Mutual Funds Research Newsletter 1st Qtr 2006. Copyright 2006 Tom Madell, PhD Updated 2-11-06 Dear Subscribers: While the major stock indices performed in a subpar manner in 2005, it has been another pretty good year for the categories of funds my newsletters have been recommending. In fact, had one followed the allocations to stock categories I recommended at the start of '05, they would have posted an 8.54% return, handily beating the 4.9% return of the S&P 500. Additional d ata on how our Model Portfolios performed will be posted at my web site within a few days. For those of you who were subscribers a year ago, you may recall I stated at the end of 2004 that I felt stock funds would show tepid returns in the 3-6% range for 2005. We further ventured that the typical bond fund would return only about 0-2% while returns on good money market funds might reach about 3-4%. All these estimates wound up being absolutely identical to the actual 2005 results. The average taxable bond fund returned 1.9% while my recommended Vanguard Prime Money Market fund returned 3.01% with a current yield, at the close of 2005, of 4.08%. To do better than these low to middle single digit returns, therefore, you had to have at least a smattering of funds in categories that wound up widely outperforming the overall averages. In our case, we accomplished this mainly by our 25 to 30% allocation to foreign funds whose average performance was approximately triple that of the S&P 500. We also did incrementally better with our small emphasis back to the growth and mid-cap areas, in our larger than usual cash position relative to bonds, and in our overweighting of long-term bonds vs all other bond categories. New Forecasts We don't really focus on making predictions as to the future level of the markets: They're usually far too unpredictable (in spite of our last year's nearly perfect foresight.) But, unless you are a totally buy and hold investor, it does help to have a framework for the upcoming months and year. In spite of the hazards of putting forth such predictions, my best guess is that, for stocks, we may be in for more of the same subpar results. In fact, stock funds may possibly do even worse in 2006 than in 2005. (This appears to be at odds with what most forecasters seem to be predicting of high single digit stock retur n s. ) Why? Let's just say that especially when looking out over several years, I think the average stock fund investor will not likely be getting the average 10% return he may have come to expect. Unfortunately, though, that is too long a period to wait to see if I am right. But I will be quick to change my forecasts if new data warrant, which is why I think it still pays to revisit these kinds of forecasts every quarter, not just once a year. While the economy is doing well as of this moment, there are enough risks on the horizon that things could easily deteriorate. And most categories of stocks appear ripe for a pullback. Just check the 3 yr. category average returns for stock funds on the following web page, which is always one of my favorites, when trying to get a glimpse of possible over-valuation from a contrarian perspective: http://news.morningstar.com/fundReturns/CategoryReturns.html?fsection=ListCatPerformance Since the typical stock fund tends to average a return of about 10% yearly, whenever returns are significantly greater over a prolonged period, it increases the odds that they will need to correct back to a lower level in the future. With most U.S. stock fund categories showing around 20% increases for the 3 yrs. ending 12-31-05, and foreign funds 25% or more per yr., it would be risky to assume that such good long-term performance can continue. Therefore, it wouldn't be unreasonable to expect 0% or even negative yearly performance some time in the near future. But of all the stock categories, the large caps, especially growth, are the least overvalued. This is confirmed by their 5 yr. performance records which show at best a 0% return. This could mean either more of the same bad performance, or from our perspective, the likelihood of growing back to the long-term 10% per year norm. And the tide seems to be turning m ore to ward the latter than the former, especially more recently. As for bonds, we also expect more of the same middling performance, at least for a while. Short-term bonds can't really do well as long as the Fed keeps raising interest rates. But, quality long-term bonds, which normally also fare poorly when the Fed is raising rates, have continued to do reasonably well (eg. my currently recommended Vanguard Long-Term Investment Grade fund returned over 5%, and my previously recommended Vanguard Long-Term Treasury fund was up over 6.6% for 2005). Obviously, this does not apply to high yield junk bonds which averaged returns of only 2.4% in 2005). But we agree with many analysts that when the Fed stops raising rates, likely within the next 6 mos., the bond market could rally. If so, long-term bonds again should be the main beneficiaries. Incidentally, if other bond investors are thinking along these same lines, you can understand why some short-term rates have risen above long-term rates, producing a much discussed "yield inversion." If long-term bonds seem considerably more attractive as a result of the potential to make larger capital gains since they will get larger upward price movement than short-term ones, investors will continue to prefer them, while ignoring short-term bonds. This can occur even if current yields on the longer term securities are equal or less than those on short-term bonds. Given our overview, here are our specific recommendations. Follow these if, in our opinion, you