Recently, a friend was told that their parents were going to have them take the reigns of a trust left to them by their grandparents. The trust had approximately $1 million in it and had my friend and his sister as beneficiaries.

As someone on the older end of the millennial scale at 37, this friend turned to me to ask how they should invest the money. Rather than just tell him, I thought I would take the time to write down a guide that can benefit others should they come into a large sum of money which is common as many of us approach middle age when grandparents and parents pass on and start to leave a legacy for their children.

Gauging Risk Tolerance

Before I could recommend a portfolio, I had to speak with this friend and his sibling to understand their risk tolerance and how aggressive they wanted to be with their investments. I also asked to see the current trust portfolio.

The portfolio had about 55% invested in various equity mutual funds from the likes of familiar names like Fidelity. There were a few small positions in income oriented stocks like AT&T and Verizon and approximately 40% was held in fixed income funds. So essentially, this trust mimicked a 60/40 equity to fixed income portfolio, which has been the staple recommendation for conservative investors from the financial advisor space.

Both of the siblings were educated professionals in their 30’s, one with a family and the other single. They had no immediate need for this money. Each of them had a place to live, was on track with their retirement savings and in the case of the sibling with children, had an adequately funded 529 for his child.

I noted to them how the current portfolio was somewhat conservative, especially for two people who didn’t have a need to touch the money for many years. They acknowledged this and explained how they were familiar with the risks of equity and bonds and that they would like this trust invested more aggressively in order to grow it as much as possible in the next 20 years when they could potentially tap this fund for an early retirement or career change.

They also expressed their desire to use part of the trust as a short term backstop if either of them were to experience any short term unemployment. They both had adequate disability insurance, so there was not a fear that the trust would need to be tapped should one of them become permanently disabled.

Views on the Market

Given their risk tolerance and their goal of maximizing the total return on the trust over a span of 20 years, they asked for my views on the market and how I would recommend they position the portfolio given my outlook for the next 5, 10 and 20 years.

The first thing I did was note the profile of the current portfolio and the historical return on portfolios built like this over the past 80 years or so in the US. I explained how it’s composition was similar to that of a 60/40 equity and fixed income portfolio, for which you can see the long term volatility and return below.

Although this type of portfolio has performed relatively well over the past 100 or so years, it may not be the ideal portfolio for the next 20 years and here are my reasons why.

• This type of portfolio offered lower volatility with a competitive return when equities returned 10% to 12% annually and government bonds returned 7% to 8%. 30 year treasury rates currently offer yields of 1.6% compared to almost 15% forty years ago. Despite lower inflation, yields are still at historic lows, too much fixed income risks not keeping up with inflation.

• The other reason I think the fixed income allocation is too high is that although everyone is expecting inflation to stay low, there is a risk to the upside. If inflation were to suddenly swing up in future years and the Fed forced to raise rates, medium and long term fixed income securities would get crushed. Keep in mind that yields and prices for bonds move in opposite directions. Higher yields mean lower prices.

In terms of my outlook on equity returns, I noted the recent run up in tech shares, especially in the last 5 years. Remember how 5 years ago Apple was selling at a P/E of 14 because everyone thought they were dependent on Steve Job’s next idea and he was on his deathbed? Those times are long gone and the world has piled into tech stocks, pushing the Nasdaq to almost double the return of the S&P 500. Big tech makes up around 20% of the S&P 500 itself right now. Although we have seen a great run in tech and it may not end right away, it may be better to diversify away towards some areas that haven’t seen such rapid growth. These neglected stocks may have some gains ahead of them rather than behind them.

In addition, the prospect of another stimulus package being pushed through with a new administration as well as continued low rates for the foreseeable future, hurts the prospects for the US dollar. Keep in mind that foreign returns, unless they are hedged, also have a currency component to their return, a falling US dollar means higher return in foreign stocks, which have been left in the dust by their US counterparts over the past 10 years.

US stocks go through periods of outperformance versus the world but as can be seen below, when there is a period of strong outperformance and a run up in valuations, like in the late 90’s, a period of US growth hangover can ensue. After the 90’s dot com bubble burst, we also saw government spending pick up after 9/11 and the Iraq war, fiscal stimulus can offer the same push to spending which can increase imports and drive down the dollar. This is the reason I am a bit bearish on the dollar and bullish on foreign stocks for at least the medium term.

