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Paring The Leaders, ETF Performance Review: Major Asset Classes

The U.S. equity market has regained front-runner status for the trailing one-year return (250 trading days) among the major asset classes, but the edge is looking considerably less impressive compared with the glory days of recent years. In fact, rolling one-year returns overall are a diminished lot lately, based on our standard set of ETF proxies that track broad measures of the global opportunity set. There are fewer positive returns for the trailing 250-day period while the performance histories that are still in the black reflect relatively modest gains vs. recent history. In short, earning a risk premium isn’t getting any easier. That’s another way of saying that there’s more red ink weighing on the one-year profiles. Ten of the 14 ETFs that track the major asset classes have lost ground over the past 250 trading days. One thing that hasn’t changed: the deeply bearish trend for commodities in broad terms. The iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSEARCA: DJP ) is still the big loser, shedding nearly 28% over the past year. Here’s a graphical recap of the relative performance histories for each of the major asset classes for the past 250 trading days via the ETF proxies. The chart below shows the performance records through June 12, 2015, with all the ETFs rebased to a year-ago starting-value of 100. U.S. equities are again in the lead (blue line at top), but the edge is razor thin over U.S. real estate investment trusts (black line), which is the number-two performer at the moment. Meanwhile, let’s review an ETF-based version of an unmanaged, market-value-weighted mix of all the major asset classes – the Global Market Index Fund, or GMI.F, which holds all the ETFs in the table above. Here’s how GMI.F stacks up for the past 250 trading days through June 12, 2015. This investable strategy is ahead by just 1.7% over that span – well below the performance for U.S. stocks, via the Vanguard Total Stock Market ETF (NYSEARCA: VTI ) and slightly behind the 2.0% return for U.S. bonds via the Vanguard Total Bond Market ETF (NYSEARCA: BND ). Comparing the median dispersion for rolling 250-day returns for the major asset classes via ETFs suggests that the general rebalancing opportunity has fallen for GMI.F vs. recent history after surging in recent months. Analyzing the components of GMI.F with a rolling median absolute deviation via one-year returns for the ETFs implies a moderately diminished potential for adding value by reweighting this portfolio in comparison with recent history. Keep in mind that the implied opportunity for productive rebalancing will vary depending on the choice of holdings and historical time window. Also, any given pair of ETFs may present a significantly greater or lesser degree of rebalancing opportunity vs. analyzing GMI.F’s components collectively, which is the methodology that’s reflected in the chart below. Note, too, that the chart focuses on looking backward. If you’re confident in your forecast for risk and return, the ex ante view of rebalancing opportunity may paint a distinctly different outlook vs. an ex post analysis. Finally, let’s compare the rolling one-year returns for the ETFs in GMI.F via boxplots to review performance momentum in the context of recent history. The gray boxes in the chart below reflect the middle range of historical 250-day returns for each ETF – the 25th to 75th return percentiles. The red dots show the current 250-day return (through June 12) vs. the equivalent from 30 trading days earlier (blue dots, which may be hiding behind red dots in some cases). For instance, the chart shows that the U.S. stock market is currently the top performer among the major asset classes, as shown by red dot. But in a sign of the times, the current performance is a touch below VTI’s median return (horizontal black line).

