- 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. 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.
- 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 $8 billion for giant- and large-cap funds, $3 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 $3.0 billion and 1% or less if assets are over $3 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 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.
- New Rule: 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.
- 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 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.
- 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: No Complaints for 2005
by James B. Cloonan
Figure 1 shows the results of the Actual Fund Portfolio compared to the S&P 500 (represented by the Vanguard 500 Index Fund [VFINX]) and the small-cap Russell 2000 (represented by the Vanguard Small Cap Index Fund [NAESX]). The performance of the individual funds on both an absolute and a risk-adjusted basis can be seen in Table 1.
Our actual portfolio is now 2½ years old, but many of you have been following it for a shorter period and your actual results will be a bit different, particularly if you were unable to invest in funds that closed to investors after our recommendation. Figure 2 shows the results of a portfolio of our recommended funds still open to new investors.
|Table 1. Model Mutual Fund Portfolio|
|Fund (Ticker)||Style||Market-Cap Size||YTD Return (%)||Annual Return (%)||Fund Assets ($ Mil)||Exp Ratio (%)||1-Yr RiskGrade||1-Yr Risk-Adj Ret (%)|
|CGM Focus (CGMFX)||Very Low Value||Large-Cap||25.3||25.3||32.8||na||1,636.10||1.12||109||16.3|
|Fenimore Value Fd (FAMVX)||Low Value||Mid-Cap||5.6||5.6||15.6||12.1||1,111.40||1.2||52||5.9|
|Meridian Growth Fund (MERDX)||Low Value||Mid-Cap||0.3||0.3||19.3||12.3||1,635.60||0.86||73||0.8|
|Meridian Value (MVALX)||High Value||Mid-Cap||2.9||2.9||16.9||18.9||1,902.70||1.08||59||2.8|
|Mosaic Eq Mid-Cap (GTSGX)||High Value||Mid-Cap||0.6||0.6||15.4||10.3||146.3||1.24||52||-0.2|
|Royce PA Mutual/Inv (PENNX)||Moderate Value||Small-Cap||12.5||12.5||23.8||14.2||1,803.00||0.89||64||12.4|
|T Rowe Price Cap Apprec (PRWCX)||Moderate Value||Giant-Cap||6.9||6.9||15.6||12.4||7,280.30||0.78||41||8.4|
|Northern Small Cap Value (NOSGX)*||Very High Value||Small-Cap||8.1||8.1||23.3||12.6||512.9||1||65||7.9|
Recommended funds now closed to new investors but still recommended for those who hold them
|FMI Common Stock (FMIMX)**||High Value||Small-Cap||9.5||9.5||17.3||12.6||445.5||1.21||62||9.5|
|Tamarack Micro Cap Val S (TMVSX)***||Very High Value||Micro-Cap||7.3||7.3||25.8||14.3||227.2||1.07||73||6.9|
Recommended substitutes for closed funds (listed by preference)
|Exeter Pro Blend Ext Term A (MNBAX)||Low Value||Giant-Cap||7.6||7.6||13.4||9.3||367.9||1.17||38||9.9|
|Mairs & Power Growth (MPGFX)||Very Low Value||Large-Cap||4.4||4.4||15.9||13.9||2,522.60||0.73||54||4.4|
|Average of recommended funds||7.6||7.6||19.6||13||1,632.60||1.03||44||9.1|
|Vanguard 500 Idx/Inv (VFINX)||Low Value||Giant-Cap||4.8||4.8||14.3||9||69,375.10||0.18||63||4.8|
|*Northern Small Cap Value (NOSGX) replaces Thompson Plumb Growth (THPGX) during 2005 year-end review.
**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 don’t recommend funds carrying loads for this portfolio, we consider it closed to new shareholders.
Data as of 12/31/2005.
See the Mutual Fund Portfolio area at AAII.com for more information and commentary on this portfolio.
We are selling Thompson Plumb Growth Fund (THPGX), not because it had a poor year, but because we think its large concentration in Fannie Mae and Freddie Mac represents too much risk, even though those two investments may well turn around.
In addition, we were able to find a small-cap value stock that is still open and the portfolio, particularly for those who did not buy FMI Common Stock and Tamarack Micro Cap Value before they closed, needs additional smaller-cap holdings. The fund we recommend is Northern Small Cap Value (NOSGX), and we recommend it for immediate inclusion in the portfolio (as opposed to being put on the substitute list) because of its value and cap-size attributes.
Even though there is much talk about large-cap and growth stocks coming back, I still feel small-cap and value stocks will compete well.
Somewhere along the way we will probably have a significant market adjustment, but I feeland I am no guru in predicting future marketsthat it is still a ways in the future. When and if it does come, value stocks may be the least affected.
Because of market changes and our switch to measuring the price-to-book value ratio with a geometric rather than arithmetic mean, the cap-size and style definitions have changed, as can be seen in the box on page 32. This, along with individual fund holdings, changed the description of some funds in Table 1.
There have been no big changes in our portfolio rules, which are shown in the Selection Rules box at the end of this article.
However, there are two issues that have been on my mind for awhile. Based on E-mail I have received, these thoughts have occurred to many of you, as well.
The first issue is that our requirement of a 10-year (or close to a 10-year) performance history conflicts with the fact that most micro-cap funds, if they are any good, tend to close well before a 10-year history can be established.
The solution to this problem requires the evaluation of micro-cap funds using less historical evidence. I am looking into this, and hope I can come up with a compromise solution.
The second issue is the advantage that can be gained by using an approach that focuses on exchange-traded funds (ETFs), except for the fact that ETFs also lack performance history. I am not interested in the ETFs that are based on general indexes, but instead want to focus more on those that follow innovative indexes based on a particular investment philosophy. I feel that the ETF format is much better than the rather artificial and inefficient structure of mutual funds.
In truth, I believe the best structure would be similar to that used by hedge funds, but Congress would have to pass legislation permitting the pass-through privilege to these kinds of investment pools. In my opinion, maintaining the illusion of investor ownership or control of funds is wasteful and inefficient. However, since such a change is unlikely, the ETF is the next best thing.
On the other hand, the lack of performance history makes it difficult to recommend ETFs. But we will be watching them as they go through different market conditions.
The whole area of ETFs deserves more attention. The AAII Journal provides an exceptionally detailed description of these funds each year (for the latest edition, see The Individual Investors Guide to Exchange-Traded Funds in the October 2005 issue of the AAII Journal, or at the AAII Guides area of AAII.com) and in my next mutual fund column I will examine how a portfolio might be developed as we see more performance history.
The next column dedicated to the Model Fund Portfolio will be in August, but if there is any urgent news, I will include it in my quarterly Shadow Stock Portfolio columns.
|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:|
|Size Category||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||1.79 and below|
|High Value||1.80 to 2.29|
|Moderate Value (Blend)||2.30 to 2.54|
|Low Value (Growth)||2.55 to 2.99|
|Very Low Value (High Growth)||3.00 and above|
|Model Mutual Fund Portfolio: Selection Rules|
To make it into the Model Mutual Fund Portfolio, a fund must meet the following criteria:
How Many Funds Should You Hold?
|Model Shadow Stock Portfolio Update|
|Concerning McRae Industries decision to de-register: According to D. Gary McRae, president of the company, it is their current intention to provide quarterly and annual reports to the shareholders, as well as have an annual audit. On that basis, I will continue to hold the stock in the model portfolio for the time being. I will discuss this issue further in my Model Portfolios column in the April issue of the AAII Journal.|
James B. Cloonan is founder and chairman of AAII. Cara Scatizzi, associate financial analyst at AAII, provided research assistance.