Close

Building an All-ETF Subset From the Model Fund Portfolio

by James B. Cloonan

Building An All ETF Subset From The Model Fund Portfolio Splash image

Over the past three months the stock market has continued its upward climb despite the dangers on the horizon.

The Model Fund Portfolio is up 17.4% year-to-date but lags the S&P 500 index as measured by Vanguard 500 Index fund (VFINX), which is up 19.7%. As we mentioned previously, the lower return is largely due to our two holdings that provide diversification—Fidelity Capital & Income fund (FAGIX) and Vanguard REIT Index ETF (VNQ).

Figure 1 and Table 2 show performance figures over the long term for the portfolio, the index comparison and the Conservative Portfolio, which is 75% Model Fund Portfolio and 25% iShares Barclays 1-3 Year Treasury ETF (SHY).

No Portfolio Changes

Table 1 shows the current holdings for the Model Fund Portfolio. There are no portfolio changes at this time.

Our change from WisdomTree Emerging Markets SmallCap Dividend ETF (DGS) to iShares MSCI Frontier 100 ETF (FM) proved timely but the area of frontier markets is still new. We will feel more confident when there are longer-term results. We particularly would like to see how frontier markets perform in a down market.

The ETF Quandary

I continue to believe that traditional mutual funds can invest in certain ways that exchange-traded funds cannot, and some of these areas have been profitable in the past. Consequently, I believe that they have a place in a fund portfolio. However, many of our members feel that ETFs are easier to trade, have lower costs, and are far superior for tax planning. They would prefer an all-ETF approach.

Depending on individual circumstances, the advantages of ETFs may outweigh any potential gain from maintaining traditional mutual funds in the portfolio. This makes sense, so we are going to track an all-ETF portfolio, called the Pure ETF Portfolio. It can be used as a guide, and it will provide insight into how the approaches differ over the long run.

Setting Up the All-ETF Portfolio

I feel that our five current exchange-traded funds are diversified enough to make up a balanced portfolio that zeros in on investment areas that have outperformed the market in the past. iShares MSCI Frontier 100 ETF does not have such a history, but it is in keeping with a micro-cap stock philosophy.

SPECIAL OFFER: Get AAII membership FREE for 30 days!
Get full access to AAII.com, including our market-beating Model Stock Portfolio, currently outperforming the S&P 500 by 4-to-1. Plus 60 stock screens based on the winning strategies of legendary investors like Warren Start your trial now and get immediate access to our market-beating Model Stock Portfolio (beating the S&P 500 4-to-1) plus 60 stock screens based on the strategies of legendary investors like Warren Buffett and Benjamin Graham. PLUS get unbiased investor education with our award-winning AAII Journal, our comprehensive ETF Guide and more – FREE for 30 days
sign-up

    Market
Cap
Size
YTD
Return
(%)
Annual Return (%) Fund
Assets
($ Mil)
Exp
Ratio
(%)
Std
Dev
(36 Mo.
Ann’l)
(%)
Worst
3-Yr
Cal
Period
(%)
 
