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2016 Investment Strategy With ETFs Part 1

ETFs are transforming. According to PWC (2013) exchange traded funds have benefitted over 20 years from massive growth due to their fine advantages for investors. By August (2013) it is reported that global ETF assets stood at $2.2 trillion in assets. This two part series will look at how the ETF industry has been changing and what this means for investors. As PWC explains: Evolving and proliferating as the attracted new users, ETFs went from a single vehicle providing exposure to large cap US equities to thousands of products representing a dizzying range of asset classes and strategies. What is an ETF? Understanding this change is helpful for investors, but before progressing further, it is helpful to understand what an ETF is. Mitch Tuchman (2013) writing for Forbes does a good job of explaining this. He explains that an ETF is a type of an index fund because it has the same goal. The goal of the ETF is: To provide investors with a benchmark return at minimal cost. There is one very important difference between ETFs and index funds. Index funds are expensive to trade, but ETFs have the advantage of being traded commission free in many cases. It is explained that not all ETFs work in the way that they copy index funds, so some caution needs to be taken during the selection process. It is argued that the flexibility of an ETF with its low trading cost, along with the performance of an index fund is likely to be best achieved by utilizing the biggest and best known ETFs on the market. These are the ones that have proven ability to meet widely understood benchmarks and which have a good track record showing that they can achieve their goals. Source: The next generation of ETFs, PWC ETF as a disruptor As PWC points out, ETFs have been an important disruptor and it is estimated that they are going to continue to grow at tremendous rates. They have been popular because they are low cost, offer tax efficiency, liquidity, transparency and intra-day pricing. As of August 2013, it is reported that there were 5,000 ETFs and exchange traded products (ETPs) worldwide. This has been threefold increase since the financial crisis. The USA is the biggest market for ETFs, and 70% of global ETF assets are found there. Europe comprises the second biggest market, but has only a quarter of the assets found in the USA are found there. Meanwhile, ETFs are growing extremely rapidly in Asia. One of the most important trends in this area has been the advent of actively managed funds. There have been a number of barriers to this development, but actively managed ETFs account for $13.8 billion in the USA alone. ETFs are not only launching at a very fast rate, but are also closing down very quickly. There were 117 ETF fund closures in the six months to the middle of 2013. It is argued that ETFs are moving from a situation of security selection to asset selection, and this change is especially noticeable in large, liquid markets. Indeed, ETFs in the USA have had a big effect on displacing mutual funds. Popularity has been driven by the ability to produce specific exposure. (click to enlarge) Source: ETFs: $3 Trillion is Nice, but $6 Trillion is Better In the past institutional investors showed a lot of interest in ETFs, but this has been changing to some degree, in regard to how these are seen and used. The reason for institutional investors using ETFs at the outset was for transition management, but at the current time these are viewed as long term holdings, as core allocation vehicles. By 2012, nearly 3,400 institutional investors spread across 50 different countries held ETFs or ETPs, which is double the number that used ETFs seven years ago. In addition to this, 90% of institutional investors are planning to at least maintain, if not increase their level of ETF investments in 2013. Investment advisors and hedge funds comprised 90% of institutional investments in ETFs, with the largest holdings mostly being among large global financial institutions. ETFs have not been a huge success in the retirement market, though it is explained that this is not a big surprise as mutual funds already have low cost share classes that are good for retirement plans. Also the retirement market is not as interested in tax efficiency. Nonetheless it is projected that this sector could grow, particularly in the annuity market. Lower costs are driving this change. Top ETFs for 2016 As suggested by Forbes, the best ETFs to invest in 2016 are as follows: 1. Vanguard Total Stock Market (NYSEARCA: VTI ) 2. Schwab US Broad Market (NYSEARCA: SCHB ) 3. Schwab US Large-Cap (NYSEARCA: SCHX ) 4. Schwab US Small Cap (NYSEARCA: SCHA ) 5. iShares Russel 2000 (NYSEARCA: IWM ) 6. Vanguard Extended Market (NYSEARCA: VXF ) 7. Vanguard FTSE Developed Market (NYSEARCA: VEA ) 8. Vanguard Total International Stock (NASDAQ: VXUS ) 9. iShares Core US Aggregated Bond (NYSEARCA: AGG ) 10. Schwab US Aggregated Bond (NYSEARCA: SCHZ )

