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There Are Few Bargains In Tax-Free Income… Here’s 3

Summary Municipal bonds are coming off one of their best years in a long time. Most municipal bond, closed-end funds are selling well above their usual discount/premium status, a situation nearly exactly opposite that of a few months past. In this article I consider three funds that still present attractive valuations and propose one as my top choice. Few Bargains in Tax-Free Income. Here’s Three. After a dismal 2013, municipal-bond closed-end funds turned in a strong showing in 2014. Let’s start by looking at the largest and most liquid municipal bond ETF as a benchmark. iShares S&P National AMT-Free Muni Bond ETF (NYSEARCA: MUB ) is up 5.42% for the past 12 months and has a 12 month tax-free yield of 2.74%. Not bad for muni bonds, but it doesn’t sound all that terrific, does it? Now, compare that to the median national municipal-bond closed-end fund: 12 month price return of 17.09% coupled with a current, tax-free yield of 5.87%. That’s a total return difference of nearly three fold. How is it that closed-end funds outperformed the benchmark ETF to such an extent? First is their use of leverage: the median muni-bond CEF is leveraged at 34.9%. This can provide a substantial boost in a year such as 2014 but will, of course, drag a fund’s performance down in a less favorable year such as 2013. A second factor is credit quality. Many CEFs will delve more deeply into the credit risk pool than MUB which holds 83% of its portfolio in bonds rated A and above compared to the category average of 74%. Here again, when things go well taking on credit risk can pay off. But in 2013 exaggerated fears of credit risk, driven largely by sentsationalist media coverage of the municipal bond market, proved costly to investors in this asset class. Finally, there’s the factor unique to CEFs: most sell at a discount to their NAVs. This cuts two ways: A discount pumps up the yield on NAV; buying a fund that pays, say, 6% on NAV at a 10% discount turns that 6% into 6.67% at market price. Plus, if a discount compresses, the holder of the fund enjoys capital appreciation unrelated to the price movements of the underlying assets. The first two factors, leverage and portfolio quality, tend to be stable for any given fund. The third, premium/discount status, tends to be quite volatile for municipal bond CEFs, and will often offer attractive buying opportunities. The strong showing for municipal bond CEFs over the last year, and the past few months in particular, has been driven in considerable part by discount compression. This has left few bargains for the tax-free income shopper. The median discount for national municipal-bond CEFs stands at -6.81%. Nearly -7% may look good at first glance but it compares poorly with recent history for the category. How poorly? That -6.81% is more than 2 standard deviations higher (i.e. less discounted) than the median discounts of 3 or 6 months ago. Such numbers do not offer much of an attractive market for buyers. Recent Changes in Premium/Discount Status in Municipal Bond CEFs The metric used to measure how a closed-end fund’s current premium/discount relates to its recent history is the Z-score which indicates how far from the average discount or premium a fund’s current discount or premium is. A fund with a positive Z-score is currently trading at discount or premium higher than its average. Negative Z-scores indicate distance below the average (deeper discounts). Only 4 months ago, when I last wrote about muni-bond CEFs, negative Z-scores were overwhelmingly the rule. That’s now turned around completely with the median Z-scores for 3, 6 and 12 months standing at 2.26, 2.17 and 0.97, respectively. This chart shows distributions of Z-scores for 3 and 6 month periods for 99 national municipal-bond closed-end funds. To see mean reversion in action, it’s worth comparing these to charts of the same metric in Figure 2 from October 2014 which present nearly exact mirror images of these charts in shape if not scale. Figure 1. Z-score distributions for national municipal-bond closed-end funds. In the entire universe of municipal-bond closed-end funds 5% have discounts deeper than their average for the last 3 months and only 8% for the 6 month average. A Moderate Fund-Trading Strategy for Muni-Bond CEFs That Combines Tax-Free Income and Periodic Capital Profits I consider closed-end funds to provide the best choice for exposure to tax-free income. I would argue that the municipal bond arena is the space where CEFs are the clear investment option of choice. They return consistently high-distribution yields on an absolute measure, and very high yields on a tax-adjusted basis in an investment category typified by low yield for essentially every other investment vehicle. Because CEFs often use high leverage and credit-risk as mechanisms to achieve those high returns they tend to be riskier alternatives in comparison with municipal-bond ETFs or holding individual bonds. To