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Model Mutual Fund and ETF Portfolios: Choosing a Benchmark Isn't Easy

by James B. Cloonan

Model Mutual Fund And ETF Portfolios: Choosing A Benchmark Isn't Easy Splash image

Through March, the 2012 equity market has been a friendlier place than we have seen for a while.

The S&P 500 index was up 12.5%, as measured by the Vanguard S&P 500 Index fund (VFINX). This is somewhat better than our Model Mutual Fund Portfolio at 10.0% and our portfolio of exchange-traded funds (ETFs), the Model ETF Portfolio, at 10.9%. Tables 1 and 2 show the longer-term performance of the Model Mutual Fund Portfolio, and Tables 3 and 4 show the history of the Model ETF Portfolio.

Performance Comparisons

It has been brought to our attention that we have used the term “benchmark” incorrectly in relation to the Vanguard S&P 500 Index fund, the SPDR S&P 500 Index ETF (SPY) and the iShares MSCI EAFE Index ETF (EFA). These index funds are based on giant capitalization and moderate value equity holdings, and most of the holdings of both model portfolios are not in this subcategory. A benchmark should show the average performance of all portfolios following the same approach as the portfolio being evaluated. Therefore, we will use the term “comparisons” for these index funds going forward.

VFINX, SPY and EFA are funds based on what most people consider the overall equity market here and abroad to be valid bases for comparison, if not for fund evaluation. Since they are capitalization-weighted, they represent the average performance of all portfolios. In addition, when evaluating a portfolio of funds, should the composite fund get credit or blame for both the selection of equity subcategories as well as the specific funds within each subcategory? The subcategory weightings are not static, and the portfolio’s ultimate performance is an ever-changing combination of subcategory weightings and specific fund selection.

Portfolio Changes and News

There are no portfolio changes in either of the model portfolios. FMI Common Stock fund (FMIMX) continues to be closed to new investors. If you own it, you should continue to hold it. If you do not own it and are new to the portfolio, you should make any selection from the remaining nine funds.

The rationale for the Model ETF Portfolio is provided here. The rules for the Model Mutual Fund Portfolio can be found in the March 2012 issue of the AAII Journal and in the Model Portfolios area here.

Looking Ahead

Not much has changed since my comments in the March Model Portfolios column. The market climb has slowed somewhat, and the day-to-day news has brought back some of last year’s volatility.

I continue to be modestly bullish for the balance of the year, but not enough to change normal allocations.

Fund (Ticker) Style Market-
Cap
Size
YTD
Return
(%)
Annual Return (%) Fund
Assets
($ Mil)
Exp
Ratio
(%)
Std
Dev
(36 Mo
Ann’l)
(%)
Worst 3-Yr
Calendar
Period
1-
Yr
5-
Yr
Since
Incep*
Return
(%)
Aston/Fairpointe Mid Cap N (CHTTX) Moderate Value Mid-Cap 13.0 -1.4 6.1 10.4 1,659.50 1.14 23.4 -7.9
CGM Realty (CGMRX) Low Value Mid-Cap 11.3 6.9 6.3 17.7 1,655.20 0.89 27.7 -2.7
Fidelity Capital & Income (FAGIX) na** na** 7.8 0.6 7.9 9.4 9,462.00 0.76 13.5 -7.2
FMI Common Stock (FMIMX)*** Moderate Value Mid-Cap 10.1 7.7 6.8 11.3 1,199.90 1.21 18.2 -3.0
Madison Mosaic Mid-Cap (GTSGX) Low Value Large-Cap 10.8 6.5 3.3 7.8 185.30 1.25 16.4 -7.1
Manning & Napier Pro-Blend Ext S (MNBAX) Moderate Value Giant-Cap 7.8 2.3 3.3 7.3 752.10 1.09 11.9 -2.2
Meridian Value (MVALX) Low Value Mid-Cap 11.2 8.0 2.4 8.1 740.60 1.09 17.6 -4.5
Northern Small Cap Value (NOSGX) High Value Small-Cap 10.5 3.1 2.4 9.7 1,782.30 1.00 21.3 -6.3
Royce PA Mutual Investment (PENNX) Moderate Value Small-Cap 12.1 -1.5 3.3 10.2 4,712.10 0.90 21.6 -8.4
Yacktman Focused (YAFFX) Low Value Giant-Cap 6.8 8.6 10.7 10.6 5,926.50 1.25 17.7 -2.8
Avg of Funds in Model Fund Portfolio†

10.1 4.1 5.2 10.2 2,807.60 1.10 18.9 -5.2
Actual Fund Portfolio Performance††

10.0 2.8 2.1 na 18.1 -6.4
Vanguard 500 Index (VFINX) Moderate Value Giant-Cap 12.5 8.4 1.9 6.3 27,927.20 0.17 20.9 -8.4
 
  Average Annual Return (%)
Model
Mutual
Fund
Portfolio
Vanguard
S&P 500
Index
(VFINX)
2003* 18.6 15
2004 17.7 10.8
2005 5.4 4.8
2006 16.1 15.6
2007 10.2 5.4
2008 -35.9 -37
2009 24.9 26.5
2010 20.3 14.9
2011 -1.7 2
YTD** 10 12.5
Since Incep** 8 6.3
 

ETFs: A New Look

We began the Model ETF Portfolio six years ago on an experimental basis. We invited you to join with us in examining what was then a new product. We suggested that members simply observe or invest only a small amount until we had a chance to get some history.

