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VNQI: International REITs For Diversification

Summary The Vanguard Global Ex-U.S. Real Estate ETF offers investors a fairly unique risk exposure. To improve portfolio diversification, ETFs like VNQI make sense as a small allocation. The best way to establish international diversification, in my opinion, is to focus on the map. Rather than focusing just on emerging vs developed markets, investors should look at the individual countries to ensure proper diversification. 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. One of the funds in my portfolio is Vanguard Global ex-U.S. Real Estate ETF (NASDAQ: VNQI ). 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. When I first looked at VNQI, it seemed like a great way to add a very unique exposure to my portfolio that would be not be duplicated by any of my other holdings. Since then, my perspective has been changing. This is still a good fund, but I think I weighted it too heavily in my portfolio. Expense Ratio While Vanguard funds are known for low expense ratios, this is ETF has the highest expense ratio of any of my holdings at .24%. I accepted that higher expense ratio strictly because I wanted the highly unique exposure and there are only a few liquid competitors in this niche of the market. Regions The following chart breaks down the regional exposure of the ETF. It is a useful chart, but it is remarkably vague about the specific exposures. For instance, I can tell that this fund offers me some emerging market exposure, but I can’t tell exactly which countries we are talking about. If an investor wants to ensure that their international diversification is giving them the full benefits of diversification, they will want to check the individual country allocations. Country Allocations I grabbed the following chart from Charles Schwab: (click to enlarge) This map is much easier for me to read. The allocations look fairly reasonable. Japan certainly appears to have a high weight relative to the amount of actual land there, but the country has a very developed market and makes sense as a key holding for the portfolio. As we go down the list the allocations to individual countries begin to rapidly decline which is another favorable factor in my opinion. Since the inclusion of the ETF is intended to diversify my portfolio, I want a diversified group of holdings. As you’ll see in the holdings section, the individual holdings are low enough in weight that the country allocations may be a larger factor than the individual holdings which include many companies you’ve probably never researched. Highlights Since I was a big bear on China, I like to see China with a lower weight in my international investments. After fierce selling and the falls we saw over the last couple months, the strength of my conviction is weakening and I’m more willing to accept exposure to China in my portfolio. I don’t think I’m to the point of actively seeking it, but I can deal with about 8.7% to China and 8.7% to Hong Kong. Missing Allocations Notice that only one small part of Africa is present and there are no allocations to Latin America. If you’re trying to build a thoroughly diversified international position for the portfolio, it would be wise to consider including ETFs that have these areas. That doesn’t mean investors should avoid VNQI, it just means the ideal compliments to VNQI will likely include exposures to Africa and Latin America. REITs The other thing investors should remember is that this international allocation is investing in REITs. In the domestic market REITs and regular equity markets can diverge quite substantially over years so investors would be wise to consider including allocations to the normal corporate international market. Holdings I built the following chart to represent the top 10 holdings. If you don’t recognize several of these names, don’t worry. I don’t recognize them either and I’m holding quite a bit of VNQI. I selected the ETF because of the country allocations and the REIT structure rather than the individual companies. (click to enlarge) Conclusion The Vanguard Global Ex-U.S. Real Estate ETF offers investors a fairly unique risk exposure. The fund is best used as part of a diversified portfolio and it should not be the only international equity ETF in a portfolio. I would favor complimenting the ETF with other funds that offer exposure to Latin America or Africa as well as some normal equity exposure to other develop markets.

