Portfolio Newsletter Year End Update 2014

Last year’s newsletter updated you on portfolio changes made through the annual year-end rebalance. This year we will also share strategy updates, economic outlook, and portfolio performance, in addition to fund changes.

Topics and information you will find in this year’s newsletter:

  • Elimination of two portfolios for each risk class
  • Implementation of a biannual rebalance
  • Navigating the risks in the bond market
  • Improving equity returns by focusing on rising sectors
  • Proposed funds
  • Proposed allocations
  • Trade dates

Reduction in portfolios for each risk class

Presently, there are two portfolios for each risk class: a portfolio for accounts over $100,000, and a corresponding “Low Min” portfolio for accounts under $100,000. This came about because Schwab offered a variety of funds on their platform, including some with a minimum investment greater than $1. Data suggested funds with a high minimum balance might have the same performance with less risk, so it originally made sense to run two separate classes of portfolios.

After two years of researching and managing two identical portfolios for each risk class, I have come to the conclusion this is a duplication of efforts. My time will be better spent researching sector rotation and looking for ways to improve performance on the equity side of each portfolio. As far as the outcome goes, both portfolios have similar performance in each risk class.

Moving forward there will be no more “Low Min” portfolio. This means there will not be both a “Moderate” and “Moderate (Low Min)” portfolio. There will only be one “Moderate” portfolio.

The additional time saved will be used to identify economic and sector trends, and then research funds that will hopefully outperform the market.

One additional change is Schwab continues to expand the number of OneSource mutual funds available on their platform that have a $1 minimum purchase. This will provide an even greater selection from which to choose.

Biannual Rebalance

Last year’s performance of portfolios was exceptional. We outperformed similar portfolios by a few percentage points. The 2014 portfolios are in the top 20% of performance when compared to their peers, but have significantly less risk than their peers. In order to improve performance, I will increase my research time and make appropriate adjustments more frequently.

Our economy is on the eve of entering a rising interest rate market. This is something we have not seen in more than 30 years. Navigating a rising interest rate market will not be easy. Returns will come from investing in the right sector of the economy at the right time and adjusting as the sectors rotate.

Different economic sectors perform well in a pre-rate hike market (where we are now). They then shift as short-term rates begin to rise. There is a subsequent shift in the middle of the rate hike cycle, and again in later stages. Being in the wrong sector at the wrong time could be devastating – just take a look at the recent fall in the energy sector if you need convincing!

We need to be proactive and not reactive. Limiting portfolio changes to once a year is not going to work unless the sectors always happen to shift at the end of the year, which they obviously won’t.

Going into 2015, we are adding a mid-year or biannual rebalance. This allows us to replace underperforming funds and to make sure all portfolios are invested in the sectors expected to perform well for the given economic climate.

Bond Market Risks

As you may recall, at the beginning of the year we adjusted the bond allocation of the portfolio to low duration risk bond funds to mitigate any risk of rising interest rates. Keep in mind, the Fed began paring back their Quantitive Easing (QE) program early in 2014. Interest rates continued to fall until the QE program ended in October. Subsequently, rates rose sharply for approximately one month. Since then, the ten year Treasury has slowly declined to 2%. Some economists are suggesting it may drop as low as 1%.

The reason interest rates are once again falling is that other nations have implemented or expanded their own Quantitative Easing programs. While our QE program was limited to buying our own debt, theirs includes purchase of U.S. debt. The net effect of other nations buying our debt is that it looks like we never ended our QE program. While the ten year Treasury may hit 1%, there is still considerable risk in the bond market once interest rates begin to rise again.

Schwab added a number of low duration bond funds to their OneSource mutual fund platform in 2014. I’m very excited these choices are available. We plan to incorporate them into the portfolios to further reduce duration risk in the bond allocation.

Improvement of Equity Returns through Sector Focus

Throughout 2014, my research has been dedicated to the equity side of the portfolios in order to seek ways to improve performance without significantly increasing risk. As you may recall from our November portfolio update, there are 10 broad sectors that make up the stock market:

Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunications and Utilities. At any given time, some sectors outperform the market while others underperform the market.

Have you ever wondered why a “hot” performing mutual fund can turn cold? This is partly due to the fund investing in a hot sector that is no longer the place to be. Every mutual fund reports the percentage of their holdings allocated to each sector. It’s easy to check a fund to see if it is still heavily allocated in a sector that has fallen out of favor. The recent drop in the energy sector is a perfect example. Funds previously overweighted in energy enjoyed above average returns, but are now underperforming.

If one could accurately and consistently select the four best sectors (which is not possible without a crystal ball), they would consistently outperform the market. Combining all available data from economists on the direction of the economy, plus data on the best historical sectors during those periods, and the data available from the mutual fund companies, I attempted to run simulations to see if it were possible to target proper sectors to boost performance.

It didn’t take long to find out this just isn’t possible. Instead, I turned my research to identifying 3-4 sectors that are expected to underperform. I wasn’t looking for the underperformers to invest in, but to avoid.

I then ran simulations where I would select and track funds from the six top sectors based on that research. It was, and continues to be, successful!

It may sound as simple as selecting mutual funds overweighted in those sectors, but it’s not. Mutual fund companies deliberately lag in reporting their sectors’ weightings by three to six months so competitors can’t copy them. Some funds selected for my simulations should have performed well. I later discovered the sector data was inaccurate in terms of where the fund was presently invested, yet current in terms of data publically available.

Fortunately, there are a few mutual fund companies that make sector- focused funds. This means they only invest in a specific sector by design, making it easier to select a target. For example, an Information Technology sector fund only invests in technology companies.

Going forward, rather than select one Large Growth fund that potentially invests in 10 different sectors, we will further diversify the portfolios by selecting two funds for each investment style wherever possible. In a sense, this creates a focused portfolio using sector funds. It’s also why we need to implement a biannual rebalance to make any necessary changes.

The portfolio models will stay intact as you know them. They will now be focused (and still fully diversified) among the six sectors expected to outperform based on current and upcoming economic climates.