FSO Editorials: Mutual Fund Portfolios for Risk Averse by Robert B. Gordon 10/28/2003

Mutual Fund Portfolios For the Risk Averse
Special Note on Mutual Fund Corruption
by Robert B. Gordon, Sc. D.
October 28, 2003

I have long expected to see great changes in the mutual fund industry resulting from the effects of the great bear market which appears ready to gather downside momentum again, but I never imagined the corruption now being exposed. So far it seems to primarily involve (1) some bad practices in handing sales commissions on loaded funds and (2) illegal trading by hedge funds and fund managers in complete violation of written industry standards.

The size and scope of the current problems remains to be determined but, when this situation is finally resolved, the discredited fund industry will no doubt have some new restraints on what it can and cannot do to harm its unsuspecting clients. I am confident that the entire industry will not be found guilty of serious crimes and that the funds that remain will be even safer than before. I have always been strongly opposed to loaded funds because of the loss in the sales load when selling the fund for it’s poor performance. Following the practice of using no load funds only may solve more than one problem when the facts are all known.

The problems now coming to the fore place new emphasis on the great need for investors to learn early on the standards needed to pick the very best fund for a special portfolio need. In nearly every one of my essays, I have emphasized the urgency for investors to look before the leap into any mutual fund. The really outstanding funds are few and far between. It is well within the capability of any investor to learn to separate the good funds from the bad. There is no better time to start separating the good from the bad than right now.

It is entirely natural for investors to become more conservative as they approach the end of their working career, especially if their retirement funds are less than adequate. It can also occur at any age for those who have suffered severe financial losses from any source. And, after ending their working careers, most people tend to be quite conservative in their investing. That is certainly my understanding of my 400 fellow retired residents.

We live in a large retirement complex with the average age probably in the low eighties, Females outnumber males by a wide margin. I do not have and do not want to have specific information on any person’s financial assets. However, I do have some general information. Some residents still hold common stocks they have held for a very long time and will not sell because of the tax consequences. Others hold mainly tax free municipal bonds or Certificates of Deposit in local banks. Many of them are dependent on the advice they get from brokers in our local communities.

Many of these residents, both men and women, have attended one or more of the educational seminars I have given here over the past 6 years. I am not aware from their comments that I have changed any minds or investment habits. Since I started my writing career on the web two years ago, I have given just one presentation to a local resident group. The subject was the history of market manias and duplicated one I gave here in October 1997. I was surprised, in a show of hands, that some in the group had heard my 1997 talk, but again, there was little evidence of minds being changed with respect to investing.

It has been a great pleasure for me to receive e-mails from thousand of readers from young to old and living in many geographic locations. Their comments and questions stimulate me to write on many different subjects.

Hoping to generate some interest from our older readers, I am going to present some ideas for portfolios designed for ultra conservative investors who have an over riding need for safety of principal in tumultuous markets.

What risks do investors face in addition to the ever present problem of losing principal? Right now the dollar is losing strength against major foreign currencies, so we must plan to reduce this risk. Another great risk is that of inflation which reduces the buying power of the dollar. Higher interest rates are very harmful to fixed dollar investments since they drop in price as interest rates rise. Regardless of how conservative they may be, fixed income investors have to seriously consider using at least modest amounts of precious metals and short positions in order to protect against all known and unknown problems that may arise.

There may be severe credit risks in coming years by investors holding individual bonds, both taxable and tax free. Corporate and state issuers are in danger of being unable to meet their interest payments. Even in the case of insured bonds, the insurer may be unable to cover missing interest payments when the number of defaults becomes too large in a nationwide depression.

In the difficult and potentially dangerous days that lie ahead, it will make sense to spread your risks much more than might be advisable in more normal times. This means using diversified mutual funds when they are available, even with the risk of not having a bond maturity date. This problem can be solved by using special funds, known as Target funds, that do have a maturity date as a result of owning bonds stripped of their coupons. Another plan known as "building a ladder" can be used for individual bonds and bank CD’s. The average yield for both bonds and CD’s can usually be increased by splitting the available dollars into say five or more maturity dates, each one a year apart. When the one year CD or bond matures it is replaced by one with a 5 year maturity data. Each year this process is repeated.

Depending on the amount of money to be invested, we like to build some level of diversity into each portfolio. This may mean using more than one stock or mutual fund for the same asset class. We are more likely to do this with a stock portfolio than a conservative bond portfolio.

Short to intermediate U. S. Treasury bonds, both regular and inflation-protected, are a typical starting place. However, to prevent losses from a declining dollar, we have been recommending that portfolios should include an equal percentage of highest grade short to intermediate Foreign Government bonds. Fortunately, there are quite a number of good foreign bond funds to choose from. We would also include the unusual Total Return fund described in our recent essay, www.hussmanfunds.com, which can own both foreign and domestic bonds, dividend paying stocks and gold shares.

