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A Hedged ETF Strategy For Rising Interest Rates

The 10-year Treasury Yield at 1.8% is 1.2% below where it started 2014. Forecasts that rates would rise in 2014 were very, very wrong. With the 10-year yield now at a record low level, the probability of rising rates from here are better. Outlined below is a hedged strategy using short and long bond ETFs to profit from rising long term interest rates. In one of my accounts I hold about 20% in cash that I did not want to put into the equities market. My plan is to hold that money as available investment capital for the next time the equities market experiences a strong correction. In the current 0% interest on cash environment, I started to think about ways to put that money to work in a relatively low-risk way. I am also concerning about the effects of rising interest rates on the overall value of my income focused equity holdings. With the current level of interest rates paid on bonds, you need to take on quite a bit of duration to earn any meaningful rate of yield and I am unwilling to go 100% into a bond ETF with the prospects of higher interest rates somewhere in the not to distant future. In contrast, an inverse Treasury bond ETF will gain value when interest rates rise, but does not pay any income and will lose value if rates continue to decline. My research led me to try set up a combination investment of a bond ETF and an inverse Treasury bond ETF. The plan is to sell off the inverse ETF in stages as interest rates rise, reinvest the proceeds into the bond fund to generate a growing income stream from the bond ETF. The goal is to end up a few years down the road with the initial investment amount intact and all of the money in the bond ETF earning a higher yield than what is currently available in the market. Half of the cash in the account has been employed into this strategy. To put the strategy in play I initially selected the Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) and the ProShares Short 7-10 Year Treasury (NYSEARCA: TBX ) . SCHZ currently yields 2.03% with an average yield-to-maturity of 2.56%. Expenses are 0.06%. TBX is intended to provide a one-times inverse return of the Barclays U.S. 7-10 Year Treasury Bond Index and has expenses of 0.95%. Over the last year, the yield on the 10-year Treasury has declined by about 100 basis points (1.00%). For that period, the SCHZ share price appreciated by 4.50% and the TBX share price declined by 11.35%. With dividends reinvested for SCHZ you have roughly a 2 to 1 inverse return differential between TBX and SCHZ. Since I expect interest rates to increase over the next few years, my initial plan was to split the invested capital 40/60 between SCHZ and TBX. I started to leg into the two ETFs at the beginning of this year. At that time the 10-year Treasury carried a 2.12% yield, down 0.88% from where it started 2014. As the first two weeks of 2015 unfolded, the Treasury yield marched steadily lower. As the price of TBX dropped, I made two buy trades to establish an initial position. A point of interest, TBX is thinly traded and day only limit orders at or near the low end of the bid/ask spread typically get filled. When the 10-year yield dropped below 1.9%, I got more aggressive and I made two purchases of the ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA: TBT ) , spread a week apart. TBT is a longer duration bond, leveraged ETF, so will change value at about 4 times the rate of TBX. With the 10-year yield setting record lows, I decided that there is an opportunity to make a relatively quick profit on an interest rate bounce off the 1.77% T-note yield bottom set on Thursday, January 15. Now with the full planned amount invested in the three ETFs, I am much more aggressively skewed towards rising interest rates than I initially planned. Here are the percentages invested in each ETF: SCHZ: 35% TBX: 48% TBT: 17% Currently, the total value of the three funds down 1.3% from the amounts invested. From this point, the plan is to profit from rising interest rates. As the share price of TBT rises, it will be sold off first with the proceeds invested into SCHZ. Even a modest rate climb back about 2% for the 10-year will turn this into a profitable trade. The SCHZ and TBX positions will be managed based on an expected slow 2-3 year rise in interest rates. Now that you’ve read this, are you Bullish or Bearish on ? Bullish Bearish Sentiment on ( ) Thanks for sharing your thoughts. Why are you ? Submit & View Results Skip to results » Share this article with a colleague

The Indexer Who Was Saved By His Stock Picks

