First Half Model Fund Portfolio Update and a New Model ETF Portfolio

    by James B. Cloonan

    Right up to the middle of May, 2006 was an amazing year for the market.

    Then reality set in, with the market giving up much of its gain as of this date (June 30).

    The Model Mutual Fund Portfolio is down from its high for the year, but it is still up a respectable 6.1% for the first half year. That puts it considerably above the 3.3% of the Vanguard Total Stock Market fund (VTSMX).

    Model Fund Results

    The Model Fund Portfolio has existed for three years now. The results for the entire period can be seen in Figures 1 (the actual portfolio) and 2 (the recommended funds), and in Table 1.

    The difference between the results for the actual portfolio and the currently recommended funds is that the recommended list includes funds that have not been held in the actual portfolio for the full period, and some funds that have been in the actual portfolio in the past are no longer recommended.

    There are no changes recommended for the portfolio at this time, nor are there any changes in the rules. (See the Model Fund Portfolio area at for a list of the portfolio’s rules.)

    However, in my previous update I promised to give thought to two particular issues: finding good small-cap funds before they close to new investors, and how to take advantage of exchange-traded funds.

    Finding Micro-Cap Funds

    Any long-term solution to the first issue will require more research. The problem is that our requirement of a 10-year performance history conflicts with the fact that most micro-cap funds, if they are any good, tend to close well before the 10-year history can be established. The solution requires the evaluation of funds using less historical evidence.

    However, a short-term solution, particularly for those members who started following our advice after FMI Common Stock and Tamarack Microcap Value closed, is to overweight our two remaining small-cap funds, Northern Small Cap Value and Royce PA Mutual.

    Figure 1.
    Actual Mutual Fund
    Portfolio vs. Benchmarks

    Figure 2.
    Recommended Mutual
    Fund Portfolio
    vs. Benchmarks


    Exchange-Traded Funds

    Because I feel exchange-traded funds offer many advantages over traditional open- and closed-end mutual funds, AAII has started an experimental model portfolio of exchange-traded funds.

    The portfolio was developed based on concepts similar to the development of the Model Fund Portfolio—it focuses on low-cost, smaller-cap, value-oriented exchange-traded funds, and the individual funds were selected to work as a portfolio.

    The Model ETF Portfolio consists of:

    • Four stock funds,
    • One REIT fund, and
    • One short-term Treasury fund.

    For individual investors using the portfolio as a guideline, note that the latter two exchange-traded funds should be considered optional and would be used to control risk. Since every investor has a unique risk situation, the use of these two funds would vary.

    Over time, when there is more experience with the risk aspects of the portfolio, we will analyze what impact various holdings of real estate and short-term governments would have on the overall portfolio.

    The ETF portfolio that AAII is starting is an actual portfolio but with a limited amount of cash.

    As I will explain in more detail in a future article, I feel the philosophy behind the selection of these particular exchange-traded funds is valid—the combination of these funds should provide effective risk reduction through diversification. But I want to emphasize that the portfolio is experimental, and the extent to which the portfolio succeeds in my goals won’t be known until there is more history with the actual working portfolio.

    Several of the funds selected for the portfolio are not entirely passive portfolios—that is, their individual holdings are not held strictly in proportion to their market capitalizations, which means they require active rebalancing of the stock holdings within the fund. So what I don’t know yet is whether these exchange-traded fund managers can effectively apply their theories on an ongoing basis.

    I personally do not like cap-weighted funds because the largest market capitalization stocks dominate the fund. However, constant rebalancing can be expensive.

    Also, I must point out that my choices were made from existing exchange-traded funds. There are literally thousands more coming to market and some new ones might have advantages over the ones I have chosen. If so, I will make changes to the model ETF portfolio.

    You are welcome to just track our model ETF portfolio, but if you choose to follow it with your own real money, please keep in mind that the portfolio is experimental and do so with only a small upfront amount at this point.

    Since there are commissions of $7 to $10 per transaction, you can’t make your investment too small or the commissions will be too high as a percentage of the investment—probably $2,000 to $3,000 per position is necessary, which would involve a total investment of $8,000 to $10,000 total. But remember, you can also simply track our real portfolio results.