In addition to the usual expected asset classes mentioned above, we feel that every conservative portfolio needs to make room for three other profit opportunities.

1. Participation in major bear market rallies such as the recent 12 month long rise. Our choice here is the very special Strategic Growth fund which is a companion to the Total Return Fund. It hedges common stocks to prevent loss in bear phases and uses leverage to increase gains in bullish markets. The 3 year bear market record of this fund is superb.

2. Protection against severe increases in bond yields and decreases in bond prices by a small hedge position in RYJUX, the only mutual fund with short bond positions.

3. Holding a small permanent position in a gold fund to participate in any major gold price rally.

These 3 unconventional asset classes will provide some excellent opportunities to capture capital gains in a volatile bear market. When used in sensible amounts, they should provide small consistent profits thru the unpredictable ups and downs of a long and severe bear market.

We start with a large 65% position in U.S. Treasuries, Foreign Government Bonds and income stocks and then add lesser amounts of the three asset classes mentioned directly above. First, we will give the 13 month performance dating from the first available prices on the Total Return fund in our FastTrack database.

Annualized Returns 9/18/02 - 10/24/03
Asset Class	%	Asset Return	Weighted Return
US Short Treas.	20%	-0.01%	0.0%
Foreign Bond Fund	25%	17.9%	4.4%
Total Return Fund	20%	6.8%	1.3%

Strategic Growth Fund	20%	7.3%	1.4%
RYJUX Short Bond Fund	7.5%	0.0%	0.0%
Diverse Gold Fund	7.5%	37.3%	2.8%
Total			9.9%

This 13 month period occurred during a major bear market rally in which the 3 minor asset classes provided a disproportionate amount of the gains. But that is why we placed them in this very conservative portfolio. With the Dollar continuing its decline, the Foreign bond fund holding 16% gold and silver bullion was the largest contributor to the total return.

We highly recommend that investors should rebalance this portfolio about once per year, bringing its composition back to the original percentages. Few investors have been taught to do this with the result that, in a few years, their portfolio has changed, perhaps drastically. But, even worse, they have missed taking a number of capital gain opportunities, which if not taken when available, often disappear in future market action. Conservative investors need to be reminded of this fleeting opportunity to increase the overall return of their portfolio.

For this 13 month period, we will arbitrarily choose 4 intermediate dates for rebalancing and hope that it will show the desired effects.

Asset Class	Original Amount	Final Return w/o Rebalancing	Final Return w/ 4 Rebalancings
US Short Treas.	$20,000	$19,779	$22,099
Foreign Bond Fund	25,000	29,492	27,623
Total Return Fund	20,000	21,361	22,099

Strategic Growth Fund	20,000	21,455	22,099
RYJUX Short Bond Fund	7,500	7,507	8,287
Diverse Gold Fund	7,500	10,298	8,287
Total	$100,000	$109,892	$110,494

Please understand that we do not recommend making 4 rebalancings in one year. We did it only to illustrate how it holds a growing portfolio closely to the original desired asset mix. There are two great benefits from rebalancing a portfolio. First, it keeps the portfolio from outgrowing its original intended proportions of the various constituent asset classes. Second, it takes profits from the more volatile classes and moves them to the less volatile classes where they will be safer from market fluctuations. It is a tremendous boon for conservative investors, permitting them to take small profits from gold and short positions without changing the basic conservative portfolio structure. The portfolio illustrated above had 85% of its assets in conservative bonds and hedged positions and yet earned a quite respectable return in its 13-month history. It’s success to date comes from a careful understanding of how different asset classes behave in bull and bear markets.

I suspect that many conservative investors would be quite satisfied with a 9% return over the past 13 months, while margined investors seeking Tech stock gains on the NASDAQ in the past year would not be happy. These differing views will almost certainly change as this bear market continues. The margined investor will probably lose much if not all of his assets while the conservative investor will still be enjoying his conservative gains.

In my considered opinion, it is extremely important that any do-it-yourself investor pick the specific mutual funds for each and every portfolio. There is a tremendous amount of fund information available on numerous web sites that I have mentioned in past essays. I have found my FastTrack data base covering about 6000 funds to be indispensable in comparing performance. The Windows program is free, as is unlimited 800 phone support. The daily data costs about $30 per month on a yearly basis. For a free 30 day trial, phone 1-800-749-1348. The FastTrack program is quite complex and I only use a small part of it, mainly by viewing any six fund performance charts on my screen. The data base is very extensive and each price chart is corrected for all fund distributions.

I hope that most of you have taken action on my many past warnings. The sleeping bear market is about to become awake and very vicious in the months ahead. So please take action right now to get rid of your losers. Remember, big bear markets have a long history of separating a tiny group of winners from a huge crowd of losers. Act now and good luck to all.