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AAII Model Portfolios Level3 Passive Portfolio

Model Fund Portfolios: Answers to Questions About the Level3 Approach

Find out why foreign and small-cap stocks are excluded and how the new approach fits into an individual investor’s portfolio.

by James B. Cloonan | November 2016

Featured Tickers:

The market continues to show more strength than many analysts expected.

At the end of three quarters, however, it is still just about an average year so far.

The Model Fund Portfolio is up 10.1% through September 30, 2016, compared to a return of 7.7% for the S&P 500 index as represented by the exchange-traded fund (ETF) SPDR S&P 500 (SPY).

Longer-term results can be seen in Figure 1 and Tables 1 and 2.

Portfolio Changes

There are no changes in the holdings of the Model Fund Portfolio at this time. As I mentioned in my August column, with the advent of the Level3 Passive Portfolio, the Model Fund Portfolio can be a bit more aggressive in seeking funds that may have an advantage in the intermediate term (two to five years). The portfolio will still not engage in any short-term trading.

The Level3 Passive Portfolio

I have had many questions regarding the Level3 Passive Portfolio, which was introduced in my August column. Many of them are due to my lack of clarity in explaining what this new portfolio is. The underpinnings of the portfolio come from my book “Investing at Level3,” but you do not need to purchase the book to utilize this portfolio either as an investment approach or as a standard against which to compare active approaches. (Active approaches are defined as those using individual stocks or non-index funds and ETFs.) The investment rationale and process for the portfolio is explained below.

The Level3 Passive Portfolio is intended to be a simple and basic approach for investors who do not want to be active investors. It is not expected to be among the best-performing portfolios, particularly over a one- to five-year horizon. However, it should outperform the average investor as represented by the S&P 500 or Wilshire 5000 index. So, it is basically an index approach that takes advantage of some of the factors shown to lead to better returns.

Figure 1. Model Fund Portfolio vs. Comparison
(Through 9/30/2016)

Figure 1. Model Fund Portfolio vs. Comparison (Through 9/30/2016)
 

That approach leads to some aspects of the portfolio that have raised questions. The most prominent question is: Where is the foreign and small-cap representation? As for foreign stocks, I don’t believe that their presence provides any meaningful risk reduction for the long-term investor. While some individual foreign stocks may be excellent investments and some funds that target specific investment areas such as emerging or frontier markets may provide excellent returns, these are not passive long-term index investments.

While I am a strong advocate of small and micro-cap stocks, I don’t feel that mutual funds or ETFs can operate effectively in this area because of transaction costs and panic selling in severe down markets.

The Level3 Passive Portfolio does not have to be your entire portfolio. If there is to be an active part of your portfolio, I strongly suggest small and micro-cap value stocks. All of my model portfolios—mutual fund, ETF and Shadow Stock—are meant as educational tools and are a starting point from which I hope many of you will progress.

Table 3 shows performance for the Level3 Passive Portfolio since inception on May 31, 2016.

