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I Like The Risk Level On SPLV, But I’m Not Entirely Sold

Summary I’m taking a look at SPLV as a candidate for inclusion in my ETF portfolio. I’m not huge on the expense ratio, but I like the other aspects of the ETF. The ETF is incredibly well-diversified which favorably impacts the standard deviation of returns. In the context of Modern Portfolio, the correlation and standard deviation of returns are very important. The ETF looks favorable in those regards. 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 PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA: SPLV ). 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 SPLV do? SPLV attempts to track the total return of the S&P 500® Low Volatility Index. At least 90% of funds are invested in companies that are part of the index. SPLV falls under the category of “Large Value.” Does SPLV 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 about 86%. This is pretty great for making the ETF fit under modern portfolio theory. The low correlation means it should be possible to use the ETF without raising the standard deviation of returns unless the risk ETF has a very high standard of deviation of returns. Standard deviation of daily returns (dividend adjusted, measured since January 2012) The standard deviation is phenomenal. For SPLV it is .5978%. For SPY, it is 0.7300% for the same period. SPY usually beats other ETFs in this regard, so the combination of reasonable correlation and lower standard deviation than SPY is giving this ETF a real chance at being selected for my portfolio. 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 SPLV, the standard deviation of daily returns across the entire portfolio is 0.6410%. If we drop the position to 20% the standard deviation goes to .6899%. Once we drop it down to a 5% position the standard deviation is .7195%. I haven’t decided what exposure level I would use yet, but probably 5% to 10%. I really like the combination of low volatility and moderate to low correlation. If it wasn’t for the higher expense ratio, I’d consider making this a core holding. 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 2.21%. The yield seems strong enough that it could be included in a retirees portfolio to bring some diversification benefits and a moderate dividend yield. I’m not a CPA or CFP, so I’m not assessing any tax impacts. If I were using SPLV, I would want it to be in a tax exempt account to remove any headaches associated with frequent rebalancing. Expense Ratio The ETF is posting .25% for an expense ratio. I want diversification, I want stability, and I don’t want to pay for them. In my opinion, a .25% expense ratio is higher than I want to pay for equity investments. It’s still low relative to many other methods of investing, but I’m looking for long term holdings and I don’t want to give my investments away. I haven’t decided if it’s worth paying the higher expense ratio to include SPLV. If the expense ratio was under .10%, this ETF would have a very strong case for being included. Market to NAV The ETF is at a .05% 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 is extremely well diversified. The largest position is around 1.25% of the portfolio. That is solid diversification. The intense diversification is part of the reason the volatility of the ETF is so low. Check out the chart below: (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 SPLV 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. SPLV is a difficult ETF to make a decision on. For equity investments, the expense ratio is a bit high, but the relatively low correlation and standard deviation of returns make a pretty good argument for using at least a small position such as 5% in a long term portfolio. I could go either way on this one. I won’t consider it as a core holding (20%+) because of the higher expense ratio. Disclaimer: 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.

