The Latest, Greatest Improvement to
SMI's Just-the-Basics Strategy
[This article is primarily of interest to those currently following (1) none of our recommended investing strategies, (2) our Just-the-Basics strategy, or (3) our Enhanced Just-the-Basics 
advanced strategy for SMI web members. —AP]
From the earliest days of SMI, we have suggested that the easiest investing strategy to follow is one built on the convenience and diversification of index funds. It requires attention only once a year, and has outperformed the market over the past 5- and 10-year periods. We call it Just-the-Basics (JtB). (For more, see Third Quarter Review: Another Summer Swoon and Jumpstart pages 7-8. )
Several years ago, we introduced another version of this strategy that is only slightly more demanding—it requires a little housekeeping attention quarterly. So as not to confuse newcomers to SMI, we limit this "enhanced" approach (EJtB) to the "Advanced Strategies" section. Implementing the EJtB strategy requires access to the full range of Fidelity stock funds, so what follows below assumes an investor has an investment account at Fidelity.
The first two data columns in the table below shows the quarter by quarter performance results of the two strategies over the past eight years. As you can see, the little extra time required to implement and monitor EJtB has proven quite rewarding, boosting the average annual return from 6.1% per year to 10.8% annually. To put these results into perspective, consider that the stock market returned just 4.5% annually, on average, during the same period.
The purpose of this article is to share with you the results of some research we recently undertook in an effort to improve our execution of the EJtB strategy. As currently constructed, it has two drawbacks. First, it is locked into portfolio allocations that are inflexible, that is, the percentages devoted to large company stocks, smaller company stocks, and foreign stocks are fixed. As a result, the strategy is unable to respond to market trends by allocating a larger proportion of the portfolio to those areas of the market experiencing the greatest strength at the present time.
Second, there is a timeliness factor that requires the quarter-ending data to be gathered, processed, and published on the first trading day of each new three-month period. This is often difficult for the SMI staff, in that these dates fall on the New Year's holiday as well as the 4th of July weekend. If there were a way to get the data into our web members hands sooner and let them proceed at their own convenience, this would make life a little easier for all of us.
So, the research was seeking to find a way to resolve both of these issues without, of course, sacrificing performance results. We're happy to report "mission accomplished" on all fronts. The third data column in the table shows what the results would have been if the new methodology (which we're about to explain) had been in place in recent years. As you can see, the overall numbers are significantly better with only a slight increase in the relative risk score. Also, the new approach is more consistently successful on a quarter by quarter basis (the bullet points indicate the best performance for the quarter when comparing the old vs. new EJtB methodology)..
To illustrate how the new EJtB startegy will work, we'll use an example of how it would apply to a $40,000 stock portfolio. First, we take one-half of the portfolio and divide it between large- and small-company index funds. Investing $10,000 in Spartan 500 Index (FSMKX) gives us our stake in large-companies, and $10,000 in Spartan Extended Market Index (FSEMX) provides exposure to the growth potential of smaller companies. These passively-managed funds are permanent holdings, and provide an anchor of stability to the portfolio.
The remaining half of the portfolio will be flexible. It will be divided among the four actively-managed stock funds in the Fidelity lineup currently displaying the greatest strength as measured by each fund's SMI momentum score. To learn the identities of these funds, we will use the 401(k) Tracker tool available to our web members.
We would take the remaining $20,000 and invest $5,000 in each of the funds. We would hold these funds for the next calendar quarter—the January-March period—and review them in late March to see if any changes are needed going into the April-June period. As long as a fund remains ranked in the top 12 (based on its momentum score) of the 50+ Fidelity stock funds we're tracking, we continue to hold it. If it drops out of the top 12, it needs to promptly be replaced with the highest ranking Fidelity fund available to you that you don't already own. If two funds drop out, you buy the two highest ranked funds available to you, and so on.
The key to success is being faithful in carrying out this quarterly housekeeping task. You can do it more frequently if you wish, but in our research even monthly reviews didn't help the performance results. In fact, the greater activity actually lowered the overall gains somewhat.
Also, it should be noted that the fund performance data in the Fund Tracker is about three weeks old by the time it is distributed by Morningstar, processed by us, and uploaded to the Tracker tool. This is in contrast to the current system where the SMI staff does the heavy lifting necessary to post timely data on the first day of the new quarter. It would be logical to assume the delay would lower performance, but as the numbers show, they're still excellent. Might the results be even better if we could publish more timely data? Perhaps, but given that our back-tested results were actually worse when changes were made more frequently (monthly rather than quarterly), it's not clear that eliminating the delay would necessarily improve results.
So, there you go—results that are significantly better than the old Enhanced JtB approach (and more than twice as good as the original Just-the-Basics strategy). Plus, the data is available early, giving investors a week or so to make the changes rather than a window of just a single trading day.
We will no longer be publishing Fidelity fund recommendations based on the old methodology. If you're an SMI web member and you wish to follow the new EJtB approach, visit the Editors' Weblog starting around December 20, and we'll walk you through how to set up your portfolio for 2008 using the latest data in the 401(k) Tracker tool.
If you're not yet following an SMI investing strategy, or are following the original JtB approach, late December would be an excellent time to adopt the EJtB strategy for the coming year. Consider the difference it would have made during the test period in the hypothetical $40,000 portfolio. If your gains equalled those of the market (4.5% per year), you would have made $16,884 in profits. Compare this to the $24,237 (at 6.1%) from Just-the-Basics, and $63,363 (at 12.6%) from the new Enhanced version.
Of course, past results are no guarantee of future success, but there's a lot of margin for error in the performance superiority the new EJtB has enjoyed in recent years. It certainly seems worth the little extra effort it requires. 
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