Battling the benchmarks

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By Bill Donoghue, MarketWatch

HEALDSBURG, Calif. (MarketWatch) -- The first five years of The Proactive Fund Investor newsletter have yielded some key lessons about succeeding in today's unpredictable markets.

For starters, investment objectives were set to earn high and positive returns at lower risk, using broad diversification within narrow sectors and investing only in liquid funds (no-load, low trading cost and zero redemption fees).

Over five years, PFI's concentrated, global exchange-traded fund portfolio turned $100,000 into $163,260 while PFI's Best Portfolio turned $100,000 into $158,000. Performance didn't move in a straight line, but the trend was up. Meanwhile, the same amount in an index fund tracking the Standard & Poor's 500 Index /quotes/comstock/21z!i1:in\x (SPX 1,105, +14.41, +1.32%) would have left you just about even.

Passive investing doesn't work nowadays. It didn't work in the last decade either, and it won't work in the coming decade. Somewhere between passive index-fund investing and rapid-trading market timers is a calm, proactive approach that attempts to find ETFs and mutual funds in underpriced market sectors with the strongest momentum, diversifies among those sectors, and for the most part uses cash for capital preservation.

Here's what we've learned:

1. Diversify among liquid sector investments that are rising in value

Sector Funds and ETFs are excellent tools, especially if you minimize transaction costs. Search the world for sectors with strong positive momentum and you'll be led to countries whose economies are strong and where currencies are strengthening against the fundamentally weak U.S. dollar.

Right now Turkey /quotes/comstock/13*!tur/quotes/nls/tur (TUR 63.01, -0.10, -0.16%) , Chile /quotes/comstock/13*!ech/quotes/nls/ech (ECH 70.30, -0.01, -0.01%) , Malaysia /quotes/comstock/13*!ewm/quotes/nls/ewm (EWM 13.35, 0.00, 0.00%) and Thailand /quotes/comstock/13*!thd/quotes/nls/thd (THD 57.34, 0.00, 0.00%) top those lists. Domestically, REIT funds are leading the pack and precious metals (gold, silver and gold-mining shares) still look undervalued. We don't invest in what we think will rise; we invest in what is rising and sell when it is not.

2. Exercise care with bear market and "inverse" ETFs and funds

Corrections tend to unfold faster than rallies and preserving cash is preferable to the hope of catching a falling knife.

That's why sometimes we've been as much as 50% in money funds in some portfolios. It's a lot safer and may build more wealth than betting against the market (a strategy that can make money long-term but can tempt you to overstay your welcome in a short downturn.

3. PFI portfolios require discipline

The portfolios tend to rotate among industrial sectors and countries as the economic cycle evolves. Two of the longest running portfolios have made about 60% over the past five years but twice in that time they approached a 100% cumulative performance.

Results for PFI portfolios started 7/26/05 (through 7/25/10):

Sector ETF Portfolio: 63.26%; S&P 500 benchmark: -0.8%.

PFI's Best Portfolio: 58%, compared to the S&P 500's negative 0.8% return.

Cool Income Portfolio: 16.3% versus 15.6% for Federated Money Market Fund.

Brand-name portfolios started 5/28/08

Three "brand-name" portfolios were introduced 32 months ago to address specific strategies. The diversified trend-following strategies, except for ProFunds, have outperformed their benchmark S&P 500 average.

New Rydex All Weather Portfolio: Invests directly in Rydex mutual funds, with transaction cost-free trading in Rydex single-beta bullish and bearish sector funds for those who can meet Rydex's $25,000 minimum account balance.

New ProFunds All Weather Portfolio: ProFunds requires a $15,000 minimum account balance and offers primarily 1.5-beta leveraged sector funds.

New Fidelity Sector Portfolio: Fidelity is a respected mutual fund family that pioneered a wide range of industry, regional and country funds but does not offer leveraged or inverse funds.

Bill Donoghue is editor of The Proactive Fund Investor, a weekly newsletter published by MarketWatch, and is chairman W.E. Donoghue & Co. based in Norwood, Mass.