VWCE is one of the most broadly diversified index funds available. It seems that choosing VWCE as the only fund in your portfolio is a great strategy for the long run. But is it?
We demonstrate the importance of defining the right investor profile, even for the typical passive investor, before deciding to purchase one fund or another. We’ll start by explaining the role that equities and bonds have in a portfolio. We then dig deeper into the criteria to establish a correct investor profile that matches your goals and needs. These are important to select the right strategy in terms of risk and return, and that will bring you financial serenity.
What is VWCE?
The VWCE fund (IE00BK5BQT80) is very popular amongst the passive investing community. This fund, launched by Vanguard in 2019 to track the performance of the FTSE All-World Index, currently holds more than €11 billion under management. Because that index is so diversified, investors can find in VWCE a great way to follow the market and hold a significant portion of the world's company stocks such as Apple, Tesla, Alibaba, etc… The fund holds close to 3,700 stocks compared to approximately 4,000 for its index. The index has returned approximately 9.4% annually since 2005, so it seems that choosing VWCE as the only fund in your portfolio is a great strategy for the long run… But is it?
Finding the portfolio of ETFs that lets you sleep at night
The role of stocks and bonds
Stocks are the main drivers for returns. Throughout the decades, companies all over the world have continued to innovate and thereby yield solid gains to their investors. Global stocks have made an average annual return of 5.2% over the last 120 years, and that's after inflation. There is no sign that this trend will stop: the drive to create and innovate is an innate trait of human beings. Yet, there's no free lunch in investing. Higher returns always come with higher risks. In the world of finance, this risk translates to greater fluctuations in the prices of stocks. They can go up and down very quickly, sometimes as much as 45% in a good year like 1999, but also as low as -40% during a "once in a lifetime" crisis like in 2008. In finance jargon, we say that stocks are highly volatile and do not prevent systemic risk, that is the risk of a global market meltdown... and that’s when bonds come into play.
As Ben Felix explained in his interview with us, bonds are designed not to seek return, but to decrease volatility and stabilize a portfolio. Indeed, it turns out that oftentimes when stocks are dropping, bonds are rising, and vice versa. So the losses of one type of asset can be partially offset by the gains of the other. In finance speak, we say that there is little correlation between stocks and bonds. This means that going for a 100% equity strategy or not should come in line with how smooth you wish your returns to be, to offset the potential impact of a downturn over your investment journey.
To show this, let’s compare the drawdown of 100% VWCE and a portfolio of 60% VWCE and 40% bonds:
The downturns of the 100% VWCE portfolio are much deeper and wider than the portfolio with bonds. The drops for stocks are sharper and take a lot longer to recover than for bonds. This is because stocks are a much riskier asset than bonds.
Don’t forget the taxes
When considering the right portfolio that matches your goals, you cannot steer clear from the tax aspects. Indeed, as we address in our article, the tax treatment of an ETF will impact the performance and return. The difference in the tax treatment will come from the fund’s domicile, its composition and the way it handles dividends. It is important that you figure out the taxes you could end up paying before you select your investment.
For instance, bond and mixed funds held by Belgian investors are subject to the Reynders tax, which is 30% charged on capital gains. Yet this doesn’t outweigh the argument for holding bonds in your portfolio. The consequence of selling your portfolio at the wrong time because it was too risky for you is much worse than losing some of your bond profits to the tax man.
What about sustainability?
VWCE does not apply sustainability criteria when selecting the companies that it invests in. Due to its globally diversified nature, tracking the performance of close to 3,700 companies of all types around the world, you can't consider VWCE to be sustainable in terms of environmental, social, and corporate governance criteria (ESG). For instance, an investment in VWCE means an investment in companies that manufacture and sell controversial weapons. The lack of ethical concerns in the selection of companies within VWCE can be a drag on investors wishing to follow responsible investment ethics.