I am an indexer who completely understands that most professionals and most retail investors do not match the simple long term market index gains available. Benchmarking is important even for those with lower risk balanced portfolios. I have been correcting my Canadian home bias by dollar cost averaging portfolio income into U.S. holdings, that is starting to pay off. In 2014, ironically it was my 5 individual stock picks that carried the day for this indexer. 2014 was a very solid year for the stock markets and a very solid year for those with balanced portfolios. In fact, many investors with balanced portfolios were able to obtain near market gains, or market beating gains with much lower volatility. Based on risk adjusted returns, 2014 was certainly the year of the balanced portfolio. In 2014 and according to low-risk-investing.com the U.S. markets (NYSEARCA: SPY ) delivered 13.5%, a broad based bond index (NYSEARCA: AGG ) delivered 6%, long term Treasuries (NYSEARCA: TLT ) delivered 27.3%, International Markets (NYSEARCA: EFA ) delivered -6.2% and the Canadian Markets (NYSEARCA: EWC ) delivered 1.1%. Most of the poor results in the Canadian and International holdings for US investors were courtesy of the very strong US dollar. The Canadian markets (TSX capped composite) actually delivered 7.4% to a Canadian in 2014 according to Standard and Poor’s. On the dividend growth front the dividend aristocrats (NYSEARCA: NOBL ) delivered 15.6% while the Dividend Achievers (NYSEARCA: VIG ) delivered 9.5% in 2014. Higher yielders (NYSEARCA: VYM ) delivered 13.5%. A simple balanced portfolio with 66.6% SPY and 33.3% comprised of AGG and TLT would have delivered a very healthy 14.5% in 2014. A 50/50 stock to bond portfolio of same parts would have delivered 15.1% in 2014, and that’s with a portfolio of a volatility level of 4.8% compared to 8.2% based on the beta metrics applied on low-risk-investing.com. TLT delivered on so many fronts in 2014. I often suggest that readers consider TLT as portfolio insurance as long term treasuries often offer an inverse relationship to the equity markets in modest to severe market corrections. Here’s my article , “The Best Market Correction Insurance”. Certainly not many would have predicted that TLT would beat the pants off of the equity markets in 2014 but that was the case. I suggest TLT for periods such as this example when the markets were throwing a little tantrum. Here’s TLT vs. SPY from January 1 of 2014 to March 30 2014. The x axis represents months in duration, the y axis represents returns. TLT is in racing green. The markets are skittish, and TLT delivered in 2014 even in the most minor of corrections. TLT finished the year very strong as oil price concerns added some uncertainty. In 2014 I put my Cranky Maneuver into play with respect to our discount brokerage accounts at TD Waterhouse. For context, this investment story begins in the early to mid part of the 2000s when my approach involved a combination of ETFs and a few individual company holdings. I did very well approaching and moving through the market correction, yes I beat the broad market indices by a very large degree by buying when markets corrected and by taking on even more risk by investing in small cap and higher risk sectors such as materials and developing markets. I was also lucky enough to invest in one of Canada’s best managed funds ever – Sprott Canadian Equity. I was also lucky enough to make a mistake and have a terrible Canadian home bias. Canadian markets did very well in the last decade for U.S. 2000-2009. I was also lucky enough to have Barrick Gold (NYSE: ABX ) as a client at the time, and as I was hanging around with and befriending gold bugs they encouraged me to buy a healthy allotment of gold investments. I sold out of those toward the top of the gold price trend. Here’s Barrick from early 2002 to year end 2011. (click to enlarge) When all was said and done, I found myself with meaningful monies (well at least to me) moving out of the recession. I quickly, and early in the recovery, began moving to a more balanced approached to protect those gains. I will admit that my very conservative approach has left some money on the table if I consider the market gains that have been available from 2011. But my goal was to protect assets and create a very low volatility portfolio. Even entering 2014 our discount brokerage accounts were in the area of only 30-40% equities, and they entered the year with a still pronounced Canadian home bias (not enough US or International exposure). The portfolios displayed a very crazy low beta of .2 through any market turbulence in the years approaching 2014. In retrospect I was too conservative, especially considering that I had displayed a very high risk tolerance level through the market corrections of 2000 and the Great Recession. That said, my goal for 2014 was to ‘fix’ my home bias on the fly by investing all portfolio income into the US