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Investors need to pay attention to their asset allocation if they wish to earn consistently good returns. By so doing, they decide on which categories and sub-categories of ETFs should be represented in their portfolios and, if included, to what degree. For example, if I decide on a 60% allocation to stocks, should these be half in growth-oriented ETFs and half in value-oriented ones, or, some other combination? Since there are indeed many sub-categories of ETFs, how does one choose and does it really make a difference? And once chosen, should your allocations remain fixed at these levels, or are there reasons, other than rebalancing or a change in your objectives to alter them?

Research has shown that the choice of which categories, or sub-categories, to invest in is the most important determinant of a portfolio's above par or sub-par performance. This means it is even more important than which specific, individual ETFs you include in the portfolio. If so, then the above questions become even more important. So, these decisions should attempt to make use of whatever data might be available to help ensure a favorable outcome.

Overall stock or bond ETF category performance can be typically observed to run in multi-year cycles of relatively good vs. sub-par performance as compared to long-term average returns. This is also true of the various sub-categories by which individual securities are frequently organized when they are pooled into ETFs. Investors willing to use knowledge of prior investment cycles as well as where we seem to be currently in that cycle to periodically adjust their portfolios may be able to achieve significantly better returns by focusing on particular sub-categories within the overall asset classes of stocks and bonds.

In order to do this, one may need to "un-brainwash" oneself from the seemingly popular notion that past performance of investment categories has no relationship with subsequent performance. Such a view essentially espouses that stock prices are nearly, if not totally, unpredictable from year to year. While it is true that one is never guaranteed to succeed by following past trends, we know that asset prices, whether for stocks, bonds, houses, precious metals, or whatever, tend to either rise or fall, not at random from year to year, but over multi-year stretches of either doing well or doing poorly. Then, at some point, the trend reverses, often carrying investment performance in the opposite direction, again often for a number of years.

The problem, though, for most investors is that even within multi-year trends, it is relatively rare to see many years of uninterrupted investment performance in the same direction. Rather, just to confuse things it seems, a rising or falling trend can often take a "break." The result is that investors who otherwise might have proceeded with confidence now must weigh the chances that the trend has indeed been broken with prices headed in the opposite direction.

We have had a good example of that just recently. After two straight years of excellent yearly performance beginning in 2009, 2011 was a subpar year with the average diversified U.S. stock fund down 2.9%, although the S&P 500 index squeezed out a 2.1% gain.

Many investors could have easily surmised that the then new bull market was likely over. I, on the other hand, did not assume that; I continued to raise my Newsletter's overall Model Portfolio allocation to stocks for moderate risk investors to 62.5% in Jan. 2012 and 67.5% in Apr. 2012. 2012 turned out to have been another good year with the S&P rising 16%. And, of course, 2013 is off to a good start with the index up about 6.5% through Feb. 28th.

Thus, the multi-year rising trend for stocks, which began in early March 2009 will now apparently reach four years, rising a total of approximately 130% from that bottom for large-cap stocks, in spite of taking a long enough break in 2011 to convince some investors that no further bull market gains could be expected.

It turns out that rather than being a highly unusual occurrence, such multi-year thrusts actually follow the pattern of at least 85+ years of historical yearly returns for the S&P 500 index and other equivalent indices.

The following table shows average five-year returns for stocks broken down by half-decades.

Total Returns on the S&P 500 Index
1925-1954 1955-1984 1985-2012
Half-Decade Avr.
Yearly
Ret.
Half-Decade Avr.
Yearly
Ret.
Half-Decade Avr.
Yearly
Ret.
1925-29 22.0% 1955-59 16.6% 1985-89 20.8%
1930-34 -4.8 1960-64 11.6 1990-94 9.3
1935-39 15.5 1965-69 5.8 1995-99 28.7
1940-44 8.9 1970-74 -0.8 2000-04 -5.7
1945-49 11.7 1975-79 15.8 2005-09 3.1
1950-54 25.5 1980-84 15.5 2010-12 11.1

Note: Data shown is for 3 years of the current half-decade.

It should be obvious to anyone that stock returns vary greatly from year to year. But what might be a little less obvious is that even when investing over five-year periods (or more), returns can vary a great deal. The mean return for each of the 17 full five-year periods shown is 11.7% per year. Thus, there is a "bias" for generally good returns. But if yearly returns were truly independent (random) from year to year, the means of each five-year period would be highly unlikely to vary as much from each other as shown, since, if so, "good" and "bad" years should come closer to balancing each other out over any given five-year period.

But, as I have stated, the fact is that particularly good and subpar years run in streaks. Actual year-by-year data (not shown) reveal that while at times these streaks are uninterrupted, in most instances, good repeating yearly investment performance is interrupted at some point by a relatively subpar year before continuing, just as our above recent example showed. Why there are such long streaks, and why they are frequently interrupted, is not the subject of this article. However, my own explanation might be that they are paralleled by the fact of multi-year economic cycles, with pauses when investors begin to get spooked by certain economic circumstances, or merely pause in order to take profits.

Growth vs. Value ETFs

The same has been shown to be true in head-to-head comparisons of growth vs. value stocks, which the S&P 500 index can be broken down into. Rather than seeing predominance by growth vs. value as largely being a random affair, history shows that one category has tended to outperform the other over a number of years with the average being about six years since 1980.

