Tag Archives: security

Cybersecurity – Beating HACK And CIBR From The Inside

Summary The ETFs, HACK and CIBR, overlap on 23 companies, six of which are among the top-ten holdings of each fund. Given the strength of the performance of some of the companies on which the ETFs overlap, it seems plausible to derive a smaller portfolio that would outperform either ETF. I consider two portfolios made up of holdings shared by both ETFs, and consider whether the performance gains are worth the tradeoff in security. When looking at a new ETF, I often find myself wondering if – given the ETF’s portfolio – there was a subset of that portfolio that would outperform the ETF itself, and not just outperform it, but outperform it by a significant amount . 1 How would one go about identifying that subset? I began thinking about this in detail as I wrote my last article, a comparison of two new ETFs – the PureFunds ISE Cyber Security ETF (NYSEARCA: HACK ) and the First Trust NASDAQ CEA Cybersecurity ETF (NASDAQ: CIBR ). 2 The funds, which take two fairly different approaches to investing in cybersecurity, have holdings that overlap with 23 companies. What I thought was particularly interesting was that the top-ten holdings in each portfolio overlapped on six companies. The funds weighted their holdings differently, with HACK having a modified equal-weighting structure, and CIBR being weighted according to market liquidity over the preceding 90 days. Would stocks in these companies outperform either or both ETFs? Group I The six companies that were among the top-ten-weighted holdings in both portfolios are: Cisco Systems, Inc. (NASDAQ: CSCO ) Fortinet, Inc. (NASDAQ: FTNT ) Imperva, Inc. (NYSE: IMPV ) Palo Alto Networks, Inc. (NYSE: PANW ) Proofpoint, Inc. (NASDAQ: PFPT ) Trend Micro Inc. ( OTCPK:TMICY ) The question: could holdings in these six companies ( Group I ) be reasonably expected to outperform HACK and/or CIBR? To answer the question, I traced the portfolios of the two ETFs back to August 1, 2010, and charted their performance through August 31, 2015. 3 I then tracked Group I apart from the ETFs. Each portfolio started with a $25,000.00 stake. 4 The results: (click to enlarge) Group I quite clearly outperformed both ETFs, growing the initial stake to $88,971.99 (a gain of more than 255% ), compared to HACK with $55,925.78 (~ 123%) and CIBR with $57,892.92 (~ 131%). A difference in growth of that magnitude over a period of five years certainly seems significant, by just about any standards. In principle, it would seem rational for an investor to choose to invest in the six companies that make up Group I rather than investing in either of the ETFs. A Caveat But while it might seem to be a good bet to buy shares in the Group I companies, upon closer examination there are some problems to consider. The following table lists some of these companies’ fundamental data: Of the six companies, only Cisco , Fortinet and Trend Micro stand up to close scrutiny. Each one is profitable; 5 all have manageable debt ( Cisco has the highest debt/equity ratio, at 0.44%, but its quick ratio is a very healthy 3.15); gross margin and operating margin for each are comparable to or better than those of their peers. The remaining three companies – Imperva , Palo Alto and Proofpoint – present a significantly different picture. None of these companies has made a profit in the five-plus years represented in the test; indeed, these companies have been losing substantial amounts of money annually. The companies have financed operations through sale of shares – thus diluting shareholders’ holdings – and by incurring debt. Only Imperva has maintained a low D/E ratio, with Palo Alto ‘s D/E rising just above 1, and Proofpoint ‘s D/E topping out at 3.78. Readers familiar with my approach to companies know that I focus heavily on fundamentals, particularly operating margin, returns, debt/equity and quick ratio. Only Cisco and Trend Micro come close to meeting my usual minimum standards. 6 Investing in companies that have a losing track record is a very subjective enterprise. On the one hand, I dismiss companies that habitually post losses out of hand; on the other hand, not all “losing” companies are bad bets. But investing in one requires that one take a leap of faith, and it’s not a leap to be taken lightly. I highly recommend serious study of such a company before investing in it. 7 Group II To go around the problem of investing in “losing” companies, I graded the 23 holdings over which HACK and CIBR overlapped. Interestingly, nine of those companies were operating in the red, and since operating margin and the three returns count heavily in my ranking system, those nine companies were excluded. Three more companies were excluded because they are foreign (this includes Trend Micro , even though it is one of the companies in Group I ). I still feel uncertain about foreign investments. After ranking the 11 companies remaining, I ended up with the following set of five stocks to make up Group II : 8 Check Point Software Technologies Ltd. (NASDAQ: CHKP ) CyberArk Software Ltd. (NASDAQ: CYBR ) F5 Networks, Inc. (NASDAQ: FFIV ) Qualys, Inc. (NASDAQ: QLYS ) VASCO Data Security International, Inc. (NASDAQ: VDSI ) The following table shows their “vital statistics”: In principle – on the basis of their fundamentals – I would consider these to be the top five of the 23 companies shared by the two ETFs. How do they perform? I subjected Group II to the same test I ran for Group I , with the following results: (click to enlarge) While it is clear that Group II does markedly better than either HACK or CIBR, it is also clear that