commodity ETF. As noted above, the asset allocations of the model portfolios loosely mirror those of Morningstar's Lifetime Allocation Indexes, which reduced their commodities weightings last year. Morningstar senior portfolio manager Brian Huckstep detailed the rationale in this video, noting that a phenomenon called negative roll yield has served as an additional, unavoidable toll on funds that buy commodities futures. The indexes didn't cut commodities altogether--most hold roughly 2% positions. But my goal for these portfolios is to limit complexity, and maintaining a 2% position in a niche asset class doesn't jibe with that goal. I steered the 5% of assets that had previously been earmarked for commodities into Metropolitan West Total Return Bond.
How to Use
As with my model Bucket portfolios, the goal of the Saver portfolios isn't to shoot out the lights over short time frames. Rather, it's to demonstrate sound asset-allocation principles and to showcase some of Morningstar's best ideas in the context of a goal-based portfolio. I'll employ a strategic approach to asset allocation, making changes on an annual basis, and only to rebalance back to the baseline asset-allocation targets.
I've used ETFs in these portfolios, but investors could reasonably use traditional index mutual funds instead. Equity exchange-traded funds will generally be more tax-efficient over time than comparable index mutual funds, but both types of products are extremely tax-efficient. (In Vanguard's case, because the ETFs are actually separate share classes of traditional index funds, the tax differential should be negligible to nonexistent.) And while this portfolio tilts heavily toward Vanguard's ETF lineup, investors might reasonably employ a similar basket of ETFs from other providers.
Finally, it's worth noting that I've developed these portfolios without regard for tax efficiency. Investors who wish to hold the portfolios inside of a taxable account should consider holding total market U.S. and international equity ETFs rather than the more narrow ETFs that appear in the portfolio. They might also consider holding municipal bond funds instead of the taxable fixed-income holding featured here.
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.