• AAII Model Portfolios
  • Bear Market Bites Model Fund Portfolio and Stock-Based Mutual Funds

    by James B. Cloonan

    Bear Market Bites Model Fund Portfolio And Stock Based
Mutual Funds Splash image

    Until May came along, it looked like the Model Mutual Fund Portfolio might have an exceptionally good year.

    But the May and June weakness hit hard, and the Model Mutual Fund Portfolio is down 5.0% year–to-date (as of June 30, 2010). While it is small comfort, we are outperforming our benchmark, the Vanguard Total Stock Market Index Fund VTSMX, which is down 6.0%.

    The results for other periods can be seen in Figure 1. All of the funds except one are up over the last year, as shown in Table 1, but they are all down significantly over the past quarter.

    The funds pretty much reflect the direction of the general stock market as well as its volatility.

    Accounting for Higher Risk

    We are still searching for variations on our previous rules that would reflect the greater risk that seems inherent in the stock market of the last 20 years but not commit us to funds that shine only in bear markets. In choosing funds, our criteria generally compare funds to other funds, but Rule 4 (as shown in the box below) is an absolute: The fund cannot have had a three-year period with negative returns. Virtually all funds now have a three-year period with negative returns and the market as a whole has had five-year and 10-year periods of negative returns as well. A bad bear market, particularly one that crosses virtually every market sector, is very difficult to protect against in a fully invested portfolio. That’s why it’s important that the Mutual Fund Portfolio and equities in general are not 100% of your portfolio.

    We anticipate making some rule changes and changing some funds in our next review, which will appear in the March 2011 column. The portfolio has now been in existence for about seven years and has faced the worst bear market since the 1930s. While returns are below the long-term averages, the portfolio has positive returns and has outperformed the overall stock market since inception. The results for each of the seven years for the portfolio can be seen in Table 2.

    Fund Closed to New Investors

    The FMI Common Stock Fund FMIMX has closed to new investors. Those of you who own shares in the fund can continue to buy more shares when you choose. We are not adding a substitute fund for new investors

    because we feel nine funds provide sufficient diversification and we will be making changes next March based on new criteria.

    Maintain Allocations

    There seems little to say about the market’s direction for the rest of the year that has not been said already. In general, I think individual investors are best off maintaining their long-term allocations.

    The next article on the Model Fund Portfolio will be in the March 2011 AAII Journal. We will review performance and report any changes to the portfolio.

    In the meantime, you can keep up with all the Model Portfolios at AAII.com.

    Fund (Ticker)
    Annual Return (%)
    ($ Mil)
    CGM Focus (CGMFX) Very Low Value Giant-Cap -16.7 -1.7 1.6 15.0 2,670 1.23 177 -15.6
    CGM Realty (CGMRX) Very Low Value Large-Cap -0.1 43.8 7.5 17.3 1,284 0.93 229 -12.1
    FMI Common Stock (FMIMX)* Low Value Small-Cap -0.2 21.2 5.8 9.4 870 1.26 160 -3.2
    Madison Mosaic Mid-Cap Fund (GTSGX) Very Low Value Mid-Cap -3.4 14.4 -0.4 5.5 141 1.26 137 -8.8
    Manning & Napier Pro-Blend Ext S (MNBAX) Very Low Value Giant-Cap -2.7 12.5 3.5 5.3 601 1.10 96 -0.9
    Meridian Value (MVALX) Very Low Value Large-Cap -7.0 12.2 0.2 6.2 803 1.12 133 -8.2
    Northern Small Cap Value (NOSGX) High Value Small-Cap -2.3 22.8 0.6 6.3 1,324 1.00 176 -10.9
    Royce PA Mutual/Inv (PENNX) Very Low Value Small-Cap -2.5 22.7 2.3 8.8 3,666 0.92 167 -9.0
    Stratton Multi-Cap (STRGX) Very Low Value Giant-Cap -11.4 4.5 -2.2 5.1 61 1.19 152 -12.1
    RBC Microcap Value S (TMVSX)** High Value Nano-Cap 0.6 22.7 -1.4 6.3 148 1.08 182 -17.3
    Average of Funds in Model Fund Portfolio†

    -4.6 17.5 1.7 8.5 1157 1.11 161 -9.8
    Model Fund Portfolio Performance††

    -5.0 15.6 0.6 na 1,157 1.11 151 -9.7
    Vanguard Tot Stock Mkt Idx (VTSMX) Very Low Value Giant-Cap -6.0 15.9 -0.3 -0.8 58,509 0.18 139 -9.2
    Avg Ann’l
    Ret Since
    Incep (%)
    Rate of Return (%)
    2009 2008 2007 2006 2005 2004 2003**
    Model Mutual Fund Portfolio 4.4 -5 24.9 -35.9 10.2 16.1 5.4 17.7 18.6
    Vanguard Tot Stock Mkt Idx (VTSMX) 3.7 -6 28.7 -37.0 5.5 15.5 6.0 12.5 16.4

    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

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    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 0.80 and below
    High Value 0.81 to 1.30
    Moderate Value (Blend) 1.31 to 1.50
    Low Value (Growth) 1.51 to 1.90
    Very Low Value (High Growth) 1.91 and above


    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 10 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.


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