Placing our favorite sprouts in the shopping cart, your wife says after your conversation the other day she read an Event Driven Daily article about an event driven hedge fund. “What is the 3 fund rule?” she asks. Smiling, you add a head of lettuce to the cart, and you tell her this …

What is the 3 Fund Rule?

The 3 fund rule is a low cost, simplistic investment strategy that uses three different types of index funds to diversify a securities portfolio. The premise is to minimize the systematic risk inherent to investment classes, eliminate idiosyncratic risk, which is the risk specific to individual companies in the portfolio, and mitigate losses through the cross-correlation of the index fund’s holdings. To properly address the question, what is the 3 fund rule? let’s delve into the fund selections, the strategy’s benefits, assets allocation, and rebalancing.

Fund Selections – The strategy is constructed by selecting three index funds that give an investor exposure to equities (stocks) and fixed-income (bonds)securities in the domestic and international markets. Portfolio diversification is achieved through the combination of these features, coupled with the oscillating positive-negative correlation of the index fund’s assets. The usual fund selections are:

  • US Total Market Index Fund – The fund’s broad market exposure seeks to mirror the entire US stock market returns of small, medium, and large cap stocks.
  • US Total Market Index Fund – This fund provides developed and emerging markets exposure through its international equities concentration.
  • Total Bond Market Index Fund – The fund’s holdings are government, municipal, corporate bonds, and mortgage-back securities. These US investment-grade bonds generate income and reduce portfolio volatility.

What is the 3 fund rule? It is a strategy built on the domestic and international market exposure of three index funds, which are at times negatively correlated.

The Strategy Benefits

  • Ease of Management – It is easier to manage three funds. The simplified investment process makes monitoring and rebalancing a less complicated periodic task.
  • Diversification – Broad diversification is achieved through US domestic and international stock investments, with the addition of bonds. This asset class blending mitigates market risk and the risk associated with investing in a single asset class.
  • Cost Effective – Index funds feature a lower expense ratio than managed funds. The investor benefit is more investor funds are vested in the portfolio which can lead to greater capital appreciation. Managed funds are funds actively managed by a fund manager who may trade (rebalance) shares in the fund more often leading to increased trading fees and, thus higher fund expenses.
  • Tax Efficient – Due to the lower turnover rate (continual trading of shares), and fewer capital gains distributions, index funds are more tax efficient.

Asset Allocation – Index fund allocation depends on risk tolerance, investment objectives, and the desired holding period. Here is the typical asset allocation:

  • US Total Market Index Fund: 60%
  • US Total Market Index Fund: 20%
  • Total Bond Market Index Fund: 20%

Increasing the stock allocation will satisfy higher risk tolerance investors and increasing the bond allocation provides an investor with a more risk conservative portfolio.

Rebalancing – The asset allocation must be rebalanced as market conditions, investment goals and holding periods change. An investor’s capital appreciation results are augmented by effective rebalancing implementation.

What is the 3 fund rule? The 3 fund rule is a diversified investment strategy using three index funds to provide broad domestic and international equities and bond market exposure to capture the average returns of the overall market.

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