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The Muscular Portfolios NewsletterNo. 9 June 1, 2018
Preorder "Muscular Portfolios" at AmazonBook set for October 2018 release date

Our book, Muscular Portfolios, has been scheduled by BenBella Books for release on Oct. 2, 2018. Booksellers are already taking preorders. Buyers will receive their books in the order they were reserved. and some other vendors offer a price-matching guarantee, so you can order now but pay only the discounted price that'll be offered on the ship date. Please see:

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Newsletter goes monthly

In the past three years, as the book Muscular Portfolios has been in development, we've published nine beta newsletters for testing purposes. Today's newsletter will be the last beta. The next newsletter you receive will be the first in a regular series of monthly issues. Thanks for supporting our research along the way!

For a description of how Muscular Portfolios work, see our May 2, 2016, newsletter.
What are the best ETFs for individual investors?

Brian LivingstonBy Brian Livingston

Exchange-traded funds (ETFs) have a lot of advantages over older securities like mutual funds. For one thing, ETFs can be priced and bought or sold at any time during the trading day. By contrats, you don't know the price of a mutual fund until hours after the market has closed. For another thing, mutual funds declare "distributions" each year that your taxable accounts must pay taxes on, even if you never sold a single share. ETFs are legally structured so taxable distributions are almost never a problem.

But which ETFs should individual investors actually buy? We know that most funds that try to pick individual stocks underperform the benchmark for their type of asset (small-cap stocks, emerging-market stocks, and so forth). ETFs avoid the high costs of stock-picking and rapid turnover. This enables most ETFs to deliver 99% of the return of whatever asset class is being tracked.

There were more than 1,700 ETFs based in the US in 2016, according to a Statista article. At the website, we've boiled down for you that riot of choices. We've identified a set of nine ETFs covering all the essential asset classes, and an expanded set of 13 if you want a slightly more complex menu (also called an "investing universe"). These two ETF menus are called the Mama Bear and the Papa Bear.

The Mama Bear menu
The Mama Bear menu
Figure 1. The Mama Bear Portfolio chooses each month the strongest three ETFs from the above menu of nine.
The global marketplace has three overarching divisions: equities (stocks), hard assets (real estate, commodities, and precious metals), and bonds (US and international bonds, notes, and bills).

Within those categories, the Mama Bear Portfolio selects each month from subdivisions called asset classes. Each asset class behaves a little differently from the others. For example, in the equity division, US large-cap stocks might be going up while small-cap stocks are going down.

The same variations in behavior — giving a portfolio the benefit of diversification — can occur among stocks in the US, in other developed countries (such as markets in Europe), and in emerging economies (such as India).

The Mama Bear Portfolio is a "clone" of a strategy published by Steve LeCompte of the CXO Advisory Group. A clone is a translation of a theoretical investing strategy into specific funds that individual investors can actually buy. LeCompte has tracked a specific set of ETFs since 2006. The Mama Bear uses ETFs that have been launched later than that date, mostly Vanguard ETFs with lower fees than the funds that were available in 2006.

Followers of the Mama Bear Portfolio buy the three ETFs with the highest rankings once a month — on a day of their choosing — as determined by the rules described at the Mama Bear webpage.

The Papa Bear menu
The Papa Bear menu
Figure 2. The Papa Bear menu chooses from 13 asset classes.
The four additional asset classes that the Papa Bear has that the Mama Bear does not come from two sources:

First of all, US large-cap and small-cap equities are divided into value stocks and growth stocks. This gives us four different investments to choose from. There are entire decades when growth stocks outperform value stocks and large-caps outperform small-caps (and vice versa). Dividing US equities into four possible investments enables us to hold whichever asset class is currently doing better.

Second, the Papa Bear adds two fixed-income asset classes: investment-grade corporate bonds and non-US bonds. The Papa Bear also uses 10-year Treasury notes as a safe-harbor investment rather than the Mama Bear's use of cash (money-market funds).

The Papa Bear Portfolio is a clone of a 2007 paper by Mebane Faber that was published in 2009 as The Ivy Portfolio and later expanded.

Over the 43-year period 1973–2015, computer simulations show that the Papa Bear would have returned about 16.2% annualized, slightly better than the Mama Bear's 14.3%. (The S&P 500's total return was about 10%.) The tradeoff is that the Papa Bear had a maximum drawdown of 25%, which was slightly more scary that the Mama Bear's 18% loss. (The S&P 500 fell an intolerable 50% in the 2007–2009 financial crisis — just one of its four crashes of 30% or worse during the 43-year period.)

Followers of the Papa Bear Portfolio buy the three ETFs with the highest rankings as described on the Papa Bear webpage.
The S&P’s small-caps are better than Russell’s

During the development of the book Muscular Portfolios, the above menus used the Russell 2000 to represent small-cap US stocks. The Russell 2000 index tracks almost every publicly traded small-cap stock in the US. (Definitions of "small cap" vary, but the Russell 2000 generally holds stocks with a market capitalization between $150 million and $3 billion.)

