Tag Archives: opinion

VGSH: For The Investor That Wants Reduced Exposure To A Hot Equity Market

Summary The Vanguard Short-Term Government Bond Index ETF is an intelligent holding within a portfolio, especially when the equity market is hot. The ETF has low volatility and low correlation with other important investments. The credit quality is excellent and the expense ratio is reasonable. The big weakness is a very weak yield. The fund is relatively similar to simply holding cash within the account. Within a diversified portfolio almost all of the risk (volatility) attributed to VGSH is eliminated. The Vanguard Short-Term Government Bond Index ETF (NASDAQ: VGSH ) is a very solid choice for investors trying to limit volatility in an equity market that has been trading at fairly high levels over the summer. By many fundamental measures, such as P/E, the equity market is feeling expensive enough that investors may want to consider increasing their bond exposure. Unfortunately, the yields on debt have been very low, contributing to higher valuations in the equity market. For investors wanting to see their portfolio risk reduced, VGSH is a great tool to get there. Duration The following chart breaks down the duration of the funds. Holdings are all less than 3 years and usually more than 1 year. Again, this is a solid choice. It shouldn’t be surprising that such short-term debt is unlikely to have any meaningful volatility since this is high quality government debt and the short duration limits any volatility from shifts in the yield curve. Of course, there is one major weakness, which is the fund having a yield of .56%. That is a pretty severe weakness for the ETF, but it is a cost of acquiring such low volatility. Some investors may point out that they might as well just deposit their cash in the bank. If the investor has that as an option, that is a fine choice. However, if the investor is working with funds in retirement accounts, that may not be an option. If the account is a 401k and the exposure needs to be accomplished through mutual funds, VGSH also trades as a mutual fund under the ticker (MUTF: VSBSX ). A Hypothetical Portfolio I put together a very simple sample portfolio using Invest Spy. Due to some of the ETFs being newer, the sample period is limited to a little over two years. (click to enlarge) This hypothetical portfolio is weighted to 60% equity and 40% bonds. To break that down, the weights from the equity section are 30% total market index (NYSEARCA: VTI ), 10% equity REITs (NYSEARCA: VNQ ), 5% Utilities, 5% Consumer Staples (NYSEARCA: VDC ), 10% International Equity. The bond section is holding 10% in junk bonds (NYSEARCA: JNK ), 5% in extended duration treasuries (NYSEARCA: EDV ), 5% in emerging market government bonds (NASDAQ: VWOB ), 5% short term corporate debt (NASDAQ: VCSH ), 5% in short term government debt , 5% in mortgage backed securities (NASDAQ: VMBS ), and 5% in intermediate-term corporate bonds (NYSEARCA: BIV ). This portfolio won’t be perfect for hitting the efficient frontier, but it should beat the vast majority of real portfolios investors are using on a risk-adjusted basis. If long-term rates were higher, I would have used a higher weighting for long duration bonds due to their exceptional correlation to major equity classes. My disclosure already states it, but I’ll reiterate that I am long VTI and VNQ. Annualized Volatility When measuring risk-adjusted returns for a portfolio, the most efficient method is usually to use the Sharpe ratio. For that ratio, we are taking the total return annualized return and subtracting the risk free rate. Then we divide the resulting number by the annualized volatility. The problem is that this metric is only really known after the fact. Predicting the level of returns in advance is problematic, but correlations and relative volatility are more reliable over time than returns. Within the chart investors can see the annualized volatility of each holding as well as the resulting annualized volatility for the portfolio. While some holdings have higher annualized volatility scores, such as EDV, the ETF makes up for that by having negative correlation to a few of the equity holdings. As a result, the ETF only contributes .6% of the total risk in the portfolio. VGSH has an annualized volatility of .9%, which is extremely low. Once we adjust for correlation, the risk contribution to the portfolio is only .1% of the total. That means VGSH fits extremely well in this kind of hypothetical portfolio. This is fairly similar to using cash as part of the portfolio value except the returns over time here should be positive. I wouldn’t bother using VGSH outside of a retirement account, but it is a fine holding to use within the retirement account if the investor is concerned about the high valuations in the market. Correlation I want to dive a little deeper into the correlation statistics. The table below provides the correlation across each of those ETFs, which should make it very quick to see which ones are work very well together. When a correlation is shown in the tan color, it indicates a negative correlation which is very attractive for reaching the efficient frontier. You’ll notice that quite a few of the bond funds have negative correlations to VTI and the S&P 500 (NYSEARCA: SPY ). Since VTI and SPY have a correlation ranging between 99% and 99.9%, depending on the measurement period, it should not be surprising that those two funds have very similar correlations to other holdings. Here is the correlation table: (click to enlarge) Conclusion The expected returns on VGSH will regularly be weak when yields are already very low. On the other hand, with high valuations throughout the equity market, there is a solid argument for keeping part of the portfolio protected from the fluctuations in equity valuations. Disclosure: I am/we are long VTI,VNQ. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. 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.

