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An ETF Portfolio Yielding 9%

Summary The ETF Portfolio yielded 9% with a relatively low volatility. Over the past 3 years, the ETF Portfolio outperformed high yield bonds on a risk-adjusted basis. Over the past 3 years, the ETF Portfolio under-performed the S&P 500 on a risk-adjusted basis. January is a traditional time to reassess the markets and position your portfolio for the New Year As a retiree, I am continually looking for sources of high income, but I also don’t want to court excessive risk. I recently wrote an article on constructing a high income, lower risk, CEF portfolio for 2015. This article will attempt to construct a similar portfolio using Exchange Traded Funds (ETFs) that provides high yields at a reasonable risk. My first step was to screen the ETF database for high yielding funds. I used the FinViz website and selected 6% as the minimum yield. This is a high bar for an ETF, which does not use leverage and usually tracks a passive index. There were only 20 ETFs that satisfied the 6% yield criteria. I wanted the ETFs to be relatively liquid, so I also required that the fund have an average volume of at least 50,000 shares per day. Eighteen ETFs passed both screens, but many of these had been recently launched, so I narrowed the field by requiring at least a 3 year history. I would have preferred a longer history, but 3 years seemed to a good compromise. The 9 ETFs summarized below passed all my criteria. The quoted yields were sourced from Morningstar and the holdings were sourced from ETFdb . Alerian MLP (NYSEARCA: AMLP ). The ETF tracks the Alerian MLP Infrastructure Index, which tracks 25 energy infrastructure Master Limited Partnership [MLP] firms. This is one of the fastest growing MLP funds. It issue a standard 1099 at tax time rather than the more complex K-1 forms usually associated with partnerships. The ETF is structured as a C-corporation rather than as a Regulated Investment Company [RIC], because a RIC is prohibited from having more than 25% of the portfolio in MLPs. As a C-corporation, AMLP may invest exclusively in MLPs, but must also pay corporate income tax. This is the reason for the high expense ratio of 8.56% (the management fee is only 0.85%). This fund does however yield 6.46%, which is better than most other MLP ETFs. E-TRACS Wells Fargo Business Development Company Index (NYSEARCA: BDCS ). This is an ETN that tracks the Wells Fargo Business Development Company [BDC] Index, which tracks 114 BDCs selected from the NYSE and Nasdaq. BDCs obtain high yields by lending money to small and midsized businesses. BDCs may also take an active equity stake in some of the companies. This fund has an expense ratio of 0.85% and yields 8.18%. iShares MSCI United Kingdom (NYSEARCA: EWU ). This ETF tracks the MSCI United Kingdom Index, which measures the performance of the British market for large and midsized companies. The fund objective is to provide exposure to 85% of the UK stock market. The portfolio is allocated to sectors as follows: 21% in financials, 17% in energy, 16% in consumer stables, 9% in materials, 9% in healthcare, and 8% in consumer discretionary. The remaining 20% of the portfolio is spread over other sectors. The fund has an expense ratio of 0.48% and yields 7.51%. Peritus High Yield (NYSEARCA: HYLD ). This ETF is not linked to a specific benchmark. The portfolio holds 75 securities, with 4% in U.S. stocks, 4% in international stocks, and 92% in bonds (65% in U.S bonds with the other 27% in international bonds). All the bonds are below investment grade, with the majority invested in corporate bonds. The fund has an expense ratio of 1.18% and yields 9.66%. iShares Global Telecom (NYSEARCA: IXP ). This ETF seeks to match the performance of the S&P Global 1200 Telecommunications Sector Index. The fund contains 46 companies in the telecommunications sector. About 34% of the holdings are domiciled in the U.S. with the rest primarily spread across companies in Europe, Japan, and Canada. About 75% of the companies are diversified telecommunication services with the other 