Comparing Bond ETF vs. Fixed Return Investment in a Diversified Portfolio
Introduction
As a fan of the Boglehead strategy and simplicity overall, I wanted to examine the 3-fund portfolio from several different angles and provide options that might be suitable to fellow Bogleheads.
Investors often diversify their portfolios by including bonds to manage risk and reduce volatility. However, considering a fixed-return investment instead of bonds might offer different benefits. This case study explores and compares the performance of diversified portfolios with bond ETFs and fixed-return investments using a Monte Carlo simulation approach.
Assumptions and Data
Historical Returns and Standard Deviations:
- Equity Fund 1: Average Annual Return: 8.31%, Standard Deviation: 15.5%
- Equity Fund 2: Average Annual Return: 4.48%, Standard Deviation: 17.0%
- Bond ETF: Average Annual Return: 3.20%, Standard Deviation: 3.0%
- Fixed Return Investment: Fixed Annual Return: 5.2%, Standard Deviation: 0%
Portfolio Allocations:
- 100% Equities: 60% Equity Fund 1, 40% Equity Fund 2
- 80% Equities / 20% Bonds: 48% Equity Fund 1, 32% Equity Fund 2, 20% Bond ETF
- 60% Equities / 40% Bonds: 36% Equity Fund 1, 24% Equity Fund 2, 40% Bond ETF
- 80% Equities / 20% Fixed Return: 48% Equity Fund 1, 32% Equity Fund 2, 20% Fixed Return
- 60% Equities / 40% Fixed Return: 36% Equity Fund 1, 24% Equity Fund 2, 40% Fixed Return
Simulation Parameters:
- Time Horizon: 20 years
- Number of Simulations*: 10,000
- AI-generated Monte Carlo simulation method
- Rebalancing: Annual rebalancing to maintain the target allocation
Simulation Methodology
The Monte Carlo simulation generates random returns for each asset class based on the historical average returns and standard deviations. By running 10,000 simulations for each portfolio, we can estimate the distribution of potential outcomes, including mean returns, median returns, standard deviation, and percentiles.
Results
Original Portfolios with Bond ETF
- 100% Equities:
- Mean Return: 169.43%
- Median Return: 133.35%
- Standard Deviation: 185.36%
- 5th Percentile: 45.32%
- 95th Percentile: 526.24%
- 80% Equities / 20% Bonds:
- Mean Return: 125.61%
- Median Return: 101.57%
- Standard Deviation: 131.93%
- 5th Percentile: 58.64%
- 95th Percentile: 373.24%
- 60% Equities / 40% Bonds:
- Mean Return: 84.24%
- Median Return: 71.83%
- Standard Deviation: 87.91%
- 5th Percentile: 63.48%
- 95th Percentile: 248.69%
Updated Portfolios with Fixed Return Investment
- 100% Equities:
- Mean Return: 169.48%
- Median Return: 131.03%
- Standard Deviation: 188.83%
- 5th Percentile: 43.67%
- 95th Percentile: 529.45%
- 80% Equities / 20% Fixed Return:
- Mean Return: 151.57%
- Median Return: 127.17%
- Standard Deviation: 141.38%
- 5th Percentile: 71.20%
- 95th Percentile: 415.51%
- 60% Equities / 40% Fixed Return:
- Mean Return: 130.29%
- Median Return: 116.93%
- Standard Deviation: 98.73%
- 5th Percentile: 93.62%
- 95th Percentile: 313.08%
Analysis
Higher Mean and Median Returns with Fixed Return Investment
Portfolios with fixed-return investments generally have higher mean and median returns than those with bond ETFs. This can be attributed to the higher fixed return rate (5.2%) compared to the historical average return of the bond ETF (3.2%).
Lower Volatility with Fixed Return Investment
Fixed-return investments significantly reduce portfolio volatility due to their zero standard deviation. This is evident from the lower standard deviations in the portfolios with fixed-return investments compared to those with bond ETFs.
Reduced Downside Risk
Portfolios with fixed-return investments show higher 5th-percentile returns, indicating better protection against significant losses. This is particularly beneficial for conservative investors seeking stability.
Less Extreme Upside Potential
While portfolios with fixed-return investments reduce risk, they also slightly limit the extreme upside potential. This is reflected in the slightly lower 95th percentile returns compared to portfolios with bond ETFs.
Conclusion part 1
Pros of Replacing Bonds with Fixed Return Investment:
- Higher Mean and Median Returns: The fixed return rate of 5.2% boosts overall portfolio returns.
