- 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 reductionat least not initially.
- 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.
ETFs Get Active: AAII's Model Portfolio and the Evolving Marketplace
by James B. Cloonan
I always smile a little when the White House announces that the deficit has been reduced, when what actually has happened is that the rate of deficit increase has gone down.
Now I find myself in a similar situation with the AAII Model ETF Portfolio.
But I will report it without the spin: Our portfolio of exchange-traded funds (ETFs) continues to underperform the market as a whole, although the rate of underperformance has gone down and, in fact, year-to-date it is outperforming the market. Unfortunately, outperformance only means going down less.
Value stocks, small-cap stocks and REITs, which are heavily weighted in our portfolio, had a long period of underperformance but are starting to again outperform the general market.
A Rough Start
It has often been said that the worst thing that can happen to new investors is to do extremely well in their first stock picks, thereby setting a level of expectation and over-confidence that cripples their investment performance for a long time.
We have had the opposite problem.
When we set up our experimental ETF portfolio two years ago, we chose our holdings based on long-term market behavior, only to have a period of unusual weakness where we had the most weight.
While there certainly was a temptation to make adjustments, I think history and research are on our side and that we are properly positioned for the long term. So we have made no changes in the investment direction of the portfolio, particularly in terms of the weightings by size and value.
While we feel comfortable with these weightings, we also want to make sure we have the best exchange-traded fund in each area.
Unfortunately it is difficult to make intelligent changes to our portfolio based on historical performance, because there is simply not enough history to evaluate. However, we will keep monitoring the specific ETFs we have chosenparticularly in light of the new possibilities (discussed below).
The Evolving ETF Marketplace
The development of the ETF market has gone through two stages, and is now moving into the third and final stage, which could lead to the gradual replacement of conventional mutual funds. The first stage was the creation of the concept of the exchange-traded fund and its application to traditional stock indexes and, later, the bond indexes.
The second stage saw the creation of new, non-traditional indexes that could then be matched up with an exchange-traded fund. This led to a dramatic expansion of ETFs.
But even a created index has to be consistent with its rules over time, and thus still puts limits on the short-term investment decisions of the ETF.
Now the Securities and Exchange Commission (SEC) has approved the first ETF funds that are not index-based. Thus, we enter the third stage, where active ETFs can invest in a broad range of strategies and perhapsthe SEC willingdo everything a traditional mutual fund can do.
Advantages to the investor, of course, will depend on the fees charged by such funds, and by the tightness of bid/ask spreads. We certainly look forward to evaluating this new breed of fund. Ironically, the first active ETF was brought out by Bear Stearns, but it is a debt rather than an equity fund.
While the SEC is proposing new procedures for approving ETFs to reduce the backlog of applications, these new procedures may not apply to active ETFs and so they may appear slowly.
We will review the ETF portfolio again in the November AAII Journal, and should have more news about the new active ETFs.
In the meantime, you can keep up with changes at AAII.com.
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:
In U.S. investments:
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.