2013 Tom Madell, Ph.D.

July 2013

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Mutual Fund/ETF Research Newsletter

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New Model Portfolios

by Tom Madell

As I see it, stocks will remain the place to be long term for investors who wish to maximize returns as compared to bonds and cash. That's obviously not to say that there won't be periods during the next year or so when stocks don't do well, or at best, show only minimal gains.

During such periods, some who have been avoiding stocks may feel vindicated by their prior decisions. While reticience to own stocks based on short-term considerations may result in reluctance to enter or remain the market, my research suggests that now is still a good time to expect decent stock performance until such time that most segments of the market have indeed become overvalued, which is not now the case.

Although that eventual possibility is real and may not be too far off (as suggested in June's Newsletter), unless you are of the disposition to continuously monitor your portfolio, you may be better off merely deciding on a prudent stock exposure and sticking with that position.

Investors should remember that it's not a few day's, week's, or even month's happenings that determine the course of asset prices. Rather, trend-setting downswings or upswings are usually based on a confluence of events that can require up to 6 months or even a year to transpire. Therefore, current market turmoil may suggest nothing about the future direction of stock prices. However, that said, it is likely that many categories of bond prices have already shown the requisite characteristics to suggest continued uninspiring future performance.

New Model Portfolios, continued on page 4

Is Your Stock Portfolio Ahead or Behind? A Lot Depends on Your International Allocation

by Tom Madell

While most stock fund returns have been exceptional over the last 12 months, you may find that your stock funds as a whole have delivered somewhat disappointing returns over the last 5 years. While the financial crisis that began in 2007 appears to have been a big reason, investors should realize that international funds were far more impacted than US stocks and are still struggling to return to pre-crisis levels. As a result, investments allocated abroad since mid-2007 have badly underperformed US stocks, pulling down overall portfolio returns.

For US investors who invest abroad, how well international stocks do looking forward will likely play a big role, as they have in the last decade, in determining whether one's overall returns will normalize or continue to lag historical averages. While relatively high allocations to international stock funds have detracted from returns over the last 5 years, the time may be near to expect such allocations will enhance portfolio returns.

There is good reason to hold international stocks except perhaps for the most conservative of investors. Mainly, such holdings provide diversification in the event the US market underperforms or international stocks are able to do significantly better than domestic ones, boosting your overall returns.

Of course, the reverse may continue to be true. But by diversifying, you are attempting to lessen your risks by gaining exposure to more markets than just one. It is the same principle as why one typically is prudent to invest in at least a handful of individual stocks, rather than in just one or two.

It has been pointed out innumerable times that, lately at least, when US stocks run into trouble, international stocks haven't proven to be much of a buffer. Thus, during the stock meltdown in 2008, while the S&P 500 index sank 37%, the average international stock fund dived over 44%. However, during the worst year of the prior bear market, in 2002, the S&P was down about 22% while the average international fund fell a lesser 16%.

Over long periods of time, say 10 years or more, US results should likely not vary by a great deal from international performance, with perhaps a slim advantage to the latter, especially if faster growing emerging markets are included. This has been the case since mid-2003; through May, the average annualized 10 year return for international funds has been a tad better than the S&P 500 (8.1 vs 7.6%). But such results mask a very important fact:

continued below

Page 2

July 2013

(Is Your Stock Portfolio Ahead or Behind? A Lot Depends on Your International Allocation, continued from page 1)

Over periods of 5 years or even longer, it is surprising how much the performance of US stocks has at times differed from that of international stocks. In fact, going back to late June 2008, the S&P 500 has outpaced the performance of the average international stock fund by about 7% per year. Yet, to the contrary, from mid-2003 to mid-2008, the average international stock fund returned a whopping annualized 16.1 vs. the S&P's 7.6%.

Before proceding, it may be helpful to distinguish between investments in international funds vs. those that invest worldwide. An international, or foreign, fund usually includes various foreign countries, but excludes the US. A worldwide, world, or global fund, on the other hand, typically has both foreign and domestic stocks.

For the investor who truly wants to diversify his or her US holdings, it makes more sense to include one or more international funds, as opposed to global funds. Why? If you purchase a global fund, you may not be diversifying as much because you may already own many of the same US stocks as in your domestic funds.

