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Real Estate Holding Distinguishes ETF Model Portfolio From Benchmark

by James B. Cloonan

Real Estate Holding Distinguishes ETF Model Portfolio From Benchmark Splash image

There is little more to say that hasn’t already been said about the stock market. As I write this, the market appears to be stabilizing—but we have been fooled before in this extended downturn.

As you can see in the performance data in Table 1, AAII’s Model ETF Portfolio, at –19.3% year-to-date, is underperforming its benchmark, which is at –11.2% year-to-date (the ETF benchmark is a weighted portfolio that is invested 80% in the iShares Dow Jones U.S. Index and 20% in the iShares MSCI EAFE Index). This underperformance is due largely to our holding in real estate (the iShares Cohen & Steers Realty Majors Fund).

In our last performance review of the ETF Portfolio (November 2008), the model portfolio was beating the benchmark over various time periods primarily due to this same real estate holding.

And as I write this two weeks after the data in Table 1 was compiled, I notice that during that period, the real estate exchange-traded fund is up over 24%, with our benchmark up just under 8% (versus 14.1% for the Model ETF Portfolio as a whole).

Although the short-term news is positive, 2009 remains a poor year for real estate. But the important point to note is that, regardless of whether real estate leads or lags the rest of the equity market, it moves differently than the market. And this lack of correlation provides risk reduction through diversification over the long term. Our real estate interest is in real estate equity holdings and not in mortgages or other real estate debt.

ETF (Ticker) Weight
in
Portfolio
(%)
YTD
Return
(%)
1-Year
Annual
Return
(%)
Annualized
Return
Since
4/1/2006
(%)
First Trust Dow Jones Select MicroCap Index (FDM) 16 -19.5 -40.4 -19.3
PowerShares FTSE RAFI US 1000 (PRF) 16 -14.0 -42.8 -16.1
Rydex S&P MidCap 400 Pure Value (RFV) 16 -21.8 -52.1 -21.1
Rydex S&P SmallCap 600 Pure Value (RZV) 16 -24.4 -55.4 -27.7
iShares Cohen & Steers Realty Majors (ICF) 16 -35.7 -62.9 -28.1
SPDR S&P International Small Cap (GWX)* 5 -11.3 -48.3 na
SPDR DJ Wilshire International Real Estate (RWX)* 5 -16.9 -56.4 na
Vanguard FTSE All-World  Ex-U.S. (VEU)* 5 -12.3 -46.3 na
Vanguard Emerging Markets (VWO) 5 0.1 -47.2 -28.8
Portfolio Return**   -19.3 -49.1 -21.3
Optional Investment:        
  iShares Lehman 1-3 Year Treasury Bond (SHY)   0.0 3.5 1.8
Benchmarks:        
  iShares D.J. U.S. Index (IYY)   -10.5 -37.9 -14.9
  iShares MSCI EAFE Index (EFA)   -14.0 -46.4 -16.7
  ETF Benchmark (80% IYY/20% EFA)   -11.2 -39.6 -15.3
         

ETF Descriptions

U.S. Domestic ETF Holdings

  • First Trust Dow Jones Select MicroCap Index Fund FDM: Stocks are selected from the universe of micro-cap stocks (defined as the cap of the lowest two deciles of the NYSE) based on a combination of value and growth factors. The weighting of each stock is based on a modified market cap. It uses the shares in the float (as defined by the fund) rather than total shares to determine the market cap.
  • PowerShares FTSE RAFI US 1000 Portfolio PRF: This index selects the top 1,000 stocks by market cap, but weights them on proprietary fundamental factors rather than market cap.
  • Rydex S&P MidCap 400 Pure Value RFV: Stocks for this index are selected from the S&P MidCap 400 based on a number of value criteria.
  • Rydex S&P SmallCap 600 Pure Value RZV: Stocks are selected from the S&P SmallCap 600 based on a number of value criteria.
  • iShares Cohen & Steers Realty Majors Index Fund ICF: I feel this is the best REIT exchange-traded fund at this time, but wish it contained more smaller REITs and was not market-cap-weighted.

International ETF Holdings

  • SDPR S&P International Small Cap GWX: An index of small-cap (market cap under $2 billion) stocks of developed nations, and capitalization weighted.
  • SDPR DJ Wilshire International Real Estate RWX: Basically an index of non-U.S. REITs and other foreign real estate holdings.
  • Vanguard FTSE All-World Ex-U.S. VEU: A cap-weighted index of the equities of 47 countries.
  • Vanguard Emerging Markets VWO: Focuses on emerging markets and follows the MSCI emerging markets index.

Optional ETF Holding

  • iShares Lehman 1-3 Year Treasury Bond SHY: Use of this exchange-traded fund as a way of controlling portfolio risk shows my preference for the low-risk element to be as low risk as possible. With a three-year investment horizon, this exchange-traded fund has virtually no risk.

The Portfolio

I believe the equity market sectors in which the model portfolio is invested will provide returns above the general stock market over the long term because there is more exposure to value stocks and small-cap stocks. For that reason, we will continue with the approach, which is described in the “Selection Rationale” provided in the accompanying box.

At the present time, the exchange-traded funds we have selected to be in the Model ETF Portfolio are the best ETF choices for following the various strategies outlined in the selection rationale. However, there are some traditional mutual funds in a few of these strategy areas that actually have better performance than the exchange-traded funds. For that reason, some individual investors may prefer to turn to traditional mutual funds in these instances—i.e., hold a portfolio that combines exchange-traded funds and traditional mutual funds. However, since AAII’s Model ETF Portfolio is an ETF-only portfolio, we hold the exchange-traded fund rather than the mutual fund. However, we will continue to look for any new ETFs that might represent an improvement over the ones currently held in the model portfolio.

What Next?

We set up the experimental ETF portfolio three years ago to see what contributions exchange-traded funds could make to an individual’s portfolio, and to search for a combination of ETFs that would provide a portfolio that could outperform the general market. We now have three years of data, except for the three funds that started after April 1, 2006.

While there was an up market at the start of the ETF test portfolio, the overall period has been bearish. The timing for a start of a long-term upturn is anybody’s guess—and most everyone is guessing.

Since the stock market tends to be perverse, the turn will probably be earlier than the bullish consensus estimates, or later than the bearish consensus.

I certainly hope it is the former because the stock market is a leading indicator for the economy as a whole.

We will review the Model ETF Portfolio again in November. In the meantime, you may follow it at AAII.com. The entire ETF universe will be covered in the October AAII Journal.

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Model ETF Portfolio: Selection Rationale

The rationale used in building the Model ETF Portfolo is to achieve diversification across the equity 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 will not use foreign bonds for risk reduction—at least not initially.

In U.S. investments:

  • We will diversify across equities, real estate, 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 as we have for the Model Mutual Fund Portfolio. 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.

James B. Cloonan is founder and chairman of AAII.


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