Vanguard's decision last summer to adopt a largely no-fee model for exchange-traded funds (ETFs) was welcome news for SMI Upgraders, as well as for Vanguard account holders following our premium-level Dynamic Asset Allocation (DAA) strategy.
The company's move to no-fee ETFs also was a plus for SMI members implementing our 50/40/10 approach, which combines DAA, Upgrading, and Sector Rotation.
Unfortunately, Vanguard has just unveiled a policy change that isn't good news for SMI investors, specifically those following Sector Rotation or 50/40/10. As noted in a company news release, the change takes effect next Tuesday.
Beginning January 22, 2019, Vanguard clients will no longer be able to purchase leveraged or inverse mutual funds [or] ETFs....
This change is part of an ongoing effort to align the products and services we offer with our investors' focus on the long term. These investments, which are generally incompatible with a buy-and-hold strategy, run counter to this long-term focus....
[Leveraged traditional funds and ETFs]...are extremely speculative in nature and can be quite volatile. Most are designed to deliver their stated returns for only a short period.... Their extremely short-term, speculative nature is contrary to the long-term focus shared by most Vanguard investors.
The reason this change affects only Sector Rotation and 50/40/10 investors is because SMI doesn't recommend leveraged funds in our other strategies (and we don't recommend "inverse" funds at all).
Here's a quick reminder of what a leveraged fund is — from our June 2016 issue:
[Such funds] use derivatives and debt to "amplify" returns. For example, a leveraged ETF with a 2:1 ratio is designed to provide double the return of a specific underlying index — such as the S&P 500. Of course, this leverage works both ways, amplifying both gains and losses....
Pick the right market direction and the gains can come quickly.... If you get the market direction wrong, the losses can also mount quickly.
Given that heightened risk, why do we occasionally recommend a leveraged fund for SR?
[W]e think the potential rewards of including leveraged funds outweigh the additional risks. Hopefully, any SMI member using Sector Rotation recognizes that it is a high-risk, high-reward strategy and is respecting the limitations we place on it within the context of a broader portfolio. We certainly try to keep its riskiness front and center, plastering risk warnings on virtually every mention of Sector Rotation.
In that context, the marginal additional risk isn't so significant. Remember, the SR strategy itself is providing a timing mechanism of sorts, telling us when these particular sector funds are most likely to succeed, as well as providing a rigorous selling discipline to limit our losses once a sector's momentum changes.
As it happens, our current Sector Rotation fund is a leveraged fund, which means that as of next Tuesday, you won't be able to buy it via Vanguard.
The good news is that Vanguard customers who've already invested in the current Sector fund, which was recommended just a couple of weeks ago, can continue to hold it. However, if you want to add to your Sector holding, you'll need to do so before January 22. After that, Vanguard won't allow additional investments into the fund.
Obviously, we don't know at this point if the next Sector recommendation (whenever that may be chosen) will be a leveraged fund or not. If it is, Vanguard customers will have to pick an alternative SR fund from the top-quartile rankings. As always, we'll post those rankings along with our new "official" recommendation when the time comes.