© 2015 Tom Madell, Ph.D.

Apr. 2015: New Data Added Apr. 10

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Stock Fund Prices: Too Much of a Good Thing Usually Isn't

Here's a puzzler: You want to maximize your returns in spite of the fact that you're not a trader. You find you have some extra money to invest and you've narrowed down your choice to two stock funds. So which of the following two funds should you pick? I'll give you my answer shortly.

  • Choice 1) One that has a 5 year annualized return of 16+%, or

  • Choice 2) One that has a 5 year annualized return between 2 and 6%?

This isn't a trick question - it is the kind of choice investors are actually making all the time.

Of course, you might argue there isn't enough information here to make a sound decision. (E.g. Maybe one fund has a much higher expense ratio, or perhaps, recently changed managers; such information might be crucial to your decision.) Some might also be inclined to conclude that each fund should have an equal chance of besting the other going forward believing that past performance is basically irrelevant to predicting future performance.

But assuming you do not have any other information, or such additional information is not enough to sway you one way or another, the performance data would appear to loom large. Therefore, it's an easy bet to assume that the majority of investors would pick choice 1).

Although I can't give an answer that will always be true for every such fund comparison, my choice would most likely be 2).

In the remainder of this article, I will explain why, given just this limited performance information on the two choices, I would lean strongly to 2).

(continued, page 5)

New Model Portfolios

By Tom Madell

Interest rates are headed up, or are they?

Of course, no one can know for sure what will happen regarding the future economy. This has always been the case. This includes not only with regard to interest rates, but for the stock market too.

While it appears that interest rates are set to go up, the Fed just two weeks ago seemed to want to calm investors' fears and offered the possibility that maybe they might not go up after all. This seemed to be the trigger for one of the biggest stock market rallies of the year on that day.

Janet Yellen, Fed Chairwoman, has expressed the view that it's getting close to the time to raise interest rates to protect the economy from the eventual risk of overheating and to "normalize" interest rates. (After all, when in our history have interest rates hovered near zero for so long? Never.) But, and here is the bugaboo, if everyone is sure interest rates are going up, guess what will likely start to happen?

As money moves around the globe seeking out the highest returns, foreign investors will want to invest in the US, since in most rest of the world, interest rates are currently still going down, or have already gone down, to near zero, or even below. In the US, one can still invest in a long-term treasury bond and earn about 2 to 2.5% interest. This near-certainty that interest rates will go up in the US, and stay low elsewhere, is resulting in investors pouring into US investments which has the effect of causing the US dollar to go up.

So where's the problem? This should certainly be good for US investors as new money flows into US stocks and bonds from abroad. It's that if the dollar goes up, this means that inflation here will not go up toward 2%, as desired by the Fed from less than 1.5% now, but instead, likely go down. The reason is complicated but involves allowing foreign manufacturers to sell their products cheaper in the US. This means that in order to stay competitive, US manufacturers may have to lower their prices, which is the opposite of inflation.

(continued on page 2 below)

Page 2

Apr 2015

(New Model Portfolios, continued from page 1)

This is a long way of saying that the Fed does not want investors to believe that it's a sure thing that interest rates, and the dollar, will rise. So my hunch is that even though it looks quite certain that the Fed will raise interest rates in the near future, they don't want investors to flock to the US and possibly hurt the US economy with too little inflation.

So Yellen is being very evasive, and almost talking out of both sides of her mouth: Yes, interest rates might go up, but no, we are not "impatient" to raise them. This appears to be an example of the Fed using their words to try to influence the markets and, in this case, to achieve one of their current goals, that of stoking somewhat higher inflation.

Bottom Line: No matter what the Fed might say, interest rates are headed higher. However, sorting out the implications of higher rates is no easy task. I believe that initially several small increases in rates will possibly have at most a temporary negative effect on the stock market. However, rising rates should most likely put a dent in US bond prices.