However, just like in the 90’s we don’t know when the momentum play will stop so it still pays to have a foot in the US big tech growth game.

My Recommendation

Given the market developments and the current state of things, as well as the sibling’s risk return profile, I suggested an 80/20 equity to fixed income portfolio.

For the equity portion, I suggested a mix of both US based and international equities. We can use a global equity index as a general guide as how to allocate these. The current MSCI Global Equity index is around 58% US based an 42% foreign stock based. Keep in mind though, that these large indexes are also weighted towards large cap stocks like the Apples and Microsoft’s of the world.

It’s easier for a company to grow from a market cap of $100 million to $1 billion than it is for a company to grow from $10 billion to $100 billion. For this reason, I like to recommend to growth oriented investors to increase their exposure outside of large cap oriented indexes to small and mid cap indexes. This goes for inside as well as outside the US.

Emerging markets, dominated by China, offer another source of potential growth from a diversification perspective. Keep in mind we are looking at the next 20 years, not the last, so although emerging markets have been flat the past 10 years, this means valuations are also reasons compared to the US.

Finally for the fixed income portion, I recommended a blend of different funds which would capture higher yield, mainly corporate and international investment grade bonds. Another position I recommended was a medium term treasuries exposure, which offered some pickup in yield versus short term investments.

Given the short term rates and the plunge recently in commercial real estate, I also recommended a REIT fund. Commercial real estate may be in flux for the near future but residential real estate is seeing a boom, especially in the suburbs, as people move to larger suburban space and take advantage of record low interest rates. REITs allow investors to capture some of the higher home prices that will inevitably follow this trend.

Finally, I recommended they place about 3% of the trust in cash for any emergencies or short term needs just in case. The recommended portfolio and the funds are below.

Cash – 3%

Corporate Bonds – 4% – Vanguard Corp Bond ETF – VTC

Global Bonds – 4% – PIMCO International Bond Fund – PFORX

Intermediate Corporate Bonds – 4% – Vanguard Intermediate Term Bond ETF – BIV

Intermediate Treasuries – 5% – iShares Intermediate term treasury ETF – IEI

Emerging Markets- 8% – Vanguard Emerging Markets ETF – VWO

International Growth – 8% – Vanguard International Growth Fund – VWILX

US Small Cap – 8% – Vanguard US Small Cap ETF – VB

US Mid Cap – 12% – Vanguard US Mid Cap ETF – VO

US Large Cap – Fidelity Total Market Index Fund – 16% – FSKAX

Ex US Large Cap – 16% – Fidelity Ex US Index Fund – FSGGX

REIT – 8% – Vanguard REIT ETF – VNQ

International Small Cap – 4% Vanguard International Small Cap ETF – VSS

A Few Notes

You’ll notice that the funds are mostly ETF’s or index funds. The reason for this is to lower the cost as much as possible. If we are investing for the long term, few managers beat index funds over a horizon of 20 years, especially large cap managers. Small cap and international funds have more of an argument for managerial skills so I have suggested one managed fund in that space and could consider others.

The other point to note is that I suggested a relatively low proportion of US sovereign bonds. This is because the yield just doesn’t make sense for the long term. US medium and long term bonds have a place for a small portion for safety but longer term the pickup in yield from corporate and international dollar bonds will keep this portfolio yielding something above inflation.

If they have the option and the risk appetite, I would also probably recommend a 15% to 20% allocation to private equity. This is more complex and would require more in depth analysis but would help the portfolio follow the “Yale” endowment model, which has produced superior returns over time for many college endowment funds. The strategy has now become a favorite of the ultra high net worth and wealthy investor profile. The details required exceed the scope of this post but could offer an additional long term enhancement here. I would suggest swapping the small cap international and REIT funds for private equity on the above portfolio were they to take this route.

Indexes and funds provide the average investor with a lot of low cost tools today to take advantage of a wide range of investments. Keeping an eye on diversification and long term returns will pay off for this risk seeking pair should they choose to move forward with this portfolio.

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