Building an All-ETF Subset From the Model Fund Portfolio

Over the past three months the stock market has continued its upward climb despite the dangers on the horizon.

The Model Fund Portfolio is up 17.4% year-to-date but lags the S&P 500 index as measured by Vanguard 500 Index fund (VFINX), which is up 19.7%. As we mentioned previously, the lower return is largely due to our two holdings that provide diversification—Fidelity Capital & Income fund (FAGIX) and Vanguard REIT Index ETF (VNQ).

Figure 1 and Table 2 show performance figures over the long term for the portfolio, the index comparison and the Conservative Portfolio, which is 75% Model Fund Portfolio and 25% iShares Barclays 1-3 Year Treasury ETF (SHY).

No Portfolio Changes

Table 1 shows the current holdings for the Model Fund Portfolio. There are no portfolio changes at this time.

Our change from WisdomTree Emerging Markets SmallCap Dividend ETF (DGS) to iShares MSCI Frontier 100 ETF (FM) proved timely but the area of frontier markets is still new. We will feel more confident when there are longer-term results. We particularly would like to see how frontier markets perform in a down market.

Figure 1. Model Fund Portfolio vs. Benchmark (through 9/30/13)

 

The ETF Quandary

I continue to believe that traditional mutual funds can invest in certain ways that exchange-traded funds cannot, and some of these areas have been profitable in the past. Consequently, I believe that they have a place in a fund portfolio. However, many of our members feel that ETFs are easier to trade, have lower costs, and are far superior for tax planning. They would prefer an all-ETF approach.

Depending on individual circumstances, the advantages of ETFs may outweigh any potential gain from maintaining traditional mutual funds in the portfolio. This makes sense, so we are going to track an all-ETF portfolio, called the Pure ETF Portfolio. It can be used as a guide, and it will provide insight into how the approaches differ over the long run.

Setting Up the All-ETF Portfolio

I feel that our five current exchange-traded funds are diversified enough to make up a balanced portfolio that zeros in on investment areas that have outperformed the market in the past. iShares MSCI Frontier 100 ETF does not have such a history, but it is in keeping with a micro-cap stock philosophy.

The reduction in the number of holdings requires an unequal weighting of each of the holdings. Table 3 shows the new Pure ETF Portfolio and the weights given each of the holdings. We only look at the results for this year-to-date and will have to wait for longer-term results to be meaningful.

If you wish to mimic this portfolio, simply determine the total dollars you wish to invest and multiply this by the fraction assigned to each exchange-traded fund as indicated in Table 3. (RSP, 0.40; RFV, 0.20; RZV, 0.20; VNQ, 0.10; and FM, 0.10). Don’t be tempted to bypass the Vanguard REIT Index ETF just because real estate is performing poorly so far this year. Over the long term, it has done well and it is likely a bargain now.

We will rebalance this portfolio, but not frequently and only when a holding gets far out of line. We will let you know when we rebalance. If you have this portfolio and add money to it, add the funds so as to help restore original weightings. The same applies if you are withdrawing funds.

Switching to an all-ETF portfolio means that the second methodology in our selection rationale will dominate the portfolio. We gain something and we lose something; only time (five to 10 years) and your personal experience with tax considerations will tell us which approach is best. New ETFs may provide additional opportunities for better portfolio performance.

Outlook

With all the uncertainty in Washington, I don’t feel competent to comment about an outlook. I hope much is resolved by the next discussion of the Model Fund Portfolio in the March 2014 AAII Journal. In the meantime, you can follow performance here.