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Equity CEFs: Your Best Market Moves In Closed-End Funds

Summary Equity CEFs have seen a definitive widening of their discounts over the summer despite half the funds I follow outperforming the S&P 500 at the NAV level. Nonetheless, it’s easy to see which funds are working when the markets turn back up and which ones continue to lag behind. The question is – do you stick with what’s worked in the past or should you consider the more heavily discounted CEFs in underperforming sectors that might be turning around? At this point in the market correction, the question that most investors are grappling with, if they want to stay invested in the markets, is whether to stick with the stocks that have worked in the past or do you play a rotation into stocks which have been weak this year and are already in their own bear market? In the world of equity CEFs, the same could be said. There are funds that are seeing great support and seem to bounce back immediately when the markets turn up. And then there are funds that are in a deep freeze and with little to no interest even when the markets turn around. However, based on my research which takes into account market price valuations (discounts and premiums) as well as historic one-year, three-year and five-year NAV performances, not all of the top-performing CEFs present good values now and some of the bottom-performing CEFs offer much better risk/reward despite their poor NAV and market price performances. In my portfolio, it’s best to have exposure to both because despite the urge to go back to what has worked all year, there are signs that a rotation is afoot. Of course, we may be in for a more difficult period all the way around and if that’s the case, then cash is your best alternative. Top-Performing CEFs To Buy And Sell The first step in this analysis is to take a look at the top-performing funds at the NAV level and see which funds may present an opportunity and which funds may be getting ahead of themselves. So here are the top 35 or so equity CEFs out of roughly 100 I follow, sorted by their year-to-date total return NAV performance through September 3, 2015. Funds in green (all of them) have outperformed the S&P 500, as represented by the SPDR S&P 500 Trust (NYSEARCA: SPY ) . YTD, SPY is down -3.9%, including dividends. (click to enlarge) As has been the case most of the year, the healthcare-related equity CEFs are way out in front with the Tekla funds, (NYSE: HQL ) and (NYSE: HQH ), leading the way. However, one top five performing fund that I have been recommending for the past couple years, The Gabelli Healthcare & WellnessRX fund (NYSE: GRX ) , $10.35 market price, 12.06 NAV, -14.2% discount, 5.0% current market yield , has dropped to its widest discount since initiating a regular $0.10/share quarterly distribution back in June of 2012. (click to enlarge) Since initiating the distribution, GRX has raised its distribution twice to $0.12/share in 2014 and then to $0.13/share in 2015 (5.0% annualized) all the while distributing significant capital gains each year as well. And yet none of this seems to help GRX’s market price despite a NAV that has outperformed the Nasdaq-100 since 2012. That’s right, GRX’s NAV has outperformed the NASDAQ-100 index, 93.6% to 91.3% since December 31, 2011. And if investors would only stop and think that this fund also has been yielding over 10% each year going back to 2012, if you included all distributions and capital gains, then maybe they would treat GRX with a little more respect than a -14.2% discount, one of the widest of all CEFs. As it is, you can pick up one of the best-performing CEFs at the NAV level and receive a windfall 5% current market yield (windfall means you get a higher market yield than the fund is paying on its NAV). And, in case you think GRX is only about healthcare and thus may be too sector-specific, the wellness and nutrition part of the fund’s investment strategy means that half its equity portfolio is actually in consumer staple names, mostly foods. This is why I picked GRX as a must-own fund because you can take a relatively large position in it knowing that you have diversification beyond just biotech, healthcare providers, healthcare equipment and other healthcare services. Oh, and a final note on GRX. Five months ago in early April I wrote this article, The Insanity Of CEF Investors , in which I said that it wouldn’t be long before GRX’s NAV would overtake the PIMCO Global Stocks Plus & Income fund’s (NYSE: PGP ) NAV, despite the fact that PGP traded at a market price over twice that of GRX at the time (PGP has since dropped from $22.83 to a current $16.77). Note: See above for PGP’s position in the table. And how has that prediction turned out? Today, GRX’s NAV is $12.06 while PGP’s NAV is $11.74 and I don’t think GRX will ever look back. So I ask you, does nobody get this? Does nobody understand that a fund’s distribution comes from its NAV and, if the NAV is eroding, then an outsized distribution becomes a heavier and heavier