Special Note

As I planned for at least semi-retirement, I couldn’t help but think about the 37 years since I started AAII, and what has happened to the stock market and to the approaches and methods of investing during that time. Lower commissions, tighter bid/ask spreads, no-load funds, exchange-traded funds, index funds, and other new products have all changed the shape of the investment landscape. While our investing has been improved by these advances, I believe that investment strategy—which I feel is even more important—has not advanced as far as it could have and should have.

I am proud of the contribution AAII has made toward helping over a million individual investors move from an unstructured approach to investing, which I call Level 1 investing, to a more structured approach that incorporates contemporary portfolio theory and practice, which I call Level 2 investing.

Looking back over past progress and based on real-world experience, I feel that we can move forward to a new level of investing strategy and I have written a book in that vein called “Investing at Level3.” It departs quite a bit from conventional wisdom, but I believe it could lead to twice the assets at retirement over an investment lifetime as compared to current best practice.

More information about the book can be found here, but I mention it here because the All-ETF Portfolio will be changed over the coming months to reflect the basic passive portfolio approach I describe in “Investing at Level3.”

—Jim Cloonan

Model Fund Portfolio: Selection Rationale

First Methodology

The fund selection rationale consists of two distinct approaches. The first approach is to select actively managed funds where the managers have shown a long-term ability to outperform the market after allowing for additional portfolio risk, regardless of the sector invested in. A fund must have the following characteristics to be considered for the Model Fund Portfolio:

• 1.  It must be a pure no-load fund. Short-term holding penalties are allowed if paid to the fund and not the manager.
• 2.  It must have been active for 10 years. However, exceptions are possible.
• 3.  It must have outperformed the S&P 500 index over the past five-year and 10-year periods.
• 4.  In its worst three-year (calendar) period, it must not have had a loss; or, in particularly difficult market periods, its loss must have been substantially less than that of the S&P 500 index.
• 5.  Its expense ratio must not be above 1.25%. Lower ratios will increase desirability.
• 6.  Fund assets must not be over $10 billion. Some exceptions are permitted, depending on fund objectives.
• 7.  It must currently be open to individual investors, with a minimum investment of $25,000 or less.

The above rules apply to new fund selections. Funds will not automatically be eliminated if they later violate the rules without considering other factors.

Second Methodology

The second methodology selects investment approaches that have provided excess returns or reduced portfolio risk to investors over the long term and then searches for the best traditional fund or exchange-traded fund (ETF) in that area. Factors to be considered are:

• 1.  The liquidity of the fund.
• 2.  The resources of the management company, in the case of ETFs.
• 3.  The investment returns and risk over as long a term as possible, given the newness of so many ETFs.
• 4.  Selection of areas with demonstrated long-term excess returns: value stocks, small-cap stocks, real estate and special areas where individuals cannot easily invest. An example of a fund in a special area would be Fidelity Capital & Income fund (FAGIX), which invests in distressed securities.

Portfolio Management Notes

• •  The Model Fund Portfolio is meant to be a portfolio, and we suggest you invest in the entire portfolio on an equal investment basis—that is, invest equal dollar amounts in each fund initially. If you are building an All-ETF Portfolio, see the recommended weightings shown in Table 3.
• •  If a fund is closed, create your portfolio from the remaining funds.
• •  You may make adjustments based on your non-fund holdings. For example, if you have partnership or individual holdings in investment real estate (not personal housing), you may reduce or eliminate any REIT funds.
• •  There is no need to rebalance on a regular basis. Rebalancing can be accomplished when there are portfolio changes or if one holding gets way out of line. We will notify you of any rebalancing in the Model Fund Portfolio.