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What Do 2014 Winners Say About 2015?

Summary The yield curve flattened in 2014 as short-term rates increased and long-term rates declined. Utilities benefited from lower long-term rates and is set to finish the year as the best performing sector. The U.S. dollar rally in 2014 looks like the early stage of a much larger rally. One of the biggest trends in 2014, for both length of time and the size of the move, was the bull market in long-term government bonds. The 30-year U.S. Treasury bond will finish the year near its highest level in decades. The 10-year treasury yield of nearly 2.2 percent is off the lows set in 2012, but near the levels reached at the depth of the 2008 financial crisis. There may even be room to move lower because that yield looks plentiful next to German and Japanese 10-year government bonds, which yield a paltry 0.55 percent and 0.33 percent, respectively. Investors who purchased iShares Barclays 20+ Year Treasury (NYSEARCA: TLT ) at the start of the year would be sitting on gains of more than 26 percent as of December 29. That is competitive with the best performing S&P 500 sectors in 2014 and gives it a better than 10 percent lead on both the S&P 500 Index and the Nasdaq this year. As for those best performing sectors, utilities and healthcare are set to grab the top two spots. (click to enlarge) In the currency market, a bull rally in the U.S. dollar kicked off in mid-summer against the yen and euro, and this extended to emerging market currencies by the start of autumn. The U.S. dollar heads into 2015 in a widespread bull market against all major currencies, with even the Chinese yuan showing signs of weakness. A Look Back At Interest Rates In 2014 This year started with investors expecting a rise in interest rates after the Federal Reserve began tapering its asset purchases in December 2013. The Fed ended its third round of quantitative easing (QE3) in October, but history proved superior to expectations: each time the Federal Reserve has exited quantitative easing, interest rates moved lower, not higher, and this time was no different. Rates peaked at the start of the year and never looked back, beginning an almost uninterrupted slide that has yet to finish. (click to enlarge) Economic growth failed to spur general rate increases. GDP growth dipped in the first quarter, then picked up strongly in the subsequent quarters, eventually climbing to 5.0 percent annualized growth in the third quarter. Despite these robust growth numbers, long-term bonds will close out 2014 at or near their highs for the year. Interest rates didn’t fall across the board though. The 2-year treasury yield has been rising since the Federal Reserve announced the taper in May 2013. The 5-year treasury yield didn’t gain in 2014, but it didn’t fall either. (click to enlarge) (click to enlarge) Rising short-term rates and stable or falling long-term interest rates makes for a flatter yield curve. A flat yield curve usually occurs in the middle of an economic expansion, when the economy is firing on all cylinders. Sector Performance Utilities and healthcare are the best performing S&P 500 sectors by a wide margin in 2014. Utilities last delivered a sector topping performance in 2011, when long-term interest rates sank to their lowest point in decades and stocks generally struggled-the S&P 500 Index gained only 2.1 percent that year. Going back further, utilities topped the list of S&P 500 sectors in 2006 as well. Investors with good memories will remember many early recession calls at that time due to a flat yield curve. Healthcare and utilities get lumped in with consumer staples as “defensive” sectors, but the strength seen in these sectors doesn’t indicate a weak market ahead. Healthcare has benefited mightily from the performance of the non-defensive biotechnology sector. SPDR Biotechnology (NYSEARCA: XBI ) is up more than 44 percent this year, for example, well ahead of the healthcare sector. If investors were looking for defensive plays, the sector would be led by pharmaceuticals or healthcare providers rather than biotechnology. Utilities are generally a conservative choice for investors, but the utilities sector was in a downtrend from 2009 to 2014. Working in the sector’s favor is a strong economy and lack of exposure to foreign markets. (click to enlarge) Currency Markets The U.S. Dollar Index broke out to a multi-year high in 2014 and will finish the year near its highs. The greenback was aided by six factors. First, the Federal Reserve tightened monetary policy with its exit from QE. Second, the European Central Bank is moving towards loosening monetary policy with its own version quantitative easing. Third, the Bank of Japan did a surprise expansion of QE on Halloween. Fourth, the collapse in oil prices dragged emerging market currencies