We feel we have learned a lot in those six years. In the August 2012 issue of the AAII Journal we will discuss our observations at length and propose a plan for the integration of exchange-traded funds into an overall portfolio.

Until then, you can check for monthly performance updates to both the Model Mutual Fund and ETF Portfolios here.

ETF (Ticker) Weight
in
Port
(%)
YTD
Ret
(%)
Annual Return (%) Fund
Assets
($ Mil)
Exp
Ratio
(%)
Std
Dev
(36 Mo
Ann’l)
(%)
3-Yr
Risk-
Adj
1-
Yr
3-
Yr
5-
Yr
Since
Incep*
Ret
(%)
PowerShares FTSE RAFI US 1000 (PRF) 13.33 11.3 4.5 29.7 2.5 4.4 1394.9 0.39 20.4 32.3
Rydex S&P MidCap 400 Pure Value (RFV) 13.33 14.4 0.9 39.0 1.9 4.4 41.5 0.36 29.0 31.3
Rydex S&P SmallCap 600 Pure Value (RZV) 13.33 13.9 0.8 43.7 0.5 1.8 80.0 0.36 40.6 26.1
First Trust DJ Select MicroCap Index (FDM) 13.33 11.8 -4.9 24.5 -0.7 0.2 58.5 0.60 24.6 22.7
iShares Cohen & Steers Realty Majors (ICF) 13.33 9.9 12.7 45.0 -1.8 2.1 2750.8 0.35 27.4 37.7
ALPS Alerian MLP ETF (AMLP) 13.33 1.7 8.3 nmf nmf nmf 2878.5 0.85 nmf nmf
Vanguard FTSE All-World Ex-U.S. (VEU) 5.00 11.9 -7.0 19.4 -1.3 nmf 6853.6 0.18 22.1 19.7
SPDR S&P International Small Cap (GWX) 5.00 14.1 -9.0 23.0 nmf nmf 741.3 0.59 20.9 24.5
Vanguard Emerging Markets (VWO) 5.00 14.0 -9.0 24.7 4.5 6.8 54228.9 0.20 25.5 22.4
SPDR Dow Jones Int’l Real Estate (RWX) 5.00 15.3 -3.1 25.4 -7.0 nmf 2663.2 0.59 21.6 26.4
Portfolio Average**
10.9 1.6 31.2 -0.3 2.1 4184.7 0.47 23.4 30.2
Optional Investment:
iShares Barclays 1-3 Year Treasury Bond (SHY)   -0.1 1.3 1.4 3.3 3.5 10193.0 0.15 1.0 3.9
Comparisons:
SPDR S&P 500 Index (SPY)   12.5 8.3 23.2 1.9 3.5 105621.2 0.10 15.9 31.2
iShares MSCI EAFE Index (EFA)   10.8 -5.9 16.9 -3.6 0.0 38014.6 0.34 20.5 18.2
80% SPY/20% EFA   12.1 5.5 21.9 0.8 2.8 92099.9 0.14 16.6 28.5
 
  Average Annual Return (%)
Model
ETF
Portfolio
 
80%SPY/
20% EFA
2006* 11.7 11.9
2007 -6.6 6.5
2008 -40.5 -38.1
2009 40.0 27.4
2010 21.9 13.4
2011 -3.7 -0.9
YTD** 10.9 12.1
Since Incep** 2.1 2.8
 
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Model ETF Portfolio: Selection Rationale

The rationale used in building the Model ETF Portfolo is to achieve diversification across the asset 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 do not intend to use foreign bonds for risk reduction.

In U.S. investments:

  • We will diversify across equities, real estate, master limited partnerships, 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. 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.

ETF Descriptions

Domestic Stock ETF Holdings

  • PowerShares FTSE RAFI US 1000 (PRF): Tracks a fundamentally weighted index that holds the 1,000 largest domestic stocks based on four factors—book value, cash flow, sales, and dividends. Stocks in the portfolio are weighted by their fundamental scores.
  • Rydex S&P MidCap 400 Pure Value (RFV): Tracks the “pure value” segment of S&P MidCap 400 index, which holds approximately one third of the index ranked on price-to-book-value, price-earnings, and price-to-sales ratios.
  • Rydex S&P SmallCap 600 Pure Value (RZV): Tracks the “pure value” segment of the S&P SmallCap 600 index, which holds approximately one third of the index ranked on price-to-book-value, price-earnings, and price-to-sales ratios.
  • First Trust Dow Jones Select MicroCap Index (FDM): Tracks an index constructed from micro-cap stocks based on a combination of value and growth factors. The weighting of each stock is based on a modified market capitalization determined using float rather than total shares.

