Copyright 2017 Tom Madell, PhD, Publisher
Oct. 2017. Published Oct. 1, 2017.

Looking For Fund Outperformance Potential? Consider This

By Tom Madell

It may be hard to believe that investing, at times, might seem to be so easy. Yet by merely holding a passive, three fund stock index portfolio, starting approximately one year ago, such a portfolio would have grown approximately 20%. (Note: All data reported in this article reflect fund total returns in late September.) That is indeed the outcome assuming one had invested in the following 3 funds in percentages shown below: (These percentages are subjective but represent my best estimate of an all-weather, all-inclusive world portfolio, highly appropriate over the years.)

  • Vanguard Total Stock Market Index (VTSMX) (65%)
  • Vanguard Total Developed Stock Market Index Admiral (VTMGX) (30%)
  • Vanguard Emerging Markets Index (VEIEX) (5%)

This tough to beat portfolio is actually the one I use as the benchmark for judging the success of my own Model Stock Portfolios. In fact, each of the 3 aforementioned funds returned close that 20% figure. Results for similar broad-based index funds (or ETFs) were likely in that same ballpark. No wonder many investors continue to swear by these or similar index funds/ETFs.

My own Model Stock Portfolios, on the other hand, published quarterly in my Newsletter since the start of 2000, are composed of a mixture of index funds and managed funds for even more diversification and flexibility. You might expect such a mixed portfolio would be hard to beat the 20% performance of the high flying indexes over the last 12 months. While it is a bit too early to tally the exact final performance figures through Sept. 30th, it appears that if my Model Portfolio did trail, the degree of performance difference was fairly miniscule. One reason for any underperformance could be that while the cash position of the index portfolio averaged about 1.5%, it averaged about 3.5% for the 16 funds in my mixed Portfolio. Such would account for at least some of the performance difference since money resting in cash would have had a negliable return.

Stated otherwise, when raised during a bull market, a managed fund's cash position likely hurts performance so long as the bull market continues. On the other hand, it can potentially help performance if stock prices start to show no gains or enter a downward trend because it can allow the fund manager to avoid being almost fully exposed to stocks, as index funds are, during that period.

Having been in a extended bull market for so long now, it's not hard to see why the low or even no cash position funds (including managed ones), have had the advantage. But near full exposure to stocks is generally riskier than having at least the choice as to whether to reduce exposure, if and when the time comes. In fact, some prognosticators are now suggesting that when a bear market does hit, index and ETF investors may find themselves experiencing unexpectedly big "paper" losses, possibly pressuring them to sell at much lower prices. Investors in managed funds may face similar pressures, although IF their manager is skillful enough in using the going-to-cash option (which is a big IF), they may be able to better ride out such a storm. Of course, additionally, once a high cash position is established, this gives an active manager the option to add stock back into the fund when prices are considerably lower, potentially aiding subsequent performance.

Fund Performance During 2008

The year 2008 was the last full year the overall stock market showed bear market returns, nearly 10 years ago now. During that year, the funds in the above mentioned three index fund portfolio returned the following:

  • VTSMX -37.0
  • VTMGX -41.3
  • VEIEX -52.8

The overall return for a portfolio allocated using percentages shown above was -39.1%.

On the other hand, the five specific index funds included in my current Model Stock Portfolio (see below) also performed poorly during 2008:

  • VISVX -32.1
  • VFINX -37.0
  • VIGRX -38.3
  • VPACX -34.4
  • VEURX -44.7

Note: My Portfolio also includes VEIEX that is in the 3 index portfolio.

Including VEIEX, the average performance of these 6 funds assuming an equal allocation to all 6 funds, was -39.9. This is close to, but even a little worse, than 3 fund-only portfolio.

Additionally, my current Model Stock Portfolio contains 9 managed funds, all of which existed in 2008. How would they have fared if held in 2008? The average performance of these 9 funds would have been -36.8. Thus, while still suffering severe losses, these managed funds would have done 2.3% better than the 3 index fund portfolio and 3.1% better than my own Portfolio's present index funds. Obviously, while a great many managed funds will fail to outperform index funds in a bear market, it appears that well-chosen ones can have a significant advantage.

But would the 9 managed funds within my own Portfolio, if previously included, have underperformed the 6 index funds over the last 10 years, perhaps as a partial consequence of opting for too high a cash position? Apparently not. The average annualized 10 year return of the 9 managed funds was 6.1 while for the 6 index funds was 4.9. Similarly, the average 10 year return of the 3 fund index portfolio was 3.5% However, since most investors would not have had an equal amount (i.e. 33.3%) in each of these three funds, using the 65, 30, 5% portfolio allocation from above, the 10 year return would improve to 5.5.

You may be surprised how low these 10 year returns are; in spite of the on-going, over 8 year bull market, even today's highly performing funds, and especially index funds, have not performed as well as you might be inclined to believe. In fact, even an investment in typical intermediate corporate bond fund appears to have done about as well the the 3 index stock portfolio.

The reason these returns appear so low is because the 2007-2009 multi-year bear market started in Oct. 2007. Therefore, 10 year returns still reflect the over 50% drop during that period. So, bear markets can be devastating to your returns even many, many years later. That is why any advantage one can potentially have during such a period could be extremely important.

This analysis shows, then, that our current Portfolio's managed funds, if held over the same 10 year period, have shown better returns than either the 3 fund-only index portfolio or our current Portfolio's 6 index funds. This performance advantage over a relatively long period presumably reflects the skill of the manager(s) in spite of typically higher fund management costs passed on to the investor. This could argue for the former's better future performance potential than the indexes, although not conclusively, since past performance doesn't necessarily predict future results. This comes alongside with the former's flexibility to reduce portfolio commitment to stocks if a bear market hits, seeming to offer an additional advantage.

