The need for a simple, basic long-term approach for those who do not want to be active investors prompted the late AAII founder James Cloonan to develop the Level3 Passive Portfolio while writing his book “Investing at Level3.”

Cloonan envisioned the use of the Level3 Passive Portfolio as a complete equity portfolio for individual investors who wish to manage their own portfolio but do not have the desire to get involved in individual stock selection. It can also be used as an equity portion of a whole portfolio for investors interested in selecting some individual stocks and actively managed funds, but with a desire to keep the majority of their portfolio in index funds. We started tracking the actual portfolio on May 31, 2016, as shown in Figure 1.

The Level3 Passive Portfolio is composed of four exchange-traded funds (ETFs) selected based upon long term observations and research on market segments and strategies that had performed well over the long term relative to the S&P 500 index. Many of these ETFs are called smart beta indexes in that they vary the weighting of stocks held in the index using factors such as valuation or size instead of the more common market-capitalization weighting. The performance over short periods of these various market segments will likely diverge (for better or worse) from traditional market-cap-weighted index funds.

Large-cap domestic stocks as measured by the S&P 500 have offered investors a long-term annual rate of return around 10.3% using studies such as the SBBI Yearbook that examines market returns, interest rates and inflation since 1926. In selecting ETFs for the Level3 Passive Portfolio, Cloonan considered how investors can potentially improve upon the long-term return of the market-cap-weighted S&P 500 by incorporating index funds that extend the reach of the S&P 500 into smaller companies, value-oriented stocks and real estate.

In a market-cap-weighted index such as the S&P 500, the proportional weight of each company in the index is determined according to the total market value of its outstanding shares. Market cap is simply the number of shares outstanding times the share price. The index is rebalanced quarterly and by its nature the price performance of its largest holdings has a greater impact on the index. The smallest company in the S&P 500 has a market cap of $3.857 billion, while the largest has a market cap of $2.434 trillion. The average market cap is $77.6 billion.

The largest company, Apple Inc. (AAPL), makes up 6.1% of the index. Apple, Microsoft Corp. (MSFT), Amazon.com Inc. (AMZN), Facebook Inc. Class A (FB), Alphabet Inc. Class A (GOOGL), Alphabet Inc. Class C (GOOG), Tesla Inc. (TSLA), Berkshire Hathaway (BRK.B), Nvidia Corp. (NVDA), and JPMorgan Chase & Co. (JPM) are the top 10 constituents and account for 27.7% of the index. Tesla, Nvidia and JPMorgan Chase made it into the top 10 over the last year, displacing Johnson & Johnson (JNJ), Procter & Gamble Co. (PG) and Visa Inc. Class A (V).

With a market-cap-weighted index, popular stocks can become an overweighted segment of the index, leaving the less popular and potentially underpriced stocks underweighted. By design, smaller companies compose a smaller percentage of market-cap-weighted indexes. Companies must have positive reported earnings over the most recent quarter, as well as over the most recent four quarters (summed together) to be added to the index.

Portfolio Performance

Looking at the recent performance, the Level3 Passive Portfolio is up 19.9% during the first seven months of 2021 compared to a net asset value (NAV) total return of 17.9% for the SPDR S&P 500 ETF (SPY). Value stocks, smaller-company stocks and real estate segments have performed well this year after lagging large-cap growth approaches over the last decade. The Level3 Passive Portfolio continues to lag the S&P 500 since its formation, up 12.9% annually compared to a 17.5% gain for the SPDR S&P 500 ETF over the same time frame.

When the Level3 Passive Portfolio was established, it was noted that changes to the portfolio should be relatively rare and will occur only when a new or different ETF appears to be more effective at accomplishing a similar objective than one of the current holdings.

Looking forward, the overlap of the Russell 1000 equal weight index and S&P 500 equal weight index used for two of the holdings is being examined to determine if one of the ETFs can be removed. The potential benefits of adding a domestic small-cap stock element as well as an international component to the Level3 Passive Portfolio are also being examined. These are the equity market segments that make up the asset allocation models found on AAII.com.

Table 1 provides the target weights, recent performance and basic characteristics of the ETFs in the Level3 Passive Portfolio.