wish to do better than the average investor who does not typically alter his portfolio from one year to the next. Even if you diversify only once every five years, we think you will do better than the typical investor, with less risk in your portfolio. Twenty of 21 of our quarterly stock Model Portfolio strategies going back to Jan 2000 have subsequently beaten the major indices year after year, even 5 yrs. after our recommended allocations were originally published. Allocations Stocks 52.5% Bonds 30 Cash-Like Funds 17.5 The above allocations are for moderate risk investors. The recommendations for investors willing to assume higher risk are 60, 20, 20, while 35, 40, 25 for more conservative investors. Stock Fund Portfolio Category (Our recommended fund ) Percent of Stock Portfolio Large Blend + (Vanguard Growth & Inc) +++++++++ 25% Large Growth ++ (Fidelity Contra) +++++++++++++ 15 Large Value/Equity Inc ++ (ICAP Equity) ++++++++ 10 Mid Cap Blend ++ (Hussman Strategic Growth) ++++ 15 Small Growth ++(Vanguard Explorer) +++++++++++ 5 Foreign ++ (Vanguard International Growth) ++++++ 22.5 Foreign Asia/Japan ++ (Vanguard Pacific Idx) ++++++ 7.5 Note 1: Effective Feb. 2006, Vanguard Explorer Fund has closed to new investors. In its place, we now suggest Vanguard Small Cap Growth Index. Note 2: Many individual investors do not have as many stock fund categories in their portfolio as we recommend. Obviously, you will need to have sufficient resources available to spread your funds out this way. But this is how virtually all of the best performing, large, institutional investors do it. So if you want to try to emulate their results, you probably should do this too. (Another option might be to select a smaller number of funds that approximate these allocations. For example, our above recommended Fidelity Contra fund already has over 20% of its assets in foreign investments. You can get an estimate of your portfolio's category breakdown by going to the following Morningstar.com link http://www.morningstar.com/Cover/Funds.html?pgid=hetabfunds and clicking on Instant X-Ray on the upper left.) And, if you are willing to more closely monitor your portfolio, you may want to include a few other categories too . For example, as my previous newsletters down thru the years have recommended, had you owned some real estate, energy, emerging market, or small cap value funds, you would have done particularly well during the last few years. Since the first 3 of these of these categories, especially, can be so prone to volatility, you will want to be particularly vigilant if you do own them. They could easily change direction, more so than more diversified categories, leaving you with a more poorly performing portfolio rather than a better one. Bond Fund Portfolio The same reasoning suggesting owning multiple categories applies to your bond funds. Here are our current recommendations: Category (Our recommended fund ) Percent of Bond Portfolio Long Term ++ (Vanguard Long Term Inv Grade) +++++++++ 20% Long Term Treasuries (Vanguard Long Term Treasury) ++++ 15 Short Term ++(PIMCO Total Return or Harbor Bond Fund) + 10 Lg T e rm Municipal Bd ++ (Vanguard LT Tax Ex) ++++++++ +15 Inflation-Protected ++ (Vanguard Inflation Protected Securities) 15 High Yield ++(Vanguard High Yield) +++++++++++++++++ 12.5 International ++ (American Century International Bond) +++++ 12.5 Notes: We recommend you invest in a muni fund if you are in at least the 25% combined Fed/State tax bracket. Select a state-specific muni fund if available. Otherwise, in its place choose a GNMA fund such as Vanguard's GNMA. If you are investing in a fund that contains mainly US treasurys, best to keep that investment in your taxable, not tax-deferred account. This may allow you to take advantage of the tax deduction for such funds usually available if you pay state income taxes. I hope you find our recommendations helpful in the New Year. Best wishes, Tom Madell, PhD http://funds-newsletter.com Mar. 16 Update: The following is a quick update on how you would have done if a) you were a subscriber starting at least 12 months ago, and b) you invested as we recommended in our Jan. 2005 newsletter: 10.83% Stock Benchmark return (S&P 500 Index) 14.11% Return on my Stock Model Portfolio (1 yr. total returns as of 3-15-06) The return for bond funds has been much poorer. The 1 yr. total return on my benchmark is 3.03 as of 3-15-06. Two of our 5 recommended bond funds beat that benchmark but my Bond Model Portfolio underperformed the benchmark. On the good side, though, I had recommended only a 25% overall allocation to bonds and a 20% overall allocation to cash. Cash has outperformed bonds over the last year, justifying our very high allocation to this category during this period. I also recommended more aggressive investors a) have a 75% allocation to stocks and only 15% to bonds and b) consider stock funds focusing on Japan, emerging markets, and mid-cap growth and bond funds in emerging markets and the "multisector" category. Had you ventured into these categories, you would have been highly rewarded as shown below: Stock Funds ============ Japan 31.87 Emerging Markets 39.17 Mid-cap growth 19.54 Bond Funds ========== Emerging Markets 14.86 Multisector 3.11 (1 yr. total category returns as of 3-15-06) Our next quarterly Model Portfolio will be sent to you around Apr. 1st. Right now, we continue to think that bond funds will underperform both stocks and cash for at least the next few months. We still have the inclination to think that bond funds will start to outperform cash as the economy eventually shows signs of weakness, perhaps toward the latter part of this year or even sooner.