- It must be a pure no-load fund. While it may charge a penalty for short-term redemptions, the penalty must be paid to the fund and benefit the shareholders. I feel this type of penalty is desirable particularly for small-cap and mid-cap funds to offset the transaction costs caused by short-term traders.
- It must have been in existence for at least 10 years. However, it makes sense to consider exceptions to this rule in certain circumstances. The major exception is if the results to date almost guarantee qualification at the 10-year mark.
- It must have had higher returns than the S&P 500 index on both an absolute and risk-adjusted basis for the most recent five-year and 10-year periods. I am interested in future performance, and the funds with the highest returns in the past are not necessarily those that will perform best in the future. But I feel that better funds always outperform the market (S&P 500 index) in the long and intermediate run, and risk-adjusted return is an essential risk control.
- It must never have had a three-year period with negative returns. This requirement seeks consistency. In addition, I feel an investment horizon of three years is the minimum for equity investing. This rule emphasizes the importance of never having to sell your portfolio holdings at a loss.
- Net assets must be less than $8 billion for giant- and large-cap funds, $3 billion for mid- and small-cap funds, and $1 billion for micro- and nano-cap funds. I believe it is too difficult to invest in areas that offer unusual opportunities with a cumbersome amount of assets.
- It must have an expense ratio no greater than 1.25% if assets are less than $2.5 billion and 1% or less if assets are over $3 billion. Many of the selected funds will be smaller in size, and I can therefore justify the 1.25% level, which is somewhat above the average for stock funds. However, I believe that a higher expense ratio not only will cost in the future (past expenses are reflected in past returns), but says something about managements attitude. However, there may be justifiable exceptions.
- It must currently be open to individuals, with a minimum investment of less than $25,000 and available to residents of larger states. However, I will follow openings and closings of otherwise qualified funds.
- If more funds qualify than are needed, new qualifiers are listed in terms of preference based on a number of quantitative and qualitative factors. These may include: stability of risk, turnover ratio, manager tenure, and shareholder services, in addition to basic criteria.
- Equal dollar amounts are invested in each fund initially.
- If you buy mutual funds through a discount broker, having 10 funds is easy enough. If you want fewer funds, you can apply your own criteria to reduce the group.
- It is not necessary to have a portfolio of 10 funds. All of these funds are so effectively diversified that their average risk is reduced only slightly when combined with others in the portfolio.
- On the other hand, you do not want to winnow your selection down to just one fund. While these funds in the past have had similar diversification benefits, changes specific to each fund may alter its level of diversification—for instance, a fund may get a new manager who changes direction, or there may be a change in philosophy. For that reason, you should hold at least four different funds.
- Well-diversified mutual funds do not have to be changed very often, so the screen will only be performed twice a year.
Model Fund Portfolio Update: 2005 Mid-Year Review
by James B. Cloonan
The last six months have not been very good for our Model Mutual Fund Portfolio, or for the market in general. The fund portfolio was only slightly ahead of the S&P 500 index. However, it is still significantly ahead for the past 12 months and for the two-year life of the portfolio, as can be seen in Figure 1 and Figure 2.
Since the fund portfolio is now two years old, its helpful to separate the performance history of the funds currently recommended from the performance of the actual portfolio (it is a real portfolio). The history of the currently recommended funds, as shown in Figure 1, is important because it lets you see the characteristics of the funds we currently recommend and their performance over various periods.
The actual portfolio, as shown in Figure 2, is different because we have replaced some funds, and our weightings are based on prices as of June 30, 2003, or whenever we added new mutual funds. Depending on when you began investing in the Model Mutual Fund Portfolio and how many funds you bought, you will have different results. But they should be similar to the average results from Table 1 for the funds you chose and the period you have held them.
