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Copyright 2018 Tom Madell, PhD, Publisher
July/August 2018. Published June 28, 2018.

It is Almost Impossible to Beat the Market Except ...

By Tom Madell

It might seem that broad index funds that attempt to own the entire market, such as the Vanguard Total Stock Market Index (VTSMX) for US stocks and the Vanguard Developed Markets Index (VTMGX or VDVIX) for non-US stocks (or their comparable Vanguard ETFs) are nearly impossible to beat. That's certainly why so many fund investors have made these or highly similar funds a significant part of their portfolios. But funds that invest in somewhat more narrow slices of the market, as opposed to the broad ownership of nearly all stocks, as well as non-index (i.e. managed) funds, can still make sense too.

I have owned many stock funds down through the years, and frankly, not all of them have proven to be stellar performers, nor anywhere as good as the above two funds. But the only funds I have managed to hold on to year-in and year-out and still do (for 15 or more years to be exact) turned out to be solid performers. In fact, seven out of these ten funds wound up doing better than the above index funds. The table below shows them and their long-term results as compared to VTSMX or VTMGX. Each of these funds remain highly recommended regardless of whether they might currently be excluded from my latest Model Portfolio.

Fund Name
(Symbol)
15-Year
Ann. Return
Vs. Index
Performance
(Annualized)
Vang. Small Cap Idx (NAESX) 11.35% +1.64%
Vang. Pacific Stock Idx (VPACX) 8.37 +0.54
Vang. International Growth (VWIGX) 9.84 +2.01
Vang. Extended Mkt Idx (VEXMX) 11.20 +1.49
Vang. Energy Fund (VGENX) 9.78 +0.07
Vang. 500 Idx (VFINX) 9.22 -0.49
Vang. Europe Idx (VEURX) 7.39 -0.44
Tweedy, Browne Global Val (TBGVX) 8.77 +0.94
T Rowe Price Val Fund (TRVLX) 9.60 -0.11
Fidelity Contra (FCNTX) 11.96 +2.25
Notes:
1. 15-annualized performances as compared to either 9.71% for VTSMX or 7.83% for VTMGX depending on whether a US or international focus.
2. Period from June '03 thru May '18.

In fact, for many years I have operated under the assumption that acquiring in-depth knowledge including doing careful research can enable you to do better than fund investors not so engaged, and indeed, to even to come out ahead of the broad market indexes. The results above would appear to help confirm that. But especially over the last 10 years, the second part of this assumption has begun to look more and more dubious. Here's why.

Year after year, most of my individual fund selections have certainly done better than the average fund in its category. And initially, for about 6 or 7 years between 2000 and 2007, my overall Model Stock Portfolios, taking into consideration individual fund selections and percent of the Portfolio allocated to each, additionally were able to come out ahead of returns on a broad market index such as the S&P 500. However, more recently, my results, while always quite close to such benchmarks, usually have tended to trail them by a small amount in the range of 1/2 to 1 percentage point.

Were my selections and possibly recommended allocations becoming poorer, or is there something fundamentally different now vs. then that likely accounts for this? While there is no way to know for sure, here is my guess as to an explanation.

As investors came to realize how hard it was to come out ahead of broad index funds through more costly actively managed funds, index funds became more and more popular, and along with the ETF "revolution," investors began to pour more and more money into these passive "vanilla" index funds. Of all of the incoming money flowing into the broad index fund stocks, 100% of it had to be used to purchase the stocks that made up these indexes, seemingly forever boosting their prices.

Of course, index funds are not the only purchasers of their underlying stocks, but these days, they own a significant percentage of the total outstanding shares. And not all index fund stocks will always "automatically" go up because there may be selling activity by non-index owners. But as a general rule, index fund stocks will always get a performance boost the more money that flows into these funds.

If a fund is actively managed, it presumably is investing in perhaps some of the same index stocks, but also in less popular, non-index stocks thought to possibly help performance based on the manager's judgment. Without the constant boosting of index fund stocks, managed funds with a different make-up could only win out by a very superior stock portfolio composition, or, if there was a marked changed in which types of stocks were or not doing well, allowing the highly skilled manager to potentially recognize and capitalize on such opportunities.