it falls far short of the performance of Group I . The following chart shows how the two groups compare: (click to enlarge) Group I clearly outperforms Group II and does so quite handily, with its growth outpacing the latter group by more than 25%. I’m not certain that this means Group I is the better set of stocks, though; consider this chart: (click to enlarge) The past 20 months or so have been rough on the market in general, and particularly so for tech stocks. The spring of 2014 saw tech stocks take a hit with no general, significant driving force other than that the stocks were perceived as overvalued; this past summer saw the market as a whole go through a “correction” attributed to ((a)) growing concern over weakness in the Chinese economy , ((b)) a perceived weakening of the economic recovery in America , ((c)) a meltdown in oil prices , and ((d)) the prospect of the Fed raising interest rates . It is interesting to note, then, that Group II outperformed Group I during the stretch from January 1, 2014, through August 2015. The difference is not great, all things considered, but it serves to remind investors that a stock’s (or a portfolio’s) performance is dependent upon the perspective from which it is viewed. Assessment Moreover, since we are supposed to acknowledge that we cannot infer future performance simply on the basis of past performance, we need to look at an investment from a variety of perspectives. There is a distinct difference between the market of 2010 – 2013 and the market of 2014 – mid-2015 . The former was a significant part of the extended bull market that led the economy out of the Great Recession; the latter has been a period where the bull market has weakened (and maybe died), culminating in a summer-long correction . There is no surprise that stocks are going to rise (some, dramatically) when the market is hot; the surprise would be those companies that (continued to) drop in value. On the other hand, when the market in general is stumbling, one should maybe take note of performance that seems to “buck” the trend by showing a little strength; during such a period, 1200bps may have no small significance in comparing the relative strengths of a couple of portfolios. Looking at Group I , Imperva , Palo Alto and Proofpoint are losing money annually and persistently. According to Capital Cube, all three stocks are overvalued; Palo Alto has lost over $375 million in the past two years, yet currently commands a price over $179.00/share – with key valuations well in excess of its peers. 9 The stocks in Group II , on the other hand, have maintained solid fundamentals. Three of the companies ( Check Point , CyberArk and Qualys ) are perhaps overpriced, but Check Point is posting solid numbers comparable to F5 and VASCO , and none of the companies seems to be showing any problem areas. Being somewhat (!) risk averse, I would likely prefer the holdings listed in Group II , perhaps with Cisco (or Trend Micro ) added for good measure. However The advantage of an ETF such as HACK or CIBR is that one does not have to worry about the performance of the individual stocks in one’s portfolio – that is the fund manager’s job. There is a tradeoff involved, and it is up to the individual investor to decide if the prospective loss of growth that might be realized by investing in a basket of stocks is worth the work involved in choosing and monitoring a hand-picked selection of individual holdings. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from the Company’s SEC filings to the extent possible. All tables, charts and graphs are produced by me using pertinent SEC filings as provided by Capital Cube ; historical price data is from The Wall Street Journal . Data from any other sources (if used) is cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. ——————– 1 Of course, what counts as a “significant amount” is fairly subjective. A 25% improvement would be significant, I should think, but would 5% be significant – and in one year? Five years? I should think there would be a correlation between the length of time one was discussing and the level one would consider “significant” an improvement of 1000bps (when speaking of performance), or 10% (when talking about value) over five years would seem to be a safe margin to consider significant – while an improvement of 500 bps (or 5%) over 2 years would be perhaps a little less significant. Also, we can ask what it means to be “significant.” Again, this is fairly subjective, but let’s suppose we’re talking about the level of difference at which one would seriously consider investing in the subset, rather than in the ETF itself. I might consider the chance of a 2% improvement over the first year to be enough to convince me, while someone else might not be convinced with anything less than 5%. Yet another person might opt for the ETF even if there was reasonable prospect of improving the payout by 25% by investing in the subset. 2 ” 2 New ETFs Track Cybersecurity Growth ,” Seeking Alpha , August 24, 2015. 3 While the ETFs are new within the past nine months, I traced the performance of their portfolios as they existed on August 21, 2015, maintaining the same weighting throughout as they had on that date. Companies that did not start trading until after August 2010 were added during quarterly rebalancing and reconstitution; funds that would have applied to those companies were held in reserve until they “formally” joined the portfolio. To differentiate between the ETFs and the extension of their portfolios, I will refer to the portfolios as HACKʹ and CIBRʹ . Please note that the data for their portfolios is not intended to indicate how the ETFs themselves would have performed over the same period. 