This Small-Cap International ETF Is Really Growing On Me

Summary SCHC has incredible diversification within the holdings. The ETF needs to be combined with domestic equity ETFs and bond ETFs to be at its best. The expense ratio is higher than most of the ETFs I’m considering, but .18% is better than most international ETFs. I may need to sell off some VNQI and add some SCHC. 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 contemplating changing the way I structure my portfolio and I’m going to be analyzing several of the ETFs that I am considering. One of the options is the Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ). 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. Expense Ratio The expense ratio is .18% which is one of the higher expense ratios out of the ETFs I’m consider, however it is vastly lower than many international options and is in a fairly small niche with targeting small-cap international equity. Most international equity funds would simply hold the international companies with larger market capitalizations. This ETF is nice because it allows investors a different exposure. Largest Holdings The internal diversification is out of this world. There are no holdings higher than 1% and only 1 that is higher than .45%. For getting diversification of holdings into the portfolio SCHC is a very impressive option. (click to enlarge) The diversification includes over 1600 companies which is more than I can recall for any of the international ETF options I’ve considered. Investors should be aware that during periods of financial stress in the international markets the correlation of returns is increased so SCHC may exhibit high correlation despite having very different holdings. I would treat that correlation as a market failure and just keep rebalancing the portfolio as necessary. Even if the high correlation in international investments is a market failure that does not reflect underlying value, remember that values can remain irrational for longer than some investors can remain solvent. Building the Portfolio I put together a hypothetical portfolio using only ETFs that fall under the “free to trade” category for Charles Schwab accounts. My bias towards these ETFs is simple, I have my solo 401k there and recently moved my IRA accounts there as well. When I’m building a list of ETFs to consider I want to focus on things I can trade freely so that I can keep making small transactions to buy more when the market falls. Within the hypothetical portfolio there are no expense ratios higher than .18%. Just like trading costs, I want to be frugal with expense ratios. The portfolio is fairly aggressive. Only 30% of the total is allocated to bonds and I would consider that the weakest area in the portfolio. I’d like to see more bond options (with very low expense ratios) show up on the “One Source” list for free trading. (click to enlarge) A quick rundown of the portfolio The Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) is a dividend index. The Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) is a broad market index. The Schwab U.S. Large-Cap ETF (SCHX ) is focused on blended large cap exposure. The Schwab International Equity ETF (NYSEARCA: SCHF ) is developed international equity. The Schwab Emerging Markets ETF (NYSEARCA: SCHE ) is emerging market equity. The Schwab U.S. REIT ETF (NYSEARCA: SCHH ) is domestic equity REITs. The Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) is a remarkably complete bond fund. The SPDR Barclays Long Term Treasury ETF (NYSEARCA: TLO ) is a long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) is an extremely long term treasury ETF. Notice that the 3 international equity ETFs have only been weighted at 5% while the broad market index has been weighted at 25%. I find heavy exposure to international equity to bring more risk than expected returns so I try to keep my international exposure low. I prefer no more than 20% in international equity. Plenty of domestic companies already have enormous international operations so the benefit of international diversification is not as strong as it would be if the markets were isolated from each other. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. When TLO and ZROZ post negative risk contribution it is because the negative correlation to most of the equity holdings results in the long term treasury ETFs reducing the total portfolio risk. In my opinion, this is the best argument for including them in the portfolio. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Best Partners SCHC stands to benefit from being mixed with bond funds. The longer bond funds such as TLO and ZROZ exhibit the strongest negative correlation at -.42 and -.44 respectively. To reach a more optimal portfolio when using SCHC it would be wise for the investor to use a material allocation to bonds. Within the equity investments the lowest correlations are SCHH and SCHD. When I first looked at SCHC last year, I didn’t like it as much because the .18 expense ratio was higher than I wanted to pay on my ETF investments. I do have a strong desire for low expense ratios, but I think SCHC is investing in a smart area. Small capitalization was a great area for indexing in the U.S. market for a long time before investors caught on and widespread use of whole market indexes and broad market indexes allowed the average investor to gain effective small-cap exposure. While the international markets used in SCHC are reasonably developed, there may still be some outperformance in those markets. At the very least, there are 1600 companies that won’t get heavy exposure anywhere else in my portfolio. Conclusion I like SCHC now more than I did when I first looked at it. Perhaps it is simply seeing the market fall in August, but I’m placing a larger emphasis on designing my portfolio to be simple for rebalancing and to drive the portfolio volatility down. Currently all of my international equity exposure is through SCHF and the Vanguard Global ex-U.S. Real Estate ETF (NASDAQ: VNQI ). I’m contemplating selling off the VNQI and reallocating it to Schwab funds to make my portfolio easier to rebalance and to take advantage of lower expense ratios. I like the use of international REITs in VNQI, but I don’t like the expense ratio of .24%. I may initiate a small long position in SCHC in the near future. As of submission, I have a small limit buy order entered that is significantly below the market price. If shares take a sudden fall, I will be starting a small position. Disclosure: I am/we are long SCHB, SCHD, SCHF, SCHH, VNQI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. 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.

