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Model ETF Portfolio Versus Benchmark: More Diversification, Similar Returns

by James B. Cloonan

Model ETF Portfolio Versus Benchmark: More Diversification,
Similar Returns Splash image

The Model Exchange-Traded Fund (ETF) Portfolio is now five years old.

The portfolio’s performance has been very close to that of our benchmark, although we have done somewhat better since we filled out our holdings three years ago.
Figure 1 and Table 1 show the performance of the Model ETF Portfolio through March 31, 2011.
It is worthwhile to note that we have an 18% commitment to real estate while our benchmarks do not. Without

real estate our returns would have been higher, but I feel that real estate is an essential part of an investment portfolio. It is unfortunate to have a 75% pullback during a short five-year holding period, but real estate’s previous performance, as well as its recovery from its low, support the desirability of its place in a long-term portfolio.
Table 2 on page 36 provides insight into the year-by-year performance of the Model ETF Portfolio and its benchmark.

Change in Review Schedule

Though the Model ETF and Model Mutual Fund Portfolios are kept up to date monthly at AAII.com, a number of members suggested that it would be helpful to cover them more frequently in the AAII Journal. Consequently, we have decided to review both the ETF and mutual fund model portfolios in the AAII Journal four times a year.

My Model Portfolios column in the August 2011 issue will be the first to discuss both portfolios in conjunction; subsequently, every March, May, August and November column will review both portfolios together. We will alternate printing the rules for the portfolios in these issues, but updated rules for both the Model ETF and Model Mutual Fund Portfolios are always available on our website at AAII.com. We hope this will be of help to all of our members who follow these model portfolios.

 

 

 

Looking Ahead

The market continues to vacillate within a fairly narrow range but maintains a positive trend.
As I mentioned previously, the emphasis on reducing government spending by both parties in Congress may offset the usual pre-presidential election programs that have made the third year in the election cycle a bullish one.
We will review the Model ETF Portfolio in August in conjunction with the Model Mutual Fund Portfolio, under the new schedule.
In the meantime you can follow it in the Model Portfolios area of AAII.com.

ETF (Ticker) Weight
in
Port
(%)
YTD
Return
(%)
Annual Return (%) Fund
Assets
($ Mil)
Exp
Ratio
(%)
 
St
1-
Yr
3-
Yr
Since
4/1/2006
Dev*
(%)
PowerShares FTSE RAFI US 1000 (PRF) 13.33 6.1 16.5 6.1 4.4 1,146.0 0.39 26.5
Rydex S&P MidCap 400 Pure Value (RFV) 13.33 7.2 15.5 8.4 5.1 56.3 0.35 37.6
Rydex S&P SmallCap 600 Pure Value (RZV) 13.33 4.0 11.9 9.5 2.0 95.9 0.35 48.1
First Trust DJ Select MicroCap Index (FDM) 13.33 7.4 26.2 6.5 1.3 155.9 0.60 28.7
iShares Cohen & Steers Realty Majors (ICF) 13.33 7.4 26.3 0.1 0.2 2,473.1 0.35 41.9
ALPS Alerian MLP ETF (AMLP) 13.33 2.9 na na na 939.8 0.85 na
Vanguard FTSE All-World Ex-U.S. (VEU) 5.00 3.2 13.4 -0.6 na 7,375.0 0.22 28.0
SPDR S&P International Small Cap (GWX) 5.00 3.0 22.2 1.9 na 928.9 0.59 27.4
Vanguard Emerging Markets (VWO) 5.00 1.8 18.1 4.0 10.3 47,079.8 0.22 32.3
SPDR Dow Jones Int’l Real Estate (RWX) 5.00 0.8 20.9 -3.9 na 1,745.4 0.59 29.3
Portfolio Average**
5.2 16.9 4.2 2.2 3,505.2 0.47 31.1
Optional Investment:                
iShares Barclays 1-3 Year Treasury Bond (SHY)   0.0 1.6 2.1 4.0 7,837.1 0.15 1.5
Benchmarks:                
iShares D.J. U.S. Index (IYY)   6.2 17.0 3.3 3.0 657.4 0.20 22.1
iShares MSCI EAFE Index (EFA)   3.3 10.4 -3.1 1.2 39,097.9 0.35 25.7
ETF Benchmark (80% IYY/20% EFA)   5.6 15.7 2.1 2.7 8,345.5 0.23 22.5

ETF Descriptions

Domestic Stock ETF Holdings

  • PowerShares FTSE RAFI US 1000 (PRF): Tracks a fundamentally weighted index that holds the 1,000 largest domestic stocks based on four factors—book value, cash flow, sales, and dividends. Stocks in the portfolio are weighted by their fundamental scores.
  • Rydex S&P MidCap 400 Pure Value (RFV): Tracks the “pure value” segment of S&P MidCap 400 index, which holds approximately one third of the index ranked on price-to-book-value, price-earnings, and price-to-sales ratios.
  • Rydex S&P SmallCap 600 Pure Value (RZV): Tracks the “pure value” segment of the S&P SmallCap 600 index, which holds approximately one third of the index ranked on price-to-book-value, price-earnings, and price-to-sales ratios.
  • First Trust Dow Jones Select MicroCap Index (FDM): Tracks an index constructed from micro-cap stocks based on a combination of value and growth factors. The weighting of each stock is based on a modified market capitalization determined using float rather than total shares.