holdings. That strategy was designed to perform 2 functions, it would increase my equity exposure and growth potential, and it would also gradually increase my US exposure. It is also an interesting risk management tool or strategy. In rising equity markets the portfolio is obviously increasing in value while the volatility level also increases with that added equity exposure. Two measures are increasing the equity component, new monies put into the equities and those rising equity prices. The risk is managed by way of that higher portfolio value. I can look at my portfolio and say that based on historical performance of certain stock to bond allocations, my portfolio value might only drop by 15% in a 50% stock market correction. If a portfolio value went from $220,000 to $250,000 in the year and that $250,000 portfolio might potentially only fall to $212,500 in a severe correction – that draw down might be easy to stomach. The increased risk is managed by a rising portfolio value. In 2014 I was able to move the brokerage accounts to the area of 50% equities – I am happy to play this market scenario down the middle. The portfolios are set up to protect capital and they are also set up to take advantage of any real market correction that might occur. Based on the teachings of Benjamin Graham I am more than willing to move my portfolio back to 75% equities or more if ‘normal’ valuations ever return. I would or will even borrow $250,000 to invest in equities if a real opportunity presents itself. OK, to the returns for this Scaredy Cat investor. Our discount brokerage accounts offered returns in the area of 8.4% to 21% based on the return calculation function on TD Waterhouse accounts. With the best news first here’s the chart for that best performing account. Here are the returns for calendar year 2014 at 20.6%. What’s of interest in that chart is the currency adjusted benchmark of the S&P 500, it shows returns above 20% for Canadian investors. (click to enlarge) We can see that the healthy returns in this account are related to an event in August of 2014, and that event was the purchase of Tim Hortons (THI) by Burger King (BKW). I sold out all of my Tim Hortons at silly profits. As you may know Tim Hortons is the only individual pick that I hold “on purpose”. I knew the company well having been a creative director of the business back in the day when they were originally spun off from Wendy’s (NASDAQ: WEN ) in 2007; then I was a buyer. As I wrote in this article selling all of my Tim’s was a no brainer, I then put some of the profits into Berkshire Hathaway (NYSE: BRK.B ). From September of 2014 BRK.B also had a healthy beat of the market delivering a 9.4% return compared to 3.5% for SPY according to low-risk-investing.com. This Canuck of course also had an additional currency boost included in those BRK.B dollars thanks to the U.S. dollar. Do I wish I had put all of my Tims’ profits into BRK.B? Yes. And here are the returns for one of our other discount brokerage accounts. (click to enlarge) Solid returns for a very low beta portfolio, but I certainly paid for my Canadian home bias. I would have been in better shape to cut the Canadian cord and move to a more sensible US and international equity exposure at the end of 2013. But I have no regrets having recognized my ‘mistake’. I openly admit to fixing my mistakes on the fly. Sometimes your mistakes pay off (the lost decade for me) and sometimes they don’t. But the key might be that benchmarking allows you to recognize your shortcomings and fix your portfolio. So why do I think I underperformed the benchmark in that account when my incredibly low beta portfolio beat the Canadian Stock Market Benchmark? Because of this chart showing the returns for the Tangerine Portfolios. The returns are for the calendar year 2014. (click to enlarge) I would consider the Tangerine Portfolios a benchmark. They are comprised of the market indices of Canada, U.S., International along with a broad base Canadian bond index. The portfolios are rebalanced. Most of our new monies are invested into the Tangerine Balanced Portfolio in a Tax Free and RSP (Retirement Savings Plan). The Balanced Income Portfolio holds 70% bonds, the Balanced Portfolio holds 40% bonds. I have similar returns (to the 8.39% annual) in our third major discount brokerage account, but those returns were aided by the three individual stock holdings of Enbridge (NYSE: ENB ), TransCanada (NYSE: TRP ) and Apple ( AAPL ) all of which outperformed the Canadian and U.S. market indices. Apple was added in June – let’s call that a company I hold on purpose as a growth candidate. Enbridge and TransCanada are simply companies that I could not bring myself to sell when I made the switch to indexing. Apple was purchased with the same reasoning