lower. Fifth, China’s rebalancing has weakened emerging markets by reducing commodities demand. Sixth, the U.S. economy is among the strongest of the developed economies. The chart below is a price ratio of PowerShares DB U.S. Dollar Index Bullish Fund (NYSEARCA: UUP ) versus SPDR S&P 500 (NYSEARCA: SPY ). It shows that since July, investors could have earned more by investing in the U.S. dollar (going short a basket of foreign currencies that make up the dollar index) than from stocks. This is surprising for a bullish phase of the market-since 2008, U.S. dollar rallies have typically come along with stock market corrections. (click to enlarge) There is a lot of positive sentiment around the U.S. dollar, but structurally the global economy is still short the U.S. dollar. Well into 2014, for instance, Chinese property developers were borrowing in U.S. dollars . An extended U.S. dollar rally could be the only fuel needed for an even bigger and longer U.S. dollar rally if borrowers in emerging markets are forced to hedge their dollar exposure or repay debt. Rising interest rates in the United States, a bias towards rate cuts in China, plus easy money in Europe and Japan, puts the greenback in a strong position in 2015. What It All Says for 2015 Although sector performance in 2014 flashes a caution light, the yield curve is flattening, not flat. The yield curve would need to flatten much more before it would signal a possible recession, but the Federal Reserve isn’t going to raise rates enough to flatten out the yield curve in 2015. The U.S. economy continues to expand and the political situation is favorable for stocks. The Republican Congress and President Obama are unlikely to agree on much, but they do agree on trade deals and possibly even some tax reform. If the U.S. dollar rally continues into 2015, the macro environment will bear a striking similarity to the late 1990s. A continued rise in short-term interest rates is coming, at least until the Federal Reserve signals otherwise. It remains to be seen how long-term interest rates behave, but they could remain low whether short-term rates rise or fall. Far lower interest rates in Europe and Japan, in addition to the rising U.S. dollar, could keep a lid on interest rates if foreigners move capital into the U.S. bond market. Weakness in high yield debt, the fallout from low oil prices, will also work in favor of government bonds. Among S&P 500 sectors, utilities are most affected by the 10-year interest rates. This chart shows the 10-year treasury bond yield versus the price ratio of SPDR S&P 500 and SPDR Utilities (NYSEARCA: XLU ). The falling black line indicates XLU beating SPY, which has occurred for most of 2014 as interest rates declined. Utilities are unlikely to lead again in 2015, but as long as the rate environment isn’t a drag on returns, the strong economy and relatively high yield of the sector could keep it among the better performing sectors next year. (click to enlarge) If both short-term and long-term interest rates increase, the sector that stands to benefit the most is financials. Any broad ETF such as iShares US Financials (NYSEARCA: IYF ) or SPDR Financials (NYSEARCA: XLF ) delivers good exposure. The strong dollar and strong economy work in its favor, and if the dollar rally is a major trend in 2015, financials will benefit as foreign capital flows into the U.S. through American financial institutions. Under performing sectors such as energy and materials could rebound in 2015 after a dismal 2014, but if the global economy doesn’t pick up, a rally could be short lived. A major issue that could affect healthcare stocks in 2015 is the Supreme Court ruling on Affordable Care Act subsidies. The law as written does not allow subsidies for states without exchanges and if the Supreme Court were to rule against them, the history of the Obama Administration’s handling of the law suggests a period of confusion will follow. A Republican Congress doesn’t make the administration’s job any easier – if a fix requires Congressional approval, they may not get it. Finally, an important test for the euro will come in January. The European Central Bank meets in January and Greece’s election is at the end of the month. Sentiment is negative right now because the market expects the ECB to implement some type of QE policy and Greece to elect an anti-austerity government. If one or both of those things don’t occur, the U.S. Dollar Index, which has nearly 58 percent of its basket in the euro, could run out of steam at least temporarily. Barring such an outcome, the strong U.S. dollar will continue to weigh on stocks denominated in foreign currency. A QE policy in Europe would likely boost equity markets though, so funds that hedge away currency exposure, such as WisdomTree Europe Hedged Equity (NYSEARCA: HEDJ ), will do better than their unhedged competition.