Domestic Stock Sector ETF Holdings

  • iShares Cohen & Steers Realty Majors Index Fund (ICF): Tracks a modified capitalization-weighted index of large, liquid domestic real estate investment trusts (REITs) that is diversified across property sectors in an attempt to represent the current market.
  • ALPS Alerian MLP ETF (AMLP): Tracks the modified capitalization-weighted Alerian MLP Infrastructure Index, which consists of master limited partnerships (MLP) and limited liability companies (LLC) that earn the majority of their cash flow from energy commodities, but are not directly exposed to changes in commodity prices. AMLP is taxed as a regular corporation, and the net asset value (NAV) of fund shares will be reduced by the accrual of any deferred tax liabilities. Therefore, the fund’s NAV performance could differ from the index.

Foreign Stock ETF Holdings

  • Vanguard FTSE All-World ex-US (VEU): Tracks the float-adjusted capitalization-weighted FTSE All-World ex US Index, which includes approximately 2,220 non-U.S. large- and mid-cap stocks from both the developed and emerging markets.
  • SPDR S&P International Small Cap (GWX): Tracks the float-adjusted capitalization-weighted S&P Developed Ex-U.S. Under USD2 Billion Index, which is constructed of small-cap, publicly traded companies domiciled in developed countries outside the U.S.
  • Vanguard Emerging Markets (VWO): Tracks the float-adjusted capitalization-weighted MSCI Emerging Markets Index, which is designed to provide broad exposure to the equity markets of emerging countries in Europe, Asia, Africa, and Latin America.

Foreign Stock Sector ETF Holding

  • SPDR Dow Jones International Real Estate (RWX): Tracks the float-adjusted capitalization-weighted Dow Jones Global ex-U.S. Real Estate Securities Index, which holds publicly traded real estate securities in developed and emerging countries excluding the United States.
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Optional ETF Holding

  • iShares Barclays 1-3 Year Treasury Bond (SHY): Use of this ETF should be considered as a way of controlling portfolio risk. The index tracked is capitalization-weighted and includes U.S. Treasury bonds and notes that have a remaining maturity of between one and three years.

Updates for the ETF Portfolio will appear in the March, May, August and November issues of the AAII Journal. See the Model ETF Portfolio area of AAII.com for more information.

  Avg Ann’l
Ret Since
Incep*(%)
YTD
Ret*
(%)
   
Annual Rate of Return (%)
2010 2009 2008 2007 2006**
Model ETF Portfolio 2.2 5.2 21.9 40.0 -40.5 -6.6 11.7
ETF Benchmark (80% IYY/20% EFA) 2.7 5.6 14.7 29.1 -38.4 6.8 11.2
 

Model ETF Portfolio: Selection Rationale

The rationale used in building the Model ETF Portfolo is to achieve diversification across the asset classes listed below while maintaining a weighting that, in our assessment of historical data, will provide the maximum opportunity for long-term rates of return. We have a bias toward smaller-cap and value stocks and so does history.

Across national boundaries—U.S. versus foreign:

We begin with an 80% U.S. and 20% foreign portfolio but this could change. Foreign stock returns involve currency relationships as well as the usual equity analysis. The initial weighting takes into consideration the fact that many U.S. companies have significant foreign involvement.

In foreign investments:

  • Style will be diversified. We will seek emphasis on value stocks when it is possible.
  • We will seek a heavier weighting in the small-capitalization area than the typical portfolio.
  • We will diversify across equities and real estate, but will not use foreign bonds for risk reduction—at least not initially.

In U.S. investments:

  • We will diversify across equities, real estate, master limited partnerships, and short-term bonds. Short-term bond ETFs will be included as an option for investors who need further risk reduction. However, they will not be in the actual Model ETF Portfolio.
  • Our style diversification will aim for a heavier emphasis on value than the overall market.
  • The capitalization weightings will place considerably more emphasis on small-capitalization stocks than the overall market. We will seek to achieve this not only by including small-cap ETFs but by choosing larger-cap ETFs that do not weight solely on capitalization.

Which specific ETFs?

Although the above outlines the areas in which we will look for ETFs, it does not explain how we will choose specific ETFs when there are multiple ETFs in an area.

It will be many years before we have enough history to develop a solid set of criteria as we have for the Model Mutual Fund Portfolio. Many of the sponsors of ETFs, however, have a history with other investment vehicles that can provide a guide, as can liquidity, expense ratios, and the philosophy espoused in prospectuses. Over time, we should be able to harden our criteria.

How the portfolio is managed

We will not make trades solely for the purpose of rebalancing, except under unusual conditions. When we make trades for other reasons, we will do so in a way that repositions the portfolio back toward the initial weighting.

The current recommended initial weighting is to give each domestic holding an equal weight (for a total of 80% in domestic ETFs) and each foreign issue an equal weight (for a total of 20% in foreign stock ETFs). If you choose not to hold a particular ETF, maintain the equal weightings in each of the domestic and foreign areas, and keep the balance of 80% domestic stock ETFs and 20% foreign stock ETFs.

James B. Cloonan is founder and chairman of AAII.


Discussion

Charles from VA posted over 3 years ago:

I am heading into retirement within the next two years, can you recommend a more conservative % for each of the ETFS listed in the model portfolio incorporating less equities and more bond or higher yielding choices


Mary from CA posted over 3 years ago:

we have retired and have 30%invested in high yielding stocks (12% yearly)
60 % IBM, GE and MRO HD,NOK,PFE
10% cash
I need $ 50,000 a year to live on without touching my capital.
Am I doing OK.I have a about $500,000 total
How safe are those hi yielding stocks ARR-CIM- NLY-CYS-TWO????


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