that was behind the Tim Hortons purchase – it is a company with incredible sales and profit growth and is one of the strongest brands on the planet. As a still recovering Ad Guy I don’t mind using brand strength as a guideline for a stock pick or two (I allow myself to have a little fun when investing) and I hope that Apple turns out to be as profitable as the Tim Hortons venture. So far, so good. Here’s Enbridge and TransCanada combined total return vs. SPY over the last 10 years, courtesy of low-risk-investing.com. The time horizon is January 1, 2005 to December 31, 2014. Those two dividend challengers can stay around as long as they like – but I don’t pay them much attention. All combined, our 3 major discount brokerage accounts delivered just over 11% in 2014. Of course on a risk-adjusted return evaluation that’s more than good. I beat the Canadian index with portfolios that started year with beta(s) in the area of .2. But I did give up some gains with that tardy rebalancing. I would estimate that it cost me several thousand dollars. It’s best to use benchmarking to identify weakness and put those mistakes into dollars and cents and then extrapolate those lost returns into the future. We should know the cost of our mistakes and underperformance. Moving forward I plan to continue to invest new monies into the Tangerine Balanced Portfolio, and all portfolio income in the discount brokerage accounts will be invested into U.S. equities. It’s possible that if there is a major drop in the Canadian markets some portfolio income (in the name of rebalancing) will be redirected to Canadian ETFs. Energy is certainly taking its toll on Canadian energy companies and potentially the Canadian economy. My “Learnings” Moving to eliminate my Canadian home bias was a common sense decision. A tardy rebalancing approach led to two self-directed portfolios underperforming their assigned benchmark. The non-thinking Tangerine Balanced Portfolio continues to teach me lessons that I do not always respond to. I am comfortable making a stock selection or three. A future article will explore that strategy of holding a market index as a core and then confining a few stock selections to what an investor actually knows quite well. If one is going to be a “stock picker” perhaps there is value in buying fewer companies; but companies that an investor can hold with extreme confidence. Thanks for reading, happy benchmarking, be careful out there and always know your risk tolerance level. And I’ll add “Got International?”.

Pick Your Poison: No Return On Safety Or More Risk On Your Return

Summary Oil price moves and fluctuations in foreign exchange rates have increased the amount of risk associated with financial assets. The tail risk has increased as a result of the need for central banks to respond to oil prices and the performance of their trading partners. The size of the foreign exchange market and the amount of leverage involved make changes in exchange rates far more risky than changes in any other prices. Markets in Motion Lower oil prices are beneficial for oil consumers whether they be oil-consuming countries or consumers in the US filling up at the gas pump. That does not mean they are beneficial to financial markets. The price of a financial asset is determined by the return one expects to earn from holding the asset and the amount of risk or uncertainty associated with that return. A rapid change in any environmental factor increases the uncertainty associated with the return and therefore reduces the value of the financial asset. There have been numerous articles about the falling fortunes of the oil sector. On January 19, 2015 Barron’s presented a summary of one analyst’s estimates of how much the earnings of the S&P 500 would be reduced by the reduced earnings of the energy sector. The estimates do not seem worth quoting since they were developed without addressing the issue raised by the first sentence of this posting. While the energy sector’s earnings will be reduced, earnings in some other sectors will benefit. The net result is the introduction of considerable uncertainty into any forecasts of the profitability of a large number of companies. That uncertainty will repress stock prices. Thus, the uncertainty introduced by rapidly changing energy prices definitely has stock market implications. However, the December 17, 2014 posting entitled “Oil Prices” pointed out that the greatest macroeconomic risk associated with falling oil prices would be their impact on foreign exchange markets: “The foreign exchange markets are so big that a major dislocation there can have all sorts of unanticipated consequences.” Furthermore, it is quite conceivable that foreign exchange markets and oil markets could reinforce each other in terms of their financial