Jimbo strikes again with a question worth highlighting. My answer will teach you about using ETFs instead of mutual funds and how I think about passive investing until moving into options trading.

Here’s the thought-provoking query:

Hypothetically if an investor had a Vanguard 401k in VTSAX and VFINX at 80/20 allocations, would a comparable IRA Portfolio be 100% SPY ETF?

Would a more conservative approach in a self-directed IRA be 80% SPY and 20% TLT? This would be for buy-and-hold until one learns to trade and protect with options.

J-J-Jimbo

Let’s first breakdown the question for the layman. VTSAX is the ticker symbol for the Vanguard Total Stock Market Index Fund. It offers an extremely low-cost avenue for mutual fund investors to get exposure to the entire stock market. The equivalent ETF is VTI. But since VTI moves virtually identical to the S&P 500 ETF (SPY), you could use it instead.

To confirm the strong link between SPY and VTSAX, here is a chart overlay complete with correlation indicator in the lower panel:

If you were trying to mimic a portfolio with 80% allocated to VTSAX, then you would invest 80% in SPY.

VFINX is the ticker symbol for the Vanguard 500 Index Fund. Because it moves in lockstep with VTSAX, the S&P 500 is an acceptable proxy for it as well. If anything, SPY is an even better substitute for VFINX than VTSAX, but we’re splitting hairs here. To visualize, check out the following chart overlay of all three tickers.

If you were trying to mimic a portfolio with 20% allocated to VFINX, then you would invest 20% in SPY. But in Jimbo’s case, the other 80% of the account is in VTSAX which effectively is SPY.

So the answer to his first question is YES! An 80/20 portfolio in VTSAX and VFINX could be replicated by placing 100% in SPY. One benefit of using SPY is it opens the door to selling covered calls or quickly buying portfolio protection.

The second question asked whether a more conservative approach would be to only place 80% of the portfolio in SPY (stocks) and 20% in TLT (bonds).

I bet Jimbo already knows the answer to the question. Maybe he threw me a softball so I could knock it out of the park. Lowering your allocation to stocks and increasing it to bonds is indeed more conservative! Whether or not 80/20 is the right mix, or 70/30 or 50/50 or some other variation depends on the individual’s risk tolerance and investment objectives. To prove a higher bond allocation reduces portfolio volatility and drawdowns, feast your eyes on this:

In 2008 a 100% stock portfolio suffered a 54.92% plunge in value, but a 50/50 portfolio only saw a 27.54% whack.

I’ll hasten to add I’m not sure it TLT would be the best proxy for bond exposure. It targets long-term treasuries which carry much more volatility than other durations. Because it’s more sensitive to interest rate movements you’ll see a much larger tailwind when rates drop (like the past three months), but a bigger headwind when rates rise.

If you wanted a more diversified bond ETF, you could try something like AGG which holds a broad basket of fixed income. Here’s the spec sheet from www.etfdb.com:

The final point I’ll make involves the time horizon for passively investing in stocks and bonds. Just remember, the longer your hold period, the higher the probability you will come out with a profit. This is true for both stocks and bonds. So if Jimbo is wondering if I approve of moving cash into a portfolio of SPY/AGG until one learns how to trade it, I have two thoughts.

First, if you’re parking it in SPY/AGG for years, then I’m a fan. But if you’re going to take it out in the next few months, then it’s hard to have confidence that the market will be higher over such a short time frame. You could grow your capital, sure. But what if a bear market strikes in the interim? Are you okay taking a drawdown on the money? If not, it might be safest to park it T-bills or a high yield savings account while you’re learning.

Second, if you’re moving money that was invested in VFINX and VSATX into SPY, then there isn’t any difference in how much your capital will grow/shrink over the coming months. If you do add a bond component, then you would be reducing risk.

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