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INVESTING AT LEVEL3

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Level3 Passive Approaches

In “Investing at Level3,” three levels of investor involvement are considered: passive, intermediate, and active. But it is really a continuum where investors can find a level of involvement that matches their interests, time availability and abilities.

The passive Level3 approaches primarily use a variety of index mutual funds and ETFs. The active approaches involve developing strategies from guru approaches, from academic and institutional research, from advisory services, and possibly from one�s own original research.

The intermediate approach would combine some active approach elements with some passive approaches.

Here we cover the various Level3 passive approaches covered in the book. You can also download this helpful Quick Start Guide to get started with your own Level3 passive investment strategy.

Plan Z:

The book uses an example of a hypothetical portfolio of John and Mary Smith using a Level3 approach called �Plan Z.� Plan Z entails simply putting 100% of your portfolio in the Guggenheim S&P 500 Equal Weight ETF (RSP), an exchange-traded fund that invests in the S&P 500 index but equally weights each stock. As discussed, over the long run such a portfolio should return 2% to 3% above a cap-weighted index, based on its real performance since 2004 as compared to the cap-weighted S&P 500.

The equal-weighted Wilshire 5000 index has returned 17.1% a year over the last 45 years compared to 10.5% for the cap-weighted Wilshire 5000 index holding the same stocks. That means a dart-throwing investor equally weighting selections could have averaged a return of 17.1% a year over the long term. Of course, depending on the number of darts, the returns could have ranged widely around that average.

Plan Z �Enhanced�:

While investing the entire portfolio in Guggenheim S&P 500 Equal Weight ETF (RSP) would beat the vast majority of portfolios and mutual funds, data indicates that Plan Z can be improved on by some diversification.

While diversification may reduce volatility, it does not necessarily reduce �real risk.� Real risk is the likelihood that our portfolio will have a lower dollar value than expected when we need to withdraw money from the portfolio. Diversification is not a free lunch and it is typically overdone.

However, some diversification can reduce real risk indirectly because it can reduce the chance of an extreme pullback in the portfolio and it can reduce the duration of a pullback so that in the withdrawal stage we need to invest less in lower-returning safe investments.

While the use of the Guggenheim S&P 500 Equal Weight ETF (RSP) will provide some allocation of assets to real estate, it is still underrepresented in term of its significance in the economy. Equity REITs have outperformed the S&P 500 over the past 40 years by 1.7%, according to Ibbotson�s SBBI 2015 Yearbook, and they provided some useful diversification. The �enhanced� Plan Z portfolio allocates 10% of the portfolio to Vanguard REIT ETF (VNQ), resulting in a portfolio of:

Level3 Passive Portfolio:

Over time, new ETFs might replace both of the funds used for the enhanced Plan Z portfolio. PowerShares Russell 1000 Equal Weight Portfolio (EQAL) includes some mid-cap stocks, so it could provide a higher return (and may be a better investment) than Guggenheim S&P 500 Equal Weight. However, it is relatively new, has higher costs, and is more thinly traded, which might offset better performance.

That being said, the PowerShares Russell 1000 Equal Weight Portfolio is far enough along at this time to use it in conjunction with the Guggenheim S&P 500 Equal Weight ETF (RSP). It has an interesting feature in that it equally weights in two stages. It first equally weights the nine investment sectors and then equally weights the stocks in each sector. The fund managers feel that approach gives better diversification and I agree, but it is likely to reduce the return a bit.

Using PowerShares Russell 1000 Equal Weight Portfolio for part of the passive portfolio provides an opportunity to compare it to Guggenheim S&P 500 Equal Weight ETF. If enough investors start using it, the liquidity will improve.

Even though the Guggenheim S&P 500 Equal Weight ETF increases the emphasis on value stocks beyond that of the cap-weighted S&P 500 and the PowerShares Russell 1000 Equal Weight Portfolio gives some weight to value and mid-cap stocks, since the value and mid-cap segments are superior performers they should be given additional weight. For that reason, the Vanguard Mid-Cap Value (VOE) is added to the suggested passive portfolio. There are several other ETFs similar to Vanguard Mid-Cap Value that could be used, but this fund�s very low expense ratio (0.09%) makes it likely that it will continue to outperform in this category.

This leads to the Level3 Portfolio of:

What to Expect From the Passive Portfolio

There are two important things to notice about the Level3 Passive Portfolio (consisting of the four equity ETFs). First, it provides diversification, but the diversification does not sacrifice return since all of the additions to the Guggenheim S&P 500 Equal Weight (RSP) have expected returns equal to or better than RSP.

Second, it has no exposure to the higher expected returns of small-capitalization stocks, particularly micro caps. I believe that it is very difficult for a fund to specialize in micro-cap stocks. Bid/ask spreads are wide and micro-cap funds get hit extra hard in a downturn because some of their investors panic, driving the losses deeper when the fund has to sell to honor withdrawal requests.

If you wish to be partially active, micro- and small-cap stocks are the most rewarding segments. You can do this following the selection strategies outlined in the Level3 Active Strategies section either by using someone else�s model or by developing your own.

While there is no history of portfolios with the make-up of the Level3 Passive Portfolio, estimates can be made based on the history of other similar indexes and research. I believe a reasonable�conservative�expected long-term return for the Passive Portfolio that is 100% equities would be 12% annualized in the accumulation stage.

In the withdrawal stage—where four years' needs are kept in safe short-term investments�a reasonable expected long-term return for the Passive Portfolio would be 10% annualized. That should permit an annual withdrawal of 5% of portfolio value each year with no reduction in portfolio value over the years, although there will be fluctuations.

Tracking the Level3 Passive Portfolio

We began tracking a model Level3 Passive Portfolio on May 31, 2016. Updates and performance are reported on a regular basis in the AAII Journal. Click here to access the current and past Level3 Passive Portfolio columns.

Level3 Passive Approaches
My Level3 Worksheet
Level3 Active Strategies
Bibliography
AAII Resources
Figures, Updates & Errata