Mutual Fund Trends & Research Newsletter

Contents:

• Our Model Portfolio Way Ahead of the Indexes for the 2nd Quarter and Prior 12 Months
• Our Long-Term Results
• Our Recommended Fund Categories for the 3rd Qtr
• Our Stock vs Bond vs Cash Recommendations for the 3rd Qtr

Our Model Portfolio Way Ahead of the Indexes for the Quarter and Prior 12 Months

While this has been a terrible quarter and past year for stock funds in general, to the contrary, anyone who held a bond fund - either as a diversification tool, for income, or as a short or long term investment (in spite of the negative view that many investors still tend to hold toward this valuable investment category) - did relatively OK, at least with that segment of their investments.

Stocks - 2nd Qtr

For stock funds, it was not a matter of making money - almost nobody did that (including us). Rather, it was a matter of keeping your losses as contained as possible. Let's see how our recommended stock funds did during the 2nd Qtr:

Fund	Morningstar Style	2nd Qtr Allocation	2nd Qtr Total Return
Vanguard Growth and Income	Large Value	5	-12.1%
Vanguard Extended Market Index	Mid Cap Blend	15	-10.0
Vanguard Windsor	Large Value	20	-13.4
Vanguard Emerging Markets Index	Foreign	10	-8.3
Vanguard Explorer	Small Cap Growth	10	-14.1
Fidelity Low Priced Stock	Small Cap Value	10	-0.3
Vanguard International Growth	Foreign (Large Blend)	10	-4.4
Tweedy Browne Global Value	Foreign (Mid Cap Value)	10	-5.8
Vanguard REIT Index	Real Estate	10	+4.8

We use the Vanguard 500 Index as our benchmark: It lost -13.4% over the quarter. You can see that 7 of our 9 choices did better than this benchmark, some by a significant amount. Only one of our choices underperformed it, by a slight amount, while one showed exactly identical results.

Using the above percentage allotments to each of our stock portfolio funds, as initially presented at the start of the quarter (Newsletter 61), our stock funds as a group returned -7.9%, fully 5.5% better than the benchmark.

Bonds - 2nd Qtr

Here's how our recommended bond funds did:

Fund	Morningstar "Interest Rate Sensitivity"	2nd Qtr Allocation	2nd Qtr Total Return
Vanguard Short Term Corporate	Low	35%	+1.1%
Vanguard Inflation Protected Securities	Low	30	+5.9
PIMCO Total Return Instit.	Medium	15	+3.3
Vanguard High Yield	Medium	20	-2.0

Using our above Letter 61 percentage allotments, our total quarterly return for the 4 bond funds combined was 2.3%, above the 1.4% return shown for the average taxable bond fund during the quarter at www.morningstar.com. Our money market return for the quarter, using the Vanguard Prime as our recommended money fund, was approximately 0.5%.

Assuming an average allocation of 66.25% to stocks, 28.75 to bonds, and 5% to cash by averaging our recommended allocations presented in Newsletter 61, and then modified in Newsletter 63, the resulting Model Portfolio total return for the 2nd qtr. was -4.6%.

Stocks - One Year

Although our Model Portfolio has a usual time frame of only one quarter, at the end of which we may make minor adjustments, we have pointed out before that it is extremely unlikely that such quarterly picks can consistently predict accurately over such a short time as just 3 months. It is informative, therefore, to see how our Model Portfolio funds perform over longer periods. Here, then, are the 1 yr. results for the Model Portfolio that we presented exactly 1 year ago in Newsletter 51, showing our suggested allocations. Note that the picks and allocations are not very different than those originally given in Newsletter 61 as shown above:

Fund	Morningstar Style	Allocation (July 2001)	1 yr Return
Vanguard Growth and Income	Large Value	10	-17.0%
Vanguard Extended Market Index	Mid Cap Blend	10	-13.4
Vanguard Windsor	Large Value	20	-12.1
Vanguard Small Cap Index	Small Cap Blend	10	-5.5
TIAA-CREF Growth Equity	Large Growth	5	-29.7
Fidelity Low Priced Stock	Small Cap Value	10	+16.4
Vanguard International Growth	Foreign (Large Blend)	10	-8.6
Tweedy Browne Global Value	Foreign (Mid Cap Value)	10	-6.2
Vanguard Index Europe	Foreign (Large Blend)	10	-7.0
Vanguard REIT Index	Real Estate	5	+16.3

Over the 1 year period since July 1, 2001, the benchmark Vanguard 500 Index returned -18.2%. Out of our 10 stock funds, 9 outperformed this benchmark; only 1 underperformed, our only large growth fund with our smallest weighting of 5%. We correctly foresaw that large growth funds, where most investors had, and still do as far as we know, have the majority of their investments, was not a good place to be. With our heavy emphasis on value, smaller stocks, foreign stocks and real estate (an emphasis since we first started presenting our Model Portfolio at the beginning of 2000), we - as we consistently have since we started the Model Portfolio - again outperformed our benchmark, this time by 9.3%, with a total return of -8.9%. More on negative returns below.

