Tag Archives: demographics

PFF: A Quick Way To Get Your Preferred Stock Exposure

Summary There are two issues with the ETF, one is a high expense ratio and the other is sector concentration. The geography exposure is not a problem for me, but I wouldn’t mind seeing a little more diversification. The fund offers negative correlation with at least one treasury ETF while delivering a beta of around .22. Many investors build their portfolio without any meaningful positions in preferred stock. The iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) is one quick solution to that problem. Expense Ratio The expense ratio on the ETF is .47%. I’d really prefer to see a lower expense ratio with long term holdings since the nature of preferred stock suggests positions would not need to be changed frequently. When I pulled up the turnover ratio for the portfolio, it was coming up as 13%. That is higher than I would have expected but not high enough that I would expect the high expense ratio to be necessary. This may simply be a case of an ETF in a niche market having a long track record (established in 2007) and high volume (over 3 million shares per day) being a position where it can demand a higher expense ratio. Largest Holdings The largest holdings of the ETF show a heavy concentration towards the financial sectors. It isn’t just the top 10 though, as you’ll see in the next section. The sector exposure for PFF is heavily concentrated on banks and “Diversified Financials.” Sector The sector exposure is extremely concentrated and that would be an area of concern for me. Since my goals in using preferred shares within a portfolio would be to diversify the risk factors for the portfolio, I would prefer to only need one ETF of preferred stock and to have that ETF bring in a substantially lower level of concentration. I don’t know what would cause the sector to tumble, but very heavy sector exposure leaves investors hoping no black swans appear. This is a risk I would prefer to avoid if possible. Since black swan events by their very nature are unpredictable, the most effective defense is simply to include substantial diversification. Geography The map below shows the geographic distribution of the holdings. I don’t see any problems here. It is interesting that the U.K. was showing up as more than 12% of the portfolio, but diversification is exactly what I was wanting. I’d be interested in seeing even more diversification here, but doubt it will happen. That could make PFF an interesting fit with an international bond portfolio. 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 the iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) for higher yielding debt from emerging markets and the iShares 7-10 Year Treasury Bond ETF (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 the iShares MSCI USA Minimum Volatility ETF (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 the PowerShares Buyback Achievers Portfolio ETF (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 the 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, the 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. 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 PFF has a positive correlation with each of the hypothetical holdings except for the treasury ETF which is interesting. Since PFF should have more duration exposure than IEF, but also more credit risk, there is some fairly solid diversification benefits here. The beta of only .22% is also excellent for indicating that PFF will fit very well within a portfolio. While EMB (emerging market bonds) also have a very low beta, PFF is has done it without having a positive correlation with treasury ETFs. That makes it a great fit for the more conservative investor that is holding more treasuries in the portfolio and less equity. The distribution yield on PFF is over 6%, so this is an option for solid income while maintaining a favorable risk profile. Ideally an investor would be able to combine this with a position in an emerging bond fund like EMB to avoid concentration of risk and then toss some higher dividend yielding ETFs in at the core position and offset the equity risk with some long term treasury exposure. In short, I’m not thrilled with the expense ratio but the fund fits very well within a portfolio. I would love to see more preferred share ETFs coming out to drive up competition and drive down expense ratios. 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.

