Rick Ferri tweeted four phases that an successful index fund investor goes through. Numbers three and four were interesting; they were about complexity which I just wrote about the other day and using just a few total market funds for a portfolio which I kind of touched on more recently. Ferri is a big name in the RIA world, very well known as an indexer in about the purest form that one can be. I met Ferri about ten years ago at a conference through Tom Lydon. I don't remember a lot about the conversation but he was unimpressed because I hadn't written a book.

The shortest way I can think to explain the benefits of simple is that the market has an average annual gain of 8-10% depending on the period studied. That includes all the great years, terrible years and everything in between. Getting close to the market return combined with an adequate savings rate and suitable asset allocation will get you pretty close to having enough money when you need it.

There is a lot to learn from trying to build portfolios on paper that go beyond just buying something like iShares S&P 1500 Index Fund (ITOT), not so much as a practical deployment of cash but for learning how to look through to portfolio holdings, to not end up grossly overweight some sector or duplicating a bunch of stock holdings for a portfolio you would actually implement as an advisor for clients or for yourself.

In building a very simple portfolio with two or three funds I would want the exposures to include one broad-based fund but something that might offer a little resiliency in the face of bear market, one thematic fund that offers the opportunity to out perform the broad market and if there was to be a third fund, maybe that could target some sort of alternative strategy such that if the next bear market is accompanied by rising rates, or is because of rising rates, interest rate risk would be avoided.

Clearly ITOT, or any other broad beta exposure, will offer no protection in a bear market. Those funds are the market and will drop accordingly. Following up on the post from earlier this week, what about iShares Edge MSCI Min Vol USA ETF (USMV), low volatility ETFs could smooth out the ride a little but as I mentioned the other day, USMV actually has a higher beta the the S&P 500. While USMV has relatively good sector diversification, there is no reason to expect that in a down 50% world, it would only drop 25%. Anything could happen including it dropping just as much as the broad market.

This is true of any factor fund. Depending on how the next bear market shakes out a given factor fund could offer lots of protection or go down even more than the market, it is unknowable. For broad but resilient exposure I will mention a fund I use for most clients, the Pacer Trendpilot US Large CapETF (PTLC). It switches from being fully invested in the 750 largest domestic stocks to T-bills when its underlying index has been under its 200 day moving average for five days. It switches back once the index retakes its 200 dma for five days. In 2017 it was up 21.41% on a price basis, lagging the S&P 500 by 42 basis points. Much of the lag can be attributed to it costing 0.60% versus most broad based index funds costing in the single digits of basis points. It will lose out on short term whipsaw trades in the market but should miss the full brunt of the next meaningful decline.

For a thematic fund choice, just about anything will do in terms of concept to study. The Global X Fertilizer ETF (SOIL) is a valid theme that has almost no overlap with PTLC; at fist glance only two names overlap and those two don't add up to 0.10% of PTLC. When I first had the idea for this post I thought maybe one of the new blockchain ETFs paired with USMV but there is more overlap with those two. BLCN has 12 names in common with USMV adding up to about 10% of USMV. Is that too much overlap? I think it is too soon to know. Both the existing blockchain ETFs (First Trust launched one today that is very similar to the other two) are very broad based as opposed to being comprised of a bunch of nano cap pure plays, and need to show whether they correlate closely to the broad market or not. The value/opportunity of a thematic fund is diluted somewhat if it correlates very closely to the broad market. SOIL, and keep in mind that is just an example, tends to have 0.50-0.60 correlation to the S&P 500.

As far as an alternative strategy to serve as a fixed income proxy there are many choices. I am a fan of managed futures, they have a low to negative correlation to equities. This means though it might struggle to tread water as a cash proxy when the equity market is going up which of course it does most of the time. The WisdomTree Managed Futures ETF (WTMF) is down 7.5% in the last three years. Another choice is the recently launched JP Morgan Managed Futures ETF (JPMF), I have no reason to think it will be much different than WTMF but it just started trading. I've long been a fan of merger arbitrage in this context. The IndexIQ Merger Arbitrage ETF (MNA) is a good proxy here. IndexIQ has several other alternatives as does JP Morgan. I am believer in these but it is true that they are expensive but if they offer what investors typically hope for from the bond market without interest rate risk, then they'd be viewed as being wildly successful. Whatever the case they certainly would not overlap performance-wise with equities.

In terms of sizing, I would want to go heaviest by far in the broad market exposure whether that is PTLC or something else. A thematic fund is of course riskier. SOIL lagged far behind the market in 2017. As a materials sector proxy, SOIL and the sector have been out of favor far more often than not in the last few years. At some point it will outperform the index, this is generically true of any theme; periods where it lags and periods where it out performs.

Finally just to repeat, this is an exercise to promote looking through to portfolio holdings and see how they do or don't, preferably don't, sync with other funds with the goal of building better diversification when that is an objective.