This being said, the definition currently in place with regards to ESG criteria isn’t clearly established yet. Ethical values and beliefs are subjective by nature. As demand from investors looking for socially-responsible investment products is becoming mainstream, governments and institutions from around the world such as the UN, are working with the financial industry to offer a legal framework that will be accepted worldwide.
Defining your investor profile
There are a few crucial questions to ask yourself before starting your investment journey. Those are:
- when will you need your money?
- how long can you stand losing before you panic sell?
- what ethical values are important to you when investing in companies?
These questions are important to define your objectives and your investment philosophy. They will also make it possible to define the type of investment that will suit you best in terms of risk and return, taking into account how long you wish and can stay invested, and your reactions to uncertain events.
Investment firms use questionnaires to establish your profile. Based on your answers, they will assign you a risk profile, going from more conservative and risk-averse to more risk taker. While we won’t go through each question usually asked in those questionnaires, we will highlight some of the key categories of questions.
Setting your investment horizon
The investment horizon is the period during which you can invest without having to use that money for other purposes. For instance, a 10-year investment horizon implies that you are financially able to live without having to withdraw from your investment for at least 10 years. Setting a timeline is crucial to determine the type of assets you will be investing into, and their proportion in your portfolio.
The longer the investment horizon, the more you can afford to take risks because you'll have enough time to recover from any short-term downturns. It's ok to invest more in equities and less in bonds to achieve higher returns when investing for a long time.
Setting your investment horizon depends on how much savings you have and your financial goals. A 65-year old will not have the same investment horizon as someone aged 25 so their portfolio will look very differently. The older person will be invested mostly in less risky assets such as bonds, whereas the young person can afford to invest in riskier assets.
Defining your risk tolerance
Your risk tolerance determines how you deal emotionally with investment risks, like sharp downturns. Typically, 4 factors enable you to rate your appetite for risk:
- Experience: How long have you had experience with investing?
- Expectations: Do you believe riskier products with higher potential return to be more attractive than less riskier products with a lower potential return over the long term?
- Risk awareness: How would you split your assets according to certain risk/return frameworks?
- Loss sensitivity: How would you react if your portfolio were to drop by 30%?
Defining the risks you're capable of taking
Once you know how comfortable you are with taking risks, you also need to know how much of it you can afford to take. Indeed, while you might feel comfortable emotionally with setbacks, you would not want to put your financial situation into jeopardy by taking more risk than you can afford to. This is best described as your financial ability, or capacity, to cope with investment risks. Unlike your risk tolerance, it’s not based on your feelings about risks but has to do with your financial situation, as well as your age and it includes your time horizon. Typically, 3 main figures are used:
- Savings capacity: How much can you save on a yearly basis, taking every expense and financial obligation into account?
- Time horizon: Have a look at the assets at your disposal. Do you need a substantial sum in the future? If so, when?
- Capital erosion duration: Assume you lose your annual income, how long will your savings last to maintain your standard of living?
When investing, your risk tolerance should be in line with your risk capacity. Risk tolerance is a measure of how much risk you can withstand emotionally, while risk capacity is how much risk you can handle financially. In the end, your tolerance doesn't mean much if it exceeds your capacity.
Defining your ethical values
Sustainability is of increasing concern for investors. Here again, you should ask yourself some personal questions:
- What are the values you feel are important when investing, such as the impact on climate, diversity and inclusion, etc...?
- Which type of companies would you consider as “no-gos”, for instance weapons industry or tobacco?
- Would you be able to sleep easy knowing you’ve invested in companies that are not aligned with your values?
- To what extent are you ready to give away a portion of your returns to the benefit of being 100% aligned with your ethics?
Maybe you believe that your investment horizon is long enough and a 100% equities portfolio will get you the highest return. In that case, a portfolio solely consisting of VWVCE may be a good option. But it is also the best way to make poor decisions should markets tumble and you cannot sleep at night. It's then a good decision to reduce the riskiness of your portfolio by including bonds, if it will prevent you from selling at the worst possible time and incur a much bigger loss. That’s why it’s important to understand your own unique approach to risk, how it affects you and find the right balance.