Model Fund Portfolio Update and a Look at How Various Indexes Are Weighted

    by James B. Cloonan

    Model Fund Portfolio Update And A Look At How Various Indexes Are Weighted Splash image

    The 2008 stock market continues to be weak for an election year despite congressional spending.

    The Model Mutual Fund Portfolio is down for the year to date at –3.8%, but that is considerably better than the overall market, represented by the Vanguard Total Stock Market Fund (VTSMX), which is at –10.9% year to date.

    The performance of the individual funds in the Model Fund Portfolio is shown in Table 1; the performance for the portfolio itself is shown in Figure 1 and 2.

    Why is there a difference in returns between the actual portfolio (Figure 1) and the average return of the funds currently in the portfolio (Figure 2)?

    Figure 1.
    Model Fund Portfolio
    Performance vs. Benchmark

    The difference is due to the fact that we have changed holdings over time, and because market movements have resulted in weightings in each fund that are no longer equal.

    There have been no changes in the selection rules (see page 22), but we have made one clarification: In criterion 4, we only go back 15 years looking at three-year returns since some funds are very old and others are not. The new changes in the portfolio:

    • In the last week of June, we sold American Century Equity Income (TWEIX) and Meridian Growth (MERDX). In both cases, their five-year performance fell below our requirements for absolute and risk-adjusted returns; in addition, it appears, based on their three-year performance, that they will continue to underperform.
    • We have also added CGM Realty Fund (CGMRX) to increase our diversification and increase our exposure to a useful sector (discussed later in this article).
    • For those of you who were not able to buy FMI Common Stock Fund (FMIMX) because it was closed when you started to follow the Model Mutual Fund Portfolio, it is now open and continues to be held in the portfolio.

       Model Mutual Fund Portfolio: Selection Rules

    To make it into the Model Mutual Fund Portfolio, a fund must meet the following criteria:

    1) 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.

    2) 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.

    3) 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.

    4) 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. We only go back 15 years for this criterion.

    5) Net assets must be less than $9 billion for giant- and large-cap funds, $4 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.

    6) It must have an expense ratio no greater than 1.25% if assets are less than $3.5 billion and 1% or less if assets are over $3.5 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 no-load 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 management’s attitude. However, there may be justifiable exceptions.

    7) 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.

    8) 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.

    9) Funds can be sold for violation of the above rules or if we feel that because of other changes there are better funds available. However, we do not anticipate much turnover.

    How many funds should you hold?

    • 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.
    • No matter how many funds you buy, equal dollar amounts are invested in each fund initially.
    • Well-diversified mutual funds do not have to be changed very often, so the screen will only be performed twice a year.

    Adding REITs

    I have debated the issue of a real estate holding in the mutual fund portfolio for some time.

    When we started the mutual fund portfolio five years ago, I resisted adding a real estate holding because I thought many investors would have other real estate holdings—for instance, their homes.

    However, I feel that even if an investor has other real estate holdings, there nonetheless should also be some real estate in a mutual fund portfolio. The long-term return in this sector is competitive with other equities, and holdings in real estate reduce the overall risk of a portfolio.

    CGM Realty is a mutual fund of real estate investment trusts (REITs) and other companies involved in real estate. The fund itself is not involved in direct real estate operations. CGM Realty fund also meets all of our regular requirements and, as you can see in Table 1, it has an excellent track record. So, this fund now represents the Model Mutual Fund Portfolio’s real estate commitment.


    Day-to-Day Issues

    While it is now water under the bridge, I thought you might be interested in the problems that can occur day-to-day in the management of a mutual fund portfolio.

    When we sold American Century Equity Income and Meridian Growth, we decided to buy the CGM Realty Fund and Mairs and Power Growth Fund (MPGFX) as replacements. Mairs and Power Growth had been an “alternative fund” [a substitute for funds within the portfolio that are closed to new investors], and we decided to make it part of the regular portfolio.

