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AAII Model Portfolios

Model Fund Portfolio: REITs Show Their Long-Term Value

During the portfolio’s past 12 years, long-term equity REITs have provided excellent diversification without sacrificing return.

by James B. Cloonan | March 2016

Featured Tickers:

The S&P 500 index down 5.0% in January??? Small-cap value stocks, usually strongest in January, down even more at –9.3% [as measured by the Guggenheim S&P SmallCap 600 Pure Value (RZV)]??? All this coming off the worst pre-election year since the great depression???

Let’s hope the next break with history is in the bullish direction.

Year to date, the Model Fund Portfolio was down 7.7% and the All-ETF Portfolio was down 7.0% as of January 31, 2016. Those results and longer-term performance can be seen in Figure 1 and Tables 1, 2 and 3.

I have discussed the value of real estate investment trusts (REITs) before, but the performance of the Model Fund Portfolio over the last 12 years illustrates how effective they can be. Very long-term equity REITs return about the same as the rest of the market, but they move at different times and provide excellent diversification without having to sacrifice return. In the Model Fund Portfolio, REITs are represented by the Vanguard REIT Index fund (VNQ): It has an average annual return of 10.3% since the portfolio’s inception, and lost only 3.3% year to date as of January 31, 2016.

The other significantly different return was that of iShares MSCI Frontier 100 (FM). The impact of lower oil prices combined with general foreign economy weakness hit the exchange-traded fund hard in 2015. That impact seems to have lessened.

Portfolio Changes

There are no changes in either the Model Fund Portfolio or the All-ETF Portfolio for this quarterly review period.

Some ETF Concerns

Several AAII members have pointed out that many employee defined-contribution retirement plans do not permit use of exchange-traded funds. I think companies still feel that ETF tradability makes them unsuitable—or at least that is what they say. The fact that fees for non-index ETFs are lower than for the equivalent mutual funds might be a factor. The only recourse for this situation is to complain to the retirement fund administrator through your benefits department. If enough people voice an opinion, there may be a change.

Somewhat on the other side of the argument is the fact that with the growth of actively managed ETFs, the difference between market value and book value of the funds is widening. When that occurs, a whole new decision factor appears and these ETFs have to be viewed as an investor would view closed-end funds.


Figure 1. Model Fund Portfolio vs. Comparison
(through 1/31/2016)
Figure 1. Model Fund Portfolio vs. Comparison (through 1/31/2016)

Looking Forward

I should write “Guessing Forward.” I don’t think I or anyone else can make sense out of the last year. Bad things make the market go up and good things push it down. There is a lot of uncertainty about the market, the economy (here and abroad) and politics, and uncertainty is usually not bullish. However, the elimination of uncertainty can be very bullish.

If I had to choose a single indicator, my favorite would be “what are the talking heads saying?” and they almost all (in mid-February) are saying it is a bear market and that investors should reduce equity holdings. That gives me real hope that a market recovery is not far off.

We will publish our next Model Fund Portfolio update in the May issue of the AAII Journal, and by then it should be clearer. We may even know who the real candidates for president are. In the meantime, you can keep abreast of the Model Fund Portfolio here.

Table 1. Model Fund Portfolio

        Annual Return (%)

     
Type Fund (Ticker)
Market
Cap
Size
YTD
Return
(%)
1-
Yr
5-
Yr
10-
Yr
Since
6/30/2003
Fund
Assets
($ Mil)
Exp
Ratio
(%)
Std
Dev
(36 Mo.
Ann’l)
(%)
Worst
3-Yr
Cal
Period
(%)
MF Aston/Fairpointe Mid Cap N (CHTTX)*
Large-Cap
-9.0
-15.4
6.8
7.6
9.6
1,487.1
1.11
14.7
-7.9
MF Fidelity Capital & Income (FAGIX)
**
-3.2
-5.1
4.4
7.3
8.1
9,756.2
0.72
6.0
-7.2
MF Fidelity OTC (FOCPX)
Large-Cap
-12.7
-3.1
12.0
9.8
11.2
8,737.6
0.83
15.9
-9.3
ETF First Trust US IPO (FPX)
Large-Cap
-7.4
-3.1
15.7
nmf
nmf
639.0
0.60
13.7
-2.3
ETF Guggenheim S&P 500 Equal Weight (RSP)
Large-Cap
-5.6
-5.3
10.1
6.9
9.3
8,438.7
0.40
11.0
-11.4
ETF Guggenheim S&P MidCap 400 Pure Value (RFV)
Mid-Cap
-7.8
-12.5
6.3
nmf
nmf
87.8
0.37
14.5
-4.3
ETF Guggenheim S&P SmCap 600 Pure Value (RZV)
Small-Cap
-9.3
-13.6
6.2
nmf
nmf
124.6
0.36
17.6
-8.0
ETF iShares MSCI Frontier 100 (FM)
Large-Cap
-7.2
-18.4
nmf
nmf
nmf
425.3
0.79
13.3
3.4
ETF Vanguard REIT Index (VNQ)***
Large-Cap
-3.3
-7.3
10.3
6.3
10.3
27,007.0
0.12
14.6
-11.9
Avg of Funds in Actual Model Fund Portfolio†

