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Investing Specialists

A Midyear Bucket Portfolio Checkup

As interest rates roil the bond market in 2018's first half, we assess the damage.

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Investors typically hold bonds to provide stability and a modicum of income, to serve as ballast for higher-returning/higher-volatility stocks. But occasionally the opposite performance pattern prevails: Losses in a portfolio come from the bond side of the house, not from stocks. Such was the case in the first half of 2018.

Indeed, the Federal Reserve's interest-rate hikes--two in 2018's first half with two more likely on the way before the year is over--are the primary explanation for performance in my bucket retirement portfolios so far this year. Despite decent, albeit unspectacular, returns in the portfolios' equity holdings, those gainers were offset by more rate-sensitive bond positions. Those countervailing forces led to flat or modestly negative results across all six of the core Bucket portfolios. (There are three portfolios for mutual fund investors--Aggressive, Moderate, and Conservative--and AggressiveModerate, and Conservative portfolios for retired ETF investors.)

A Bucket Strategy Review
Before we delve into the Bucket portfolios' performance, let's first review what the Bucket approach is designed to do. As pioneered by financial planner Harold Evensky, the Bucket strategy for retirement portfolios centers around an extraordinarily simple premise: By holding enough cash to meet living expenses during periodic weakness in stock or bond holdings--or both--a retiree won't need to sell fallen holdings. That leaves more of the portfolio in place to recover when the market eventually does.

In each of my Model Bucket Portfolios, I've included three buckets that are invested based on withdrawal horizon in a worst-case scenario. Bucket 1 holds the aforementioned cash for near-term portfolio withdrawals--anywhere from six months' to two years' worth of portfolio withdrawals. Meanwhile, Bucket 2 consists primarily of bonds (amounting to eight years' worth of portfolio withdrawals), which offer higher long-term returns than cash with much lower volatility than stocks. Bucket 3 is the longest-term component of the portfolio, offering higher long-term return potential than Buckets 1 or 2 but with substantially higher expected volatility.

The beauty of the three-bucket setup is that holding cash and bonds at the "front end" of the portfolio provides an ample cushion of money to meet living expenses in case stocks fall and stay down for an extended period. Holding cash also provides peace of mind, though it also has the potential to weigh down results in periods of strong performance for stocks and bonds. (My Bucket "stress tests' have demonstrated that a Bucket portfolio with a cash component would have underperformed a fully invested portfolio with the same basic asset allocation from 2000-2017.)

Note that these portfolios are designed to be customized based on a retiree's own expected portfolio withdrawals. For example, a retiree who's withdrawing $30,000 per year from his or her portfolio would earmark anywhere from $15,000 to $60,000 in cash (six months’ to two years' worth of withdrawals), another $240,000 in bonds (eight years' worth of withdrawals), and the remainder in stocks. This article takes a closer look at customizing your own Bucket portfolios.

Mutual Fund Bucket Portfolio Performance

Performance Recap
Aggressive Mutual Fund Bucket Portfolio: -0.05% (YTD through 6/30/2018)
Moderate Mutual Fund Bucket Portfolio: 0.17% (YTD through 6/30/2018)
Conservative Mutual Fund Bucket Portfolio: -0.15% (YTD through 6/30/2018)

Of the three Bucket portfolios composed of traditional mutual funds, the Aggressive and Conservative portfolios posted tiny losses in the first six months of 2018. The Moderate portfolio made it into the black, but just barely. The Conservative portfolio, which is geared toward retirees with time horizons of 15 years and holds more than 50% of its assets in bonds and another 12% in cash, performed the worst of the three portfolios over the past six months. Its bond holdings experienced losses, especially in the year's first quarter, while it benefited less than its counterparts from a decent equity market environment. I might've expected the Aggressive portfolio, which features a 60% equity weighting, to fare the best of the three so far this year, but its larger allocation to foreign stocks was a drawback relative to the Moderate portfolio.

Best Performers
One bright spot in the Moderate and Conservative portfolios was their small positions in  Fidelity Floating Rate High Income (FFRHX), a floating-rate fund. Because the interest rates on the senior loans in its portfolio reset to keep pace with prevailing interest rates, that gives floating-rate, or senior-loan, funds like this one an imperviousness to rising interest rates. But the products aren't without risk, as discussed here, which is why I've maintained modes positions in the portfolios.

Meanwhile, the Aggressive and Moderate portfolios got at least a small boost from their positions in  Vanguard Total Stock Market Index (VTSAX), which includes ample exposure to high-flying growth stocks in the technology sector. The Conservative portfolio, which has a smaller overall equity weighting, doesn't hold the total market index.

Worst Performer
 Vanguard Wellesley Income (VWIAX) was the worst-performing holding in the three portfolios. While a stellar long-term performer, that fund's bond portfolio was stung in a period of rising rates. On the equity side, the fund's passel of value-priced dividend payers (especially tobacco stocks) underperformed in a market environment that continued to favor growth stocks.

ETF Bucket Portfolios

Performance Recap
Aggressive ETF Bucket Portfolio: -0.36% (YTD through 6/30/2018)
Moderate ETF Bucket Portfolio: -0.16% (YTD through 6/30/2018)
Conservative ETF Bucket Portfolio: -0.50% (YTD through 6/30/2018)

All of the ETF Bucket portfolios experienced small losses in 2018's first half. As with the mutual fund portfolios, the Moderate ETF portfolio held its ground better than its Aggressive and Conservative counterparts.

Best Performer: As with the mutual fund portfolios, the ETF portfolios' positions in  Vanguard Total Stock Market Index (VTI) provided the biggest boost to the portfolios, injecting a shot of exposure to strong-performing large-cap growth stocks. The Conservative portfolio obtains all of its U.S. equity exposure via  Vanguard Dividend Appreciation (VIG); with a focus on dividend growth, it tends to skimp on the high-octane technology names that have performed best lately.

Worst Performers:  iShares JP Morgan USD Emerging Markets Bond (EMB) was the worst performer in all three portfolios, losing more than 6% for the year to date through June. As a dollar-denominated fund, it hasn't been hurt by foreign-currency exposure--the bane of many foreign-bond funds amid the dollar's strength. But emerging markets bonds as a group have struggled in 2018, roiled by tariff concerns and rising rates in the U.S. (Higher rates on safe bonds tend to cut into demand for riskier bonds like emerging markets.) It's a fairly small position in all three portfolios, so the damaged was contained.

 Vanguard FTSE All-World Ex-US ETF (VEU) also dragged down results, especially in the Aggressive portfolio where it takes up 15% of assets. Its healthy complement of emerging markets equities--20% of assets--hindered its year-to-date results. 


Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.