Trade Winds

April 2, 2005

In our last Our Favorite Funds report (released in February) we downgraded several fund categories. Generally strong performance over the last few years in those categories, coupled with investor enthusiasm, were the two main reasons for the downgrades. Later this month we’ll be making allocation changes to our model portfolios to reflect these changes. Such a move requires us to shift our model portfolios holdings a bit, as these portfolios were build to reflect our revised outlooks for several fund categories.

It’s worth noting that we don’t give up on an area simply because it has whipped the S&P500 for a period of time (although this is a factor): Valuations are also considered. While booms don’t stop on a dime merely because the underlying investments get expensive, eventually sanity catches up and overvalued stock prices fall back to realistic levels.

The third, and arguably the most important variable (which proves a category’s days of out-performance are up), is when virtually every dollar that could work its way into the category already has. We know that a fund category is ‘overstuffed’ with money when 1) funds in the category begin to close to new cash, 2) massive inflows head into open funds in the category, 3) there is rampant talk about the category on CNBC and in the financial press, 4) we see huge trading volume in ETFs and other exchange traded ways to “play” the category, 5) there is a rash of new fund launches looking to profit from the investor exuberance.

Unfortunately we’re seeing many of these danger signs in the categories we have previously favored. As anyone who has owned funds in our model portfolios over the last few years has noticed, we’ve been heavily weighted in funds that invest in foreign stocks and bonds (notably emerging market stocks and bonds), small cap stocks (even microcap stocks), junk bonds, utility stocks, and value stocks.

Many of these areas have been red hot recently, which is part of the reason our portfolios have all at least doubled the return of the S&P500 since we launched them in 2002, even though we’ve owned cash and short term bonds. Since we started the aggressive growth portfolio – which is almost as risky as the S&P500 – we’ve gained 53% (as of February 28th, 2005) compared to the S&P500’s 10%.

What’s getting cut?

Broadly speaking, we’re going to be easing up on foreign stock funds, notably emerging markets and small cap. We’ve had a stake in emerging market stock funds since the beginning, and are up over 100% on the position.

Investors have been discovering emerging markets in greater numbers. Valuations are not nearly as good as they were a few years ago. Today the Vanguard Emerging Markets Index fund has a dividend yield about where the Vanguard 500 Index fund is – a sign that emerging market stocks are about as expensive as U.S. large cap stocks.

Emerging market stocks are inherently riskier than U.S. large cap stocks, and should be cheaper to warrant a large allocation. We downgraded emerging market funds to a 4 (Weak – should under-perform) in February of this year. In 2002 the category was rated 2 (Interesting – should outperform). So far, this seems pretty timely, since emerging market funds tanked in March – some funds as much as 10%.

The asset level of emerging market ETFs is growing fast. iShares MSCI Emerging Markets Index Fund (EEM) has ballooned to over $4.5 billion in assets, putting it in the top 10 iShares ETFs by asset. What’s number one? iShares MSCI EAFE index (international stock index) – even more than the iShares S&P500. This is why we’re easing up on foreign stocks in general.

Utilities have been on a hot run, which is a big part of the reason we’re cutting back (but not eliminating) our utilities holdings. Investors seem to like the way utility stock dividends offer some insurance against inflation and rising rates because utility companies can increase prices to consumers (state governments permitting) and therefore raise dividends.

That said, dividend yields are not spectacular in utilities anymore given the run up in prices, and investors are coming into the picture. Utilities ETFs have tripled their assets in recent years. We largely got into this area because investors hated utility stocks three years ago (which is why Vanguard changed the scope of their Vanguard Utilities Income fund away from utilities – near the bottom of the market for utility stocks). We have been selling down our stakes in utility funds in our managed accounts.

Goldman Sachs recently predicted oil would top $100 a barrel in the near future. This reminds us of another famous prediction by an analyst at a major investment bank fairly close to the top of the Internet bubble – Amazon was going to over $400 a share (which it did, before collapsing). Needless to say, we just downgraded natural resource funds to a 4, a category we used to have at a 1 before the major run of out-performance. Please read our category review in the latest report.

So what are we buying? As we’ve noted before, we believe almost all categories are expensive at the moment. But there are certain areas that are less expensive than others.

We believe larger cap U.S. growth stocks will beat most other fund categories by a slim margin over the next 1 to 3 years. Technology is getting interesting again, primarily because it is uninteresting to most fund investors.

As for bonds, we continue to stay light on higher risk debt – both by credit quality and maturity – for the time being. If rates rise significantly from these levels, or if investors run from junk bonds and emerging market debt, we will go into these areas. For now we’re sticking mostly with shorter term, investment-grade, corporate bonds.

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Trade Winds

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