Since my stock fund Portfolios have always been a combination of managed and unmanaged funds, my choices too have suffered from this, as of now, still on-going disadvantage as compared to index fund stocks. Indeed, "the rich (I.e. index funds, their stocks, and their owners) were getting richer" as a self-reinforcing cycle became rooted.

If and when this situation will change is obviously unknown, but for now at least, it appears that broad index funds with their constant inflow of new money into a given set of stocks will continue to enjoy a performance advantage over most managed funds. But, at some point, there will likely come an extended period when the higher fees charged by many managed funds will be offset by their inherent flexibility in portfolio decision making.

New Model Portfolios Beginning July 2018

It's time for another quarterly update to my Model Portfolios. But first, let's clarify a few things.

You might think that because these Portfolios change every 3 months, I am recommending that investors keep changing the funds in their portfolios as frequently.

I might have once thought that that would be a good idea, but no longer. Not only does that entail more effort than most investors want to engage in, but in my experience, it simply doesn't help you get better returns in most cases than just sticking with funds you have been able to identify as good selections and merely "staying the course." The above table testifies to that.

My extensive data and research shows that the best way for most investors to make the most money long term is to identify your best performing funds and to hold them indefinitely. This is as opposed to being influenced what amount to short-term market "hiccups" that often may seem to suggest that a fund or market sector is going to be negatively impacted by one thing or another.

Of course, there will always be funds or those within specific market segments that fail to meet your expectations. No doubt these funds should, after being given a few years chance to come back, find their way out of your portfolio. But well-chosen funds with a good long-term track record should generally be retained through thick and thin.

So what then is the primary purpose of my Model Portfolios? As I now see it, these portfolios are primarily for investors discovering my recommendations for the first time. As I have always believed, investing can be likened to shooting at a moving target; conditions are always changing, leading to changes in recommendations. But for the investor who has already landed in good funds, very little change to the funds their portfolio is usually necessary.

Along the same lines, good funds sometimes close to new investors, or their minimum opening investment can now become prohibitively high. An investor who wishes to start investing in such a fund may be effectively shut out. Therefore, it seems only reasonable for me to drop that fund and possibly recommend an alternative.

Another use for my Model Portfolios is to suggest additional funds, if an investor already has his/her basic funds picked out and wants to expand for diversification, or on the expectation that an additional fund may outperform.

A final use of these Portfolios is to "fine tune" the percentage allocations to your funds. However, this is only for sophisticated investors who want to consider portfolio weighting of funds or categories based on my best guesses as to the funds that may deliver the best performance vs. my lesser favorites. Fund weightings provide a suggested guideline for a portfolio but may not turn out to be any better than merely holding each chosen fund in an equal amount. As you should realize, any type of economic/portfolio forecasting in nowhere near like an exact science.

3rd Quarter 2018 Model Portfolios

Overall Allocations to Stocks, Bonds, and Cash

The current period of nine plus years of rising stock prices since 2009 has been one of the most spectacular in history. Since no one can predict when it might end, your best course of action is probably to maintain a decent allocation to stocks without being tempted to either go overboard, or, to pull out.

With stock prices quite volatile lately, and with much more uncertainty in the world during the last year or two, investors should try to maintain a long-term focus rather than trying to figure out what might be in store for stocks the rest of this year or perhaps in 2019. As far as bonds are concerned, rising rates should put a damper on returns and so cash parked in a high paying money market fund such as Vanguard's Prime remains a viable alternative.

Recommended For Moderate Risk Investors

Asset Current (Last Qtr.)
Stocks 57% (57%)
Bonds 25 (26)
Cash 18 (17)

Recommended For Aggressive Risk Investors

Asset Current (Last Qtr.)
Stocks 73% (72%)
Bonds 14 (15)
Cash 13 (13)

Recommended For Conservative Risk Investors

Asset Current (Last Qtr.)
Stocks 20% (20%)
Bonds 35 (40)
Cash 45 (40)

Model Stock Portfolio


Our Specific Fund and Allocation
Recommendations Now (vs Last Qtr.)

Fund
Category

 Recommended 
Category
Weighting
Now
(vs Last Qtr.)

