MUTUAL FUNDS INVESTING NEWSLETTER http://funds-newsletter.home.att.net email: funds-newsletter@att.net Investment Newsletter #21 (Apr 1, 2000) Tom Madell. Copyright 2000 Changes to Recommended Allocations and to Our Model Portfolio ----------------------------------------------------- We get the sense that change may be in the air in the financial markets. We don't anticipate huge changes in the performance of the categories of funds we cover, but enough to make a difference in some of our suggested allocations. So here are our new suggestions beginning on Apr. 3 to replace the ones we made in the 12-31-99 issue. Also included is a discussion of current circum- stances. Overall Allocation ------------------------------------------------------ Current Previous Stocks 60% 60% Bonds 25 25 "Other" 15 15 ------------------------------------------------------ As you can see, no change is recommended in overall allocation to stocks vs bonds vs "other". Although the stock market may be beginning a shift of emphasis away from riskier investment choices, if your specific holdings within various stock fund categories are chosen correctly, you should be able to continue to do well in spite of the damage that may occur in some areas. Nothing transpiring in the last 90 days seems to have made bonds a more attractive alternative than before in spite of lower rates on long-term bonds. With the Fed still engaged in its campaign of raising interest rates, there is little temptation at this point to divert stock money into bonds. And while yields are rising on cash investments, it's still not significant enough to offer an enticing alternative. As always, there will be those among you who may have chosen NOT to invest in bonds at all for a variety of good reasons. If so, just be sure you can withstand the volatility that comes with a portfolio that is almost entirely made up of stock funds. Stock Fund Categories Where we recommend you put your stock fund holdings do show some small changes as a result of current happenings: ------------------------------------------------------ Current Previous Large Cap (US) 40% 35% Small/Mid Cap (US) 20 25 International 40 40 ------------------------------------------------------ We continue to suggest a much larger portion in international funds than most people own. There are a variety of reasons for this: 1) The economies of most other countries, with a few exceptions such as Britain and Canada, are just starting to pick up some steam as compared to the US. As you may be aware, economic strength tends to rise and fall in cycles. Stock markets closer to the beginning or middle of a cycle tend to have better prospects than those nearer the end of a cycle as exemplified, we suggest, by the US. 2) Studies have shown that the best risk/reward tradeoff (that is, lower risk accompanied by higher returns) tends to be achieved with a stock portfolio made up of approximately 40% foreign stocks and 60% US stocks. This is as compared to a portfolio with no or only a relatively small percentage of foreign stocks. 3) Although many foreign stocks, especially in Europe, have advanced broadly for the last few years, most are still more reasonably priced than those in the US. While large US stocks must still be thought of at risk resulting from many years of outperformance in this bull market, they appear to have become increasingly attractive lately. At the same time, small and mid caps have been run up a lot of late by over-eager investors. Therefore, we think that the time may have come to lighten up a little on the latter. And in the event of a more severe correction, the smaller stocks will be pummeled more than the blue chips, especially after the current run the smaller issues have enjoyed over the last 6 months or so. Bonds Fund Categories Bonds peformed quite decently this past quarter for the first time in a while. Nevertheless, we do suggest some changes in how you allocate if you currently invest in bond funds. ---------------------------------------------------- Current Previous Long Term 40% 30% Intermediate 50 60 Short Term 10 10 ---------------------------------------------------- Surprisingly, long-term Treasury bonds did exceptionally well this past quarter. However, much of the reason had little to do with the overall economic backdrop which would almost always lead to LOWER bond prices. It was a direct result of the government's plan to remove long- term Treasuries from circulation. (Reduced supply means greater scarcity and therefore higher prices.) Secondary reasons for the good performance appear to have been: 1) Bond investors guessing that the Fed may be close to an end to its rate raising campaign. This, of course, is nothing more than a guess, and possibly a bad one at that, given the strength of the economy. 