What can we expect from stocks, bonds and cash in the coming decade? This was one of the topics we discussed with SF Bay Area clients, subscribers and shareholders last month at our FundX Open House.

Most investors allocate their portfolio to stocks, bonds and cash based on past returns. Since 1925, stocks have handily outperformed bonds on average, and bonds have outpaced cash, which has essentially kept pace with inflation. But the problem is that returns are rarely average, even for periods of a decade or longer. Over the last 10 years, for example, stock returns have been far lower than their historic average, while bond returns have been much higher than average.

When we look at stocks, bonds and cash today, we find that stock valuations are still in line with their long-term historical average, earnings continue to grow, and there is very limited competition from other asset classes like bonds and cash. Given this, we believe it is reasonable to assume that stocks can return at or near their long-term average over the next decade. That also implies that stock investors will need to accept volatility that has also been consistent with stocks over the long-term including an average of three 5% pullbacks per year, one 10% correction per year and one bear market decline of 15-30% every 3-5 years. Of course, this compares favorably to the rather extreme volatility of the trailing decade when valuations were much richer.

We believe bond investors may have a hard time doing better than their current coupon yield over the next decade. For investors in a bond index, this implies returns as low as 1 to 2%. More diversified bond portfolios yield closer to 3%. There are bonds that yield more than 3%, but those can be as volatile as stocks over time and therefore most bond Investors will probably want to limit their exposure to higher-yielding bonds. The benefit to bonds is that they remain less volatile than stocks, they yield more than cash and they continue to outpace inflation (at least for now). An allocation to bonds buffers one’s portfolio during stock market dips and rebalancing helps improve participation in recoveries. Bonds also allow investors to reap the benefits of stocks by helping investors remaining invested through full market cycles.

Cash yields basically zero and low cash yields are expected to continue for at least the next 2 to 3 years. The fact that cash no longer keeps up with inflation is punitive – especially considering that stock and bond investors are enjoying good performance. This implies that investors either need to expect relatively lower returns or consider accepting greater volatility in their portfolios.

Retirees want to make sure their retirement accounts last longer than they do, but investors can’t know precisely how much they’ll need in retirement or how long they’ll be living off their retirement accounts.

There are a few ways that investors can increase the probability of outlasting their money, and a June 9, 2013 New York Times article, For Retirees, a Million-Dollar Illusion, highlighted three of them:

1. Investors can withdraw less from their retirement accounts; and/or
2. Investors can delay their retirement age; and/or
3. Investors can add stocks to their portfolios.

A chart that accompanied the article showed how each of these options reduced investors’ probability of running out of money in retirement.

Some of these options may be more feasible than others. Not all investors can change their cost of living or retire at a later age, but most investors can invest in stocks. The Times’ chart indicated that investing in stocks can dramatically reduce the probability of running out of money in retirement. The charts showed that a couple who retired at 65 and was entirely invested in bonds would have a frightening 70% chance of running out of money. If the couple invested 60% of their portfolio in stocks and 40% in bonds, they’d have less than a 20% chance of running out of money.

We include stocks in the retirement accounts we manage for clients because retirees don’t need all of their money at once; instead, their money is paid out over many years. And we want to make sure our clients’ accounts will last through their retirements.  The trade-off is that stocks can be volatile, and some retirees may not believe they have enough time to recover from stock market declines. But remember that the bond market isn’t immune from declines. As the Times noted, “Bond investing is likely to remain challenging for years to come. Investors may face a double-whammy — low yields now and the prospect of significant losses as yields rise.”

We believe a mix of stocks and bonds can help control downside risk and provide long-term growth and income for investors in or near retirement. The right mix of stocks and bonds depends on investors’ need for growth and their ability to withstand volatility. If you want to discuss your retirement allocation with one of our portfolio managers, please contact us.

