SMI Strategies Capitalize on
A Strong Market in 2010
By Mark Biller
© Sound Mind Investing | February 2011
As is often the case, the final return numbers for 2010 don't do justice to the emotional ride the market took investors on this year. How tough could the year have been when the market ended up 17.2%? Plenty tough.
After a strong start to the year, the market peaked in April, then began an extended and deep correction — punctuated by the frightening "Flash Crash" in May — that didn't end until early July. At that point, the market was down roughly 8% from the beginning of the year, and 16% from its April highs.
Those who stayed invested, however, were rewarded with a strong finish to the year, as the market was up sharply in September, October, and December, leading to the year's strong overall gain.
SMI's primary strategies fared reasonably well in this up-and-down environment. Our Just-the-Basics strategy, which is based on index funds and features the appealing prospect of setting your portfolio once in January and then ignoring it the rest of the year, turned in a second consecutive year of not only beating the market, but beating Upgrading, SMI's actively-managed fund strategy.
As we've pointed out before, indexing performs best during periods when the markets are posting big gains. That's because index funds are always fully invested and hold little or no cash. In other words, the huge gains since the market bottomed in March of 2009 are exactly the type of environment in which we would expect JtB to do its best work, and it has.
However, a quick review of the strategy's track record reveals that the same dynamic has an opposite effect when the market is falling — bear market years can be especially painful for indexers, as their approach provides no safety net from falling stock prices.
SMI's Fund Upgrading strategy also managed to beat the market in 2010, albeit by a narrow margin. As the table above shows, our hefty allocation to foreign funds didn't do us any favors last year. Based on the average performance of all funds in each stock risk category, Foreign was the worst-performing of the five. Thankfully, our Upgrading discipline was able to improve on the performance in that category somewhat.
In contrast, the performance of Upgrading's fund selections in both growth categories lagged their category averages. There's no obvious explanation as to why that happened, though certainly the protracted mid-year correction contributed to it, as that forced a shift in our holdings from aggressive funds to conservative ones, then back toward aggressive choices by year-end.
Small-company stocks clearly dominated large-company stocks, further extending the trend discussed in Size and Style Trends Provide Clues about Future Allocations  .
There were relatively few surprises in the bond market last year. The Fed, as promised, kept short-term interest rates extremely low and continued buying longer-term bonds in an effort to keep those yields low as well. Perhaps one unanticipated development was the continued fear-based selling of stock funds by individual investors, and the huge corresponding inflows into bond funds. This dynamic pushed bond prices up even further (which pushed yields down), helping bond returns.
It's interesting to note what the long-term impact of adding bonds to our model portfolios has been. Granted, we are only looking at one specific 10-year period, so we should be careful about drawing broad conclusions. But within Upgrading, as bonds have been added to a portfolio (as you move from left to right across the allocations shown in our 2001-2010 performance table), the annual rate of return has fallen only slightly. The fact that this particular decade included two large bear markets likely accounts for the reason why there is relatively little change in results between the 100/0, 80/20, and 60/40 portfolios.
Interestingly though, the JtB strategy displays exactly the opposite pattern. In that strategy, returns have actually improved as bonds have been added. This is due to the fact that the broad stock market (and by extension, the JtB index funds that follow the broad market's movements) has been so weak, while bonds have performed quite well.
The biggest lesson to draw from the long-term results in the ten-year performance table is that those who have been patient and stuck with the Upgrading approach have been consistently and amply rewarded. Yes, there have been a few setbacks along the way, including many short, but scary, periods like we experienced in May-June of last year. But those who stayed the Upgrading course have now beaten the market in 11 of the past 12 years. That's great consistency.
More importantly, those consistent gains have compounded to total returns that dwarf those of the "lost decade" broad stock market results. Upgrading's 8.4% annualized gain over the past decade is more than triple that of the 2.5% produced by the Wilshire 5000, and more than double that of JtB's 4.0%. That consistent outperformance has been worth hundreds of thousands of dollars in additional profits to long-term SMI readers following the Upgrading strategy. 
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Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds. |
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