We are selling Royce Premier (RYPRX) because its expense ratio was too high for a fund of its size and it violates Rule 6 (See the Selection Rules box). Royce Premier continues to grow rapidly, likely because of the marketing of the fund available from the 12b-1 fees that keep the expense ratio up and will, in my judgment, reduce effectiveness. This is the kind of rule violation that we might let slide for awhile—and we did let it slide for six months. But we also feel that the holdings of Royce Premier and Royce PA Mutual (PENNX) are so similar that there is no reason to keep them both, and we feel that Royce PA Mutual has a better future outlook.
Why do we report a risk-adjusted return? Lower risk is directly exchangeable for higher return.
There are two ways to exchange risk for return. Lets use a simple example to illustrate both approaches. The first approach uses borrowed funds. Assume that both the market, as represented by an S&P 500 index fund, and Portfolio A have the same rate of return: 12%. Also, assume that the S&P 500 index fund has a risk level of 0.18 (standard deviation) and Portfolio A has a risk level of 0.12. If your suitable risk level is 0.18, then you can simply buy the S&P 500 index fund and have your return of 12%.
However, you could buy 150% of Portfolio A and also have a risk level of 0.18. In this case, your return would be 12% on the original investment plus 3.5% on the additional 50%, or a return of 15.5%. The additional 3.5% return is calculated by multiplying 50% by 7% (12%—5%), where 5% is the cost of borrowing. The lower risk is directly convertible into a higher rate of return.
Not everyone is comfortable borrowing to invest and, in most cases, individual investors do not want the risk level inherent in an all-stock portfolio. Therefore, we can look at the conversion in an alternate fashion, using an S&P 500 index fund and Portfolio A once again. If you invest two-thirds of your portfolio in an S&P 500 index fund returning 12% with a risk of 0.18, and one-third in short-term Treasuries yielding 3% with a zero risk level, your portfolio will have a risk level of 0.12 (two-thirds of 0.18 + one-third of 0) and a return of 9% (two-thirds of 12% + one-third of 3%). Investing completely in Portfolio A with its lower risk level will earn a 12% return for the same risk level of 0.12. This illustrates that adjusting your asset allocation allows you to convert risk reduction into increased returns.
We are replacing Royce Premier with CGM Focus Fund (CGMFX). This requires some explanation since the fund is not 10 years old (Rule 2). If you examine Rule 2, however, you will see that it says a shorter life is acceptable under certain circumstances. CGM Focus meets all our criteria except the 10year history, and because of the exceptional performance to date from the funds inception, it is very likely that it will meet those requirements when it is 10 years old. More importantly, because of its performance we feel that it likely will be closed before its 10th birthday.
I want to emphasize that we are not selecting this fund because it has been the top performer for various periods over recent years, but because it meets our criteria now and most likely will meet them in 2007. The reason we are introducing CGM Focus to the model portfolio now rather than making it an alternative fund and moving up one of the two alternatives instead is our concern that it may close. Individual mutual fund performance, because of internal diversification, changes much more slowly than that of individual stocks, so there is no reason to rush to sell, particularly if you are nearing long-term capital gain treatment on Royce Premier. However, it might be wise to take a minimum position in CGM Focus to reduce the chance of being shut out by a closing if you wish to keep Royce Premier longer.
|Mutual Fund Cap Size and Style|
We categorize mutual funds by both the size and style of their stock holdings. Size is measured by the average market capitalization (share price times the number of shares outstanding) of the stocks held by the fund, and style is based on the price-to-book value ratios (price per share divided by net assets per share) of the underlying stocks. Here is how we break down these categories:
Changes in Rules and Definitions
Because of overall stock market changes over the past year, we are changing the definitions of size, as shown in the Mutual Fund Cap Size and Style box.
Due to the inflow of dollars to mutual funds and the increase of market value over the past year, we are adjusting the size limitations in Rules 5 and 6, as shown in the Selection Rules box.
The rest of this year should be challenging. I will be reviewing the portfolio holdings of the Model Mutual Fund Portfolio in the February 2006 AAII Journal and performance figures will be updated monthly on AAII.com.
|Model Mutual Fund Portfolio: Selection Rules|
To make it into the Model Mutual Fund Portfolio, a fund must meet the following criteria: