Our most aggressive core strategy, Fund Upgrading is a “momentum” strategy premised on the idea that recent past performance tends to persist. The strategy has you diversify your portfolio across five stock fund “risk categories” and up to four bond fund categories. You then buy the funds SMI objectively determines to have the highest momentum, occasionally replacing lagging funds with those showing stronger momentum. With only monthly maintenance, Fund Upgrading has generated considerably better long-term returns than the overall market. This article explains the changes to put in place for the coming month.

In the Foreign group, Oakmark International (OAKIX, 1/2013) is being replaced.$
Last month, we replaced a recommended fund that had been held just shy of two years. This month, we're replacing one that has been recommended for over a year (January 2013). These long-term holdings do a few things for us as Upgraders:

  1. They keep the amount of trading down to a tolerable level.
  2. They allow our winners to run by not selling funds when they're still performing strongly relative to their peers.
  3. They help many of our biggest gainers to jump over the 12-month holding period requirement to qualify for long-term capital gains tax treatment, which makes Upgrading more tax-efficient than one might otherwise expect.

Oakmark International is the type of fund that's never fun to sell. Due to the fact that it spends more time than most near the top of the category momentum rankings, SMI has recommended this Oakmark fund numerous times. Also, that the fund is now closed to new investors compounds the displeasure—we may not be able to buy back in should we want to at a later date.

Yet our Upgrading discipline drives our investment decisions, including those to sell "great" funds when the momentum scores say it's time. Oakmark International performed very well for us in the first 13 months we owned it, gaining 24.8%, which was significantly better than the 15.9% gain of the average fund in our foreign group. However, the January 31 performance numbers are instructive. They show that over the past six months Oakmark International gained 6.0%, while over the last 12 months it earned 16.8%. This indicates the fund's performance was considerably stronger during last year's February-July period (the more distant six months) than it was during August-January (the most recent six months). In addition, the fund actually lost money over the most recent three months (November-January). This reveals a clear pattern of slowing momentum: the most distant six months of performance was the best, the three months that followed were still positive but at a lower rate, and the most recent three months were actually negative.