2) Extreme volatility in stocks perhaps leading more investors to see value in the safety of Treasuries. Unfortunately, short-term interest rates have continued to climb suggesting that bonds undoubtedly have a rocky road ahead. Given that some of the above unusual factors will likely continue to influence rates as the year progresses, we would gradually begin to move a slightly greater amount into long-term issues at this time. Our Updated Model Portfolio With this overview in mind, we are making a small number of changes to our model portfolio. Reasons for our choices, in addition to those above, follow the table. Note: Please keep in mind that unless you have a large amount invested in funds, you will not want to have as many funds as in our model. In this case, we suggest you "collapse" our suggestions by category. So, for ex- ample, instead of having 4 foreign funds, we suggest you just pick one or two. Our model also exists as a tool by which you can check on how well this Newsletter serves its readers, since we periodically report our overall returns based on calculations made on the specific funds and percentages shown. Stocks -------------------------------------------------------- Current 1-1 to Fund Morningstar Allo- 3-31 Style cation; Return; last 3 yr. Qtr. ann. Alloc. return in ( ) in ( ) -------------------------------------------------------- Vanguard Foreign International (Large 15%(10%) 6.0% Growth Blend) (16.8%) American Century Foreign 5 (10) 4.5% International (Large Growth) (32.4) Growth Vanguard Index Foreign 10 (10) -0.2 Pacific (Large Value) (9.8) Vanguard Index Foreign 5 (5) 0.2 Europe (Large Growth) (21.3) Janus Overseas Foreign (Large 5 (5) 14.6 (Note: Janus World- Growth) (39.7) wide is similar but also has US stocks) Janus Fund Large Growth 10 (10) 10.4 (40.5) Vanguard Index 500 Large Blend 10 (10) 2.2 (27.4) Vanguard Growth Large Value 10 (10) 0.9 and Income (28.0) Vanguard Windsor Large Value 10 (0) -0.4 (9.7) ICAP Equity Large Value 0 (5) 1.3 (17.7) Vanguard Small Cap Small Cap Blend 5 (10) 6.9 Index (18.9) Vanguard Extended Mid Cap Blend 5 (5) 9.7 Market Index (28.6) T. Rowe Price Mid Cap Value 5 (5) 0.4 Value (13.7) Fidelity Low Small Cap Value 5 (5) 4.5 Priced Stock (11.7) Bonds --------------------------------------------------------- Current 1-1 to Fund Morningstar Allo- 3-31 "Interest cation Return Rate (last (3 yr. Sensitivity" Qtr. ann. alloc.) ret.) --------------------------------------------------------- Vanguard Long High 15% (10%) 7.5% Term Treasury (9.3) Vanguard Long High 15 (15) 2.6 Term Corporate (6.9) Vanguard CA Ins High 10 (0) 4.4 Long Term (5.8) (Note: Choose a fund for your own state; or, Van- guard Long Term Insured) PIMCO Total Medium 50 (50) 2.2 Return Instit (7.4) Vanguard High Medium 10 (15) -1.6 Yield (6.0) Fidelity Inter- Medium 0 (10) 1.5 mediate Bond (5.8) "Other" Fund Categories ------------------------------------------------------- Current 1-1 to 3-31 Fund Allocation Return (last (3 yr. Qtr alloc.) return) ------------------------------------------------------- Vanguard Prime Money Market 67% (67) 1.4 (5.3 approx.) Vanguard REIT Index 33 (33) 2.6 (-0.8) "Growth vs. Value" Funds We don't provide specific growth vs. value allocation percentages since these terms may mean different things to different fund managers. However, we are beginning to see signs that value funds may at last be starting to reverse their dreadfully long period of under- performance as compared to growth funds. Even some of my own badly lagging value funds are now pretty regularly beginning to outperform some of my own previous hottest growth performers. So, for example, Fidelity Low Price Stock, a 4% performer last year, has actually been outperforming Janus Venture (141% last year; not in the model portfolio), over the last two months. High Yield (Junk) Bonds We previously suggested high yield bonds for some investors for a small portion of their bond holdings. Unfortunately, these bonds have not had a good quarter so we are lowering our recommendation by a tad. However, for buy and hold investors, since the yield for the above Vanguard fund has now climbed to nearly 10%, you are getting a high payout if you can wait it out for a price recovery. Municipal Bonds As stated in earlier letters, if you are in the 28% Fed income tax bracket or greater, we highly recommend municipal bonds instead of the other bond fund categories for taxable accounts. They have smartly outformed most other bond categories this year, save for long-term Treasuries. Even taking into consideration the lower yields they offer, we think they will probably outperform all the other types of bonds shown above. REITs We continue to recommend REITs for individuals who wish extra diversification. These can also be a good substitute for bonds, although they are actually stocks. We feel that all the fundamentals are in place at this time for funds that invest in real estate, including fairly low long-term interest rates and very under-valued conditions. For individuals choosing REITs, we continue to sug- gest an overall 5% position within your portfolio. Tom Madell, Ph.D.