Domestic Stock Sector ETF Holdings

  • iShares Cohen & Steers Realty Majors Index Fund (ICF): Tracks a modified capitalization-weighted index of large, liquid domestic real estate investment trusts (REITs) that is diversified across property sectors in an attempt to represent the current market.
  • ALSPS Alerian MLP ETF (AMLP): Tracks the modified capitalization-weighted Alerian MLP Infrastructure Index, which consists of master limited partnerships (MLP) and limited liability companies (LLC) that earn the majority of their cash flow from energy commodities, but are not directly exposed to changes in commodity prices. AMLP issues Form-1099 like a regular corporation, and the net asset value (NAV) of fund shares will be reduced by the accrual of any deferred tax liabilities. Therefore, the fund’s NAV performance could differ from the index.

Foreign Stock ETF Holdings

  • Vanguard FTSE All-World ex-US (VEU): Tracks the float-adjusted capitalization-weighted FTSE All-World ex US Index, which includes approximately 2,220 non-U.S. large- and mid-cap stocks from both the developed and emerging markets.
  • SPDR S&P International Small Cap (GWX): Tracks the float-adjusted capitalization-weighted S&P Developed Ex-U.S. Under USD2 Billion Index, which is constructed of small-cap, publicly traded companies domiciled in developed countries outside the U.S.
  • Vanguard Emerging Markets (VWO): Tracks the float-adjusted capitalization-weighted MSCI Emerging Markets Index, which is designed to provide broad exposure to the equity markets of emerging countries in Europe, Asia, Africa, and Latin America.

Foreign Stock Sector ETF Holding

  • SPDR Dow Jones International Real Estate (RWX): Tracks the float-adjusted capitalization-weighted Dow Jones Global ex-U.S. Real Estate Securities Index, which holds publicly traded real estate securities in developed and emerging countries.

Optional ETF Holding

  • iShares Barclays 1-3 Year Treasury Bond (SHY): Use of this ETF should be considered as a way of controlling portfolio risk. The index tracked is capitalization-weighted and includes U.S. Treasury bonds and notes that have a remaining maturity of between one and three years.
James B. Cloonan is founder and chairman of AAII.


Discussion

Thomas from MA posted over 2 years ago:

Looking at the small cap mutual funds NOSGX and PENNX, both Yahoo and Google finance show much lower results that your table above. The annual five and ten year returns are as follows:
NOSGX: -1.0, +3.3
PENNX: -1.0, +4.0

Am I misreading something?


Jean from IL posted over 2 years ago:

Thomas - The column we had marked as "10-Year Return" should read "Since 6/30/03," and we are making that change. Sorry for the confusion. As for the 5-year returns, I see 2.4% for NOSGX and 3.27% for PENNX at Yahoo! and Google (data from Morningstar), matching our figures. Ten-year returns on Yahoo! and Google for these 2 funds are: NOSGX = 7.8%; and PENNX = 8.24%. Jean at AAII


Thomas from MA posted over 2 years ago:

Thanks Jean. I think the difference in the 5-year returns is because I calculated the returns from the charts which don't include dividends.


Raymond from AR posted over 2 years ago:

Just learned today that AMLP is registered as a corporation and not as an MLP. Am now wondering if the 0.85 expense ration can be justified.


Peter from MD posted over 2 years ago:

Is there a reason why the mutual fund portfolio doesn't include an international fund? The ETF does, and several past article in the AAII Journal said that an international exposure would enhance performance and reduce risk.
What am I missing?


Aaii from IL posted over 2 years ago:

Thank you for your comment. We are making some changes in the Mutual Fund and ETF portfolios in August and the subject of international diversification will be examined more carefully. In general it appears that foreign index funds provide less return than similar domestic funds and that the diversification produces only very short term risk reduction. Obviously some foreign funds, such as emerging market funds, provide excellent returns but in general they do not have the promised benefits. We would always consider a foreign fund on the same basis as domestic funds but would not include it just because it was foreign. -James Cloonan


Nick from NJ posted over 2 years ago:

Few domestic mutual stock fund do invest in foreign country. So i guess exposure and risk is involved.Can we know how much is that exposure from current portfolio


Richard Gillman from CA posted about 1 year ago:

Why is there not a "Weight in Portfolio" column for the Model Mutual Fund Portfolio. I'm new here.

Thanks


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