Replacing a Mutual Fund With an ETF in the Model Fund Portfolio

Small and mid-cap stocks continue to underperform large caps through September

As a result, the Model Fund Portfolio now lags the S&P 500 index, as measured by the Vanguard 500 Index fund (VFINX); their returns are 5.1% and 8.2%, respectively, for the year as of September 30. This outperformance by large-cap stocks takes place about 30% of the time and affected the performance of the All-ETF Portfolio as well.

The stock market has turned much more volatile recently. If you are a true long-term investor, that portends higher future returns as short-term investors panic and keep prices down to where they provide higher long-term returns.

Portfolio Changes

There are two changes to the Model Fund Portfolio, as listed in the Transaction History table.

We are selling FMI Common Stock Fund (FMIMX). We just could not justify the 1.19% expense ratio based on the performance. In addition, the fund is closed to new investors, and we believe that managers do best with new funds flowing in. When mutual funds have to sell holdings in order to buy new stocks, they tend to sell the wrong stocks. FMI Common Stock fund was up 1.6% year-to-date as of the end of September.

Aston/Fairpointe Mid Cap N (CHTTX) is also closed to new investors, but its performance is better and its expense ratio somewhat lower. Investors holding it should continue to do so. Those following the model portfolio who do not own Aston/Fairpointe Mid Cap fund should make up their portfolio from the remaining eight funds.

We are adding First Trust US IPO ETF (FPX) to the portfolio. First Trust US IPO is an exchange-traded fund that tracks an index of larger U.S. initial public offerings. It modifies the capital weighting so that very large-capitalization companies do not dominate. The theory that large-cap IPOs provide excess returns for the first two years has been tested by this fund for nine years now, and I feel convinced.

First Trust US IPO should be equally weighted with the other eight funds (seven others if you don’t own Aston/Fairpointe Mid Cap) in the portfolio—subject, of course, to your particular needs. You can accomplish this most easily by selling FMI Common Stock fund and putting the proceeds into the First Trust US IPO fund.

Changes to the All-ETF Portfolio

We are not selling any holdings in the All-ETF Portfolio, but the addition of First Trust US IPO requires a rebalancing. Since First Trust US IPO is a large-cap fund, we split the original 40% allocation to Guggenheim S&P 500 Equal Weight (RSP) in half to 20% and bought First Trust US IPO with the proceeds. With the new addition, the weights of the six exchange-traded funds in the All-ETF Portfolio are now as follows: 20% in FPX, 20% in RSP, 20% in RFV, 20% in RZV, 10% in FM, and 10% in VNQ.

With the recent change, our Model Fund Portfolio now has three traditional mutual funds and six exchange-traded funds. As more actively managed ETFs appear and traditional mutual funds resist cutting fees, we expect ETFs to eventually dominate the fund area. But it will take a long, long time because investors resist making changes.

The Mystery Cycle

In my October Model Shadow Stock Portfolio commentary, I mentioned what I call the mystery cycle. I repeat it here for those who do not follow that commentary.

The election cycle indicates an above-average return in the year prior to the U.S. national election; this has been widely discussed and will be in the news as we approach 2015. Twenty years ago, I came across another cycle for which I can find no rationale but that has been pervasive for the last 100 years. It is the positive impact on the market of years ending in 5. This cycle is particularly important in years when it coincides with the election cycle. This combination occurs only every 20 years, and the year 2015 is one of those years.

I have always been suspicious of data like this that indicates a possible anomaly when I can’t find a rationale for the behavior. In the election cycle we have the rationale that government spending and talk of government spending prior to the election boosts

expectations, but I cannot think of any cycle for years ending in 5, or any 10-year cycle, to explain this rather dramatic impact. While it could be coincidence, it is also possible that I simply can’t find the explanation. Note that although the data covers a large number of years, the actual sample size is small.

I must admit that in 1995, I was extra bullish and was rewarded. I will be a little extra bullish in 2015, although I hesitate to suggest that anyone should do the same. Here are the numbers.

Average annual returns since 1935:

11.0% = S&P 500 index

20.7% = year 3 of the election cycle

28.4% = years ending in 5

42.4% = year 3 + years ending in 5

0 = number of times year 3 was negative

Just an observation.

Outlook

Nothing has really changed over the last few months. There seems to be a balance between those nervous about protecting profits, who sell with every market run up, and those who missed out on part of the long market rise and view every pull back as a chance to get in.

With all the volatility and negative attitudes, it is still an up year that is not far from average. Large caps, which had fallen way behind, are catching up a bit; small caps, which have had a record run, are giving up part of their lead.

The mid-year election is upon us, and it is considered more important than usual because control of the U.S. Senate is up for grabs. We cannot predict whether the results will significantly affect the market, but we will know by the time the next Model Fund Portfolio commentary appears in March 2015.

In the meantime you can follow the model portfolios here.