Look, for example, at the holdings of a fund that holds stocks from all over the world, including the US, the Vanguard Total World Stock Index Fund (VTWSX) or its similarly composed ETF (VT). What stocks might you expect to be included in its 10 largest holdings? None other than Apple, Exxon Mobil, Microsoft, General Electric, Chevron, Google, International Business Machines, Johnson & Johnson, Royal Dutch Shell, and Wells Fargo & Co. Sorry to say this for those trying to diversify away from the US, but only Royal Dutch Shell is located outside of the US. Therefore, surprisingly, if you own both a S&P 500 index fund, such as VFINX or VOO, along with VTWSX, the top 8 largest holdings are currently the same.

Given the broad diversification afforded by many such global funds, if one wanted to own just one single fund without perhaps the need to own other stock funds, such a fund might be the way to go. But to do so, one would have to fully embrace stocks from all over the world in the regional percentages contained within the portfolio. Thus, VTWSX currently contains only about 50% US stocks with the remaining 50% from foreign countries, including 10% from emerging markets.

Since many US investors might feel uncomfortable with such large foreign allocations, a better way to go for them might be some combination of perhaps US-only and foreign funds, allowing for a varying percentage of domestic vs. foreign stocks. Although there is no one agreed upon "best" allocation between US and foreign stocks within a portfolio, many would suggest a foreign percentage typically ranging from 20 to 40%.

If your portfolio puts you in or near this range, it may be quite well diversified, but there is still a problem which may not immediately be apparent: How can you determine how well your overall stock portfolio is doing as compared to some standard? (i.e., is it performing satisfactorily or is it underperforming? Or, has your advisor or newsletter done a good job for you or would you have done noticeably better with different choices?)

US investors, such as myself, typically compare how well our entire stock portfolio did over given periods in relation to the S&P 500 index. Using this comparison may make sense because most US investors likely do have the majority of their investments in US stock funds, so that index is a popular, widely available basis of comparison.

However, when you have chosen to have at least some of your fund investments in international stocks, does it still make sense to compare your overall performance to the S&P 500 index which is made up only of US stocks? This has been a very important issue over the last 10 years because foreign stocks may have either considerably hurt or considerably helped your portfolio's performance vis-a-vis the S&P 500 index over different time periods.

If domestic stocks are doing better than foreign stocks over an extended period as over the last 5 years, the S&P will likely consistently outperform your globally diversified portfolio. (This assumes your specific fund choices do not depart drastically from their peers.) In examining your results, you may have concluded that somehow you, or your advisor (or newsletter), were on the wrong track. But if you invest internationally and compare your portfolio results to the S&P 500, the only thing that may be wrong is using the wrong index.

And when foreign stock indexes are doing better over an extended period as compared to US stocks indexes, the reverse will be true: Your worldwide portfolio will typically show that it is beating the S&P 500 index.

Of course, the larger your allocation to international stocks, the more your portfolio will be subject to this effect. That is, someone's portfolio with a 40% allocation to such stocks will suffer a bigger underperformance as compared to the S&P 500 than someone with a 20% allocation, and reap a bigger benefit, if such stocks outperform.

Therefore, rather than using the S&P 500 index to judge how well a mixed portfolio of US and foreign stocks is doing, it makes more sense to measure a worldwide portfolio of stocks against a similarly composed worldwide index. Otherwise, you may realize either trailing (or market-beating) portfolio performance solely because you chose to include a 20 to 40% range of foreign allocation in your portfolio, and not because of any other reason.


Page 3

July 2013

I have now posted a brief review of our long-term Stock Model Portfolio performance over the last one, three, and five years. Please click here to see this important update, newly published on July 8th.

The Importance of Your International Allocations

The data that I will now present illustrate just how important your international allocations can be in getting an accurate picture of how well your portfolio has done over at least the last 10 years. It will also help to clarify how well the Model Stock Portfolios presented in my Newsletters have done. And perhaps most importantly, it may be highly significant if you wish to maximize your future returns.

