Retirement Planning: Stress Testing a Simple 5 ETF Portfolio

As mentioned in a recent post, stress testing the portfolio is one useful method of checking to see if there will be sufficient funds available to comfortably retire.  In this QPP analysis of a simple five ETF portfolio we will make some initial assumptions that will vary from investor to investor.

Assume this investor is 50 and plans to retire at age 67.  The current portfolio is valued at $400,000 and $6,000 is added each year.  Inflation is set at 3.5% and the S&P 500 is projected to grow at 7.0% each year.

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Charles Ellis: Revisit Loser’s Game of Stock Picking

Let’s revisit* Charles D. Ellis’ 1995 paper, “The Loser’s Game,” where he describes his Break-Even Return (BER) equation. Here is a review of this equation.

* I checked the readership of this blog and only nine readers picked up this information.  That is too few so I am bringing this material forward in hopes more folks will walk through the math to see the importance of cost when operating a portfolio.

BER = [(Turnover percentage x Transaction Cost) + Management Fee + Target Return]/Market Return

It is quite easy to set up this equation in an Excel spreadsheet and play around with different variables. I discussed these variables with an Internet friend and using what we think are reasonable “modern-day” assumptions we came up with this BER value.

It is not unusual for actively managed mutual funds to have a 100% turnover and management fees to run 75 basis points. If we assume Target Return equals Market Return at 9% and the transaction costs are 1.5% going in and coming out of the market, the equation will look like this.

BER = [(1.0 x (.015 + .015) + 0.0075 + .09)]/0.09 = 1.4166 or 1.42. This money manager must then turn in a return 1.42 x 9% or 12.7% to equal the market. Costs do matter.

Assume you are managing an ETF portfolio and you are able to reduce the portfolio turnover down to 10% per year or a reduction of 1/10 the active money manager. This is not unusual based on my experience working with passive portfolios. Further, assume we can reduce commissions and bid/ask slippage to 1% in and 1% out. If we find liquid ETFs that are not actively managed, we should be able to reduce the management fee to 30 to 40 bases points. Since we are likely to have some emerging markets, let us raise this to 50 basis points. Now the BER equation will look like this.

BER = [(0.1 x (0.01 0.01) + 0.0050 + 0.09)]/0.09 = 1.08. This ETF manager must generate a return of 1.08 x 9% or 9.7% to match the market. That is a 0.7% return to match the market return of 9.0%. Quite a change.

Here are the important points to remember.

  • Reduce trades in order to bring down the turnover percentage.
  • Purchase in large enough quantities to lower commissions. Use a deep discount broker. Use limit orders to reduce bid/ask slippage.
  • Use commission free ETFs when possible.
  • Find liquid ETFs with low expense ratios so as to minimize management fees. Look for low expense ratios.