I’m an advocate of the three-fund portfolio, but I understand why many investors might want to slice and dice their portfolio. Most prefer to tilt their portfolio to small cap and value stocks, as there is a body of academic research beginning with the seminal Fama and French study in 1992 that small cap and value stocks are associated with higher historical returns (and higher volatility).
However, Gasem, a reader and commenter on man physician personal finance blogs, dropped this comment in my post about index funds, which I’ve paraphrased below:
“An efficient frontier analysis of a standard three-fund portfolio of VTSMX 50%, VGTSX 30%, VBMFX 20%) has an expected return of 9.7% and a volatility of 10.3% per year. On the other hand, a portfolio of 53% IWY and 47% VBMFX has the same expected return, but with a much lower volatility (6.1%). Alternatively, if you want to match the volatility of the three-fund portfolio, you could buy an 85% IWY / 15% VBMFX portfolio, which has an expected return of 13.45%.”
In short, he notes that the large-cap growth ETF IWY, since its inception in 2009, has achieved better returns with lower risk than the total stock market index.
What’s in IWY?
IWY is a large-cap growth ETF that tracks the Russell Top 200 Growth Price Index. The Russell Top 200 Index consists of the largest 200 companies in the United States. Not surprisingly, it includes many of the top tech companies, with the top 5 holdings being Apple, Microsoft, Amazon, Facebook, and Google. The Russell Top 200 Value Index, on the other hand, contains companies such as JP Morgan, Berkshire Hathaway, Exxon Mobil, Johnson and Johnson, and Bank of America.
Historical Performance of IWY
Using data from Portfolio Visualizer, IWY has had an annualized return of 15.8% with standard deviation of 12.2% from 2010-2017 (IWY was created in 2009). This is compared to an annualized return of 14.8% with standard deviation of 12.4% for the Vanguard Total Stock Market Index VTI.
So over this relatively short period, IWY has had higher returns and lower volatility than the total stock market index.
Expense Ratio of IWY
IWY has an expense ratio of 0.20%, which is higher than most of the large index funds at Vanguard, Fidelity, or Schwab. However, if it truly could give you higher returns at lower risk, as it has during its lifetime from 2010-2017, then this extra 15 basis points of fees would certainly be worth it.
Why Large-Cap Growth? Isn’t the Risk Premium in Small-Cap Value Stocks?
It’s interesting that a large-cap growth ETF has been the ETF sector that has done the best since 2010. Most investors who tilt their portfolio actually prefer small cap value, not large-cap growth.
Small Sample Size?
IWY has only been around since 2009, so its outperformance could simply be due to a small “sample size”.
Large-cap growth (i.e. tech stocks) have done very well during the current bull market. And IWY is especially concentrated in these types of stocks. 30% of IWY is in just 5 technology companies: Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), and Alphabet/Google (GOOG, GOOGL). This is compared to a 15% weighting in these five stocks for the S&P 500. Therefore, it’s concentrated in the stocks that have done the best over this time period. Potentially, IWY could underperform during a bear market.
Unplanned Subset Analysis At Work?
Unfortunately, much of the investing literature is retrospective, using past stock market returns to try to predict the future. Simply using past stock market returns and volatilities and plugging into an efficient frontier model is fraught with danger.
When clinical trials report their results, the study will first report whether the new drug is effective in the entire patient cohort. Later, they often will also do a series of subset analyses to determine whether certain groups of patients may do better or worse than the average. For example, they might see whether older patients might do better than younger patients, or whether early-stage patients might do better than later-stage patients.
The financial world has done a similar subset analysis when evaluating stock returns. They’ve split the universe of stocks into small cap versus large cap, and value stocks versus growth stocks. By definition, if one subset does better than the average, then the opposite subset will do worse.
The challenge for clinicians and investors is whether the results of subset analyses are real or spurious findings. The recent outperformance of large-cap growth stocks as seen by the returns of IWY runs counter to much of the previous literature that documented a risk premium in small-cap value stocks. It makes you wonder whether slicing and dicing provide any significant benefit at all — maybe you’re just better off owning the entire index.
Conclusion
IWY tracks large-cap growth stocks and has outperformed the Total Stock Market index since its inception in 2009. However, it’s difficult to say if this outperformance will persist in the future. Its portfolio is heavily weighted to the tech stocks that have powered much of the current bull market. Small-cap value has been the popular way to tilt a portfolio for over 25 years — it’s unclear why large-cap growth would now be the superior risk-adjusted way to slice and dice a portfolio.
What do you think? Would you invest in IWY? Do you think there is value (no pun intended) in tilting your portfolio value to small-cap value, large-cap growth, or some other combination?
This is interesting, but KISS does not include IWY for me.
Less than a decade is just noise in terms of financial data. Overall, growth companies are safer than value companies: less risk means lower expected return. I believe large growth companies, while safer companies, their stocks are subject to bubble risk.
Dave
Interesting. I too think 10 years and 200 stocks is not enough.
Put IWY and SPY in the efficient frontier analyzer and the analyzer chooses IWY 100% as the best risk adjusted portfolio. The whole point of the efficient frontier is to look at non correlated diversity so the 200 stock argument doesn’t make any sense. 200 stocks, 500 stocks or 3000 stocks all represent a diverse stock asset. Just piling more and more stocks on the pile at some point tends to reduce diversity. In a 1970’s study by Elton and Gruber found diversity was achieved at 30 assets. 1000 assets had a virtually identical diversity. The problem with piling on more and more funds for better diversity is you wind up paying twice or thrice to own some percentage of the same stocks. This kind of diversity is a marketing gimmick, and Bogelheads are nothing if not into marketing.
The correlation between IWY and SPY is 96% meaning they will behave identically in a bear market. Stock diversity does not buy you protection in a bear market. Almost all stocks are pretty highly correlated in a bear market meaning all the arrows point into the ground in a bear. The more they point into the ground the more correlated they become as everybody pulls the rip cord. If you add VBMFX to the SPY IWY mix, SPY is not on the efficient frontier. IWY has a 12bp greater return on a risk adjusted basis. 10 years is enough for the calculator to statically do its thing. Below 5 years it starts to get iffy. Your point on fund cost makes the 2 choices a wash. IWY 20bp SPY 9bP
Finally >25% of the S&P’s returns are due to the same 6 stocks as IWY’s. This is borne out in the high .96 correlation. BRK.B’s correlation to IWY is .37 and to SPY is .45. BRK.B is notorious for not holding tech hence the low correlation.
also
http://www.arborinvestmentplanner.com/over-diversification/
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