-Vanguard Extended Market Idx (VEXMX) 9 (7%)

   Mid-Cap/
   Small Cap


      9% (7%)


-Vang. International Growth (VWIGX) 11 (11) (A)
   (See Note 1.)
-Vang. Pacific Index (VPACX) 10 (10) (A) (See Note 2.)
-Vang. Emerging Markets Idx (VEIEX) 11 (13) (A)
-Vang. Europe Index (VEURX) 7 (8) (M)


 International 


     39 (42)
  

-T. Rowe Price Dividend Growth (PRDGX) (M) 5 (5)
-Vang. 500 Index (VFINX) 6 (5)
-Oakmark Investor (OAKMX) (A) 5 (5)


    Large
    Blend 


    16 (15)


-Vang. Growth Index (VIGRX) 5 (5)
-Fidelity Contra (FCNTX) 6 (6)
    Large
    Growth 

    11 (11)


-Vang. Equity Inc (VEIPX) 5 (6) (M)
-Vang. Value ETF (VTV) 3 (3) (A)
-T. Rowe Price Eq. Inc (PRFDX) 4 (4)

    Large
    Value


    12 (13)


-Vang. Energy (VGENX) 8 (6) (A)
-Vanguard Global ex-US Real Est Idx (VGXRX) 5 (6) (A)

    Sector
    Fund


    13 (12)

Notes:
  1. A stock or bond fund shown with (C), (M), or (A) indicates it has characteristics that may make it most suited for Conservative, Moderate, or Aggressive investors, respectively.
  2. Vanguard ETFs (exchange traded funds) are often practically identical to similarly named Vanguard "Investor" index funds with even lower expense ratios and without the higher minimums required for the "Admiral" funds. Therefore, these ETFs can be substituted for any Vanguard stock or bond index fund shown in tables. E.g. Vanguard FTSE Pacific ETF (VPL) can be substituted for VPACX; Admiral funds can also be substituted when available, e.g. VPADX.

Model Bond Portfolio

Our Specific Fund
and Allocation
Recommendations
Now (vs Last Qtr.)

Fund
Category

Recommended
Category
Weighting
Now
(vs Last Qtr.)

 
-PIMCO Total Return Instit (PTTRX) 17% (17%), or
-Harbor Bond Fund (HABDX) (See Note 1.)
-Vanguard Total Bond Market ETF (BND) 3 (3)

  Diversified 


   20% (20%) 

 
-DoubleLine Tot Ret Bond I (DBLTX) 6 (6), or
-DoubleLine Tot Ret Bond N (DLTNX) (See Note 2.)
-Dodge & Cox Income (DODIX) 11 (11)    

   Interm.
    Term   


     17 (17)


-Vang. Intermed.-Tm Tax-Ex (VWITX) 12 (12)
   

     Muni


    12 (12)


-Vang. Sh. Term Inv. Grade (VFSTX) 4 (4)
 Short-Term 
   Corp.

     4 (4)


-Vang. Inflation Prot. Sec (VIPSX) 3 (3)
-PIMCO Real Rate Instl (PRRIX) 9 (9), or
-Harbor Real Return Instl (HARRX)
    (See Note 4.)
   Inflat.
    Prot.

     12 (12)

-Vang. High Yield (VWEHX) 13 (13)

  High Yield


    13 (13)

-PIMCO For. Bd (USD-Hdged) Adm (PFRAX) 19 (18) 
-Vang. Emerging Mkt Govt. Bd (VGOVX) 3 (4)

  Internat.


    22 (22)

Notes:

  1. When possible, select PTTRX, although the minimum initial investment is quite high; HABDX is nearly identical if you want a lower minimum.
  2. The two funds are the same but have different minimums; select DBLTX if possible because of lower expense ratio.
  3. Muni bonds are only suitable for taxable accounts. Invest in a fund with bonds specific to your own state, if available, for the greatest tax savings.
  4. When possible, select PRRIX, although the minimum initial investment is quite high; HARRX is nearly identical if you want a lower minimum.

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The next Newsletter will appear around the beginning of September. However, in early July, I published the latest performance update which shows how my Model Portfolios from 1, 3, and 5 years ago would have done if one held each fund over the entire period. See it here.

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