SMI Portfolios Post Healthy Third-Quarter Gains

The beginning of the third quarter saw the market's summer rally really kick into high gear. July was a particularly strong month, and while stocks cooled a bit over the following two months (and dropped considerably as October ushered in the fourth quarter), the third quarter still produced solid returns for equity investors.

Not to be outdone, both of SMI's primary investment strategies turned in even better results than the market. Our Just-the-Basics indexing strategy continued to be helped by owning a larger percentage of small-company stocks than the broad market indexes. As the table at the bottom of this article shows, that small-company boost has helped JtB investors move ahead of the market by a considerable margin over the past six years. Historically, six years is longer than the usual period of small-cap outperformance, so it could be that this helpful "wind at our backs" may not last much longer. But the allocations in JtB are fixed and don't shift in response to market events, so we'll keep enjoying that performance edge for as long as it lasts. Our normal 20% allocation to foreign stocks in JtB has also been a big plus.

Upgrading also produced another very strong quarter. As the small table above shows, Upgrading's recommended funds beat the category averages in four of five risk categories. The exception was in Category 4, the small-company/growth category, which for the second quarter in a row lagged its peer group. A closer look at the recent activity in Category 4 offers some helpful insights into the Upgrading process.

One noteworthy aspect of our risk category system is that our "growth" categories are broader and more diverse than our "value" categories. That's because, to simplify things for the average investor, we include the so-called "blend" funds—those that don't demonstrate a clear growth or value style—in the growth categories. As the third quarter began, all four recommended funds in Category 4 were "value-oriented" blend funds, despite belonging to this growth category. Our lineup started to change in August when two of these conservative funds were replaced with "true growth" choices, and continued with a third replacement in September. But since much of the quarter's gains occurred in July when our fund recommendations were still relatively conservative, our results for the category lagged slightly.

However, it's worth noting that defining our categories broadly, while hurting performance slightly this quarter, helps us more often than not. Continuing to look at Category 4, it's true that our Upgrading recommendations have lagged the average fund in Category 4 by 1.2% and 0.5% respectively the past two quarters. But those conservative holdings more than made up that difference during the first quarter of 2005, when a falling market caused our conservative Upgrading selections to beat their peer group by 3.2%.

The Upgrading process can be a bit frustrating at times. It's hard not to grumble when the Upgrading process moves us out of conservative funds and into more aggressive choices just in time for a drop—like the one provided by the opening weeks of October. But in reality, it's this gradual repositioning of our portfolios that Upgrading accomplishes so well. The past six years have vividly illustrated that Upgrading can respond to the market's significant cycle changes in plenty of time to profit handsomely. We don't have to catch each and every gust of wind blowing through the market to be successful. It's easy to think "I wish I hadn't made those recent changes" when a brief wind jolts the market. But both the short- and long-term track records below illustrate that the gradual changes Upgrading responds to are enough to engineer impressive margins of victory when compared to the market as a whole.

So it is that, despite lagging a bit in Category 4 lately, Upgrading as a whole has managed to more than double the market's return through the first nine months of the year. Speaking of doubling, the long-term track record reveals that Upgrading has more than doubled our money over the past six years. Pretty good for a period when the market has generated total returns of only a little more than 14%.

• Overview of SMI's Fund Upgrading Strategy
• Overview of SMI's Just-the-Basics Strategy
• Performance History of SMI's Model Portfolios
• From the SMI Weblog: Grinding it out 
• SMI Subscription Information

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