Table 1. Model Fund Portfolio

Type Fund (Ticker) Market Cap Size YTD Return (%) Annual Return (%) Fund Assets ($Mil) Exp Ratio (%) Std Dev (36 Mo. Ann’l)(%) Worst 3-Yr Cal Period (%)
1-Yr 5-Yr 10-Yr Since 6/30/2003
MF Aston/Fairpointe Mid Cap N (CHTTX)* Large-Cap 9.7 15.3 16.3 9.7 10.7 1,446.5 1.11 14.7 -7.9
MF Fidelity Capital & Income (FAGIX) ** 9.1 9.1 9.0 8.0 8.6 10,487.7 0.75 6.2 -7.2
MF Fidelity OTC (FOCPX) Large-Cap 4.3 18.2 18.5 12.1 12.1 10,009.2 0.91 15.8 -9.3
ETF First Trust US IPO (FPX) Large-Cap 7.0 12.4 21.5 11.8 nmf 578.7 0.60 13.2 -2.3
ETF Guggenheim S&P 500 Equal Weight (RSP) Large-Cap 10.2 15.7 16.9 8.2 10.1 10,077.9 0.40 11.0 -11.4
ETF Guggenheim S&P MidCap 400 Pure Value (RFV) Mid-Cap 17.5 17.4 16.8 7.7 nmf 130.3 0.35 15.7 -4.3
ETF Guggenheim S&P SmCap 600 Pure Value (RZV) Small-Cap 14.9 17.8 16.4 6.3 nmf 175.9 0.35 18.1 -8.0
ETF iShares MSCI Frontier 100 (FM) Large-Cap 1.3 0.1 nmf nmf nmf 481.3 0.79 12.8 3.4
ETF Vanguard REIT Index (VNQ)*** Large-Cap 11.9 19.7 15.7 6.5 11.0 36,523.0 0.12 14.8 -11.9
Avg of Funds in Actual Model Fund Portfolio†
 9.5 14.0 16.4 8.8 10.5 7,767.8 0.60 10.9 -6.5
Actual Fund Portfolio Performance††
 10.1 14.9 13.2 6.3 8.5 — — 11.4 -6.4
Optional Investment:
ETF iShares Barclays 1-3 Year Treasury Bond (SHY) Bonds 1.3 0.8 0.6 2.1 2.6 10646.4 0.15 0.7 0.3
Comparison:
ETF SPDR S&P 500 (SPY) Giant-Cap 7.7 15.3 16.2 7.1 8.3 197215.9 0.10 10.6 -8.4
nmf= no meaningful figure
*Reopened to new investors on 2/29/2016.
**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 9/30/2016.

 

Table 2. Model Fund Portfolio Annual Performance


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

Model Fund Portfolio S&P 500 SPDR ETF (SPY) Model Fund Portfolio S&P 500 SPDR ETF (SPY)


Year
2003* 18.6 15.0 11,858 11,500
2004 17.7 10.7 13,955 12,735
2005 5.4 4.8 14,711 13,350
2006 16.1 15.6 17,086 15,438
2007 10.2 5.4 18,820 16,268
2008 (35.9) (36.9) 12,071 10,273
2009 24.9 26.4 15,080 12,981
2010 20.3 14.9 18,136 14,914
2011 (1.7) 2.0 17,827 15,207
2012 12.6 15.8 20,075 17,608
2013 26.7 32.2 25,436 23,279
2014 9.9 13.6 27,962 26,439
2015 (4.5) 1.3 26,711 26,793
2016 YTD** 10.1 7.7 29,403 28,861
Since Incep** 8.5 8.3 29,403 28,861
*June 30 to December 31, 2003  
**Through Sep. 30, 2016. Portfolio was started on June 30, 2003.


Table 3. Level3 Passive Portfolio

Fund (Ticker) Weight Return % Since5/31/2016
Guggenheim S&P 500 Equal Weight (RSP) 40% 4.3
PowerShares Russell 1000 Equal Weight (EQAL) 20% 4.5
Vanguard Mid-Cap Value (VOE) 20% 5.9
Vanguard REIT Index (VNQ) 20% 5.3
Weighted Avg of ETFs in Portfolio*
4.9
Actual ETF Portfolio**
4.9
Comparison: SPDR S&P 500 (SPY)   4.1
*A weighted average return of the ETFs in the current Level3 Passive Portfolio.
**Performance of actual Level3 Passive Portfolio, including reinvested dividends.
Source: Morningstar, Inc. Data as of 9/30/2016.

 

Looking Forward

As I write this in October, we still have the uncertainty of the election hanging over our heads as well as the mystery of whether the Federal Reserve will act in December. While, based on history, neither of these outcomes will likely make a difference in the intermediate term, they could very well impact December market behavior and thus the returns for 2016.

I don’t believe I have ever seen so much uncertainty at once about so many significant issues—the economy, politics and even the weather. I hope some of the uncertainty will be behind us by the time of my next Model Fund Portfolio column in March 2017. In the meantime, you can keep up with the model portfolios at AAII.com and by signing up to receive the monthly Model Portfolios Update email at www.aaii.com/email.