moderate some of that risk, I buy muni-bond closed-end funds when they are priced attractively relative to their typical discounts/premiums. To this end I rely on Z-scores to provide a measure of that relationship. I base this on an assumption that the funds with outsized Z-scores will tend to revert to their means over time. Some readers object to this emphasis on Z-scores, which I can appreciate. For the buy-and-hold investor they may be a relatively minor factor in an investment decision. But, I have been able to identify appealing opportunities by including this metric along with the more important considerations of yield and portfolio quality. Understand, as well, that I am always prepared to trade out of a fund if that carefully selected extreme discount reverts to the fund’s less deeply discounted mean, which is, in fact, what I expect to happen most of the time. An investor less inclined to trade funds will, of course, be less inclined to value this metric. Over the past few years I have purchased funds at outsized discounts and sold them at a profit as they reverted to something closer to their mean discounts, using the proceeds to purchase other funds with attractive entry points. With about 100 national muni-bond CEFs and another couple of dozen funds from my home state of California to select from there is always a lot of choice. This approach has provided steady, tax-free income in the 6 to 7% range and modest profits as I traded into new funds. By following this strategy, I presently hold muni-bond funds purchased when they had deeply negative Z-scores. Riding the rising tide in the asset class, they have logged substantial capital appreciation, a fair portion of which is attributable to mean reversion of their discounts. In fact they presently have Z-scores well over 2, so I would like to trade out of them and capture those profits. But there are precious few funds that meet the standards I’m looking for in a replacement. Screen Criteria and Results Can we find some reasonable buys in spite of the clear lack of the sorts of bargains that were available in the recent past? To find out, I downloaded the full list of national muni-bond CEFs from cefanlayzer.com and screened them using the following criteria: Market price yield at or above the median of 5.87%. Discount at or below the median of -6.81%. Z-score for 1, 6 and 12 months being negative for at least 2 of the 3 periods. These are pretty open filters. A few months ago they would have returned dozens of selections to explore. Today the screen passed only two funds: BlackRock Strategic Municipal Trust (NYSE: BSD ) and Dreyfus Strategic Municipal Bond Fund (NYSE: DSM ). With so few candidates, I opened the filter a bit more, stretching the market-price yield down to 5.80%, a bit below the median yield of 5.87%. This added a third candidate, Eaton Vance Municipal Bond Fund II (NYSEMKT: EIV ). This table summarizes yield on market-price, discount and Z-score values for the three funds. Figure 2. Yield, Discount and Z-Scores (Source: cefanlayzer.com ). When I write about tax-free municipal bond funds I like to show the equivalent tax-free yields for investors at a range of marginal tax rates, which I feel gives a better sense of how appropriate a yield point may be in for any individual’s case. Here’s the table. Figure 3. Taxable equivalents for Federal Marginal Tax Rates. As you can see, for an investor in the mid to upper tax brackets, the CEFs are providing extremely attractive tax-adjusted yields compared to what’s available in today’s fixed-income environment. Even at the lowest tax brackets one would be hard pressed to find fixed-income investments with comparable yield and safety. The Funds This next table summarizes some key features of each of the three closed-end funds under consideration. Figure 4. Leverage, Maturity, Duration, Credit Quality and Morningstar Ratings (Sources: cefanalyzer.com and Morningstar). BlackRock Strategic Municipal Trust has been selling at a discount between -4 and -8% since mid-2013. It’s current discount reflects a move upward from a low of -9.84% in August 2014. Distributions are paid monthly and have been steady at $0.074/share since 2010. The fund has not paid out return of capital since its inception. The top 5 states represented are Texas (13.3%), Illinois (11.2%), New York (9.2%), California (8.7%), New Jersey (6.1%). Tobacco bonds, generally considered the riskiest of muni bond categories, are not included in the top 5 sectors held in the portfolio. Morningstar rates the fund as having high to above average risk. The fund has a Sharpe ratio of 1.63 relative to the benchmark Barclays Index of 1.14. Dreyfus Strategic Municipal Bond Fund has been selling at a discount near -5% since early in 2013. Its present discount of -6.8% is marginally lower than its recent history and a full standard deviation below its one year average discount. Distributions are paid monthly. They were cut from $0.0475 to $0.0415/share in November 2014. The fund does not pay any return of capital in its