What the 3-Fund Porfolios Are Missing

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar.com. There's a lot to like about the idea of building an ultra-minimalist portfolio with just three index funds or ETFs. But investors who pursue this strategy leave a few asset classes on the cutting-room floor. Joining me to discuss those leave-behinds and how much they matter is Christine Benz. She is director of personal finance for Morningstar.

Christine, thank you for joining me today.

Christine Benz: Susan, great to be here.

Dziubinski: Let's take a step back and talk a little bit about what is the basic three-fund portfolio? What are the building blocks?

Benz: Right. First, I have to give credit to the Bogleheads and specifically, Taylor Larimore, one of the lead Bogleheads. He has been a big proponent of this ultra-minimalist, ultra-low-cost portfolio where you've got a total bond market index, a total U.S. stock market index, and a total international index. And the idea is that this set of three funds gives you very comprehensive well-diversified exposure. So, it is a great starting point for most investors.

Dziubinski: And then how would an investor allocate among those three funds?

Benz: Well, that's an important question. So, for young accumulators, you probably want to have a more equity-heavy portfolio. You might be sort of equally represented between foreign and U.S. stocks. I often recommend that people use target-date funds as kind of a starting point for saying, "Well, for someone with my general anticipated retirement date, what are these professionals recommending?" I think that can be a good starting point. For people who are in retirement, I think it pays to put a little bit of a finer point on it. As you know, I'm a big proponent of the Bucket approach to retirement portfolio allocation. The basic idea is that you are putting a couple of years' worth of portfolio withdrawals in cash to meet near-term spending needs. Then you're stepping out on the risk spectrum. People can read about some of these bucket allocations that I've used, but I've typically thought of like another eight years' worth of portfolio withdrawals going in bonds and then the remainder of the portfolio going into equities.

Dziubinski: Now, these three-fund portfolios are very well-diversified as you mentioned, but obviously, they are leaving some asset classes out. Let's talk a little bit about what isn't represented in those three-fund portfolios.

Benz: Right. One of the biggies that I just mentioned, Susan, is cash holdings. So, it's up to each of us to really think about what we have going on to determine how much is an appropriate cash allocation. For people who are still working, you definitely need that emergency fund, which at a minimum would be like three to six months' worth of living expenses held in true cash investments. For retirees, I think they want to think about their portfolio withdrawals, their anticipated portfolio withdrawals. As I mentioned, I've typically recommended one to two years' worth of portfolio withdrawals in cash investments.

Dziubinski: So, clearly, we all need to think about sort of managing that cash piece outside of our three-fund portfolio. But for those people who are retiring or about to retire or in retirement, some other omissions that are important for us to talk about. One would probably be short-term bonds?

Benz: I think so. So, when you think about your retirement portfolio and you've maybe got that cash allocation, well, you think about, "What if at some catastrophic environment where I've spent my cash, where do I go if I still need additional living expenses, what will I tap?" And I think that's the value of having a dedicated allocation to a short-term bond fund in a portfolio. Short-term bonds do in fact appear in a total bond market index tracker. But unfortunately, you can't tell your fund manager that you just want that piece of the portfolio. You'd need to sell a whole chunk of it, and it may or may not be a good time to do so. So, that's one reason why in my bucket portfolios I have in fact recommended a dedicated allocation to short-term bonds.

Dziubinski: Now, another type of slice of the bond market that could be very important for retirees are Treasury Inflation-Protected Securities. Now, those aren't represented in the three-fund portfolio, are they?

Benz: They aren't. So, if you buy a total bond market index tracker, it will not include an allocation to TIPS. So, here's one to think about if you are assembling a portfolio, especially if you are getting close to or in retirement. If you are a younger investor, probably no reason to worry about carving out a dedicated allocation to TIPS. But once you are putting more of your portfolio into bonds and into nominal bonds that aren't giving you any inflation adjustment, I think it's important to think about, "Well, how do I inflation-hedge that portion of the portfolio?" So, when I look at the allocations to Treasury Inflation-Protected Securities recommended by some of our colleagues in Morningstar Investment Management, when they put together portfolios, typically, 25% to upwards of 30% of the fixed-income portfolio goes into TIPS for retirees. So, that's an allocation that you might want to think about carving out a specific fund for.

Dziubinski: And then, what about high-yield bonds? Is this something we should be considering if we're building these portfolios?

Benz: Well, it's important to note that a total bond market index tracker would not include an allocation to high-yield bonds. There are some very low-cost ETFs that do have at least a small allocation to high-yield bonds. One our team likes is called iShares Core Total USD Bond Market Index. The ticker is IUSB. So, you could use that as kind of your core bond fund. But in terms of whether a total bond market index, if it's a significant omission that it doesn't include an allocation to high-yield, I would say not so much. In part because when we look at high-yield bond performance, what we see is a pretty high correlation to the equity market. So, if you go without high-yield bonds, I don't think it's a disaster.

Dziubinski: And what about non-U.S. bonds?

Benz: Well, this is an area of consideration and where there's been some research recently looking at how much value a hedged non-U.S. bond portfolio adds. There is some modest diversification benefit. So, if you don't mind having an additional holding, that might be a category to consider. But by all means, I would focus, for a retirement portfolio, on a hedged bond product. Because anytime you have an unhedged bond product, you are getting a lot of currency-related volatility, which probably isn't what you want from your bond portfolio. So, if you are looking to perhaps add a little bit of a diversification to your bond portfolio, think about a hedged international fund and make sure you're focusing on one that has very low costs because this is a pretty low-returning asset class.

Dziubinski: Got it. Thank you very much, Christine, for joining us today to talk about some ways we might supplement the three-fund portfolio if we so choose.

Benz: Thank you, Susan.

Dziubinski: Thanks. For Morningstar.com, I'm Susan Dziubinski. Thank you for tuning in.