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Vanguard's Two-Fund Portfolio Just Had Its Best Decade

Keeping it simple has been anything but stupid.

Securities In This Article
Vanguard Balanced Index Adm
Vanguard LifeStrategy Mod Gr Inv Shrs
Vanguard Total Intl Stock Index Inv
Vanguard Total Intl Bd Idx Investor
Vanguard Total Bond Market Index Adm

If it feels like diversifying beyond a simple moderate portfolio that owns one U.S. stock index fund and one U.S. bond index fund has been a fool's errand over the past decade, there's good reason for that. Vanguard Balanced Index VBIAX had its best decade of risk-adjusted returns since it launched in 1992, and it invests in just two broad U.S. index funds. To be fair, seven of the 153 funds in the allocation--50% to 70% equity Morningstar Category had as good or slightly better risk-adjusted returns over the decade, so there was some room for improvement, but it has still been a fantastic time for simplicity.

Vanguard Balanced Index is a moderate-allocation fund that earns a Morningstar Analyst Rating of Gold. It uses 60% of its assets to track the same index that underlies Gold-rated Vanguard Total Stock Market Index VTSAX and 40% of its assets to track the same index underlying Silver-rated Vanguard Total Bond Market Index VBTLX.

To measure how great the past decade has been for the fund, we looked at rolling 10-year returns, volatility, and risk-adjusted returns since December 1992, its first full month of returns.

The results showed that the portfolio's 10-year annualized returns of 10.79% over the period ended April 30, 2019, were the third-best out of the 198 rolling 10-year periods we looked at (the best was the 11.69% annualized return for the period ended Feb. 28, 2019, so apologies to readers for being two months late on catching this phenomenon). Not only were the returns in the top 1% of the periods we looked at, but the portfolio's 7.61% annualized standard deviation (a measure of volatility) was the lowest out of the 198 periods (on that front, our timing worked out pretty well!).

Putting those risk and return characteristics together, not only has it been one of the most profitable times for this two-fund portfolio, it's also been the smoothest ride to get there. This translates directly to the fund's risk-adjusted returns, as measured by Sharpe ratio, also being in the top 1% of periods we looked at.

Exhibit 1 shows how the most recent 10-year returns, standard deviation, and Sharpe ratio rank compared with all periods and the average over those periods.

Setting Expectations Going Forward How long can the good times last? It seems unlikely that the portfolio's unusually smooth ride will continue for the next 10 years, although its volatility can easily stay well below its long-term average for an extended period. Over the past 12 months, however, the fund's standard deviation has already been showing signs of reverting to the mean as macro factors like the U.S.-China trade war and the level of U.S. interest rates have led to increased market volatility. The fund's standard deviation for the 12-months ended April 30, was 10.31%, about one-third higher than it was over the trailing 10-year period.

For its part, Vanguard is also forecasting a return to the mean for the fund's volatility over the next decade. In Vanguard's 2019 economic and market outlook, it forecasts future a median volatility of 16.3% for U.S. equities and 5.3% for U.S. bonds. If the correlation of U.S. stocks and bonds stays near zero, which it was over the previous 10 years, that would translate to annualized volatility of about 9.69% over the next decade for this fund, which is basically equal to the average over all the rolling 10-year periods since the fund launched.

While investors should at least be prepared for higher volatility from the fund going forward, return expectations should also be moderated. Stocks' elevated valuations in the United States after their blistering decade of performance point toward lower expected future returns. The Vanguard Capital Markets Model projects U.S stocks to return between 3% and 5% annualized and U.S. bonds to return between 3% and 4% annualized. If the median range of those forecasts is correct, that would translate to annualized returns of about 3.8% for the fund going forward.

Of course, these are just educated estimates and no one, not even Vanguard, expects to hit their 10-year estimates on the nose. Still, it seems likely the fund's volatility will be higher over the next decade and that returns will be lower. Simple mean reversion points in this direction. Keeping moderated expectations in mind should help investors stick to the strategy over the long term as it is still one of the best passive allocation funds, in our view. After all, the higher volatility and lower returns in U.S. equities and bonds aren't a unique headwind for this fund compared with its peers, which also invest in the same asset classes. Its low costs and thoughtfully designed portfolio of U.S stocks and high-quality bonds should keep it ahead of most rivals, even with more-difficult markets going forward.

The Next Best Alternative? Investors concerned about lower returns and higher volatility coming from U.S. allocation funds do have a solid alternative in Vanguard LifeStrategy Moderate Growth VSMGX. It also earns a Gold rating and has a similar risk profile to Vanguard Balanced Index. Vanguard LifeStrategy Moderate Growth invests in the total U.S. stock and bond markets, too, but it distinguishes itself from its sibling through a significant allocation to international stocks and bonds. It allocates 24% of its portfolio to Gold-rated Vanguard Total International Stock Index VGTSX and 11% to Silver-rated Vanguard Total International Bond Index VTIBX. That puts its allocation in line with Vanguard's Target Retirement Series, which dedicates 40% of its equity exposure and 20% of its fixed-income exposure to international securities throughout the glide path. The target-date series reflects the firm's best asset-allocation thinking for long-term investing.

The Vanguard Capital Markets Model also paints a rosier picture for more globally diversified portfolios going forward. The model's base case for a globally diversified 60/40 fund over the next decade is 4.9% returns with roughly similar volatility as a U.S.-only 60/40 portfolio. That's still lower returns than a global 60/40 would have returned over the previous decade, but it's potentially more upside without more risk.

Conclusion Vanguard Balanced Index has had a unique trailing decade of top-decile returns and bottom-decile risk compared with its history. Going forward, both returns and risk are likely to revert closer to their long-term averages. That translates into lower returns and higher risk. The fund remains a standout option in its category, but investors looking for an alternative may find an intriguing option in the more globally diversified Vanguard LifeStrategy Moderate Growth.

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About the Author

Jason Kephart

Director, Multi-Asset Ratings
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Jason Kephart, CFA, is director of multi-asset ratings for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He is responsible for Morningstar’s multi-asset ratings methodology and shares responsibility for research priorities. Kephart leads the firm’s global and North American multi-asset ratings committees. Kephart regularly contributes to Morningstar’s thought leadership on target-date strategies, 60/40 portfolios, model portfolios, and other multi-asset outcome-based products. He has been the lead analyst for multi-asset strategies from firms such as Vanguard, BlackRock, T. Rowe Price, and Dodge & Cox.

Before joining Morningstar in 2014, Kephart spent seven years as a journalist for InvestmentNews, Fund Action, and SmartMoney, reporting primarily on the mutual fund and exchange-traded fund industries.

Kephart holds a bachelor’s degree in English from Florida State University. He also holds the Chartered Financial Analyst® designation.

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