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Building a Diversified Portfolio - The Best Mutual Funds

In another article we looked at managing risk (as measure by the standard deviation of returns) by combining funds in our portfolio that were uncorrelated, (that is they don’t track each other very well on a day to day basis.)

How does this work out when applying it to a typical mutual fund portfolio?

Let’s start by taking a quick look at one of the standard examples.

One common allocation model (taken from “The Intelligent Asset Allocator” book discussed in other articles) is below. The ticker in parenthesis is the fund we will use in our study, we’re using Vanguard funds as they are the “gold standard” of index funds (that is that they are the most popular index funds, not necessarily the best mutual funds as there are comparable funds with Fidelity and most of the major fund families:

25% in Large US Stocks (VFINX)
25% in small cap US stocks (NAESX)
25% in intermediate term bonds (VBIIX)
25% in international stocks (VGTSX)

For the examples we will look at, we set up a portfolio with the percentages shown, and then rebalance every quarter. We looked at the 11 year period from 1995 to 2005 inclusive.

Diversified Portfolio Performance

Ann Rtn MDD Std Dev
VFINX 10.7% 47.5% 20.2%
VGTSX 4.8 50.6 19.6
NAESX 11.9 43.1 17.4
VBIIX 7.6 7.3 6.1
Port 10.1 29.9 12.5

Port = Portfolio rebalanced quarterly
Ann Rtn = Annualized return over the 11 years
MDD = Maximum Drawdown (our simple measure of risk)
Std Dev = Standard Deviation of the annual returns, another measure of risk

These results are simulated, and are not a prediction of future results

So this really works! The overall return was still over 10%, just under that of the S&P 500, but the MDD for the portfolio is only about 2/3 of the S&P alone, and the standard deviation of the returns dropped to about 2/3 as much as well. We got 94% of the returns, but less than 2/3 the risk. That’s great.

Now, here’s where I will part company with William Bernstein, the author of “The Intelligent Asset Allocator.” His contention is the only way to generate above market returns with lower risk is through asset allocation. We think that by sector rotation we can generate returns above the market, and with lower risk as well.

So, what if we start with those funds that have higher overall returns, and lower risk as well.

The next step is to use a fund combination that start with higher returns and lower volatility.

Filed under Asset Allocation

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