• Letters to the Editor
  • Letters to the Editor

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    To the Editors:

    To the Editors:
    I would like to comment on the article “Model Fund Portfolio Update: A 2004 Performance Report,” by Dr. James Cloonan in the February 2005 AAII Journal. [See also the Portfolios area on AAII.com.]

    Starting with the Selection Rules, most of the rules have weak investment justifications behind them. For example, why must a selected fund have been in existence for at least 10 years?

    Another requirement is that a fund must have had higher returns than the S&P 500 index on both an absolute and risk-adjusted basis for five- and 10-year periods. But shouldn’t only large-cap funds be compared to the S&P 500 index to keep the comparison on an apples-to-apples basis?

    When I entered the AAII portfolio’s asset mix (with the closed funds or with the new funds as replacements) into Morningstar’s X-Ray tool (this tool is also available, free upon registration, at the T. Rowe Price Web site), the first astonishing finding was the lack of any fixed-income asset class in the portfolio. Results from the X-Ray show a 9% allocation to cash, 84% to U.S. stocks, 4.7% to foreign stocks, 0.3% to bonds, and 1.8% to other. The meager allocations to fixed-income and foreign stocks are clear.

    The Stock Style Box indicates large-cap value at 16.5%, large-cap growth at 16.8%, mid/small value at 26%, and mid/small growth at 40%. Stock exposure is heavily biased toward small- and mid-cap companies. This is in contrast to the Wilshire 5000 index’s 14% allocation to mid/small value, and 14% to mid/small growth. The asset mix employed by the AAII Fund Portfolio generally produces high long-term returns but can be volatile. Its high risk is indicated by a price-earning ratio of 19.2, which happens to be higher than that of the S&P 500; and its RiskGrade is 46 vs. 50 for the S&P 500 (the portfolio’s beta is also above 0.9). This portfolio is unsuitable for most investors, except for young ones in the accumulation stages—investors who have investment horizons of longer than 10 years, seek high returns, and can accept the high level of risk.

    In “The Four Pillars of Investing,” William J. Bernstein writes the following regarding the absence of asset classes such as foreign equity and fixed income, and the over emphasis on small and value stocks in a portfolio:

    1. The most important asset allocation decision revolves around the overall split between risky assets (stock) and riskless assets (short-term bonds, bills, CDs, and money market funds).


    2. The primary diversifying stock assets are foreign equity and REITs.


    3. Exposure to small stocks, value stocks, and precious metals stocks is worthwhile, but not essential.

    Is this one portfolio meant to suit all AAII investors? If yes, then it conflicts sharply with Larry Swedroe’s motto that says “There is no one right portfolio, but there is one right portfolio for you.”

    Also, is the portfolio intended for a tax-deferred or a taxable account? We all know that, generally, tax-inefficient funds should be placed in tax-deferred accounts and tax- efficient in the taxable accounts.

    Given the aggressiveness and the lack of multiple asset-class diversification in the AAII Fund Portfolio, is it really the way to go?

    Avigdor Goren
    Via E-mai

    James Cloonan Responds:
    Thank you for your considered comments on the Fund Portfolio: Your comments fall into two categories. The first indicates that I have not been clear enough in my series of articles. I certainly do not feel that the fund portfolio, or the Shadow Stock portfolio for that matter, should be an entire investment portfolio. The individualizing of an overall portfolio comes from the assignment of weights to the three major components: equity, real estate, and debt.

    The second category consists of areas where I disagree with much of conventional wisdom. These concern diversification within each major investment component, the analysis of risk, and predicting future investment success. I feel many of these areas are worth discussing and will devote upcoming columns to them. They are not simple. For example, while it makes intuitive sense to diversify internationally, the correlation between foreign stocks and domestic stocks is 0.90, which provides minimal risk reduction and an average 10-year return that is 6.3% lower. You point out that small stocks and value stocks always excel in the long run. I strongly agree and I don’t encourage short-term participation in the market. I feel small and value should dominate a portfolio. One of the criterion for fund selection is that a fund not have had a loss for 10 years, but I require a 36-month holding period.

    While I agree that the best-performing funds do not necessarily perform best in the future, I believe successful funds in the long run will not have performed poorly in the past. I consider any fund not beating the S&P 500 on a risk-adjusted basis to be performing poorly. These funds were not the highest-returning funds, but they have good historical records and are low risk. I believe risk levels, unlike returns, have some consistency.

    While it is true that diversifying across these 10 funds provides little risk reduction, it is because each is well diversified itself. I do not even suggest the need to hold more than four of them. In any event, I will try to discuss all of these topics in my column—many of them are the center of academic as well as industry conflict.


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