Yellen’s Inflation Compensation And GLD

Summary The Fed is an important influencer of inflation, and for 2015, the Fed is ready to accept inflation as low as 1% and this will push down gold prices. The Fed is ready to fight possible long-term inflation as the economy grows by raising Fed Rates and gradually reducing its $4.55 trillion balance sheet if necessary. Yellen is signaling that the Fed is going to ignore market based weak inflation expectations as seen by the new term ‘inflation compensation’ on the Treasury market. Slim possibility that inflation will overshoot the 2% target, it is more likely to undershoot as energy prices are not transitory. A significant portion of gold holders still see high inflation as the economy strengthens. This is not applicable now and it is time to sell GLD before the crowd does. Fed, Inflation and Gold Frequent readers of my articles on gold will realize that I have been bearish on gold for quite some time now. Gold has many purposes and one of which is for its usage as storage of value. There will always be someone who is willing to buy and store gold if they do not believe in today’s monetary order or simply to form part of a diversified portfolio, and there are those who buy gold as an inflation hedge. This article is targeted for those who view gold as an inflation hedge. There will be a significant portion of investors who will buy gold as an inflation hedge, and it is the changes in inflation or inflation expectations which will have a big impact on the price of gold. There is no other institution that has more influence on inflation than the Federal Reserve, and this is why I believe that by following the Fed closely, we can better inform ourselves on inflation and that is why most of my gold article involves the Fed in one way or the other. The latest Fed document comes in the form of Chair Janet Yellen’s press conference on 17 December 2014. As always, the mainstream media is obsessed with when the Fed will raise interest rates, and there are a number of questions on it with the word ‘patient’ being the new buzz word. If you read the press articles elsewhere, you will probably be informed that the Fed will not raise rates for ‘a couple’ of meetings. Indeed, during the question and answer session, one reporter even wanted to confirm with the Chair if ‘a couple’ means 2 meetings which was subsequently confirmed. However, this is actually quite meaningless for the serious investors because Yellen has qualified her response as data dependent so who is to stop her from raising rates in the next meeting or 5 meetings down the road? She has certainly kept that possibility open, and remember that the US grew by 5% in the third quarter of 2014. My article may have come after all the buzz has subsided, but as you read about it in the new year of 2015, I hope to bring about new perspective based on some points that are largely ignored by the media. Let me bring your attention to the idea of inflation compensation, the existing size of the Fed’s balance sheet, and the Fed’s own inflation expectation for 2015, together with their view of a transitory low energy prices. Rate Hikes and Balance Sheet – Tools ready to Cap Growth Related Inflation Let us first begin with the concept that monetary policy works with a lag time. So the appropriate response to do is to predict as best as possible what will happen in the future and set policy that will ensure that the Fed’s dual mandate of stable prices and maximum employment is achieved as much as possible when the monetary policy takes effect. The Fed views that stable price means a 2% inflation target and predicts that this will be reached in 2017. Stable prices can only be achieved together with an appropriate Federal Funds Rate, which stands at 3.75% in the long run. However, the Fed set a target of 2.5% by 2017 to accommodate for the economic recovery and deal with the residual effect of the Great Recession. This will fit into the narrative where they would start to raise rates in 2015 and gradually guide rates towards their target as they expect the economy to grow in strength. For the shorter term, the Fed’s own forecast, which they would have factored in their own rate hikes, expects inflation to stay between 1% to 1.6% in 2015. This range is within the current Personal Consumption Expenditure inflation reading of 1.4% . So at least in the short term, the Fed is willing to accept lower inflation reading and this is going to be bearish on gold. However, gold might still catch a bid if there is a reasonable expectation for inflation to increase significantly in the future. This is where the size of the Fed balance sheet comes into the picture and where the uncertainty over the inflation compensation comes into play. The Fed is holding $4.55 trillion of assets as of 24 December 2014 and $4.47 trillion comes in the form of Federal Reserve credit. While this may have been accommodative in the past, it can also be used to keep a lid on inflation as seen in the quote by Yellen below. “Rather than actively planning to sell the assets that we’ve put onto our balance sheet, sometime after we begin raising our targets for short-term interest rates, depending on economic and financial conditions, we’re likely to reduce or cease reinvestment and gradually run down the stock of our assets. But our active tool for adjusting monetary – the stance of monetary policy so that it is appropriate for the economic needs for the country, that will be done through adjusting our short-term target range for the federal funds rate.” Yellen’s quote above shows that the Fed is ready to tighten monetary policy not only through the federal rate hike that is in the spotlight recently, but also through a gradual reduction of its balance sheet assets. Hence, we can conclude that the Fed is poised to reign in any runaway inflation that they