Using Leverage To Get More Out Of Your Bond Allocation

Summary A 50/50 stocks and bonds portfolio typically generates better risk-adjusted returns than a stocks-only portfolio. This is because bond funds generate positive alpha. For an S&P 500 index fund paired with an uncorrelated bond fund, the net beta is 0.5 and the net alpha is one-half the bond fund’s alpha. An easy way to improve raw and risk-adjusted returns is to allocate one-sixth to a 3x S&P 500 fund, and five-sixths to the bond fund. The portfolio beta is still 0.5, but portfolio alpha is five-sixths rather than one-half of the bond fund’s alpha. The strategy generalizes to asset allocations other than 50/50 and allows for non-zero correlation between the bond fund and the S&P 500. Fixed Stock/Bond Portfolios Personal investors typically increase exposure to bonds as they get closer to retirement, reducing risk and drawdown potential while also sacrificing raw returns. Consider a 50% stocks, 50% bonds portfolio based on a simple S&P 500 index fund and a total bond mutual fund or ETF. The beta for such a portfolio is simply the average beta of the two funds. If there is no correlation between the two funds, the portfolio beta is 0.5. That means it tends to move 0.5% for every 1% the S&P 500 moves, which of course reduces both growth potential and drawdown potential. The portfolio alpha for a 50/50 strategy is one-half the bond fund’s alpha. So if the bond fund has positive alpha due to maturing bonds and/or falling interest rates, the portfolio will have positive alpha. This is unlike a 100% S&P 500 portfolio, which by definition has zero alpha. Notably, net positive alpha is the reason that portfolios with both stocks and bonds generally have better risk-adjusted returns than portfolios with only stocks. If bond funds didn’t generate positive alpha, you’d be better off allocating a fixed percentage to cash rather than bonds to reduce your portfolio’s beta. The same logic here applies to asset allocations other than 50/50. For example, the net alpha and beta for a 20% S&P 500, 80% total bond fund would be four-fifths the bond fund’s alpha and 0.2, respectively. Again, we are assuming zero correlation between the two funds for the moment. Fixed Stock/Bond Portfolios With Leverage A common approach to achieve a net beta of 0.5 is to allocate 50% of assets to an S&P 500 fund, and 50% to a bond fund. But we can gain a notable advantage by using a leveraged S&P 500 fund to achieve the same beta. If we used a 3x daily S&P 500 fund, we would need to allocate 16.67% of assets to the 3x fund and the remaining 83.33% to the bond fund. Our portfolio beta is still 0.5, but our portfolio alpha is now five-sixths (rather than one-half) the bond fund’s alpha. A higher alpha for the same 0.5 beta translates to better raw and risk-adjusted returns. A More General Framework Suppose you wish to achieve some target beta by combining a leveraged S&P 500 fund and a particular bond fund. Let a represent the allocation to the leveraged S&P 500 fund. This is what we want to calculate. Let b represent the bond fund’s beta. Let c represent the leveraged fund’s target multiple. Let beta represent your desired portfolio beta. The necessary allocation to the leveraged fund is given by: a = ( b eta – b ) / ( c – b ) For a concrete example, suppose we wanted to use ProShares UltraPro S&P 500 (NYSEARCA: UPRO ), a 3x daily S&P 500 ETF, and Vanguard Total Bond Market ETF (NYSEARCA: BND ), to achieve a portfolio beta of 0.75. For b , I’ll use BND’s beta since inception, which is -0.035. Our target beta is 0.75 and c is UPRO’s leverage multiple, which is 3. a = (0.75 – -0.035) / (3 – -0.035) = 0.259. So we need to allocate 