More About Model Portfolios

By Tom Madell

First, thanks to those readers who responded to my request for feedback on the Jan. Newsletter in which I discussed the phasing out of my forward-looking Model Portfolios, along with their allocation percentages to each recommended fund.

Among those who responded, most seemed happy enough with the changes discussed. However, several readers expressed regrets that Model Portfolios, as formerly defined, will no longer appear. And several stated they would particularly miss the suggested allocations.

In reality, these recommendations typically didn't change much from Quarter to Quarter. Therefore, if I had published new Model Portfolios in January, they would have been quite similar to the one published in Oct. '18. Since Model Portfolios, especially for stocks, were envisioned as remaining valid for up to five years, there is no reason to believe that a new Model Portfolio would be significantly different than one three months earlier.

If there is anything I have learned from many years of investing it's this: Once you have analyzed your investment choices, you have to be extremely patient with most of your selections. For example, I have favored Value stocks over Growth for several years now and I still do. But it has been only over the last 6 months that Large Cap Value is now starting to show signs of doing better than Large Cap Growth, as you will see in the table presented shortly. As previously, I still expect this outperformance to continue for at least several years when considering long term results.

The change you will now see is that I have chosen to replace my prior Model Portfolios (which were, in essence, predictions of what the future might hold) with an analysis based on past history, and represent a summary of all the investment decisions I have made since the mid-1980s. As I have come to recognize, making predictions about which specific funds, especially stock funds, will performance best is nearly impossible. Therefore, I am now choosing to recommend funds that have proven to me that they are the most worthy of holding based on past performance. These are the funds I have the largest positions in. Because I have retained them as my largest positions, in spite of some occasional ups and downs and adjustments, this means they remain the funds I have the most confidence in. The tables presently shortly should help show you why.

All these funds are the same as presented in the January Newsletter and all have improved their short- and long-term performance since the start of this year (as of Jan 19th), showing them to be even better investments as compared to then.

So how do the returns of my biggest holdings compare to the returns I would have received, if instead, I had just invested in the broad index for the total US stock market, a broad index of foreign stocks, and a broad index of high quality bonds? To show this visually in the tables below, every return in bold type did better (or equal to) their respective comparative index fund over that interval.

My Recommended Stock Funds

Note: The following shows the returns for the same period for broad stock index funds :

My Recommended Bond Funds

Note 1: After-tax returns are higher for Muni funds than taxable funds; try to choose a fund with bonds from your particular state.
Note 2: The returns of VBMFX, one of my recommended funds, as shown in the table, serves as my benchmark index fund.

Are There Any Conclusions to Be Drawn From the Above Data?

Fifteen years of data, both long and short term, may not represent what to expect in the future, but to my thinking, are likely the best estimates of what may lie ahead performance-wise in picking and sticking with these funds.

Here, in words, is a summary of what these tables actually do show:

-Most US stock funds have done poorly over the last 6-12 mos. but quite well over the long term.

-My US stock fund recommendations (except Vanguard Energy) were generally competitive with my benchmark index fund over the short and intermediate term, and tended to outperform over the long term.

-My international recommendations were generally competitive with my benchmark index fund over the short term but outperformed over the intermediate and long term.

-Most bond funds have done better than stock funds over the the last 6-12 mos.

-My bond recommendations have nearly always outperformed the bond index fund over every period.

One important overriding conclusion appears to be that broad index funds, while immensely popular these days, may not always outperform other possible fund choices, especially over the long term. In fact, 8 out of 12 of my recommended stock fund holdings had better long-term (15 year) results.

And, for bond funds, I can unequivocally state that the broad bond market index fund lost out in 29 out of 33 performance comparisons! Clearly, while investors have done quite well with broad stock index funds, it appears they might continue to be better off in well-chosen bond fund alternatives to the broad bond market fund.

A Quick Review of Prior Model Portfolio Performance

As I have mentioned previously in my Newsletters, it has been nearly impossible to consistently beat broad stock market index funds in recent years. So too, my Model Stock Portfolios have trailed the indexes over 1, 3, and 5 years as of 12/31/18. While, for 2018, I trailed a diversified portfolio of US, International and Emerging Market Index funds by nearly 2%, the gap was about 0.75% for 3 and 5 years.

The story was quite different for my bond portfolio vs. the most popular bond benchmark. While I was about even after 1 year, my recommended Model Bond Portfolio beat the index after 3 years by about 1% annually and 0.5% annually over 5 years. And a relatively high allocation to Muni bonds meant an even higher after-tax return.

Which Bond Funds Are Most Highly Recommended Right Now?

Most bond fund investors are probably bewildered by the sheer number of bond funds/ETFs available for them to choose from, just as is the case for stock funds. This likely is a contributing factor to going with broad index funds. Just as the Vanguard Total Stock Market Index is the stock fund sopping up the most investor dollars, the Vanguard Total Bond Market Index leads the pack for bond funds.

But is a broad bond index fund such as VBMFX really a bond investor's best choice, either now or in the past? As my bond fund performance chart above shows, against other available choices, it has generally been lagging. Why this is difficult to say; after all, broad stock index funds have generally been leaders, so why wouldn't the broad bond index fund be as well?

If I were to venture a guess, I would say that a moderately high concentration of short to medium term US treasury bonds may be the culprit. Such bonds are not likely to be the best choices if interest rates are low and we are not in a recession. Rather, under such conditions, non-government and longer-term bonds are likely to do better. Since these are the conditions we have been under since the last recession, it is no wonder that alternative funds have done better.

As shown in my last Model Bond Portfolio in Oct. '18, international bond funds, and specifically, PIMCO For. Bd (USD-Hdged) Adm (PFRAX) (or the Vanguard Total International Bond Index (VTIBX) ) currently look to be among your best choices. While international investing in bonds might sound risky, in truth, both of these funds carry below average risk.

In general, bonds do better when their issuing countries are not raising interest rates. While in the US interest rates have gone up over the last several years, most foreign countries are mired in slow growth and therefore unable to withstand higher rates. This differential gives international bonds an edge.

Both the above mentioned bond funds are able to "hedge out" the risk that occurs when US interest rates go higher, possibly causing currency losses for international investments, including stocks, since the higher US rates can result in the US dollar climbing in value. In 2018, the dollar did climb against other major currencies but hedging "protected" US investors from their investments losing some of their value due to currency conversion back to the US dollar.

Which Bond Funds Suggest Some Caution Right Now?

One category of bond funds that I have tended to recommend year in and year out are high yield funds, and specifically, Vanguard High Yield (VWEHX). When held for the long term, this fund has far outpaced the broad bond market. High yield bonds are corporate bonds with below average credit quality meaning that, although they pay above average dividends, if the economy goes bad, some of the portfolio's bonds may not be able to make their promised payments.

During the decade-long economic expansion, such bonds would likely have been the best place to earn a high return. However, if the economy starts to slow or run into trouble, such bonds might falter considerably. In fact, in the last year and a half, while yields have remained high compared to other bonds, the price of shares has dipped, cutting into total return. In this case, since Aug. '17, a broad bond fund such as VBMFX has actually outperformed VWEHX.

High yield bonds tend to be somewhat positively correlated to the performance of the stock market and so if one is nervous about stocks, you might also be nervous about high yield bonds. While stocks have gotten off to a good start in 2019, as have high yield bonds, a portfolio loaded with high percentages of each would not be as diversified as by owning stocks and higher quality bonds as in the broad market bond index. In this case, over the last 10 years, we see a moderately negative correlation between US stocks and VBMFX, meaning if stocks falter, the bond index is likely to benefit somewhat.

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