As the quarter started, interest rates were beginning to move higher. While they have backed off their recent peak, their current behavior indicates to us that June was probably the bottom of the interest rate market. As is often the case when the economy is getting stronger, high yield bonds have begun to outperform other bond categories.
While you do not have to rush out and move all of your money from Intermediate Bonds and Mortgage Securities (Intermediate Government Bond). We suggest that you consider placing 1/3 of your bond allocation into High Yield Bonds and 2/3 into Short-Term Bonds or Short-Term Municipal Bonds in your taxable accounts if you are in a high tax bracket.
Real Estate Funds continue to be a good way to generate income on some of the assets in your portfolio. While these funds have yields similar to Intermediate Bonds, for now they look like a safer place to achieve high yields and superb total returns.
We prefer Value funds in the Large Cap Category for several reasons, not the least of which was the recent reduction in the tax rate on stock dividends. While Growth Funds performed a little better this quarter, we have found Large Cap Value to be a better choice in the long run for this portion of your portfolio, especially for those investors who do not have the time to keep up with the markets on a regular basis.
As they have for at least the last 5 years, Mid Cap Stock Funds continued to produce returns between those of Large Cap and Small Cap funds. In addition, these funds exhibit less volatility than their Large Cap and Small Cap counterparts, which makes one of these a good choice if you are getting started with your ‘first’ mutual fund.
We continue to believe that money managers have a better opportunity to add value to a portfolio of small company stocks than they do with large company stocks. This is one area of the stock market where we feel actively managed Mutual Funds have an advantage over passive Index Funds or Exchange Traded Funds (ETFs).
Investment companies that specialize in small companies have done a better job than the big fund families in this area. Unfortunately, many of these funds are closed to new investors, so you will not find some of the best performers over the past 3 years as one of our choices.
Small Cap Value funds have been the top performing stock category over that past five years. Even though a 23% return so far this year has not kept pace with the 27.9% return of Small Cap Growth funds, they are clearly doing very well overall. With this in mind, we suggest your first Small Cap Fund be chosen from the Blend category. After that consider adding both a Small Cap Value and a Small Cap Growth fund.
Technology funds have been on a roll in 2003. Keep in mind that even with gains of over 35% this year, these funds are still down over 30% on average from where they were three years ago. Manager performance varies significantly in this category, so we choose funds whose managers have had good results over the long run.
There are several important points to consider regarding these highly volatile funds. Do not put more than 10% of your portfolio in them, do not be afraid to take your profits, and cut your loses quickly when this sector of the economy starts heading south.
While world economies have become more dependent on one another, there are still good investment opportunities outside the United States. Even though the EAFE International Index has performed similarly to the S & P 500 over the last 5 years, the best International Funds have outperformed the best Large Cap Fund Managers by a considerable margin. This quarter was no exception, so we continue to feel a small allocation to one of these funds is worthwhile.
Even if you are fully invested in the stock and bond markets, it may be time for you to adjust your portfolio. Review our asset allocations to see how well your investments match up with these targets. A well-balanced portfolio should earn you more than keeping your investments in Money Market Funds, and if you make some insightful investment choices, you will come out ahead of the crowd.
A list of our Favorite Mutual Funds was updated in July with information through June 2003.
Asset Allocation for 4th Quarter 2003
There are a couple of items to notice about our list of funds this quarter. First, we have added High Yield Bonds. Second, we have broken out Large Cap Funds and Mid Cap Funds into Growth and Value Categories. Since there are several new categories, there are several additional new stock and bond funds. The only real change was the removal of Wasatch Small Cap Growth (WAAEX). The reason for that is it has been closed to new investors, so you will no longer be able to purchase this fund. This has happened in the past, so we will keep an eye on it and let you know if you should purchase this fund if it becomes available again.
Last Quarter we suggested that investors put any new money targeted for bond funds in Short Term Bonds. With the economy starting to show some signs of life and interest rates appearing to have hit bottom in June we think its now time for investors to change their bond allocation. As the economy starts to grow again, interest rates eventually start to rise. When this happens the prices for bonds start to fall, especially for those that have a longer duration. With this in mind, it is best to have your bond allocation in Short-Term Bonds.
High Yield Bonds, on the other hand, tend to perform better on a relative basis than investment quality bonds when the economy is growing strongly. This is because the riskier businesses that issued these bonds are more likely to survive in a strong economy. Because of this relationship, we suggest you start moving some of your assets out of Intermediate Bonds and Mortgage Securities (Intermediate Government Bond). A good rule of thumb would be to consider placing 1/3 of your bond allocation into High Yield Bonds and 2/3 into Short-Term Bonds or Short-Term Municipal Bonds in your taxable accounts if you are in a high tax bracket.