Model Mutual Fund and ETF Portfolios: Waiting for Value and Small-Cap to Improve

Model ETF Portfolio: Selection Rationale

The rationale used in building the Model ETF Portfolo is to achieve diversification across the asset classes listed below while maintaining a weighting that, in our assessment of historical data, will provide the maximum opportunity for long-term rates of return. We have a bias toward smaller-cap and value stocks and so does history.

Across national boundaries—U.S. versus foreign:

We begin with an 80% U.S. and 20% foreign portfolio, but this could change. Foreign stock returns involve currency relationships as well as the usual equity analysis. The initial weighting takes into consideration the fact that many U.S. companies have significant foreign involvement.

In foreign investments:

• Style will be diversified. We will seek emphasis on value stocks when it is possible.
• We will seek a heavier weighting in the small-capitalization area than the typical portfolio.
• We will diversify across equities and real estate, but do not intend to use foreign bonds for risk reduction.

In U.S. investments:

• We will diversify across equities, real estate, master limited partnerships, and short-term bonds. Short-term bond ETFs will be included as an option for investors who need further risk reduction. However, they will not be in the actual Model ETF Portfolio.
• Our style diversification will aim for a heavier emphasis on value than the overall market.
• The capitalization weightings will place considerably more emphasis on small-capitalization stocks than the overall market. We will seek to achieve this not only by including small-cap ETFs, but by choosing larger-cap ETFs that do not weight solely on capitalization.

Which specific ETFs?

Although the above outlines the areas in which we will look for ETFs, it does not explain how we will choose specific ETFs when there are multiple ETFs in an area.

It will be many years before we have enough history to develop a solid set of criteria. Many of the sponsors of ETFs, however, have a history with other investment vehicles that can provide a guide, as can liquidity, expense ratios, and the philosophy espoused in prospectuses. Over time, we should be able to harden our criteria.

How the portfolio is managed

We will not make trades solely for the purpose of rebalancing, except under unusual conditions. When we make trades for other reasons, we will do so in a way that repositions the portfolio back toward the initial weighting.

The current recommended initial weighting is to give each domestic holding an equal weight (for a total of 80% in domestic ETFs) and each foreign issue an equal weight (for a total of 20% in foreign stock ETFs). If you choose not to hold a particular ETF, maintain the equal weightings in each of the domestic and foreign areas, and keep the balance of 80% domestic stock ETFs and 20% foreign stock ETFs.

ETF Descriptions

Domestic Stock ETF Holdings

• PowerShares FTSE RAFI US 1000 (PRF): Tracks a fundamentally weighted index that holds the 1,000 largest domestic stocks based on four factors—book value, cash flow, sales, and dividends. Stocks in the portfolio are weighted by their fundamental scores.
• Rydex S&P MidCap 400 Pure Value (RFV): Tracks the “pure value” segment of S&P MidCap 400 index, which holds approximately one third of the index ranked on price-to-book-value, price-earnings, and price-to-sales ratios.
• Rydex S&P SmallCap 600 Pure Value (RZV): Tracks the “pure value” segment of the S&P SmallCap 600 index, which holds approximately one third of the index ranked on price-to-book-value, price-earnings, and price-to-sales ratios.
• First Trust Dow Jones Select MicroCap Index (FDM): Tracks an index constructed from micro-cap stocks based on a combination of value and growth factors. The weighting of each stock is based on a modified market capitalization determined using float rather than total shares.

Domestic Stock Sector ETF Holdings

• iShares Cohen & Steers Realty Majors Index Fund (ICF): Tracks a modified capitalization-weighted index of large, liquid domestic real estate investment trusts (REITs) that is diversified across property sectors in an attempt to represent the current market.
• Alerian MLP ETF (AMLP): Tracks the modified capitalization-weighted Alerian MLP Infrastructure Index, which consists of master limited partnerships (MLP) and limited liability companies (LLC) that earn the majority of their cash flow from energy commodities, but are not directly exposed to changes in commodity prices. AMLP issues Form-1099 like a regular corporation, and the net asset value (NAV) of fund shares will be reduced by the accrual of any deferred tax liabilities. Therefore, the fund’s NAV performance could differ from the index.

Foreign Stock ETF Holdings

• Vanguard FTSE All-World ex-US (VEU): Tracks the float-adjusted capitalization-weighted FTSE All-World ex US Index, which includes approximately 2,220 non-U.S. large- and mid-cap stocks from both the developed and emerging markets.
• SPDR S&P International Small Cap (GWX): Tracks the float-adjusted capitalization-weighted S&P Developed Ex-U.S. Under USD2 Billion Index, which is constructed of small-cap, publicly traded companies domiciled in developed countries outside the U.S.
• Vanguard Emerging Markets (VWO): Tracks the float-

adjusted capitalization-weighted MSCI Emerging Markets Index, which is designed to provide broad exposure to the equity markets of emerging countries in Europe, Asia, Africa, and Latin America.

Foreign Stock Sector ETF Holding

• SPDR Dow Jones International Real Estate (RWX): Tracks the float-adjusted capitalization-weighted Dow Jones Global ex-U.S. Real Estate Securities Index, which holds publicly traded real estate securities in developed and emerging countries.

Optional ETF Holding

• iShares Barclays 1-3 Year Treasury Bond (SHY): Use of this ETF should be considered as a way of controlling portfolio risk. The index tracked is capitalization-weighted and includes U.S. Treasury bonds and notes that have a remaining maturity of between one and three years.