New Fund Added to the Model ETF Portfolio
The Model Exchange-Traded Fund (ETF) Portfolio continues to outperform its benchmark year to date.
The portfolio is up 8.3% as of September 30, 2010, compared to the benchmark which is up 3.9%. The performance for various periods can be seen in Table 1.
While the portfolio has performed quite well since the 2008–2009 bear market, it has not regained its pre-crash high. Real estate continues to improve but has not yet recovered as much as other equities.
We have added a new ETF to the portfolio: ALPS Alerian MLP (AMLP). For the first time it is possible to invest in master limited partnerships (MLPs) through an exchange-traded fund. Investing in MLPs this way eliminates dealing with the complex K-1 tax forms that accompany direct MLP investments. Master limited partnerships generate significant income, which will be passed on by the ETF. Alerian feels that the ETF can be held in retirement plans without creating unrelated business income, which could be taxable. AMLP accomplishes this by being structured as a corporation for federal income tax purposes and must pay taxes on its taxable income. AMLP follows the Alerian MLP Infrastructure Index which invests in prominent MLPs that are primarily in oil and gas infrastructure—i.e., pipelines and storage. For the complete details of how master limited partnerships work, there is excellent coverage at Investopedia.com and the National Association of Publicly Traded Partnerships (www.naptp.org).
How to Adjust Your Portfolio
If you are starting a new ETF portfolio each of the six domestic holdings should be 13¹/³% of the total investment and each of the foreign holdings should be 5%. If you already are invested in the Model ETF Portfolio and wish to add Alerian MLP, I would purchase an amount equal to the average of the other domestic holdings. That approach will slightly reduce the relative holdings in foreign stocks but should not make a significant difference. That is what we are doing in the Model ETF Portfolio. If we make another addition or deletion, we will consider rebalancing more extensively.
The market continues to be volatile and, as always, unpredictable. Adding to the usual daily impacts on the market, there is a significant United States election prior to the year end. Even if I knew the outcome of the election, I am not sure I’d know what it would mean to the stock market.
There will certainly be many changes before I review the Model ETF Portfolio again in the May 2011 AAII Journal. In the meantime, you can follow it in the Model Portfolios area at AAII.com.
|Annual Return (%)||
|PowerShares FTSE RAFI US 1000 (PRF)||13 1/3||6.9||8.1||-4.7||1||784.5||0.39||170|
|Rydex S&P MidCap 400 Pure Value (RFV)||13 1/3||7.5||13.8||-2.7||1.1||41.8||0.35||244|
|Rydex S&P SmallCap 600 Pure Value (RZV)||13 1/3||6.1||-4.8||-3.3||-2.8||86.4||0.35||276|
|First Trust DJ Select MicroCap Index (FDM)||13 1/3||4.6||8.5||-7.9||-4.2||54.6||0.60||181|
|iShares Cohen & Steers Realty Majors (ICF)||13 1/3||20.6||31.7||-8.4||-2.9||2,269.40||0.35||246|
|ALPS Alerian MLP ETF (AMLP)||13 1/3||na||na||na||na||170.6||0.85||na|
|Vanguard FTSE All-World Ex-U.S. (VEU)||5||4.2||7.5||-7.1||na||6,058.30||0.25||160|
|SPDR S&P International Small Cap (GWX)||5||11.5||11.5||-6.6||na||622.6||0.59||156|
|Vanguard Emerging Markets (VWO)||5||10.7||19.8||-1.8||9.3||36,199.10||0.27||180|
|SPDR Dow Jones Int’l Real Estate (RWX)||5||12.1||12.2||-12||na||1,314.30||0.59||187|
|iShares Barclays 1-3 Year Treasury Bond (SHY)||2.4||2.4||4||4.5||8,606.20||0.15||10|
|iShares D.J. U.S. Index (IYY)||4.6||10.8||-6.6||-0.4||537.6||0.2||138|
|iShares MSCI EAFE Index (EFA)||1.1||3.3||-9.6||-0.6||34,937.10||0.35||153|
|ETF Benchmark (80% IYY/20% EFA)||3.9||9.3||-7.2||-0.5||7,417.50||0.23||140|
*Performance of actual portfolio including reinvested dividends. Other figures are weighted averages.
Source: Morningstar, Inc., RiskGrades.com. Data as of 9/30/2010. na=not available.
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 USD 2 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.
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 May and November issues of the AAII Journal. See the Model ETF Portfolio area of AAII.com for more information.
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.