• AAII Model Portfolios
  • Sub-Par Performance by Market in Pre-Election Year Drama

    by James B. Cloonan

    Sub Par Performance By Market In Pre Election Year Drama Splash image

    The year 2007 was a below-average year for the general market—and it was exceptionally low for a pre-election year.

    The average return for the S&P 500 during the year before an election is 21.7%; for all years, the average is 10.4%. However, this past year the S&P 500 came in below both figures at 5.5% (coincidentally, the Vanguard Total Stock Market Index fund, our benchmark in Figure 1, also returned 5.5% in 2007). The Model Mutual Fund Portfolio did considerably better at 10.2%, but there was wide disparity within the portfolio.

    The superior performance of the Model Mutual Fund Portfolio was due to one fund—CGM Focus CGMFX—which was up an astounding 80% in 2007.

    At the other extreme, the two small-cap value funds, Tamarack Microcap Value “S” TMVSX and Northern Small Cap Value NOSGX had negative returns for the year. In fact, contrary to long-term performance, the greater the value focus and the smaller the capitalization focus, the worse the 2007 performance.

    This happens every so often for a year or sometimes two—and that is why we don’t put only small-cap and heavy value-focused funds in our portfolio, even though we expect their long-term performance to outperform the market and most funds. Our decisions about buying and selling funds are based on five- and 10-year performance unless there are three down years in a row.

    Steady as She Goes

    I am not making any changes in the portfolio at this time, although the American Century Equity Income Fund TWEIX will be watched closely because its longer-term performance is weakening.

    However, the maximum size allowed for the different categories of funds, as measured by net assets, was adjusted to keep up with rising prices of stocks (see Selection Rule number five on the box).

    Annual Return (%) Fund
    ($ Mil)
    Fund (Ticker) Style (%)
    American Century Eq Inc (TWEIX) Low Value Giant-Cap 1.8 1.8 7.6 9.7 4,316.3 0.97 37 9.1
    CGM Focus (CGMFX) Very Low Value Large-Cap 79.9 79.9 37.4 26.1 5,460.5 1.02 104 20.7
    Manning & Napier Pro-Blend Ext A (MNBAX) Low Value Giant-Cap 6.9 6.9 10.5 8.5 587.6 1.14 35 13.6
    Meridian Growth Fund (MERDX) Very Low Value Mid-Cap 5.4 5.4 7.0 11.3 1,871.1 0.84 60 6.6
    Meridian Value (MVALX) Low Value Mid-Cap 7.8 7.8 9.6 16.1 1,593.3 1.08 55 9.3
    Madison Mosaic Mid-Cap (GTSGX) Low Value Mid-Cap 8.6 8.6 8.3 10.5 147.6 1.25 50 8.5
    Northern Small Cap Value (NOSGX) High Value Small-Cap –8.7 –8.7 5.9 8.9 929.0 1.00 75 5.3
    Royce PA Mutual/Inv (PENNX) Moderate Value Small-Cap 2.8 2.8 9.9 12.1 3,157.7 0.87 67 8.6
    Tamarack Microcap Value “S” (TMVSX)* Very High Value Micro-Cap –9.2 –9.2 5.9 10.6 301.8 1.07 72 5.3
    Funds now closed to new investors but still listed for those who hold them
    FMI Common Stock (FMIMX) Moderate Value Small-Cap –2.0 –2.0 7.9 9.6 420.9 1.20 64 7.2
    Avg of Funds in Model Fund Portfolio†

    9.3 9.3 11.0 12.3 1,878.6 1.05 62 9.9
    Substitute for closed fund
    Mairs & Power Growth (MPGFX) Very Low Value Large-Cap 4.9 4.9 6.5 10.1 2,613.9 0.69 49 6.6
    Actual Fund Portfolio Performance††

    10.2 10.2 10.5 na 1,878.6 1.05 55 10.1
    Vanguard Tot Stock Mkt Idx (VTSMX) Low Value Giant-Cap 5.5 5.5 8.9 6.3 50,183.0 0.19 52 8.9
    *James Cloonan has been an advisor to the TMVSX fund since its inception as the Babson Shadow Stock Fund in 1987.
    † A simple average of all funds in the actual Model Fund Portfolio. 
    †† Performance of actual portfolio since inception including reinvested dividends.
    Source: S&P Micropal, RiskGrades.com. Data as of 12/31/2007.

    Performance Differences

    I have had several questions about why the actual portfolio result is different from the average fund performance or the results members may have obtained.

    For the Model Fund Portfolio, we don’t rebalance on a regular basis, so our performance is based on holdings that are not equal. If we receive dividends that can’t be reinvested automatically, we would invest them in the fund with the lowest weight. We would suggest you do that also, if you have fresh money to invest. But don’t sell and buy just to rebalance.

    The Outlook

    If you based your outlook for 2008 on historical performance, the long-term election year average for the S&P 500 is 12.9%.

    However, the volatility in the beginning of the year and the poor early January performance hints at an unusual year.

    I will cover the Model Fund Portfolio again in the August issue of the AAII Journal. In the meantime, you can follow it on a more frequent basis at www.aaii.com.

    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

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    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.
    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.


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