distributions. Top five states are Texas (15.2%), California (12.6%), New York (11.8%), Massachusetts (8.1%), and Arizona ((4.5%). Morningstar rates the fund as having average risk. The fund’s Sharpe ratio is 1.09 relative to the benchmark’s 1.14. Some might express concern about the lead role of Texas in these two portfolios in light of the possible negative impacts of the oil crash on local municipal revenues. It’s just about impossible to sort out how much or little of a factor this may be. My inclination is to dismiss this as an immediate worry. Municipal bond default rates are so low relative to essentially all other bond categories, that I consider this risk exceptionally low on the list of possible risks for the funds. Eaton Vance Municipal Bond Fund II is the final of the three funds. It has seen its discount move to -8.1% at present which is above the -9% range it fell to during November and December 2014. Otherwise it’s about as low as it has been since late 2013. This is just short of one standard deviation below its 12 month average discount. The fund’s monthly $0.0631/share distribution has held steady since a drop in 2012. The fund does not pay return of capital in its distributions. The top holdings in the portfolio comprise bonds from New York (10.3%), Florida (7.5%), Pennsylvania (7.5%), New Jersey (7.1%) and Massachusetts (5.8%). Morningstar rates the fund as having above average risk metrics. Its Sharpe ratio is 1.21 compared to the benchmark’s 1.14. Most notable about EIV is that it has excellent credit quality. Recall that the category average for bonds rated A and above is 74% and for MUB, the benchmark ETF, it’s 83%. Compare EIV: With 92% of its bond portfolio rated A or better, credit risk becomes a near insignificant factor. Finally, EIV outperformed its category in 2014 on a NAV and market price basis despite having not suffered the significant discount compression along the way that its peer funds did. Summary and My Top Choice Any of the three I’ve listed here are, in my view, worthy of a hard, close look for those exploring an investment in tax-free high-yield. My top choice would be the Eaton Vance offering, EIV, but my enthusiasm for it as top choice is somewhat tempered. On the plus side is its portfolio characteristics (credit quality, maturity and duration) which are clearly the best of the three. At

The 6 Best Passive Large-Cap ETFs

By Michael Rawson The S&P 500 outperformed 80% of active managers in 2014 and beat the small-cap Russell 2000 Index by more than 8 percentage points. Strong fund flows reflected investor preference for large-cap funds as the three exchange-traded funds with the strongest flows in 2014 each track the S&P 500, an index of large-capitalization stocks. While the S&P 500 is the most popular, it is not the only large-cap index that investors can choose. A total stock market index fund is usually the most efficient way for index investors to get exposure to the U.S. stock market because they offer comprehensive coverage of the market with very low turnover. However, there are at least two scenarios where it could make sense to hold separate size segment funds. They could be appropriate for investors who want to give an overweighting to certain size segments, such as small-cap stocks, when they believe that segment will outperform. However, it is very difficult to consistently get these calls right. Because different size segments tend to exhibit different risk and return characteristics, investors could also use these funds to exercise more control over their strategic portfolio allocations. In addition, investors may use size segment funds to balance out a portfolio of active managers. The chart below illustrates the annualized volatility and return for stocks sorted by market capitalization and grouped by quintile dating back to 1926. While smaller-cap stocks have generally offered higher returns over the very long term, there have been several market cycles that favored different size segments. The S&P 500 beat the Russell 2000 each year from 1994 through 1998, but that reversed in each year from 1999 through 2004. – source: Morningstar Analysts There is no industry-agreed-upon definition for large cap , so each index provider defines the large-cap universe in its own way. Morningstar defines large cap as all of the largest stocks, which in aggregate make up 70% of the market value of all stocks; this currently corresponds to stocks with a market cap larger than $17 billion. In terms of index performance, it’s a statistical dead heat. Because the indexes have similar risk and return profiles, the choice of which ETF to use largely comes down to factors such as fees, liquidity, tax efficiency, and personal issues such as which brokerage platform is used or how the other assets in the portfolio are positioned. There are 11 ETFs that track market-cap-weighted passive indexes, excluding mega-cap and total stock market funds that also land in the large-blend Morningstar Category. In terms of fees, they charge between 