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Evaluating bond funds for the most effective 60/40 portfolio

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What’s the best way to effectively build the classic 60% equity, 40% fixed-income portfolio?

In order to answer this question, advisors should evaluate the logic and performance of various combinations of stock and bond funds. I’ve done this for you here, using Vanguard bond funds specifically.

Vanguard may not be the first firm you think of when you consider bond funds, as it is likely best-known for its index-based equity funds. But Vanguard does have a diverse bond fund selection.

As of Jan. 31, Vanguard offers a total of 114 bond funds in the Morningstar database. To be sure, that is small percentage of the 7,170 total bond funds (both numbers include all share classes). But Vanguard’s market share accounts for fully 23% of the $4.45 trillion in assets held by all bond funds. So Vanguard is actually a major player in the bond mutual fund and bond ETF arena.

Vanguard is also known for its low fees, of course. Its average bond fund expense ratio is .12%, compared to .87% for the 7,170 bond funds.

For this analysis, the stock fund chosen was Vanguard 500 Index (VFINX). And each bond fund in the table was paired with VFINX to measure overall performance over the past 10 years. VFINX was given a 60% allocation, and each respective bond fund was given a 40% allocation. To keep the allocations constant, the pair of funds was rebalanced at the end of each year. Taxes and inflation were not taken into account here.

In the chart called “Vanguard bond funds: A sampling,” you’ll find a list of 17 funds. This table attempts to highlight a fund from each of the major categories, as classified by Morningstar. Also included is the performance of the Barclay’s Aggregate Bond Index, along with the 10-year average annualized return and 10-year standard deviation. The correlation between each Vanguard bond fund and the Barclay’s Aggregate Bond Index is also shown.

As you can see, the Vanguard Total Bond Market Index Admiral share class (VBTLX) has the highest correlation to the bond benchmark index, with a 10-year correlation of 1. The listed fund with the lowest correlation to the Barclay’s index is Vanguard High-Yield Corporate Admiral share class (VWEAX), at 0.19.

Ten of the Vanguard bond funds in this sample outperformed the Barclay’s Aggregate Bond Index over the past 10 years. But in every case, that performance is at the cost of higher volatility. In the case of Vanguard Extended Duration Treasury ETF (EDV), the standard deviation of return was more than 10 times higher.

As portrayed in the table, there is considerable variety among the funds’ performance over the past decade, with 10-year annualized returns ranging from 1.70% to 8.26%. While interesting, the real value is in knowing how well a bond fund performs as a teammate to a stock fund in the 60/40 allocation.

The results of the 60/40 analysis are shown in the chart, “Vanguard 60/40 portfolios.” The top row of the table shows the annual returns of VFINX, as well as the 10-year annualized return and 10-year standard deviation of VFINX’s annual returns. The remainder of the table shows all the pairings of VFINX and each of the 17 Vanguard bond funds sampled for this study.

The first 60/40 portfolio is VFINX and EDV. The year-to-year returns of the VFINX/EDV 60/40 mix are shown. You can see this particular 60/40 mix had a return of -0.05% in 2008, in spite of the -37.02% return experienced by VFINX. This was the result of EDV having a return of 55.41%, which is remarkable for a bond fund. In fact, the 10-year correlation between VFINX and EDV was -0.69. Clearly, those two funds march to very different drummers — a valuable trait when pairing funds.

Over the period from 2008 to 2017, a 60/40 tandem of VFINX and EDV produced a 10-year annualized return of 10.72%, with a 10-year standard deviation of return of 9.57%. Both of these are better than Vanguard Balanced Index, which had a 10-year annualized return of 7% and a 10-year standard deviation of 12.03%.

Interestingly, as you study the results in “Vanguard 60/40 portfolios,” you will observe that 13 of the 17 60/40 combinations outperformed Vanguard Balanced Index. Amazingly, in eight of those 13 tandems, the volatility of return was lower than VBINX, representing better performance with reduced volatility.

Perhaps even more interesting is the fact that four of the 60/40 combos (VINFX/EDV, VFINX/VUSUX, VFINX/VWETX and VFINX/VBLTX) outperformed VFINX by itself. And, of course, the 60/40 combos that did outperform a 100% VFINX investment did so with considerably lower standard deviation, due to the bond fund component’s naturally lower volatility and/or low correlation to VFINX.

So what’s the message here? When building a 60/40 portfolio, you have lots of choices when it comes to funds. In this analysis, we simply used an S&P 500 clone fund as the 60% equity piece, then inserted a variety of Vanguard bond funds. You can design portfolios for clients in this manner, or simply use a pre-built 60/40 portfolio in the form of Vanguard Balanced Index.

If you decide to build your own 60/40 portfolio, you might consider a bond fund that doesn’t attempt to mimic the aggregate bond index (as indicated by a low correlation between the two). Or you can identify bond funds that have a low correlation to the equity fund you intend to use.

Of course, past performance is not an indicator of future performance, as sports fans know all too well when an incoming star doesn’t shine as brightly on a new team.

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