Model ETF Portfolio: Real Estate Holdings Boost Performance
by James B. Cloonan
Our model portfolio of exchange-traded funds ETFs has now been in existence for four years—four pretty dramatic years. That it has averaged less than 1% a year return would certainly be a disappointment were it not for the fact that most all of the market as well as the benchmarks have negative returns for the four years.
While the Model ETF Portfolio rebounded very well in both of the last two quarters, it has not reached its pre-2008 highs, as can be seen in Figure 1.
Strengths and Weaknesses
Year-to-date the ETF portfolio is up 8.9% compared to 4.7% for our ETF benchmark.
A major difference between the model portfolio and its benchmark is that our Model ETF Portfolio has a 21% real estate component and the benchmark does not. This hurt relative performance when real estate was hit even harder than the overall market in 2008, but is helping now that real estate has begun to recover. I should point out again that the real estate investments in our two ETFs are mostly real estate investment trusts REITs in diversified commercial real estate holdings and not houses.
Another point of interest is the recent relative weakness in foreign stocks—even the emerging markets. While some individual countries continue to outperform, overall foreign stocks are performing less well and the correlation with U.S. stocks is increasing so the diversification advantage, while it still exists, is not as strong as two years ago. All of the returns can be reviewed in Table 1.
No Changes to Portfolio or Outlook
We are not making any changes in the portfolio. We continue to wish there was a more value-oriented micro-cap ETF, but it is unlikely to happen because of a lack of interest. Over the intermediate term, the real estate portfolios are still lagging a bit, probably due to worries about some portions of the commercial real estate market. We continue to believe that real estate is an important part of a portfolio and will provide returns similar to equities and, at the same time, provide diversification and risk reduction.
Although there was early volatility this year, the stock market seems, as of early April, to be having a fairly normal year. Half the experts say the valuations are too high and the other half say they are too low, which would portend for reasonable growth and stability. But we are all a bit rocky from the last two years and there are a number of unknowns, so it is hard to be too optimistic. I continue to feel that there is no reason to leave one’s normal allocations.
I will be reviewing the Model ETF portfolio again in the November 2010 AAII Journal, but you can follow it at AAII.com in the meantime.
Table 1. AAII’s Model ETF Portfolio
| ETF (Ticker) |
Weight in Portfolio (%) |
YTD Return (%) |
Annual Return | Annualized | |
| Return | |||||
| Since | |||||
| 1 Year | 3 Year | 4/1/2006 | |||
| (%) | (%) | (%) | |||
| First Trust Dow Jones Select MicroCap Index (FDM) | 16 | 7.0 | 60.6 | -7.1 | -4.2 |
| PowerShares FTSE RAFI US 1000 (PRF) | 16 | 8.8 | 79.0 | -2.5 | 1.5 |
| Rydex S&P MidCap 400 Pure Value (RFV) | 16 | 13.7 | 130.3 | -1.9 | 2.6 |
| Rydex S&P SmallCap 600 Pure Value (RZV) | 16 | 19.0 | 163.0 | -3.1 | -0.4 |
| iShares Cohen & Steers Realty Majors (ICF) | 16 | 9.9 | 114.1 | -13.7 | -5.4 |
| SPDR S&P International Small Cap (GWX)* | 5 | 5.0 | 67.5 | na | na |
| SPDR Dow Jones International Real Estate (RWX)* | 5 | 0.9 | 68.3 | -15.9 | na |
| Vanguard FTSE All-World Ex-U.S. (VEU)* | 5 | 1.8 | 61.3 | -3.8 | na |
| Vanguard Emerging Markets (VWO) | 5 | 2.5 | 80.4 | 5.0 | 35.2 |
| Portfolio Return** | 8.9 | 103.7 | -3.8 | 0.8 | |
| Optional Investment: | |||||
| iShares Barclays 1-3 Year Treasury Bond (SHY) | 0.6 | 1.2 | 4.5 | 1.0 | |
| Benchmarks: | |||||
| iShares D.J. U.S. Index (IYY) | 5.7 | 51.8 | -3.8 | -2.0 | |
| iShares MSCI EAFE Index (EFA) | 0.7 | 53.8 | -7.1 | -3.6 | |
| ETF Benchmark (80% IYY/20% EFA) | 4.7 | 52.2 | -4.4 | -2.4 | |
|
*Funds have not been in existence long enough for certain performance numbers to be calculated. **Performance of actual portfolio including reinvested dividends. Sources: Yahoo! Finance and Morningstar Principia. Data as of 3/31/2010. |
|||||
ETF Descriptions
U.S. Domestic ETF Holdings
- First Trust Dow Jones Select MicroCap Index Fund FDM: The fund normally invests at least 90% of assets in stocks in the Dow Jones Select MicroCap index, which is comprised of selected U.S. micro-cap companies chosen from all common stocks traded on the NYSE, Amex, and NASDAQ, excluding limited partnerships.
- PowerShares FTSE RAFI US 1000 Portfolio PRF: The index tracks 1,000 U.S. stocks based on proprietary fundamental factors measuring financial strength (book value, cash flow, sale, and dividends), and the stocks are then weighted based on financial strength.
- Rydex S&P MidCap 400 Pure Value RFV: Stocks for this index are selected from the S&P MidCap 400 based on a number of value criteria.
- Rydex S&P SmallCap 600 Pure Value RZV: Stocks are selected from the S&P SmallCap 600 based on a number of value criteria.
- iShares Cohen & Steers Realty Majors Index Fund ICF: I feel this is the best REIT exchange-traded fund at this time, but wish it contained more smaller REITs and was not market-cap-weighted.
International ETF Holdings
- SDPR S&P International Small Cap GWX: An index of small-cap (market cap under $2 billion) stocks of developed nations, and capitalization weighted.
- SDPR Dow Jones International Real Estate RWX: Basically an index of non-U.S. REITs and other foreign real estate holdings.
- Vanguard FTSE All-World Ex-U.S. VEU: A cap-weighted index of the equities of 47 countries.
- Vanguard Emerging Markets VWO: Focuses on emerging markets and follows the MSCI emerging markets index.
Optional ETF Holding
- iShares Barclays 1-3 Year Treasury Bond SHY: Use of this exchange-traded fund as a way of controlling portfolio risk shows my preference for the low-risk element to be as low risk as possible. With a three-year investment horizon, this exchange-traded fund has virtually no risk.
Updates for the ETF Portfolio will appear in the May and November issues of the AAII Journal. See the ETF Portfolio area of AAII.com for more information.
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:
- 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 reduction—at least not initially.
In U.S. investments:
- 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.
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.