Overall Asset Allocations

I am recommending no change from the Jan. 2015 overall allocations to stocks, bonds, and cash.

Remember that these allocations, especially for stocks and bonds, are made with the intent of maximizing returns, and minimizing poor ones, over at least the next few years. Although recognizing that we are still in a bull market for stocks, we don't expect longer-term returns for stocks to continue to hold up. (See the accompanying page 1 article.)

Although our strategy may not squeeze out every last dollar out of the bull market, we believe that investors who build up a large cash position in advance of potentially poor upcoming stock returns will eventually do better than those who remain more fully invested. And eventually, the high cash position should enable investors so positioned to be a position to add to their holdings once their prices have become considerably more reasonable.

For Moderate Risk Investors

Asset Current (Last Qtr.)
Stocks 50% (50%)
Bonds 25 (25)
Cash 25 (25)

For Aggressive Risk Investors

Asset Current (Last Qtr.)
Stocks 65% (65%)
Bonds 12.5 (12.5)
Cash 22.5 (22.5)

For Conservative Investors

Asset Current (Last Qtr.)
Stocks 15% (15%)
Bonds 40 (40)
Cash 45 (45)

Page 3

Apr 2015

Model Stock Fund Portfolio

I continue to think that Small/Mid-Cap stocks are the most unlikely to continue to show the kind of stretched returns they have achieved over recent years, thus explaining our low allocation. However, Fidelity Low-Priced Stock's (FLPSX) well diversified portfolio may be able to beat the average fund in its category, especially given its orientation toward Value stocks. Its 15 year track record puts it in the top 3% against its competition.

We are raising our allocation to International stock funds as these are highly undervalued as compared to US stock funds. We continue to favor Tweedy, Browne Global Value (TBGVX), a fund which can help prevent deterioration in otherwise positive foreign returns if the US dollar continues to strengthen. Its 15-year track record puts it in the top 4% against its competition.

We are lowering our allocation to the Large Blend category which includes our recommended Vanguard 500 Index (VFINX) or ETF-equivalent VOO, because that index while strong, is heavily weighted toward stocks that tend to be overvalued. We remain heavily invested in the Large Value category in spite of its lagging performance; our Large Value choices have each outperformed their 5-yr. category averages, and 2 out of 3 are in the top 4% against their competition (TRVLX and VUVLX).

Our currently recommended Sector funds should be approached highly cautiously and only by investors able to wait out long periods of potential underperformance.

One possible consideration in owning Vanguard Utilities (VPU) is a high dividend yield, currently at 3.39%. In a taxable account, stock dividends are typically considered "qualified" and therefore generally taxable only at 15%. If you are seeking income, this is a reasonable alternative for many investors to owning bond funds in a taxable account whose dividends are taxed at your top bracket which is frequently considerably higher.

Our Specific
Fund Recommendations


 Category Weighting 
Now (vs Last Qtr.)

-Fidelity Low-Priced Stock (FLPSX)

   Small Cap

   10% (7.5%)

-Tweedy, Browne Global
  Value (TBGVX) (C & M)
-Vanguard Europe (VEURX) (M)
-DFA Internat Small Cap Value I
  (DISVX) (A)
-Vanguard Emerging Markets Idx
  (VEIEX)  (A)
-Vanguard Pacific Idx (VPACX)  (A)
(See Notes 1 and 2.)