VFORX: How A Target Date Fund Should Be Built

Summary The Vanguard Target Retirement 2040 Fund has a simple construction and a low expense ratio. Despite being a very simple portfolio, they have covered exposure to most of the important asset classes to reach the efficient frontier. The fund is mostly in equity but has materially underperformed the S&P 500 over because of a strong allocation to international equity. Lately I have been doing some research on target date retirement funds. Despite the concept of a target date retirement fund being fairly simple, the investment options appear to vary quite dramatically in quality. Some of the funds have dramatically more complex holdings consisting with a high volume of various funds while others use only a few funds and yet achieve excellent diversification. My goal is help investors recognize which funds are the most useful tools for planning for retirement. In this article I’m focusing on the Vanguard Target Retirement 2040 Fund Inv (MUTF: VFORX ). What do funds like VFORX do? They establish a portfolio based on a hypothetical start to retirement period. The portfolios are generally going to be designed under Modern Portfolio Theory so the goal is to maximize the expected return relative to the amount of risk the portfolio takes on. As investors are approaching retirement it is assumed that their risk tolerance will be decreasing and thus the holdings of the fund should become more conservative over time. That won’t be the case for every investor, but it is a reasonable starting place for creating a retirement option when each investor cannot be surveyed about their own unique risk tolerances. Therefore, the holdings of VFORX should be more aggressive now than they would be 3 years from now, but at all points we would expect the fund to be more conservative than a fund designed for investors that are expected to retire 5 years later. What Must Investors Know? The most important things to know about the funds are the expenses and either the individual holdings or the volatility of the portfolio as a whole. Regardless of the planned retirement date, high expense ratios are a problem. Depending on the individual, they may wish to modify their portfolio to be more or less aggressive than the holdings of VFORX. Expense Ratio The expense ratio of Vanguard Target Retirement 2040 Fund is .18%. That is higher than some of the underlying funds, but overall this is a very reasonable expense ratio for a fund that is creating an exceptionally efficient portfolio for investors and rebalancing it over time to reflect a reduced risk tolerance as investors get closer to retirement. In short, this is a very solid value for investors that don’t want to be constantly actively management their portfolio. Composition The fund is running almost 89% stocks to about 11% bonds, but over time the portfolio shifts to sell off stocks and hold more bonds as Vanguard assumes that investors nearing retirement will have a reduced risk tolerance. This portfolio strategy is the embodiment of what financial advisors seek to do for clients. Unfortunately Vanguard does not know the unique circumstances of every client, but for a .18% expense ratio they are doing a great job. Holdings The following chart demonstrates the holdings of the Vanguard Target Retirement 2040 Fund: (click to enlarge) This is a fairly simple portfolio. Only four total funds are included so the fund can gradually be shifted to more conservative allocations by making small decreases in equity weightings and increases in bond weightings. The funds included are the kind of funds you would expect from Vanguard. They are all solid funds with strong internal diversification in the holdings and low expense ratios. The Vanguard Total Stock Market Index Fund is also available as an ETF. The ETF version is the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). To be fair, Vanguard has a great reputation for running funds but not for coming up with creative names. I have a significant position in VTI because it carries an extremely low expense ratio and offers excellent diversification across the U.S. economy. Volatility An investor may choose to use VFORX in an employer sponsored account (if their employer has it on the approved list) while creating their own portfolio in separate accounts. Since I can’t predict what investors will choose to combine with the fund, I analyze it as being an entire portfolio. Since the fund includes domestic and international exposure to both equity and bonds, that seems like a fair way to analyze it. (click to enlarge) When we look at the volatility on VFORX, it is only slightly lower than the volatility on SPY. Despite similar levels of volatility, it has underperformed SPY. Generally investors will expect a target date fund to hold up better in a bear market and to fall behind in a bull market. For a portfolio with a target date as distant as 2040, investors have to expect strong equity positions will result in similar returns to the market. The real weakness demonstrated here was largely a function of the international equity markets underperforming the domestic equity markets. A Suggested Modification Even though this portfolio is designed for investors that are 25 years away from retirement, for the sake of lower annualized volatility I would like to see a slightly larger allocation to very long term treasury bonds. Since Vanguard is regularly rebalancing the fund it should be able to benefit from the strong negative correlation between the domestic equity market and the long term treasuries. To be fair, international markets have also been showing a negative correlation with long term treasury returns, so it really should be able to dramatically reduce the volatility without creating a very large drag on earnings. The benefit of the negative correlation with frequent rebalancing allows investors to be regularly buying low and selling high. Compared to most active investment strategies, a simple rebalancing plan that combines long term treasuries with domestic equities has been a very solid and remarkably simple strategy. Conclusion VFORX is a great mutual fund for investors looking for a simple “set it and forget it” option for their employer sponsored retirement accounts. It is ideally designed for investors planning to retire around 2040, but can also be used by younger employees with lower risk tolerances or older workers with higher risk tolerances.