25% are focused on wireless services. Almost all (97%) are from large-cap to giant companies, and the top ten holdings make up 70% of the total assets. The expense ratio is 0.48% and the yield is a whopping 12.32%. KB High Dividend Yield Financial Portfolio (NYSEARCA: KBWD ). This ETF utilizes a dividend-weighted methodology to track companies in the financial and real estate sectors. The portfolio consists of 38 firms with 56% in financial services and 42% in real estate. All companies are domiciled in the U.S and most have small to medium market capitalizations. The fund has an expense ratio of 1.55% and yields 8.3%. CEF Income Composite Portfolio (NYSEARCA: PCEF ) . This ETF is intended to provide a means for investors to track a global index of closed end funds (CEFs). The portfolio consists of 149 CEFs, with a composite asset allocation of 19% U.S stocks, 5% international stocks, 69% bonds (about two thirds domestic and one third international), and 7% preferred stocks. The bond portfolio is almost all investment grade. The fund has an expense ratio of 1.77% and yields 8.02%. iShares U.S. Preferred Stock (NYSEARCA: PFF ). This ETF holds a portfolio of 284 preferred stocks, each of which have a market cap of at least $100 million and have at least 12 months to maturity. About 87% of the portfolio are stocks from financial firms (banks, insurance, and real estate). About 63% of the holdings are rated BBB or better. The fund has an expense ratio of 0.47% and yield 6.33%. i Shares Mortgage Real Estate Capped (NYSEARCA: REM ). This ETF tracks the FTSE NAREIT All Mortgage Capped Index. This fund has 39 holdings with the top 10 comprising about 68% of the assets. Most of the holdings are either medium or small capitalization. The fund is capped so that no company can constitute more than 25% of the portfolio. The fund has an expense ratio of 0.48% and yields a spectacular 14.5%. Reference ETFs To compare this portfolio to the general stock market and to other high-yielding assets, I included the following two funds for reference: iShares iBoxx $ High Yield Corporate Bonds (NYSEARCA: HYG ) . This ETF tracks the high yield corporate bond market and has a portfolio of about 1000 bonds. It has an expense ratio of 0.50% and yields 5.7%. I understand that this bond fund is not a good benchmark for equities, but it does provide an alternative for many investors seeking yield. SPDR S&P 500 (NYSEARCA: SPY ). This ETF tracks the S&P 500, so it is a good proxy for the equity stock market. It has an expense ratio of 0.09% and yields 1.9%. ETF Composite Portfolio If you equal weight the selected ETFs, the allocations for the composite portfolio are shown graphically in Figure 1. Numerically, the allocations are: 7% for general U.S stocks, 11% for MLPs, 11% for business development firms, 11% for companies specialized in mortgage REITs, 11% for companies in the financial sector, 19% international stocks, 12% preferred stocks, and 18% bonds. Summing these individual allocations gives an overall mix of about 70% equities, 12% preferred stocks, and 18% bonds. Figure 1 Composition of ETF Portfolio The composite portfolio has an average distribution of 9%, which certainly meets my criteria for high income. But total return and risk are as important to me as income, so I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility for each of the component funds. I used a look-back period from January, 2012 to January, 2015, a period of 3 years. The Smartfolio 3 program was used to generate this plot that is shown in Figure 2. (click to enlarge) Figure 2. ETF Portfolio risks versus rewards (3 years) The plot illustrates that these high yielding ETFs have booked a wide range of returns and volatilities over the past 3 years. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 2, I plotted a red line that represents the Sharpe Ratio associated with HYG, the high yield bond ETF. If an asset is above the line, it has a higher Sharpe Ratio than HYG. Conversely, if an asset is below the line, the reward-to-risk is worse than HYG. Similarly, the blue line represents the Sharpe Ratio associated with SPY. Some interesting observations are evident from the plot. With the exception of preferred stocks, all the other ETFs were more volatile than the high yield bond fund. Most of the ETFs were less volatile than the S&P 500. However, business development firms, mortgage REITs, and United Kingdom stocks were slightly more volatile. Over the last 3 years, the S&P 500 has been in a strong bull market. Thus, it is not surprising that the total return associated with SPY was substantially greater than any of the other funds in the analysis. On a risk-adjusted basis, only preferred stocks were able to keep pace with SPY. On a risk adjusted basis, high yield bonds performed well compared to the other high yielding ETFs. Only three of the ETFs (PFF, PCEF, and KBWD) outperformed HYG. Most of the other ETFs were below but close to the “red line”. The exceptions were HYLD and EWU, both of which lagged in performance. Somewhat surprising, HYG outperformed HYLD on both an absolute and risk-adjusted basis. When I combined the high yielding ETFs into an equally weighted portfolio, the composite portfolio had a reasonably good return with a relatively low volatility. The risk and reward associated with this composite portfolio are denoted by the yellow dot on the figure. This is an illustration of an amazing discovery made by an economist named Markowitz in 1950. He found that if you combined certain types of risky assets, you could construct a portfolio that had less risk than the components. His work was so revolutionary that he was awarded the Nobel Prize. The key to constructing such a portfolio was to select components that were not highly correlated with one another. In other words, the more diversified the portfolio, the more potential volatility reduction you can receive. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. I also included SPY to assess the correlation of the funds with the S&P 500 and HYG to check the correlations with high yield bonds. The data is presented in Figure 3. As you might expect, the equity funds were the most correlated with SPY (correlations in the 50% to 80% range). Mortgage REITs and high yield bonds had smaller correlations with SPY. It is interesting that HYLD and HYG were only 53% correlated. It should also be noted that HYG was 68% correlated with SPY, which is consistent with the idea that high yield bonds typically respond similar to equities. Overall, these results were consistent with a well-diversified portfolio. (click to enlarge) Figure 3. Correlations over past 3 year. Bottom Line As seen from Figure 2, the ETF composite portfolio returned more than HYG, but had a higher volatility than high yield bonds. The reverse was true when compared to S&P 500. The ETF portfolio had lower volatility, but also had significantly less return. On a risk adjusted basis, the ETF portfolio outperformed high yield bonds but underperformed the S&P 500. If you had decided to invest in ETF portfolio in January, 2012, Figure 4 provides a graphic of how your wealth would have increased. This plot assumes that the portfolio is re-balanced frequently in order to maintain the equal weighting over the look-back period. The figure indicates a relatively smooth accumulation of wealth with a few periods of sharp draw-downs. (click to enlarge) Figure 4 ETF Portfolio wealth growth Figure 5 focuses on the potential draw-downs on the past 3 years. The draw-downs were typically relatively small (less than 6%). Over the period of the analysis, there were only 2 instances where the draw-downs exceeded 7%. The largest drawdown occurred late last year when the portfolio lost over 9%. (click to enlarge) Figure 5 ETF Portfolio wealth draw-downs. No one knows how this portfolio will perform in the future, but based on past history, if you are a risk adverse investor looking for income, the ETF portfolio may be worthy of consideration. It outperformed the reference high yield bond fund on a risk-adjusted basis and also provided significantly higher income. On the other hand, if you can handle more risk, the S&P 500 was hard to beat in terms of total return.