0.04% and 0.20%. While these fees are low relative to the average large-blend mutual fund, which charges 1.1%, there is no reason to pay more than necessary. We can eliminate the funds charging 0.20%. In fact, it is somewhat odd that iShares is willing to charge just 0.07% for iShares Core S&P 500 (NYSEARCA: IVV ) but charges 0.15% for iShares Russell 1000 (NYSEARCA: IWB ) , which offers similar exposure. The expense ratio is just one aspect of cost. Trading costs also have an impact on total return. While the underlying stocks in each of these indexes are mostly the same and are all liquid, some of the ETFs with fewer assets trade less and have wider bid-ask spreads. For example, the iShares MSCI USA (NYSEARCA: EUSA ) has just $57 million in assets and trades less than $1 million of volume a day. The average bid-ask spread of 17 basis points would quickly eat into the returns of a frequent trader. In contrast, SPDR S&P 500 ETF (NYSEARCA: SPY ) trades more than $20 billion a day, and its bid-ask spread is frequently less than 1 basis point. U.S. equity ETFs tend to be tax-efficient because of their ability to transfer low-cost-basis shares out of the portfolio through in-kind redemptions. However, there have been instances where they have issued capital gains. This is more likely to happen to ETFs with a smaller asset base or trading volume or that happen to switch indexes. The only ETF in this group that has issued a capital gains distribution in the past 14 years is SPDR Russell 1000 ETF (NYSEARCA: ONEK ) . Personal factors also enter into the equation. Brokers such as Schwab, Vanguard, and Fidelity offer trading commission discounts for using certain ETFs (check with your broker). A $10 savings per trade can have a big impact for those investing small sums or making frequent trades. Investors should also consider how their choice will have an impact on their overall portfolio. Investors who already have assets with one index family may want to stick with that suite of index products. For example, if you have a Russell 2000 fund for small-cap exposure, you may want to use a Russell 1000 fund for large-cap exposure to avoid overlaps. After eliminating the higher-cost, less-liquid, and less-tax-efficient ETFs from the list of 11, we are left with IVV, SPY, IWB, Vanguard S&P 500 ETF (NYSEARCA: VOO ) , Vanguard Large-Cap ETF (NYSEARCA: VV ) , and Schwab US Large-Cap ETF (NYSEARCA: SCHX ) . These funds track the four market-cap-weighted indexes in the table below. S&P 500 Unlike the other indexes listed, the constituents of the S&P 500 are selected by a committee that has some discretion over which stocks make it into the index and has stricter rules regarding public float and profitability for new index additions. These rules do not have much of an impact for large caps but can have a bigger impact for small caps. In addition, S&P does not follow a set rebalancing calendar, which helps to keep turnover low. Of the four indexes, S&P has the highest average market cap and includes the fewest mid-cap stocks. The lower exposure to mid-caps explains why the S&P 500 slightly underperformed the other indexes. However, the S&P MidCap 400 outperformed most mid-cap indexes. Of the three ETFs tracking the S&P 500, we prefer IVV or VOO over SPY. While SPY is the most liquid, it is technically organized as a unit investment trust, a more restrictive legal structure, which prevents it from engaging in securities lending, reinvesting dividends, and using index futures. Consequently, SPY has lagged the S&P 500 by more than its expense ratio. CRSP US Large Cap Index This benchmark is more comprehensive than the S&P 500. It targets the largest 85% of the market and applies buffering rules to limit turnover. This sweeps in both large- and mid-cap stocks. VV adopted this index in 2013. Vanguard has a history of working with index providers to refine best practices and negotiate better fees. In fact, it previously switched some index funds to MSCI from S&P. Russell 1000 The Russell 1000 Index dips even deeper into mid-cap territory. The average market capitalization of its holdings is $54 billion compared with $72 billion for the S&P 500. The index includes all but six of the stocks that are in the S&P 500 as well as many more mid-caps. IWB is lower-cost and has better liquidity than the ETFs from Vanguard and SPDR that track the same index. Dow Jones US Large Cap Total Stock Market This index tracks approximately the 750 largest U.S. stocks and is available through SCHX. Schwab offers a suite of ETFs based on Dow Jones indexes. The Dow Jones Small Cap Total Stock Market Index includes the next largest 1,750 stocks, while the mid-cap index encompass 501st to 1,000th largest stocks. S&P acquired the Dow Jones indexes business in 2010. Schwab’s size segment funds have the lowest expense ratios in their respective categories, and liquidity has improved as these funds have gained assets. Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

XLF: How Would The Financial Select Sector ETF Fit In My Portfolio?