ball and chain, further eroding the NAV? It’s just amazing that investors don’t get this and they continue to buy funds (not just PGP) at premium valuations that are seeing continuous NAV erosion over the years. Time To Rebalance The Eaton Vance Option Income Funds By far the best performing option income funds this year at the NAV and market price levels have been from Eaton Vance. This has actually been going on for the last couple years and for those readers who took my advice beginning in 2011 and loaded up on these funds when they were at up to -16% discount, it has been a great ride. Looking back at the table above, five out of the top 20 funds are from Eaton Vance and their market price performances have, for the most part, been even better. However, their popularity has gotten so widespread that one fund, the Eaton Vance Tax-Managed Buy/Write fund (NYSE: ETB ) , $15.98 market price, $15.24 NAV, 4.9% premium, 8.1% current market yield , has moved solidly into an overvaluation position based on its premium market price of 4.9%. A premium market price wouldn’t necessarily trigger a sell recommendation, but compared to most of the other Eaton Vance option income funds, ETB has a lagging NAV as well as one of the lowest yields of all the Eaton Vance funds. In other words, it would make a lot more sense to swap out of ETB at a 4.9% premium and into a couple other Eaton Vance’s option income funds at much lower valuations, higher yields and better NAV performances. The ones I would recommend are the Eaton Vance Tax-Managed Diversified Equity Income fund (NYSE: ETY ) , $10.87 market price, $11.61 NAV, -6.4% discount, 9.3% current market yield, or the Eaton Vance Enhanced Equity Income fund II (NYSE: EOS ) , $13.12 market price, $13.99 NAV, -6.2% discount, 8.0% current market yield . I would also consider (NYSE: ETV ) and (NYSE: ETW ) as swap-into candidates, but they also trade at narrower discounts. The Eaton Vance option income funds get a lot of buy interest when the markets rebound, primarily because they all own many of the same high-flying technology names that institutions like to pile into when the markets turn up. Names like Apple (NASDAQ: AAPL ) , Amazon (NASDAQ: AMZN ) , Facebook (NASDAQ: FB ) , Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ) and Priceline (NASDAQ: PCLN ) are among many of the Eaton Vance option fund’s top holdings. However, if these Nasdaq generals fall out of favor, then you can expect that the more richly valued Eaton Vance option income funds will probably see their discounts widen as well, especially when you consider that most other equity CEFs have fallen to double digit discounts in this market environment. Other Equity CEFs With Strong Buy Interest The Eaton Vance option income funds aren’t the only funds I’ve noticed that get a lot of buy interest when the markets turn up. One fund that shows up in the top 20 list above is the BlackRock Enhanced Capital And Income fund (NYSE: CII ) , $13.86 market price, $14.89 NAV, -6.9% discount, 8.7% current market yield . This is quite a change for CII, a fund you couldn’t give away when it was cutting its distribution not that long ago. And finally, one global fund, the Voya Global Advantage And Premium Opportunity fund (NYSE: IGA ) , $11.07 market price, $11.88 NAV, -6.8% discount, 10.1% current market yield , also appears to catch a bid when the markets firm. I would keep my eye on all of these funds when the inevitable bounce occurs after a market sell-off. CEFs Which Could Benefit In a Rotation Though the trend has been to buy the historically strong stocks and funds when the markets turn up, I’ve noticed that there seems to be less conviction each time that occurs now. At the same time, some of the down and out stocks/funds that used to be in free fall seem to be holding up better on each downturn. If that’s the case, then it may be time to include some of the more severe laggards in equity CEFs as the selling pressure abates. Most of these are in the commodity sectors, particularly energy and energy MLPs, but they also represent a number of utility funds as well. The following list of equity CEFs represents the bottom 35 or so funds that have seen their NAVs lag the most this year. All of these funds show red NAV total return performances, that is they lag the SPY’s -3.9% total return. (click to enlarge) The one fund that jumps out at me that has historically been one of the best performing CEFs over the years is the Cohen & Steers Infrastructure fund (NYSE: UTF ) , $19.20 market price, $23.15 NAV, -17.1% discount, 8.3% current market yield . At an unbelievable -17.1% discount, UTF is a great fund that has gotten caught up in the downdraft of the global utility and infrastructure stock sectors despite showing superb NAV total return performance on a longer three-year and five-year term basis. Surprisingly, UTF is one of the more volatile funds despite its large market cap (for a CEF) at almost $2.8 billion, $2 billion of which is in net assets. Just to show you where a -17.1% discount ranks, that would put