Peer Inside The iShares S&P 500 Value ETF

Summary The individual holdings look fairly solid with a heavy exposure to XOM. The sector allocations are going heavy on the financial sector. While those financial firms may benefit from raising short term rates, I’d rather hedge rate risk and add more exposure to utilities. The iShares S&P 500 Value ETF (NYSEARCA: IVE ) is one way to get the value exposure for your portfolio. On the other hand, if you prefer to look at individual sectors you may find the holdings a little more concerning as 25% of the equity is invested in the financial sector. Generally I have tendency to prefer the value side of the index, but going so overweight on financials is an interesting aspect of the fund. Quick Facts The expense ratio is .18%. I have a strong preference for very low expense ratios, so this is a bit higher than I like to see. With over $8 billion in assets under management, it seems better economies of scale could be achieved, but the higher expense ratio may simply reflect more profits to the sponsor of the fund. Holdings I put together the following chart to demonstrate the weight of the top 10 holdings: (click to enlarge) I love seeing Exxon Mobil (NYSE: XOM ) as a top holding. Investors may be concerned about cheap gas being here to stay, but I think money in politics will be around decades (centuries?) longer than cheap gas. Bet against big oil at your own peril. I find the exposure to AT&T (NYSE: T ) interesting simply because the 2.4% weighting is almost twice that of Verizon (NYSE: VZ ). I find the telecommunications sector a little risky because of the intense price based competition brought by Sprint (NYSE: S ). The sector will probably find a solution to the intense competition, but I’ve gotten burned pretty badly by the mining sector where industry competition reached absurd levels and companies opted to focus on lowering their own costs by increasing production and driving down prices. Declining prices for the product combined with increased production and intense capital expenditures is a pretty ugly situation. Outside the Top 10 Outside of the top 10 you’ll find Johnson & Johnson (NYSE: JNJ ) as 1.64% of the portfolio. This is another great dividend company to hold. They have an effective R&D team and a global market presence. Just look at their dividend history and try to come up with a reason that this company shouldn’t be in a dividend growth portfolio: (click to enlarge) Beyond JNJ you’ll also see other dividend champions like Wal-Mart (NYSE: WMT ) and Pepsi (NYSE: PEP ). The heavy exposure to dividend champions is one reason for investors to appreciate the value side of the index. Wal-Mart has been on a massive slide lately but I don’t see it getting much worse before it gets better. The market for equity can be a little too short sighted in valuations. While Wal-Mart is seeing their already thin operating margins get pressed even thinner amid higher wages, they are also the low cost leader. When Wal-Mart raises prices, the rest of the industry should follow. Who will undercut Wal-Mart? Will it be Target (NYSE: TGT )? I doubt Target really wants to do that since they raised wages also and have the same challenge. Sectors Going heavy on financials hasn’t been my style, but increasing interest rates may benefit them more than the rest of the economy. It’ll be interesting to see how much higher the Federal Reserve can push interest rates without crashing the economy. What to Add The biggest weakness here in my opinion is the relatively small position in utilities. Since utilities often have a material correlation with bonds, I’d like to see a little more utility exposure in the portfolio. An investor could modify the exposure by simply adding the Vanguard Utilities ETF (NYSEARCA: VPU ) to their portfolio when using IVE as a substantial holding. Conclusion The expense ratio is a bit high and the concentration in the financial sector is a little higher than I’d like to see. However, the rest of the portfolio exhibits some great traits with a focus on established dividend growth champions that have the size and experience to whether difficult market environments. All things considered, I think there is more to like than to dislike in this portfolio. Some investors with a very long holding period may want to look for options with slightly lower expense ratios. If investors have a shorter time frame or intend to move their positions more frequently the healthy liquidity on IVE should be attractive for creating a smaller bid-ask spread.