Building The Core With Vanguard: Domestic Bonds

Summary Every ETF investor needs to consider what holdings will form the very core of their portfolio. For the portion relating to domestic bonds, Vanguard’s Total Bond Market ETF is a compelling choice. Also discussed are reasons every investor should consider holding bonds in their portfolio, despite what is often described as a negative current environment. For my first articles for Seeking Alpha, I decided to start simple: tackling the question of building a solid core portfolio using ETFs offered by Vanguard Funds. I started with domestic stocks featuring the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). For this second article, I turn to domestic bonds, and will be featuring the Vanguard Total Bond Market ETF (NYSEARCA: BND ). Bonds? Now? Really…? This might seem an odd time to be featuring bonds. After all, interest rates are at, or close to, historical lows, and common wisdom says they are sure to rise from here. Couldn’t our time be better spent considering other options? I might best answer that question by sharing a personal observation of mine. I tend to have CNBC.com up most of the time as one of the tabs in my browser. Last July (2014), this article titled “Why a $60B fund manager is sitting on 20 percent cash,” featuring BlackRock portfolio manager Dennis Stattman, caught my eye. To explain why he was sitting on 20% cash, the article starts with this attention-grabbing quote from the fund manager: “We don’t like the bond market.” The article goes on to enumerate all of his reasons for that view. But once you got past all that, here was the part that caught my eye. His allocations were 58% in stocks, 23% in bonds , and 19% in cash. My takeaway: Regardless of his stated feelings concerning bonds, that fund manager still had some portion of his portfolio in that asset class. Here is a second point of reference to consider. This resource from Vanguard features historical returns going all the way back to 1926 for various model portfolios, in 10% intervals – ranging all the way from 100% stocks and 0% bonds to the other extreme, 0% stocks and 100% bonds. I selected two of these to look at quickly. The first, a portfolio with 100% stocks, and the second with 60% stocks and 40% bonds: I won’t belabor the points, but a couple of things jump out. On the one hand, the allocation with 40% bonds has an average annual return of 1.4% less than one with 100% stocks. On the other hand, the worst single-year loss is 26.6% as opposed to 43.1%. Depending on a vast array of variables – including the possibility of having to sell at precisely the wrong time due to personal financial circumstances – that could make a big difference. You also derive consistent income from bonds (although, admittedly, not so much at present). This can provide you with funds to reinvest in whatever asset class you wish. Putting it all together, that BlackRock investment manager, at some level, had virtually a 60/40 stock versus bond allocation, but he chose to hold 19% in cash because he “[didn’t] like the bond market.” On a personal note, at the time that this article caught my eye, my personal bond allocation was higher than his, and I actually made an adjustment to bring it more in line with what he was doing. In summary, while you may make various decisions as to their weighting , if you believe in a disciplined portfolio as opposed to market timing, bonds deserve a place. And That Brings Us To BND (Composition) What makes BND such a good ETF to serve as the core for this portion of your portfolio? I believe it boils down to two factors: Outstanding diversification Reasonable duration BND tracks the Barclays U.S. Aggregate Float Adjusted Bond Index . This includes a wide range of government, corporate, and even international dollar-denominated bonds. All are investment-grade (Moody’s rating Baa and above), meaning you are not getting into “junk bond” territory in this particular ETF. I will have more on the risk characteristics below. The fund does not actually own every constituent in the index, but rather samples the index, holding a basket of securities that approximate the full index. The latest datasheet reveals 9,330 bonds in the actual index and 7,364 in the fund itself. As featured in this introductory article , bonds have two main risks: interest rate risk and default risk. Fortunately, the information that you need to evaluate this is provided on the datasheet for any bond ETF you are likely to consider. Here is that information directly from the latest datasheet for BND: (click to enlarge) Interest Rate Risk Let’s start with interest rate risk. When it comes to a bond mutual fund or ETF, the key data point that you need to identify is the fund’s duration . Once you identity this, the general rule is simply to multiply the fund’s duration by the change in rates . In other words, if a fund has a duration of 2 years and there is a 1% upwards move in interest rates, the value of the fund is likely to decrease by 2%. This is intended to be a general guideline as opposed to a precise number, because interest rates may rise or fall by different amounts across various terms. As an example, BND holds bonds with maturities basically ranging from 1 year to 30 years. Still, this serves as a reasonable measure of the amount of risk that you are assuming. With that in mind, note the average duration of 5.6 years displayed on the datasheet for BND. Given that, a 1% increase in interest rates could lead to a temporary loss of 5.6% of principal. I say “temporary” because unless you need to sell, this is only on paper. Remember, bonds have a face value , and this is the amount the bond is ultimately worth on the date of maturity . Also, when evaluating this, perhaps against just leaving your money in cash, consider the current SEC yield (as of 6/9/15) of 2.06%. Default Risk The second main risk with bonds is default risk. This refers to the possibility that the issuer could experience financial difficulties such that they are unable to meet the obligation to pay the face value, to return the original capital invested. Fortunately, ratings agencies rate the creditworthiness of bonds on a descending scale. Even more fortunately, default data is available for each rating category, due to the Municipal Bond Fairness Act of 2008. With that in mind, here is my analysis of this risk for BND: Essentially, I started with the weightings by Moody’s rating as published on the BND datasheet. I then multiplied this by the default risk as identified in the above-linked report, to arrive at a weighted default risk. For BND, my calculation reveals a default risk of .86%. The counterpoint to that, of course, is that lower-rated bond issuers have to offer a higher coupon or interest rate to attract buyers for their bonds. So, funds have to pick a balance of risk/reward. In other words, how far down the scale of default risk are they willing to go in search of higher returns? In the case of BND, the lowest rating currently accepted in the ETF is Baa , which is defined by Moody’s as: “… judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics.” You may also note that, cumulatively, 86.2% of the fund’s securities are rated A or higher, with 63.4% in government securities, which are generally considered to be virtually free from default risk. In summary, BND is a solid core holding because of its moderate duration (5.6 years) and credit (or default) risk, due to all holdings being rated Baa and above. Costs and Expenses Similar to that of VTI, BND carries one of the lowest expense ratios in the ETF marketplace, at .07%. To that, of course, you have to add your trading commissions. Vanguard offers its own ETFs commission-free, and TD Ameritrade offers a decent selection of commission-free Vanguard ETFs. Suitability As a core holding, BND is suitable for all portfolios. Alternatives Other ETFs worth considering, particularly if your broker offers them commission-free, are the Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) and the iShares Core U.S. Aggregate Bond ETF (NYSEARCA: AGG ). SCHZ features an industry-low .05% expense ratio, and AGG comes in at .08%. However, even if your broker offers commission-free trading on one of these alternatives, I might still hold BND as a core position and use one of the commission-free options to make small incremental purchases, such as monthly or quarterly investments, adjust portfolio weighting and the like. As a Fidelity client, this is how I use BND and AGG (commission-free trading) in my own portfolio. Last-Minute Personal Comments As I complete this article, the interest rate environment continues to be volatile. If you are considering an initial investment in bonds at this point, I might offer two suggestions: Consider establishing your initial position in multiple increments – perhaps 25% at a time. In so doing, if interest rates rise and prices drop, you will gain some proportionate benefit. Of course, this means a commission on each transaction (for most of us), but the benefits may offset this. Consider using another Vanguard ETF, the Vanguard Short-Term Bond ETF (NYSEARCA: BSV ), for some portion of your position. This ETF has a duration of only 2.7 years and a current SEC yield of 1.08%. The trade-off, as you can clearly see, is a little less income in return for less downside risk. Disclosure: The author is long AGG, BND, BSV, VTI. (More…) 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: I am not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes, and to consult with their personal tax or financial advisors as to its applicability to their circumstances. Investing involves risk, including the loss of principal.

How To Build A Portfolio With Less Risk Than The S&P 500

Summary When measuring risk adjusted returns over a long time period, SPY regularly beats individual investors. Due to high liquidity and small spreads, SPY is a better investment for investors that don’t want to worry constantly. For investors seeking more thorough diversification, I’ll lay out my portfolio plans. The long term bear case for SPY is a doomsday scenario, short term cases are arguments for market timing. Investors dealing with practical constraints such as trading costs have extremely low chances of beating SPY for risk adjusted returns. Every investor wants to be able to beat the market, but success is difficult to judge. Posting larger gains than the market by taking on additional risk is not the same thing as outperforming the market. I believe investors can occasionally struggle to see the forest because they are so caught up in the trees. Without stepping back, it may be difficult to judge how much risk is actually involved in any given portfolio. I think if we compare portfolios over a very long time period, many investors could agree that the deviation of returns is a viable metric for assessing risk. Under CAPM (Capital Asset Pricing Model), investors use Beta to establish the level of risk. I like that method, but it still has some substantial short comings. The theory assumes that every investor is holding