For the first time in many years, we made some significant changes to our asset allocation this year. This is not something we do lightly nor frequently and we try not to do it in response to changes in the markets. These changes are changes we have been thinking and talking about for literally years and put down in writing for months before implementing to make sure we really wanted to make them.

Reasons for Changing Portfolio

Our goals with this restructuring were the following:

  1. Reduce overall number of asset classes
  2. Reduce number of accounts
  3. Maintain similar overall risk (both market risk and currency risk)
  4. Maintain a small value tilt with domestic equities
  5. Increase allocation to real estate
  6. Decrease platform risk and active management risk
  7. Decrease costs

As you will recall, our old retirement allocation looked like this:

75% Stock

  • 50% US Stock
  1. Total US Stock Market 17.5%
  2. Extended Market 10%
  3. Microcaps 5%
  4. Large Value 5%
  5. Small Value 5%
  6. REITs 7.5%
  • 25% International Stock
  1. Developed Markets Large 15%
  2. Developed Markets Small 5%
  3. Emerging Markets 5%

25% Bonds

  1. Nominal Bonds (G Fund) 10%
  2. TIPS 10%
  3. P2PLs 5%

There were 12 total asset classes, which seems okay until you realize that might mean closer to 20 different investments spread across almost ten different accounts. The portfolio complexity was overkill.

The new allocation looks like this:

60% Stock

  • 40% US Stock
  1. Total US Stock Market 25%
  2. Small Value Stocks 15%
  • 20% International Stock
  1. Total International 15%
  2. International Small 5%

20% Bonds

  1. G Fund 10%
  2. TIPS 10%

20% Real Estate

  1. REITs 5%
  2. Real Estate Debt/Hard Money Loans 5%
  3. Real Estate Equity, Small Businesses, Websites, and Other Opportunities 10%

That cuts us back to 9 asset classes and allows several accounts to be closed (eventually.)

Let’s go through each of the significant changes and discuss the reasoning behind them.

# 1 Dropping Peer to Peer Loans

This was such a significant change it got its own blog post-Why I Decided to Liquidate My Lending Club Account. The bottom line is that the asset class, and particularly the way in which I was investing in it, was becoming less and less attractive as the years went by, especially when compared to the hard money lending opportunities out there. In addition, dropping this asset class will eventually allow us to close three accounts- the Roth IRA at Lending Club and taxable accounts at both Lending Club and Prosper.

# 2 Giving Up On BRSIX

I have been a faithful holder of the Bridgeway Ultra Small Market Fund for over a decade at 5% of the portfolio. My records show that my first purchase was shortly after walking out of residency. Over that time period we have enjoyed an annualized return of 10.8%. I certainly would not call it a bad investment. However, there have been several things that have bothered me about it over the years.

First is the expense ratio. At 0.75%, it is approximately 15 times higher than many of my investment holdings.

Second, it has relatively high turnover and frequently sends out massive capital gains distributions. This doesn’t matter much to me, since I have always held it in a Roth IRA, but for a fund that is supposedly tax-managed, this has driven a lot of investors away.

Perhaps most importantly, the fund has shown that it really cannot meet its stated goal. I don’t blame John Montgomery. He and his team sure tried hard. But I think they have chosen an impossible task. It is basically impossible to capture the return of the CRSP 10 (i.e. the 10% smallest stocks on the market.) The tracking error of this fund against its stated benchmark has been both positive and negative, but it was always much more than you would hope from an index-like fund.

In many ways this fund is actively managed, and I’m not a big fan of active management. I think it’s great that Bridgeway gives away half of its profits to charity and pays it’s most poorly paid employee no less than 1/7 of the CEO’s salary, but I would rather they passed that savings on to me as the investor and owner of the fund to decide which charity I wish to support. The bottom line is that I have been using this fund to help me get my small value tilt. I think I can maintain that tilt about as effectively by just moving this 5% of my portfolio into the small value allocation. A year ago when Bridgeway raised IRA fees I moved this holding to my Vanguard account. That makes the exchange for small value that much easier and eliminates one account to track.

# 3 Dropping Large Value

In a similar manner to the microcap fund, this was an easy target when it came time to reduce the number of asset classes in the portfolio. This 5% basically went into the small value allocation.

# 4 Dropping Extended Market

When I designed this asset allocation, a major chunk of my investments were in the TSP. However, as the years go by, the TSP becomes less and less of my portfolio since I am not making any ongoing contributions to it. The only small cap fund in the TSP is really an extended market fund, which is mostly midcaps. While that helped me some to get my small value tilt and perhaps also helped me capture a unique mid-cap factor, this asset class has somewhat reluctantly made its way to the chopping block. If I want to own more real estate, something has to give. Since it will take me a while to ramp up the real estate since I’ll be doing a big chunk of it in taxable (a relatively small portion of my portfolio still), I’ll use these mid-caps (specifically the TSP S Fund) to make up the difference until I get there.

# 5 Dumping Emerging Markets

We actually never had the intention to overweight emerging markets. We simply wanted to market weight the European, Pacific, and Emerging Market components of the international stock asset class. However, since the TSP was our main investing account, we were kind of stuck with the I Fund, a developed market only fund. So we added the Vanguard EM fund in the Roth IRAs to get the EM stocks. Over the years, as more and more of the international holding has moved out of the TSP and into various other accounts and I prefer the Total International fund to the relatively highly correlated Developed Markets Fund, EM has gradually been overweighted. Seems like a good place to shave an asset class to me. It’s not like we don’t still own all of the emerging markets stocks. We’re just no longer unintentionally overweighting them. We plan to continue our 5% allocation to international small stocks as we have been pleased with this Vanguard fund since we first invested in it when it opened.

# 6 Figuring Out Real Estate

Although some people think I’m anti-real estate for some bizarre reason, I really view stocks, bonds, and real estate as the three major investment asset classes. In some ways, this formal real estate allocation is really just an acknowledgement of what we have been doing already. I have been running a separate (separate from our retirement allocation) allocation for our real estate empire. It currently includes some syndicated equity and debt investments and the administrative building for our partnership. In addition, I am going to fold the REIT allocation into this 20%, using Vanguard’s excellent index fund of publicly traded REITs to assist with rebalancing between the other major asset classes. I plan to use 5% of this 20% for hard money lending, basically real estate related debt investments. Many of these are available via the crowdfunded syndicated sites and through personal relationships I have. Holding periods are usually less than a year, often as little as six months, yet returns of 8-12% are routine and the debt is backed by the value of the asset. It seemed a great replacement for peer to peer loans in the portfolio. The remainder of the allocation will be dedicated to equity investments, both real estate and other business opportunities such as syndicated shares of my hospital or websites. Even with our 7.5% REITs we’re not at 20% yet, but we should be able to get there gradually over the next year. While many of these investments are even less liquid than our P2PLs were, it is still only a small portion of the portfolio, they generally produce good cash flow, and they reward us appropriately for the illiquidity. I’ll have an ongoing series of posts about what I’m doing with this section of the portfolio (since it is far more interesting to talk about than the 80% of the portfolio invested in boring old stock and bond index funds.)

Have you ever made changes to your asset allocation? What was your process and reasoning? What asset classes do you think belong in a portfolio? Do you invest in real estate? Why or why not and how? Comment below!