UTF in the bottom 20 equity CEFs with the widest discounts, joining most of the emerging market and emerging market debt CEFs. That is a ridiculous discount for a fund with a track record as strong as UTF’s. Since 2012, UTF’s NAV is up a very impressive 58.5% even including this year’s -7.1% drop. So don’t confuse a utility and infrastructure CEF like UTF as being boring. Leverage can turbo charge UTF’s portfolio of global utility stocks and the fund can see strong NAV and market price performance as much on the way up as on the way down. In fact, UTF raised its distribution from $0.37/share to $0.40/share earlier this year after a great 2013 and 2014, and combined with that extreme discount you can get a windfall 8.3% current market yield on a fund that only has to support a 6.9% NAV yield. Now that is attractive. When I see the crap CEFs that can trade at premium valuations that have historically destroyed their NAVs, you just wonder what someone is thinking when they sell UTF at a -17%-plus discount. Of course, that’s just it…most don’t know that they’re selling a fund around $19 that has a liquidation value of around $23. A Utility and Energy MLP CEF On Its Knees Another equity CEF that doesn’t make a lot of sense to me despite having a very weak NAV performance so far this year is the Duff & Phelps Global Utility Income fund (NYSE: DPG ) , $16.05 market price, $19.01 NAV, -15.6% discount, 8.7% current market yield . The reason why it doesn’t make a lot of sense is that a similar CEF from Duff & Phelps , the DNP Select Income fund (NYSE: DNP ) , can trade at over a 15% market price premium, despite having a lot of overlap with DPG in its utility holdings. The major difference between the two funds is that DPG has a larger exposure to energy MLPs (33% vs 14% for DNP) while DNP includes about 15% of its portfolio in fixed income corporate bonds of utility companies. DPG also is more global than DNP but why this would account for over a 30% valuation difference between the two funds is a head scratcher. I first wrote about DPG two years ago in September of 2013 in this article, Terrific Opportunity In A Duff & Phelps Utility Fund . At the time, DPG was trading at a -13.3% discount ($18.22 market price, $21.01 NAV) while DNP was trading at a 10.9% premium, so the valuation difference has just widened since then. Certainly, DNP has the longer track record and perhaps has a less volatile NAV than DPG due primarily to its corporate bond exposure, but there is no question that DPG’s portfolio managers use the same research and analysis as DNP’s portfolio managers when they select utility stocks for their fund’s portfolios. So if you owned DNP at a premium valuation and you knew you are not even getting close to the market yield at 8.1% that the fund has to support at a 9.3% NAV yield, wouldn’t it make sense to go into the other fund and get a higher windfall 8.7% market yield when DPG only has to support a 7.4% NAV yield? I would. Obviously, both funds have seen serious NAV depreciation this year but it’s certainly going to be a lot easier for a fund to support a 7.4% NAV yield than a 9.3% NAV yield. And though DPG’s NAV is down -17.5% on a total return basis YTD and a sobering -20.5% on a pure NAV depreciation basis, i.e. not including distributions, the fund’s NAV is still roughly where it came public back in 2011 at $19.07 even after paying $5.60 in total distributions. In other words, there is little danger of DPG cutting its distribution anytime soon unless the global utility sector goes into a deeper bear market than it’s already in. DPG goes ex-dividend on September 11th at a $0.35/share. Both funds use leverage in their high yielding utility, telecommunications, energy MLP and corporate bond portfolios. The one sector I would keep an eye on is the energy MLP sector. After the collapse energy MLP’s have suffered this year, if there is any indication that sector is firming up, which arguably we are seeing already, then I believe that will be your sign that it is safe to go into DPG. At a -15.6% discount, DPG’s market price has priced in far worse than a bear market already. Conclusion Do you stick with what’s worked in the past or do you try and bottom fish? I believe you should be looking at both if you want to up your equity CEF exposure (and income) in the markets right now. So to summarize, here are the funds that have been working this year and should bounce when the markets rebound: GRX – Gabelli Healthcare & WellnessRX fund ETY – Eaton Vance Tax-Managed Diversified Equity Income fund EOS – Eaton Vance Enhanced Equity Income fund II CII – BlackRock Enhanced Capital And Income fund IGA – Voya Global Advantage And Premium Opportunity fund Note: I would be swapping ou t of ETB. And here are the funds I believe present the best risk/reward based on a rotation to underperforming sectors: UTF – Cohen & Steers Infrastructure fund DPG – Duff & Phelps Global Utility Income fund Disclosure: I am/we are long GRX, ETY, EOS, CII, IGA, UTF, DPG. (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.

