How many mutual funds is enough? The simple answer might be the Bogleheads three-fund portfolio.
a total U.S. stock market index fund
a total international stock market index fund
a total bond market index fund
With popular Vanguard ETFs, this would look like the following:
Vanguard Total (U.S.) Stock Market Index Fund (VTI)
Vanguard Total International Stock Market Index Fund (VXUS)
Vanguard Total Bond Market Index Fund (BND)
(Remember these tickers VTI and VXUS for later. “VXUS” stands for means “Vanguard ex-U.S.,” as in “excluding the U.S.”)
I am happy to argue that this three-fund portfolio works for 90% of investors if not more. It can be replicated across accounts so long as good funds that fit the bill for each of these categories are available.
But could you live with two? Let’s look at some possible approaches.
VT + bonds
Given that I believe that international stock diversification is extremely important and extremely ignored, I can’t go so far as to simply remove the international stock fund. Going down to two funds for most investors would mandate a global stock fund rather than separate U.S. and international stock funds.
A standard example of this portfolio would be:
Let’s start by talking about this Total World Stock Index Fund. It is what it says it is. Instead of a U.S. index like the S&P 500, this one tracks an index that is in effect every stock in the world.
When we construct the classic three fund portfolio, one of the questions we have to answer is the preferred ratio between U.S. and international stocks. Some say zero international (which means it’s no longer three funds). A very standard answer is 70/30, where 70% represents the U.S. A “purist” answer would be somewhere around 60/40 because the U.S. as of late has been 60% of the world’s stock market value. Many experienced investors advocate a “home country bias” because you are most likely going to spend your retirement money in your home country’s currency. It’s easy enough to be a purist in this respect as an American since our country’s stocks are more than half of the market. If you’re Canadian or French for example, you have to figure out if your own country’s stocks should be only 2.9% of your portfolio.
VT is in some sense the ultimate purist answer because it takes this control out of your hands and will by default give you the market’s answer. As of right now, the U.S. is 59% of VT. If international stocks continue to do well as they have this year, this percentage could drift. So your choosing a two-fund portfolio like this one could depend on whether you want the market to control your percentage between U.S. and international stocks.
But while two-funds sounds better than three funds for simplicity, there are some drawbacks versus holding VTI + VXUS. (With thanks to a Bogleheads forum user for this list.)
VT doesn’t qualify for foreign tax credit because it holds less than 50% international stocks (for now). If you’re investing in a taxable account, you might want to hold separate U.S. and international funds in order to take foreign tax credit on the international holding.
VT is more expensive. The annual expense ratio for VT is 0.07%. VTI’s is 0.03%. VXUS’s is 0.07%. So if you hold 60% VTI and 40% VXUS to approximate VT, you’re actually paying about 0.05% on the whole stock holding.
VT has fewer holdings than VTI + VXUS. Yes, I did say “in effect every stock in the world” earlier, but VXUS goes deeper into smaller stocks. Does it matter in the end in terms of final outcome? Probably not, but you might feel pedantic.
If you hold VT in ETF form rather than the mutual fund VTWAX, VT and VTI will give you smaller trading spreads than VT because their shares are more actively traded on the market.
There really is no correct or wrong answer between VTI + VXUS or just VT, but if you must have the simplicity of a two-fund portfolio and you’re not 100% stocks, VT could be your ticket.
A variant to consider would be add international bonds. In two-fund portfolio form, this would look like:
Vanguard Total World Stock Index (VT)
Vanguard Total World Bond Index (BNDW)
But I’m not a huge fan of international bonds unless you have a strong need for currency diversification. If your bond side really is for safety, then you might be better off with the hefty allocation to U.S. treasuries in BND rather than going into BNDW.
Pedersen’s “Two Funds for Life”
One alternative two-fund strategy that is only a few years old is the “Two Funds for Life” strategy created by Chris Pedersen, which looks like this:
1.5 times your age in a target-date fund
the remaining percentage in a stock fund, preferably in small-cap and/or value stocks
The intention behind small-cap value stocks is to seek higher returns than those of the broader market. I already do this in my portfolio through concentrated funds like AVUV and AVDV. But they are not for the faint of heart due to their increased volatility and tracking error from the broad market. Also, if you add both U.S. and international funds like these, you no longer have two funds.