expect when the economy recovers. This is an old economic theory that is about to be revisited by the investment community at large. Also, consider the argument that low energy prices may be here to stay in this excellent article by Kyle Spencer. The Fed has a bullish outlook for the US economy, and this is the majority view of the FOMC and they are prepared to reign in long-term inflation. The biggest cheerleader of them all has to be the Dallas Fed President, and you can read all about it in this article, Dallas Fed Fisher’s Prescience And GLD . In that article, I gave you the reason that the USD will rise, as the strong 5% GDP growth reinforces the possibility of an earlier rate hike and this will bring down the price of gold that is denominated in USD. In this article, I am now giving you another reason to sell which is to say that the Fed has capped all possibilities of inflation going higher than 2%. In all possibilities, inflation is more included to remain lower than what the Fed expects. My view is that the economy may grow, but inflation might not move towards the 2% target that is expected by the Fed. The tightening of monetary conditions by way of rate hikes will act as an inflation dampener in 2017. I have written about it in this article, Growflation And The 1% Fed Inflation Target In 2015 so I am not going to repeat myself. I am going to bring a new perspective of the declining yield of the 5-year treasury yields and how the Fed is responding to it. Instead of seeing it as a sign of a decline in inflation expectations, they see that it is possible that this could be due to an influx of funds due to the USD safe haven status. Inflation Compensation “Well, what I would say, we refer to this in the statement as “inflation compensation” rather than “inflation expectations.” The gap between the nominal yields on 10-year Treasuries, for example, and TIPS have declined-that’s inflation compensation. And five-year, five-year-forwards,as you’ve said, have also declined. That could reflect a change in inflation expectations, but it could also reflect changes in assessment of inflation risks. The risk premium that’s necessary to compensate for inflation, that might especially have fallen if the probabilities attached to very high inflation have come down. And it can also reflect liquidity effects in markets. And, for example, it’s sometimes the case that-when there is a flight to safety, that flight tends to be concentrated in nominal Treasuries and could also serve to compress that spread. So I think the jury is out about exactly how to interpret that downward move in inflation compensation. And we indicated that we are monitoring inflation developments carefully.” I have quoted Yellen on her answer above as this is a new concept. This would imply that the Fed would not take reference from market signals as credible inflation measurement for a while. This is evident in Yellen’s renaming of inflation expectation to inflation compensation instead. In other words, investors may expect 2% inflation in 5 years time, but increased demand for Treasury bills pushed down their actual yield to 1.538% (Current Yield of 1.66%-0.125% TIPS, see chart below). Hence, this 1.538% inflation market expectation is not a good gauge of actual inflation 5 years later. Source: Bloomberg This safe haven argument is not an unreasonable one, as Europe and Japan are still mired in economic troubles. Europe, Japan and Switzerland have all instituted negative interest rates, and it is only logical that international capital would flee these financial centers and enter into secure Treasury holdings, especially when the market has reasonable expectations that rates are going to rise soon. So to summarize it even further, Yellen is telling the world that the Treasury inflation pricing mechanism is malfunctioning now so don’t take it seriously. Since the Fed is going to raise rates soon, the danger is not that it would overshoot its inflation target, but rather that it will undershoot the inflation target. This is why I am bearish on gold as there is little upside to inflation to support gold prices. As long as the market continues its expectation that inflation is coming as the economy recovers, they will continue to overprice gold as there will be investors who will hold gold with a longer time horizon. Profiting with GLD In other words, there is a very slim possibility of high inflation in the days ahead, and the greater possibility is that inflation will undershoot the 2% target in the medium term. Hence, there is no reason to hold gold as an inflation hedge. As the new consensus builds around this, gold prices will continue its secular decline. The way for investors to profit from this is to sell the SPDR Gold Trust ETF (NYSEARCA: GLD ). There are other gold ETFs, but GLD is the most liquid at $27.45 billion market capitalization and 7.9 million of last known daily transaction. (click to enlarge) As you can see on the chart above, GLD has been on the bearish decline, but periodically there will be strength for which investors can sell on. This is indicative of a healthy market for which to sell GLD. The pullback indicates the profit taking of the bears. Of course, this bearishness of GLD will end one day as it approaches its true value. However, this will only happen after we see the significant portion of gold holders who hold in expectation of higher inflation as the economy grows give up their position. For most, this will only occur when they continue to see low inflation amid high growth. Then they will question themselves why they are willing to lose out on the economic growth by tying up their funds on their gold holding when there is very low inflation. So for readers who hold gold as an inflation hedge and are persuaded by my arguments, the time to sell gold is now before a flood of sell orders enter the market.

