Mutual Fund Portfolio Tracks Market, Stumbles and All

    by James B. Cloonan

    Mutual Fund Portfolio Tracks Market, Stumbles And All Splash image

    The market stumbled a bit over the past quarter but still manages to keep up a pace that could let it attain the 22% average pre-election-year return—of course, we still have six months to go.

    I feel better about the market now that there are more bearish voices.

    Interest rates, Federal Reserve action, the housing slowdown, and the sub-prime lending problems weigh on the market, but there are always areas of concern in the stock market. Terrorism, of course, could have an impact, and the recent actions in Britain certainly raise concerns.

    The Model ETF Portfolio, composed of exchange-traded funds, has been separated from the Model Mutual Fund Portfolio coverage. You can find a review of the Model ETF Portfolio in a separate article on page 11 of this issue. Going forward, the ETF portfolio will be reviewed in the May and November issues of the AAII Journal.

    The coverage of the Model Mutual Fund Portfolio will continue to appear in the February and August issues.

    Portfolio Performance

    The Model Mutual Fund Portfolio is doing well year-to-date. It is up 9.7% compared to 7.5% for the total stock market, as measured by the Vanguard Total Stock Market Index fund (VTSMX).

    The results for year-to-date and longer terms can be seen in Figures 1 and 2 and Table 1. Within the portfolio, the CGM Focus fund (CGMFX) continues to do exceptionally well—it is up 23.3% year-to-date. However, the day-to-day volatility would inhibit sleep if it were the only fund in your portfolio—which I hope it is not.

    Figure 1.
    Model Fund Portfolio
    Performance vs. Benchmark

    Portfolio Changes

    The T. Rowe Price Capital Appreciation fund (PRWCX) has been sold from the Model Fund Portfolio. The fund’s assets are well over $10 billion, and we do not believe at that size it can significantly outperform an index fund over the long term.

    It will be replaced in the Model Fund Portfolio by Manning & Napier Pro-Blend Extended Term A (MNBAX), which had been listed as a substitute fund for the funds that are closed to new investors.

    Tamarack Microcap Value (TMVSX) has re-opened its “S” (no-load) shares to new investors. Tamarack Microcap Value is already in the Model Portfolio, but investors who started with the portfolio after the “S” shares were closed can now buy them. To keep as close to the model portfolio as possible you can take the following actions:

    • If you already have Tamarack Microcap Value, you should replace T. Rowe Price Capital Appreciation fund with the Manning & Napier fund.
    • If you did not have Tamarack Microcap Value, you would have already purchased the Manning & Napier fund as a substitute. In this case, you should replace T. Rowe Price Capital Appreciation fund with the Tamarack Fund.

    FMI Common Stock fund (FMIMX) remains closed and Mairs & Power Growth fund (MPGFX) remains the substitute for it.

    These changes in the portfolio are not based on factors that require instant action, so if your funds are in a taxable account and nearing the one-year mark for long-term capital gains treatment, wait to make any changes.

    We will cover the Mutual Fund Portfolio again in the February 2008 AAII Journal, but in the meantime you can follow it at in the Model Fund Portfolio area.

    Figure 2.
    Historical Performance
    of Funds in the
    Model Portfolio


       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.

    5) 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.

    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?

    • 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.

    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

→ James B. Cloonan