Interest rates rose sharply in May, but no one knows whether they are near the top of a trading range or if they are starting a sustained upward climb. Most bonds are negatively affected by rising interest rates since bond prices fall when interest rates rise, but not all areas of the bond market are equally affected by interest rates.

Below, we look at four kinds of bond funds that have historically held up in rising rate environments:

Short- and Ultra Short-Term Bond Funds
The shorter the average duration of a bond fund, the less the fund’s NAV will fluctuate with interest rates. Funds with durations of three years and less remain fairly stable when interest rates rise, and they offer a relatively safe haven during volatile times in the bond market. The trade-off for stability is that these funds offer very low yields. Examples include Pimco Low-Duration (PLDDX) and Weitz Short/Intermediate Term Income (WSHNX).

High Yield Bond Funds
Bonds of lower credit quality issuers have had a strong run lately and credit spreads (the difference between BBB yields and 10 year US Treasury yields) are now “normal.” The added yield these funds offer may yet be attractive if overall rates remain flat, and yields could cushion the impact of small increases in interest rates. We use high yield bond funds with care because there are risks here. These funds would suffer for example, if default rates rise or if interest rates jump dramatically. Examples include Fidelity High Income (SPHIX) and Wells Fargo Advantage Short Term High Yield (STHBX).

Floating Rate Funds
These funds invest in bank loans, which reset interest rates based on increases or decreases in a benchmark (usually the LIBOR rate). This potentially insulates these funds from the negative impact of rising rates and allows them to benefit from higher yields as rates rise. There are risks, of course, and we use these funds gingerly. Companies that use bank loans for financing tend to have lower credit quality and the market for these loans can lack liquidity. Floating rate funds may be dicier than most individual investors may like and they suffered badly in 2008 when lending dried up during the credit crisis, but they can be useful within a professionally managed portfolio. Examples include Fidelity Floating Rate (FFRHX) and PIMCO Floating Rate (PFIDX).

Inverse Bond Funds
These are funds that go up when the bond market is falling and drop in value when the bond market gains. Using derivative instruments, such as futures contracts, interest rate swaps, and options, they essentially “short” the bond market. Not for the faint of heart, they can prove to be volatile. Betting against a particular market is a fairly sophisticated strategy that may not be appropriate for all investors. And some of these funds add to their risk level through leverage. But they do provide investors with options; they can be used to make a bet on the downward direction of bonds, or as a hedging device for a bond portfolio. Examples include ProFunds Rising Rate Opportunities (RRPIX) and Rydex Inverse Government Long Bond (RYJUX).

Of course, the key to using these bond funds is to have a strategy that determines when to own these funds and when to move on to better performers. Our Flexible Income strategy is one such strategy: it leads us to invest in potentially riskier funds like high yields and floating rate funds only when these funds are outperforming less risky funds like short-term and intermediate-term bond funds. In more challenging periods in the bond market, our strategy can be 100% allocated to more stable short-term bond funds. Our strategy also limits our exposure to potentially riskier areas of the bond market, like high yields, so we can participate in the greater returns of these funds without sharply increasing the volatility of our portfolios.

Our Flexible Income strategy also has another tool in its rising-interest-rate toolbox: low volatility equity funds, which we consider to be bond fund alternatives. These funds have a history of low volatility returns like most bond funds, but because these funds are balanced funds that have exposure to both stocks and bonds, they aren’t as affected by interest rate fluctuations.

Our Upgrading strategy leads us to assess our portfolios monthly and make any necessary trades. This approach has led us to beat the S&P 500 over the long term. But could we still outperform the market if we traded less frequently?

We compared changing our portfolios monthly versus annually in the June issue of NoLoad FundX, and found that monthly Upgrading produced the best returns, but that yearly Upgrading still outperformed the market for the trailing 14 years ending March 31, 2013.

