We revisit and make a modification to our portfolio for those with shorter time horizons.
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By Christine Benz | 04-03-14 | 06:00 AM | Email Article

Investors are in "risk-on" mode, judging from Morningstar's asset-flows data. Money has been rolling into stocks following their tremendous runup in 2013. And even those investors who have been opting for bonds are generally buying higher-risk/higher-reward offerings such as bank-loan and high-yield bond funds.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

So who wants a conservative portfolio, anyway? People who are still in the accumulation phase, as well as younger retirees with long time horizons, absolutely should have a sizable share of their portfolios in stocks. By being too conservative, they heighten the risk of falling short later in retirement. But retirees with shorter time horizons may need to play it more safely because encountering a bear market could deal their portfolios a blow from which they may not recover. For them, the name of the game is protecting purchasing power during their life spans, with a secondary emphasis on capital growth.

That's the aim of my conservative bucket portfolio, geared toward older retirees with a time horizon of 15 years or fewer. Stocks are represented here, as are more economically and credit-sensitive bond holdings such as high-yield and floating-rate funds. But the overall emphasis is on safety and quality, with sizable allocations to cash and short- and intermediate-term bonds, both nominal and inflation-protected.

Like the moderate and aggressive versions, this portfolio consists entirely of exchange-traded funds. The fact that most of these offerings are passively managed helps keep the overall portfolio's cost load down, which is particularly important given that the portfolio's absolute rate of return is apt to be modest. And because broad-market ETFs are well-diversified, it's easy for an investor to reduce the complexity of the portfolio--a worthy goal for those in their later retirement years. Finally, ETFs can be effective holdings in taxable accounts, as equity ETFs (and traditional index mutual funds, too) will tend to dish out limited capital gains distributions. (There's no real tax benefit associated with holding a bond ETF instead of a bond mutual fund, however.)

This week, I'll take a closer look at my conservative bucket ETF portfolio, which first appeared on Morningstar.com in November 2012. The goal of this and all the bucket portfolios is to be as hands-off and low-maintenance as possible, but I am recommending one small shift from when the portfolios originally appeared. I'll also provide a performance update to assess how the specific holdings here have performed relative to a simple portfolio of very plain-vanilla index funds.

Bucket Basics
My conservative ETF bucket portfolio uses the same general framework and assumptions as the conservative portfolio consisting of traditional mutual funds. It's geared toward a retired couple with a $750,000 portfolio, a roughly 15-year time horizon (that is, life expectancy), and a fairly low risk capacity. The aim of the portfolio is to meet their cash flow needs throughout their retirement years. It stakes roughly 30% of assets in stocks and the remainder in cash, bonds, and a small slice of commodities.

Because the couple's time horizon is shorter than the 30 years that underpins the 4% rule, they're using a higher withdrawal rate of 5.5%. That means they will withdraw $41,250 of their portfolio in year 1 of retirement, then inflation-adjust that amount in each year thereafter. (Assuming a 3% inflation rate, the withdrawal in year 2 would be $42,488.) Income from Social Security and other sources would be on top of the $41,250 distribution.

As with the other portfolios, I've divided this portfolio into three components: the cash component (bucket 1); bucket 2, consisting of bonds and a high-quality dividend-focused fund; and a long-term growth sleeve (bucket 3) that holds stocks and higher-risk/higher-reward bond funds. As bucket 1 (cash) becomes depleted, the couple can refill it using income from their dividend-producing equities and bonds, rebalancing proceeds, or a combination of the two.

Bucket 1: Years 1 and 2

Original Portfolio

  • $82,500 (11%): Cash (certificates of deposit, money market accounts, checking and savings accounts, and so on)

Adjustment: None

The goal of bucket 1 is capital preservation, so it's stashed in cash instruments. Because inflation will bite into the purchasing power of any dollars held here, this portion of the portfolio should max out at two years' worth of living expenses to help minimize its opportunity costs. Noncash, nonguaranteed alternatives such as ultra-short-term bond funds may work in this portion of the portfolio if yields rise a bit, but right now they're a poor substitute for true cash.

Bucket 2: Years 3-12

Original Portfolio

$100,000 (13.33%):  Vanguard Short-Term Bond ETF
$50,000 (6.66%):  PowerShares Senior Loan Portfolio
$150,000 (20%):  PIMCO Total Return ETF Bond
$75,000 (10%):  iShares TIPS Bond
$37,500 (5%):  Vanguard Dividend Appreciation ETF 

Adjustment: Use  Vanguard Short-Term Inflation-Protected Securities ETF in place of iShares TIPS Bond. Both products provide inflation protection, but the relatively new short-term fund does so with less sensitivity to interest rates.

The rest of the portfolio remains the same. Vanguard Short-Term Bond and Vanguard Short-Term Inflation-Protected Securities serve as the portfolio's next-line reserves in case bucket 1 should run dry and income production and/or rebalancing proceeds from buckets 2 and 3 are insufficient to refill it. As with the other portfolios, PIMCO Total Return ETF remains the core fixed-income position here. Despite concerns about succession at the firm, which prompted Morningstar to downgrade its Parent rating for PIMCO to Neutral, Morningstar senior fund analyst Eric Jacobson remains confident in manager Bill Gross' abilities and in the PIMCO's deep analytical resources.

Bucket 2's stake in a bank-loan offering, as well as a small position in Vanguard Dividend Appreciation, supply this part of the portfolio with sensitivity to the economic cycle and the equity market.

Bucket 3: Years 13 and beyond

$120,000 (16%):  Vanguard Dividend Appreciation ETF
$50,000 (6.66%):  Vanguard FTSE All-World ex-US ETF
$35,000 (4.66%):  PowerShares DB Commodity Index Tracking
$25,000 (3.33%):  SPDR Barclays High Yield Bond
$25,000 (3.33%):   WisdomTree Emerging Markets Local Debt

Adjustments: None

The growth engine of the portfolio, bucket 3 is anchored with two core equity funds, one domestic and the other focused on foreign stocks. I've used Vanguard Dividend Appreciation to supply a tilt toward higher-quality firms and reduce overall volatility, but one could use a total U.S.-stock market index fund instead. 

This portion of the portfolio also features noncore fixed-income positions--small stakes in a junk-bond ETF as well as an actively managed ETF that buys emerging-markets bonds denominated in local currencies. The latter fund has struggled along with most emerging-markets vehicles during the past year, but it's a small position and still has merit as a diversifier. And though the equity holdings in bucket 3 give it a good shot at outpacing inflation over time, PowerShares' commodity ETF provides an additional layer of inflation protection.

The conservative bucket portfolio has underperformed its blended benchmark (11% cash, 57% total bond market index, 7% total international-stock index, 5% commodity index, and 21% total U.S.-stock index) by roughly 1 percentage point since its launch in November 2012. Vanguard Dividend Appreciation, while producing strong absolute gains, has lagged a total stock market tracker during that stretch. That owes in large part to Dividend Appreciation's modest stakes in the strong-performing technology and health-care sectors.

The bond stake of the bucket portfolio performed better than a total bond market index, however. Although the positions in TIPS and emerging-markets bonds were drawbacks, the portfolio's holdings in PIMCO Total Return, SPDR High-Yield, and PowerShares Senior Loan Portfolio all turned in strong gains.

See More Articles by Christine Benz

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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