Mutual Fund Research Newsletter
Copyright 2010 Tom Madell, PhD, Publisher
Oct. 2010. Published: Sept 20, 2010; Updated Oct 8, 2010

How Long Will "Flat" Returns Stymie Investors?

by Tom Madell

In the last few years, I have noticed there has been an extreme lack of longer-term performance variation across different categories of domestic stock funds. No matter which category of fund you might have held over the last 5 years, the average result has generally been poor. As a consequence, there has been a remarkable diminishment in one's ability to pick out and hold winning categories while trying to avoid holding losing ones.

For example, thru Aug. 31, 2010, the benchmark S&P 500 Index returned -0.9%, the exact same amount as the average diversified stock fund which might have been a small cap, mid-cap, value or growth fund. And those who invested in a worldwide diversified international fund hardly did better than those who invested domestically, earning only 1.1%. (Note: all returns mentioned are annualized returns over the prior 5 years.)

So where might have one gotten the best or worst stock fund returns? The only main US diversified stock category to get positive returns over 5 years was the Mid-Cap Growth category at +0.4%. A few categories of funds focused on narrow, non-diversified segments of the market came in better such as, for example, those specializing in utilities at 2.6% and gold at 21.2%. And those that invest primarily in emerging markets, Latin America, and the Pacific region averaged 10.2, 17.2, and 7.8 respectively. However, such investments all would have entailed a higher degree of risk.

The worst main US diversified average returns came in the Large Value category at -2.1. Thus, the degree of difference between the best main US category and the worst was a mere 2.5%. (+0.4 vs -2.1).

This turns out to have been a far cry from the situation for investors who bought and held their funds throughout most of the first 7 or so years of the past decade when there were often huge differences between the best and the worst performing categories.

For example, back on Mar. 31, 2005, you would have gotten +15.1% over the prior 5 yrs. in Small Value funds. Compare this to a -10.2 average return in the Large Growth category. That's a 25.3% difference per year! (If you held a S&P 500 Index fund, your 5 yr. return would have been -3.7%.) And had you invested in certain specialized funds, such as Real Estate, Gold, or Science and Technology, the opportunities to either excel or do badly would have been much greater.

So why was it that fund category selection might have made a big difference in how well fund investors did earlier in the decade but hardly so over the last several years?

Our research shows that during both the 2007-2009 and 2000-2002 bear markets, comparative performance across all fund categories became constricted. As might be expected, investors sold off virtually all categories of funds. However, they appear to have sold off the previously best performing categories the most. Why? Perhaps it was in an effort to protect whatever profits still remained. Or, they may have recognized these funds had become too "frothy" or overvalued. Or, maybe they simply became scared that the funds that had performed best for them were now the most likely to lose money for them in a serious market decline.

Whatever the cause, this resulted in a "flattening" of category returns as the best performers started to lose their advantage over the worst. When no one category becomes barely any better than another no matter which ones an investor chooses, almost all investors just get about the overall market return.

Back in 2003, when a bull market returned, it appeared that investors no longer craved the prior winning categories which they continued to sell. Instead, those who did start investing again sought out the prior bull market's "undervalued" categories. As a result, the types of funds that outperformed the most during the ensuing relatively long rising market were the ones that had been underperformers during the preceding bull market.

We believe we may now be transitioning from flat category returns to more opportunity to outperform through your category selections. While the constriction of bear market returns is still visible in recent performance data, there does appear to be the beginning of a trend toward somewhat less constriction which seemed to bottom at a meager 1.4% difference between best vs worse at the end of June '09. (It is now at approximately 3.1% as of Sept. 19 but still, admittedly, has a long way to go to reach the big differences in 5 year category performance shown during the bullish times earlier in the decade ).

If you believe as I do that the we are still likely in the early stages of a longer-term rising market that started in Mar. '09, the following actions could prove to increase your returns in the years ahead:

October Model Portfolios

Our latest Stock Fund Model Portfolio reflects what our above research seems to suggest about getting onboard relatively early in undervalued categories, as we apparently continue to transition from the end of the 2007-2009 bear market to what has already shown to be more than an 18 mo. bullish market. And in spite of the more recent correction, looking out over the longer term, we expect a continuation of the gains which started in Mar. '09.

Note: I believe that no matter how deep my convictions, I owe it to readers to keep risk lower by recommending investments in a broad range of different types of funds. This not only offsets some category predictions which will undoubtedly go awry, but helps to ensure capturing one or more categories that wind up near the top of the performance charts. So within my Model Portfolio recommendations, I believe in carrying this plain and simple diversification strategy to what some others might consider a near excess: I almost always recommend about a half dozen stock, and usually, nearly as many bond funds.

For Moderate Risk Investors


Current (Last Qtr.)