You'll notice that the S&P 600 small-cap index is used in the menus shown above. ETFs that hold the S&P 600 — or a value or growth subset of the 600 stocks — will be used in the book when it's released.

The reason for the change is that the S&P 600 small-cap index consistently gains more than the Russell 2000 small-cap index. Figure 3 shows the gains of two ETFs that have publicly traded the indexes since CXO Advisory started tracking the performance of the nine-ETF portfolio in 2006.
S&P 600 vs. Russell 2000
Figure 3. Standard & Poor's selection of 600 small-cap stocks gains more than Russell's selection of 2000. The S&P 600 loses less during corrections, too. Source: Yahoo Finance.
The reason for the S&P 600's outperformance is that the index primarily includes small-cap companies that are profitable. The Russell 2000 includes almost every company within its small-cap range. Standard & Poor's so-called quality filter generates almost 2 percentage points more annualized return (10.0% vs. 8.4%), as shown in Figure 3.

Long-term gains are nice, but what we really want to know is this: How does the S&P 600 perform when the Mama Bear and Papa Bear are holding small-cap stocks? Based on the rules shown at the website, the Mama Bear held a US small-cap ETF in about 37% of the months from August 2006 through February 2018 (52 out of 139 months).

Figure 4 shows that the S&P 600 gained more than the Russell 2000 during those 52 specific months. Equally important for investors' peace of mind, the S&P 600 lost less money during the four significant down periods in those 11+ years.
S&P 600 vs. Russell 2000 gains & losses
Figure 4. In the 52 out of 139 months when the Mama Bear Portfolio held small-cap ETFs, the S&P 600 gained more than the Russell 2000 and had smaller losses in each of the four slumps. Source: Yahoo Finance.
The Papa Bear showed similar outperformance for the S&P 600's value and growth subclasses, compared with the Russell 2000's value and growth segments.

What about the large-cap S&P 500 vs. the Russell 1000? Both indexes hold the largest US stocks by market capitalization.

The two large-cap indexes show no significant difference. For this reason, the Mama Bear and the Papa Bear will continue to buy ETFs that track the Russell 1000 index, which has the theoretical advantage of being more diversified than the more-famous S&P 500.
Free stuff you might enjoy

If you've read this far, you deserve a reward — a downloadable one-page PDF that summarizes the whole book free of charge:

Executive summary of the book Muscular Portfolios

If you missed any of our previous newsletters, links to them can be found in the lower-right corner of our home page.

If you have comments to contribute, start a new email message to a special address that goes directly to me:

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The Muscular Portfolios Newsletter

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About the author: Brian Livingston is the author of the forthcoming book Muscular Portfolios (November 2017). He is also the co-author of 11 books in the Windows Secrets series, 1991–2007 (John Wiley & Sons), with over 2.5 million copies sold. From 1986 to 1991, he worked in New York City as assistant IT manager of UBS Securities; a consultant for Morgan Guaranty Trust (now JPMorgan Chase); and technology adviser for Lazard Frères (now Lazard Ltd.). He was the weekly Windows columnist for InfoWorld magazine from 1991 to 2003. During portions of that period, he was also a contributing editor of CNET, PC World, eWeek, PC/Computing, Datamation, and Windows magazine. In 2003, he founded the Windows Secrets Newsletter, which grew from zero to 400,000 email subscribers. He served as its editorial director until he sold the business in 2010. He is currently president of the Seattle regional chapter of the American Association of Individual Investors (AAII).

This newsletter and our other publications are protected by copyright law. The terms Muscular Portfolios, Mama Bear Portfolio, Papa Bear Portfolio, and Baby Bear Portfolio are registered trademarks of Publica Press. The term Publica Press and related designs are trademarks and service marks of Publica Press. Other parties' copyrights, trademarks, and service marks are the property of their respective owners. You may print a copy of the information for your personal use only, but you may not reproduce or distribute the information to others without prior written permission from us.

This newsletter and the information contained herein are impersonal and do not provide individualized advice or recommendations for any specific subscriber or portfolio. Investing involves substantial risk. Neither the publisher of this newsletter, its authors, nor any of their respective affiliates make any guarantee or other promise as to any results that may be obtained from using the newsletter. While past performance may be analyzed in the newsletter, past performance should not be considered indicative of future performance. No reader should make any investment decision without first consulting his or her own personal financial adviser and conducting his or her own research and due diligence, including carefully reviewing the prospectus and other public filings of the issuer. To the maximum extent permitted by law, each author, the publisher, and their respective affiliates disclaim any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations in the newsletter prove to be inaccurate, incomplete, or unreliable, or result in any investment or other losses. The newsletter’s commentary, analysis, opinions, advice, and recommendations represent the personal and subjective views of the authors, and are subject to change at any time without notice. Some of the information provided in the newsletter is obtained from sources which the authors believe to be reliable. However, the authors have not independently verified or otherwise investigated all such information. Neither the publisher, its authors, nor any of their respective affiliates guarantee the accuracy or completeness of any such information. Neither the publisher, its authors, nor any of their respective affiliates are responsible for any errors or omissions in this newsletter.

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