    32.5 (30.0)

-Vanguard 500 Index (VFINX)
-Fidelity Large Cap Stock (FLCSX)

   Large Blend 

    17.5 (20.0)

-Vanguard Growth Index (VIGRX)
-Fidelity Contra (FCNTX)

    12.5 (12.5)

-T Rowe Price Value (TRVLX) (M)
-Vanguard Windsor II (VWNFX) (M)
-Vanguard US Value (VUVLX) (A)


    22.5 (22.5)

-Vanguard Utilities ETF (VPU) (M)
-Vanguard Energy (VGENX) (A), or
-Vanguard Energy ETF (VDE) (A)
-Vanguard Precious Metals
  and Mining Inv (VGPMX) (A)


    5 (7.5)

1. Stock or bond funds with (C) are particularly recommended for Conservative investors; likewise, (M) for Moderate; (A) for Aggressive.
2. Highly similar ETFs (exchange traded funds) of the same category can often be substituted for any index mutual fund shown in this table; e.g. Vanguard FTSE Europe ETF (VGK) can be substituted for Vanguard Europe (VEURX).
Page 4

Apr 2015

Model Bond Fund Portfolio

As noted above, upcoming interest rate increases may have the immediate effect of lowering bond prices. However, over the longer term, bonds should do at least as well as cash, although cash serves the additional purpose of allowing one to buy either stocks and/or bonds more cheaply if prices drop.

Our main recommended change to the Model Bond Portfolio is to re-think our prior moderate position in the Loomis Sayles Retail Fund (LSBRX). While this has been an excellent fund for many, many years (15 year track record putting it in the top 11% against its competition), the fund tends to invest substantially in low quality bonds which have tended to correlate considerably with the peaks and valleys of the stock market. During the past year, the fund has started to stagnate. Therefore, we have reduced our position. (Note: While our recommended High Yield bond fund, Vanguard High Yield (VWEHX), also invests in low quality bonds, its portfolio has shown less of a tendency to shadow the volatile returns of stocks.)

Given this adjustment, this allows us to recommend somewhat more to our Diversified and Intermediate Term Muni categories.

Our Specific
Fund Recommendations
Fund Category Recommended
Weighting Now
(vs Last Qtr.)

-PIMCO Total Return Instit (PTTRX)
 (High minimum investm. outside 401k), or 
-Harbor Bond Fund (HABDX) (1K min.) or
-PIMCO Total Return ETF (BOND)
-Metropolitan West Total Return Bond M (MWTRX)


    35.0% (30.0%) 

-PIMCO Real Return (PRRIX)
 (High minimum investm. outside 401k), or
-Harbor Real Return (HARRX) (1K min.)


    5.0 (5.0)

-Vanguard Intermed. Term Tax-Ex.
 (VWITX) (see Note)

    17.5 (15.0)

-Vanguard Sh. Term Inv. Grade (VFSTX)


    5.0 (5.0)

-Loomis Sayles Retail
 (LSBRX) (A)


    5.0 (12.5)

-Vanguard High Yield (VWEHX)

  High Yield 

    10.0 (10.0)

-PIMCO Foreign Bond (USD-Hedged)
 Adm (PFRAX)


    22.5 (22.5)

Note: Select a fund, if available, that has your own state's bonds for double-tax exemption, such as, for example, the California Intermediate-Term Tax-Exempt Fund (VCAIX) if you live in California.

Performance of Our Previous Model Portfolios

As you may know, we regularly publish how our prior Model Portfolios have performed. The purpose for doing this is to keep regular and newer readers informed, as no investor should merely rely on current recommendations of anyone when considering whether to take their advice seriously. In our opinion, all persons who provide recommendations should make available their prior track record to help investors judge how useful their earlier recommendations have been. Sadly, most advisors don't and too many investors fail to request it.

Results for Model Portfolios from 1, 3, and 5 years ago are now available and we think one should examine them carefully, especially if you are considering following some or all of our new recommendations. Please click here to view these newly published (Apr. 10th) results.

Page 5

Apr 2015

(Stock Fund Prices: Too Much of a Good Thing Usually Isn't, continued from page 1)

The best way to demonstrate why I think 2) is usually a better choice is to show some actual examples that are likely not just isolated instances.

Let's go back to a little more than 4 years ago. If, at that time, you examined a chart of the best performing funds/ETFs from a multitude of fund categories, based on one year performance data, you would have observed that through the end of 2010, there were only small number of funds that returned 16% or more annualized over the prior five years. These exceptionally strong returning funds at that time are shown in Table 1 below.

