2014 Tom Madell, Ph.D.

Jan. 2014

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Mutual Fund/ETF Research Newsletter


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You May Not Need These Funds/ETFs in Your Portfolio

by Tom Madell

In the jungle of funds and ETFs available, many long-term investors, both relatively seasoned and those newer to the game, typically are uncertain what kind of funds they should put the most emphasis on. Especially given the proliferation of ETFs, it may have become all too easy to select choices that focus quite narrowly on particular sectors within the stock or bond market at the expense of having investments that are invested across a broad spectrum.

Investors should realize that too much focus on specific sub-sectors of the overall market can leave you with a higher likelihood of attempting to manage what may amount to an undiversified portfolio. For most investors, therefore, if you do choose one or more funds to hone in on highly specific subsets of the market, this should be done mainly to supplement your broader-based funds. An over-emphasis on such so-called "sector" funds in effect suggests one is trying to guess which segments of the markets are going to offer the best return, something that is extremely difficult even for investing professionals, as you will see shortly.

It should be remembered that most diversified stock mutual funds and ETFs, whether index funds or actively managed, already include investments across a wide spectrum of sectors. And among these funds that are actively managed, the manager will already be engaged in selecting which sectors appear the most promising from his or her perspective.

If you are an investor who likes to do research and follow the markets regularly, then a small to moderate amount of investments in funds/ETFs focusing on specific market niches can make sense

You May Not Need These Funds/ETFs in Your Portfolio, continued on page 5

New Model Portfolios for the New Year

Since we lowered our allocation to stocks for Moderate Risk investors from 65% of an overall portfolio to a still substantial 55% this past October, the S&P 500 has continued to rise approximately 10%, including dividends (all data cited is through Dec. 27), or over 3% per month. While what appear to be close to promises of continued low rates by the Fed remain a positive for stocks, one's best strategy, even as a long-term investor, may be to nail down some of your excellent returns when they present themselves because over your investing lifetime, you won't see a repeat of such returns very often. In fact, returns of the magnitude seen over the prior 5 years, namely nearly 18% annualized for the S&P 500 index, have occurred only 13 times out of the last 83 years, or 16% of the time.

While leaving one's entire stock portfolio on hold while the market basks in this extended winning streak will be the likely path chosen by many investors, eventually, all such returns regardless of which funds they were achieved in will, with an extremely high probability, be whittled down to a lower average annual return. While it is true historically that once returns as large as we've seen over the last 5 years are reached at the end of a calendar year, the pace has sometimes continued for one additional year, only once in the last 83 years has the same level of outperformance lasted for two further years. Assuming the same is true for all funds, not just the S&P 500, I recommend that some portion of such a large annualized 5 year return, such as is so widespread now, should be captured by the prudent investor - it's unlikely to be around long.

Need more to convince you? Looking at historical instances where the S&P has averaged at least 18% over the prior 5 years, that is, close to what it has done between the end of 2008 and the end of 2013, the average return the following year was only 2.84%; the average annualized return over the subsequent 5 years slowed to 6.14%. If returns over the next year, or even 5 years prove similar, investors may be disappointed. While historical results can't guarantee these below par results, they certainly should inject a heavy dose of reality reflecting what has indeed happened under similar circumstances going back to 1931. That said, however, assuming alternative investments such as bonds

continued below

Page 2

Jan 2014

(New Model Portfolios for the New Year, continued from page 1)

will still be unlikely to beat such returns, it should still to pay off for most investors to keep the majority of their investments in stocks.

We believe that many well-chosen bond funds, such as those we list in our Model Bond Portfolio below, are still likely to produce positive, although relatively small, returns over the next several years provided that the Federal Reserve keeps its word and holds short term rates near zero, helping to anchor long-term rates. Eventually, when such rates do go up further, this could indeed create some negative returns for bond fund investors (as we have seen for many funds this year) but this may not occur until a few years out. In fact, over the last 5 to 6 months, as the markets recovered from the "shock" that the Fed was highly likely to begin tapering, most bond funds have stopped hemorrhaging and have nearly been able to earn returns on a par with their dividend payments, many in the range of 2 to over 4% when annualized over the period.