XLG Doesn’t Belong On The Efficient Frontier, I Can Name 3 Superior ETFs

Summary I’m taking a look at XLG as a candidate for inclusion in my ETF portfolio. The expense ratio relative to the diversification is simply poor. The high correlation with other major funds (like SPY) limit the uses for the ETF. I can’t see any way to include XLG in a portfolio on the efficient frontier. I’m not assessing any tax impacts. Investors should check their own situation for tax exposure. 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 Guggenheim Russell Top 50® Mega Cap ETF (NYSEARCA: XLG ). 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 XLG do? XLG attempts to track the total return of the Russell Top 50® Mega Cap Index. At least 90% of funds are invested in companies that are part of the index. XLG falls under the category of “Large Blend”. Does XLG provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use (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 almost 97.5%. That high correlation will limit the potential for benefits through diversification and puts XLG in a difficult situation where it may have to be considered as an alternative to SPY rather than as a complimentary holding. Standard deviation of daily returns (dividend adjusted, measured since January 2012) The standard deviation is excellent. For XLG it is .6868%. For SPY, it is 0.7300% for the same period. SPY usually beats other ETFs in this regard, so having a lower standard deviation is excellent. Mixing it with SPY I also 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 XLG, the standard deviation of daily returns across the entire portfolio is 0.7038%. If an investor wanted to use XLG as a supplement to their portfolio, the standard deviation across the portfolio with 95% in SPY and 5% in XLG would have been .7270%. 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 1.91%. The yield is almost 2%, which I think is about the minimum yield for a large position in a portfolio if the investor is retiring. It’s close enough to that arbitrary cut off that it could certainly be used, though I don’t find it very attractive for that. I’m not a CPA or CFP, so I’m not assessing any tax impacts. Expense Ratio The ETF is posting .20% for an expense ratio. I want diversification, I want stability, and I don’t want to pay for them. The expense ratio on this fund is higher than I want to pay for an ETF that invests in U.S. equity securities. I understand some ETFs will need higher expense ratios because of their operations, but I have not found any justification for this expense ratio. I’ll touch on this again in the part on holdings. Market to NAV The ETF is at a .11% premium to NAV currently. Premiums or discounts to NAV can change very quickly so investors should check prior to putting in an order. I wouldn’t want to pay a premium greater than .1% when investing in the ETF, though there could be arguments for various accounting issues which may justify the premium. Largest Holdings Consider me unimpressed by the holdings here. It’s not that I don’t like the individual holdings of the ETF, but I want diversification in an ETF. Diversification costs money. If the expense ratio is going to be .20%, I would want substantially better diversification. If an investor has a fairly large pool of money, they could just buy all of the underlying securities and eliminate the expense ratio. If the holding period was long enough, their costs may end up being lower. I’m picking ETFs based on diversification at cheap prices. This is the opposite of that. (click to enlarge) Conclusion I’m currently screening a large volume of ETFs for my own portfolio. The portfolio I’m building is through Schwab, so I’m able to trade XLG with no commissions. I have a strong preference for researching ETFs that are free to trade in my account, so most of my research will be on ETFs that fall under the “ETF OneSource” program. I’m not impressed with XLG. I like the low standard deviation of returns, but the fairly high correlation means I’m not able to diversify away much of the remaining risk. It could be used as a replacement for SPY because of the low standard deviation of returns, but there are other ETFs with lower expense ratios that can be used for those purposes. For instance, I would use (NYSEARCA: SCHD ) or (NYSEARCA: SCHV ) before XLG if I was looking for exposure to huge U.S. Companies with slightly less volatility. If I was willing to pay higher expense ratios than those two funds, I’d look at (NYSEARCA: SPLV ) with an expense ratio of .25% but a significantly lower standard deviation of returns. In my opinion, XLG is suffering from high expense ratios that cause the ETF to be slightly less efficient than competitors. I might come back and analyze XLG further at some point, but with so many great ETFs to choose from I’m not sure I’ll find time to spend one that was weak in my first pass. 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.

