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A 4-fund portfolio you can buy and hold
A single index fund thats hostage to the S&P 500 is a recipe for red ink. But these funds together will likely outperform the S&P and with less risk.
By Timothy Middleton
What does "buy and hold" mean, exactly?
"I say 'buy and hold' what?" says Don Cassidy, senior research analyst at Lipper, a mutual-fund consulting firm. "The economy changes. We have much faster-moving technologies and international trade than we did 10 or 15 years ago."
Cassidy says investors have to be more aggressive in managing their portfolios in today's sideways market. That's the opposite of everything we've been taught.
But remember this: Our chief tutor has been the mutual-fund industry, which not only preaches the gospel of holding on forever but enforces it with redemption fees and other rules against trading.
Of course it does. Fund companies pocket about 1% of your entire portfolio every year in the form of fees -- but only if you're still around. It doesn't matter to a fund company if you buy a good fund, only that you buy their fund.
Buy, hold and lose
The poster child of this old-school malarkey is the Vanguard 500 Index Fund (VFINX), which has sold itself so successfully -- as the ultimate buy-and-hold portfolio -- that is has become the nation's largest mutual fund. But what is its claim on your loyalty? If you had invested $10,000 in it five years ago, you'd have $8,825 today. Your mattress has been a better financial steward.
What's an investor to do? You have two choices. One is to be nimble, shifting money from growth to value or from energy to utilities. The other is to buy something that really is worth holding for a long, long time.
If you want to build a portfolio you won't have to touch for the next 25 years, buy sector funds that invest in financial services, health care, leisure and technology. Over the last five years, which represents the worst bear market in modern times, a mix of those four sectors would have beaten Vanguard's 500 fund by 2.55 percentage points a year. Over the last 10 years, which includes a bull market and a bear market of roughly equal length, the sector portfolio outperformed by 216 basis points (or 2.16 percentage points) a year.
Related news and commentary on MSN Money
How good is that? Only 20 of the 1,696 mutual funds in Morningstar's large blend category have done that well in the last decade. Among the distinguished giants you would have beaten are Davis New York Venture (NYVTX), Fidelity Dividend Growth (FDGFX) and Vanguard Growth & Income (VQNPX), which between them have nearly $40 billion of assets.
An out-of-whack index
What's so bad about the S&P 500 ($INX)? The stocks that make it up are weighted in accordance with their market capitalization. That means stocks that are overvalued by the market hurt you more than stocks that are undervalued help you, because both kinds inevitably trend toward the middle.
"At the top of the bubble in 2000, Cisco Systems (CSCO, news, msgs) was 4% of the S&P 500," says Robert D. Arnott, manager of the Pimco All Asset Fund (PASAX). "At the same time, by our measures Cisco was 0.02% of the economy. How do you assign 200 times the weight in the index relative to a company's scale in the economy?"
Where is the real economic muscle? It's in four sectors that are benefiting from demographic and economic trends of historic proportions.
| The fabulous four | | Fund | 5-year avg. annual return | 10-year avg. annual return | | Fidelity Select Financial Services (FIDSX) | 8.1 | 14.2 | | Fidelity Select Health Care (FSPHX) | 0.5 | 12.6 | | Fidelity Select Leisure (FDLSX) | 2.1 | 12.2 | | Fidelity Select Technology (FSPTX) | -17.0 | 9.7 | | Blend category overall | 0.1 | 12 | | Vanguard 500 Index (VFINX) | - 2.5 | 9.9 |
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Note: As of 6/30/2005. Sources: Morningstar, MSN Money
If you had bought these four sector funds in equal measures five years ago, an investment of $10,000 would be worth $10,006 now. You would have outperformed Vanguard 500 by a total of 13.4%. Importantly, you would have lost nothing in the worst bear market in generations.
Over the last 10 years, the four sectors would have lifted your initial investment to $31,734, some 23.8% more than the Vanguard fund's rise to $25,633.
The largest generation
How can I be so confident these sectors, which have been the top performers of the last 15 years, will continue to shine in the future? Consider these statistics:
- According to Standard & Poor's, people over 50 will, by far, be the fastest growing age group in the United States in the coming decade. S&P estimates that between 2003 and 2015, the number of people aged 50 through 54 will grow 17%; the number between 55 and 64, 46%; and the number 65 and over, 29%.
