Tag Archives: demographics

XLY: Do You Need More Aggressive Allocations?

Summary XLY offers investors a fairly aggressive portfolio that is more volatile than the market but benefits from diversification. Most of the allocations seem very reasonable, but MCD looks like a fairly conservative option. If an investor is going to buy into this aggressive fund, they should have a rebalancing plan in place. 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 reviewing is the Consumer Discretionary Select Sector SPDR ETF (NYSEARCA: XLY ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so the goal is to design portfolios that perform well on a risk adjusted basis, not portfolios that necessarily beat the market. Expense Ratio The expense ratio for XLY is .15%. That isn’t too bad. I’m usually expecting to see high expense ratios that drain away the investor’s money, but XLY scores well in this regard. Largest Holdings (click to enlarge) The top of the holdings for XLY is Amazon (NASDAQ: AMZN ). For investors seeking to find companies trading at low fundamentals such as P/E ratios, Amazon’s history of not turning a meaningful profit may be a concern. While earnings are a concern for Amazon, sales have been an area of strength as the company blossomed over the last 15 years and has become a household name. The difficulty for this portfolio is the reliance on discretionary spending. This is a reason for the portfolio to show some substantial volatility when investors are concerned about another recession and falling personal expenditures. The interesting holding here is McDonald’s (NYSE: MCD ) coming in as the 5th holding. I would not put MCD in the same category as the other top holdings. MCD pays a very strong dividend, has a long history of doing so, and in a bad economy the restaurant can pick up new customers that are trading down to buy McDonald’s products rather than more expensive food. The rest of the top 10 holdings are all companies that I would expect to perform best when consumers are readily disposing of income. Building the Portfolio This hypothetical portfolio has a fairly 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 XLY offers investors a fairly aggressive allocation that is heavy on companies that should succeed when the market is doing well and should struggle more during a market downturn. To take advantage of the investment investors would want to be ready to buy into the ETF when fear is stronger in the economy. In my opinion, the most effective way to do that would be to set up an automatic rebalancing schedule or use allocation bands and buy in/sell off whenever the allocation was exceeding the desired range. Due to some diversification benefits, a small allocation can be used in a portfolio without driving up the total risk of the portfolio. However, investors aiming to use the ETF for more than 10% or so of the portfolio may find their volatility across the portfolio increasing. An investor could counteract some of that additional risk by increasing their allocation to treasury securities with an ETF like PLW where the correlation between the two funds is a negative .4. Despite a fairly low expense ratio, if an investor is using a large enough portfolio they may still find it worthwhile to imitate the portfolio by buying up the major holdings because so much of the portfolio is held in the top 10. For the investor that wants to get a little more aggressive without a large enough portfolio to replicate XLY, it looks like a fairly solid option for the sector. 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.

