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Model Mutual Fund Portfolio: Revisiting Fund Selection Rules

by James B. Cloonan

Model Mutual Fund Portfolio: Revisiting Fund Selection Rules Splash image

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.

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.

Portfolio Changes

We have sold Stratton Multi-Cap Fund (STRGX) and replaced it with Aston/Optimum Mid Cap Fund (CHTTX). STRGX seems to have changed direction over the last few years. Despite its name, it is dominated by large-cap stocks, and I feel its risk-adjusted return is too low. It’s five-year Sharpe ratio is negative.

Looking Ahead

Over the past three years I have heard more and more comments and advertisements for investment services saying that the market has proven that “buy and hold” is dead—that you have to trade in and out to survive. However, the stock market is looking somewhat stronger and all of our funds are approaching their highs from before the recession. I don’t know how well the “in and outers” did, but if this year approaches the 21.7% increase that is the average of the pre-presidential election year since the depression era, the market will be back to 2007 highs. The market, of course, may not go up 21.7%, but this year in the election cycle has never been negative. In fact, the most frightening thing about the coming year is the preponderance of bullishness.

The next review of the Model Mutual Fund Portfolio will be in the August 2011 AAII Journal, but you may keep up with all the model portfolios at AAII.com.

Fund (Ticker) Style Market-
Cap
Size
YTD
Return
(%)
Annual Return (%) Fund
Assets
($ Mil)
Exp
Ratio
(%)
Std
Dev
(36-Mo.
Ann’l)
(%)
3-Yr
Risk-
Adj
1-
Yr
5-
Yr
10-
Yr
Ret
(%)
Aston/Optimum Mid Cap N (CHTTX) Low Value Mid-Cap 1.1 27.1 8.3 8.8 1,700 1.21 29.2 6.9
CGM Focus (CGMFX) Very Low Value Giant-Cap -2.0 27.8 3.2 17.6 3,182 1.23 32.9 -17.7
CGM Realty (CGMRX) Low Value Mid-Cap 2.1 42.3 8.5 19.6 1,677 0.93 39.6 -3.5
FMI Common Stock (FMIMX)* Low Value Mid-Cap 2.1 26.8 7.6 10.7 1,053 1.26 24.3 10.2
Madison Mosaic Mid-Cap (GTSGX) Low Value Mid-Cap 3.6 29.8 4.0 6.2 160 1.26 22.0 1.7
Manning & Napier Pro-Blend Ext S (MNBAX) Very Low Value Giant-Cap 1.2 15.9 5.0 5.9 733 1.10 15.8 3.2
Meridian Value (MVALX) Low Value Mid-Cap 1.5 24.9 3.8 6.6 935 1.09 21.6 2.0
Northern Small Cap Value (NOSGX) High Value Small-Cap -0.2 28.4 2.6 8.0 1,641 1.00 26.5 4.8
Royce PA Mutual Invst (PENNX) Moderate Value Small-Cap 1.0 30.4 3.9 9.7 4,857 0.92 26.4 5.6
RBC Microcap Value S (TMVSX)** Very High Value Nano-Cap -0.5 26.8 0.1 8.0 142 1.07 28.0 0.2
Average of Funds in Model Fund Portfolio

1.0 28.0 4.7 10.1 1,608 1.11 26.6 nmf
Model Fund Portfolio Performance††

1.0 26.6 3.2 na 1,608 1.11 24.2 0.6
Vanguard Tot Stock Mkt Idx (VTSMX) Low Value Giant-Cap 2.2 24.0 2.7 2.3 57,504 0.18 22.3 1.1
 
Go to the Model Mutual Fund Portfolio area of AAII.com for the definitions of style, market-cap size and risk-adjusted return.
  Avg Ann’l
Ret Since
Incep* (%)
YTD
Ret*
(%)
 
Annual Rate of Return (%)
2010 2009 2008 2007 2006 2005 2004 2003**
Model Mutual Fund Portfolio 8.3 1.0 20.3 24.9 -35.9 10.2 16.1 5.4 17.7 18.6
Vanguard Tot Stock Mkt Idx (VTSMX) 6.7 2.2 17.1 28.7 -37.0 5.5 15.5 6.0 12.5 16.4

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. 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. We only go back 10 years for this criterion.
  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 twice a year.

* Performance for 2008 excluded when applying rules.

James B. Cloonan is founder and chairman of AAII.


Discussion

D. from MD posted over 3 years ago:

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.


robert sadofsky from NY posted over 3 years ago:

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


Richard from MO posted over 3 years ago:

Do you plan to start model ETF portfolio similar to the Mutual Fund portfolio ?


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