Investment Rationale and Processes

Level3 Passive Portfolio

This portfolio is intended to be either the complete equity portfolio for those investors who wish to manage their own portfolio but do not choose to be involved in individual stock selection, or one portion of a whole portfolio for those who may wish to select individual equities and actively managed funds on a limited basis but keep the majority of their portfolio in index funds.

The portfolio consists of index ETFs that should have, based on their approach, returns above that of the S&P 500 index. As a portfolio, it is more diversified than the S&P 500, which should reduce portfolio downturns that are based on the impact of a few sectors.

Portfolio changes should be relatively rare and will occur only when a new or different ETF is felt to be more effective at accomplishing a similar objective than one of the current holdings. There are some new index ETFs with promising approaches, but there will be at least a year of observation before they can be considered.

Level3 Portfolio Holdings

Four ETFs make up the Level3 Passive Portfolio. The weights of the holdings in the portfolio are very likely to change over time based on experience.

A more thorough discussion of the ETFs in the Level3 Passive Portfolio and other new funds that might qualify when they have sufficient volume and history are discussed in my book “Investing at Level3.”

Note: The Vanguard Mid-Cap Value ETF (VOE) is being held in the Level3 Passive Portfolio, but the Guggenheim S&P MidCap 400 Pure Value ETF (RFV) is being retained in the Model Fund Portfolio. The difference between the two funds is slight. Since the Model Fund Portfolio may be experiencing other changes soon, the decision was made to leave it as is for now.

Guggenheim S&P 500 Equal Weight ETF (RSP)

This exchange-traded fund has outperformed the cap-weighted S&P 500 index over the 13 years of its existence. Other indexes also indicate that equal weighting provides higher returns. Equal weighting gives more weight to value stocks and smaller-cap stocks in an index, which leads to superior performance over the long run.

This fund, because of its size and history, is given a portfolio weight of 40%.

PowerShares Russell 1000 Equal Weight ETF (EQAL)

This ETF includes the top 1,000 stocks by capitalization size and gives some exposure to mid-cap stocks. Mid-cap stocks historically have had higher returns than large caps. It is a new fund, however, and uses an innovative approach that needs some observation before comparing it to Guggenheim S&P 500 Equal Weight ETF.

For now, it is weighted at 20% of the portfolio.

Vanguard Mid-Cap Value ETF (VOE)

Mid-cap value has had higher returns than large stocks or mid-cap growth stocks.

It is weighted at 20% of the portfolio.

Vanguard REIT Index ETF (VNQ)

The returns of real estate investment trusts (REITs) have exceeded the returns of the S&P 500 over the long run and provide diversification as well.

This ETF is weighted at 20%.

The Model Fund Portfolio

The new approach to the Model Fund Portfolio will be more aggressive than in the past, including switching some holdings over to those with an intermediate-term focus. The portfolio will focus on:

  • Actively managed funds that seem able to adjust to the market and outperform the S&P 500 over the intermediate and long term,
  • Actively managed funds in investment areas that have proven to outperform in the intermediate and long term,
  • Some index funds in investment areas that have been long-term winners.

Portfolio changes will only be made every three months, as in the past, but changes will be posted the evening of the change at the Model Portfolios section of AAII.com and sent out in the Model Portfolios Update email.

Portfolio Management Notes

For the Model Fund Portfolio, the initial holdings are equally weighted. For the Level3 Passive Portfolio, the initial weightings are as previously indicated and as shown in Table 3. The approach to rebalancing in both cases is to keep it to a minimum. While momentum is less of a factor with funds than it might be with stocks, and transaction costs for funds are much less than for stocks, 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. In the 12 years of the Model Fund Portfolio, no rebalancing has been thought necessary. If over time a holding gets significantly out of line, adjustments can be made.

Decisions will have to be made by the individual since every investor will have 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 with 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 with the planned weight, bring it back to the appropriate level by selling the excess and using the funds to buy underweighted holdings.

Discussion

C Murray from CA posted over 9 years ago:

Why does the Vanguard REIT Index Fund ETF (VNQ) have a ** indicator, describe in the footnote as indicating "**Distressed securities - stock and Bond"? Wrong note?