The study we published in NoLoad FundX used the current funds in Class 3, and not all Class 3 funds have been around for the full 14 year period. So we ran the same study using a universe of over 200 diversified funds that had a full 14-year record. The results, shown below, were very similar: adjusting our portfolios on a monthly basis produced the best returns, but yearly trading also handily beat the market over this 14-year period.

Stocks continued to climb in May amid mixed economic reports, while bonds suffered when interest rates rose.

As markets consolidate near all-time highs, it’s helpful to remember that market pullbacks are normal. Preparing for pullbacks is very different from attempting to predict them. We prepare for pullbacks by owning balanced portfolios, diversifying our holdings, and reminding ourselves that pullbacks are normal so that we don’t lose sight of our long-term goals when the market moves against us.

After the remarkable run stocks have had this year-to-date, it is fair to expect some volatility. But that doesn’t mean stocks will decline now. A number of investors have been forecasting a correction for the last few months. Eventually, they will be correct, but when, and from what level? As May’s solid gains remind us, the market can keep going up – and we want to participate.

What’s Working
Most longer-term market leadership trends remain in place: developed markets continue to outperform emerging markets, and value continues to outperform growth. But shorter-term trends reversed: most Asia Pacific funds fell steeply and were replaced, while some financials rose back up the ranks.

In core Class 3 funds, the top ranked funds are primarily U.S. value funds (both large- and mid-cap). In Class 2, small-cap growth and value funds led, replacing previously strong international and Asia Pacific funds. Class 1 sector leadership can change quickly as we saw with Japan funds in May, but biotech and homebuilders remain strong, as they have been for over a year now.

Fixed Income
The bond market’s momentum seemed unrelenting, until suddenly it sputtered. The 10-year Treasury yield reached a 13-month high of 2.17% on May 28 and pulled back only slightly from that level by month-end. That jump caused intermediate Treasuries to sink almost 3% for the month. High-grade corporate bonds fell over 2.5% on the month and bringing them into negative territory for the year. High yields held up better, losing only 1.2%. The average junk bond risk premium is 4.55 percentage points over comparable Treasury yields, and this has helped buffer high yields somewhat from rising Treasury rates. World funds were hit also, especially emerging market debt.

This piece originally appeared in the June 2013 issue of NoLoad FundX. Click here to subscribe.

Each month, we highlight any changes we’ve made to the NoLoad FundX fund and ETF listings.

Name Changes

• Class 3 Stratton Multi-Cap (STRGX) renamed Stratton Mid Cap Value.

Aberdeen acquired Artio Funds and the following Artio Funds were renamed:

• Class 3 Artio International Equity II A (JETAX) renamed Aberdeen Select International Equity II.

• Online Supplement Class 3 Artio International Equity (BJBIX) renamed Aberdeen Select International Equity (BJBIX). Note: BJBIX is still closed to new investors.

• Class 5 Bonds (Strategic) Artio Total Return Bond (BJBGX) renamed Aberdeen Total Return Bond.

Closed to New Investors
Class 2 Matthews Asia Dividend (MAPIX) will close to new investors on June 14. We usually move funds that are closed to new investors to the online supplement, but we are keeping MAPIX in Class 2 for a few more months because the Fund was recently highly ranked and we believe some subscribers may be holding it. We will move the Fund to the supplement once it is lower ranked and we believe most investors no longer hold it.

Newly Added to Class 2
Primecap Odyssey Aggressive Growth (POAGX) was moved from the online Supplement Class 2 into the newsletter’s Class 2.

Reclassified
Forester Value (FVALX) was reclassified from the online Supplement Class 2 to supplement Class 4.

How do we winnow the universe of 1,200 ETFs down to the 170 ETFs we cover in NoLoad FundX? Here’s a closer look at our screening process:

Risk – Nearly 200 ETFs currently on the market are leveraged and inverse ETFs, but we believe that the potential benefit of leveraged ETFs is generally outweighed by the risks. Eliminating these ETFs brings the number of possible ETFs down to about 1,030.