Table 1. Level3 Passive Portfolio
Fund (Ticker)	Weight	Ann’l Return Since 5/31/2016	Total Return (%)						Div Yield (%)	Avg P/B Ratio (X)	% in Exp Ratio (%)	Top 10 Hldgs (%)	Total Assets ($ Mil)
			YTD	2020	2019	2018	2017	2016*
Invesco S&P 500 Equal Weight (RSP)	30%	15.2	20.6	12.7	28.9	(7.8)	18.5	8.2	1.3	3.26	0.2	2.5	28,616
Invesco Russell 1000 Equal Weight (EQAL)	30%	14	17.7	16.4	24.6	(8.9)	17.2	7.9	1.5	2.88	0.2	4.8	609
Vanguard Mid-Cap Value (VOE)	30%	11.8	19.7	2.5	28	(12.4)	17.1	10.7	1.9	2.39	0.07	10.4	14,379
Vanguard Real Estate (VNQ)	10%	9.1	26.8	(4.7)	28.9	(5.9)	4.9	2.2	2.2	2.98	0.12	45.6	43,815
Weighted Avg of ETFs in Portfolio**		13.2	20.1	9	27.3	(9.3)	16.3	8.3	1.6	2.86	0.15	9.9	17,463
Actual Level3 Passive Portfolio***		12.9	19.9	9.1	27.2	(9.5)	15.5	7.5	—	—	—	—	—
Comparison:
SPDR S&P 500 (SPY)		17.5	17.9	18.4	31.3	(4.4)	21.7	8	1.3	4.52	0.1	27.7	382,511
*May 31 to December 31, 2016. **A weighted average return of the ETFs in the current Level3 Passive Portfolio using current weights. ***Performance of actual Level3 Passive Portfolio, including reinvested dividends. Source: Morningstar, Inc. Data as of 7/31/2021.

Invesco S&P 500 Equal Weight Portfolio ETF (RSP)

This ETF is given a portfolio weight of 30% in the Level3 Passive Portfolio.

The Invesco S&P 500 Equal Weight Portfolio ETF (RSP) invests in the stocks that make up the S&P 500, but weights the holdings equally, with the holdings rebalanced quarterly. In effect, each quarter, the ETF is selling the relative winning stocks that are potentially overvalued and investing the proceeds into last quarter’s losers, which might be undervalued.

The percentage of holdings that make up the top 10 of the portfolio’s holdings helps to indicate the level of portfolio concentration and serves as a measure of portfolio risk. The higher the percentage, the more concentrated the ETF is in a few companies, and the more the ETF is susceptible to the market fluctuations of these few holdings. Because the stocks in the ETF are held in equal proportion, the top 10 holdings of the Invesco S&P 500 Equal Weight ETF make up only 2.5% of total assets, versus 27.7% of the market-cap-weighted SPDR S&P 500 ETF that holds the same companies. The top five stocks alone in the SPDR S&P 500 ETF constitute 22.2% of the ETF: Apple (6.1%), Microsoft (5.8%), Alphabet (4.2%), Amazon (3.8%) and Facebook (2.3%).

The dividend yield on mutual funds and ETFs is calculated by dividing the income distributions over the last 12 months by the ending net asset value. Dividend distributions for mutual funds and ETFs are made net of expenses. The dividend yield of the Invesco S&P 500 Equal Weight ETF is 1.3%, equal to the yield of the SPDR S&P 500 ETF. The Invesco S&P 500 Equal Weight ETF’s expense ratio is low at 0.20%, but above the 0.095% expense ratio of the SPDR S&P 500 ETF.

The price-to-book-value ratio is a common measure of company value that equates the share price to the accounting equity value of the company. The higher the price-to-book ratio, the more investors have bid up the price of the company relative to its accounting value. Value investors typically seek out companies trading with lower price-to-book ratios and much research supports the approach. The average price-to-book ratio of the market-cap-weighted SPDR S&P 500 ETF is 4.52 compared to 3.26 for the S&P 500 Equal Weight ETF.

The total assets figure indicates the total dollars invested in the ETF and gauges the interest in its strategy. Greater total assets under management (AUM) should also result in lower expense ratios, as fixed expenses are spread over a larger asset base. The S&P 500 Equal Weight ETF has $28.6 billion in total assets. The SPDR S&P 500 ETF has $382.5 billion in total assets.

Invesco Russell 1000 Equal Weight ETF (EQAL)

This ETF is given a portfolio weight of 30% in the Level3 Passive Portfolio.

The Invesco Russell 1000 Equal Weight ETF includes securities in the Russell 1000 index, which consists of the top 1,000 stocks by market cap. This ETF is equally weighted across the nine sector groups, with each security within the sector given an equal weighting. The ETF and the index are reweighted at the close of the third Friday in March, September and December. The index is also reweighted at the close of the last Friday in June when the Russell 1000 is reconstituted. This index provides some additional exposure to mid-cap stocks over those found in the S&P 500, especially since the ETF is equally weighted and not weighted by market cap. Mid-cap stocks historically have had higher returns than large caps.