My First Look At SCHM And It Falls Just A Little Short

Summary I’m taking a look at SCHM as a candidate for inclusion in my ETF portfolio. SCHM looks just a tad too risky for its high correlation. The ETF has great diversification in its investments, but the value still fluctuates slightly too much. If the risk was slightly lower, I would want to carve out a small space for it. I’m not assessing any tax impacts. Investors should check their own situation for tax exposure. 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 Schwab U.S. Mid-Cap ETF (NYSEARCA: SCHM ). 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 SCHM do? SCHM attempts to track the total return of the Dow Jones U.S. Mid-Cap Total Stock Market Index. At least 90% of funds are invested in companies that are part of the index. SCHM falls under the category of “Mid-Cap Blend”. Does SCHM provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use (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. For investors curious about my personal choices, I will probably use (NYSEARCA: SCHX ) in place of SPY. I stick to using SPY in these articles because it is better known. I start with an ANOVA table: (click to enlarge) The correlation is about 94%. Diversification with SPY (or an alternative) will still provide some benefits. At 94%, the diversification benefits won’t be huge but I would still consider SCHM as an addition to a portfolio rather than replacing SPY as a core holding. Standard deviation of daily returns (dividend adjusted, measured since January 2012) The standard deviation is higher. For SCHM it is .8614%. For SPY, it is 0.7300% over the same period. SPY usually beats other ETFs in this regard. Because the correlation is fairly high and the volatility is higher, it will be more difficult for me to find a way to use SCHM for risk adjusted returns. Mixing it with SPY At a 50/50 weighting, the standard deviation of the portfolio is .7837%. Even with 95% in SPY and 5% in SCHM, the standard deviation of the portfolio is .7341%. The strong correlation makes it very difficult to get a level of diversification that is high enough to really offset the additional risk. 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. Under standard deviation of daily returns, the S&P 500 is remarkably efficient in long term growth relative to volatility. Yield & Taxes The distribution yield is 1.41%. The SEC yield is 1.33%. Based on the yields, I think the ETF isn’t a great pick for investors nearing retirement and they should consider leaning towards higher yield “value” funds. For a retiree, a position in SPY (or SCHX) still makes sense, but I just don’t see a good way to use SCHM unless it is a very small position. In my opinion, most readers aren’t interested in the case for putting one half of one percent into an ETF. It just wouldn’t be worth the hassle for individual retirees. I’m not a CPA or CFP, so I’m not assessing any tax impacts. Expense Ratio The ETF is posting .07% for an expense ratio. I want diversification, I want stability, and I don’t want to pay for them. That is cheaper than SPY, but more expensive than SCHB. All around, 07% is still a very solid ratio. Market to NAV The ETF is at a .02% premium to NAV currently. In my opinion, that’s not worth worrying about. It is practically trading right on top of NAV. However, premiums or discounts to NAV can change very quickly so investors should check prior to putting in an order. Largest Holdings The portfolio has spectacular diversification. Having less than .60% in any single stock is the kind of diversification I’m willing to pay the higher expense ratio for, but I think this sector of the market is offering a compelling level of risk adjusted returns on an aggregate basis. (click to enlarge) Conclusion I’m currently screening a large volume of ETFs for my own portfolio. The portfolio I’m building is through Schwab, so I’m able to trade SCHM with no commissions. I have a strong preference for researching ETFs that are free to trade in my account, so most of my research will be on ETFs that fall under the “ETF OneSource” program. SCHM doesn’t look like a bad ETF. It isn’t a terrible investment by any means, but I don’t think it will fit in the portfolio I’m building. I’m still defining risk as the deviation of returns, and so long as the historical deviation is fairly accurate, I don’t think I can allocate enough of my portfolio to SCHM to make it worth having the additional position. Even without monetary trading costs or taxes to consider. When my portfolio gets so large that one percent is meaningful, I may reconsider using a small exposure to SCHM. If the correlation was only 83 to 80% or if the standard deviation of daily returns was in the .79% to .81% range I’d be much more likely to consider a 5% allocation to SCHM. If I saw the ETF trading at a .3% to .4% discount to NAV, I’d consider that fairly attractive, but I don’t expect such a discount to exist during open trading hours. 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.