2Q Market Review and 2 Fund Changes
Asset Class Recap as of 6/30/2021
The second quarter was terrific for investors, as every asset class and fund we include in our portfolios produced positive returns. The U.S. government’s progress toward passing a plan to massively increase federal spending has been perceived by investors as a positive for future stock earnings, pushing stock prices up accordingly. Large Growth stocks led the charge last quarter as the largest U.S. growth oriented corporations including Microsoft, Amazon, Facebook and Apple saw their stock prices increase more than 10% this last quarter.
The chart below shows three year growth over time for these same asset classes, presented as the hypothetical growth of $1 in each asset class. It is easy to pick out the COVID related market pull back between 12/31/19 and 3/31/20 and it is equally clear that broad markets have done quite well when viewed over the longer term. Large Growth’s run is starting to stand out on this chart like a classic bubble, as this asset class has been on a tear for the last five quarters. Many market timers who strongly underweighted Growth after its first couple quarters of outperformance have missed out on a lot of momentum based return. Although long term oriented investors like us may wring their hands in worry about high valuations, we do not try to time markets month to month and put our savings at risk by focusing our investments into narrow market segments. That said, our return expectations for Growth have dropped meaningfully, as Growth has earned 23.7% (geometric annualized) over the last five years. We have already been carrying a slight Value tilt in our more aggressive portfolios and I increased our Value target by 2% in our three most aggressive portfolios using Vanguard Value ETF (ticker: VTV).
Two Fund Replacements - One Active Mutual Fund and One ETF
We have not made changes to the funds we use in our portfolios since they were officially rolled out at 7/31/2020. There are two funds that I have been following for many years that we are adding to our model portfolios. These funds will be added to client portfolios at each client’s next update, taking each account’s tax status into consideration - tax deferred accounts can trade freely without tax ramifications, but taxable accounts will be reviewed carefully before fund replacement trades are done.
Dimensional Fund Advisors (DFA) Small Cap Equity (ticker: DFSVX) -
This was one of the first fund strategies that I worked with when I started at Northern Trust in 1994. One of my large corporate clients in Portland included this fund in their pension and it left an impression on me for a few reasons. The strategy purchases a large number of very small companies that were difficult to value because some of them did not trade often. This made it difficult to produce accurate accounting reports (my first investments related job). But when we did catch up and collect fresh stock prices and it came time to calculate fund performance, many times this fund’s return was so high that I initially thought it was an error, but it wasn’t. This fund has been around since 1993 and has performed very well. Its outsized returns come with significant volatility though. This fund can go through long periods of underperformance, including consecutive negative years, and it has one of the highest standard deviations for a mutual fund in Morningstar’s database. That is one reason our allocations are below 6% in our aggressive portfolios, with lower allocations in the more conservative portfolios.
There is a lot of academic research on small-cap and value outperformance, with many theories about the sources of outperformance, and Dimensional Fund Advisors (DFA) was founded by academics with the goal of incorporating many of these theories. DFA requires advisors to go through a vetting process before they allow the advisor to sell their funds, which I wrapped up last month. This website has more information on the fund https://us.dimensional.com/funds/us-small-cap-value This fund will replace JP Morgan Small Cap Value in our portfolios.
VanEck Vectors Fallen Angel High Yield Bond ETF (ticker: ANGL) -
We currently use iShares Broad USD High Yield Corporate Bond ETF (ticker: USHY) in our portfolios to get high yield exposure. USHY is a traditional, diverse, index-based product that holds 2,125 individual bonds that are rated below investment grade. I believe USHY is a fine product, but I have also been following ANGL since it rolled out in 2012. ANGL follows a unique high yield index nicknamed a “fallen angel” strategy. This strategy buys bonds that were recently high quality (investment grade) whose parent companies have recently run into financial difficulty that has caused ratings agencies to move their bond quality ratings down to low quality (non-investment grade). Research has shown that the market often overreacts and pushes prices for these bonds down too far, offering a bargain for investors who are willing to “bottom feed”.
There are two ETF’s for sale in the U.S. that incorporate a fallen angel strategy; ANGL from VanEck and FALN from iShares. After doing a lot of research on both ETF’s, I believe ANGL may be a slightly more attractive option for our portfolios. If you would like me to send you my research document that compares ANGL to FALN, send me an email and I will send it to you. This site has detailed information for ANGL. https://www.vaneck.com/us/en/investments/angel-high-yield-bond-etf-angl/
These are our updated model portfolio target allocations after the two fund changes.
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