    A few days after we purchased Mairs and Power Growth, our data was updated and, due to an incredibly poor June, the fund became a sell. In light of the new data, we didn’t want to keep this fund in the portfolio, so we sold it and have selected Stratton Multi-Cap (STRGX) instead. While we may have lost money on the transaction costs, we felt it was better to take action quickly. Also, we didn’t want anyone following the portfolio to buy it only to be taking it out of the portfolio in six months.

    If you are duplicating the Model Fund Portfolio you should make the following changes:

    • Sell American Century Equity Income and Meridian Growth.
    • If you already own FMI Common Stock, then buy CGM Realty and Stratton Multi-Cap.
    • If you do not own FMI Common Stock but instead own Mairs and Power Growth, then sell it and buy FMI Common Stock, CGM Realty and Stratton Multi-Cap.
    • In the Model Fund Portfolio, we are splitting the proceeds from the American Century and Meridian funds equally between the CGM Realty and Stratton funds.
    • While there usually is no rush to make portfolio changes, I would suggest buying at least some of FMI Common Stock quickly if you don’t own it, as it might close again.

    Details of the revised portfolio are presented in Table 1.

       A Question of Proportions: How Various Indexes Are Weighted

    With a number of new approaches to weighting the individual stock holdings in index mutual funds, I though it worthwhile to discuss the topic.

    The term “weighting” in a stock index applies to the percentage of the portfolio that is committed to each individual stock.

    Stock index fund weightings are determined by the type of index the fund is following, which has rules for the weightings. In addition, an index, even if newly created and unusual, has certain characteristics not necessary in a non-indexed portfolio. An index fund must include all the stocks in the underlying index (there are some exceptions for very small-cap indexes), and the stock components can change only gradually.

    There are three basic approaches to stock index weightings (although there are some arbitrary approaches—the Dow Jones averages, which are based on share price alone, being the most noteworthy):

    • A Capitalization-Weighted Index: The percentages held in each issue are based on the market capitalization (number of shares outstanding times share price) of each stock;
    • An Equal-Weighted Index: The percentages held in each stock are equal; and
    • A Fundamental Index: The percentages held in each stock are based on the expected return or risk-adjusted return of the equities.

    A Closer Look

    Which of these approaches is best?

    Clearly the last approach would be superior if anyone was able to predict future returns with any accuracy, even on a probability basis.

    In fact, if you throw a “zero weighting” into the approach mix—making decisions not to hold certain stocks along with decisions to hold others—this is the approach used by most actively managed mutual funds, as well as individuals managing their own portfolios.

    These approaches are based on the belief that there are certain characteristics that make a specific equity more likely to have excess returns.

    And it is likely that this is, in fact, the case. Historically, capitalization size and the price-to-book ratio have been successful overall predictors of excess returns. In general, however, methods for making return predictions with any degree of accuracy on a long-term portfolio basis have not been successful.

    Market-Cap Weightings

    Weighting based on market capitalization has been the dominant approach, and was the only approach for index funds until a few years ago.

    If one’s mindset is that an index is meant to convey information about how well the stock market is doing, then a measure of the change in total market value of all stocks certainly makes sense. It is not a perfect measure because the price of the last hundred shares transferred is not necessarily an indication of the value of all shares if the company was bought out or liquidated, but it is probably the best approach for a simple system of measuring market value changes.

    But wait! Most of us are not macro economists, and while we have a curiosity about the market in general, our real goal is to improve market returns. If we are going to invest in index funds, then our concern is an approach to stock weightings that will provide higher returns than the market, not necessarily be an accurate economic measure.

    Equal Weightings

    Equally weighting all stocks in an index has some significant advantages. Since small-cap stocks have outperformed over the long run, an index portfolio using equal weightings should outperform capitalization-weighted indexes, because smaller-cap stocks will be a greater percentage of the equal-weighted index than the capitalization-weighted indexes.

    In addition, value stocks are underweighted in a capitalization-weighted portfolio, even though historically they outperform growth stocks, because their share prices are typically depressed (and remember, a stock’s market capitalization is based on the number of shares outstanding times its share price). So, equal weightings of all stocks will increase the weight of value stocks (relative to a capitalization-weighted portfolio) and thus the return of the portfolio.