The 4 bond funds in our Model Portfolio of July 2001 were the same as the ones for the 2nd qtr. shown above. The following shows our July 2001 bond fund allocations and the 1 year total returns since then:

Bonds - One Year

The total return of our 4 bond funds over the last 12 months was +7.6%, again well ahead of the return of 4.6% for the average taxable bond fund over the last year as shown at www.morningstar.com.

Overall, using stocks, bonds, and money market funds, had you had a portfolio similar to the one recommended last year in Newsletter 51 and in the percentages we allocated, your total return would have been -3.9%. Such a negative return, while not what we hoped to achieve, is a far cry from much deeper losses suffered by many investors over the last year, especially many people who did not properly diversify.

Our Long-Term Results

Naturally, our hope is to be able to make a good positive return for ourselves and our readers. But since stocks represent a significant portion of our recommendations, we, and virtually no other stock fund investors, have been able to overcome the severe bear market we all have been operating under. But in spite of the severe bear market, a diversified portfolio resembling ours has led to relatively mild losses, especially when contrasted against the aggressive fund and individual stock holdings which make up far too many investors portfolios.

Some people might kick themselves for not having gotten out of the market altogether, thereby avoiding these losses. And likewise, they might say to me why couldn't I have steered them around all these loses and into positive territory. The fact is that if anyone could tell you exactly when to be invested in stocks and when not to be, they would never have to work or worry about money for another day for the rest of their lives! (So, why are most of these prognosticators still working or still worrying, like the rest of us?) Such an ability, as most of us including me know, just is not possible. Investing, therefore, is not really about an attempt to get in and get out as many people try to do - just nearly impossible to our way of thinking. Rather, what it is about is sensibly allocating, and perhaps, re-allocating, the latter if you have good reason to believe that changes across asset classes make sense at certain junctures.

Doing well in making investing decisions is a relative matter - no one can be anywhere even close to being completely successful. For comparison, look at the major league baseball teams - all of the first place teams have winning percentages only in the 60% range. For proof, look at the major league standings right now (a .600 winning percentage is the same as 60% of games won.)

Any investor, likewise, who can be around 60% correct in their investment decisions will outperform the vast majority of other investors whose winning percentage is typically around 50%, at best, and often worse since investors often tend to choose investments counter to the psychological principles so important for success we have often discussed in these Newsletters. And since a 50% winning percentage is no better than chance, many investors will do best by sticking to low cost index funds and not making any switches down through the years. But if you can periodically adjust your portfolio and be right about 60% or more of the time, then you can do considerably better than the major investment indexes, and certainly better than the average returns of other investors.

That is roughly in a nutshell what we attempt to do, and for the last 3 years during the time we have published this Newsletter, we have been successful.

During 1999, the last full year of the bull market, the average stock fund in our portfolio increased in value by 34.5%. This compared to the average diversified stock fund return of 26% according to the Wall Street Journal and 19.5% for the S&P 500. During that year, not a single one of our stock funds had a negative performance. Since then, our quarterly results while typically suffering as have most other investors, have nearly always outperformed the major averages.

Our Recommended Fund Categories for the 3rd Qtr

The following tables show our stock and bond category preferences for the upcoming 3rd Qtr.

The particular funds shown are our own picks and make up our Model Portfolio. Since few investors will decide to own the identical funds as we have, the tables are probably most valuable to you in showing the categories where we are putting our major emphases. We particular recommend foreign stock investments at this time.

Stocks

Note: The benchmark Vanguard 500 Index returned +3.6% over the last 5 years. The Vanguard Growth and Income fund in last Qtr's Model Portfolio (Large Value, allocated at 5%) has been removed for this Qtr. This fund closely parallels the Vanguard 500 Index which we feel may not be through its long-term malaise. We are replacing it with Fidelity Contra which did better than both of these funds during the bull market, and less poorly than either during the last few years.

Bonds

Bond funds consisting of corporate bonds are at greater risk right now as a result of the accounting irregularities that have cropped up at WorldCom, Enron, etc. However, we don't think Treasuries are particularly attractive going forward since interest rates are near rock bottom already and Treasuries are best when rates have the potential to fall.

Fund	Morningstar "Interest Rate Sensitivity"	Previous Allocation	New Allo- cation	5 Yr Total Return
Vanguard Short Term Corporate	Low	35%	20%	6.3%
Vanguard Inflation Protected Securities	Low	30	30	NA
PIMCO Total Return Instit.	Medium	15	20	8.2
Vanguard High Yield	Medium	20	20	3.1
American Century International Bond	Not Available	0	10	3.1

Note: The American Century International Bond has been added because it will do well if the dollar continues to fall as it has of late. We feel that the dollar has been overvalued for several years now and will continue to weaken, enhancing returns on foreign investments.

Our Stock vs Bond vs Cash Recommendations for the 3rd Qtr

The following are our short-term oriented suggested allocations for the coming 3rd qtr. As we have discussed many times, the primary reason we make these allocations is serve as a "checkpoint" when we look back to see what our returns were every qtr. We do not expect anyone to modify their portfolio to exactly reflect these allocations - we don't even do this ourselves. With that in mind, here are our best guesses as to the best relative weights of asset classes for now based on all the information we follow:

Class	Previous	New
Stocks	62.5%	60%
Bonds	32.5	32.5
Cash	5	7.5

Tom Madell, PhD

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