The dividend yield of the Invesco Russell 1000 Equal Weight ETF is 1.5%. On average, smaller companies normally pay out less in dividends than larger, more mature companies, but the 1.5% yield of the Invesco Russell 1000 Equal Weight ETF is above the 1.3% yield of the SPDR S&P 500 ETF.

The average price-to-book ratio for the stocks in this ETF is 2.88 compared to 4.52 for the SPDR S&P 500 ETF. The top 10 holdings constitute 4.8% of the portfolio holdings. The ETF has $609 million in total assets, the lowest in the Level3 Passive Portfolio. The expense ratio is 0.20%.

Vanguard Mid-Cap Value ETF (VOE)

This ETF is given a portfolio weight of 30% in the Level3 Passive Portfolio.

The Vanguard Mid-Cap Value ETF tracks the CRSP U.S. Mid Cap Value Index, which targets stocks representing the value and lower-growing half of the mid-cap market and weights the stocks by market cap. CRSP classifies value securities using book-to-price, forward earnings-to-price, historical earnings-to-price, dividend-to-price and sales-to-price ratios. To measure growth, CRSP looks at future long-term growth and short-term growth in earnings per share, historical growth in sales and earnings, current investment-to-assets ratio and return on assets.

Historically, mid-cap value stocks have had higher returns than large-cap stocks or mid-cap growth stocks. The value focus helps to boost the dividend yield of the Vanguard Mid-Cap Value ETF. The ETF has a dividend yield of 1.9% compared to the SPDR S&P 500 ETF’s yield of 1.3%. The average dividend yield of mid-cap blend funds is 0.5%, but mid-cap growth funds have an average dividend yield of 0.0% and mid-cap value funds have an average dividend yield of 0.8%. The Vanguard Mid-Cap Value ETF has the lowest price-to-book ratio in the Level3 Passive Portfolio with a ratio of 2.39, well below the 4.52 ratio of the SPDR S&P 500 ETF.

The top 10 holdings in the Vanguard Mid-Cap Value ETF make up 10.4% of the portfolio’s holdings. The ETF had 208 holdings at the end of June and $14.4 billion in total assets. The expense ratio is a low 0.07%.

Vanguard Real Estate ETF (VNQ)

This ETF is given a portfolio weight of 10% in the Level3 Passive Portfolio.

Vanguard Real Estate ETF tracks the return of the MSCI U.S. Investable Market Real Estate 25/50 index, which measures the performance of publicly traded equity real estate investment trusts (REITs), companies that purchase office buildings, hotels and other real property. Historically, the returns of REITs have exceeded the returns of the S&P 500 over the long run and provide diversification as well.

The Vanguard Real Estate ETF has a dividend yield of 2.2%, reflecting the higher payouts common with this sector. The higher yield also makes the group more sensitive to interest rates—falling in price when interest rates rise and moving up in price when interest rates decline.

The price-to-book ratio for the holdings in the Vanguard Real Estate ETF averages 2.98, compared to 4.52 for the SPDR S&P 500 ETF. The top 10 holdings account for 45.6% of the portfolio holdings, but it is worth noting that the measure is boosted as it holds 11.6% of its assets in the Vanguard Real Estate II Index fund, which tracks the MSCI U.S. Investable Market Real Estate 25/50 index. The Vanguard Real Estate ETF’s expense ratio is 0.12% and it has $43.8 billion in assets.

Portfolio Management Notes

For the Level3 Passive Portfolio, the initial weightings are as previously indicated and shown in Table 1. The approach to rebalancing is to keep it to a minimum. While transaction costs for ETFs are generally low now with zero commissions, rebalancing frequently is a distraction and can make taxes a significant consideration. You should be able to achieve almost all the rebalancing necessary when you add and withdraw funds or when changes are made in the holdings.

Rebalancing decisions will have to be made by the individual since every investor will add or has added assets at a different time, so everyone’s weights will be different. But the following are some general guidelines:

• Don’t rebalance any holding unless you have held it for over a year.
• If a holding is 25% below where it should be in relation to the planned weight, bring it back to the appropriate level by selling some overweighted holdings to provide funds.
• If a holding is 33% above where it should be in relation to the planned weight, bring it back to the appropriate level by selling the excess and using the funds to buy underweighted holdings.

The next review of the Level3 Passive Portfolio will be in the March 2022 AAII Journal.

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