    While there are few equal-weight index funds, there are simulated returns for equal weighting as compared to cap weighting. You can view the comparison over various time periods by going to the Wilshire Web site

    Particularly illuminating is that, while the cap-weighted NASDAQ composite index was losing 30% of its value during 2000–2002, the average NASDAQ stock was up—and an equally weighted NASDAQ index was up 50% during the same period.

    However, these comparisons do not include transaction costs, which may be significant. The major problem with equal weighting is that rebalancing is required; otherwise price changes will slowly move the portfolio toward cap weightings.

    Experience with equal weighting indicates that rebalancing should not be done frequently. My opinion is that rebalancing should be done no more than once a year, and much of it can be accomplished when regular portfolio changes occur.

    We have not rebalanced the Model Fund Portfolio as yet, and we have never made transactions just for rebalancing in the Model Shadow Stock Portfolio.

    The only equally weighted index with any history (five years) is the Rydex S&P Equal-Weighted Fund (RSP), which is an exchange-traded fund based on the equally weighted S&P 500. It can be compared to the iShares S&P 500 ETF (IVV), which is an exchange-traded fund based on the cap-weighted S&P 500.

    Five years is very short, and while over five years the Rydex ETF has outperformed iShares S&P 500 9.42% to 7.48% annually (market returns as of June 30), the last year and a half has been one of the few periods in which small-cap and value stocks have underperformed, so these results may not be indicative of the long-term differences.

    There is some additional information that provides insight into the rebalancing problem. The Rydex Fund averaged 25% turnover a year, as compared to 5% for the iShares S&P 500. My estimate is that for very large cap, active stocks this would reduce return less than 0.1%, but for small-cap, illiquid stocks it could be significant, particularly with frequent rebalancing.

    Both cap weightings and equal weightings, to the extent they are widespread, will tend to make stock prices “stickier”—that is, make prices slower to respond to company performance.

    Fundamental Weightings

    Recently there have been a number of new funds, mostly exchange-traded funds, that use “fundamental weightings.” This is weighting based on the fundamental values of the company (price-earnings ratio, price-to-book-value ratio, dividends, etc.). [I use “fundamental weighting” here to mean any weighting based on stock fundamentals; however, “Fundamental Index” is a trademark of Research Associates, LLC.]

    This, of course, is the approach taken by most non-index mutual funds, except they use these fundamentals to determine whether to buy a stock or not (zero weightings), as well as to determine the weight.

    When these fundamental-weighted funds were first introduced, there was a claim that there was an inherent mathematical advantage in such weightings because stocks deviate from fair value, and fundamental indexing takes advantage of this deviation. This would mean that fundamental indexing could increase returns even under efficient market assumptions.

    After dozens of mathematical articles in academic journals, it seems doubtful that this is a valid claim.

    Even though such an advantage does not exist, it is still possible that fundamentally weighted index funds may outperform their cap-weighted equivalents. In fact, unless rebalancing is too frequent and expensive, they are almost bound to outperform because they are closer to an equally weighted index and thus give greater weight to small-cap and value stocks.

    In addition, if price relative to book value is one of the fundamentals used, then they will obtain some of the excess return of value stocks.

    One can’t help but wonder, though: If you are a long-term investor and want higher returns, why not just select the value stocks of whatever market segment is of interest and equally weight them? Of course, short-term volatility would likely increase.

    You can view comparisons of equal-weighted and cap-weighted indexes over various time periods by going to the Wilshire Web site

    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:
    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

    Moving Forward

    Over the last year or so, I have read more and more discussion of the proper weighting of the stocks in an index fund, as well as the introduction of index funds that have departed from the traditional weightings based on market capitalization (number of shares times share price). I thought it worthwhile to review this topic, and the overview appears in the accompanying boxed area.

    At this point the market seems torn between the positive and the negative influences. There continues to be a great deal of bearish sentiment and that may be the most bullish thing going. As always, the market is highly unpredictable, and I suggest sticking to one’s long-term allocation.

    I will cover the Model Mutual Fund Portfolio again in the February 2009 issue of the AAII Journal, and in the meantime you may follow it at

→ James B. Cloonan