- Lower Volatility: Fixed return investments reduce portfolio volatility more effectively than bond ETFs.
- Reduced Downside Risk: Higher 5th percentile returns indicate better protection against losses.
Cons of Replacing Bonds with Fixed Return Investment:
- Slightly Lower Extreme Upside Potential: The 95th percentile returns are slightly lower, indicating a potential trade-off between reduced risk and extreme returns.
Portfolio Recommendations:
- Aggressive Investors: A fully equity-based portfolio remains suitable for those seeking maximum growth.
- Balanced Approach: An 80% equities / 20% fixed return portfolio offers a good balance of growth and risk reduction.
- Conservative Investors: A 60% equities / 40% fixed-return portfolio is ideal for those who prioritize stability and reduced risk.
4-ETF Portfolio for UK Investors: A Boglehead 3-Fund Portfolio Alternative
For UK investors seeking to replicate the popular Boglehead 3-fund portfolio, a well-diversified and cost-effective approach can be achieved using the following four ETFs. Although this is not the only alternative portfolio composition, it still aims to offer broad market exposure and aligns with the principles of simplicity and diversification championed by the Boglehead philosophy.
Portfolio Composition
- Vanguard FTSE Developed World UCITS ETF (Acc):
- ISIN: IE00BK5BQV03
- Total Expense Ratio: 0.12%
- Description: This ETF provides exposure to developed markets worldwide, excluding emerging markets. It covers a wide range of large and mid-cap stocks, providing a solid foundation for global equity exposure.
- Vanguard FTSE Emerging Markets UCITS ETF (Acc):
- ISIN: IE00BK5BR733
- Total Expense Ratio: 0.22%
- Description: This ETF focuses on emerging markets, offering exposure to stocks in developing economies. This addition enhances diversification by including regions with higher growth potential compared to developed markets.
- Vanguard S&P 500 UCITS ETF (USD) Accumulating:
- ISIN: IE00BFMXXD54
- Total Expense Ratio: 0.07%
- Description: This ETF tracks the performance of the S&P 500 Index, representing the largest 500 companies in the United States. Given the significant influence of the US market, this ETF ensures substantial exposure to one of the world’s most important equity markets.
- iShares US Aggregate Bond UCITS ETF (Acc):
- ISIN: IE00BYXYYM63
- Total Expense Ratio: 0.25%
- Description: This ETF provides exposure to US investment-grade bonds, including government, corporate, and mortgage-backed securities. It serves as the fixed-income component aimed at reducing portfolio volatility and providing stability during market downturns.
Suitability for UK Investors
This 4-ETF portfolio is designed to offer a diversified investment strategy similar to the Boglehead 3-fund portfolio, tailored for the UK market. Here’s how it compares and why it’s suitable:
- Broad Market Exposure: The inclusion of developed and emerging market ETFs ensures comprehensive global equity exposure, similar to the international stock component in the Boglehead 3-fund portfolio.
- US Market Coverage: The Vanguard S&P 500 ETF provides significant exposure to the US market, a key element of the original Boglehead strategy.
- Fixed Income Component: The iShares US Aggregate Bond ETF offers a diversified bond exposure, similar to the total bond market component in the Boglehead portfolio, providing stability and reducing overall portfolio risk.
- Cost-Effective: All selected ETFs have relatively low expense ratios, ensuring cost-effective portfolio management.
- Diversification: By combining multiple asset classes and geographies, this portfolio achieves a high level of diversification, spreading risk across different markets and sectors.
Forecasts based on historical data
The expected return and standard deviation are calculated from the historical data.
The simulation was done on the 18th July 2024, using the website curvo.eu
Considering this simulation was done for UK investors, the following parameters have been used.
- Account type: ISA Stock & Shares
- Contribution: £20,000 per year (current maximum ISA allowance)
- Investment horizon: up to 30 years
- Weighting*: VHVG=24%, VFEG=6%, VUAG=60%, IUAA=10%
- Can be changed to suit the investor’s preference.
Conclusion part 2
UK investors can effectively replicate the Boglehead 3-fund portfolio using this 4-ETF portfolio. This approach provides broad market exposure, diversification, and low costs, aligning well with the core principles of the Boglehead investment philosophy. By adopting this portfolio, investors can aim for steady long-term growth while managing risk through a diversified and balanced investment strategy.
I hope this analysis was helpful.
I look forward to hearing your thoughts.
Happy investing!