EMB Offers Investors An Interesting Play On Credit Risk With Mixed Durations

Summary The portfolio for EMB is heavy on bonds that are just barely investment grade. The maturity of those bonds is heavily diversified but the one empty part of the curve is short durations. A mixed duration on the bonds allows it to have a positive correlation with medium-term treasury ETFs. Despite the positive correlation with treasuries, it also has a positive correlation with the equity markets due to the credit risk exposure. The iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) is a very interesting option for investors wanting to add some new exposures to their portfolio. There are plenty of reasons for investors to be worried, but it remains an interesting allocation for a small part of the portfolio. Expense Ratio The expense ratio on EMB is .40% which feels like it would be typical for finding exposure to a somewhat niche market like investing in the bonds of emerging markets. That would probably be a fair assessment as well. While Vanguard also runs a fund in this niche market, the Vanguard Emerging Markets Government Bond Index Fund ETF (NASDAQ: VWOB ), the expense ratio in that fund is .34%. While there is a difference in the expense ratios, the difference is not very substantial. While EMB does have a higher expense ratio, it also has more than ten times the average volume with around 1.3 million shares per day changing hands compared to a hundred thousand for VWOB. Since shares of EMB are more expensive, adjusting for the difference in price would only extend the liquidity advantage of EMB. Credit Ratings The credit ratings on bonds in the portfolio can be seen below The majority of the bonds can be considered investment grade since the heaviest position is in the BBB rated bonds. However, it should be clear that there is still a substantial weighting to investments with lower credit ratings and this portfolio should be seen as being a fairly aggressive debt investment and share prices could be hit from factors as simple as an increase in the credit spread between riskier bonds and treasury securities. Maturity The following chart shows the maturities: This portfolio is incredibly diversified in the maturity of the securities. However, since the diversification includes a very material allocation over 20 years and very little at the shortest end of the yield curve it would be wise for investors to keep in mind that they are facing both substantial credit risk and duration risk. That makes this an interesting ETF for investors trying to optimize their portfolio for low volatility. Building the Portfolio This hypothetical portfolio has a slightly aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to emerging market bonds. However, another 10% of the portfolio is given to preferred shares and 10% is given to a minimum volatility fund that has proven to be fairly stable. Within the bond portfolio, the portion of bonds that are not from emerging markets are high quality medium term treasury securities that show a negative correlation to most equity assets. The result is a portfolio that is substantially less volatile than what most investors would build for themselves. For a younger investor with a high risk tolerance this may be significantly more conservative than they would need. 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. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are for higher yielding debt from emerging markets and (NYSEARCA: IEF ) for medium term treasury debt. IEF should be useful for the highly negative correlation it provides relative to the equity positions. EMB on the other hand is attempting to produce more current income with less duration risk by taking on some risk from investing in emerging markets. The position in (NYSEARCA: USMV ) offers investors substantially lower volatility with a beta of only .7 which makes the fund an excellent fit for many investors. It won’t climb as fast as the rest of the market, but it also does better at resisting drawdowns. It may not be “exciting”, but there are plenty of other areas to find “excitement” in life. Wondering if your retirement account is going to implode should not be a source of excitement. The position in (NYSEARCA: PKW ) makes the portfolio overweight on companies that are performing buybacks. The strategy has produced surprisingly solid returns over the sample period. I wouldn’t normally consider this as a necessary exposure for investors, but it seemed like an interesting one to include and with a very high correlation to SPY and similar levels of volatility it has little impact on the numbers for the rest of the portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. 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 IEF’s heavy negative correlation, it receives a weighting of 20%. Since SPY is used as the core of the portfolio, it merits a weighting of 40%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500 . 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. Conclusion When EMB is measured simply on the annualized volatility it does very fairly well. However, the difficult part about having mixed duration emerging market debt is that the poor credit rating encourages the portfolio to have a positive correlation with the market. If an investor is trying to minimize volatility they may be using a position in medium or long term treasury ETFs which would create some overlap on the long duration exposure but at very different credit ratings. Simply put, EMB manages to have positive correlation with both the market and with the treasury securities that have a negative correlation with the market. I like this bond space, however due to the strange situation with the correlations I would lean toward using it as a small portion of the portfolio. In this example I used it at 10%, but I suspect that 5% might be a more reasonable way to allocate it into the portfolio. Overall, you could say I find more things to like than dislike, but I would still limit the size of the exposure. 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.

