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Model Portfolios: What to Overweight, What to Minimize

No matter what happens over the next year, or even decade, stocks continue to be the place to be for very long-term investors. However, this glosses over the question as to where investors may want to keep their money over less lengthy periods. If you think of yourself as this very long-term investor, you may not be particularly concerned if stocks don't do well from time to time. So long as you are able to keep focused on the long term, these temporary setbacks should not matter. But pullbacks can last far longer and drop far deeper than many investors may be prepared for, testing even the long-term investor's resolve.

So here are some questions to consider as we approach possibly changing market conditions. No one should delude themselves into thinking that this, or any bull market, will last forever.

Can stocks continue to do well once interest rates begin rising? And can investors be sufficiently confident of achieving good enough positive returns going forward to offset the risk of possible negative returns as stocks gravitate back toward more typical variable yearly patterns, sometimes up and sometimes down, as they seem certain to do at some point?

Since highly reliable answers to these questions are basically unknowable, it makes sense not to over rely on returns from one asset class but to invest across at least several classes. One thing we do know with a rather high degree of assuredness: Returns on cash (i.e. money markets, CDs) will continue to be paltry, not far from zero, for at least the next year and possibly for as much as a few years. Therefore, questions over the next year or two become: a) Which asset class, stocks or bonds, or both, will achieve cash-beating, positive returns justifying your investment?, and b) Which of the two will come out ahead of the other? And, of course, even considering these choices, having a relatively high cash allocation can be viewed as providing the advantage of allowing one to invest more aggressively in an asset class at the point there is a significant correction in either which are both highly priced right now.

That said, I realize most investors likely will not choose to change their allocation percentages regularly as my updated quarterly Model Portfolios suggest. Why not? Perhaps too little time available, or merely the belief that fine tuning a portfolio (or even changing it at all) cannot be successfully navigated by most investors. After all, as suggested above, can anyone say with assurance that one asset category will do better in the future than another? Well, maybe not. But certainly, as a matter of the odds, I feel that investors thinking ahead several years may understand why it may make sense to tend to accumulate stocks and bonds when prices are more attractively low and to sell off some when prices are uncomfortably high.

This is a personal choice involving how much you want to tinker with your portfolio. However, for those who do have the inclination and time to do so, we think that such a strategy is certainly better than another alternative - making unplanned sales from your portfolio, especially during times that the markets are declining, or adding to a portfolio after the market has already been surging for years on end.


Overall Allocations to Stocks, Bonds, and Cash

There are virtually no changes to overall asset category allocations to recommend this quarter as compared to July except for self-classified Conservative Investors. Because of the high levels of both stocks and bonds, I now recommend a slight reduction in both stock and bond investments for such investors, who by definition, are less comfortable as the risk level rises, which it certainly has. The risk level is higher for stocks because the longer a bull market continues and high annual returns continue, the greater likelihood of a correction, or even a bear market. The risk level is now higher for bonds due to impending Fed rate increases and the fact that dividends, the biggest determinant of bond returns, are exceptionally low.

For Moderate Risk Investors

Asset Current (Last Qtr.)
Stocks 50% (50%)
Bonds 25 (25)
Cash 25 (25)

For Aggressive Risk Investors

Asset Current (Last Qtr.)
Stocks 67.5% (67.5%)
Bonds 10 (10)
Cash 22.5 (22.5)

For Conservative Investors

Asset Current (Last Qtr.)
Stocks 20% (22.5%)
Bonds 35 (37.5)
Cash 45 (40)


Allocations to Specific Funds

The tables below show our current recommendations as to where and how much to put percentage wise into a stock and bond portfolio.

Following each table is a more detailed discussion of each of the funds as well as why we may have recommended either a large or smaller allocation than last quarter's portfolio.

You will notice that our list of funds has grown since last quarter. Of course, not everyone may have the funds recommended available to them as choices, such as in a 401(k) with a limited number of offerings. In that case, we recommend selecting a fund of the same category as shown that is available to you.