4 The portfolios for HACKʹ and CIBRʹ were weighted according to note 3 above. Group I was weighted equally. All portfolios were rebalanced and reconstituted quarterly. 5 For the period of the test (August 2010 – present) each of the three companies has recorded net profit for each of the years included. 6 In many of my articles I rely on a fairly small set of fundamental criteria that emphasize efficiency, effective management and financial responsibility. In the past, my basic standards were: OM > 25%; RoE, RoA and RoI > 15%; D/E < 0.5; QR > 1. 7 For my part, I have a moderate stake in Neuralstem, Inc. (NASDAQ: CUR ), and have had one for a few years. It has not made a profit since before I bought shares. I did my homework before investing in Neuralstem, and while its fundamentals are very weak, I believe that their business – and the science behind it – is sound, and all indications are that it will, in the very near future, show some of the enormous promise it has. Before it took a serious dive this year, it had been a four-bagger for me. 8 The number five is totally arbitrary. A group of six or more (or four or less) might work, but five seems like a nice number to work with. As luck would have it, an extension to six would have included Cisco, which missed membership in Group II by only a few points. 9 See here , for instance. Also, as a matter of fact, according to Capital Cube only Cisco – out of all of Group I – is undervalued. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: I am/we are long CUR. (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.

Building A Hedged Portfolio Of Governance Metrics International’s Top-Ranked Stocks

Summary A way to potentially boost your returns when building a concentrated portfolio is to start with stocks that are rated highly by quantitative analysis. The Governance Metrics International, or GMI, rating system uses quantitative analysis to assess financial reporting and corporate governance, and determine which stocks are likely to substantially outperform the market. With any quantitative system, there’s a risk the analysis will be wrong, or the market will move against you. Using the hedged portfolio method can limit your downside risk. We show how to create a hedged portfolio starting with top-rated GMI stocks, and provide a sample hedged portfolio designed to limit downside risk to a 20% drawdown. In the Wake of Enron, A Focus On Financial Reporting One of the forensic accounting firms founded in the wake of Enron’s fraud was Audit Integrity, which later changed its name to Governance Metrics International (GMI), and was acquired by MSCI ‘s ESG Integration Unit last year. GMI uses a proprietary quantitative approach to analyze the financial reports and governance practices of public companies. The best-known indicator GMI uses is its Accounting and Governance Risk ( AGR ) ratings, which range from “Very Aggressive” to “Conservative.” According to GMI, companies rated “Very Aggressive” are 10 times more likely to face SEC enforcement actions than those rated “Conservative,” and 4 times more likely to file for bankruptcy. GMI uses its AGR ratings to derive its AGR Equity Risk Factor, which it considers to be a leading indication of share performance. AGR Equity Risk Factor ratings range from 1 (“Substantially Outperform Market”) to 5 (“Substantially Underperform Market”). We’re going to start with the universe of GMI’s 1-rated stocks to build a concentrated, hedged portfolio. Why a Concentrated Portfolio The point of a concentrated portfolio is to invest in a handful of securities with high potential returns, instead of a larger number of securities with lower potential returns. As Warren Buffett noted in a lecture at the University of Florida’s business school in 1998: If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is going to be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. Why a Hedged Portfolio Because we’re not Warren Buffett. We don’t have vast wealth to absorb large losses, and hedging limits our downside risk in the event that we pick the wrong stocks, or the market moves against us. There is, of course, a tradeoff between what we are willing to risk and our potential return. Risk Tolerance and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance — the greater the maximum drawdown he is willing to risk (his “threshold”, in our terminology) – the higher his potential return will be. So, we should expect that an investor who is willing to risk a 25% decline will have a chance at higher returns than one who is only willing to risk, say, a 15% drawdown. For the purposes of this example, we’ll split the difference and create a hedged portfolio designed for an investor with $100,000 who is willing to risk a drawdown of no more than 20%. Constructing A Hedged Portfolio We’ll summarize process the hedged portfolio process here, and then explain how you can implement it yourself. Finally, we’ll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this: Find securities with high potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion — or the market moves against you — your downside will be strictly limited. How to Implement This Approach Finding promising stocks In this case, we’re going to start with the universe of stocks rated by GMI as likely to “substantially outperform the market”. To quantify potential returns for these stocks, you can, for example, use analysts’ price targets for them and then convert these to percentage returns from current prices. In general, though, you’ll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net