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Fund/ETF Selection in an Uncertain Environment

Many fund investors are looking at the stock market and concerned with just one basic overriding question: What are the prospects for overall stock returns going forward? A second related question that might parallel this is: What are the prospects for growth, corporate profits, and the job market since these can be important indicators of stock prices. Of course, a third much more indirectly related question might be: What are the prospects for bonds, since bonds make up the other large asset category in competition with stocks for investors' money, and whose good performance may at times seem to be associated with poor stock performance.

In this article, however, I will present data on something that far fewer investors may have considered which could also have a major impact on their returns: Are there currently compelling reasons why, looking forward, fund investors should gravitate more to certain categories of stock funds/ETFs as opposed to others? Specifically, I will examine what appear to be the prospects for Large Cap vs. Small Cap funds, and Growth vs. Value funds.

Approaches to Fund Category Selection

The three questions in the first paragraph above are all worthy to focus on, but like most investing issues, cannot yield clear-cut answers. Arguments can be made on both the positive and negative sides of each. Each of us have likely come across some of these arguments, including those already expressed in this Newsletter.

But regardless of where one comes down on the initial basic question, that of the stock market's most likely future path, stock ETF/fund investors will still have to decide which particular categories of investments they want to commit their money to.

Given the lack of certainty, many investors might choose one of the following approaches: a) pick one or more highly inclusive index funds such as a S&P 500 index fund or "total market" index fund; b) divide your stock investments into roughly equal segments, such as one-third in Large Cap, one-third in Growth, and one-third in Small Cap, or perhaps somewhat less in each to allow for an International position; or c) invest in funds with excellent track records, or those that may be recommended by advisors, or other sources, paying little or no attention to fund categories at all.

Uncertainty suggests that one choose a diversified stock fund portfolio so as not to lean too far in any one direction. So, even if you are highly confident about stocks, you should spread your bets broadly across major categories and still keep a small reserve in cash, and perhaps bonds, in case you, or the advisors who look favorably on stocks, are wrong resulting in out-sized losses.

While both approaches a) and b) would appear to result in a fully diversified stock portfolio, it really depends on which specific funds you use to implement them. The S&P 500 is made up of just Large Cap stocks and even a "total market" index is predominantly so. A "total world" index adds International stocks but is still focused on Large Caps. Approach b) might come closer, but should also include some weighting in Value stocks as well as Mid Caps. Approach c) would appear to risk "tuning out" an investor's involvement in selecting diversified category choices at all; in its extreme, it would seem to be an undifferentiated bet on a positive outcome for stocks, plain and simple, or perhaps, on one or more specific fund managers.

If you are well diversified, you likely own at least a handful of categories of stock funds, in particular, the Large Cap, Small and Mid Caps, Growth, Value and International groups mentioned above. But, likely, the majority of fund investors would be reluctant to stray too far afield from a balanced distribution for these major categories. That is, they choose not to deliberately tilt their category allocation any further.

While owning funds spread across at least several different areas helps one to avoid having too much at any given time in a single poorly performing area, yet able to capture at least some of the benefit of a potentially high performing area, the pitfall is that one fails to both optimize the strengths and minimize the weaknesses usually inherent in stock category performance over surprisingly long stretches of time.

Consider again an investment solely in a S&P 500 index fund. This would have led to great results for the entire decade of the 1990s when the Large Cap stocks in the index outperformed most other fund areas. Broad category diversification away from the Large Caps would have not paid off, and would have most likely even detracted from performance. But during the decade of the 2000s, Large Cap stocks trailed the performance of many other fund categories. In the latter ten year period, by investing across categories, one would have participated in the outperformance of these other categories while having less money tied up in a single index which was essentially "going nowhere."

Obviously, most investors consider ten years a very long period. The outperformances above were not mere short-term advantages; in each case, a full ten years went by either favoring or frowning upon the Large Caps vs. other categories. If the advantages were more of a short-term nature, and totally random and independent outcomes from one year to the next, then a steady, equally weighted approach between Large Caps and other categories would likely be perfectly adequate. If true, the odds would favor a category such as Large Cap stocks being a winner one year and just as likely to trail in another, making the balanced strategy effective over most multi-year stretches.

But, in the past at least, there has indeed been a considerable long lastingness to many of these outperformances, perhaps as a result of certain categories becoming extremely over- or under-valued, or that markets and investors tend to become extremely "stuck" on certain overriding themes. An optimum or optimized portfolio would attempt to make use of what history has shown are these rather long-term, even though never permanent, instances of better and worse places to be with your investments.

With that in mind, we now discuss whether it makes sense at this particular juncture to concentrate more, but not all, of your stock investments in either Large Cap funds or Small Cap funds. We will then examine the same question for Growth vs. Value funds.