 
  1-
Yr
5-
Yr
10-
Yr
Since
6/30/2003
Type Fund (Ticker)
MF Aston/Fairpointe Mid Cap N (CHTTX) Large-Cap 32.3 36.0 15.6 12.0 12.2 2,303.4 1.11 18.5 -7.9
MF Fidelity Capital & Income (FAGIX) na* 4.3 7.9 13.1 9.3 9.3 9,464.4 0.73 8.5 -7.2
MF FMI Common Stock (FMIMX)** Mid-Cap 21.4 26.6 12.9 11.7 11.7 1,260.2 1.20 12.8 -3.0
ETF Guggenheim S&P 500 Equal Weight (RSP) Large-Cap 23.6 26.9 13.1 9.8 10.1 5,210.7 0.40 14.1 -11.4
ETF Guggenheim S&P MidCap 400 Pure Val (RFV) Mid-Cap 26.5 35.2 12.6 na na 72.1 0.40 16.5 -4.3
ETF Guggenheim S&P SmallCap 600 Pure Val (RZV) Small-Cap 29.4 35.3 14.1 na na 116.7 0.38 19.9 -7.9
ETF iShares MSCI Frontier 100 (FM) Large-Cap 17.9 21.1 na na na 305.2 0.79 na na
ETF Vanguard REIT Index (VNQ) Large-Cap 1.5 4.1 6.0 na na 17,171.3 0.10 16.5 -11.9
MF Yacktman Focused (YAFFX) Giant-Cap 18.8 18.4 15.8 11.1 11.2 7,987.6 1.25 9.0 -2.8
  Avg of Funds in Actual Model Fund Portfolio†   19.5 23.5 12.9 10.8 10.9 4,876.8 0.71 15.0 -7.1
  Actual Fund Portfolio Performance††   17.4 21.7 8.1 8.7 9.0 13.0 -6.4
  Optional Investment:
ETF iShares Barclays 1-3 Year Treasury (SHY)   0.2 0.2 1.5 2.5 3.4 8,300.6 0.15 0.5 1.3
  Conservative Portfolio   13.0 16.1 6.9 7.4 7.6 9.7 -2.6
  Comparison:
MF Vanguard 500 Index (VFINX) Giant-Cap 19.7 19.2 9.9 7.5 7.5 26,502.5 0.17 12.2 -8.4
*Distressed securities - stock and bond.
**Closed to new investors. Current shareholders can continue to invest in the fund. Other investors should simply use the other eight funds to form their portfolio.
†A simple average of the funds in the current Model Fund Portfolio.
††Performance of actual portfolio since inception (June 2003) including reinvested dividends.
Source: Morningstar, Inc. Data as of 9/30/2013.

The reduction in the number of holdings requires an unequal weighting of each of the holdings. Table 3 shows the new Pure ETF Portfolio and the weights given each of the holdings. We only look at the results for this year-to-date and will have to wait for longer-term results to be meaningful.

  Average Annual Return (%) Cumulative Return of $10,000 ($)
  Model
Fund
Portfolio
Conser-
Vative
Portfolio
Vanguard
500 Index
(VFINX)
Model
Fund
Portfolio
Conser-
Vative
Portfolio
Vanguard
500 Index
(VFINX)
 
 
2003* 18.6 13.9 15.0 11,858 11,388 11,503
2004 17.7 13.3 10.8 13,955 12,905 12,742
2005 5.4 4.5 4.8 14,711 13,486 13,350
2006 16.1 13.0 15.6 17,086 15,243 15,436
2007 10.2 9.5 5.4 18,820 16,696 16,267
2008 -35.9 -26.4 -37.0 12,071 12,281 10,245
2009 24.9 19.0 26.5 15,080 14,609 12,959
2010 20.3 16.0 14.9 18,136 16,941 14,892
2011 -1.7 -0.7 2.0 17,827 16,825 15,186
2012 15.5 11.6 15.8 20,597 18,783 17,589
2013 YTD** 17.4 13.0 19.7 24,191 21,221 21,048
Since Incep** 9.0 7.6 7.5 24,191 21,221 21,048
*June 30 to December 31, 2003.
**Through September 30, 2013. Portfolio was started on June 30, 2003.

If you wish to mimic this portfolio, simply determine the total dollars you wish to invest and multiply this by the fraction assigned to each exchange-traded fund as indicated in Table 3. (RSP, 0.40; RFV, 0.20; RZV, 0.20; VNQ, 0.10; and FM, 0.10). Don’t be tempted to bypass the Vanguard REIT Index ETF just because real estate is performing poorly so far this year. Over the long term, it has done well and it is likely a bargain now.

We will rebalance this portfolio, but not frequently and only when a holding gets far out of line. We will let you know when we rebalance. If you have this portfolio and add money to it, add the funds so as to help restore original weightings. The same applies if you are withdrawing funds.