-7.3
-9.3
9.0
7.6
9.7
5,868.4
0.59
10.8
-6.5
Actual Fund Portfolio Performance††

-7.7
-9.6
6.1
4.7
7.4


11.1
-6.4
Optional Investment:
ETF iShares Barclays 1-3 Year Treasury Bond (SHY)
Bonds
0.6
0.5
0.7
2.4
2.7
12,580.5
0.15
0.7
0.3
Comparison:
MF Vanguard 500 Index (VFINX)
Giant-Cap
-5.0
-0.8
10.7
6.4
10.8
24,799.3
0.17
10.8
-8.4

nmf= no meaningful figure.
*CHTTX is closed to new investors. Current shareholders can continue to invest in the fund. Other investors should simply use the other eight funds to form their portfolio.
**Distressed securities - stock and bond.
***VGSIX returns used before October 2004.
†A simple average of the funds in the current Model Fund Portfolio.
††Performance of actual portfolio since inception (June 2003) including reinvested dividends.
Source: Morningstar, Inc. Data as of 1/31/2016.

Table 2. Model Fund Portfolio Annual Performance


 Average Annual
Return (%)		 Cumulative Growth of $10,000 ($)


Model
Fund
Portfolio		 Vanguard
500 Index
(VFINX)		 Model
Fund
Portfolio		 Vanguard
500 Index
(VFINX)


2003* 18.6 15.0 11,858 11,503
2004 17.7 10.8 13,955 12,742
2005 5.4 4.8 14,711 13,350
2006 16.1 15.6 17,086 15,436
2007 10.2 5.4 18,820 16,267
2008 -35.9 -37.0 12,071 10,245
2009 24.9 26.5 15,080 12,959
2010 20.3 14.9 18,136 14,892
2011 -1.7 2.0 17,827 15,186
2012 12.6 15.8 20,075 17,589
2013 26.7 32.2 25,436 23,250
2014 9.9 13.5 27,962 26,388
2015 -4.5 1.3 $26,711 $26,719
2016 YTD** -7.7 -5.0 $24,656 $25,389
Since Incep** 7.4 7.7 $24,656 $25,389

*June 30 to December 31, 2003.
**Through January 31, 2016. Portfolio was started on June 30, 2003.

Table 3. Alternative All-ETF Portfolio

Fund (Ticker) Weight* YTD Return (%) Annual Return (%)
1-Yr 3-Yr Since 12/31/2012
First Trust US IPO ETF (FPX) 20% -7.4 -3.1 13.1 13.1
Guggenheim S&P 500 Equal Weight (RSP) 20% -5.6 -5.3 10.1 10.1
Guggenheim S&P MidCap 400 Pure Val (RFV) 20% -7.8 -12.5 4.6 4.6
Guggenheim S&P SmCap 600 Pure Val (RZV) 20% -9.3 -13.6 3.8 3.8
iShares MSCI Frontier 100 (FM) 10% -7.2 -18.4 -1.4 -1.4
Vanguard REIT Index (VNQ) 10% -3.3 -7.3 8.4 8.4
Weighted Avg of ETFs in Portfolio†
-7.1 -9.5 7.0 7.0
Actual ETF Portfolio††
-7.0 -9.2 6.7 6.7
Comparison: Spider S&P 500 (SPY)   -5.0 -0.7 11.2 11.2
* Weights were adjusted at the close of 9/30/2014.
†A weighted average return of the ETFs in the current All-ETF Portfolio.
††Performance of actual All-ETF Portfolio, including reinvested dividends.
Source: Morningstar, Inc. Data as of 1/31/2016.


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.

Discussion

Peter from MD posted over 10 years ago:

Some of the funds have significantly higher three year losses than the VFINX. The Model Fund Portfolio Selection Rationale paragraph 4 states that a 3 year loss must be significantly lower than the VFINX and not higher. Maybe this needs to be revisited. Your thoughts, please. Peter


Doug E. from NY posted over 10 years ago:

This portfolio might be an example of "the perfect is the enemy of the good". Individually, the many restrictive filters may SOUND reasonable, but the net effect seems to cancel out their advantage over the S&P 500. I imagine that loosening (or dropping) some of the conditions (say, allowing less than a 10-year history) might improve returns -- especially given the average manager tenure these days. It might even produce better FUTURE returns. Perhaps simpler could actually be better?


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