Gross Shocks Conventional Wisdom

Bill Gross told investors this week to Beware the Ides of March, or the Ides of any month in 2015 for that matter. When the year is done, there will be minus signs in front of returns for many asset classes. The good times are over. Gross is the legendary bond fund manager who left the company he founded, PIMCO, for a job as a portfolio manager at Janus Global Unconstrained Bond Fund, so most people pay attention when he writes. The prediction came inside the January Investment Outlook for investors. But for the mainstream financial media, he might as well have expelled foul smelling gas at a crowded party. The media quickly pointed out how contrarian his forecast is. For example, the Bloomberg reporter wrote: Gross is putting himself way out on a limb: Not one of Wall Street’s professional forecasters predict the S&P 500 will drop in 2015. Their average estimate calls for an 8.1 percent rise. And while the global economy looks weak, the U.S. has been heating up, with GDP up 5 percent in the third quarter. Of course, he forgets that mainstream financial experts and economics have failed to see every recession for the past century, especially the latest. They have failed because their business cycle theory asserts that recessions and the stock market collapses that precede them are random events. In other words, @#$% happens! So while insisting that business cycles are random events and by definition unpredictable, they continue to insist they can predict them! Gross makes one mistake that shows the bad influence behavioral finance has inflicted on him. He wrote, Manias can outlast any forecaster because they are driven not only by rational inputs, but by irrational human expressions of fear and greed. Stock and bond market “bubbles” are not manias; humans are not irrational with their money and the current market levels don’t illustrate greed or fear. As my forecasts show, the stock market reflects historically high profits plus greater tolerance for risk by investors. And the bond market is responding rationally to the Fed’s loose monetary policy. Fortunately, Gross doesn’t follow mainstream economics. His rationale comes from the “debt super cycle.” Gross attributes the theory to the research and investment advisory firm Bank Credit Analyst, but the cycle has been a major theme of the Bank for International Settlements for years. You can find a good intro in Claudio Borio’s The financial cycle and macro economics: What have we learnt? In short, the theory says that debt increases when central banks pump money into the economy through artificially low interest rates and open market operations, that is, buying bonds, also known as quantitative easing. Much of the debt increases the value of capital that has been used as collateral on loans and makes further borrowing on the same collateral possible. Credit continues to expand, asset prices rise and GDP increases as part of the expansion phase until debt service burdens become too great for businesses or households to bear, causing them to cut back on spending. As a result, asset prices fall and banks demand more collateral for outstanding loans. Some companies default and the financial system spirals downward, taking the economy with it. The latest debt super cycle extended almost 20 years peak-to-peak, from about 1989 to 2007. Business cycles last up to 8 years, but when a recession coincides with a peak in the debt cycle, it’s much more severe. There is a lot of truth in the debt super cycle theory. But it doesn’t explain why debt service becomes unbearable. After all, if asset prices are increasing and the economy is growing, debt service should become easier. The debt theory needs the Austrian business-cycle theory to make it whole. Debt service becomes a burden when sales fall in the capital goods sector because sales are soaring in the consumer goods sector. This is Hayek’s Ricardo Effect kicking in. However, the debt theory helps flesh out some of the financial aspects of the ABCT. So what does Gross advise investors to do? He recommends buying Treasuries and high quality corporate bonds. He cautions that rising interest rates could hurt such investments, but if the debt cycle theory is correct, that won’t happen in 2015. Only contrarians like Gross make money when the market morphs from a bull to a bear.

Health Care ETF: XLV No. 2 Select Sector SPDR In 2014

Summary The Health Care exchange-traded fund finished second by return among the nine Select Sector SPDRs in 2014. As it did so, the ETF posted the second best annual percentage gain in its 16-year history. Seasonality analysis indicates the good times may continue rolling in the first quarter. The Health Care Select Sector SPDR ETF (NYSEARCA: XLV ) was ranked No. 2 in 2014 by return among the Select Sector SPDRs that carve the S&P 500 into nine slices. On an adjusted closing daily share price basis, XLV ballooned to $68.38 from $54.64, a swelling of $13.74, or 25.15 percent. As a result, it behaved better than its parent proxy SPDR S&P 500 ETF (NYSEARCA: SPY ) by 11.68 percentage points and worse than its sibling Utilities Select Sector SPDR ETF (NYSEARCA: XLU ) by -3.59 points. (XLV closed at $70.84 Thursday.) XLV ranked No. 4 among the sector SPDRs in the fourth quarter, when it led SPY by 2.50 percentage points and