Of course, another factor to consider is the fact that the volatility of stock returns in the year or two following such large annualized gains has proven to been quite high. If that happens again, many investors will be tempted to sell if a strong downdraft occurs, thereby likely preventing them from achieving the returns they might have earned just by riding it all out.

Given all these considerations, we are dropping our recommended allocation to stocks for Moderate Risk investors to 52.5% which is still over double our recommendation for either bonds or cash. While stocks are likely to continue to outperform bonds in the next half decade, the margin of potential outperformance may not justify the kind of relatively heavy weighting we have given to stocks during the last 4 years. Our overall allocations to stocks for Aggressive or Conservative investors remain unchanged. Only at the point there is at least a 10 to 20% correction in most stock prices, will we again consider raising our overall stock allocation.

Overall Allocations to Stocks, Bonds, and Cash

For Moderate Risk Investors

Asset Current (Last Qtr.)
Stocks 52.5% (55%)
Bonds 25 (25)
Cash 22.5 (20)

For Aggressive Risk Investors

Asset Current (Last Qtr.)
Stocks 70% (70%)
Bonds 10 (10)
Cash 20 (20)

For Conservative Investors

Asset Current (Last Qtr.)
Stocks 25% (25%)
Bonds 40 (35)
Cash 35 (40)

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Jan 2014

Model Stock Fund Portfolio

Our Specific
Fund Recommendations

Fund Category

 Recommended Category
Weighting Now 
(vs Last Qtr.)
-Fidelity Low Priced Stock (FLPSX)


    10% (10%)

-Tweedy Brown Global Value (TBGVX) (C & M)
-Vanguard Internat. Growth (VWIGX) (M)
-Vanguard Pacific Index (VPACX) (A)
-Dodge & Cox International Stock (DODFX)  (A)
  (See Notes 1, 2, and 3.)


    32.5 (32.5)

-Vanguard 500 Index (VFINX)
-Yacktman Fund (YACKX)

   Large Blend 

    15 (15)

-Vanguard Growth  Index (VIGRX)
-Fidelity Contra  (FCNTX)
  Large Growth
    10 (10)

-Vanguard US Value


    17.5 (17.5)

-Vanguard Financials ETF (VFH) (A)
-Vanguard Energy ETF (VDE) (M)
-Vanguard Consumer Staples ETF (VDC) (A)
  (See Note 4.)


    15 (15)


  1. Stock or bond funds with (C) are particularly recommended for Conservative investors; likewise, (M) for Moderate; (A) for Aggressive.
  2. ETFs (exchange traded funds) of the same category can be substituted for any index mutual fund in this table; e.g. Vanguard MSCI Pacific ETF (VPL) can be substituted for VPACX.
  3. Our Oct. recommendation, Oakmark International I, is now closed to new investors. In its place we now recommend Dodge & Cox International Stock (DODFX)
  4. See our accompanying article on sector fund investing. So long as the economy remains in mid- to late-cycle expansion, as we are apparently in now, the sector that has done the best in the past is Energy. If you do not wish to invest in sector funds at all, add the remaining 15% to your international, large blend, and large value positions.

Comments on Our Selections

As mentioned in our accompanying article on sector fund investing, the Fidelity Low-Priced Stock Fund (FLPSX) remains a good choice. However, in general, the Small/Mid-Cap category remains the most overvalued segment of the market, and most likely to face a bigger correction when one occurs.

We continue to favor Large Cap Value funds over Large Cap Growth. As with the Small/Mid-Cap category, when a correction finally comes, we believe Large Cap Growth will suffer more than Large Cap Value.

In spite of somewhat lower returns over the last year, we favor TBGVX over VWIGX right now because TBGVX hedges currency exposure, eliminating loses due to the stronger trending dollar since mid-2011 which can be expected to continue, especially as quantitative easing is phased out and US interest rates outpace those from much of Europe as well as Japan.

