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Summary After taking a look at PFF, I decided it would be worth looking into ways that an investor could use it heavily in a low risk portfolio. The resulting portfolio underperforms SPY in a strong bull market, but does very well at limiting volatility. Looking at the max drawdown shows that over the last 4 years the worst drawdown on the portfolio was only 7.9%. If investors are considering holding cash in their portfolio to reduce the volatility, they may want to consider this style of portfolio instead. After covering the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) and noticing that it had some very attractive risk characteristics and a very strong yield at 6%, I decided it was worth looking into the impacts of designing a portfolio for very low volatility at the portfolio level while maintaining a fairly strong yield for investors. I think this is one of the most reasonable ways to incorporate a heavy allocation to PFF in a portfolio. I built a portfolio using only a few tickers so it is reasonably simple to duplicate. Portfolio The Portfolio uses the Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) as the core of the portfolio since it has been noticeably less volatile than whole market ETFs, has a respectable dividend yield with dividends regularly growing, and an expense ratio of only .07%. The next major allocation is a very long duration treasury ETF, the Vanguard Extended Duration Treasury ETF (NYSEARCA: EDV ). The iShares U.S. Preferred Stock ETF gets the same 20% allocation as EDV. The next holding is the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) because it has a fairly low beta and fits very well in portfolios designed to minimize total risk at the portfolio level. The final allocation goes to the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) with 5% of the portfolio. This is incorporated because it has such unique risk factors that it ends up having only moderate correlations with each other investment while having a yield just over 4.5%. The portfolio is demonstrated below: (click to enlarge) The great thing about this portfolio is that over a sample period of nearly 4 years the annualized volatility is only 6.5% which puts the portfolio volatility at slightly under half of the volatility on the SPDR S&P 500 Trust ETF ( SPY). In other words, an investor holding 50% SPY and 50% cash would have witnessed a higher level of volatility in their portfolio. During the period the worst drawdown was falling 7.9%. All around this is a very resilient portfolio because the risk factors have been so effectively diversified. Alpha Investors may notice that this portfolio has materially underperformed SPY over the sample period, but it is meant to underperform SPY during strong bull markets. When SPY is up almost 77% in less than 4 years, I’m going to call that a strong bull market even if we saw some huge shocks in August. The annual rate of return on SPY is about 16%. The annual rate of return on the portfolio was 11.4%. If investors start from portfolio volatility (rather than beta) for establishing alpha, this portfolio would to create about half of the difference between SPY and the risk free rate. Since the portfolio only underperformed SPY by 4.66% annually during a solid bull market. If we round up the risk on the portfolio to being half of SPY, then we subtract (4.66% * 2) or 9.31% to find the risk free rate necessary to eliminate the entire alpha. The risk free rate that would have neutralized the alpha is 6.73%. I think it is reasonable to say that this portfolio performed very well on a risk adjusted basis relative to investors that were going 100% into SPY or another very similar broad ETF. Correlations A major reason for the strong performance is the correlation within the portfolio. The long term treasury ETF has only a slight positive correlation with the emerging market bond fund, but it is negative with everything else. Both SCHD and USMV have lower levels of volatility than SPY and PFF and EMB have reasonably low levels of annualized volatility combined with moderate correlations to the rest of the portfolio. Conclusion Over the last 4 years this ETF strategy has demonstrated very reasonable returns while being substantially more resilient to periods of weakness. In a prolonged bull market it will fall behind SPY, but on a risk adjusted basis it is still performing very well and if there was a major correction it would be in position to lose substantially less. In my opinion, this kind of strategy is the most reasonable way to incorporate a heavy allocation of PFF into a portfolio. Why would you want to build a portfolio with a heavy allocation to a preferred share ETF? I can think of one solid reason off the top of my head, a dividend yield over 6% at a time when interest rates in much of the economy fail to offer any compelling returns. Disclosure: I am/we are long SCHD. (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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