- At the same time, the 35-to-50 cohort in the U.S. will actually shrink, and younger groups will grow much less than the oldest ones.
- Among the implications is that this over-50 set -- the richest generation in American history, largely in its peak earnings years -- will flood banks, investment companies and insurers with money.
Mark Mulholland, manager of the Matthew 25 Fund (MXXVX), is a pure bottoms-up stock picker. But he has 55% of his assets in financial-services stocks. "Look at 401(k)s; look at the administration trying to play up the whole idea of the owner/citizen," he says. "The macro trend on financial services is very, very positive."
Unless health care is socialized -- and that is an unfortunate priority of the left wing of the Democratic Party -- the oldest age cohorts will spend much more on pharmaceuticals, medical equipment and health-care facilities. "Heath-care inflation is running at a rate more than twice that of the (consumer price index)," notes Sam Stovall, chief investment strategist at S&P. "There are likely to be many profits at hand in this sector."
Old, rich and bored
Once geezers have taken care of their finances and their health, they will turn to what retirement offers the most of -- leisure. And they won't be the only folks looking to be entertained: In the developing world, youthful cadres are growing rapidly, adding their spending power to those of America's elderly.
"The demographics of the world are different than the demographics of the United States," says Larry Haverty, a portfolio manager with Gabelli Funds, a group long associated with media stocks. "In the U.S., you're looking at cruise lines and gaming companies. Worldwide, you're looking at media companies, particularly the new media, which is cell phones and the Internet."
Fidelity Select Leisure owns all these groups, from Yahoo! (YHOO, news, msgs) and Walt Disney (DIS, news, msgs) to Carnival (CCL, news, msgs) and Penn National Gaming (PENN, news, msgs).
The world also relies on technology to increase productivity which, you'll recall from Economics 101, is the only way wages can rise without inflation. Technology stocks have fared disastrously in the last five years, but that's because of the bursting of the Internet bubble. Going forward, the entire world will depend on technology to raise standards of living, just as it has since the invention of the steam engine.
Smoother sailing
Aside from increased returns, this blend of funds does an excellent diversification job, because these sectors move independently of each other. When financial services were booming in 1998 and 1999, health care was lagging. When leisure declined sharply in 2000, both finance and health care were up. None of the three experienced anything like the spike technology enjoyed in 1999 -- or the crash it endured later.
You don't have to be a Fidelity customer to take advantage of these trends, although Fidelity has the best one-stop sector operation in the industry. Both Rydex and ProFunds offer a host of sector funds. Many mutual-fund complexes offer excellent ones, such as ING Financial Services (PBTAX), Merrill Lynch Health Care (MDHCX), AIM Leisure (ILSAX) and Waddell & Reed Adviser Science & Technology (UNSCX).
Exchange-traded index funds are yet another way to play sectors, and they have the advantage of having the lowest expenses in the industry.
Investing in the S&P 500 is not necessarily bad. It's an excellent proxy for big-capitalization growth stocks (which I think are due for a rebound) and can play a role in nearly every portfolio.
There's nothing wrong with this index, unless you think it can be the foundation of your financial future. It can't. It can only play a supporting role.
An update
After this column first appeared, I received a flock of emails from readers asking for specific exchange-traded fund recommendations in the four favored sectors.
My choices:
Vanguard Financial Viper (VFH, news, msgs)
Health Care SPDR (XLV, news, msgs)
PowerShares Leisure & Entertainment (PEJ, news, msgs)
iShares Goldman Sachs Technology (IGM, news, msgs)
Aside from PowerShares Leisure, which is the only ETF in that sector, there are multiple portfolios available in each sector. Vanguard, iShares and Standard & Poor's SPDR are easily researched at their respective websites.
Note: My colleague Jon Markman has also written about the problems of the S&P 500. Check "Behind the curtain at Standard & Poor's," "Make a bundle on S&P's rejects," "The S&P 500 is a mutual fund -- and a bad one" and "S&P is lousy at make-or-break bingo."
At the time of publication, Timothy Middleton did not own any securities mentioned in this article.
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