VAW Is A Great Idea, But The Portfolio Is Not Optimized For The Lowest Risk In The Sector

Summary VAW has a great expense ratio that makes it seem appealing at first glance. When I get into the holdings, I have to question their use of FCX rather than combining RIO or BHP with XOM to replicate mining and oil. With a weak dividend yield, high volatility, and high correlation to the S&P 500, I don’t see a long term holding. The ETF may be a solid option for making short term bets on the direction of the sector. The Vanguard Materials ETF (NYSEARCA: VAW ) offers investors a concentrated sector exposure. The holdings are fairly concentrated within the portfolio, but it is a Vanguard fund with a .12% expense ratio which makes it worthy of consideration Does VAW provide diversification benefits to a portfolio? Diversification benefits are primarily a factor of correlations and variance of returns. Looking back to January 2004 the correlation between VAW and the SPDR S&P 500 Trust ETF ( SPY) was 88% and the volatility for VAW was substantially higher at 25.4% compared to 19.4%. Due to the high correlation and high variance, it is not feasible to use VAW to reduce the risk at the portfolio level unless the starting level of risk was exceptionally high. If the core holding in the portfolio is representing the S&P 500 or the a broad market index, the position in VAW increases the total volatility. Yield & Taxes The distribution yield is 1.86%. That is not high enough to be considered for a dividend growth investor, but the volatility would have made this portfolio less desirable for those dividend growth investors and retirees anyway. Market to NAV The ETF is at a .01% discount to NAV currently. Premiums or discounts to NAV can change very quickly. Liquidity is not terrible, but an average volume around 60,000 shares is not as high as investors might be expecting for a Vanguard fund. Largest Holdings The chart below shows the top 10 holdings: (click to enlarge) The diversification within the ETF is not very strong if we are simply looking at the percentage of the portfolio in each company. On the other hand, if we look at the operations of the individual companies the picture changes materially. For instance, Freeport-McMoRan (NYSE: FCX ) is in my portfolio and regularly helps me lose money. I’m not too happy about that last sentence either, but the portfolio values don’t lie. Freeport-McMoRan is heavily invested in copper mining and oil drilling. The other companies offer investors very different exposure. While the fund is concentrated on the “Materials” sector, the individual companies are still fairly different. If the intent was to own a mining company, I’m a little surprised that Vanguard did not choose to hold shares in a more stable mining company such as BHP Billiton (NYSE: BHP ) or Rio Tinto (NYSE: RIO ) since they both have more diversified mining portfolios and lower cost operations. I assume they did not select Freeport-McMoRan for the oil exposure because they could have picked a much more stable like Exxon Mobile (NYSE: XOM ) if they were trying to include oil exposure. Volatility Comparison To show how much more volatile FCX is compared to using a combination of Rio Tinto and Exxon Mobil, I pulled the following chart from Investspy: (click to enlarge) For comparison sake I set the weight on FCX to 50% and the weights on RIO and XOM to 25% each. While Rio Tinto and Freeport-McMoRan had similar levels of volatility over the sample period, Rio-Tinto would have given the mining exposure with a smaller allocation so the oil exposure could be picked up by XOM. In this simple example FCX would have contributed 61.5% of the risk and XOM and RIO would have combined to contribute only 39.5%. This is a function of XOM simply being a much safer play for including oil exposure in the portfolio. If the oil exposure is not wanted, then the use of Freeport-McMoRan feels pretty strange. Conclusion VAW has a great expense ratio but it simply brings too much volatility for having such a high correlation with the S&P 500. When it comes to selecting companies for the portfolio, it seems like part of the risk stems from selecting companies that are riskier than necessary for creating the desired exposure. I’d rather see VAW modify the portfolio to get the “materials” sector exposure with as little volatility as possible. As it stands, VAW seems like a more useful ETF for making bets on sector movements than as a long term tool for generating wealth with the lowest level of risk possible for the expected returns. Disclosure: I am/we are long FCX. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. 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.