62.5% (60%)


35 (35)


2.5 (5)

For Aggressive Risk Investors


Current (Last Qtr.)


85% (80%)


15 (15)


0 (5)

For Conservative Investors


Current (Last Qtr.)


30% (20%)


65 (60)


5 (20)

Specific Category Allocations


Large Cap funds remain the most undervalued categories, although small caps tend to do well coming out of recessionary periods. Remember though that small and mid caps were far and away the best performers during the '03-'07 bull market. Therefore, we do not expect them to continue to excel indefinitely in spite of having regained the lead lately.

We currently think that financial stocks may offer the best opportunity to outperform so that aggressive investors may want to consider going beyond a diversified Large Cap Value mutual fund well-endowed with financials and instead (or also) invest in an exchange traded fund (ETF) specializing in that category.

Our recommendations include several choices, signified by the (C), that may be valuable additions to a portfolio for conservative investors. We also signify the ETF fund with (Aggr) as being for more aggressive investors.

Favored Categories

Recommended % of
Stock Portfolio
(last qtr's %)

Our Current
Recommended Fund

Large Growth

22.5% (25%)

Vanguard Growth Idx

International Large Blend or
International Large Value (C)

25 (25)

Vanguard Internat. Growth or
Tweedy, Browne Global Val (TBGVX) (C)

Large Blend

20 (20)

Vang. Large-Cap Idx

Mid-Cap Value

5 (5)

Fidelity Low Price Stock (FLPSX)

Large Value

12.5 (10)

T Rowe Price Equity Income (PRFDX)
Vanguard Financials ETF (VFH) (Aggr)

Mid-Cap Growth

5 (0)

Vanguard Mid-Cap Growth Index (VMGIX)

Small Blend

10 (10)

Vanguard Small Cap Index

Notes: Investors who think the economy will do more poorly than the consensus view of upcoming moderate growth
may want to go with Hussman Strategic Growth (HSGFX) (C) as a substitute for some of the small or mid-cap position
because it usually does better than most other stock funds when stocks overall are doing poorly.
Tweedy, Browne Global Value has less risk than most international funds; further, it will not
suffer currency losses if the Euro resumes its drop.


There are hardly any changes to our Bond Fund Model Portfolio.

Favored Categories

Recommended % of
Bond Portfolio
(last qtr's %)

Our Current
Recommended Fund

Interm Term Govt

12.5% (15%)

Vanguard Tot. Bond Market


45 (45)

PIMCO Total Return Instit (PTTRX)
or Harbor Bond Fund (HABDX)

Intermediate Term Muni Bonds

10 (10)

Vang. Interm. Term Tax-Exempt


7.5 (7.5)

PIMCO Real Return Instit (PRRIX)
or Harbor Real Return (HARRX)


5 (5)

T Rowe Price Intl Bond

Short-Term Non-Govt

5 (5)

Vang. ST Investment Gr.

Long-Term Non-Govt

5 (5)

Vang. LT Investment Gr.

High Yield

10 (7.5)

Vang. High Yield

How Our Prior Model Portfolio Recommendations Have Performed

In order to get a better idea of how much trust you can place in our Stock Model Portfolio recommendations, we regularly publish how our prior recommendations from 1, 3, and 5 yrs. ago fared vs the S&P 500 Index.

Given the "flat" returns discussed above, it has become more difficult to outperform using the method of focusing on undervalued fund categories that we primarily use. As a result, selecting our recommended categories using the percentage allocations we suggested 1 and 3 years ago continued to slightly trail the S&P 500 Index, as they did for the prior two quarters although by an even smaller amount. However, over the entire 10 years we have made these comparisons, buying and holding our recommended categories over the following 1 or 3 yrs. continue to show a substantial advantage over the Index; the outperformance is nearly 3% per year.

Our perfect record for outperforming the Index after 5 years remains intact. What this means is that for 24 straight quarters, each of our recommended Model Stock Portfolios have beaten the Index. The average yearly outperformance has exceeded 3.5%!

We don't regularly report performance results for our Bond Model Portfolio. One of the reasons is that our picks do not always fall into neat categories that can be tracked, such as when we recommend PIMCO Total Return Fund which invests in a variety of categories.

In the last few years, we have encouraged investors to invest heavily in either the PIMCO Total Return Fund Instit (PTTRX), or if not available, the Harbor Bond Fund (HABDX). Also, we have recommended the Vanguard Total Bond Market Fund (VBMFX), which also serves as our benchmark. We have found that over the years, it has been nearly impossible to beat the returns from these funds. However, over the last 1 yr., our specific fund recommendations, which also included PTTRX, did outperform the benchmark fund.

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Continue to Part 2 of this Month's Newsletter

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