I’ll take a look at XLF to see if it makes sense for me. The liquidity is fantastic, but the description of the holdings sounded more diversified than the actual holdings in the portfolio. The ETF looks very solid for investors that have a large enough portfolio to make it worth investing a small percentage. The holdings aren’t bad, and the expense ratio looks very appealing. 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 Financial Select Sector SPDR ETF (NYSEARCA: XLF ). 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. What does XLF do? XLF attempts to track the total return (before fees and expenses) of the Financial Select Sector Index. Substantially all of the assets (at least 95%) are invested in funds included in this index. XLF falls under the category of “Financial.” It sounds like the ETF would be very highly concentrated, but it includes everything from diversified financial services to REITs and banks. When I was first reading about the holdings, I was expecting more diversification than I found. You’ll see what I mean when I get to the holdings section. Does XLF provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as the basis for my analysis. I believe SPY, or another large cap U.S. fund with similar properties, represents the reasonable first step for many investors designing an ETF portfolio. Therefore, I start my diversification analysis by seeing how it works with SPY. I start with an ANOVA table: (click to enlarge) The correlation is just over 91%. That’s a strong correlation and substantially higher than I would expect for the REITs inside the ETF. I’m expecting the banks may be pushing the correlation higher. As an investor using modern portfolio theory, I can still work with 91%. Of course, the computed correlation wouldn’t mean much if the values were being distorted by poor liquidity. The average volume of more than 40 million shares per day suggests that liquidity shouldn’t be a concern. That’s a good sign for investors wanting verification of the statistics or wanting to know that they can exit the position with less concern about it deviating from NAV. Standard deviation of daily returns (dividend adjusted, measured since November 2013) The standard deviation is a bit high, but not absurd. For XLF it is .939%. For SPY, it is 0.736% for the same period. The ETF is definitely showing more volatility than SPY by a noticeable margin when we compare returns on a daily basis. Given the fairly strong correlation, I’m not expecting the ETF to be able to lower the risk level in the portfolio. Mixing it with SPY I run comparisons on the standard deviation of daily returns for the portfolio assuming that the portfolio is combined with the S&P 500. For research, I assume daily rebalancing because it dramatically simplifies the math. With a 50/50 weighting in a portfolio holding only SPY and XLF, the standard deviation of daily returns across the entire portfolio is 0.819%. With 80% in SPY and 20% in XLF, the standard deviation of the portfolio would have been .763%. If an investor wanted to use XLF as a supplement to their portfolio, the standard deviation across the portfolio with 95% in SPY and 5% in XLF would have been .742%. As expected, even solid diversification can’t quite eliminate the additional volatility. However, that does not necessarily indicate that there is anything wrong with the ETF. 40 million shares don’t trade hands without plenty of buyers. Why I use standard deviation of daily returns I don’t believe historical returns have predictive power for future returns, but I do believe historical values for standard deviations of returns relative to other ETFs have some predictive power on future risks and correlations. Yield & Taxes The distribution yield is 1.61%. The SEC yield is 1.52%. I like to see strong yields for retiring portfolios because I don’t want to touch the principal. By investing in ETFs I’m removing some of the human emotions, such as panic. Higher yields imply lower growth rates (without reinvestment) over the long term, but that is an acceptable trade off in my opinion. The yield is a little low for those purposes, but not low enough to make it unworkable. Expense Ratio The ETF is posting an expense ratio of .16%. I want diversification, I want stability, and I don’t want to pay for them. An expense ratio of .16% is great. I’ve got no issues there. That’s a very reasonable expense ratio to pay on the ETF. Market to NAV The ETF is at a .01% premium to NAV currently. Premiums or discounts to NAV can change very quickly so investors should check prior to putting in an order. For the extremely high volume of shares trading hands, I would expect the NAV and price to move hand in hand. Largest Holdings The diversification in the holdings isn’t going to be a strong selling point. I certainly don’t mind Berkshire Hathaway as a top holding, but to me this remains a bank ETF. The biggest REIT position is Simon Property Group (NYSE: SPG ). I have nothing against SPG, but it is also the biggest REIT position in most REIT ETFs. I like REIT ETFs, and I’m planning to use one or two in my portfolios. I don’t see much reason to get the same stock in the bank ETF, but with an expense ratio of only .16% it isn’t like I’d be getting charged much for holding it. (click to enlarge) Conclusion The correlation is a bit high, but given the major holdings I can’t expect anything less. I’m not overly bullish on the bank industry at the moment, but I’m not going to focus my ETF selections on my short term feelings about an industry. While I’m concerned about regulatory pressures, my concerns should already be priced into the stocks. For investors looking at the very long term picture, the extremely low expense ratio is great. When I’m putting together hypothetical portfolio positions, one of the things I include is the expense ratio of the ETFs to track the overall expense ratio on the portfolio. In that regard, I think XLF would do quite nicely. During my three year sample period the ETF did thoroughly outperform SPY. I wouldn’t count on it to happen again, but I would consider it as a significant possibility. Since I believe my regulatory concerns are already factored into the share prices for the major banks, I think the ETF would make a solid fit. The only real challenge I have in using the ETF is that I would want to limit the position to 5% of the portfolio. When the goal of the ETF portfolio is to minimize trading costs while maximizing diversification, investors have an incentive to avoid using ETF’s that are most suitable for small positions unless they have a way to trade it with no commissions. If I had a way to trade this ETF with no commissions, I’d probably put it in my portfolio. As it stands, paying the trading costs for 5% of the portfolio doesn’t offer enough benefits for me. Without substantial diversification benefits, I’m more likely to just use the extra money to buy more shares of the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). When my portfolio grows to the point that it is worth separating out another 5%, I may take another look at XLF. It’s a solid ETF that just doesn’t happen to be the right match for my smaller portfolio. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has 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. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.