lagged XLU, the Consumer Discretionary Select Sector SPDR ETF (NYSEARCA: XLY ) and the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) by -5.79, -1.25 and -0.86 points, in that order. However, XLV ranked No. 8 among the sector SPDRs in December, when it performed better than the Technology Select Sector SPDR ETF (NYSEARCA: XLK ) by 0.78 percentage point and worse than SPY by 1.15 points. Overall, XLV posted the second best annual percentage return in its 16-year history: Its record was set in 2013, when it astounded by skyrocketing 41.41 percent. Figure 1: XLV Monthly Change, 2014 Vs. 1999-2013 Mean (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing monthly share prices at Yahoo Finance . XLV behaved a lot better in 2014 than it did during its initial 15 full years of existence based on the monthly means calculated by employing data associated with that historical time frame (Figure 1). The same data set shows the average year’s weakest quarter was the third, with a relatively large negative return, and its strongest quarter was the fourth, with an absolutely large positive return. Inconsistent with this pattern, the ETF had excellent gains each and every quarter last year. Figure 2: XLV Monthly Change, 2014 Versus 1999-2013 Median (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing monthly share prices at Yahoo Finance. XLV also performed a lot better in 2014 than it did during its initial 15 full years of existence based on the monthly medians calculated by using data associated with that historical time frame (Figure 2). The same data set shows the average year’s weakest quarter was the third, with a relatively small negative return, and its strongest quarter was the fourth, with an absolutely large positive return. Meanwhile, there is a historical statistical tendency for the ETF to do well in Q1. Figure 3: XLV’s Top 10 Holdings and P/E-G Ratios, Jan. 8 (click to enlarge) Note: The XLV holding-weight-by-percentage scale is on the left (green), and the company price/earnings-to-growth ratio scale is on the right (red). Source: This J.J.’s Risky Business chart is based on data at the XLV microsite and FinViz.com (both current as of Jan. 8). The health-care sector in general and XLV in particular progressed from a sweet spot to a sweeter spot to an even sweeter spot between June 2012 and October 2014. As discussed elsewhere previously, it appears XLV’s share price was driven by these key factors: Obamacare: The Affordable Care Act’s constitutionality was established in the landmark National Federation of Independent Business v. Sebelius decision handed down by the U.S. Supreme Court June 28, 2012, as documented by the court. Quantitative Easing: The Federal Open Market Committee announced the launch of the U.S. Federal Reserve’s latest QE program Sept. 13 the same year, as noted in “SPY, MDY And IJR At The Fed’s QE3+ Market Top.” Sector Rotation: A signal for such rotation, the beginning of the end of the Fed’s QE3+ program was announced by the FOMC Dec. 18, 2012, as pointed out in “Building A Martin Zweig-Like Fed Indicator Integrating Innovations Of The 21st Century.” The FOMC announced the completion of asset purchases under the QE3+ program last Oct. 29, so QE will not be a key driver of XLV in the first quarter. However, the other two factors may continue to be in play. A big risk to XLV and its constituent companies is the Obamacare-related King v. Burwell case currently before the U.S. Supreme Court. The justices most likely will hear arguments in March, according to the SCOTUSblog . They are expected to deliver a decision by July, with the ruling constituting a binary event for the Health Care ETF, as follows: If the decision is favorable to Obamacare, then its effect on XLV’s share price may be relatively small and short lasting. One analog might be the move in SPY between Dec. 17 and Dec. 29, associated with the FOMC statement on the former date. If the ruling is unfavorable to Obamacare, then its impact on XLV’s share price may be absolutely large and long lasting. One analog might be the move in the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) from June 20 to the present, associated with the crude oil price attaining either a long term or a cycle peak on the former date. Incredibly, the health-care sector’s and XLV’s awesome performances the past couple of years have not resulted in too many absurd valuations, as indicated by the above chart (Figure 3) and numbers reported by S&P Senior Index Analyst Howard Silverblatt, Dec. 31. At that time, Silverblatt indicated the P/E-G ratio of the S&P 500 healthcare sector was 1.38, which may look a little dear to growth and value folks like me but a lot cheap to normal people. Disclaimer: The opinions expressed herein by the author do not constitute an investment recommendation, and they are unsuitable for employment in the making of investment decisions. The opinions expressed herein address only certain aspects of potential investment in any securities and cannot substitute for comprehensive investment analysis. The opinions expressed herein are based on an incomplete set of information, illustrative in nature, and limited in scope. In addition, the opinions expressed herein reflect the author’s best judgment as of the date of publication, and they are subject to change without notice.