ZROZ: One Of The Fastest Ways To Fix The Beta In Your Portfolio

Summary ZROZ has very long duration treasury securities. The ETF has shown a very strong negative correlation with major market indexes. When used in a portfolio that is overweight on equity investments the result is a rapid reduction in portfolio volatility. The volatility on ZROZ would make it better for speculation than investment if the investor did not have a large equity allocation. The high volatility on the ETF is encouraging the very strong negative beta which makes it an incredible tool under modern portfolio theory. 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 PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ). 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 Call me cheap, frugal, or whatever other name you like. The simple fact is that I despise high expense ratios. The expense ratio on ZROZ is .15%. That is low enough for me to use it, but I’d really prefer to see something that was closer to single digits. In my experience, most ETFs and the vast majority of mutual funds have expense ratios way higher than I am comfortable paying. Compared to the rest of the market, ZROZ is doing just fine on controlling the expense ratio. The other useful for factor in analyzing total expenses is the cost of trading. Since ZROZ is on the “free to trade” list for Schwab clients, that makes it substantially more attractive for me. As you’ll see, I’m looking at ZROZ as a portfolio hedge since I’ve gone so heavily overweight on equity securities. Quick Numbers The average effective duration and maturity are incredible with scores over 25 years. (click to enlarge) The quick take on this extremely long duration treasury play should be that it makes sense for two kinds of people. One would be investors like me that go heavily overweight on equity positions and want then use modern portfolio theory to look for a way to reduce the volatility stemming from the heavy equity positions. The other group of people would be speculators that want to make bets on which way the interest rates will be moving. As you might guess, I’m going to focus on using the ETF for long term investors seeking to reduce volatility in the total value of the portfolio. Maturity The maturity breakdown for ZROZ is incredibly simple. Very long term treasury are not only the core of the portfolio, they are the entire portfolio. (click to enlarge) Building the Portfolio I put together a hypothetical portfolio using only ETF’s that fall under the “free to trade” category for Charles Schwab accounts. My bias towards these ETFs is simple, I have my solo 401k there and recently moved my IRA accounts there as well. When I’m building a list of ETFs to consider I want to focus on things I can trade freely so that I can keep making small transactions to buy more when the market falls. Within the hypothetical portfolio there are no expense ratios higher than .18%. Just like trading costs, I want to be frugal with expense ratios. The portfolio is fairly aggressive. Only 30% of the total is allocated to bonds and I would consider that the weakest area in the portfolio. I’d like to see more bond options (with very low expense ratios) show up on the “One Source” list for free trading. (click to enlarge) A quick rundown of the portfolio The Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) is a dividend index. The Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) is a broad market index. The Schwab U.S. Large-Cap ETF (NYSEARCA: SCHX ) is focused on blended large cap exposure. The Schwab International Equity ETF (NYSEARCA: SCHF ) is developed international equity. The Schwab Emerging Markets ETF (NYSEARCA: SCHE ) is emerging market equity. The Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ) is developed small capitalization equity. The Schwab U.S. REIT ETF (NYSEARCA: SCHH ) is domestic equity REITs. The Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) is a remarkably complete bond fund. The SPDR Barclays Long Term Treasury ETF (NYSEARCA: TLO ) is a moderately long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF is an extremely long term treasury ETF. Notice that the 3 international equity ETFs have only been weighted at 5% while the broad market index has been weighted at 25%. I find heavy exposure to international equity to bring more risk than expected returns so I try to keep my international exposure low. I prefer no more than 20% in international equity. Plenty of domestic companies already have enormous international operations so the benefit of international diversification is not as strong as it would be if the markets were isolated from each other. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. When TLO and ZROZ post negative risk contribution it is because the negative correlation to most of the equity holdings results in the long term treasury ETFs reducing the total portfolio risk. In my opinion, this is the best argument for including them in the portfolio. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). 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) Why I like ZROZ The argument for a long term investor with a very long time horizon and a large margin of safety buying treasury securities when their yields are fairly mediocre is actually quite simple. It comes down to negative beta. Bond ETFs with extremely negative betas are able to provide substantial diversification benefits with even small allocations. I put together one more chart to demonstrate the impact of simply tossing ZROZ and TLO into a portfolio that is very overweight on SCHB. (click to enlarge) For an investor going overweight on equity exposure with 80% in a broad market index, ZROZ is providing a risk contribution to the total portfolio of minus 5.8% compared with TLO providing minus 3% when both are given a 10% allocation. The annualized volatility of the portfolio at 11.3% is dramatically lower than the annualized volatility of any of the individual holdings. Both TLO and ZROZ are reducing the portfolio volatility, but ZROZ is doing it more effectively because it has a stronger negative beta. That doesn’t mean TLO cannot accomplish the same goal, it simply takes a larger allocation to TLO to achieve it. The point of using ZROZ is to get the negative beta into the portfolio without having to use a large allocation. Given that treasury yields are fairly weak, I don’t see any other major reasons to use it. If yields were higher, I would certainly want to use a larger allocation because I would appreciate the expected income as well as the negative beta. On the other hand, if yields were fairly solid, say 5% to 6% on TLO, I would be much more inclined to allocate more of my portfolio to bonds and that would make it reasonable to use a combination of TLO and SCHZ rather than ZROZ. Conclusion ZROZ can be useful for speculators, but it also has a great purpose in the portfolio of a long term investor that simply wants to crank down the volatility of a portfolio that is already heavily overweight on equity securities. Since I am that kind of long term investor seeking to reduce the volatility in my portfolio, I see some benefits to using ZROZ for negative beta even when I find the yields fairly unattractive. Due to the very high volatility, investors using this strategy should either be using it inside a tax advantaged account so they can sell shares to fund rebalancing between the allocations or doing it with a constant inflow of new cash to the portfolio so they can rebalance without selling. As always, check with a tax consultant if you need help in that area. Disclosure: I am/we are long SCHB, SCHD, SCHF, SCHH. (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.