25.9% of our assets to UPRO, and the remaining 74.1% to BND. By doing so, we’ll retain 74.1% of BND’s alpha (which is 0.0191%). If we had used SPY rather than UPRO, we would have retained only 24.1% of BND’s alpha. The portfolio alphas would be 0.0142% and 0.0046%, respectively. Practical Considerations The main drawback of my approach is that it requires more frequent re-balancing to maintain a target asset allocation. This translates to more trading fees and possibly more short-term capital gains taxes. Also, leveraged funds have negative alpha due to their expense ratios. For example, UPRO’s expense ratio of 0.95% translates to a daily alpha of -0.0038%. For the above example, a 25.9% allocation to UPRO would contribute an alpha of -0.00098% (25.9% of -0.0038%), which is very small compared to BND’s alpha contribution of 0.0142% (74.1% of 0.0191%). An Illustration With UPRO and BND Time to put my money where my mouth is. Let’s look at growth of $100k for various target betas achieved by combining SPY with BND, and by combining UPRO with BND. For beta of 0.1, I rebalance whenever the effective beta goes outside 0.075-0.125; for beta of 0.25, 0.2-0.3; for beta of 0.5, 0.45-0.55; for beta of 0.75, 0.7-0.8; and for beta of 0.9, 0.85-0.95. I deduct $7 for each trade (i.e. $14 per rebalance) and assume BND has a beta of -0.035 throughout. (click to enlarge) Performance metrics are given below. Table 1. Performance metrics for SPY/BND and UPRO/BND portfolios with various target betas. Beta Funds Trades Final Bal. ($1k) CAGR (%) Sharpe MDD (%) Alpha (%) 0.10 SPY/BND 3 140.7 5.6 0.116 4.2 0.00018 UPRO/BND 33 143.2 5.8 0.113 4.7 0.00019 0.25 SPY/BND 3 156.4 7.3 0.109 4.2 0.00015 UPRO/BND 35 162.7 8.0 0.110 5.1 0.00018 0.50 SPY/BND 3 183.1 10.1 0.080 8.1 0.00009 UPRO/BND 82 197.5 11.4 0.090 7.7 0.00015 0.75 SPY/BND 2 214.8 12.9 0.068 12.9 0.00005 UPRO/BND 125 237.4 14.7 0.078 12.0 0.00013 0.90 SPY/BND 0 236.7 14.6 0.064 16.9 0.00001 UPRO/BND 153 264.2 16.6 0.074 14.9 0.00011 It makes sense that we see better performance with UPRO/BND with increasing target beta. The greater the target beta, the more we have to allocate to SPY in the SPY/BND portfolio, and the less alpha we retain from the BND allocation. UPRO allows us to allocate more to BND and thus utilize more of its alpha. Risks There are some reasons for caution when trading leveraged funds. I want to briefly re-iterate similar points as in my recent article, A Simple SPY Top-Off Portfolio . If SPY has an intraday loss greater than 33.33%, you could lose your entire balance in the leveraged ETF. UPRO and other leveraged S&P 500 ETFs have historically done an excellent job achieving their target multiple, but there is no guarantee they will continue to do so going forward. In between rebalancing periods, you can suffer some irrecoverable losses due to volatility decay. I would add that the strategy presented in this article uses leveraged funds, but only to achieve a net portfolio beta somewhere between 0 and 1. In that sense, some of the concerns normally associated with leveraged funds do not apply here (e.g. extreme volatility and potentially catastrophic drawdowns). Conclusions The “bonds” part of a stocks and bonds portfolio reduces risk. But so would cash. The reason we prefer bonds is that they generate positive alpha, which improves risk-adjusted returns. Typically, a stocks and bonds portfolio utilizes only a fraction of the bond fund’s alpha. An easy way to increase that fraction is to use leverage. Historical data for UPRO and BND support the notion that using a leveraged fund in place of SPY allows you to capture more a bond fund’s alpha, thus improving both raw and risk-adjusted returns.

