The Bogleheads Two-Fund Portfolio

Not everyone is out to beat the market. For many, especially beginners, simply matching the market’s long-term return is enough. Coupled with aggressive savings and contributions, dividend reinvestment, and minimal fuss, this strategy can sufficiently meet their financial goals.

This is where I personally champion simplicity in investing. Instead of slicing and dicing a portfolio into numerous components, you can achieve maximum diversification with just two ETFs.

This streamlined approach embodies the essence of the Bogleheads two-fund portfolio, named after John Bogle, the late chairman of Vanguard and a stalwart advocate for passive investing. Bogle’s philosophy was all about "buying the haystack," keeping fees low, and steadfastly staying the course.

You might be familiar with the Bogleheads three-fund portfolio, which included separate allocations for U.S. stocks, international stocks, and aggregate bonds. This strategy is a further simplification of that approach, opting for just two global ETFs to cover both stocks and bonds. Here’s how you can set it up.

Picking the right equity ETF

When picking the right equity ETF for a diversified, global portfolio, the criteria might seem daunting at first glance, but it's quite feasible to find an ETF that meets all the necessary requirements. Here's what we’re looking for:

1. Index-based: Extensive research has consistently shown that passive management outperforms active management across most asset classes and market segments over the long term.
2. Low fees: Minimizing these predictable costs is the simplest way to ensure you earn the market return.
3. Diversification across market caps: It's crucial to have large, mid, and small caps, weighted according to market cap, to capture the full spectrum of market opportunities.
4. Diversification by sector: All 11 GICS market sectors should be represented in line with their current market cap weight to ensure comprehensive exposure across the economy.
5. Diversification by country: The portfolio should include stocks from the U.S., international developed markets, and emerging markets, again weighted by their market presence.
6. Low turnover: This is important for maintaining low costs and enhancing tax efficiency. High turnover can lead to higher transaction costs and tax liabilities.

Given these parameters, some popular global equity ETFs don't quite fit the bill. For example, the iShares MSCI World ETF (URTH) is relatively expensive at a 0.24% expense ratio and lacks coverage in emerging markets and small-caps. Similarly, the iShares Global 100 ETF (IOO) is very top-heavy, holding only 100 stocks, which restricts its market representation. The iShares MSCI ACWI ETF (ACWI), while including emerging markets, also falls short due to its exclusion of small caps and higher cost at a 0.32% expense ratio.

Our search narrows down to two more suitable ETFs:

1. Vanguard Total World Stock ETF (VT): This is my preferred option with a low expense ratio of 0.07%, tracking the FTSE Global All Cap Index. It comprises 9,840 market cap-weighted stocks from the U.S., developed, and emerging markets, ensuring a broad and diversified portfolio with a low turnover rate of 4.3%. This ETF excellently meets our diversified and cost-efficient criteria.
2. SPDR Portfolio MSCI Global Stock Market ETF (SPGM): Although smaller and lesser-known than VT, with $828 million in assets under management, it tracks the MSCI ACWI IMI Index. Like ACWI, it excludes small-caps, but its low cost makes it an excellent candidate for tax-loss harvesting alongside VT.

Picking the right bond ETF

While some investors with a high-risk tolerance might opt to skip bond allocations, for most, incorporating bonds into their portfolio is a prudent strategy.

Don't be swayed by the atypical bond market performance during 2022's high inflation and rising interest rate environment. Historically, bonds have served as a useful diversifier and even outperformed stocks during periods like 1999-2009.

Here are the criteria we should consider when selecting a bond fund:

1. Index-based: While firms like PIMCO and Nuveen offer notable active bond management, for the average retail investor, there’s no need to pay higher fees for active management when index-based solutions can efficiently meet investment goals.
2. Low fees: As with equities, the costs associated with bond funds, notably expense ratios, can eat into overall returns. Minimizing these fees is crucial.
3. Diversification across maturities: A well-rounded bond portfolio should include short, intermediate, and long maturity bonds, averaging out to an intermediate maturity of about 5-8 years. This helps balance interest rate risk and return potential.
4. Diversification across issuers: A mix of government-issued bonds (like Treasuries), agency-issued bonds (such as mortgage-backed securities), and investment-grade corporate bonds can provide a healthy risk-return balance.
5. Diversification across geographies: While sticking to U.S.-only bonds is an option, it's now relatively cost-effective to gain international bond exposure, with currency risks hedged away. This adds an additional layer of diversification.

Given these criteria, the standout ETF to consider is the Vanguard Total World Bond ETF (BNDW). It has a low expense ratio of just 0.05% and tracks the Bloomberg Global Aggregate Float Adjusted Composite Index. Essentially, BNDW holds a domestic and international Vanguard bond ETF in a 50/50 weight, which simplifies global bond diversification.

With an average duration of 6.6 years and a yield to maturity of 5.1%, BNDW strikes a balance that is suitable for a wide range of investors. Its low turnover rate of 14.5% reflects its broad indexing mandate, ensuring minimal trading costs and enhanced tax efficiency.

I personally consider this ETF a "Goldilocks" holding—not too risky, not too conservative, but just right for investors looking for a straightforward, effective way to include global bond exposure.

Portfolio performance

Below is a backtest illustrating how a $10,000 investment, made on November 29, 2010, and held through July 26, 2024, would have performed. This simulation was conducted using the mutual fund equivalents of the ETFs discussed, assuming all dividends were reinvested and no transaction fees were incurred.

It's important to note, as with any historical analysis, that past performance is not indicative of future results. This backtest provides a snapshot based on specific market conditions and investment strategies during the analyzed period.

Investors should consider that economic conditions, market fluctuations, and investment strategies evolve. Future performance can vary significantly from historical results due to these and other factors, including changes in interest rates, economic growth, market cycles, and investor behavior.