SGVIX: A Bond Mutual Fund For People With Few Options

Summary SGVIX has underperformed alternative options with lower expense ratios. Some employees that have their employer-sponsored accounts through fidelity may find SGVIX is the only government bond option available under tier 1 or tier 2. SGVIX has not done as poorly as I would expect based on the difference in expense ratios, but it still falls short compared to either intermediate treasuries or MBS. Fidelity does have good treasury mutual funds, like FLBAX, but employees are at the mercy of their retirement plans. The Wells Fargo Advantage Government Securities Fund (MUTF: SGVIX ) is one of the new tier two options for some employees that have their employer-based retirement accounts going through Fidelity. This is an area of interest for me because my wife recently received some literature on the new tiered options for her account. Since I handle my wife’s retirement accounts, she dropped the documents on my desk. That puts me in the unfortunate position of having to choose from a severely limited lineup of funds. The best mutual funds by fidelity have been removed from the options and investors that fail to either deal with more headache by creating a brokerage-link account or select new options will find themselves automatically defaulted to a target date plan based on their projected retirement age. There is nothing fundamentally wrong with target date plans. However, investors are stuck with being clumped together by age regardless of risk tolerance. If you are experiencing this kind of change to your retirement plan, you may notice some major problems with the literature sent out. For instance, in 19 pages there were precisely 0 actual expense ratios mentioned. If you happen to be given the same options that were available for my wife, this is the only government bond fund included in the tier 2 options. If investors want to assign an allocation specifically to government bonds, this is the only choice. Why You May Want Government Bonds Mid to long duration government bonds show a strong negative correlation with the stock market which makes them a great tool for diversifying portfolio risk. When an investor takes a small position in the long term government bonds they can immediately and materially reduce the total volatility of their portfolio because the bonds will often move up when the market moves down and move down when the market moves up. This is great for investors that would like to see a lower level of total risk and it makes government bonds a desirable asset class even though their interest rates are currently very low. For comparison sake, I ran a comparison including a couple of ETFs. I’m using the Schwab Intermediate-Term U.S. Treasury ETF (NYSEARCA: SCHR ) and the Vanguard Mortgage-Backed Securities Index ETF (NASDAQ: VMBS ). Hypothetical Portfolio I ran a quick hypothetical portfolio over the last 5 years and one month of data. Theoretically, the only reason you would own SGVIX is because it is the only option available, but for comparison sake I’m putting it in a very simple portfolio. (click to enlarge) You’ll see immediately that SCHR is offering a beta that is further into the negative territory which indicates that it will do better at offsetting the risk from a portfolio that is heavy on domestic equity. On the other hand you’ll see a lower beta for VMBS as investors may be less prone to buy into MBS when they are fearful of negative moves in the market. As a result, the negative beta is fairly low. The interesting thing about this sample period is that the total return on SCHR and the total return on VMBS are both superior to the total return on SGVIX. Correlation The chart below shows the correlation of each ETF or mutual fund with each other. 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. You can see immediately that SGVIX has a higher correlation with SCHR than with VMBS and that makes sense since the portfolio in SGVIX better resembles SCHR than VMBS. The Holdings The chart below shows the holdings: (click to enlarge) As you can see, there is a mix of treasury securities and mortgage related securities. Due to that mix, I felt it was most appropriate to compare SGVIX with both a treasury ETF and a MBS ETF. Maturity The following chart shows the distribution of maturities in the portfolio. One major weakness here is that the portfolio is so heavily focused on the short term that it is incapable of providing a higher negative beta. The other issue is that such a strong short term focus results in weaker levels of income because the yield curve is currently providing materially higher interest by the time we look 3 to 7 years out than when we are looking at maturities under 2 years. Expense Ratio The biggest problem here, a reason that I expect SGVIX to consistently underperform similar investments is that the mutual fund carries a hefty net expense ratio of .49%. It is also showing a remarkable portfolio turnover rate of 349%. Despite heavy trading, it just can’t keep up with funds like SCHR which has an expense ratio of .09% or VMBS which has an expense ratio of .12%. Since the expense ratio is about .4% higher and the time period is about five years, I would estimate that it should underperform by about 2% during that time span. In that sense, the fund has done very well since it only underperformed VMBS by .4% and SCHR by .8%. The managers are creating value through intelligent security selections, but it is has not been enough value to pay for the higher costs. Conclusion Despite solid management, the expense ratio on SGVIX puts it in a constant uphill battle to try to stay even with lower expense options. Unfortunately, some investors may find their investing options severely restricted. The portfolio is designed reasonably well, but investors aiming to reduce portfolio risk as rapidly as possible would benefit more from using longer duration treasury ETFs to gain their diversification benefits with a smaller allocation. The only rationale I see for restricting investor’s choices is to push them into funds with substantially higher expense ratios. As I have been going over several of the funds, I’ve found the best options that were previously available have been entirely removed. It isn’t like Fidelity has no low cost long duration treasury funds. The Spartan® Long-Term Treasury Bond Index Fund – Fidelity Advantage Class (MUTF: FLBAX ) would have been a solid option and has an expense ratio of only .1%. For investors that have that fund as an option in their retirement account, I would take it in a heartbeat over SGVIX. FLBAX is far more volatile than SGVIX, but a beta of negative .47 means a fairly small allocation in the portfolio would be enough to counteract the positive betas from a portfolio that is heavily invested in the S&P 500 or a broad market index. 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.