As very long-time readers of my Newsletter may recall, up until the start of the Oct. '07 bear market, our prior overall Model Stock Portfolio returns, when allocated as we recommended, quite typically came out ahead of the S&P 500. The average outperformance of our recommended fund categories was about 4% over 1 year periods and about 5% per year over 5 year periods. These results can be reviewed by visiting an archived page from my Newsletter published in 2007.

But for the nearly 5 years of performance data available since then, we have found it harder and harder to beat the S&P 500. For example, by the end of the Sept. 2008, our overall 4th Quarter 2007 Model Stock Portfolio trailed the S&P 500 by 3.8% over the prior year. What had happened to help cause this as well as other disappointing underperformances of our Portfolios' stock recommendations?

What we have said above provides the answer. International stocks, which comprised 35% of our Model Stock Portfolio back near the end of '07 performed far more poorly than domestic stocks. The 35% of our portfolio invested abroad brought our portfolio down significantly. The average international stock fund declined by more than 30% between Oct. '07 and Sept. '08; while the S&P also declined, the decline was considerably less severe at 22%. Thus, it turns out the 8+% difference between the US and foreign stock fund performance accounted for the lion's share of our portfolio's underperformance. Of course, portfolio underperformance might have reflected poor choices of specific domestic and international funds to include, but this did not seem to be the case.

As noted above, the outperformance of domestic funds over international funds has continued long term since then. As a result, any portfolio which included the typically recommended range in international stocks down through the years as ours have (and perhaps yours as well) found it extremely difficult to beat the S&P 500. We pointed out this issue of being weighed down by foreign stocks in several of our issues. That is one reason why beginning in mid-2008, we gradually began dropping our allocation to foreign stocks to as low as 20% in Jan. 2011 and have kept them mostly low ever since. In 2011 alone, the S&P outperformed foreign stocks by 15.5% (+2.1 vs. -13.4%), so that a low allocation internationally kept our portfolio from otherwise doing worse.

In the calendar years 2002 thru 2007, by contrast, international stocks were always significantly ahead of the S&P. Therefore, with our allocations to international stocks during those years averaging about 30%, we highly consistently beat the index on a one, three and five year basis.

Looking Forward

In 2012, the average international stock fund actually outperformed the S&P, 17.7 vs 16.0%. Since international stocks now look like good candidates for doing better than many categories of US stocks according to my research model (with the exception of emerging markets), investors may be able to improve their longer-term future returns by increasing their allocation to these highly undervalued funds.

On the other side of the coin, international stocks have had a rocky first 6 months of 2013. It may indeed be too early to start to increase allocations to your international stocks, especially if you want good results immediately. Cautious investors therefore might want to wait for more signs of improvement in non-US world economies and stock performances before making such a change. However, investors with an eye toward doing well as measured several years down the road, and able to ride out possible short-term setbacks, appear to have excellent opportunities now in international equities.

In summary, whatever the future may hold, it makes sense to very carefully consider what your foreign allocation will be and to consider altering it at times, based on the ongoing longer-term trends, as a strategy to enhance your portfolio returns.





Page 4

July 2013




(New Model Portfolios, continued from page 1)

Overall Allocations to Stocks, Bonds, and Cash

For Moderate Risk Investors

Asset Current (Last Qtr.)
Stocks 65% (67.5%)
Bonds 25 (27.5)
Cash 10 (5)

For Aggressive Risk Investors

Asset Current (Last Qtr.)
Stocks 80% (85%)
Bonds 10 (10)
Cash 10 (5)

For Conservative Investors

Asset Current (Last Qtr.)
Stocks 37.5% (45%)
Bonds 32.5 (35)
Cash 30 (20)
Note: If you are very risk averse,
you obviously might want less
in stocks.

Model Stock Portfolio

We have only slightly lowered our allocation to stocks to reflect the new uncertainties that are now plaguing the markets. We do not see these issues as game changers.

The main changes to our Model Stock Portfolio are to increase exposure to Large Cap Value and to decrease exposure to Large Growth.