Tax Complications – Some ETFs are structured as partnerships, and partnership ETFs may declare income that can be taxable, even when the ETF is held in a tax-deferred account, as we noted in this June 2011 post. Given these tax issues, we exclude the 53 ETFs that are set up as partnerships. Now we’re down to 977 ETFs.

Inception Date – In order for a fund to be ranked in NoLoad FundX, it must have a 12-month track record. The 162 ETFs that launched last year don’t have full year of performance yet, so that brings the number of potential ETFs down to 815.

Liquidity (assets/trading volume) – Our biggest and perhaps most important filter is for liquidity (find out more about liquidity issues here and here). Two key measures of liquidity are asset size and trading history, and many ETFs haven’t attracted adequate assets or trading volume. Over 200 ETFs have less than $20 million in assets, and nearly 300 ETFs aren’t widely traded. Removing these from our list brings the number down to about 400 ETFs.

Duplicate Indexes – The majority of ETFs are index based, and many ETFs track the same indexes. iShares, SPDR, Vanguard and Guggenheim all offer ETFs that track the S&P 500, S&P 400, and S&P 600, as well as the growth and value versions of these indexes, too. Rather than list duplicate ETFs, we aim to include the largest or best traded option.

FundX Final Review – Finally, we consider how an ETF works with our strategy and our own experience trading an ETF. Many of these screens are moving targets (an ETF may gain or lose assets over time, for example), so the number of ETFs in NoLoad FundX will change as we periodically add or remove ETFs from our listings.

This originally appeared in the March 2013 issue of NoLoad FundX. Click here to subscribe.

Last week we hosted an open house at our San Francisco offers. We welcomed subscribers, clients and shareholders for a presentation and social hour.  Following our talk, we took questions and most of these questions centered on exchange traded funds (ETFs). FundX CIO (and resident ETF expert) Jason Browne answered most of these questions, and he noted that we’ve published a lot of information about ETFs here on the blog.

Below, we’ve shared the top five ETF questions from the FundX open house along with links to blog posts where you can find more information.

1. What do you think of bond ETFs?

Jason echoed many of the same points that FundX President Janet Brown made in her Forbes post about why we prefer bond funds to bond ETFs and focused especially on the risks of bond ETFs. “There’s a lot of innovation in the ETF industry,” Jason said, “but much of it comes with risks. We like knowing that a bond fund always trades at NAV.”  There is no guarantee that ETFs will trade at the value of their underlying net assets, or NAV.

2. Some ETFs have wide spreads. Can individual investors really get a fair price or are some ETFs better left to professional traders?

Many ETFs trade well, but some ETFs aren’t widely traded and these ETFs often have wider spreads (and the spread can add up, as we showed in our “Understanding ETF Trading Costs” post). Jason explained that investors who buy ETFs that aren’t widely traded may be trading with market makers, not other investors. “The interests of hedge funds and large institutions may not be aligned with my interests,” Jason said.

He encouraged investors to avoid ETFs that don’t trade well. “If we go through a period of market volatility and you want to sell an ETF that doesn’t have solid trading volume, you may have a hard time getting a fair price for your shares,” Jason explained. Even though we have a team of professional traders, we still tend to focus on widely traded ETFs.

3. How can I tell if an ETF is widely traded?

“If an ETF trades less than 30,000 shares, I don’t bother with it, and if an ETF doesn’t trade consistently, I don’t bother with it,” Jason said, and he pointed to an easy way to see whether an ETF trades consistently: Yahoo Finance’s 5-day charts. (You can see these charts in this July 2011 post on thinly traded ETFs and this February 2013 post on ETF trading costs.)

Another option, he said, is to focus on the ETFs in NoLoad FundX: “We try to list ETFs in NoLoad FundX that have decent volume and are fairly easy to trade.”

4. Should I invest in actively managed ETFs?

“We don’t have a bias toward passively managed ETFs or actively managed ETFs,” Jason said. “But the reality is that most widely traded ETFs seem to be index based.”