TLT: Negative Beta Makes This Bond ETF Great For The Equity Heavy Portfolios

Summary TLT is a high-duration treasury ETF. The expense ratio of .15% is within reason and the yield of 2.66% is enough to generate a small amount of income. The main reason for holding a fund like TLT is to keep portfolios values steady when equity markets fall on fear. TLT has a negative correlation with most equity investments and a negative correlation with short term high yield bond funds. 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 iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ). 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 TLT is .15%, which is within reason for long term treasury ETFs. I’d love to see expense ratios dipping towards single digits, but this is still within reason. Yield The yield on the fund is 2.66%. This is lower than investors would expect from even a short term high yield fund, but it does provide some income in exchange for investors taking on the duration risk which can cause TLT to be fairly volatile. Maturity The maturity profile for TLT is fairly simple, as shown below. Over 98% of the portfolio is in treasury securities with a maturity of at least 20 years. Given the name of the ETF, that shouldn’t be a surprise. Similarly, the fund is pretty much exclusively treasury securities. No surprises in this category. 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 TLT and the PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEARCA: HYS ) for high yield shorter term debt and 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. The Consumer Staples Select Sector SPDR ETF (NYSEARCA: 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. The 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. The 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 the 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, the 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. When it comes down to it, TLT shines in a portfolio. In a vacuum, TLT would be a fairly poor investment due to its high volatility and mediocre yield. Being over 2.6% means the income is material, but for most investors that yield is not going to cover a large portion of their living expenses and unlike dividend growth funds this won’t be rapidly compounding unless the position is increasing in value from yields falling. The additional total return would be nice, but it would leave investors with even fewer options for trying to produce material amounts of income to support their lifestyle. By including TLT in a portfolio that is heavy on equities the risk/return profile is materially improved. A strong negative correlation with equity investments means TLT generally moves up when those investments are falling in value. The combined portfolio exhibits substantially less volatility than the domestic equity market. While high volatility for an individual holding can often be considered a bad thing, negative correlations with so many other investments completely reverses the impact. Look at the chart below to see how much higher the total risk profile of the portfolio would have been if the position in TLT had been placed in SPY instead: (click to enlarge) The date range used is the same, but the annualized volatility of the portfolio has increased from 9.4% to 13.7% because this portfolio lacks balancing effect of TLT using a negative correlation to keep portfolio values steady when investors are fleeing the equity market to buy up long term treasury securities. Conclusion TLT is offering most of the things I’m looking for in a long term bond fund. The fund has high volatility, but the low correlation with the market results in a beta of negative .55. When I’m looking for long term bond funds my first areas to consider are the expense ratio and whether the fund is eligible for free trading. Unfortunately, TLT does not fall on my list for free trading which is a significant problem since I want to be regularly rebalancing the positions which means much higher trading fees if the ETF is not eligible for free trading. Despite that one weakness, TLT does well on every other metric. It offers a solid negative beta and enough income to feel like it is in the portfolio for more than just the negative beta. This is a very respectable ETF for long term treasury 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: TLT has a negative correlation with most equity investments and a negative correlation with short term high yield bond funds

SCHD: Lower Volatility Than SPY, Lower International Correlations And A New Place In My Account

Summary SCHD offers investors less volatility than broad market ETFs. The holdings themselves are not extremely diversified, but the performance over the last several years shows the ETF maintains a lower correlation with other assets. I see some benefits to including a small position in SCHD while keeping the core in broad market ETFs. Lately I’ve been considering making some modifications to my portfolio strategy. As the market fell in August I had to recognize that I’m light on bonds. Of course, when the equity markets are falling and the bond markets are rallying it is precisely the worst possible time to start buying up the bond ETFs. Rather than focus on adding the bond ETFs right away, I’m working on revising my strategy. I’m looking for a portfolio that is easier to rebalance and shows less volatility with the market. One of the ETFs that I have been admiring for a long time is the Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ). After the market started selling off hard in August, I decided it was time to look for a position in SCHD and put in a limit order to start buying SCHD. As I transfer more funds into the accounts, I expect to have SCHD regularly listed as a top contender for getting more buy orders and a higher allocation. Largest Holdings The internal diversification within the portfolio is much weaker than using whole market ETFs or broad market ETFs. However, the portfolio also has a lower level of volatility despite that challenge. The top holdings are shown below: (click to enlarge) The portfolio pays off a decent dividend yield, currently that yield is nearing 3% which seems fairly attractive as long term bonds are rallying. If we head into another recession, I want to be buying high quality stocks at lower prices (and higher yields) when the recession starts, when we are in the middle, and when it ends. One of the reasons I waited this long to get in on SCHD is that I was hoping for better prices and those seem to be coming through. My limit-buy orders are not very far out of the money and may have hit by the time the article is published. Expense Ratio The expense ratio on SCHD is .07%. That is low enough that I am happy to work with SCHD in my portfolio. 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. 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 long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) 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) One quick thing to take away from this is that mixing SCHB and SCHX does not add any material amount of diversification within the portfolio. Investors could simply pick whether they prefer a broad market ETF or a focus on larger capitalization companies. On the other hand, SCHD does some add some diversification to either SCHB or SCHX. The core of my portfolio is currently whole market ETFs and broad market ETFs (including SCHB). I don’t expect that core to change, but I’m seeing SCHD post a correlation of “only” .95 with SCHB and a lower correlation with SCHC and SCHF which helps it provide some diversification. Despite the ETF being heavily focused on providing dividends, SCHD still posts a very negative correlation with bond ETFs. However, the negative correlation is weaker for SCHD than it is for the other equity ETFs. Since I may be using heavy rebalancing and allocating more to bonds over the next few years, I don’t want to go overboard on moving SCHD into the portfolio. I’ll probably limit my holdings to a range of around 5% to 10%. Conclusion SCHD is a very strong ETF for most investors. After admiring it from afar for quite a while I decided to take the plunge and put in an order to buy some shares if they kept getting cheaper. One of those orders activated earlier in the week. I put in another order to buy more if it drops again. The ETF offers lower correlation with some of the other holdings I’m using for international exposure or considering adding to the portfolio soon. Even though the internal diversification is not as great as broad market funds, the volatility has been lower and I’m more comfortable holding SCHD going into a rough macroeconomic environment. Disclosure: I am/we are long SCHB, SCHD, 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.