- 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.
- It must have been in existence for at least 10 years. In the future, I will discuss how it might make sense to make exceptions to this rule in certain circumstances.
- 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.
- 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.
- Net assets must be less than $5 billion for giant- and large-cap funds, $2.5 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.
- It must have an expense ratio no greater than 1.25% if assets are less than $2.5 billion and 1% or less if assets are over $2.5 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 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 managements attitude. However, there may be justifiable exceptions.
- 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.
- 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.
- Equal dollar amounts are invested in each fund initially.
- 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 diversificationfor 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.
- Well-diversified mutual funds do not have to be changed very often, so the screen will only be performed twice a year.
Model Fund Portfolio Update: A 2004 Performance Report
by James B. Cloonan
As you can see in Figure 1, the Model Fund Portfolio outperformed the S&P 500 index by a wide margin in 2004 with a return of 17.7%, versus 10.7% for the S&P 500, as represented by Vanguards S&P 500 Index Fund (VFINX). The performance of the individual funds on both an absolute and a risk-adjusted basis can be seen in Table 1.
Only Thompson Plumb (THPGX) performed below the S&P 500 for the year, in large part due to heavy investment in Fannie Mae. However, over the longer term (five- and 10-year periods) it is still ahead on both an absolute and risk-adjusted basis, and thus it qualifies to stay in the portfolio. The fund has also been one of the best-performing funds over the past 10 years. If, as many pundits are saying, it is time for the large-cap stocks to shine, then Thompson Plumb will be a real asset in the portfolio.
As should be expected, the returns for the 2004 period varied with the funds in the portfolio. Except for Thompson Plumb, they ranged from a return of 14.5% to 23.8%.
Exeter Pro Blend (MNBAX) had a return of 11.0% and Mairs & Power Growth (MPGFX) returned 18.0%. These two funds are not included in the original portfolio, but are recommended for newcomers who are unable to buy the two funds in the portfolio that are now closed to new investors. While Exeter Pro Blends return was below average for the year, it performed very well in the six months after we recommended it.
|Table 1. Model Mutual Fund Portfolio|
|Annual Return (%)||Fund
|Fenimore Value Fd (FAMVX)||Moderate Value||Mid-Cap||16.9||16.9||11.6||13.6||871.4||1.24||68||20.5|
|Meridian Growth Fund (MERDX)||Low Value||Mid-Cap||14.5||14.5||11.6||14.5||1,523.70||0.88||90||14.1|
|Meridian Value (MVALX)||Moderate Value||Large-Cap||15.1||15.1||10.3||21||2,378.60||1.09||75||16.9|
|Mosaic Eq Mid-Cap (GTSGX)||Moderate Value||Large-Cap||18.9||18.9||10||12.4||105.5||1.25||76||21.1|
|Royce PA Mutual/Inv (PENNX)||High Value||Small-Cap||20.2||20.2||15.3||14.8||1,195.70||0.93||76||22.6|
|Royce Premier/Inv (RYPRX)||Moderate Value||Small-Cap||22.8||22.8||16.3||14.8||2,863.50||1.16||82||24|
|T Rowe Price Cap Apprec (PRWCX)||High Value||Giant-Cap||15.3||15.3||13.3||14||4,692.90||0.83||54||22.2|
|Thompson Plumb (THPGX)||Low Value||Giant-Cap||4.2||4.2||3||16.8||1,485.90||1.07||105||4.1|
|Funds closed to new investors|
|FMI Common Stock (FMIMX)*||High Value||Small-Cap||18.8||18.8||11.6||14.3||428.3||1.25||74||21.4|
|Tamarack Microcap Val S (TMVSX)**||High Value||Micro-Cap||23.8||23.8||17.7||15.9||234.9||1.03||84||24.5|
|Vanguard 500 Idx/Inv (VFINX)||Low Value||Giant-Cap||10.7||10.7||3.5||12||81,804.80||0.18||87||10.7|
|Recommended substitutes for closed funds (listed by preference)|
|Exeter Pro Blend Ext Term A (MNBAX)||Moderate Value||Giant-Cap||11||11||6.2||11.4||288.6||1.17||58||14.5|
|Mairs & Power Growth (MPGFX)||Low Value||Giant-Cap||18||18||11.1||18||1,933.90||0.75||74||20.4|
*Closed to new investors on April 15, 2004.
**Tamarack Micro Cap Value Fund was originally recommended when it was the Babson Shadow Stock Fund (SHSTX). Since recommendation, the fund has been converted into a multi-class fund. Shareholders of the fund prior to the conversion are able to purchase additional shares without a load, new shareholders must purchase a class of shares that carry a load. Since we dont recommend funds carrying loads for this portfolio, we consider it closed to new shareholders.
Data as of 12/31/2004.
Sources: S&P Micropal, RiskGrades.com.
See the Model Portfolios area at AAII.com for more information and commentary on the Model Fund Portfolio.
The Rules: Unchanged
Our portfolio rules, as shown in the box at the end of this article, remain unchanged. Keep in mind that our emphasis is on maintaining a portfolio that will never have a loss over any three-year period, which we believe is the minimum holding period for an equity investor. With that safety margin established, we go after mutual funds that have outperformed the market on both an absolute and risk-adjusted basis.
None of our portfolio mutual funds were closed over the past six months, and so we are not adding any new funds. The two funds that previously closed to new investorsFMI Common Stock (FMIMX) and Tamarack MicrocapValue (TMVSX)remained closed, but those investors who already hold them should retain them.
We are not changing the definitions for size and style (shown in the accompanying box below) at this time, but if the market continues to expand, we will need to make an adjustment in the next report (August 2005).
|Mutual Fund 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:
|Model Fund Portfolio: Selection Rules|
To make it into the Model Fund Portfolio, a fund must meet the following criteria:
How Many Funds Should You Hold?
James B. Cloonan is founder and chairman of AAII.