Dividend ETFs Battle It Out: Get The Right Sectors

Summary There are three big dividend ETFs from the major low cost index providers, Charles Schwab and Vanguard. Two of the three still offer yields over 3% and all three have excellent expense ratios. Investors deciding which one to buy should look at the sector allocation. These ETFs have some major differences in their allocations. Investors seeking high consumer staples exposure should look to SCHD and VIG. Investors wanting more financial exposure should look at VYM. SCHD and VYM both offer around 10% exposure to the energy sector, but VIG has very little allocation there. If you want oil in the portfolio, SCHD and VYM make. Can you smell what the dividend ETF champions are cooking? There are a few big dividend ETFs for broad exposure to companies offering respectable dividend yields. In this article I want to compare a few of them. Let’s meet the big contenders: Name Ticker Yield Expense Ratio Schwab U.S. Dividend Equity ETF SCHD 3.02% 0.07% Vanguard Dividend Appreciation ETF VIG 2.26% 0.10% Vanguard High Dividend Yield ETF VYM 3.10% 0.10% For investors that prefer to see those numbers in graphs, I put together a couple quick charts: First Impressions Investors right away may notice that the Vanguard Dividend Appreciation ETF doesn’t have a very high yield compared with the other dividend ETFs. It may be rational for investors looking at it to ask whether it should really be considered a high dividend ETF. While the Schwab U.S. Dividend Equity ETF technically only has 70% of the expense ratio of Vanguard’s options, the difference of .03% is not material. There is no viable way to spin the difference into being material. Assuming your decision isn’t based strictly on yields, the next area to look into is the sector allocations. I grabbed the sector allocations for each ETF: (click to enlarge) (click to enlarge) (click to enlarge) Sector Analysis The first thing that I’m noticing when I look at the sectors is that two of these funds go heavily overweight on consumer staples. When it comes to dividend ETFs, I like going overweight on consumer staples. Consumer Staples The nice thing about the consumer staples sector is that they are defined by the production of products that consumers will need regardless of what else is happening in the economy. Any sector can run into problems, but the kind of macroeconomic issues that can really slam my portfolio value should have a smaller hit on the earnings (and thus dividend potential) of companies in the consumer staples category. Of course, there is no free lunch. In exchange for getting companies that should be more resilient, I have to accept that during a prolonged bull market these companies are likely to rally less than other sectors. If my focus was strictly designing the portfolio for the highest projected total long term return, it would be very reasonable to argue against going heavy on consumer staples. It is up to each investor to determine how they feel about that trade off. If the investor wants more certainty that the underlying companies can sustain their dividends because they intend to use the dividends to cover living expenses, then the importance of those dividends being sustained is more important. Having to sell off part of the portfolio during the kind of recession that sees dividend cuts across the combined portfolio would be pretty painful. Financials Where SCHD and VIG put consumer staples at the top, VYM puts financials at number one. This is very interesting because SCHD placed it at 1.99% and VIG weighted it at 6.37%. Clearly the structure of the portfolio is materially different. There are some very good reasons to like the financial sector for investments. At the top of my list would be the demographic analysis showing that Generation Y is fairly weak at understanding money . If the next generation is less capable of understanding their money, then there may be more opportunities for the financial firms to make money off complicated products that the consumers don’t fully understand. That may sound cynical, but who cares? My goal is to understand where sales and profits will be flowing. If you own shares in the banks, would you encourage the CEO to ensure they have transparent pricing even if cuts earnings and means a smaller dividend? I really doubt shareholders would be thrilled to hear “We cut the dividend to make up for a cash shortfall from lowering prices when the current pricing system was working well.” My concern about aggressive allocations to the financial sector comes from regulation. If we see more regulatory pressure or cases brought against large banks for unethical actions in the pursuit of profit, the development could represent declining margins (from regulatory pressure) or cash expenses to settle cases. Energy SCHD and VYM both put energy over 10% of the portfolio. VIG holds it as just over 1% of the portfolio. There are some fairly different kinds of companies that can be considered “Energy” companies. When energy refers to enormous companies with strong dividends like Exxon Mobil (NYSE: XOM ), I like that allocation. If it was referring to much more volatile industries like off shore oil drilling, I wouldn’t be a fan. In the case of SCHD, XOM is the heaviest single holding. The same can be said for VYM. While the energy sector has been punished with oil prices at very low levels and no clear path higher, I see those issues as being priced into the shares. As long as the issues are already priced in, I want some exposure that would benefit from higher gas prices. Lower fuel prices mean more money for consumers to spend on other goods and services. If the low fuel price trend ends, I’d like to at least have the upside from earnings going up for a big dividend payer in the portfolio. What do You Think? Which dividend ETF makes the most sense for you? Do you want to overweight consumer staples for more safety in a downturn or would you rather have more upside in a prolonged bull market? Do you want to own the oil companies, or do you foresee gas as being in a long term downtrend that makes the business model much weaker?