    The ETF Portfolio

    The four stock funds are shown in Table 2, along with their June 30 year-to-date returns.

    Also included in the listing are the REIT and bond ETFs, as well as two market exchange-traded funds for comparison: Fidelity NASDAQ Composite Index Tracking Stock (ONEQ) and iShares S&P 500 Index (IVV).

    The table uses total return based on share prices rather than on index values because that is the return an investor actually receives from an investment in the fund. The style and market-cap definitions are estimates until there is more portfolio history for the funds.

    The holdings are:

    • First Trust Dow Jones Select MicroCap Index Fund (FDM): Stocks are selected from the universe of micro-cap stocks (defined as the cap of the lowest two deciles of the NYSE) based on a combination of value and growth factors. The weighting of each stock is based on a modified market cap. It uses the shares in the float (as defined by the fund) rather than total shares to determine the market cap.

    • PowerShares FTSE RAFI US 1000 Portfolio (PRF): This index selects the top 1,000 stocks by market cap, but weights them on proprietary fundamental factors rather than market cap.

    • Rydex S&P MidCap 400 Pure Value (RFV): Stocks for this index are selected from the S&P MidCap 400 based on a number of value criteria.

    • Rydex S&P SmallCap 600 Pure Value (RZV): Stocks are selected from the S&P SmallCap 600 based on a number of value criteria.

    • iShares Cohen & Steers Realty Majors Index Fund (ICF): I feel this is the best REIT exchange-traded fund at this time, but wish it contained more smaller REITs and was not market-cap-weighted.

    • iShares Lehman 1-3 Year Treasury Bond (SHY): Use of this exchange-traded fund as a way of controlling portfolio risk shows my preference for the low-risk element to be as low risk as possible. With a three-year investor horizon, this exchange-traded fund has virtually no risk.

    Table 2. AAII's Model ETF Portfolio
    ETF (Ticker) YTD Return (%)* Style Capitalization (Estimate)
    First Trust Dow Jones Select MicroCap Index (FDM) 5.5 Blend Nano- & Micro-Cap
    Power Share FTSE RAFI US 1000 (PRF) 4.9 Blend Mid- & Giant-Cap
    Rydex S&P Mid-Cap 400 Pure Value (RFV) na Value Mid-Cap
    Rydex S&P Small-Cap 600 Pure Value (RZV) na    
    Average 5.2
    Fidelity Nasdaq Composite Index (ONEQ) -1.2 Low Value Giant-Cap
    iShares S&P 500 Index (IVV) 2.7 Low Value Giant-Cap
    Optional ETF Investments
    iShares Cohen & Steers Realty (ICF) 13.9   Large REITS
    iShares Lehman 1-3 Year Treasury Bonds (SHY) 1.0    

    What the Future Holds

    There will be thousands of exchange-traded funds before long, many of which will be virtual duplicates. Some will likely disappear because of lack of investor interest.

    When the smoke has cleared several years from now, exchange-traded funds may have as many investment dollars as conventional mutual funds.

    We will try to keep abreast of the changes and keep you informed.

    I will be covering our Model Mutual Fund Portfolio again in the February 2007 AAII Journal; in the meantime, it will be updated monthly at

    On-line coverage of the model exchange-traded fund portfolio won’t begin until we have at least a year of experience.

    However, the October AAII Journal will continue to feature our annual coverage of all exchange-traded funds.

    Cap Size and Style
    We categorize mutual funds by both the size and style of their stock holdings and this can be used as a rough guideline for the ETF portfolio funds. 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:
    Size Category Market Cap
    Giant-Cap $15 billion and greater
    Large-Cap $7 billion to $14.9 billion
    Mid-Cap $2.5 billion to $6.9 billion
    Small-Cap $700 million to $2.4 billion
    Micro-Cap $300 million to $699 million
    Nano-Cap $0 to $299 million
    Style Category Price-to- Book-Value Ratio
    Very High Value 1.79 and below
    High Value 1.80 to 2.29
    Moderate Value (Blend) 2.30 to 2.54
    Low Value (Growth) 2.55 to 2.99
    Very Low Value (High Growth) 3.00 and above

→ James B. Cloonan