It should also be pointed out that you, in almost all instances, should not consider owning all these funds. You will need to make some choices among the many recommended funds based on your own preferences and other factors.


Model Stock Fund Portfolio

Our Specific Fund Recommendations Fund Category Recommended
Category Weighting
Now (vs Last Qtr.)
-Fidelity Low Priced Stock (FLPSX) Mid-Cap/ Small Cap 10.0% (12.5%)
-Tweedy, Browne Global Value (TBGVX) (C & M)
-Vanguard Europe (VEURX) (M)
-Vanguard International Growth (VWIGX) (A)
-Vanguard Emerging Markets Index (VEIEX) (A) (new)
-Dodge & Cox International Stock (DODFX) (A)
(See Notes 1 and 2.)
International 30.0 (30.0)
-Vanguard 500 Index (VFINX)
-Fidelity Large Cap Stock (FLCSX)
Large Blend 17.5 (20.0)
-Vanguard Growth Index (VIGRX)
-Fidelity Contra (FCNTX)
Large Growth 10.0 (10.0)
-T Rowe Price Value (TRVLX) (M) (new)
-Vanguard Windsor II (VWNFX) (M) (new)
-Vanguard US Value (VUVLX) (A)
Large Value 22.5 (20.0)
-Vanguard Energy ETF (VDE) (M), or
-Vanguard Energy (VGENX) (M) (new)
-Vanguard Utilities ETF (VPU) (M) (new)
-Vanguard Precious Metals and Mining Inv
(VGPMX) (A)
Sector 10 (7.5)

Notes:

  1. Stock or bond funds with (C) are particularly recommended for Conservative investors; likewise, (M) for Moderate; (A) for Aggressive.
  2. ETFs (exchange traded funds) of the same category can be substituted for any index mutual fund in this table; e.g. Vanguard FTSE Europe ETF (VGK) can be substituted for VEURX.

All data cited in the fund discussions below are believed to be accurate as of Sept. 22.

Fidelity Low Priced Stock (FLPSX). We are recommending a slightly reduced exposure to this fund and the Mid-Cap/Small Cap category in general. The category remains as most overvalued as compared to funds that invest mainly in Large Cap stocks. In fact, over the last year Large Caps have significantly outperformed Small Caps by approximately 7% and I expect that outperformance to continue.

FLPSX currently emphasizes Mid-Caps but with a significant amount invested in Small Caps. Mid-Caps have done somewhat better than Small Caps over the last year. The fund currently has a small bias toward Value stocks which have generally been doing better than Growth stocks, also over the last year. On the negative side, I don't like the fact that the fund is currently investing significant amounts in stocks that could easily be more typically found in a Growth fund, including, for example, in the Technology area.

Tweedy, Browne Global Value (TBGVX) continues to currently be my favorite broad-based international fund. The fund currently has a small Value emphasis which separates it from our other international choices. Further, it is likely to continue to enjoy a performance advantage because of not being negatively impacted by a strengthening US dollar as our other choices are. (See the discussion of PFRAX in our Model Bond Portfolio below). The fund has a high cash position which means they are conservative right now, although still doing well this year.

Vanguard Europe (VEURX). The primary advantage of European stocks now is that they are not undervalued as virtually all primary categories of US stocks are. Further, while the major economies of Europe except Britain are experiencing little or no growth, this is typically a better time to invest assuming an eventual recovery than when stocks may be nearer to the end of a favorable growth cycle leading to higher interest rates as in the US. In fact, the European Central Bank, equivalent to our Fed, is apparently ready to ease more than ever before. Such easing has been thought largely responsible for the huge run up in US stocks.

VEURX is a very low cost way to participate in the eventual recovery in Europe. While year to date, it has not done well, approximately 6% of its return abroad has been lost due to European currencies losing value when converted back to dollars. (This is one reason why TBGVX, above, which also invests heavily in Europe but "neutralizes" the role of currency, has done considerably better.)