potential returns. Our method starts with calculations of six-month potential returns. Finding inexpensive ways to hedge these securities First, you’ll need to determine whether each of these top holdings are hedgeable. Then, whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-20% decline over the time frame covered by your potential return calculations (our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months). And you’ll need to calculate your cost of hedging as a percentage of position value. Selecting the securities with highest net potential returns In order to determine which securities these are, out of the list above, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and exclude any security that has a negative potential return net of hedging costs. Fine-tuning portfolio construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you’re going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you’ll need to take into account the share prices of the securities. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. Calculating Expected Returns While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. An Automated Approach Here we’ll show an example of creating a hedged portfolio starting with 1-rated GMI stocks using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . Narrowing Down Our List of Stocks To get the universe of 1-rated GMI stocks we used Fidelity ‘s screener to screen for optionable stocks rated 1, or “substantially outperform” according to the GMI AGR Equity Risk Rating. Since over 1,000 stocks met those two criteria, we added a third: 52-week price performance in the top 20% by industry. That winnowed the list to 247 names, and we picked the top 5 to input into our automated hedged portfolio construction tool: ABIOMED (NASDAQ: ABMD ) Bassett Furniture Industries (NASDAQ: BSET ) Sketchers USA (NYSE: SKX ) JetBlue Airways (NASDAQ: JBLU ) Universal Insurance Holdings (NYSE: UVE ) Using the Automated Tool In the first step, we enter the five ticker symbols in the “Tickers” field, the dollar amount of our investor’s portfolio (100000) in the field below that, and in the third field, the maximum decline he’s willing to risk in percentage terms (20). In the second step, we are given the option of entering our own potential return estimates for each of these securities. Instead, in this case, we’ll let Portfolio Armor supply its own potential returns. A couple minutes after clicking the “Create” button, we were presented with the hedged portfolio below. The data here is as of Monday’s close. Why These Particular Securities? The site included all of the entered securities for which it calculated a positive potential return, net of hedging costs. In this case, that turned out to be three of the five stocks, ABMD, JBLU, and SKX. Since it aims to include four primary securities in a portfolio of this size, and only three of the ones we entered had positive net potential returns, Portfolio Armor added one of its own top-ranked stocks, Post Holdings (NYSE: POST ). In its fine-tuning step, it added Restoration Hardware (NYSE: RH ) as a cash substitute. Let’s turn our attention now to the portfolio level summary for a moment. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before their hedges expired, the portfolio would decline 18.78%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -0.26%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 12.07% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 4.93% represents a conservative estimate, based on the historical relationship between our calculated potential returns and backtested actual returns. By way of comparison, a hedged portfolio created on Friday using the same and decline threshold (20%), but without entering any ticker symbols (i.e., letting Portfolio Armor pick all the securities), had an expected return of 6.1%. You can see that hedged portfolio in a recent article (“Investing While Guarding Against Extensive Vertical Losses”). Each Security Is Hedged Note that each of the above securities is hedged. Restoration Hardware, the cash substitute, is hedged with an optimal collar with its cap set at 1%, and the remaining securities are hedged with optimal collars with their caps set at each underlying security’s potential return. Here is a closer look at the hedge for JetBlue: JetBlue is capped here at 14.25%, because that’s the potential return Portfolio Armor calculated for it over the next several months. As you can see at the bottom of the image above, the cost of the put protection in this collar is $1,050, or 5.7% of position value. But if you look at the image below, you’ll see the income generated from selling the calls is $735, or 3.99% of position value. So, the net cost of this optimal collar is $315, or 1.71% of position value.[i] Note that, although the cost of hedging this position is positive, the cost of hedging the portfolio as a whole is negative. Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this instablog post on hedging the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ). [i]To be conservative, this optimal collar shows the puts being purchased at their ask price, and the calls being sold at their bid price. In practice, an investor can often buy the puts for less (i.e., at some point between the bid and ask prices) and sell the calls for more (again, at some point between the bid and ask). So the actual cost of opening this collar would have likely been less. That’s true of the other hedges in this portfolio as well. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (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.

