Model Mutual Fund Portfolio: Revisiting Fund Selection Rules
by James B. Cloonan
Despite the negative effect of the May-June pullback, the Model Mutual Fund Portfolio had an excellent year in 2010.
The model portfolio had a return of 20.3% last year compared to 17.1% for the overall market, as represented by the Vanguard Total Stock Market Index Fund (VTSMX). During January the benchmark fund got a head start over the model portfolio, 2.2% to 1.0%. The performance for other periods can be seen in Figure 1 and Table 2.
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The Three-Year Rule
As we have previously discussed, the year 2008 presents a problem in applying our existing criteria. Mutual funds’ returns that year have caused virtually all to fail the three-year positive return criterion, and those that don’t fail are commodity or bear-market oriented. What we have done in applying our rules is simply ignore 2008 in all our calculations. We will do this for a while longer and then adjust the three-year positive return rule to meet the reality that disastrous downturns happen, and they happen more often than would be predicted by standard deviations of returns based on normal curves.
One way of dealing with real-world risk is to increase the required horizon for equity investments. I have expressed the opinion that capital that is needed in less than three years should not be in common stocks. The three-year positive return rule was based on this thinking, and we wanted mutual funds that would never have a negative return for anyone with a three-year holding period. But the possibility of bear markets like the one we experienced in 2008 makes it seem likely that a holding horizon of four or five years for common stocks makes more sense. This approach would require funds to have positive returns over any four- or five-year period rather than the three years currently required. We will wait and see how long it takes for the market—and, more specifically, our chosen funds—to recover to their highs reached before the “great recession” before we adjust the rules.
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Discussion
So the model portfolio is 6 times more expensive to own than the benchmark, and the benchmark has twice the risk-adjusted return?
Seems to me the model needs some tweaking.
posted over 2 years ago by D. from Maryland
I don't understand why you take yearly expenses into account as a separate criteria when the long and short term performance of the fund already accounts for fund expenses.
By doing this, you may very well exclude the very best funds, just because they either charge more because they are superior managers or charge more because they do more thorough research than comparable funds.
For whatever reasons the funds have expenses higher than your arbitrary cut off points, the real criteria should be their performance
posted over 2 years ago by robert sadofsky from New York
Do you plan to start model ETF portfolio similar to the Mutual Fund portfolio ?
posted over 2 years ago by Richard from Missouri
