• AAII Model Portfolios
  • Model Mutual Fund and ETF Portfolios: Value and Small Stocks Impact Returns

    by James B. Cloonan

    Model Mutual Fund And ETF Portfolios: Value And Small Stocks
Impact Returns Splash image

    Once again, the past quarter saw the market change direction dramatically. This time, happily, the change was strongly to the upside.

    As can be seen in Tables 1 and 3 on pages 30 and 31, both the Model Mutual Fund Portfolio and the Model ETF Portfolio outperformed their benchmarks year-to-date as of January 31, 2012.

    However, the turn to the upside was not strong enough to overcome the weak third quarter of last year. Both model portfolios underperformed for 2011, as shown in Tables 2 and 4.

    Figures 1 and 2 give a graphical representation of the portfolios’ performances compared to their benchmarks.

    Performance Determinants

    The underperformance of both portfolios is largely due to the inferior short-term performance of value stocks and small-cap stocks. Since small-cap and value stocks have always proved superior in the long run, they are emphasized in the model portfolios. As a result, the model portfolios pay a price during the occasional periods when small caps and value stocks underperform. With the recent turnaround in the market, smaller-cap and value stocks have led the way up, and we expect to see that continue.

    With an apparent solution, at least short term, to the eurozone problems, foreign equities should be recovering. Emerging markets, which were a top-performing sector for years, were hit the hardest in the 2011 pullback but seem to have regained upward strength.

    No Portfolio Changes

    There are no changes in either of the portfolios.

    FMI Common Stock fund (FMIMX) continues to be closed to new investors. If you hold FMIMX, continue to hold it. If you do not, then create your portfolio from the remaining funds. The selection rules for the Model Mutual Fund Portfolio are shown here. The May 2012 AAII Journal Model Portfolios column will give the selection rationale for the Model ETF Portfolio.

    Fund (Ticker) Style Market-
    Annual Return (%) Fund
    ($ Mil)
    (36 Mo
    Worst 3-Yr
    Aston/Optimum Mid Cap N (CHTTX) Moderate Value Mid-Cap 7.4 -0.7 5.2 8.4 1,573 1.15 25.7 -7.9
    CGM Realty (CGMRX) Low Value Mid-Cap 8.4 7.3 4.5 18.7 1,638 0.89 30.9 -2.7
    Fidelity Capital & Income (FAGIX) na* na* 4.2 -0.8 7.6 10.4 9,336 0.76 14.3 -7.2
    FMI Common Stock (FMIMX)** Moderate Value Mid-Cap 5.0 7.5 6.4 9.5 1,149 1.24 20.8 -3.0
    Madison Mosaic Mid-Cap (GTSGX) Low Value Mid-Cap 4.8 6.3 2.3 6.0 174 1.25 18.0 -7.1
    Manning & Napier Pro-Blend Ext S (MNBAX) Moderate Value Giant-Cap 3.9 1.2 2.7 6.0 732 1.08 13.3 -2.2
    Meridian Value (MVALX) Moderate Value Mid-Cap 5.5 4.1 1.7 6.3 746 1.09 20.4 -4.5
    Northern Small Cap Value (NOSGX) High Value Small-Cap 6.1 5.6 1.3 8.4 1,699 1.00 24.3 -6.3
    Royce PA Mutual Investment (PENNX) Moderate Value Small-Cap 7.1 1.6 2.7 8.5 4,557 0.90 24.1 -8.4
    Yacktman Focused (YAFFX) Low Value Giant-Cap 2.8 8.7 9.3 11.4 4,946 1.25 20.5 -2.8
    Avg of Funds in Model Fund Portfolio†

    5.5 4.1 4.4 9.3 2,655 1.06 21.2 -5.2
    Actual Fund Portfolio Performance††

    5.4 2.6 1.6 na 20.6 -6.4
    Vanguard 500 Index (VFINX) Moderate Value Giant-Cap 4.5 4.1 0.2 3.4 26,661 0.17 20.9 -8.4
      Average Annual Return (%)
    S&P 500
    2003* 18.6 15.0
    2004 17.7 10.8
    2005 5.4 4.8
    2006 16.1 15.6
    2007 10.2 5.4
    2008 -35.9 -37.0
    2009 24.9 26.5
    2010 20.3 14.9
    2011 -1.7 2.0
    YTD** 5.4 4.5
    Since Incep** 7.6 5.5

    Looking Ahead

    Most of the news is positive, and the stock market appears to be in a bullish mode.

    There are of course a number of political and economic vulnerabilities, mostly foreign, that could impact the market. I remain somewhat bullish, and my main concern is that more and more advisers are turning bullish.

    The average return (since 1932) for the fourth year in the election cycle (which is the actual election year) is 10.3% for the S&P 500, and the index is getting close to that already. Of course there is a lot to make up for from 2011, since the third year in the cycle has averaged 20.7% but 2011 was up only 2%. However last year did escape being the only pre-election year to have a negative return since 1931—but not by much. Congress has been acting a little differently lately, so the usual cyclical influence of government spending is a bit distorted.

    We will discuss the Model Mutual Fund and ETF Portfolios again in the May AAII Journal. In the meantime you may follow them at here.