Vanguard International Growth (VWIGX) is a considerably risky fund investing in broad cross-section of international stocks. Why is it risky? It currently has a 18% position in emerging market stocks. In fact, over the last 10 years, its returns have correlated extremely highly with those of our next fund which invests solely in emerging markets. At last report, its three biggest investments are all in China, accounting for over 8% of the fund's assets; each sports an extremely high PE (Price/Earnings) meaning they could easily topple if sentiment for them fades. These ratios make that of US's darling growth stock Apple look almost miniscule by comparison. But VWIGX is still a good option for long-term investors who want to fully participate in non-US opportunities around the globe.

Vanguard Emerging Markets Index (VEIEX). We are adding a new recommendation to emerging markets because this category represents the one that appears the most undervalued among all our fund recommendations. In fact, based on price alone, it still hasn't gotten back to where it was in late 2007. But be careful when combining an investment in this fund with some other international funds which may already give you a dose of emerging markets such as VWIGX, or our following recommended fund (DODFX). Remember too that in the worst of the 2008 bear market, emerging markets took a far bigger hit than the already huge hit experienced by US stocks.

Dodge & Cox International Stock (DODFX) has had a great track record since its inception in 2001 and has continued that record over the last year placing in the top 1 percent of its competition. In fact, it has a much better track record than our other international recommendations. Its management team has remained in place since its inception with the addition of some more recent personnel.

So what might be some reasons not to invest in DODFX? The fund has a low cash position and a low turnover, all good during bull markets but not so good if the tide turns. The fund did poorly against its competition during the poor bear market year of 2008.

Vanguard 500 Index (VFINX). While the fund and its category, Large Blend, remain a solid choice, we are recommending a slight drop in allocation to it. While the fund has performed near the top as compared to well-diversified alternatives over the last 5 years, it has not always done so in the past and can not be expected to continually do so in the future.

One of our biggest concerns is that many of its subcomponents reflect the already high prices within the market. The biggest such component, Technology, is currently at 18% of the fund. If the economy continues to expand beyond its current level over at least the next year or two, no problem. But if the economy stays mired in mediocre growth or starts to slow, this type of growth-oriented position, along with several others, will detract. Incidentally, the fund's largest single holding is Apple. How did Apple do during the bear market year 2008? It was down about 57%. Similarly, Technology can be expected to underperform, if and when the economy enters a new, less growth favorable cycle.

Fidelity Large Cap Stock (FLCSX). This fund also has an excellent track record, comparable or better than the S&P 500 Index. It too has a sizeable position in Technology stocks. But its manager has chosen to overweight a relatively less pricey segment of the stock market, namely Financials. Due to this fund's overall balance, except for Technology stocks, we do not consider it riskier than VFINX at this time.

Vanguard Growth Index (VIGRX). Although we like this fund and it has done very well both this year and long term, we continue to recommend a somewhat minimal allocation to the Large Cap Growth category. As is the case for the two Large Blend funds above, overvaluation of the very large Technology component (currently 24% of the fund) remains a concern. In this case, a staggering 7% of the fund is invested in Apple stock with another 4% in Google shares. A large percentage (17%) is also invested in companies producing Consumer Discretionary products/services, stocks that have been shown to do best early an economic expansion. But five years after the 2007-2009 recession has ended, we are more likely closer to the end of the expansion than the beginning.

Fidelity Contra (FCNTX). Similar to VIGRX above although it may be slightly better positioned if the overall market starts to underperform; it also has somewhat similar characteristics to FLCSX above.

T Rowe Price Value (TRVLX). We are increasing our allocation to the Large Value category because we see somewhat less overvaluation in this category than in either Small/Mid-Caps or Large Growth. (However, note that except for International funds and some categories of Sector funds, all categories remain overvalued in my opinion.)
TRVLX has had an outstanding track record compared to its Large Value brethren and is not stuffed with overvalued sectors. Its largest position is in the still fairly valued Financial sector and is quite low in Technology stocks. An overweight position in Utilities (see below) may also prove to be helpful although a large position in Health Care stocks (19%) is a concern.