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Jan 2014

Model Bond Fund Portfolio

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.)


    40% (37.5%)

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


    5 (7.5)

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

    12.5 (12.5)

-Loomis Sayles Retail


    12.5 (12.5)

-Fidelity High Income (SPHIX)

  High Yield 

    15 (15)

-PIMCO Foreign Bond (USD-Hedged) Adm


    15 (15)

Note: Select a fund, if available, that has your own state's bonds for double-tax exemption.

Comments on Our Selections

Investors should keep in mind that both the Loomis Sayles Retail Fund and Fidelity High Income Fund, while stalwart performers over the last almost 5 years, suffered mightily prior to that during the last time stocks were free-falling. Therefore, these funds are highly recommended only so long as the current economic expansion supports investing in relatively low quality, higher yielding bonds.

How Our Prior Model Portfolios Have Been Doing

While data is incomplete as of our publication date, it appears that our Model Stock Portfolio from one year ago has done extremely well as compared to benchmark portfolio of domestic and international stocks. Likewise, our Model Bond Portfolio from one year ago appears somewhat ahead of the benchmark bond fund. Results from buying and holding our Model Portfolios over 3 and 5 year periods as compared to these benchmarks appear to be more mixed.

A more complete re-cap of prior recommendations will be published on this site some time near mid-January.

Page 5

Jan 2014

(You May Not Need These Funds/ETFs in Your Portfolio, continued from page 1)

if you feel strongly that one or more sectors are likely to outperform. However, the majority of one's portfolio should still remain invested in a few core types of diversified funds as opposed to investing in sectors. These should consist of essentially three main types of stock funds and just one, or maybe, two types of bond funds.

On the stock side, all US investors should have at least a moderate amount of money invested in the broadly-defined US stock market. This most basic position should focus on large cap stocks. The second category of stock funds most investors should hold should capture the small/mid-cap stock arena. The final category of ownership should involve having at least a small, if not moderate, position in diversified international stocks.

Regardless of how these core investments are labeled (for instance, whether all-inclusive index funds, or those labeled "growth," "value," "capital appreciation," "income," etc.), the composition of these primary building blocks of one's portfolio typically should not be extremely slanted to just a few market sectors, such as, for example, technology or financial stocks.

For those choosing to invest in bonds, one's portfolio should mainly focus on funds/ ETFs that typically hold a broad sweep of bond market sectors, such as mortgage-backed, corporate, and government bonds. The only other type of bond fund that might be considered as a core holding would be those with a history of successfully investing in "high yield" corporate bonds.

Of course, certain stock funds might combine at least two of these above core components into a single fund. On the indexed side, for example, a global fund that invests in stocks from all over the world including the US with typically just large cap stocks, such as Vanguard Total World Stock Index (VTWSX), would be one. Or, on the actively managed side, a fund with a successful record of investing in both US and international stocks could be substituted. For example, one fund that juggles all three core fund types particularly well is the Fidelity Low-Priced Stock Fund (FLPSX) with a good mixture of large, mid/small-cap stocks, as well as a current 33% allocation to foreign stocks, including emerging markets.

We have already mentioned two commonly classified sectors of stocks: technology and financial stocks. Most lists include the following nine others as well, for a total of 11 stock sectors.

  • Utilities
  • Consumer Staples (also called Consumer Defensive)
  • Basic Materials
  • Industrials (also called Capital Goods; sometimes includes Transportation stocks)
  • Communications
  • Consumer Cyclical (also called Consumer Discretionary)
  • Energy
  • Real Estate (sometimes included under Financials)
  • Health Care

If you invest in an S&P 500 index fund such as the Vanguard 500 Index (VFINX) or its comparable ETF version (VOO), you will automatically get a diversified cross-section of investments in all 11 sectors in proportion to how they are approximately weighted in the S&P 500 index.

