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AGG: A Solid Bond Fund Offering Low Expenses And Diversification

Summary The expense ratio on AGG is one of the drawing factors for this fund. At .08% it is one of the cheapest bond funds in the market. The fund has extensive diversification in the maturity of the bonds which provides more diversification in the risk. The credit ratings are fairly high with a significant allocation to treasury securities. Allocation to MBS does not thrill me since mREITs are available at material discounts to book value, but the low expense ratio still helps the expected return. Overall, there is more to like about this fund than to dislike. The major risk factor facing the fund is rising domestic rates. The iShares Core Total U.S. Bond Market ETF (NYSEARCA: AGG ) is a highly diversified bond fund with a reasonable yield, great expense ratio, and great liquidity. Expenses When I’m looking for a bond ETF, I normally want to see diversification in the holdings. The only real exception would be if I’m looking for treasuries with a fairly steady maturity date. Getting any thorough due diligence on the bonds in a fund can require having a higher expense ratio to cover the costs of doing research. The challenge for a bond fund with a high expense ratio to create solid returns is that it requires them to be doing sufficient research to consistently produce superior default estimates to those available in the market or to have a method for acquiring bonds at a discount by dealing in illiquid bonds where counterparties are more difficult to find. Some funds are able to offer low expense ratios and mitigate their risks by strictly dealing in the most liquid bonds where pricing is most likely to be efficient and relying on the market to ensure that the risk/return profile is appropriate. Generally I favor ETFs that have low expense ratios and strictly deal in highly liquid bonds where the pricing will be more efficient. The expense ratio for AGG is a .08%. This is one of the funds falls into my desired strategy of using highly liquid securities and a very low expense ratio to rely on the efficient market to assist in creating fair values for the bonds. Yield The yield is 2.41%. The desire for a higher yield should be fairly easy for investors to understand. Bond funds that offer a higher yield are offering more income to the investor. Unfortunately, returns are generally compensating for risk so higher yield funds will usually require an investor either take on duration risk or credit risk. In many situations, an investor will take on a mix of the two. Junk bond funds generally carry a high degree of credit risk but low duration risk while longer duration AAA corporate funds have only slight to moderate credit risk combined with a significant amount of duration risk. Theoretically treasuries have zero credit risk and long duration treasuries would have their risk solely based on the interest rate risk. Duration The following chart demonstrates the sector exposure for this bond fund: At the present time I’m concerned about taking on duration risk in early December because of the pending FOMC (Federal Open Market Committee) meeting. I believe it is more likely than not that we will see the first rate hike in December. I think a substantial portion of that probability has already been priced into bonds, so investors willing to take the risk prior to the meeting could see significant gains if the Federal Reserve does not act. Even though most of the impact is priced in, I suspect it will happen and that there will be some impact on rates which may trigger a solid opportunity for starting investments in bonds. I’ll be looking to increase my positions in interest sensitive assets if rates move higher. I’ve been focused on bond funds that are free to trade for me or have a longer duration exposure to corporate debt, but AGG is a pretty solid option for investors looking to add bonds in December. Credit Risk The following chart demonstrates the credit exposure for this bond fund: The exceptionally high rating to triple AAA stocks includes positions in treasury securities. The very high credit rating of this fund is excellent for investors looking for something that can withstand a sharp decline in the equity market. Rather than declining with equity markets this bond fund should see strength in share prices when investors are scared about the risk of higher defaults and weaker equity performance. When things look ugly, this fund should perform well. When things look great, this fund should underperform some of the riskier options. Sectors The following chart demonstrates the sector exposure for this bond fund: I have some concerns about the sector allocation including a substantial allocation to MBS Pass-Through securities. There are several mREITs where investors can get MBS exposure at a substantial discount to book value. On the other hand, that exposure also includes exposure to hedging the portfolio with Eurodollar Futures contracts in most scenarios and the expenses of management for an mREIT will dramatically exceed the .08% expense ratio of holding AGG. Conclusion Overall the diversification here is pretty solid and I don’t see much to complain about. This is one of the largest bond funds on the market and it offers great liquidity, a decent but not incredible yield, and a very low expense ratio. That liquidity extends to the point of millions of shares trading in a single day. That keeps the bid-ask spread small and makes trading in and out the ETF much easier for investors that want to use it to stabilize their portfolio value.