market impact even when their macroeconomic impact diverges. By introducing instability, they both could be contributing to lower stock prices by increasing the risk associated with holding stocks. That can be true regardless of whether they have a positive or negative impact on the return. The December 17, 2014 posting went on to note: “One should keep in mind that financial institutions make markets in both currencies and foreign bonds. If a major financial institution gets caught with excess inventory of the wrong currencies or bonds, dislocation to the financial system could be significant.” One could argue that financial institutions also make markets in commodities such as oil, and therefore, that risk should be noted. However, as big as it seems, commodities markets are small compared to foreign exchange markets. On Jan.16, 2015 the Wall Street Journal was full of stories illustrating just how disruptive unanticipated foreign currency fluctuations can be. However, the foreign currency fluctuations were only very indirectly related to oil prices. The topic du jour was an action by central banks, current action taken by the Swiss central bank and anticipated actions by the European central bank and the Fed. Among the following articles: ” Swiss Move Roils Global Markets ,” ” Bankers, Traders Scramble to Regroup After Swiss Move ,” ” Fallout From Swiss Move Hits Banks, Brokers ,” ” Europe’s Smaller Central Banks Likely to Cut Rates After Swiss Move ,” ” Swiss Shock Tarnishes Central Banks ,” ” Swiss Bank Shares Plummet After SNB Move ,” ” Gold Shines as Traders Seek Safety From SNB’s Shock Move ,” ” Swiss National Bank’s Franc Move Buoys Dollar ,” ” U.S. Government Bond Yields Fall for Fifth Straight Session ,” and ” UBS and Credit Suisse Earnings Get a Swiss Finish ,” one gets an idea of just how important foreign currency fluctuations are. The scope includes non-oil commodity prices (e.g., gold), earnings of banks, pressures on central banks in countries like Denmark, impacts on the economies of many nations, government bond yields, stock market prices in some nations, and the reputation of central bankers. The disruption is not just restricted to turbulence in all those markets, it also involves financial institutions closing their doors (e.g., Global Brokers NZ Ltd.) or having to raise additional capital (e.g., FXCM Inc.). On January 17, 2015 the Wall Street Journal reported estimates of the losses of a number of financial institutions. The article entitled “Surge of Swiss Franc Triggers Hundreds of Millions in Losses” included estimates for Deutsche Bank (NYSE: DB ) and Citi (NYSE: C ). While the hundreds of millions of dollars involved might seem significant, for US banks they pale compared to the regulatory risk pointed out in the March 5, 2014 posting entitled “The Widows’ and Orphans’ Portfolio and US Banks.” Nevertheless, they are just one more reason to avoid US banks in a portfolio designed to have a low volatility and a stable return. Even when addressing issues that seem totally unrelated to foreign currency, it is impossible to ignore a market as large as the foreign currency market. A good illustration occurs in an article published on January 16, 2015 in the Wall Street Journal. It was entitled “What’s the Matter With Canada?” The major thrust of the article concerns Canada’s manufacturing sector, but it was impossible for the article to thoroughly address that issue without discussing the impact of oil prices on the Canadian dollar. It may well be that the decline in US stock prices so far in 2015 is an adjustment to the uncertainty introduced by the volatility in oil prices and currency markets. It certainly is consistent with the increase in uncertainty or risk associated with holding stocks. However, when foreign currency fluctuations are involved, there is a significant increase in what is known as “tail risk.” Countries can default, financial institutions can go broke, and governments can be forced to support their financial system and their economies. Such shocks are often viewed as exogenous and therefore impossible to predict. It is true; they are impossible to predict and this posting in no way constitutes a prediction that they will occur in the US. However, they are not totally exogenous and the ground is fertile for them to occur. Just that fact will impact the return on financial assets. The first half of 2015 will provide significant opportunities to investors as companies adjust to the recent volatility in oil prices and currency values. Because currency fluctuations can have large impacts on all variables from interest rates to revenue growth of individual companies, what is apparent is that regardless of what adjustments are made in a portfolio, the risk associated with any asset has increased.