I appreciate the intention of Pedersen and his colleague Paul Merriman in trying to make investing simple and helping people take advantage of small and value stocks. But I see problems. The first problem is that the very people this strategy is trying to help are the very same people who don’t want to learn what small and value stocks are and therefore are unlikely to stick to the strategy, especially in times when small and value stocks perform poorly compared to the market.
The second problem is that it is difficult to implement once we are talking about multiple accounts. Not all employer plans have small or value stock funds available. In some cases where they are available, it’s behind a significant wall of complication such as a “separately managed account” or a “mutual fund window” that would be intimidating to the very people this is supposed to help.
AVGE + bonds
One new option that has arisen only since the autumn of last year is the Avantis All Equity Markets ETF (AVGE). This is a “fund of funds.” The underlying holdings are some of Avantis’s other ETFs in proportion to form a portfolio that is about 70% U.S. stocks and 30% international stocks. The portfolio is also tilted towards small, value, and profitability stocks. As with what I said about small-cap value stocks with respect to the “Two Funds for Life” strategy, you should expect AVGE to deviate from the market, as it is diversifying among risks in a different manner than the VTs and VTIs of the world.
Full disclosure: While I do not hold AVGE directly, I do have substantial holdings in funds that AVGE holds, particularly AVDV, AVIV, AVLV, AVSC, and AVUV.
You can think of AVGE as a direct competitor and alternative to VT. Avantis also offers a core bond holding. So they would probably want your two-fund portfolio to look like:
Avantis All Equity Markets ETF (AVGE)
Avantis Core Fixed Income ETF (AVIG)
While these funds are cheaper than traditional actively managed funds, they are certainly not cheap compared to VT + BND. AVGE costs 0.23% per year (including 0.02% waived for now), and AVIG costs 0.15% per year. Its trading spread is also expectedly higher than Vanguard’s most popular index ETFs.
If you read my previous post that was in part about the futility of active management, you might be confused that I’m now talking positively about actively managed funds. These are indeed actively managed in a technical sense (there’s no index being tracked), but it’s fairer to say that these are “rules-based approaches” rather than traditional active management where researchers are digging into company books, interviewing CEOs, and trying to figure out where the market is wrong about stock prices. According to approaches like that of Avantis, the market is correct about prices, but those prices also tell us expected returns, and then securities with higher expected returns can be identified and targeted. That said, these rules themselves are active decisions, so these funds are indeed not true passive funds either.
Whether an approach like this is for you depends on (1) whether you can understand and believe in the approach and how well you are going to stick to it when negative tracking error occurs, and (2) whether you believe the approach will outperform the index by at least the difference in expense ratios. If AVGE’s strategy outperforms VT by 0.15% per year, conglaturations, you still lost compared to VT due to fees.
As much as I like and use Avantis approach, the index funds are still a reliable and tested approach that will work for most investors.
Implementation
If you’re not familiar with choosing a ratio of stocks to bonds, much ink has already been spilled. I will forward two things to influence your decision:
“Age minus something” in bonds is an imperfect but fine approach for most investors. I think twenty is the correct answer for “something.” Since I’m 38, my bond percentage would be 18%, and this is actually what I’m doing.
Think of your stock allocation as liable to lose 50% of its value in any crash. So if you look at the dollar value of your account and can’t stand the thought of losing more than 40% of it, you probably should consider not exceeding 80% in stocks.
With respect to how this looks in accounts, the “Two Funds for Life” approach is probably the most difficult to implement of these three because it requires either (1) all of your accounts have to have a good small and/or value fund available, or (2) you need to master how to track everything with a spreadsheet so that you can track different asset classes in different accounts and see them all as one portfolio. I have found convincing people to do the latter in any context to be like pulling teeth.
With respect to either the pure index approach or an AVGE+AVIG approach, there is still the problem of fund availability. Not every employer plan is going to have these funds or similar funds available. In these cases, you might have to calculate a three-fund portfolio and then implement your preferred two-fund approach elsewhere. But at that point, you also might find it simpler to implement a three-fund approach in all accounts to keep things the same.
Garrett O'Hara is not a financial professional, just a DIY investing enthusiast. This information is for your information and education only. Particular investments or trading strategies should be evaluated relative to each individual's objectives. Opinions stated constitute my judgment as of the date of when I stated them and are subject to change without notice and are provided in good faith but without responsibility for any errors or omissions contained therein. This information is supplied on the basis and understanding that I and my information sources are not to be under any responsibility of liability whatsoever in respect thereof. Get educated and make your own sound investing decisions.