Vanguard Windsor II (VWNFX). A former favorite, we are again recommending this fund. Similar, although not quite as impressive as TRVLX.

Vanguard US Value (VUVLX). We are reclassifying this fund as mainly for Aggressive investors. The reason: Over 35% of the fund is invested in Mid and Small Cap stocks which may help explain its recent excellent past performance. But such stocks are among the most overvalued and are already underperforming Large Cap stocks over the last year. The immediately prior two Value funds do not stretch as far into these smaller stocks.

Vanguard Energy (VGENX) or Vanguard Energy ETF (VDE). All of our Sector fund choices represent good choices if one wants to avoid the overvaluation problem in the remaining fund categories (except as noted in International funds). These two funds invest in different portfolios, unlike some Vanguard ETFs with the same name as corresponding mutual funds. The ETF has been outperforming VGENX, a managed fund, by significant amounts since 2010. One major difference: The ETF is almost entirely invested in US companies; VGENX has about 37% invested abroad. Since US stocks have outperformed international ones during these years, this may well account for the difference although international stocks are likely better positioned looking forward.

Vanguard Utilities ETF (VPU). The Utilities category is a good "defensive" choice for investors thinking we may be in the late innings of the current bull market and/or are interested in receiving high dividends that are taxed less than bond income dividends. (The advantage comes for non-retirement investors since its dividends, currently 3.41%, are usually taxed at 15% at the Federal level instead of at your higher income tax bracket.) Utilities tend to perform well late in the economic cycle and can hold up somewhat better during a recession. Our research indicates that the category is currently a strong Hold.

VPU has been good a performer over the last 5 years, with a ways to go before becoming overvalued.

Vanguard Precious Metals and Mining Inv (VGPMX) is within the truly undervalued category of Equity Precious Metals. Our research model indicates that the category should be considered a Buy. But realize that this fund is not for the faint of heart - it has lost investors a considerable amount of money over the last 5 years. Starting last Dec., however, it seemed to be reversing course only to drop over 10% in the last 30 days. It invests in a very narrow corner of the market and it is subject to a high degree of volatility. Therefore, only "super" Aggressive Investors might consider this fund.

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) (1K min.) or
-PIMCO Total Return ETF (BOND)
Diversified 30.0% (30.0%)
-PIMCO Real Return (PRRIX)
(High minimum investm. outside 401k), or
-Harbor Real Return (HARRX) (1K min.)
Inflation
-Protected
5.0 (5.0)
-Vanguard Intermed. Term Tax-Ex.
(VWITX) (see Note 1)
Intermed.
Term
Muni.
15.0 (15.0)
-Vanguard Sh. Term Inv. Grade
(VFSTX)
Short-Term Corp. 5.0 (2.5)
-Loomis Sayles Retail
(LSBRX) (A)
Multisector 12.5 (15.0)
-Vanguard High Yield (VWEHX) (new)
(See Note 2)
High Yield 15.0 (15.0)
-PIMCO Foreign Bond (USD-Hedged)
Adm (PFRAX)
International 17.5 (17.5)

Notes:

  1. Select a fund, if available, that has your own state's bonds for double-tax exemption, such as, for example, the California Intermediate-Term Tax-Exempt Fund (VCAIX) if you live in California.
  2. Recent Model Portfolios recommended several other High Yield funds, although we continued to prefer VWEHX. For a time, however, VWEHX was closed to new investors; we try not to recommend closed funds, necessitating our move away from the fund. The fund is now open so we can again recommend it.