    ETF (Ticker) Weight
    Annual Return (%) Fund
    ($ Mil)
    (36 Mo
    PowerShares FTSE RAFI US 1000 (PRF) 13.33 4.1 1.4 25.2 1.0 3.4 1,243.9 0.39 23.2
    Rydex S&P MidCap 400 Pure Value (RFV) 13.33 8.2 -0.2 33.1 1.1 3.5 42.8 0.35 33.1
    Rydex S&P SmallCap 600 Pure Value (RZV) 13.33 9.6 3.3 39.3 -0.4 1.2 69.3 0.35 45.4
    First Trust DJ Select MicroCap Index (FDM) 13.33 7.2 -1.5 20.7 -1.6 -0.5 56.1 0.60 27.5
    iShares Cohen & Steers Realty Majors (ICF) 13.33 6.0 12.0 32.6 -3.7 1.6 2,632.8 0.35 32.4
    ALPS Alerian MLP ETF (AMLP) 13.33 1.4 9.9 nmf nmf nmf 2,382.4 0.85 nmf
    Vanguard FTSE All-World Ex-U.S. (VEU) 5.00 7.3 -8.7 17.4 nmf nmf 6,295.9 0.22 24.3
    SPDR S&P International Small Cap (GWX) 5.00 8.5 -11.6 19.0 nmf nmf 712.6 0.59 23.0
    Vanguard Emerging Markets (VWO) 5.00 11.1 -7.2 27.3 4.5 6.5 49,811.7 0.22 28.0
    SPDR Dow Jones Int’l Real Estate (RWX) 5.00 8.2 -8.1 19.4 -7.1 nmf 2,224.1 0.59 24.5
    Portfolio Average*
    6.4 1.7 27 -1.4 1.4 3,809.0 0.47 26.4
    Optional Investment:

    iShares Barclays 1-3 Yr Treas Bond (SHY)   0.1 1.4 1.6 3.6 3.7 11,197.0 0.15 1.0
    SPDR S&P 500 Index (SPY)   4.4 4.0 19.0 0.3 2.3 99,010.5 0.10 18.5
    iShares MSCI EAFE Index (EFA)   5.3 -9.6 13.2 -3.9 -0.9 38,923.9 0.34 22.4
    ETF Benchmark (80% SPY/20% EFA)   4.6 1.3 17.9 -0.6 1.7 86,993.2 0.14 19.0
      Average Annual Return (%)
    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** 6.4 4.6
    Since Incep** 1.4 1.7
    SPECIAL OFFER: Get AAII membership FREE for 30 days!
    Get full access to AAII.com, including our market-beating Model Stock Portfolio, currently outperforming the S&P 500 by 2-to-1. Plus 60 stock screens based on the winning strategies of legendary investors like Warren Start your trial now and get immediate access to our market-beating Model Stock Portfolio (beating the S&P 500 2-to-1) plus 60 stock screens based on the strategies of legendary investors like Warren Buffett and Benjamin Graham. PLUS get unbiased investor education with our award-winning AAII Journal, our comprehensive ETF Guide and more – FREE for 30 days

    Figure 2. Model ETF Portfolio Vs. Benchmark (Through 1/31/2012)



    Model Mutual Fund Portfolio: Selection Rules

    To make it into the Model Mutual Fund Portfolio, a fund must meet the following criteria:

    1. 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.
    2. 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.
    3. 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.
    4. In its worst three-year period (based on calendar years) either it must not have had a loss or, in the case of a really bad stock market, its loss must have been substantially less than that of the S&P 500 and its recovery quicker. I feel that individuals should have at least a three-year investment horizon when investing in equities. So this rule seeks to find funds that will minimize the losses an investor might face in bear markets.
    5. Net assets must be less than $9 billion for giant- and large-cap funds, $4 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.
    6. It must have an expense ratio no greater than 1.25% if assets are less than $3.5 billion and 1% or less if assets are over $3.5 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 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 management’s attitude. However, there may be justifiable exceptions.
    7. 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.
    8. 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.
    9. 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.

    How many funds should you hold?

    • 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.
    • No matter how many funds you buy, equal dollar amounts are invested in each fund initially.
    • Well-diversified mutual funds do not have to be changed very often, so the screen will only be performed four times a year.


    Rodney from ID posted over 4 years ago:

    I am surprized that your model mutual fund portfolio is so heavy to small and midcap funds. This seems different from most other investment advice. Could you explain this?

    Dan from HI posted over 4 years ago:

    I have been using an upgrading system (NoLoad Fund X) in the past and it performed well until the '08 "crash", and doesn't seem to
    work well now with the market not going anywhere, but constantly changing. Any advise/comments?

    Matthew from WI posted over 4 years ago:

    I too noticed that the portfolio seems heavy in small & mid caps.

    Tom from TX posted over 4 years ago:

    Should we expect to underperform in these 2 portfolioes most of the time when large cap and growth stocks are in style? It looks that way to me.

    James from IL posted over 4 years ago:

    Thanks for your comments. Given that individuals do not have assets they need within four years invested in stocks, I believe investments should be long-term oriented. In the long run, micro-cap stocks outperform small stocks which outperform midcaps which outperform large caps; giant caps are the worst of all. I believe in going for the greates gain. We mix them up a bit to reduce shorter term volatility. Micro-cap stocks, the best of all (see performance of the Shadow Stock portfolio in the April Journal), don't work as well in mutual funds because of poor liquidity in down markets when funds must sell because investors are getting out when they should be getting in. James Cloonan

    You need to log in as a registered AAII user before commenting.
    Create an account

    Log In