5. Should I invest in leveraged ETFs?

“Because our strategy is geared towards taking advantage of longer-term trends, these kinds of ETFs just don’t function well in our system,” Jason said. “The penalty for buying in at the wrong time is just too high.” (We’ve published more on leveraged ETFs here.)

Do you have additional questions about ETFs? Share them in the comments and we’ll answer them in a future blog post.

The Wall Street Transcript recently published a detailed interview with FundX CIO Jason Browne in its April 26, 2013 issue. Jason offered insights into the FundX’s Upgrading process, and, since this issue of The Transcript focused on the financial services sector, he explained how we get exposure to financials.

Since The Wall Street Transcript is available by subscription only, we’ve included a few excerpts from Jason’s interview.

Jason explained the three FundX services – NoLoad FundX newsletter, mutual funds and private client accounts – and he shared how the FundX Upgrading strategy differs from other investment approaches.

“From our perspective, FundX wasn’t so much about finding Fund ‘X,’ but about monitoring mutual fund perfor­mance, trying to identify which funds are doing well in the current environment, then adjusting our portfolios to continually align with the leading funds,” Jason said. “We do that as opposed looking for fundamental stories or themes. Using quantitative models, we choose leaders between value and growth strategies, large-cap and small-cap strategies, foreign or domestic leadership.”

We apply this same process to sectors, like financials which had come up our quantitative ranks in November 2012. Jason noted that FundX portfolios had a small 3% position in financial sector ETFs like SPDR Financial Select Sector (XLF) and iShares DJ U.S. Financial Services (IYG) at the time of the interview, but these ETFs weren’t currently top ranked. (Financial sector funds were ranked as holds in April and fell into the sells in May.)

Investors don’t have to rely on specific sector funds to get exposure to areas like financials. “We get exposed to financial services in a few different ways within our portfolios, from the big, diversified financial companies to regional banks, insurance companies, global financials, and even indices or countries—such as Switzerland or Sweden, where financials are a big component,” he said.  Financial services companies are held throughout many of the underlying diversified funds in our portfolios.  As of the end of March, over 18% of our largest portfolio was in that sector.

The ability to identify leading areas of the market and avoid lagging areas is attractive to investors. Jason explained that “the biggest thing that draws people to us, in addition to the historical track record, is the concept that one style or strategy doesn’t stay in favor forever, and that you are not going to be smart enough to be able figure out in advance what’s going to lead next. If you feel that way, come talk to us.”

Morningstar and NoLoad FundX have strikingly different investment approaches, so we were surprised to read Morningstar’s Does Momentum Investing Work? (April 10, 2013). The article concludes that momentum investing does work, calling the evidence in support of momentum investing “too overwhelming to ignore.”

Morningstar cited a 1993 study that found momentum in U.S. stocks and noted that “many studies have extended this evidence to foreign stocks, commodities, currencies, and bonds. Momentum even works across individual asset classes and country stock indexes.”

Suggesting that “there are only a handful of pure momentum funds available to most investors”, Morningstar overlooked the equally overwhelming evidence that mutual funds also profit from momentum.

Twenty years ago, a groundbreaking study entitled “Hot Hands in Mutual Funds” was published by the prestigious Journal of Finance. Written by Harvard researchers Hendricks, Patel and Zeckhauser, it concluded that, “The net returns of no-load growth mutual funds…that perform well in the most recent year continue to be superior net performers in the near term (one to eight quarters).” Since then many other studies have corroborated these conclusions.  More recent research finds that momentum also exists in international funds (funds managed overseas).

Academic studies often refer to momentum in mutual funds as “persistence of performance” and NoLoad FundX’s Upgrading approach is designed to help investors capitalize on this phenomenon. We’ve compiled a list of academic studies from 1970 through 2012 that found evidence of persistence of performance in mutual funds. Click here to download the pdf.