PIMCO Total Return Instit (PTTRX). Granted the fund has had a somewhat disappointing performance so far this year, the question remains as to whether the fund has lost some of its appeal. The fund has its short-term ups and downs but remains as one of the best places to be, especially if you can invest in it rather than its mirror fund, Harbor Bond Fund (HABDX), which typically has a lower minimum to open but has a higher expense and therefore almost always a somewhat lower total return. (Note: Vanguard Brokerage offers PTTRX for a 25K minimum to open, while HABDX can be opened with 1K.)

Another, and perhaps, better option: Invest in PIMCO Total Return ETF (BOND). This is an actively managed ETF whose portfolio is not identical to that in PTTRX. It has outperformed PTTRX since its inception in 2012.

PIMCO Real Return (PRRIX). We remain only slightly positive on the inflated-protected category since the majority of holdings are US government bonds that can suffer along with non-inflation-protected government bonds when interest rates rise. While inflation may be somewhat on the upswing, it highly likely won't be gaining enough to warrant a big position. That said, PRRIX has been one of the best performers in its category and offers some diversification to a portfolio. (Note: Invest in Harbor Real Return (HARRX) to avoid the 25K minimum.)

Vanguard Intermed. Term Tax-Ex. (VWITX). Municipal bonds remain as one of our favorite bond categories right now. VWITX provides a current dividend of about 1.65%, which not while not seemingly very high, has a tax equivalent yield of about 2.25% if one is in the 28% Federal bracket. This compares favorably to investing a fully tax taxable bond fund, such as in an intermediate treasuries fund, which might have a yield similar to VWITX (or even less) but with no tax advantage. Of course, if you can find a fund that invests exclusively in your own state's bonds, you will typically get both a Federal and a state tax-exemption. (Note: Muni funds are only for investors' taxable accounts, not retirement accounts; if you are constructing a portfolio within a retirement account, skip munis and divide the 15% allocation proportionally into the remaining bond categories.)

Vanguard Sh. Term Inv. Grade (VFSTX). We are raising our allocation slightly to this fund. No bond funds can be expected to perform particularly well once interest rates start rising. Some economists think that long-term bonds may be safer than short-term ones as the Fed starts to raise interest rates, presumably by mid-2015. However, my reading of bond performance suggests that you will have a better chance of staying above water in a short-term corporate fund such as VFSTX than in a longer-term bond fund, and you will do better than if you are in a US government (i.e. treasury) bond fund.

Loomis Sayles Retail (LSBRX). This is a great fund for long-term investors willing to experience significant performance degradation in the event of a stock market correction. The fund has actually had a high correlation with the S&P 500 Index over the last 5 years, meaning it did well, or not so well, depending on how stocks were doing. This is opposite to the way the overall bond market performed - it tended to do moderately well when stock prices were falling. Therefore, one might say that if you are looking for diversification away from stocks, this fund may not be the best choice for you. In recognition of this, we consider it a fund mainly for Aggressive Investors and are lowering our recommended allocation to it slightly.

PIMCO Foreign Bond (USD-Hedged) Adm (PFRAX). International bond funds remain one of our top choices. While interest rates abroad are generally even lower than in the US, they will likely not be rising, except maybe for Britain, for at least several years. This makes the category less likely to suffer when US rates start going up. "US Dollar Hedging" is helpful in the current environment where the US currency is strengthening. Most other international bond funds, as well as international stock funds, do not hedge. Notable exceptions are TBGVX (in our Stock Portfolio above) and the Vanguard Total International Bond Index (VTIBX).

There tends to be a huge difference between how international bond funds perform, and therefore, it is important to choose carefully. PFRAX has an outstanding track record while international bond funds from other mainstream fund companies such as T. Rowe Price (RPIBX) and American Century (BEGBX) have done quite poorly. Year to date, PFRAX is up 7.2% while RPIBX 1.3% and BEGBX only 0.3%. PFRAX's long-term returns are also way ahead of the typical bond benchmark (AGG). While it may appear that PFRAX has a 1 million dollar minimum investment, Vanguard Brokerage offers it for just $5,000.

 

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