Large Cap vs. Small Cap Funds

Above, we emphasized the entire two prior decades to demonstrate divergences in performance favoring first Large Caps, as represented by the S&P 500 index, then other categories. The following table summarizes the extent of these differences honing in on Small Caps:

Annualized Returns for S&P 500 Index vs. Average Small Cap Fund
1990-1999   2000-2009
Category Total Return Category Total Return
S&P 500 18.2% S&P 500 -0.1%
Small Cap 13.1% Small Cap 5.8%

As one can readily see, the average yearly performance difference was roughly between 5 and 6 percent per year. This means, for example, for each $50,000 you had invested over a given decade, your yearly ending balance could be as much as $2,500 to 3,000 higher had you invested in the more favorably performing category, with a maximum decade-long potential advantage of $25,000 to $30,000.

While in the 1990-1999 decade, your results would still have been quite good in the lagging category, from 2000-2009, the difference was between making a respectable positive return vs. actually losing money over the decade. Of course, investing all your funds in one category while none in the other would have violated the principle of diversification. Therefore, rather than do this, it likely would have been wise to overweigh the outperforming category but only to a moderate degree. One should remember too that Small Caps are almost always more volatile, and therefore riskier, than Large Caps; too much allocation to this category could subject one to large losses if the outweighing did not work as hoped for.

More on the Large Cap vs. Small Cap Performance Cycle

Focusing on the entire Large Cap category, the average Small Cap fund consistently outperformed Large Caps funds between 2000 and the end of 2010, looking at one-year trailing returns at the end of each elapsed year. The one exception was at the start of 2008 when Large Caps did relatively better over the prior year as the economy entered recession.

Going back to at least the 1970s, Small Cap outperformance cycles have tended to average a little more than 5 years, making the recent streak of nearly uninterrupted strength appear over-extended. And, in fact, over the last 12 months, things have reversed - the average Large Cap fund is now ahead by more than 5%.

Looking at past history for clues of what to expect next, Small Caps have tended to beat Large Caps in the early stages of an economic recovery and ensuing bull market. As a bull market matures and, eventually, a recession begins, Large Caps tend to take over.

Since Small Caps have excelled for far longer than is typical, and we will soon enter into the fourth year of economic expansion which officially began in June 2009, conditions would seem right for now indeed being the start of the cycle favoring Large Caps. Such Large Cap cycles have tended to last even longer than the average Small Cap cycle, averaging a little more than 6 years.

Given these facts, we feel it makes good sense to overweight Large Caps in your stock portfolio along the lines of my April Model Portfolio. Some recommended funds with which to use this strategy could be the Vanguard 500 Index Fund (VFINX), SPDR S&P 500 ETF (SPY), or even Vanguard Mega Cap 300 ETF (MGC) to focus on the largest-capitalization stocks in the U.S.

Growth vs. Value Funds

Growth funds have been outperforming Value funds since the beginning of 2007, with the exception of 2008 during the worst of the last recession, or for 4 out of the last 5 years.

Interestingly, Growth vs. Value outperformance cycles, like Large vs. Small cycles, have also tended to last roughly a half dozen years since the early '80s with Value cycles somewhat more long lasting than Growth. Therefore, it might be premature to assume that the current predominance of Growth is likely quite close to yielding its lead back to Value. The average Large Growth fund (unlike the Mid-Cap Growth or Small-Cap Growth fund) is still a category with modest year-over-year momentum, having outperformed Large Value over the last 12 months by roughly 5%.

While we currently view the Value category as more likely to outperform Growth on a longer-term multi-year basis, our past research suggests that early calls based solely on under-valuation may not always be wise. Therefore, we would continue to wait for a clear sign of a shifting of fortunes, putting Value back ahead of Growth, before over-weighting these funds. (So far in 2012, Large Growth funds are averaging about 16% year-to-date vs. about 11% for Large Value.) Rather, a small overweighting of Growth would seem to be the most prudent action at this time.

There are many index funds available to achieve this weighting, avoiding the potential for "style drift" away from the strategy which could happen with an actively managed fund. Such funds might include the Vanguard Growth Index (VIGRX), Vanguard Growth ETF (VUG), or the Vanguard Mega Cap 300 Growth ETF (MGK). When the time comes to overweight Value, investors might shift to such a focus through the Vanguard Value Index (VIVAX), Vanguard Value ETF (VTV), or the Vanguard Mega Cap 300 Value ETF (MGV).

Final Considerations

While nobody knows how long a multi-year trend in an asset category will continue as there are always many uncertainties in investing, it is hard to deny that such extended periods of outperformance for the above categories exist, or to explain away the phenomena based on chance alone. This is one reason why it doesn't always pay to be completely balanced between different stock fund/ETF categories as true diversification might suggest.

One should keep in mind that all outperformances discussed within this article are strictly relative outperformances. This means that even though an asset category can do better than another, this does not imply that the favored category's performance will necessarily be as good as desired by an investor, or even positive at all. Thus, during 2000-2010, while Small Caps almost always outperformed Large Caps, there were several stretches when the returns were still quite negative such as during much of the period's two bear markets.

If research in investing has any value at all, it should be to suggest (but never guarantee) that noteworthy trends seen in the past are more likely than mere 50/50 to offer guidance as to what might be likely to happen again in the future. Therefore, I feel any investor who values research should consider carefully the above data when selecting and/or modifying their investment lineup.


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