Lessons From the Model Portfolios

I've just completed top-to-bottom reviews of my model portfolios, recapping performance and making a few tweaks here and there.

There are 66 long-term portfolios in all, designed to suit investors with varying proximities to retirement and preferences. (There are also four portfolios geared toward short- or intermediate-term goals.) The Bucket portfolios are designed for people who are already retired, while the Saver portfolios are meant for people who are still working and accumulating assets for retirement. There are portfolios composed of traditional mutual funds as well as exchange-traded funds. I've created general portfolios (including funds from multiple fund families) and fund-family-specific ones, as well as portfolios for tax-deferred and tax-efficient accounts. Each portfolio series has Aggressive, Moderate, and Conservative versions.

Given all of those variations--and especially the fact that their asset allocations vary so widely--it's no surprise that their performance varied, too. Stocks enjoyed dramatic gains during the period, so it was to be expected that the Aggressive Saver portfolios, with 90% or more of their assets in equities, uniformly logged the highest gains. Meanwhile, the Conservative Bucket portfolios, with the lightest stock exposure, logged smaller gains, albeit respectable in absolute terms.

Apart from that obvious conclusion that risk-taking was rewarded, there were other key takeaways from the recent performance and holdings review, as follows.

Few active U.S. equity funds earned their keep.

Three years is a fairly short time period by which to judge, and previous studies have established the tendency for pure, capitalization-weighted equity index funds to outperform in rising equity markets. Yet it's still striking the extent to which the portfolios' holdings in total U.S. equity market trackers beat almost all of the actively managed funds in these portfolios over the trailing three-year period. (S&P 500 funds performed even a bit better than total market index funds over this particular three-year period, but I favor total market index funds and ETFs because of their more inclusive exposure to small and mid-caps.) In large part the relative strength of core cap-weighted index funds owes to the fact that very few active funds are similarly weighted toward the market's largest names, many of which have logged exceedingly strong performance over the past three years. For example, total market trackers hold 3% each in

But a handful have.

Yet even as basic, low-cost total market trackers proved hard to beat, a short list of actively managed funds did manage to outperform over the period. Several of them hail from growth categories or lean more heavily toward strong-performing growth stocks than the broad market:

),

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and

, also managed to beat the market by a comfy margin over the past three years. It tends to lean toward the growth side of the Morningstar style box, and small-cap growth has been the best-performing square over the past three years. (As a tax-managed fund, it downplays dividend payers, which gives it a bit of a growth bias.)

Yet some of the total market index beaters were less obvious choices to outperform. The biggest head-scratcher, at least on the surface, was

. Its source of strength was twofold: It's a foreign large-growth fund, and growth stocks have outperformed overseas just as they have in the U.S. Additionally, the fund has gotten a boost from its stake in U.S. stocks--roughly 10% of assets at the end of August.

and

(there the holding ticker is VIG), also managed to stay neck and neck with the S&P 500 over the past three years. That was a bit surprising, given that it holds less in strong-performing growth/technology names than does the index. As of this writing, it is slightly behind the index over the period, but it was a touch ahead when I wrote about those portfolios' performance back in August. Like the aforementioned funds, it holds its share of strong-performing growth stocks--Microsoft is its top holding--but has also found strength in other quarters; returns from

But the risks shouldn't be overlooked. Yet even as total market trackers and growth-leaning funds managed to log exceptionally strong gains during the period, investors should consider how difficult the strong recent gains will be to repeat. To be sure, the operating performance of high-growth bellwethers has been exceptionally strong, and Morningstar doesn't view them as egregiously expensive today. Microsoft currently earns a 4-star rating, while Apple and Amazon each earn 3-star ratings. That said, investors in growth-leaning funds should take care to balance them with value holdings, as I have in my model portfolios that own them. Moreover, revisiting baseline asset-class exposures is crucial, especially for people who are within 10 years of retirement. After all, a portfolio that was 60% equity/40% bond 10 years ago would be more than 80% equity today.

Tax efficiency didn't cost on the performance front. One other striking takeaway was that the tax-efficient portfolios--both the Bucket portfolios geared to retirees as well as the Saver portfolios--nearly universally performed as well as or better than the portfolios created without regard for tax efficiency. There were several key reasons for that. On the equity side, an emphasis on strong-performing core index funds, ETFs, and tax-managed funds was a boon. As noted above, these funds' heavy weightings in some of the market's best-performing stocks lifted their results above most actively managed funds' on a pretax basis, and they looked even sharper on an aftertax basis. On the bond side, the tax-efficient portfolios benefited from the fact that their municipal bond holdings performed nearly as well as taxable bond funds with similar credit profiles and levels of interest-rate sensitivity over the past three years. That was a function of a strong economy and decent to improving municipal finances. In more typical market environments, the lower yields on municipal bonds will tend to lead to a lower return than a taxable bond of the same credit quality and maturity, because the municipal bond has a tax-efficiency advantage.

Global diversification didn't help--except in a few spots.

As I alluded to earlier, global diversification didn't do our portfolios many favors, nothwithstanding the unusual case of Vanguard International Growth. Yet I noticed that there was one spot where holding foreign securities did provide a boost--albeit a small one. The Vanguard Saver portfolios all have modest stakes in

The bond Armageddon really wasn't. Speaking of bonds, they definitely weren't great return drivers for these portfolios over the past three years, which helps explain why the most bond- and cash-heavy portfolios of the lot--the Conservative Bucket portfolios--were also the worst performing. But in a period in which the Fed raised the benchmark Fed Funds rate eight times, it's also fair to say that the bond Armageddon that some market prognosticators had been expecting didn't materialize. Most of the core intermediate-term bond funds in these portfolios gained about 2% on an annualized basis over the past three years, with higher yields helping to offset rate-related principal losses as rates trended up. Given that inflation was generally benign during the period and that bonds have historically served as shock absorbers during periods of equity losses, that seems reasonable to me.

Cash was a drag, but don't count it out. Last but not least, it's worth noting that the cash holdings in the Bucket portfolios detracted from returns across the board, as cash underperformed bonds by a bit and trailed stocks by a mile. That said, I'm just as big a believer in the idea of maintaining liquid reserves into retirement as I was three years ago. After all, the biggest killer for a retirement portfolio's longevity is having to tap securities as they're declining, and that danger is particularly acute if the lousy market environment happens in retirement's early years. Holding some cash reserves helps supply living expenses if losses present themselves. It also provides a valuable intangible--peace of mind in periods of extreme market volatility.