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How
to Construct an All-Weather Mutual Fund Portfolio
Equity funds perform differently in different time periods as investment styles and sectors come in and go out of favor. Mutual fund investors commonly make the mistake of chasing top performing funds for investment. Rather than chase top funds, the prudent course is to construct an all-weather portfolio. This article describes which styles and sectors generally do well in certain phases of the business cycle and brings out the need for an all-weather portfolio. It discusses two approaches to constructing an all-weather portfolio. Impact of Business Cycle Stock prices are impacted by business conditions. The business cycle has various phases to it: Recovery, Boom, Slowdown, and Recession. Different parts of the stock market as seen from market capitalization, style, or sector perspectives perform differently in different phases of the business cycle. The share price of an equity fund changes in response to the prices of stocks held in its portfolio. Diversified Funds Growth style funds, in general, fare well during expansion phases (recovery and boom) and value style funds during contraction phases (slowdown and recession). Likewise, from a capitalization perspective, small cap funds tend to perform better during expansion and large cap funds during contraction. Looking at the most recent boom-bust cycle, the large cap-growth fund, Spectra Fund was a star performer during the 1997-1999 boom but fared poorly during the 2000-2002 slowdown. In complete contrast, Hotchkis & Wiley Small Cap Value Fund failed to participate in the 1997-1999 boom but performed well during the 2000-2002 slowdown. Sector Funds Sector funds, too, tend to perform better during some phases of the business cycle. Funds that invest in economically sensitive sectors such as technology typically tend to perform better during expansion phases, while those that invest in economically less sensitive sectors like consumer staples typically tend to perform better during contraction phases. As a result, a sector fund that performs best in one time-period may not perform as well in another time-period. Among the 41 Fidelity sector funds, Fidelity Select Energy Services was the best performer in 2005 but was the worst performer in 2003. Constructing an All-Weather Portfolio Returns from investments in equity funds can be enhanced by actively selecting them based on investment style or sectors if one can accurately predict the turning points in the business cycle. However, getting the turning points of the business cycle right is less than a science. Secondly, there is no certainty that particular styles and sectors will replicate their performance each time. Finally, stock prices tend to anticipate and lead the business cycle. The list of top performing funds therefore usually changes from one economic cycle to another. A prudent course therefore is to construct a robust, all-weather portfolio. A) Constructing with Diversified Funds One approach to construct an all-weather portfolio is to use diversified funds that emphasize different types of market capitalizations and investment styles. In evaluating funds in each category, the investor should focus on the long-term track record and see how the funds have fared in different market environments. The investor should complement this by evaluating each fund on non-performance-based metrics such as manager tenure, price volatility or risk, fees & expenses, and fiduciary grade. To simplify the portfolio composition, one may construct a portfolio using the best available fund each in large cap-growth, large cap-value, small cap-growth, and small cap-value categories. If one wants to invest in only one fund to start with, one may consider a total market index fund spanning all capitalizations and styles. B) Constructing with Sector Funds Alternatively, one may use sector funds to construct an all-weather portfolio. This approach offers the advantage of creating customized diversified portfolios by including sectors and industry groups which are likely to outperform the market indexes and excluding those which are likely to under-perform. Concentrating in a few sectors or industry groups enhances the reward potential while diversifying across several sectors and industry groups serves to mitigate risk. An optimum balance between concentration and diversification helps in achieving superior nominal and risk-adjusted returns. The AlphaProfit Core model portfolio exemplifies this approach. Over the 33 month period from September 30, 2003 to June 30, 2006, the AlphaProfit Core model portfolio gained 57% compared to 39% for Dow Jones Wilshire 5000 Total Market Index. Key Points 1. There
are no top mutual funds for all times and climes. |