  Weight YTD
Return
(%)
 
Fund (Ticker) (%)
Guggenheim S&P 500 Equal Weight (RSP) 40 23.6
Guggenheim S&P MidCap 400 Pure Value (RFV) 20 26.5
Guggenheim S&P SmallCap 600 Pure Value (RZV) 20 29.4
iShares MSCI Frontier 100 (FM) 10 17.9
Vanguard REIT Index (VNQ) 10 1.5
Portfolio Weighted Performance 100 22.5
Comparison: Spider S&P 500 (SPY)   19.7
 
As of 9/30/2013.

Switching to an all-ETF portfolio means that the second methodology in our selection rationale will dominate the portfolio. We gain something and we lose something; only time (five to 10 years) and your personal experience with tax considerations will tell us which approach is best. New ETFs may provide additional opportunities for better portfolio performance.

Outlook

With all the uncertainty in Washington, I don’t feel competent to comment about an outlook. I hope much is resolved by the next discussion of the Model Fund Portfolio in the March 2014 AAII Journal. In the meantime, you can follow performance here.

Model Fund Portfolio: Selection Rationale

First Methodology

The fund selection rationale consists of two distinct approaches. The first approach is to select actively managed funds where the managers have shown a long-term ability to outperform the market after allowing for additional portfolio risk, regardless of the sector invested in. A fund must have the following characteristics to be considered for the Model Fund Portfolio:

  1. It must be a pure no-load fund. Short-term holding penalties are allowed if paid to the fund and not the manager.
  2. It must have been active for 10 years. However, exceptions are possible.
  3. It must have outperformed the S&P 500 index over the past five-year and 10-year periods.
  4. In its worst three-year (calendar) period, it must not have had a loss; or, in particularly difficult market periods, its loss must have been substantially less than that of the S&P 500 index.
  5. Its expense ratio must not be above 1.25%. Lower ratios will increase desirability.
  6. Fund assets must not be over $10 billion. Some exceptions are permitted, depending on fund objectives.
  7. It must currently be open to individual investors, with a minimum investment of $25,000 or less.

The above rules apply to new fund selections. Funds will not automatically be eliminated if they later violate the rules without considering other factors.

Second Methodology

The second methodology selects investment approaches that have provided excess returns or reduced portfolio risk to investors over the long term and then searches for the best traditional fund or exchange-traded fund (ETF) in that area. Factors to be considered are:

  1. The liquidity of the fund.
  2. The resources of the management company, in the case of ETFs.
  3. The investment returns and risk over as long a term as possible, given the newness of so many ETFs.
  4. Selection of areas with demonstrated long-term excess returns: value stocks, small-cap stocks, real estate and special areas where individuals cannot easily invest. An example of a fund in a special area would be Fidelity Capital & Income fund (FAGIX), which invests in distressed securities.

Portfolio Management Notes

  • The Model Fund Portfolio is meant to be a portfolio, and we suggest you invest in the entire portfolio on an equal investment basis—that is, invest equal dollar amounts in each fund initially.
  • If a fund is closed, create your portfolio from the remaining funds.
  • You may make adjustments based on your non-fund holdings. For example, if you have partnership or individual holdings in investment real estate (not personal housing), you may reduce or eliminate any REIT funds.
  • There is no need to rebalance on a regular basis. Rebalancing can be accomplished when there are portfolio changes or if one holding gets way out of line. We will notify you of any rebalancing in the Model Fund Portfolio.
James B. Cloonan is founder and chairman of AAII.


Discussion

William Willes from LA posted 10 months ago:

As a professional investment adviser I have recently structured an all ETF portfolio that I will be using for clients. I feel that ETF's offer many advantages over conventional funds. Several worth considering are inter-day liquidity, lower management fees and the ability to enter stops. Although I appreciate your methodology I feel that it is so conservative that you will be hard pressed to beat the indexes. Unless you are willing to step up and buy some alternative ETF strategies just buy SPY or QQQ.


Joseph Stoutenburgh from MN posted 10 months ago:

I manage my 84 year old mother's trust for income and principal security. Generally I prefer ETFs for broad stock and bond holdings due to their diversification and low cost. However, I have found that when one tries acquire alternative asses classes such as REITS, MLPs and private equity, individual security selection works best.

