Core equity funds (Class 3 for newsletter subscribers)

After several months of relentless declines, the euro finally rallied against the US dollar, bringing a couple of European-focused funds up the ranks. Recent rising stars also include dividend and value strategies, and a mix of mid-cap and large-cap funds and ETFs. In our newsletter’s model equity portfolio, most of our existing positions are still ranked as buys or holds, so this month we are only selling one core domestic value fund and investing the proceeds in foreign value funds.

Speculative equity funds (Class 1 and 2  for newsletter subscribers)

There were many trades among our speculative fund holdings this month. The domestic trend reversed last month, as foreign funds outpaced their U.S. counterparts, and we added positions in highly ranked emerging markets funds and ETFs. We favor funds and ETFs that invest in multiple countries, rather than single country funds.  Among sector funds, gold fell sharply in July and was replaced by higher ranked real estate.

This month, we are selling gold and some small cap funds and ETFs, and adding substantially to emerging markets. We are also adding to mid-cap growth, and some REITs.

We continue to benefit from a diverse portfolio of fixed income funds and ETFs including exposure to short and intermediate term bond funds, mostly consisting of  high quality corporate bonds, as well as some exposure to high yield corporate bond funds. Last month, we increased exposure to strategic, or multi-sector bond funds, whose managers have the flexibility to adjust to a dynamic environment.  Strong performance from these “go-anywhere” managers has driven them up in our scoring system. This added to our performance in an environment that was otherwise flat for the benchmark aggregate bond index.

We have moderately increased our portfolio duration since our last report, selling some shorter-term funds and increasing our current yield.  We have also added to US dollar-hedged foreign bond fund.

As the market entered 2010, our models indicated that stocks were generally over-valued and investor sentiment was too complacent (see past comments for details). The rally was still intact, but was showing signs of moderation after an incredible run off the March 2009 lows.

The market hit its first speed-bump between mid-January and early February, with the S&P 500 index correcting by about 8% before rallying to new highs in April. By late April, our measures of sentiment and valuation were again very stretched. The next correction was stronger and deeper, as the S&P 500 index lost 17% from peak to trough, and many foreign and small company stock indexes dipped into bear market territory (decline of 20% or more). Then, just as investors began throwing in the towel, citing a dow theory sell signal of “death crosses” (when the 50-day moving average crosses below the 200-day moving averages) and renewed fear of a double dip recession, the market bounced in July, pulling back up to flat for this year-to-date.

The year has been quite a roller coaster ride. Our tactical portfolios were much less volatile and boast modest gains.

Investor confidence was badly damaged by this sharp correction.  Our measures swung sharply, from excessive complacency to excessive pessimism. In our tactical portfolios, we hold considerable cash, and, until the market breaks out to new highs, we are maintaining a partial hedge.

Many investors focus on long term performance records when selecting mutual funds. I believe investors are better off choosing funds by near-term performance because the funds that have done well over the near-term tend to do well in ensuing months, a phenomenon called ‘persistence of performance’.

Our research shows that the longer term the performance period was, the less predictive it was. According to our most recent study: even including 2008’s brutal declines, our combination of using an average of a fund’s trailing 1, 3, 6, and 12-month returns still led to higher returns than selecting funds by their 3 or 5 year records.

(Click on the chart to see it in a larger format.)

For this 10+ year time period ending 8/31/2009, a portfolio that invested based on a fund’s 1, 3, 6, and 12-month returns produced 8.06% annualized, while investing in the funds with the top 3-year returns only gained an annual 2.23%. Using trailing 5-year records to select funds returned just 1.34% annualized. All of these Upgraded portfolios beat the market, however: the S&P 500 had an annualized return of negative 0.2% for this time period.

The chart only looks at the last 10+ years, but it reflects what we’ve experienced over the past 40 years and what academic research has confirmed: near term mutual fund performance is predictive.

But while near term performance can tell us where to invest now, it can’t predict how long the current trend will last and it doesn’t forecast future market changes. Following near term performance over time leads to better performance, but it doesn’t always outperform. No system can promise that.

You’ll learn:

What we’re buying and selling and how portfolios are being re-positioned.

• Core Equity Funds (Class 3 for newsletter subscribers)
• Speculative Equity Funds (Classes 1 and 2 for newsletter subscribers)
• Flexible Income
• Tactical portfolios

Guidelines for allocating among core and speculative equity funds.
Learn how we at DAL create portfolios, including:

• Growth portfolios
• Conservative Growth portfolios
• Aggressive Growth portfolios
• Tactical Allocation

Core equity funds (Class 3 for newsletter subscribers)

2010 has been a volatile year so far, but market leadership trends have been clear and consistent. We have been rapidly reducing exposure to foreign funds all year, and as of this month, our core holdings are 100% domestic. Most of our core positions remain highly ranked, and as we upgrade the few laggards, we continue to add to diversified mid-cap and mid-cap value funds and ETFs.

We want to emphasize that we have no forecast for currencies or the international versus domestic economy. Our portfolios benefited from holding significant foreign fund positions over the past years, but we have also benefited from selling foreign funds that have fallen in our rankings. Just as leadership changed from growth in the late 1990s to value in the first part of the 21^st century, followed by an extended period of leadership from foreign funds, our greatest conviction is that fund leadership will continue to change over time. For now, our highest ranked core funds are primarily mid-cap and value funds.

Summary: leadership among core equity funds remains focused on domestic mid-cap and especially mid-cap value funds and ETFs.

Speculative equity funds (Class 1 and 2  for newsletter subscribers)

We had very little turnover among speculative funds this month. Our ETF-only portfolios were prompted to reduce exposure to equities in favor of a modest position in an ETF that invests in physical gold. Otherwise, our speculative holdings remain mostly small cap funds and ETFs and some mid-cap growth funds and ETFs. Even among speculative funds, our holdings are now 100% domestic.

Summary: Our speculative holdings are 100% domestic, emphasizing smaller companies. Our ETF-only portfolios are slightly different this month because those portfolios hold a small position in a physical gold ETF.

We have enjoyed relatively low turnover in our Flexible Income portfolios lately, but this month we are selling floating rate bonds and our low volatility Class 4 positions in favor of more traditional bond funds. We had lightened up on high yield bond funds after last year’s terrific run, and we are slightly increasing exposure now to capitalize on the recent pullback. We purchased an ETF so we can remain flexible. We are also adding to more traditional intermediate term bond funds.

Our Flexible Income portfolios remain broadly diversified including very conservative short-term treasury funds and ETFs and limited exposure to more aggressive high-yield bond funds and ETFs. Our only foreign bond fund exposure is with a fund that hedges currency exposure back to the US dollar.

We recognize that bond yields are low and will start to rise at some point. The question is when and from what level? Presently, investors appear more concerned about risk than inflation. We remain flexible and our methods objective so that we can adapt as leadership changes. As with equities, the key to long-term success in fixed income is being alert to and aligned with what is working, even if what’s working feels out of sync with what we might forecast or expect. Meaningful trend changes last long enough to give us the luxury of waiting until evidence of the change emerges in our observations.

Summary: Our Flexible Income portfolios are broadly diversified. We modestly increased our position in high-yield bond funds and ETFs to capitalize on recent weakness and also added to intermediate term bond funds. Our portfolio duration remains shorter than the benchmark total bond index.