In spite of this, though, long-term investors will still want a good slug of each in their portfolio in order to maintain an adequate level of diversification. Your growth choices might include Vanguard Growth ETF (NYSEARCA:VUG), or the Vanguard Mega Cap 300 Growth ETF (NYSEARCA:MGK). Value choices might include Vanguard Value ETF VTV, or the Vanguard Mega Cap 300 Value ETF (NYSEARCA:MGV). (Note: I last wrote about allocating between growth vs. value funds/ETFs in an May 2012 Seeking Alpha article where I made similar recommendations.)

One only has to look back to the seven-year period between the start of 2000 and the end of 2006: During that long span, on a yearly basis, the average Large Cap Value mutual fund returned +5.5%. By contrast, the average Large Cap Growth fund returned -3.1%. In other words, on average, for any given year during that period, one would have lost money in a growth fund but would have made a positive return in a value fund; the difference between choosing growth vs. value would have averaged an 8.6% difference per year in an investor's pocket.

In the subsequent five years, between the start of 2007 and the end of 2011, there was a reversal of fortunes, so to speak. That is, the investor in the average Large Growth fund began to make money, at least in terms of the average yearly return. The investor in the average Large Value fund now lost, although a very small amount. But by picking growth instead of value, an investor would have now averaged keeping 4.6% per year more in their pocket.

So What Should an Investor Do Now?

Of course, as implied above, some might choose to simply remain as diversified as possible by putting an equal amount into both the growth and value sub-categories. Or, simpler still, they might merely choose to stick with a Large Cap Blend ETF, perhaps merely Vanguard S&P 500 ETF (NYSEARCA:VOO), which by definition should have roughly an equal amount in both investment styles.

But I feel that the above data and evidence presented in my aforementioned article suggest that if an investor is willing to recognize the cyclical nature of growth vs. value leadership, they will want to overweight that category that seems to suggest current leadership and thereby hope to see that category's average superior performance continue on for a sizable number of years ahead.

At the time I wrote the above May 2012 article, the Large Growth category was outperforming the Large Value category by about 5% per year, and for 4 out of the prior 5 years. And Large Growth had returned 16.3% in the 1st quarter of 2012 alone, 4.3% ahead of Large Value. But for the remainder of the year, and now two months into '13, value has started to pull ahead, giving the first inkling that perhaps the sequence was beginning a new cycle. Thus, in the prior 10 months, a proxy for Large Value has outperformed Large Growth by about 6% (not annualized). It now appears likely that growth predominance has ended and that value will be the better place to be for many years ahead, given the 6 year average length of these cycles.

Of course, this cannot guarantee that value is now assured of doing better than growth. Even with the seven- and five-year stretches of predominance described above, there was in each case one calendar year in which the predominance did not hold true although this was by relatively small amounts. The same could be happening now, meaning that once again growth could resume its leadership. But the nearly one year reversal of growth outperformance by value, if it continues at the same pace through April, will amount to a significant outperformance of 7.2% over the prior 12 months.

In my latest Model Portfolio which can be viewed at my site, I have begun to moderately outweigh value over growth, especially when you factor in that my current recommendation that aggressive investors include a position in the Financial sector, which is actually a bet on value stocks as well. (My proprietary research currently considers none of the nine basic Morningstar "grid" funds, i.e. 3 styles X 3 size factors, as Buys but rather just Holds.)

A Financial sector ETF, such as Vanguard Financials ETF (NYSEARCA:VFH), is one just two sub-categories of ETFs, along with Global Real Estate, such as SPDR Dow Jones Global Real Estate (NYSEARCA:RWO), that my research currently considers as Buys. And the sector perhaps most associated with growth, that is Technology, appears according to my research to be one of the least promising sub-categories looking forward, although still regarded as a Hold.

Note: Sector ETFs tend to be more volatile than broader-based grid ETFs. This means that a correct bet on a sector ETF invested in value stocks will likely return more than a non-sector value ETF. For example, over the last year, Vanguard Financials ETF which I began recommending in Oct. '10, has returned about 21% while a typical Large Value fund about 13% (through 2-28). But, if things do not work out as expected, especially in the short term, then a sector ETF can be expected to suffer more than the average Large Value ETF.

The above discussion applies to Large Cap ETFs. Does it also apply to Small Caps? That is, in making your Small Cap allocations, should you similarly favor Small Value over Small Growth?

Historically, at least over the last 34 years, the Russell 2000 Value Index (i.e. Small Value) has been a much better place to be than the Russell 2000 Growth Index (i.e. Small Growth) with an average outperformance of better than 4% annually (approximately 13% annualized vs. 9%.) But since the start of the bull market 4 years ago, Small Growth has had a bit of an advantage.

Now, however, Small Value appears to be following in the footsteps of Large Value in moving ahead. In fact, Small Cap Value has had about a 5% advantage over Small Cap Growth over the last 12 months. Still, I am not willing to venture forth the recommendation that Small Value is perched to perform significantly better than Small Growth.

Why not? Small Cap Value has done so much better for so many years that it would appear unlikely to me that such outperformance can continue indefinitely. In fact, small cap stocks in general appear to me to be overvalued, whether growth or value. Therefore, I would keep my recommendation mainly to emphasizing Large Value over Large Growth.

While I continue to expect decent returns for stocks in the next few years, the gist of this recommendation is one of expected relative outperformance for Large Value ETFs over Large Growth. This does not necessarily imply that any sub-category of ETFs will be assured of performing well in an absolute sense. However, Large Value should likely be your best place to be for at least the next several years within the universe of stock ETFs.

Source: Overweighting Value Stocks Should Pay Off