The Folly Of Forecasts

The new year has arrived, which means hangovers, doomed resolutions to lose weight, and a host of forecasts from the gurus in the financial media. I’m not sure which will cause more suffering. The attention investors give to market forecasts remains one of the great mysteries of human psychology. The evidence is overwhelming that no one possesses the ability to consistently call the direction of the stock market, bond yields, or currency rates. Yet every year the media invites experts to do what we know they can’t do. And every year investors listen to them, act on their recommendations and suffer the consequences . One reason this is allowed to go on is that forecasters are celebrated when they’re right but rarely held accountable for their bad calls. So last year I clipped several articles that included forecasts for 2014 so we could evaluate how accurate they turned out to be. Let’s start with the Outlook 2014 by CIBC World Markets, which included the following forecasts for equities, bonds and currencies: “US equities are hardly cheap given their run-up in 2013, but the Canadian market would appear to have more room to run … Within the equity market, what hasn’t played well in the past few years should now outperform. That includes equities tied to global growth rather than low interest rates, such as base metals and energy stocks.” The yield on 10-year Government of Canada bonds will rise from 2.68% in early December 2013 to 2.95% by the end of 2014. The Canadian dollar will strengthen modestly and the USD would end the year at about $1.05 CAD. Swing and a miss, strike three. All of these forecasts were dead wrong: US stocks outperformed Canada again, thanks in part to a very strong US dollar that closed the year near $1.16 CAD. The sectors forecast to outperform were the biggest flops in an otherwise strong market: base metals (using the BMO S&P/TSX Equal Weight Global Base Metals ETF as a proxy) were down about 10% on the year, and energy stocks (based on the iShares S&P/TSX Capped Energy ETF ) fell closer to 17%. And if you shortened your bond duration based on CIBC’s prediction of rising rates, well, that didn’t work out either: the yield on 10-year Canadas had fallen to 1.81% by December 30. The worst of the rest Next up: the Chief Investment Officer of Sun Life Global Investments, who shared his 2014 forecasts with Advisor’s Edge . He predicted the TSX would be in negative territory by the end of the year: “Stay away from Canada; we see a lot more headwinds continuing on.” Despite those headwinds, the broad Canadian market returned about 10% on the year. The CIO went on to encourage investors to invest more in Europe and emerging markets (both lagged North America significantly in 2014), reduce their bond allocations (bonds had their best year since 2011), and declared that “dividend stocks will continue to pay off” (several popular dividend-focused ETFs in Canada and the US underperformed the broad market). The forecasts from the US media were just as dismal. A survey of gurus by Business Insider resulted in a consensus forecast of 1,949 for the S&P 500 by the end of 2014: the index closed the year at 2,060, higher than all but one expert’s opinion. Over at the Motley Fool , investors were urged to shorten their bond exposure (oops, long bonds were up about 20%) and told that “Europe is particularly attractive” (for US investors, European stocks fell about 6%). Tune them out I don’t want to imply that these forecasters got everything wrong. On the contrary, some were dead on by predicting stable short-term interest rates, another strong year for US stocks, and weakness in commodity prices. Many others were half right – like those that got the direction right, but not the magnitude or the timing. But in any diverse collection of forecasts, many will turn out to be right simply by random chance. The lesson here is not that forecasts are always inaccurate: if they were, you could become wealthy being a contrarian. The point is that they’re worse than useless, as they are wrong far more often than they’re right. The only rational response is to ignore them all. Instead of listening the gurus this year, try a different tactic. Build a portfolio with a mix of stocks and bonds based on your ability, willingness and need to take risk. On the equity side, hold Canadian, US, international and emerging markets stocks at all times, and don’t try to guess which will be next year’s winner. With your fixed income, choose bonds or GICs according to your time horizon and your tolerance for volatility, not based on where you think interest rates will be next year. So listen to the talking heads if you must, but remember William Bernstein’s advice in Rational Expectations : “Don’t even think about trying to extrapolate macroeconomic, demographic, and political events into an investment strategy. Say to yourself every day, ‘I cannot predict the future, therefore I diversify.’”