the market portfolio and that diversification is in full effect. That causes some problems when we start assessing the required return. If the investor is not actually fully diversified, then the portfolio contains risks that could have been mitigated by better diversification. Making SPY the cornerstone Most textbooks will say that the S&P 500 is a viable proxy for “the market”. Since the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) is heavily focused on large cap U.S. equity, I don’t think that SPY should be seen as a proxy for every investment security. However, I do believe that SPY (or a similar ETF) should be the corner stone of most portfolios. Why SPY makes sense Even though SPY does not represent the entire market, it does represent the largest parts of the U.S. economy and many of the companies have global operations. If an investor wants to rapidly gain diversification to the market, SPY is the best place to start. The advantage of companies with global operations is that the ETF contains some of the diversification benefits of being exposed to foreign economies. Liquidity and spreads SPY offers investors extremely high levels of liquidity which lead to small spreads and a relatively easy time entering or exiting positions as necessary. On a risk adjusted basis When we adjusted for the level of risk, as measured by the deviation of returns, we find that SPY has a lower level of volatility than most ETFs. There are some ETFs with less deviation, but most of those ETFs have several of the same companies. If an ETF holds several of the same companies as SPY and posts high correlation, similar total returns, and similar levels of risk, then that ETF is a viable alternative to SPY. I’m perfectly fine with using alternatives to SPY, but I wouldn’t want to build a portfolio that did not use either SPY or one of the many similar ETFs. My strategy for building a portfolio I’m in the process of building a new retirement portfolio. The account will be tax advantaged. The difficulty for investors in opening a new account is that the balances will be relatively low. Because the balances are relatively low, trading fees are a significant detriment to the success of the account. Even if an investor has a substantial amount of money outside of the account, it won’t make a difference for the individual account. Since the new account has less capital and thus is more susceptible to trading fees, the appeal of using ETFs is even more substantial. My ideal ETF portfolio looks something like this: 30 to 50% to large cap companies (possibly split between 2 ETFs) 15% to 25% in bonds (part international, part domestic) 10% to 20% in international ETFs (probably using at least 2) 5% to 15% between precious metals and natural resource companies 10% to 20% to REITs Some ETFs that I think merit automatic consideration for those slots are listed below. In my opinion, these are some of the first ETFs investors should consider when seeking the exposures listed above. Large Cap: The Schwab U.S. Large-Cap ETF (NYSEARCA: SCHX ), the iShares Core S&P 500 ETF (NYSEARCA: IVV ) and the Vanguard S&P 500 ETF (NYSEARCA: VOO ) Bonds-International: The iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) and the PowerShares Emerging Markets Sovereign Debt Portfolio ETF (NYSEARCA: PCY ) Bonds-Domestic: The Vanguard Total Bond Market ETF (NYSEARCA: BND ), the iShares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ), the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ), the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA: JNK ), the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ) and the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) -Note: PFF uses preferred stock International ETFs: The Vanguard FTSE Developed Markets ETF (NYSEARCA: VEA ), the iShares MSCI Emerging Markets ETF (NYSEARCA: EEM ), the Schwab Emerging Markets ETF (NYSEARCA: SCHE ) and the iShares MSCI EAFE ETF (NYSEARCA: EFA ) Precious Metals: The SPDR Gold Trust ETF (NYSEARCA: GLD ), the iShares Gold Trust ETF (NYSEARCA: IAU ) and the iShares Silver Trust ETF (NYSEARCA: SLV ) Natural Resources: The Market Vectors Gold Miners ETF (NYSEARCA: GDX ), the FlexShares Morningstar Global Upstream Natural Resources Index ETF (NYSEARCA: GUNR ), the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) and the SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA: XOP ) REITs: The Schwab U.S. REIT ETF (NYSEARCA: SCHH ), the iShares U.S. Real Estate ETF (NYSEARCA: IYR ) and the Vanguard REIT Index ETF (NYSEARCA: VNQ ) As you can see from my desired exposures, the largest position by far will be substantially represented by SPY or a similar ETF. The position in natural resource companies will also duplicate some of the same stocks that I will be holding through the U.S. large cap ETF. For investors seeking to reduce risk below the levels created by SPY, the most likely way to do it still involves a fairly substantial position in either SPY or another similar fund. The strategy relies on using relatively low levels of correlation in the other investments. If the positions are relatively small, their correlation is more important than their individual volatility. Rather than building from the ground up, investors should be looking for incremental ways to reduce risk. Small positions in other ETFs have the opportunity to provide that incremental benefit. Rebalancing I will probably rebalance on a quarterly basis, but I might consider doing it as frequently as monthly. The portfolio I’ve laid out above suggests that I would probably