A 16+% per cent annualized 5-year return for a fund is a relatively unusual occurrence, even when stocks have been strong as they have been between 2010 and now. And since stock fund performance at the end of 2010 had still not escaped the effects of the severe 2007-2009 bear market, most funds/ETFs had just begun to show positive five-year annualized returns.

Each of the funds, then, in Table 1 would be similar to the one described in choice 1) above. The average annualized 5-year return of these funds was 20.2%.

Table 1: Top Performing Funds/ETFs Based on 2010 Performance
with Best 5-Yr. Annualized Performance Between 2006-2010
Fund Name 2011 Return 2012 Return 2013 Return 2014 Return Average 1 Yr. Return
Oppenheimer Gold & Special Minerals A (OPGSX) -25.69% -9.14% -47.83% -15.39% -24.5%
Tocqueville Gold (TGLDX) -15.85 -8.72 -48.26 -2.67 -18.9
BlackRock Latin America Inv A (MDLTX) -23.96 8.47 -13.72 -9.60 - 9.7
T. Rowe Price Latin America (PRLAX) -25.17 10.30 -15.95 -13.08 -11.0
DFA Asia Pacific Small Company I (DFRSX) -20.13 24.02 1.65 -8.20 -0.7
DFA Emerg Mkts Small Cap I (DEMSX) -22.62 24.44 -1.38 3.00 0.9
Matthews India Inv. (MINDX) -36.48 31.54 -5.90 63.71 13.2
Average 1 yr. return for all
diversified US stock funds
Average 1 yr. return for
International stock funds

Keeping in mind that the above 7 funds were in rarified air as the best performers over the preceding 5 years in their respective categories, pay particular note to how poorly 6 out of the 7 subsequently performed on average between 2011 and 2014 as compared to the average for all diversified US stock and International funds.

One can conclude, at least at the start of 2011, that inferring that those funds with large annualized 5-year returns were the place to remain invested (or to invest new money) over the following 4 years would largely have turned out to have been wrong-footed choices. Most subsequently proved to be severely underperforming.

Instead of looking at the best performing funds/ETFs from about 4 years ago, let's merely look at a handful that were the largest by assets, and additionally, had five-year returns of 2% to 6% on Dec. 31, 2010; these funds are shown in Table 2 below. Each of these funds, then, would be similar to the lower performing one described in choice 2) above.

Page 6

Apr 2015

Table 2: Performance of Largest Stock Funds/ETFs at End of 2010
with 5-Yr. Annualized Performance of 2% to 6% Between 2006-2010
Fund Name 2011 Return 2012 Return 2013 Return 2014 Return Average 1 Yr. Return
SPDR® S&P 500 ETF (SPY) 1.89% 15.99% 32.31% 13.46% 15.9%
American Funds Growth Fund of Amer A (AGTHX) 4.89 20.54 33.79 9.30 17.1
Vanguard Total Stock Mkt Idx Inv (VTSMX) 0.96 16.25 33.35 12.43 15.7
Fidelity® Contrafund® (FCNTX) -0.14 16.26 34.15 9.56 15.0
American Funds Capital World Gr&Inc A (CWGIX) -7.53 19.12 24.84 4.02 10.1
American Funds Invmt Co of Amer A (AIVSX) -1.76 15.60 32.43 12.09 15.6
American Funds Europacific Growth A (AEPGX) -13.58 19.21 20.15 -2.64 5.8
Average 1 yr. return for all
diversified US stock funds
Average 1 yr. return for
International stock funds

In fact, back on Dec. 31, 2010, the majority of stocks funds actually returned in the 2 to 6% range over the prior 5 years. According to the Wall Street Journal, the average diversified US stock fund returned just 2.7% annualized, while the average international fund returned 2.9% ann. between 2006 and 2010.