IJR: A Small Cap ETF With A History Of Beating Peers

Summary IJR has very solid diversification within the portfolio. No holdings were listed over .7% and most were below .5%. The ETF has a great expense ratio that is comparable to funds from Schwab and Vanguard. The fund is heavy on the financial sector. The fund reports a beta of .84; however my calculations through InvestSpy suggested a beta of 1.16 for 5 years which was similar to other ETFs holding the same size. The iShares Core S&P Small-Cap ETF (NYSEARCA: IJR ) looks like a fairly reasonable ETF for investors seeking more exposure to small capitalization markets. The fund tracks the S&P SmallCap 600 Index which covers about 3% of the domestic equity market. Stocks in the index have a market capitalization between $400 million and $1.8 billion at the time of entry, though those criteria may fluctuate over time as market valuations change. The securities within the index are selected for liquidity and for industry group representation. The fund uses a passive strategy (also known as indexing) to track the underlying index. The portfolio is not actively managed in an attempt to beat the index and the portfolio will not shift to become more or less defensive based on management’s perspective of whether the market is over or under valued. The prospectus for IJR indicates that the fund uses representative sampling to track the index. That strategy involves selecting companies based on the total portfolio resembling the index. However, when I checked the holdings of the fund there were a hair over 600 individual holdings which is more than I would expect for representative sampling. Expenses The expense ratio is a .12%. This is a very reasonable expense ratio in my estimation. I tend to be fairly cheap on expense ratios and when the ratios go over .15% for domestic ETFs, I find the costs are simply too high and rarely believe that the underlying methodology for selecting stocks will generate enough additional returns before expenses to pay for the expense ratios. For comparison, funds from Vanguard and Schwab are ranging expense ratios from .08% to .09% for exposure specifically to small capitalization stocks. Dividend Yield The dividend yield is currently running 1.41%. For the investor that wants a very strong dividend yield to support them in retirement, this is still too low to qualify. However, for investors that simply want to generate total returns on a risk adjusted basis with increased exposure to small capitalization companies, the fund is still perfectly reasonable. Holdings I created the following chart to demonstrate the weight of the top 10 holdings: (click to enlarge) None of the holdings are over .7% and it seems the most rational way to analyze the fund is to look at the sector allocations. The sector exposure may change over time as the fund follows the index, but this is as close as we can come to assessing the current risk factors. Sectors The fund is heavily overweight on the financial sector and heavily underweight on some of the more defensive allocations such as utilities and consumer staples. For me, that would indicate a more aggressive strategy than I would prefer to use. However, if the investor is buying into the small cap space on the assumption of a prolonged bull market, than this allocation may be very reasonable for them. Conclusion All around this looks like a solid fund. The expense ratio is very reasonable and the holdings include substantial diversification to reduce the impact of any single negative company-specific events. The sector allocation is a little more aggressive than I would have preferred but overall the fund offers precisely what many investors in the small capitalization space would want. The interesting thing for me regarding the risk factors is that the latest fact sheet for the fund indicated that the fund had a beta of only .84. Based on those calculations it would appear that the fund is less volatile than I would expect from the representation of the sectors. I wanted comparable numbers to other ETFs holding small capitalization stocks. I ran a comparison through InvestSpy for the last five years and found a beta of 1.16 using their methodology. Clearly the methodology and the time frame used will have a material impact on risk assessments. The value I calculated on InvestSpy put IJR around the middle of the pack for the beta scores among ETFs investing in small capitalization stocks. On the other hand, their trailing 5 year return was beating every other comparable ETF with returns over 92%. This put them just behind the S&P 500 for the period. The results are demonstrated below. (click to enlarge) When I ran the same test with a time period of 2 years, rather than 5 years, the beta calculated dropped down to .99. In this case, the apparent volatility is materially impacted by the time span that is chosen.