It should be noted too that 7 of these 9 managed funds still have at least one of the same managers who produced the above results. Presence of an outperforming manager helps give further assurance that the fund will likely operate in a similar manner as before.

The following table summarizes these results:

Bear Market Yr. and 10 Yr. Performance of Benchmark
Index Fund Portfolio vs. Current Model Portfolio
Stock Funds

Which Funds? 2008
10 Yr. Return
Portfolio (3 Funds)
-39.1 5.5
Current 9
Managed Funds
-36.8 6.1
Current 6
Index Funds
-39.9 4.9

Note: Returns from Model Portfolio represent the average return of those funds.

Bottom line: Broad index funds can be a great boon to your portfolio, especially during bull markets. But investors should realize that they are not always inherently superior to well-chosen managed funds, especially during periods when stock market returns turn poor.

New Fourth Quarter, 2017 Model Portfolios

Overall Allocations to Stocks, Bonds, and Cash

There are only slight changes to our overall allocations from last Quarter's Portfolio.

It appears that, especially for conservative investors, sticking with bonds may have become a less favorable option. This is because as money market rates go up as a result of highly likely Fed rate increases, it is increasingly likely that many bond funds will have a hard time coming out ahead, on a total return basis, of such cash investments over the next year or two. Of course, if you are investing in bonds just for current income and don't plan to sell your bond funds in the years ahead, then higher Fed interest rates will also result in higher dividend payouts, to your benefit. But most investors are probably seeking the best total return which can suffer due to price drops when rates rise.

While it appears to me, as well as many observers, that stocks may be "ripe for a fall," remember that the allocations shown in the Model Portfolios are not trying to put forth a guess on short-term market movements, down or up. Rather, the percentages shown assume that one will hold on to the stock recommendations for typically at least three to five years. Therefore, even if stocks suffer from a correction or bear market, I assume that, if held for periods of at least this length, you will still likely do well enough to justify the allocation I present.

Recommended For Moderate Risk Investors

Asset Current (Last Qtr.)
Stocks 57% (57%)
Bonds 28 (29)
Cash 15 (14)

Recommended For Aggressive Risk Investors

Asset Current (Last Qtr.)
Stocks 72% (72%)
Bonds 17 (18)
Cash 11 (10)

Recommended For Conservative Risk Investors

Asset Current (Last Qtr.)
Stocks 20% (20%)
Bonds 42 (45)
Cash 38 (35)

Model Stock Portfolio

There are no new stock funds added to the Portfolio, nor any deleted. The are only some small changes to the allocations within the Portfolio for each fund. For the most part, the explanations provided in the June/July Newsletter for my choices remain valid.

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


(vs Last Qtr.)

-Vanguard Small Cap Value Index Fund (VISVX) 8 (8%)

   Small Cap

      8% (8%)

-Vang. International Growth (VWIGX) 11 (10) (A)
   (See Note 1.)
-Vang. Pacific Index (VPACX) 8 (10) (A) (See Note 2.)
-Tweedy Browne Global Val (TBGVX) 6 (8) (C & M)
-Vang. Emerging Markets Idx (VEIEX) 12 (11) (A)
-Vang. Europe Index (VEURX) 8 (6) (M)


     45 (45)

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


    15 (15)

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

    11 (11)

-Vang. Equity Inc (VEIPX) 6 (6) (M)
-Vang. US Value (VUVLX) 4 (4) (A)
-T. Rowe Price Eq. Inc (PRFDX) 5 (5)


    15 (15)

-Vang. Energy (VGENX) 6 (6) (A)


     6 (6)

  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

Here again, there are no big changes from the last Model Bond Portfolio, just minor changes to the allocations.

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


(vs Last Qtr.)

-PIMCO Total Return Instit (PTTRX) 14% (12%), or
-Harbor Bond Fund (HABDX) (See Note 1.)
-Vanguard Total Bond Market ETF (BND) 4 (5)


   18% (17%) 

-DoubleLine Tot Ret Bond I (DBLTX) 5 (5), or
-DoubleLine Tot Ret Bond N (DLTNX) (See Note 2.)
-Dodge & Cox Income (DODIX) 11 (8)    


     16 (13)

-Vang. Intermed.-Tm Tax-Ex (VWITX) 12 (14)
   (See Note 3.)


    12 (14)

-Vang. Sh. Term Inv. Grade (VFSTX) 5 (5)

     5 (5)

-Vang. Inflation Prot. Sec (VIPSX) 4 (6.5)
-PIMCO Real Rate Instl (PRRIX) 8 (8.5), or
-Harbor Real Return Instl (HARRX)
    (See Note 4.)

     12 (15)

-Vang. GNMA (VFIIX) 3 (4)    Interm.

      3 (4)

-Vang. High Yield (VWEHX) 13 (12)

  High Yield

    13 (12)

-PIMCO For. Bd (USD-Hdged) Adm (PFRAX) 16 (17) 
-Vang. Emerging Mkt Bd (VGOVX) 5 (3)


    21 (20)


  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.

Funny, Isn't It?

In last month's Newsletter, I presented data showing that Morningstar's Analyst Ratings don't appear to be particularly useful in helping investors pick the funds with the best future potential, as claimed by Morningstar. Well, guess what has happened since my article appeared?

When I wrote the article, the Analyst Rating for funds were freely visible on their website. Now, the site wants you to become a paid subscriber to have continuing access to the ratings. So one might ask why should one pay for information that has not yet proven to be valid? Yes, life can be funny sometimes.


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