For example, Mom owns preferred shares of hospital, industrial and hotel REITS purchased at a discount to par, only from firms that have just raised the common share dividend.

MLP funds and ETFs are very high cost products. This is an area where owning 2 or 3 MLPs (e.g. MMP, EPD) with geographically diversified high quality assets and increasing payouts is better than holding a basket of 30-40 MLPs, many of which are sensitive to commodity prices.

Likewise, ETFs devoted to private equity are very expensive and you're better off owning 1 or 2 carefully business development companies (e.g. BKCC, KKR).

I like the author’s your pick of Fidelity Capital & Income (FAGIX) for investing in turn-around situations.


Jamie Morgan from Oz posted 10 months ago:

By having a large, mid and small cap ETF's from Guggenheim, why not just buy an index.


James Grant from OH posted 10 months ago:

I have 2 issues / questions I hope Mr. Cloonan will address.

Issue/Question #1 - As I read the selection criteria for the ETF-only portfolio, it says the second methodology selects approaches that "have provided excess returns or reduced risk." I am troubled by the word "or". I believe that, unless you are planning to trade the securities in the portfolio, that one cannot achieve both excess returns and reduce risk. Unless you claim otherwise, please offer a list of ETFs for a portfolio that maximizes returns and another set of ETFs that minimizes risk.


Issue/Question #2 - In addition to a "selection methodology", I would like to see some statements about the planned "trading" strategy for the portfolio. In other words, under what circumstances would you reduce holdings in one of the ETFs or drop it entirely? Even if this is intended to be a "long term buy and hold" portfolio, I think it would be appropriate to state for all readers.

Thank you for addressing these matters.


James Grant from OH posted 10 months ago:

I guess I will pose a 3rd issue to Mr. Cloonan.

As each of the 3 Guggenheim funds covers a large portion of the stock market, I believe they are very highly correlated. One of the tenets of asset allocation to achieve diversification is to build a portfolio of uncorrelated securities. (Sheldon Jacobs made this point in his article "How to Achieve the Right Asset Allocation" which was published in the AAII Journal in June 2012 and redistributed by AAII by email in the last couple of days.)

So, Mr. Cloonan, how do you justify having such highly correlated ETFs in the portfolio? Or do you believe they are uncorrelated?


John Hawkins from MD posted 10 months ago:

I'm relatively new to AAII and appreciate the information that is presented to it's readers. The comments also add to the subject content and I look forward to fine tuning my investment strategies. The ETF portfolio is something I'm very interested in !


Lee Dunn from NC posted 10 months ago:


This is a conservative portfolio. Why not add a few excellent ETFs with higher returns? For example:
BBH (Biotech)
CSD (SpinOff)
PNQI (Internet)
ITA (Aero&Defense)

There are many others highly rated by Morningstar with much higher annual returns.


Robert Mclaughlin from VA posted 10 months ago:

I appreciate the information on an all ETF portfolio. It certainly makes rebalancing a lot easier and I believe it is diversified enough to provide acceptable risk. My brokerage account is with Fidelity and many of the IShares ETFs trade for free. For example I use ITOT, IJH and IJR for large, mid and small cap ETFs. I don't use Frontier ETFs (maybe I should) but use IEFA and IEMG in a ratio of 2 to 1 for international and Emerging markets respectively and then IYR for Real Estate. All trade free and the comparable ones to the model ETF portfolio are better YTD.


Garrett Cowsert from AZ posted 10 months ago:

I agree with J Grant. Similarly, it looks like you could just about replace the first 4 etfs with something like VTI as together they seem to cover the whole market. I'd like to see a comparison of what would happen


Robert O'Neill from MA posted 10 months ago:

These comments are very refreshing and indicative of a caring, thoughtful, yet sophisticated investor base that is a tribute to AAII and its community. No hype, no hysterical comments - nice going folks


You need to log in as a registered AAII user before commenting.
Create an account

Log In