Buying Only Our 5 Top-Ranked Funds
Still Trounces the Market
By Mark Biller
© Sound Mind Investing | April 2010
Most investors have heard the narrative by now: the past decade was one of the worst on record. While it's true that the broad stock market indexes remain stuck at roughly the same levels of a decade ago, it wasn't such a terrible decade for those following SMI's Upgrading strategy.
Naturally, readers following our Upgrading recommendations hope their personal results are similar to those published in our quarterly report cards. But there's a rub. Our published results are based on the average of all four of the funds recommended in each risk category.
In other words, you would need to own all the funds shown on the monthly Recommended Funds page to get those published results. And, due to fund minimums and brokerage availability, that may not always be possible.
So, let's say you're limited to just one fund in each category. Which one should you pick?
Intuitively, it would seem logical to buy the fund listed as #1 in each category (which is normally the one with the best momentum score). But, by the same token, the ones flying the highest can fall the hardest. Would always buying the top-rated fund generate better returns, and even if so, would the perceived extra risk be worth it?
To find out, we went back to the January 2000 issue of the newsletter and started a portfolio composed of the top recommendation in each risk category. We used that year's recommended category allocations, and started tracking this portfolio's performance month by month.
Each time one of our five holdings was replaced in the newsletter, we bought whichever fund was listed as that month's #1 recommendation for the risk category (note, we changed funds only when a fund was completely removed from the recommended funds list, not when it merely fell out of the #1 slot). The only exceptions were the handful of times the new #1 recommendation was closed to new investors, in which case we dropped down to the #2 recommendation. At the beginning of each new year, we rebalanced to the new year's SMI-recommended allocations, but continued to hold the same funds from the end of the prior year.
In other words, we tracked this portfolio exactly the way we would have expected a reader following a "buy only the top-ranked funds" approach to have implemented the strategy in real life. There was no guesswork to this exercise — we used the actual funds recommended as they appeared in the newsletters from the past decade.
The far right column of the nearby table shows the results of this approach quarter-by-quarter, compared with owning all four recommended funds in each risk category (which is the standard Upgrading approach tracked in the newsletter).
As you can see, it was a back-and-forth affair between the two portfolios. The better-diversified "Buy All Four" portfolio had the slimmest of leads on a quarterly basis, besting the "Buy Top-Ranked" portfolio in 21 of the 40 quarters.
But even though each portfolio had the upper hand roughly half the time over the ten years, the "Buy All Four" portfolio managed to accumulate a meaningful performance edge. The overall performance difference between the two portfolios: a total gain of 85.0% for the "Buy All Four" portfolio versus 73.1% for the "Top Ranked" portfolio.
That's not a huge advantage given the length of the period, but it's enough to matter.
It's also worth noting that the standard "Buy All Four" Upgrading portfolio earned these higher returns with less volatility. The Relative Risk scores at the bottom of the table show that standard Upgrading was about 8% more volatile than the broad market, while the portfolio of top-ranked funds was roughly 13% more volatile.
Generally speaking then, these data indicate that owning only the top-ranked funds results in a slightly more aggressive portfolio. This idea is supported by what we find when we sort the periods based on whether the broad market (Wilshire 5000) was advancing or declining during a particular quarter.
When the market was advancing, the "Top Ranked" portfolio outperformed the "Buy All Four" portfolio in 16 of 24 quarters (67% of the time). As you might expect, owning the more aggressive funds paid off in an advancing market. But when the market was declining, the better diversified "Buy All Four" portfolio was the better performer in a whopping 13 of 16 cases (81%).
What conclusions can we draw from this exercise? First and foremost, it's important not to miss the fact that both of these Upgrading portfolios performed very well relative to the broad market. This should be encouraging to those who lack sufficient funds to invest in all four funds in each risk category — Upgrading is still very successful when practiced on a more limited basis by buying only the top-ranked fund in each category.
That said, the data also send a clear signal that SMI's "official" implementation of Upgrading — owning all four funds in each category — is preferable. Not only were returns measurably higher when using this approach, volatility was also reduced by virtue of the increased diversification. This may incline some smaller accounts towards using The Sound Mind Investing Fund (SMIFX) so as to gain the benefit of its fully diversified Upgrading portfolio, despite only having a small amount to invest. That's a nice option to have.
Either way, it's worthwhile to know that for those who can't afford to own all four funds in each category, a simplified approach of just buying the top-ranked funds nearly held its own over an extended time period. It's always been our opinion that owning as many of the recommended funds as possible is a good goal, which this research appears to confirm.
But seeing the results of both portfolios in relation to the Wilshire 5000 should relieve the pressure for those struggling to meet the initial investment minimums of multiple funds, and reassure those who can afford only one fund in each category that Upgrading is still worthwhile. Based on these findings, either approach is likely to lead to success. 
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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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