TLO: Long Term Treasury Securities For Portfolio Stability

Summary TLO offers investors a low expense ratio and a negative beta. The average effective duration is around 17 years but the actual breakdown on securities is in the 10-15 range and heavily in the 20 to 30 year range. Negative correlation with major equity investments makes TLO an intelligent choice for diversifying the portfolio. For investors that are going heavy on bond funds, I would start with SCHZ and then add on TLO as a second option. For investors going heavy on equity and only using bonds for diversification, I would start with ZROZ and then use TLO as the secondary option. The SPDR Barclays Long Term Treasury ETF (NYSEARCA: TLO ) is an option for investors seeking exposure to the longer portion of the treasury yield curve. This kind of allocation can be used for an investor seeking interest income (2.6% yield) and willing to take on duration risk. However, I think the best use of this fund by a significant margin is to use it in a portfolio that goes overweight on equity securities and uses regular rebalancing to take advantage of the highly negative correlation between TLO and the major market indexes. Expense Ratio The fund has an expense ratio of .10% which is very solid for bond ETFs. I’d still like to see it get into the single digits because I’m very frugal with expense ratios, but I wouldn’t complain about including an ETF with a .10% expense ratio in my portfolio. Quick Figures Over 99.8% of the holdings of the security are invested in domestic government debt. This is quite simply a quick way to get government debt into your portfolio without paying high trading costs. Rationale If the purpose of the position is to keep the portfolio properly balanced and reduce the volatility of the portfolio, then it makes sense to treat trading costs as a major issue due to rebalancing. TLO is one of the options on Schwab’s free ETF trading system which was a major reason for it going onto my short list of treasury ETFs. Fixed Income Statistics The statistics below provide a rough idea of the numbers on the portfolio. The bonds trade at a substantial premium due to having higher coupons. (click to enlarge) While those numbers are useful for an initial impression, I think it is important to also look at the breakdown along the yield curve because this is not a bullet fund where the bonds are all maturing in a very tight date range. Maturity The SPDR Barclays Long Term Treasury ETF is primarily using the 20 to 30 year debts but also contains a material allocation to the 10 to 15 year range. (click to enlarge) Having a small allocation to the 10 to 15 year range should make TLO less volatile than some other treasury security ETFs. On one hand that is a positive factor in isolation but for investors using their bond allocation strictly for negative correlations the longest exposures and higher volatility can produce the appropriate hedge against equity volatility with smaller allocations. 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 (NYSEARCA: 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 International Small-Cap Equity ETF (NYSEARCA: SCHC ) is developed small capitalization 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. 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) Conclusion TLO and ZROZ post fairly similar numbers on negative correlations and if I was simply using the ETF for producing some income it would be easy to select TLO over ZROZ. On the other hand, because the correlations are so negative, higher volatility in the ETF can become an attractive feature. The quickest way to demonstrate this factor is to look at the negative beta for each ETF. On TLO the beta is a negative .49 and on ZROZ the beta is a negative .90. TLO is a good option with rebalancing to make a steadier portfolio value. For the simple purpose of stabilizing portfolio values I think ZROZ a quicker way to accomplish my goal because I can use a smaller allocation to the bond ETF to maintain the negative beta exposure that reduces the overall volatility of my portfolio. If an investor wants more bond allocations, then I think they should start with diversified exposure like SCHZ and then look to add TLO before adding ZROZ. If the goal is simply creating negative beta for the portfolio, the order of the ETFs would be reversed with investors favoring ZROZ, then TLO, and finally SCHZ. Disclosure: I am/we are long SCHB, SCHD, SCHF, SCHH. (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.