XLP Has Numbers For Volatility And Correlation, But It Could Be Better

Summary The portfolio used by XLP isn’t optimized for the best possible performance. I love that the portfolio isn’t afraid to hold producers of addictive substances, but where is the BUD? The expense ratio is fairly solid at .15% and the yield isn’t too bad for an ETF used as a small allocation to overweight the sector. I’d like to see XLP increase the number of holdings within the ETF to reduce the concentrated risk of individual holdings. The low beta reflects a combination of mediocre correlation and low volatility which makes the fund a reasonable fit for a small allocation. 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. I’m working on building a new portfolio, and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ). 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 XLP is .15%. I’d like to see a little lower on domestic equity but for a sector-specific ETF, this is still within reason. Yield The ETF is yielding 2.58%. That isn’t enough for a large position in a dividend growth investor’s portfolio, but it is not low enough to really damage the dividend performance of an investor’s portfolio if it is simply being used to create a slight overweight on the sector due to the lower volatility of this sector. Allocations by Industry The following chart breaks down the allocations by each sector: The heaviest exposures are to food and retailing of staples with beverages also coming in as a “very heavy weight”. All around, it should be clear that the goal of this portfolio is to focus on companies that sell products that will maintain strong demand even if the economy is not performing very well. Accordingly, these companies as a group are less volatile than the broader market. Top Holdings The following chart breaks down the top 10 holdings in the fund: After seeing the beverage sector coming at over 18% of the portfolio, I was expecting PepsiCo (NYSE: PEP ) to have a slightly higher weighting. There are a few other things that surprised me as well though. For instance, CVS Health Corporation (NYSE: CVS ) has a higher weighting than Wal-Mart (NYSE: WMT ). I would have expected Wal-Mart to get a slightly higher allocation. I also would have expected Target (NYSE: TGT ) to get at least a small exposure in the portfolio, but when I downloaded the entire list of holdings it was not present. For tobacco being just over 15% of the portfolio, how about some alcohol exposure? I would have expected Anheuser-Busch (NYSE: BUD ) to merit a place somewhere in the list since the goal is to have companies that can continue to make sales even if the market turns down. Perhaps I’m being cynical to think I’d like to own a large company that sells low-cost alcohol as part of a strategy for hedging against a weak economy which can often include high levels of unemployment. It may be cynical, but it is also prudent financial planning. Despite my rationale for including BUD, it is not listed in the portfolio either. The portfolio has a total of only 38 holdings which is also lower than I would expect for an ETF whose primary purpose is to lower the volatility of the portfolio. Building the Portfolio This hypothetical portfolio has a moderately aggressive allocation for the middle-aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to high-yield bonds. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since the volatility on equity can be so high. 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 REITs on the assumption that the hypothetical portfolio is not going to be tax exempt. Hopefully, investors will be keeping at least a material portion of their investment portfolio in tax-advantaged accounts. 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. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEARCA: HYS ) for high yield shorter-term debt and iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) for longer-term treasury debt. TLT should be useful for the highly negative correlation it provides relative to the equity positions. HYS on the other hand is attempting to produce more current income with less duration risk by taking on some credit risk. XLP is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. iShares U.S. Utilities ETF (NYSEARCA: IDU ) is used to create a significant 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. iShares MSCI EAFE Small-Cap ETF (NYSEARCA: SCZ ) is used to provide some international diversification to the portfolio by giving it holdings in the foreign small-cap space. The core of the portfolio comes from simple exposure to the S&P 500 via SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard – Vanguard S&P 500 ETF (NYSEARCA: VOO ) – which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY, because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. 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 and with the S&P 500. 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. Conclusion The nice thing about XLP is that has a correlation of only .84 with the S&P 500 and .47 with high yield bonds. For an aggressive portfolio, a small allocation to XLP can provide a nice reduction in risk. The beta on the fund is only .65 which reflects the combination of moderate correlation to the market and lower total volatility as demonstrated by 12% annualized volatility when SPY had 15.5% annualized volatility. When it comes to the expense ratio and the statistical factors, I think XLP is doing a fairly good job. However, I can’t get past thinking that a portfolio that adds some exposure to other addictive substances like alcohol would be creating a more resilient base for the portfolio. At the same time, I’d like to see a slightly larger volume of holdings (perhaps around 70 rather than 38) to reduce the idiosyncratic risk from holding larger positions in individual companies. XLP is a decent ETF and it performs well in a portfolio. However, I think it could be optimized a little better. 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.