be using at least 9 ETFs in my portfolio. The top four positions in the list would each be represented by two ETFs. The REIT position might be through a single ETF, depending on what I can find. First looks When I run my first inspection on an ETF as a candidate, I usually compare the standard deviation on daily returns to SPY. That gives me a quick estimation of the correlation between the two ETFs. If an ETF is not liquid and no shares trade hands on days when SPY jumps up or down as investors are scared to leave their positions, that is an unappealing aspect. Therefore, I also want to know about the volume of the shares being traded. Don’t be fooled into thinking that an average trading volume of 10,000 shares implies that there is enough liquidity for statistics to be valid. I’ve seen ETFs with reasonable average trading volumes post days with 0 shares changing hands. If no shares trade hands, it results in invalid statistics. If investors resume trading the following day at a significantly higher or lower price, it may understate the correlation by assessing the price movement to the wrong day. Yield One of the things I love about SPY is the distribution yield, currently 1.87%. One of my goals in planning for retirement is to get to the point where I can live off the dividends. Yes, I could use investments with substantially higher yields, but that often means additional risks. In my portfolio, I may be able to structure it to have a higher yield, but it won’t be a major factor since the money is all staying in the retirement account. Rich Dad, Poor Dad I believe every investor should read through Rich Dad, Poor Dad. It’s a fairly simple book and contains a great deal of common sense, but I still meet people every day that don’t understand the difference between assets and liabilities in their personal life. The most basic definition is that an asset should put money into your pocket. A liability would remove money from your pocket. The problem with buying into companies (or ETFs) with no dividend yield is that they are not directly putting money into your pocket. Selling shares to create your own dividends Every finance book dealing with economics will mention that investors have the option to sell their stocks and create their own dividend when they need the money. While that is true at a technical level, it ignores behavior finance. Investors are tempted to buy when the market is high and sell when it is low. If the investor can live off the dividends, they can avoid trading mistakes. Security SPY offers investors so much diversification through international exposure, that betting on SPY going down over a very long period is betting on the world falling apart. While individual companies can and do fall from grace (remember Enron), the system behind SPY is strong enough that investors have a very reasonable case to ignore the market and just keep dollar cost averaging into their positions. Market timing is absurdly difficult Attempting to time the market is a losing game. Yes, there are periods where the market crashes. That’s why I believe in adding a few other positions to the core position in the S&P 500. I love diversification, but I don’t see a viable argument against holding SPY over the long term. If the companies comprising the S&P 500 get crushed, what investment is truly safe? I don’t believe gold or the USD will hold substantial value in a hypothetical scenario where the S&P 500 gets destroyed. If Exxon Mobile (NYSE: XOM ) and Chevron (NYSE: CVX ) are both getting destroyed, how would you get to the store for groceries? If Wal-Mart (NYSE: WMT ) is getting crushed, what retail stores are surviving? In a doomsday scenario, I don’t see many investments holding their value. How I plan to handle it When I’m able to transfer money into the account, I won’t try to time my entry into positions. Money goes in, assets get purchased. That doesn’t mean I’m willing to cross a huge spread, but that isn’t a concern with SPY. Even though I have a desired outline for my portfolio, the only position that’s really secure is that I’ll use either SPY or another ETF with very similar exposures. The point of adding other ETFs is that they provide benefits to the core position. If I can’t find enough ETFs that provide complimentary positions to SPY, I’ll just reallocate that position to even more S&P 500. Using SPY to avoid commissions If I didn’t have access to trading many ETFs without commissions, I wouldn’t expect the benefits of further diversification to outweigh the trading costs. If I hold 9 ETFs and rebalance quarterly, I’m looking at 36 trades per year. Assuming $10 per trade, we are talking about $360 per year. In a new retirement account with a starting balance of around $10,000, that’s a huge chunk. The difference between $40 and $360 over the course of the year is comparing .4% to 3.6% in expenses. Beating SPY in risk adjusted returns through active selection is very difficult. If an investor has to beat another 3.2% to cover the trading fees, it becomes nearly impossible. Remember, returns must recognize risk, so buying a single security that does very well is still taking on an enormous amount of risk. If I was paying commissions If I learned tomorrow that I would not be able to trade without commissions, I would make one trade upon getting the money into my retirement account. I would run a portfolio that was at least 80% SPY. Until I had over $50,000 in the account, I wouldn’t even consider reducing the SPY position. 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.