On June 30th, we made a series of trades in the Powerfund Portfolios. These trades were a bit different than the ones we've made since we launched our model portfolios on April 1, 2002. We bought these funds with real money.

There are real benefits to using real money to build and follow our portfolios. In order to understand the differences, we need to review how we handled things for the first eight years.

We used the MAXfunds rating system and method of choosing funds to build model portfolios for investors at various risk levels. This meant maintaining a portfolio of approximately 10 no-load mutual funds, ETFs, and closed-end funds. We traded just enough to keep our focus on out-of-favor areas of the market, and to maintain our overall allocation to stocks and bonds based on the ebbs and flows of investor enthusiasm (since we generally do the opposite of other fund investors).

We kept our model portfolios as simple as possible to follow. Allocations were always in round percentages, i.e., 5%, 10%, or 20%. We only traded on the last day of the month, and often alerted subscribers a week or more before the trades.

To understand how this worked, imagine we used a portfolio containing only two funds – 50% in a bond fund, and 50% in a stock fund. If investors avoided stock funds (usually due to a weakness in stocks,) we may have altered our allocation to 55% stocks and 45% bonds by selling 5% of our bond fund and buying 5% of our stock fund.

Performance calculations were also simple. In the month after our trade was made, if the stock fund was up 5%, and the bond fund was up 1%, we calculated our performance based on what would have happened if we had 55% in a fund returning 5%, and 45% in a fund returning 1%.

Here's the math behind this: 55% * 5% = 2.75% for the stock fund, and 45% * 1% = 0.45% for the bond fund. This indicates a total portfolio return of 3.2% (2.75% + 0.45%).

In actual money, if you had a $10,000 portfolio you wanted to allocate with us right after we moved to 55% stocks and 45% bonds, you'd have $5,500 in our stock fund choice and $4,500 in our bond fund pick. After a month, you would have earned 5% in stocks, or $275 on a $5,500 investment (2.75% of the total portfolio, based on the math above,) and 1%, or $45, on the $4,500 bond fund investment. You would have earned a total of $320 on your $10,000, or 3.2% on your total portfolio. We would have shown a 3.2% return for this "moderate" portfolio for the month.

Now let’s review for a moment what this does and does not take into account. When a mutual fund is up 5% in a month, that includes dividends and fund expenses. This return does NOT include any costs to buy or sell the fund. In this case, there is no sale made, but a broker could have charged from $0 to $75 to buy the fund. We have no way of knowing which broker you’re using, so we did not account for this drag on performance. 

Keep in mind many of our funds can be bought for no transaction fee (NTF) at many brokers, and ALL could be bought for no initial cost if you bought them directly from the fund company (which is why they're called no-load funds), so it would have been possible for investors following our newsletter to experience the exact 3.2% return we quoted. However, if an investor decided to buy both funds at a broker, and had to pay $20 to buy one of the funds, their return would have varied based on their investment amount.

Using the $10,000 example above, a $20 "drag" on returns to buy the stock fund would mean that instead of investing $5,500 into the stock fund, only $5,480 would have been invested. This smaller investment would still earn 5%, but that would only be $274 for the month on top of the $45 on the $4,500 in the bond fund for a total return in dollars of $319. While $319 is 3.19% of the $10,000 invested, keep in mind that the account is now worth just $10,299, because $20 was lost to transaction fees.

That means the total return for the month WITH commissions is only 2.99%. If the investor had a $100,000 portfolio, the drag of a $20 commission would be much less noticeable; the total return would be 3.179% for the month, not much less than our quoted return, as a result of paying no commission and buying through the fund directly.

That's why it's important to watch commissions and determine whether a fund is NTF or not when you invest smaller amounts. When you invest a larger sum, focusing on the fund expense ratio is more important. Typically, fund companies tack on an extra 0.25% in fees on NTFs, which equates to only $13.75 on a $5,500 fund investment, but a whopping $137.50 on a $55,000 stake in a fund – more than you'd pay in $20 commissions to buy and sell the fund.

