The “Three Fund” Portfolio Part 2 – Foreign Stocks

In Part 1, I looked at a better domestic solution than VTI. Now, I will examine the foreign stocks piece for a better alternative to VEU.

(Some use VXUS instead of VEU. Their returns are virtually identical but VXUS has a slightly higher three-year tax cost ratio per Morningstar, so I will use VEU in these examples.)

Continuing our theme for dividend growth stocks, Wisdom Tree’s Global ex-US Quality Dividend Growth ETF (ticker DNL) is a standout. Here’s how DNL (Portfolio 1) compares to VEU on PortfolioVisualizer from January 2008 through May 2020:

Over time, DNL outperforms VEU due primarily to its superior performance in bear markets. Notice the huge difference in the 2008 max drawdown as well as the vastly improved standard deviation.

In reviewing the monthly returns, it became apparent that a relative strength strategy might outpeform a buy and hold strategy. There were prolonged periods when DNL significantly outpeformed VEU and vice versa.

My hunch proved correct. Here are the hypothetical results from January 2008 through May 2020 showing: 1) switching to the best recent performer at the close of each month (Momentum Model) vs. 2) a portfolio equally-weighted between DNL and VEU. Note, past performance is no guarantee of future results:

So the switching strategy adds nearly 2% per year to the DNL buy and hold annual return without materially adding to the risk. Now, a couple of 12-month rolling periods saw as many as five switches back and forth (while other 12-month periods saw no switches). As such, I only use this strategy in retirement accounts.

For taxable accounts, I would either use 100% DNL (which maximizes risk adjusted return and minimizes variance) or 90% DNL and 10% VEU (which is the allocation that minimizes expected tail risk).

Next up, I will review Bonds in Part 3.

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