Large Cap Value funds have been outperforming Large Growth by about 7% over the last 12 months, with the gap widening over the last 6 months. I expect that trend will continue.







continued next page

Page 5

July 2013

We are not increasing exposure to diversified International stock funds just yet, but will monitor them closely as implied in our above discussion on the importance of international allocations. While they have been underperforming lately (11% less than the S&P 500 index since Dec. 31st, thru 6-30), they remain the most undervalued category of stocks. Although we don't know for sure when they will start to reverse that, when they do, we expect good returns for years to come. An exception to this underperformance is Japan-focused funds which have outperformed all other broad categories of domestic stocks year-to-date and over 12 months in spite of a recent drop in Japanese equities of more than 20%.


Model Stock Fund Portfolio


Our Specific
Fund Recommendations

Fund Category

 Recommended Category Weighting
Now 
(vs Last Qtr.)
-Fidelity Low Priced Stock (FLPSX)
 (See Note 1)

 Mid-Cap/Small-
      Cap


    12.5% (12.5%)

-Tweedy Brown Global Value
 (TBGVX) (C & M)
-Vanguard Internat. Growth
 (VWIGX) (M)
-Vanguard Pacific Index (VPACX)
 (A) (See Notes 2, 3 & 4)

 International 


    27.5 (27.5)


-Vanguard 500 Index (VFINX)

 Large Blend 


    15 (15)


-Vanguard Growth  Index (VIGRX)
-Fidelity Contra  (FCNTX)
  Large Growth
    10 (12.5)

-Vanguard US Value
 (VUVLX)

    Large
    Value


    20 (17.5)


-Vanguard
 Financials ETF (VFH)

    Sector


    10 (10)

-Third Avenue Real
 Estate Value Fund
 (TVRVX)

    Sector


      5 (5)

Notes:

  1. FLPSX currently has a 35% international position; we think this should pay off as international stocks are more undervalued than US stocks. If you want a fund that avoids such exposure, substitute Vanguard Extended Mkt. Idx. (VEXMX).
  2. Stock or bond funds with (C) are recommended for Conservative investors; (M) Moderate; (A) Aggressive.
  3. ETFs (exchange traded funds) of the same category can be substituted for any of the above 3 index funds; e.g. Vanguard MSCI Pacific ETF (VPL) can be substituted for VPACX.
  4. We favor TBGVX over VWIGX right now because TBGVX hedges currency exposure, eliminating loses due to the stronger trending dollar since mid-2011.




Page 6

July 2013

Model Bond Portfolio

Most bond funds have taken it on the chin recently. So does this mean most readers should largely abandon the category? While, as noted above, one may be hard-pressed to find bond fund categories that will defy an overall limited return potential, we feel long-term investors may not want to fully join the exodus out of bonds if they haven't already lightened up. Why? Some bonds are now more attractively priced than they have been for a while and offering higher yields. If interest rates stabilize near today's levels which is possible since we agree that investors may have overreacted to the Fed's recent announcements, bonds should still be able to generate modestly positive returns. In contrast, interest rates on cash will likely continue to hover near zero for a considerable time longer. So, while neither bonds nor cash appear to be an attractive option, longer-term investors should still likely do better in bonds.

I would stick with managed bond funds as opposed to index funds to give the fund the flexibility to seek out the best opportunities. I would generally minimize funds that invest primarily in government bonds, except when one needs the monthly income payments that are spun off, in which case, I would continue to hold municipal bonds for all but the lowest tax bracket investors.


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)

  Diversified 


    37.5% (37.5%)

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

 
  Inflation
  -Protected


    7.5 (10)

-Vang. Intermed. Term
 Tax-Ex. (VWITX)
 (see Note 1)
  Intermed.
  Term
  Muni.

    12.5 (12.5)

-Loomis Sayles Retail
 (LSBRX)

  Multisector 


    12.5 (12.5)

-Fidelity High Income
 (SPHIX)
 (see Note 2)

  High Yield 


    15 (15)

-PIMCO For Bond (USD-
 Hedged) Adm (PFRAX)
-T Rowe Price Emerging
 Mkts Bond (PREMX) (A)

  International


    15 (12.5)

Note 1.Select a fund, if available, that has your own state's bonds for double-tax exemption.
Note 2. Unfortunately, our prior recently recommended High Yield funds are closed to new investors.
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