We typically own funds for about two years, so this commission drag, which only occurs when you buy and sell, does not affect performance in all months. In months without a trade, your returns should closely mimic our quoted returns. That's until your account falls out of balance, another area in which real money portfolios could differ from our older model portfolios.

Here's the difference between fake money and real money trading. Next month, if the stock fund were up 2%, and the bond fund were up 1%, our official return for the portfolio would be 1.55%. This assumes you have 55% in the stock fund and 45% in the bond fund. If you're a new investor, this would be exactly what you'd have if you bought the funds at the beginning of the month before the 2% and 1% returns, respectively. However, you were in the portfolio for two months, and in the first month, the stock fund beat the bond fund.

So you don’t have 55% in stocks. You have 55.96% in stocks (assuming you didn't pay a commission to buy). Your actual return would have been 1.56% for the month, NOT 1.55%, because you had a tiny bit more in stocks. Over time, this allocation gap could grow to be quite large, particularly following a big run in stocks.

Also note that we'll show the effects of any short-term redemption fees charged by the broker or fund for selling too soon after buying. In the past, we've owned funds long enough to avoid the fees some funds charge, but if redemption fees come into play, you'll see the impact on our performance in the future.

We did trades at least every year, and if you rebalanced when we made these trades, your stock and bond allocations would have remained fairly close to our "official" allocations. 

Going forward, these two "problems" will be completely visible, because we're going to buy our funds at a broker and incur real commissions of $24.99 on non-NTF funds and $9.99 on ETFs and closed end funds.

But wait, there’s more… Trading ETFs is a bit more complicated than buying and selling mutual funds. In addition to paying commissions to buy and sell, ETF investors can lose a chunk of their initial investment to the bid-ask spread. In our opinion, ETFs are somewhat overrated compared to open end index funds due to these costs. 

The short story is this: you're buying and selling ETFs at market prices, which can be ever so slightly off from the real fund values. Like stocks, the prices at which you buy and sell are different. When you put $10,000 into a Vanguard 500 Index fund, you receive the end-of-day price with no commissions (if you bought through Vanguard,) and everyone buying and selling that day pays the same price. However, if you buy the Vanguard Total Market ETF (VTI) on that same day, you lose approximately $10 due to commissions AND some of the bid-ask spread by effectively overpaying ever so slightly for the fund. 

The spread is the difference between the bid and ask price on the fund, and roughly what you'd lose if you bought the fund and then immediately sold it. With an active ETF like VTI, the hit would be small – about .02%, or 2/100ths of one percent, or approximately $2 on a $10,000 buy, but it can add up. Worse yet, on less liquid ETFs, the bid-ask spread is quite a bit larger. Since we trade infrequently, we don’t expect this to add up to much, but any hits we take on bid-ask spreads will be evident in our official returns going forward.

We're putting $60,000 into each of our real money portfolios. You could likely beat our returns if you invest more than $60,000, which would make the weight of commissions lower on your total return.

Since 2002, the vast majority of our returns were the actual fund performance figures. If we'd used real money returns over the past eight years, we wouldn't expect the drag from commissions and other real money costs to hurt our returns much, although all other things being equal, we'd expect the returns to be lower. In some cases, the returns may have been higher: letting a fund go out of balance to 7% from 5% can help portfolio returns in an up market when that fund is climbing fast.

With our new real money portfolios (there are two now – Conservative and Aggressive,) you can expect to see a few more funds in each portfolio, and allocations won't always be in 5% increments. We may own 7% of a fund.

Keep an eye on our official allocations, say 5% to XYZ fund, and the "real money" allocations, which show how our stake that was originally 5% has grown or shrunk after market fluctuations relative to the entire portfolio.

We’ll also be updating the portfolios with the previous day’s closing performance data each morning. How did we do last week? Or yesterday? Or over the last 30 days? All of these figures will now be available daily. 

Thanks for joining us.