Morningstar - Q1 2024 - 37

to replicate the Morningstar index for its asset
class, its tracking error with that index from March 1,
2012 (the first full month in which all the ETFs
existed) through September 2023 is less than 100
basis points annualized for five of the seven.
Performance
The suitability of the ETFs to provide portfolio
exposures approximating the investment
universes of our seven Morningstar indexes shows
through in long-term, real-world performance.
EXHIBIT 3 displays the absolute and risk-adjusted
results of 10 Sharpe-optimized portfolios
with required minimum equity weightings of 0%
to 90% in increments of 10 percentage points.
The plus/minus columns compare that
performance to the results of an equivalent stock/
bond mix using Vanguard Total Stock Market
ETF and Vanguard Total Bond Market ETF BND.
For example, the 0% Required Equity portfolio,
which had a 5% equity weighting, though it could
have had none, beat a 5%/90% blend of Vanguard
Total Stock Market and Vanguard Total Bond
Market in every respect. Its 2.13% annualized gain
from March 2012 through September 2023
was 48 basis points more, its 3.73% standard
deviation was 72 basis points lower, and its 0.30
Sharpe ratio doubled its rival's. Since the
Sharpe-optimized portfolios also use Vanguard
Total Stock Market ETF for their equity weighting,
what the plus/minus columns highlight is the
difference between bond portfolio performance.
Given that the optimizer becomes more constrained
as the required minimum equity weighting
increases, the Sharpe-optimized portfolios' results
are quite competitive. Their annualized return
beat each equivalent stock/bond mix. The degree
of that outperformance declined from 48 basis
points to 31 basis points as the required minimum
equity weighting moved from 0% to 20%; it then
stayed around 30 basis points up to 60% before
declining again with each incremental equity
increase. The standard deviation of the bond-heavy
Sharpe-optimized portfolios was lower, but
as the required equity weighting moved beyond
20%, the Sharpe-optimized portfolios became more
volatile. The Sharpe ratios of the optimized
portfolios, though, continued to be superior up
to a 40% required equity weighting, at which
point they either matched or were about in line
with their stock/bond equivalents.
As EXHIBIT 3 shows, the Sharpe ratios of our
ETF portfolios increased with equity weighting
rather than decreased as they did using the
Morningstar indexes. But Vanguard Total Stock
Market's 0.78 Sharpe ratio over the period in
question versus Vanguard Total Bond Market's
0.03 explains most of that difference. Also,
our Sharpe-optimized portfolios' results are based
on that one 10-plus-year period, whereas our
study with Morningstar indexes uses resampled
data and thus draws on multiple iterations
of 15-year periods created from an almost 24-year
stretch of monthly returns. Furthermore, the
ETFs used to implement the Sharpe-optimized
portfolios are imperfect representations of
their respective Morningstar indexes. Even if
different from what we might have expected, our
Sharpe-optimized portfolios proved competitive.
Conclusion
Drawing on Morningstar Indexes data since 2000,
this article has sought to refine allocation
approaches to the bond portion of U.S.-focused
portfolios. Optimizing for the Sharpe ratio
leads to bond sector weightings that differ from
the broad fixed-income market and that evolve
as the equity allocation increases. Implementation
of these Sharpe-optimized portfolios using ETFs
has produced competitive real-world performance
over more than a decade.
Investors who opt not to implement these
portfolios may still want to consider whether the
results here should alter aspects of their approach
to portfolio construction. Big allocations to
investment-grade bonds, for example, might seem
difficult to justify based on their correlations
with other asset classes, while leveraged loans
and mortgage-backed securities should play a
greater role in most portfolios. K
Maciej Kowara, Ph.D., is a strategist, fixed-income
strategies, at Morningstar Research Services LLC.
Alec Lucas, Ph.D., is director, fixed-income strategies,
at Morningstar Research Services LLC.
EXHIBIT 3
Competitive Results The Sharpe-optimized portfolios more than held their own
against equivalent stock/bond allocations using Vanguard Total Stock Market ETF
and Vanguard Total Bond Market ETF.
Standard
Sharpe-Optimized Portfolio
0% Required Equity
10% Required Equity
20% Required Equity
30% Required Equity
40% Required Equity
50% Required Equity
60% Required Equity
70% Required Equity
80% Required Equity
90% Required Equity
Return %
2.13
2.71
3.68
4.81
5.93
7.04
8.12
9.13
10.11
11.11
+/-
0.48
0.38
0.31
0.31
0.31
0.32
0.30
0.24
0.15
0.10
Deviation %
3.73
4.14
5.07
6.33
7.68
9.02
10.29
11.48
12.57
13.67
+/-
-0.72
-0.52
-0.14
0.25
0.55
0.74
0.79
0.72
0.51
0.29
Sharpe Ratio %
0.30
0.41
0.53
0.61
0.65
+/-
0.15
0.12
0.07
0.03
0.00
0.68 -0.02
0.71 -0.02
0.73 -0.02
0.75 -0.01
0.76 -0.01
Source: Morningstar Direct. Figures are annualized and net of fees from March 1, 2012, through Sept. 30, 2023, with annual portfolio rebalancing back to
the target asset class weightings shown in Exhibits 3. Thus, the stock allocations for the Sharpe-Optimized 0% and 10% required equity portfolios are 5%
and 11%, respectively, while the 20% to 90% required equity portfolios have stock allocations matching their names. Each +/- column shows the difference
for the preceding metric between the Sharpe-Optimized portfolio and an equivalent stock/bond allocation to Vanguard Total Stock Market ETF and
Vanguard Total Bond Market ETF.
morningstar.com/products/magazine
37

https://www.morningstar.com/etfs/xnas/bnd/quote https://www.morningstar.com/people/maciej-kowara https://www.morningstar.com/people/alec-lucas http://www.morningstar.com/products/magazine

Morningstar - Q1 2024

Table of Contents for the Digital Edition of Morningstar - Q1 2024