Creating A Portfolio For Safe Retirement Income

Summary I searched through all ETFs and found six for safe income given the current environment. The portfolio I created generates safe income and has the potential for increasing income if interest rates rise. The six ETFs I found cover: U.S. Equities, International Equities, Bonds, Preferred Stocks and Cash. In this article, I will be creating a simple portfolio that balances steady income with safety for a retirement portfolio. The goal of the portfolio is to hold six ETFs to generate safe income with the potential for income to increase. U.S Equity: ProShares S&P 500 Dividend Aristocrats ETF (NYSEARCA: NOBL ) I chose NOBL because it only holds stocks from the S&P 500 (NYSEARCA: SPY ) that have increased their dividend for at least 25 consecutive years. In addition, what makes NOBL different from other dividend ETFs is that the fund equally weights its holdings, which reduces concentration risk. The chart below from the NOBL fact sheet shows that the dividend aristocrats index that NOBL tracks has outperformed the S&P 500 and done so with lower volatility. [Chart from NOBL fact sheet] International Equity: PowerShares S&P International Developed Low Volatility Portfolio ETF (NYSEARCA: IDLV ) I chose IDLV because it holds mainly large cap companies in other developed markets excluding the United States and overlays a low volatility strategy to select only the stocks with the lowest volatility. The following chart from ETFreplay shows that IDLV has underperformed the largest developed markets ETF, which is the iShares MSCI EAFE ETF (NYSEARCA: EFA ). However, as you can see IDLV has had much lower volatility than EFA and when volatility is factored in IDLV outperforms, which is shown in the table below. IDLV EFA Total Return 29.70% 35.50% Volatility 12.20% 15.20% Return/Volatility 2.43 2.34 [Chart from ETFreplay] (click to enlarge) Short-Term Corporate Bonds: Vanguard Short-Term Corporate Bond Index ETF (NASDAQ: VCSH ) I chose VCSH because the yields for investment grade corporate bonds are higher than corresponding yields on treasury bonds. I did not want to choose just any corporate bond fund; therefore, I decided to select a short-term fund because of the possibility of rising interest rates. The following chart shows a comparison between VCSH, the Vanguard Intermediate-Term Corporate Bond Index ETF (NASDAQ: VCIT ) and the Vanguard Long-Term Corporate Bond Index ETF (NASDAQ: VCLT ). The period I looked at was from February 2nd 2015, which was the low point in interest rates for the year, to June 10th, 2015, which was the high point in rates for the year. As expected VCLT performed the worst because it holds only long-dated corporate bond and VCSH performed the best because it holds only short-term bonds. (click to enlarge) [Chart from Google Finance] Floating Rate Preferred: PowerShares Variable Rate Preferred Portfolio ETF (NYSEARCA: VRP ) I chose to include VRP because of its 5% dividend yield and the fact that it has income upside potential during a rising rate environment. Like VCSH above, I compared VRP and PFF to each other during the rising rate period I described above. As you can see VRP outperformed PFF by just over 1%, which is not a large amount. PFF pays a dividend yield of 5.78%, which is higher than VRP at 5%, however, the 0.78% difference in yield does not make up entirely for the 1%+ in outperformance from VRP. With the upside potential in income during a rising rate environment, I expect VRP to be the superior choice. (click to enlarge) [Chart from Yahoo Finance] Covered Call ETF: Horizons S&P 500 Covered Call ETF (NYSEARCA: HSPX ) As part of my U.S. equity allocation, I chose to include HSPX to increase the income of the portfolio while maintaining income safety. I chose HSPX over the more popular PowerShares S&P 500 BuyWrite Portfolio ETF (NYSEARCA: PBP ) because HSPX pays a monthly dividend where PBP pays a quarterly dividend. HSPX writes out-of-the-money calls on the long positions it holds of all option eligible stocks within the S&P 500. The covered calls, along with dividend income received from individual stocks, makes the current yield based on the average dividend over the last twelve months to be 4.3%. In a declining market, covered call strategies are attractive because of the potential to capture all of the premiums from selling the calls. Cash: PIMCO Enhanced Short Maturity Strategy ETF (NYSEARCA: MINT ) My final selection was MINT because, for retirees, having cash or a cash substitute for an emergency or well-timed purchase of an income generating investment that is trading at depressed values is something to consider. For example, if a retired investor was holding cash during the financial crisis and an opportunity like the bottom of the financial crisis presented itself as a buying opportunity to dividend aristocrats that had been unjustly sold down with the rest of the market. The retired investor having cash available, would have been able to increase their income by buying an ETF with high quality companies at depressed prices. Those high-quality companies have been through ups and downs and still have paid increasing dividends for at least 25 straight years. Portfolio Overview I have provided an example of what the portfolio would look like if each category would be equally weighted. Since NOBL and HSPX both are U.S. equity funds, I split the 20% allocation between the two. Using this allocation, the portfolio yield would be 2.81%, which is not a lot, however it is higher than the rate on treasury bonds. The portfolio has the potential for increasing income in the form of increasing dividend payments from dividend aristocrats and from increasing coupon payments on short-term bonds and variable-rate preferred stocks. Weight Yield W*Y NOBL 10.00% 1.90% 0.19% IDLV 20.00% 3.11% 0.62% VCSH 20.00% 1.92% 0.38% VRP 20.00% 5.00% 1.00% HSPX 10.00% 4.30% 0.43% MINT 20.00% 0.94% 0.19% Portfolio Yield 2.81% Portfolio Composition Stocks 40.00% Bonds 20.00% Other 20.00% “Cash” 20.00% Closing Thoughts While the portfolio I created does not have a large yield, it has exposure to high quality U.S. companies with long a long history of dividend increases, international stocks with low volatility and short-term investment grade corporate bonds and variable rate preferred stocks, both of which should provide safety and increasing income during a rising rate environment. Looking back to my goal, I believe I have created a portfolio that generates safe income and has the potential for increasing income. Disclaimer : See here .