If, however, you invest in an actively managed but diversified fund (non-sector), you are implicitly giving the manager the task of selecting and occasionally modifying his/her picks from among these various sectors. This, then, should mean you do not need to own any sector funds yourself, except as noted above for perhaps a small proportion of your own stock fund investments. Of course, if one does not have confidence any manager can consistently "beat the market," it would not make sense to invest in such a managed fund since you can will get the overall market's sector percentages as well as its overall return at a lower cost in an unmanaged index fund.

Page 6

Jan 2014

Examples of Sector Proportions in Three Popular Funds

Let's look at the latest available sector breakdown of the S&P 500 index as well as that of three highly successful managed stock funds. One of these funds, Fidelity Low Priced Stock (FLPSX), has been included in our Model Stock Portfolio for quite a while; the second, Yacktman Fund (YACKX), was removed recently due to potential overvaluation, but in light of its current defensive posture, we are recommending it again; the third, Vanguard PRIMECAP (VPMCX), might have been included except that it has been closed for a while. Each of these three funds have outperformed the S&P 500 by an average of nearly 3% per year over the last 10 years (or about 30% cumulatively). The first is considered a mid-cap value fund, the 2nd a large blend fund, and the third a large growth fund.

Sectors as a Proportion of the S&P 500 Index
as Compared to Sector Proportions in Three Popular Funds
4% 3% 1% 3%
13 26 16 8
Financials 15 11 7 6
2 0 0 0
Communications 2 0 2 0
Energy 10 5 5 5
Industrials 11 7 2 15
Technology 18 19 18 30
10 8 34 1
13 8 15 33
Utilities 3 0 0 0

As you can see, there are big differences between how the funds and the index are invested in all but the smallest sectors. All have a low position (compared to the index) in Financials, Real Estate, Energy, and Utilities while some have a very high position in Consumer Cyclicals, Technology, Consumer Staples, and Health Care.

These choices should give you some clues as to how a few outstanding fund managers are betting on sectors looking forward. (In contrast, our Model Stock Portfolio choices, below, mainly suggest other choices because we think the most currently popular sectors are highly overvalued.) But they also highlight the large differences in sector selection even among the most seasoned and successful managers. Given their prior successes, one might try to follow their lead if you choose to own narrowly focused sector funds. Note, however, that the sector differences between even outstanding funds are generally so large as to suggest one or more of these funds will likely wind up having had, in hindsight, too big a position in underperforming sectors and/or too small a position in overperforming ones. In short, one or more of these sector choices will be wrong, emphasizing just how hard it is for anyone to know in advance which sectors to overweight vs.

Page 7

Jan 2014

underweight in a portfolio. Of course, misguesses can hurt forward performance, although underperforming and overperforming sector choices could balance each other out.

While we typically recommend looking for segments of the market that are undervalued, our Model Portfolios in total, have nearly always hewed to portfolios that are not very far from being composed of each of the sectors found in the broad market. Over the last several years, our sector fund choices have averaged only about 15% of the entire portfolio and emphasized Financials, Consumer Cyclicals, and Real Estate. On the other hand, if one's portfolio sector percentages are too much like those the found in the S&P 500 index, there would be little point in investing a variety of funds since they will likely perform no better than the index, and possibly worse, while management fees could be higher.

If I haven't already convinced you that sector funds should only take up a small percentage of your portfolio, consider this fact: According to morningstar.com, sector performance results for 14 sector categories over the last 1, 3, and 5 years have only beaten S&P 500 returns over the same periods in 43%, 14%, and 29% of instances, respectively. (Data through 12/27.) The 14 categories include all those above but also include Natural Resources, Precious Metals, and "Miscellaneous" sectors.

In other words, generally speaking, investors who included sector funds in their longer-term portfolios had a much reduced chance of lagging a broad-based investment such as the S&P 500 than in exceeding it. These are powerful findings that should argue for typical fund investors keeping their investments in sector funds to a minimum.


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