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Summary The portfolio for FXG just doesn’t look right to me. The ETF uses fairly low allocations for some core consumer staple holdings. I’d like to see a heavier weighting for companies with massive market share or addictive products because those firms should be able to protect margins better. Investors should be seeking to improve their risk-adjusted returns. I’m a big fan of using ETFs to achieve the risk-adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds that I’m considering is the First Trust Consumer Staples AlphaDEX ETF (NYSEARCA: FXG ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The expense ratio for FXG is a fairly unappealing .67%, which leaves me feeling that there is some substantial room for improvement. Holdings I was able to grab a chart with all of the holdings for FXG: (click to enlarge) Is this really a consumer staples portfolio? Procter & Gamble (NYSE: PG ) is only 1.68% of the portfolio? Altria Group (NYSE: MO ) is less than 1% of the portfolio? Costco (NASDAQ: COST ) is entirely absent from the portfolio. Coca-Cola (NYSE: KO ) and Pepsi (NYSE: PEP ) are entirely absent. When I’m looking at an ETF of consumer staples, I want to see products that people are going to buy regardless of what is happening in the economy. I’m not a fan of smoking, but I wouldn’t mind a substantial allocation to tobacco. For that matter, I would prefer a portfolio built on companies that have enormous market share and sell addictive products. The fundamental goal of creating a consumer staples allocation in the portfolio is to provide the portfolio with more protection from weakness in the economy. Despite the challenges with firms missing, I do think a large allocation to Tyson Foods (NYSE: TSN ) and ConAgra Foods (NYSE: CAG ) does make sense. There has been enough concentration in this part of the industry that the major players are controlling a large part of the market and are unlikely to be forced to take major price cuts even if the market enters another recession. Building the Portfolio This hypothetical portfolio has a moderately aggressive allocation for the middle-aged investor. Only 25% of the total portfolio value is placed in bonds and a fifth of that bond allocation is given to high-yield bonds. If the investor wants to treat an investment in an mREIT index as an investment in the underlying bonds that the individual mREITs hold, then the total bond allocation would be 35%. Given how substantially mREITs can deviate from book value, I’d rather consider the allocation as an equity position designed to create a very high yield. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since a major recession could still hit this pretty hard. If the investor wanted to modify the portfolio to be more appropriate for retirement, the first place to start would be increasing the bond exposure at the cost of equity. However, the diversification within the portfolio is fairly solid. Long-term treasuries work nicely with major market indexes, and I’ve designed this hypothetical portfolio without putting in the allocation I normally would for equity REITs. An allocation is created for the mortgage REITs, which can offer some fairly nice diversification relative to the rest of the portfolio and they are a major source of yield in this hypothetical portfolio. The portfolio assumes frequent rebalancing which would be a problem for short-term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment: Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 35.00% 2.06% Consumer Discretionary Select Sector SPDR ETF XLY 10.00% 1.36% First Trust Consumer Staples AlphaDEX ETF FXG 10.00% 1.60% Vanguard FTSE Emerging Markets ETF VWO 5.00% 3.17% First Trust Utilities AlphaDEX ETF FXU 5.00% 3.77% SPDR Barclays Capital Short Term High Yield Bond ETF SJNK 5.00% 5.45% PowerShares 1-30 Laddered Treasury Portfolio ETF PLW 20.00% 2.22% iShares Mortgage Real Estate Capped ETF REM 10.00% 14.45% Portfolio 100.00% 3.53% The next chart shows the annualized volatility and beta of the portfolio since April of 2012: (click to enlarge) A Quick Rundown of the Portfolio Using SJNK offers investors better yields from using short-term exposure to credit-sensitive debt. The yield on this is fairly nice, and due to the short duration of the securities, the volatility isn’t too bad. PLW on the other hand does have some material volatility, but a negative correlation to other investments allows it to reduce the total risk of the portfolio. FXG is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. FXU is used to create a small utility allocation for the portfolio to give it a higher dividend yield and help it produce more income. I find the utility sector often has some desirable risk characteristics that make it worth at least considering for an overweight representation in a portfolio. VWO is simply there to provide more diversification from being an international equity portfolio. While giving investors exposure to emerging markets, it is also offering a very solid dividend yield that enhances the overall income level from the portfolio. XLY offers investors higher expected returns in a solid economy at the cost of higher risk. Using it as more than a small weighting would result in too much risk for the portfolio, but as a small weighting, the diversification it offers relative to the core holding of SPY is eliminating most of the additional risk. REM is primarily there to offer a substantial increase in the dividend yield which is otherwise not very strong. The mREIT sector can be subject to some pretty harsh movements, and dividends from mREITs should not be the core source of income for an investor. However, they can be used to enhance the level of dividend income while investors wait for their other equity investments to increase dividends over the coming decades. If you want a really quick version to refer back to, I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Consumer Discretionary Select Sector SPDR ETF XLY Enhance Expected Returned First Trust Consumer Staples AlphaDEX ETF FXG Reduce Beta of Portfolio Vanguard FTSE Emerging Markets ETF VWO Exposure to Foreign Markets First Trust Utilities AlphaDEX ETF FXU Enhance Dividends, Lower Portfolio Risk SPDR Barclays Capital Short Term High Yield Bond ETF SJNK Low Volatility with over 5% Yield PowerShares 1-30 Laddered Treasury Portfolio ETF PLW Negative Beta Reduces Portfolio Risk iShares Mortgage Real Estate Capped ETF REM Enhance Current Income Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. Despite TLT being fairly volatile and tying SPY for the second highest volatility in the portfolio, it actually produces a negative risk contribution because it has a negative correlation with most of the portfolio. It is important to recognize that the “risk” on an investment needs to be considered in the context of the entire portfolio. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of TLT’s heavy negative correlation, it receives a weighting of 20% and as the core of the portfolio SPY was weighted as 50%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion FXG has resisted weakness in the market as demonstrated by both the lower annual volatility and the lower max “drawdown” of -9.8% relative to the market’s worst performance of -11.9%. Despite that, the portfolio composition simply does not match the way I would want the consumer staples exposure constructed. Simply put, the portfolio does not offer strong enough allocations to some of the companies that have both enormous market share and addictive products. Heavy allocations to a few food companies look solid, but I’d rather see less of the convenience stores and more of the major retail low cost leaders such as Costco and Wal-Mart (NYSE: WMT ). Even if WMT is having a rough time lately, it is a long-lived dividend champion with a large market share and powerful economies of scale. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. Scalper1 News
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