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Summary FXU has a high expense ratio, high turnover, and limited exposure to individual companies. The ETF includes some companies that I would not immediately think of as traditional utility allocations. Allocations to FXU can reduce portfolio volatility. The strong dividend yield makes it a viable long term holding if investors are convinced management can justify the high expense ratio with superior returns. 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 Utilities AlphaDEX ETF (NYSEARCA: FXU ). 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 on FXU is a hefty .70%, so management needs to be able to beat the sector by a healthy margin over time to provide superior returns to investors relative to lower cost options like the Vanguard Utilities ETF (NYSEARCA: VPU ) which has an expense ratio of only .12%. Holdings I was able to grab a fairly huge chart of the holdings within FXG: (click to enlarge) The first thing I notice in looking at the portfolio allocations is that they are definitely deviating from the indexes I am used to seeing for utility exposure. For instance, Duke Energy Corporation (NYSE: DUK ) is usually one of the largest holdings. VPU uses as the top holding with 7.6% of the portfolio, but FXU has opted to only allocation 3.22% of the portfolio. When it comes to assessing which companies are utilities, I don’t usually think of CenturyLink (NYSE: CTL ) as one of the first options. I would expect it to be in the telecommunications index, but it is interesting to see such a strong allocation here. The interesting thing to note about this portfolio is that it does not use any very heavy weights. I like that aspect of the diversification within the portfolio. When I see a portfolio with extremely concentrated holdings and a high expense ratio, I figure it would make more sense to duplicate the portfolio. Of course, with a high portfolio turnover that is not a viable option. The trailing turnover ratio was around 83%. When investors are paying an expense ratio of .70%, they should be expecting very active management it looks like FXU is certainly delivering in that regard. 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 FXU is an interesting ETF. The exposure is quite materially different from that of the more passive indexes and the individual weightings are lower but the expense ratio is also substantially higher. The fund is considered a utility fund, but they are not afraid to use a small part of the portfolio to go outside of the more traditional utility allocations. Despite a very high turnover ratio, the ETF is still offering a very solid dividend yield. If investors want active management of the allocations within the ETF, FXU is a reasonable allocation. Personally, I have a preference for taking the lower expense ratio and the more passive indexing approach for my long term allocations. Make no mistake; FXU is not a short term allocation. A heavy dividend yield around 3.7% is enough to ensure investors are receiving income from their investment so they can reasonably hold the shares over the long term and utilize the income from dividends for either growing the position or covering living expenses. From a portfolio perspective the ETF is offering a fairly nice low beta of .67 and has maintained a negative correlation with treasury ETFs despite both being influenced by movements in interest rates. Scalper1 News
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