Model ETF Portfolio: Stay the Course Despite Headwinds

    by James B. Cloonan

    Model ETF Portfolio: Stay The Course Despite Headwinds Splash image

    I look at the Model ETF Portfolio and I like it (see Table 1). It may need a few adjustments, but basically I think it is a solid portfolio.

    I say this at the same time I am looking at the data and observing that the Model ETF Portfolio is underperforming the Dow Jones U.S. Total Market Index. As you can see in the table, the Model ETF Portfolio is up 1.3% year to date, compared to 9.4% for the DJ Total Market Index.

    So, why do I like this portfolio of exchange-traded funds?

    The Strategy: Stay the Course

    This year, at least through these three quarters, has seen some unusual occurrences:

    • REITs are having a poor year for the first time since 1999;
    • Large-capitalization stocks are outperforming small-capitalization stocks;
    • Growth stocks are outperforming value stocks.

    Each of these is unusual, but to have all three occur in one year is quite rare.

    The Model ETF Portfolio has a bias toward REITs, small-cap stocks and value stocks, at least relative to the benchmark, so the performance of those segments of the market account for much of the portfolio’s lag.

    And I certainly would not change my bias toward small cap and value based on the past year alone. In addition, I feel that REITs provide risk reduction without sacrificing return, at least for those with no outside investment real estate holdings.

    All of these biases, of course, are based on a very long-term perspective, and while this is still an experimental portfolio, I will stay the strategic course for now.


    The Tactics

    I think of strategy as selecting the investment areas to be emphasized in the portfolio, and tactics as choosing the specific funds to do the job most effectively.

    The tactical choices (the individual exchange-traded funds are described at the bottom of Table 1), both domestic and foreign, appear at this point to be good in those areas where there is a choice.

    While the First Trust Dow Jones Select MicroCap Index ETF is performing better than alternatives, I still am somewhat concerned with the low volume of shares that are traded, and will continue to watch it. If you follow this ETF during the day, make sure that you watch both the bid and the ask prices, rather than just the last price; ETFs with lower volumes will tend to have bigger bid/ask spreads.

    Rebalancing Considerations

    I did not mention portfolio rebalancing in previous columns. As with our other model portfolios, the ETF portfolio will not do any trading with the sole purpose of rebalancing, except perhaps for very unusual or extreme circumstances. When we adjust the portfolio for other reasons, we will do so in a way that repositions the portfolio back toward the initial balance.

    If you begin your own actual portfolio based on the Model ETF Portfolio, then initially I would suggest:

    • 80% of the total portfolio in domestic stock ETFs, with an equal investment in each; and
    • 20% of the portfolio in foreign stock ETFs, with an equal investment in each.

    The Outlook

    Things look good for the market in the fourth quarter, but there are certainly dangers out there. I suspect that, regardless of the overall market performance, REITs, value stocks, and small caps will do well relatively. We will look at the Model ETF portfolio again in the May 2008 issue and keep it updated on

    Model ETF Portfolio: Selection Rationale

    The rationale used in building the Model ETF Portfolo is to achieve diversification across the equity 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, 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.

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