But here too in 6 out of the 7 cases in Table 2, the selected funds' subsequent average full year performance from 2011 through 2014 outpaced the performance of the previously top performing funds in Table 1, that is, those which were similar to choice 1). And in all 7 cases, Table 2 funds subsequently outperformed the yearly average for all diversified US stock funds or, if so classified, that for international funds. (Note: Although 4 of these largest funds were American Funds with loads, or sales charges, they still outperformed the average fund; however, I do not recommend owning funds with a load.)

What does this suggest? Although future fund/ETF performance results may not always resemble these results, funds with extremely high performance over the prior 5 years frequently won't be the best places to put your money over the upcoming years. Conversely, funds that may not appear to have done well, at least in terms of matching investors expectations of perhaps 9 to 10% annualized returns, may frequently be considerably better places to invest your money for the next number of years than funds that have already exhibited super-sized returns.

These are similar to the types of outcomes that have happened in the recent past. When stock prices back 2000 as well as 2008 got to extremes, those types of stock funds whose returns were at or above those shown for funds in Table 1, subsequent returns tended to suffer.

Examples include almost all US stock funds in late 2000 when the average ann. US stock fund returned about 18% for the prior 5 years; by 5 years later, the average 5-year return was 0%. However, those categories of funds that did not participate fully in the excessive run-up, namely Real Estate, Natural Resources, or Emerging Market, compiled outstanding performances over the following 5 years.

And in mid-2008, when Natural Resources, Utilities, and International funds 5 year ann. returns soared while average diversified US stock funds' ann. returns were just a little above the range given in choice 2), by 5 years later, there had been a complete reversal: All 3 of these specific categories were showing negative annualized returns while the average US fund was showing an 8.8% ann. gain.

Page 7

Apr 2015

In today's market, we can find an unusually high number of funds whose 5-year ann. return is 16% or above, as of mid-March. For example, here is a random listing of some well-known funds in each of the major fund categories meeting this criterion:

  • Vanguard Small Cap Growth Index Inv (VSGIX). Small Growth
  • T. Rowe Price Mid-Cap Growth (RPMGX). Mid-Cap Growth
  • Fidelity® Growth Company (FDGRX). Large Growth
  • Fidelity® Mid Cap Value (FSMVX). Mid-Cap Value
  • Vanguard Mid Cap Index Inv (VIMSX). Mid-Cap Blend
  • Schwab Small-Cap Equity (SWSCX). Small Blend
  • Oakmark Select I (OAKLX). Large Blend
  • Delaware Value® A (DDVAX). Large Value
  • Invesco SmallCapValue A (VSCAX). Small Value
  • Vanguard Health Care Inv (VGHCX). Health Care
  • American Century Real Estate Inv (REACX). Real Estate

    Although we won't know for sure how each of the above 11 funds (or the large number of others with very large ann. 5-yr. returns) will do over subsequent years, my research suggests that they are more likely to underperform otherwise good funds whose ann. performance might generally be a lot closer to the 2 to 6% range. Given the current long-standing bull market, these latter funds are certainly not in the majority these days. But, many such ones do occur right now in the Foreign Large Blend, Emerging Markets, and Energy categories. These, then, are the main categories of funds that appear likely to do well in the years ahead.

    Of course, there is certainly no guarantee that selected funds in the choice 2) category will start to do better than those in the choice 1) category quickly (as in the next year or even two). But investors should realize that these type of counter-intuitive flip-flops in performance are what make it so difficult for investors to pick the funds that have the best chance of outperforming in the 4 or 5 years ahead.

    To summarize: For most investors, even long-term types, there is a strong attraction to funds with excellent track records spanning the last several years. These funds may continue to excel initially. But, especially after a few years, the outcomes frequently will turn out to have reversed. While it may be extremely hard to implement, patience in awaiting for your choice 2) picks to start coming out ahead is what is required for eventual success.

    Tom Madell, Publisher


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