B Weber from PA posted over 9 years ago:

I read Level3 Investing but do not recall seeing any mention of the benefit of dividends on portfolio risk. Unless my math is wrong, I have calculated the current Model Portfolio to have a net dividend of about 1%. I do not have historical data to know if this is typical or abnormal for the Model Portfolio. It seems to me that the dividends will help reduce risk with regard to a reduction in stock price during retirement. At a 4% withdrawal rate, the dividends cover 25% of the annual withdrawal (based on the current net dividend %). Curious if my thinking is correct and if there is any data or research into this. Thanks.


Jean Henrich from AAII posted over 9 years ago:

C Murray, Yes, VNQ was pointing to the wrong note in Table 1. VNQ should have 3 asterisks to point to the footnote that says "***VGSIX returns used before October 2004." We have corrected Table 1 here and in the downloadable PDF article. Thanks for letting us know; we apologize for the error.


Michael Daillak from CA posted over 9 years ago:

I have the greatest respect for Mr. Cloonan and AAII, which is his creation. That is why many, many years ago I became a life member. Also, Stock Investor Pro, AAII's computerized investing screening software is an unparalleled asset for individual investors. With much gratitude I say: "THANK YOU Mr. Cloonan!!". And, I appreciate the merits, ease and simplicity of using his Level 3 approach, BUT I would like to call his attention to the new website www.BuySellDoNothing.com, and its approach, as a better way to accomplish the objectives of Level 3.


Mary Ann from CA posted over 9 years ago:

The book doesn't address those investors who have already retired. We have followed a strategy of simply living off the interest and dividends, with the occasional extra influx should one of our muni bonds get called or a stock become a clear sell. This never exceeds 1% of the portfolio in any year. I'm a little floored by the idea of shifting all investments to such a different strategy. On the other hand, since we retired early, I could easily live another 25 or 30 years. Have you any specific thoughts for those who are already retired?


Ja Dolben from MA posted over 9 years ago:

I've been thinking about the same question as B Weber in a broader form; namely what are the rules for dividends in the withdrawal stage? On the one hand, one could use the dividends in the defensive mode to cover or partially cover cash requirements. On the other hand isn't the down market the best time to be reinvesting the dividends in the portfolio? PS. I posted a similar question in another thread, but haven't been able to find my way back to it. Sorry for doubling up.


Steve Laube from GA posted over 9 years ago:

Just read the Level3 book, and I am in agreement with all of its concepts; I have been preaching and practicing them for years. Higher allocation to stocks / insurance costs, withdraw from stocks only when at record highs (70% of the time historically). I am wondering why there is no mention of SDOG or healthcare mutual funds (VHCIX), and why Monte Carlo was not used in the withdrawal discussions. One other interesting thing I have "discovered" is that redcuing the inflation of the withdrawals by 1% , say using 2% instead of 3, has the same effect on portfolio life as earning about 1% more on the entire portfolio..very counter intuitive that $500 (1% on a 50,000 withdrawal) is equal to $10,000 (1% on a million)


David W from KY posted over 6 years ago:

The value of the Level 3 Passive Portfolio fluctuates above and below a Line of Reasonable Expectation which Dr. Cloonan advises should increase about 12% annually. It would seem to make a big difference to your strategy where the market value is relative to the LRE. There are two ways (at least) this makes a difference: 1) If you buy into the Portfolio funds when they are above the historical LRE, then you can't expect to get the average 12% annual return on your investment until you have held them for some decades. In the shorter term, like 0-10 years, the effective growth could be much less than 12%. This suggests that it's best to get into these funds when they are below the LRE. 2) If you plan to take out 5% of the portfolio per year in retirement, you should make this 5% of the "LRE value" of your portfolio, which could be above or below the current market value. How do we know what the "LRE value" of our Portfolio is? I think we would need a historical reconstruction of the indices that the Portfolio funds are tracking, going back to 1933, say. It should be possible to compute whether the current value is X% above or below the historical LRE - that would be a very useful number to know. Does this already exist?


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