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XBI: An Aggressive ETF That Keeps Capturing Massive Returns

Summary XBI is an almost pure play on the biotechnology sector. For investors that want to rely on modern portfolio theory rather than assessing biotechnology companies, this is a solid option. The ETF has shown stronger correlations with international equity than domestic equity which suggests investors may want to limit international exposure when going heavy XBI. The negative correlation for XBI with long term treasury bonds is only mediocre. Compared to the S&P 500, it is more difficult to diversify away the portfolio risk through treasuries. 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. The biotechnology sector has been hot and despite being high risk it can be a very profitable area to invest. The challenge is that investors either need specialized knowledge to pick the companies they will hold or a simple strategy for buying into an ETF in the sector. As you might guess, I prefer the second method. My strengths are in analyzing ETFs and mREITs. I’d rather not be forced to figure out which biotechnology companies are most likely to patent the next breakthrough. That makes using an ETF a great way to get exposure. One of the biggest options for that exposure is the SPDR Biotech ETF (NYSEARCA: XBI ). Expense Ratio The expense ratio on XBI is .35%. Sector XBI is not confused about their role. The portfolio is very close to a pure play on the biotechnology sector. Largest Holdings The largest holdings are shown in the chart below: While I usually recognize all the companies within an ETF, this isn’t one of those cases. I know precisely zero of these companies, but I do appreciate that the fund has been designed to be relatively equal weight. For comparison, I also grabbed a chart of the holdings for the index. Index Holdings You may notice that the order of holdings is very materially different. XBI is not just passively tracking the index. Investors might think that means their returns would be very different from the index, but it turns out they actually track the index quite closely. Comparison The following chart shows the performance numbers for several time periods: (click to enlarge) Some investors may have a much easier time visualizing the returns with graphs, so I grabbed a bar chart as well: (click to enlarge) I think the bar chart really drives this home. Even though XBI is using a very different portfolio structure than their index, they have extremely similar returns over each time period. When I check an ETF against their index, I usually expect them to slightly underperform because of the expensive ratio. They have trailed their index, but only by around .05% on an annualized basis which is very good when you consider that the expense ratio is .35%. If they can continue to deliver that performance over the next decade it will be a testament to the management doing a solid job of deciding which companies deserve to be overweight in the portfolio. Building the Portfolio The sample portfolio I ran for this assessment is one that came out feeling a bit awkward. I’ve had some requests to include biotechnology ETFs and I decided it would be wise to also include a the related field of health care for a comparison. Since I wanted to create quite a bit of diversification, I put in 9 ETFs plus the S&P 500. The resulting portfolio is one that I think turned out to be too risky for most investors and certainly too risky for older investors. Despite that weakness, I opted to go with highlighting these ETFs in this manner because I think it is useful to show investors what it looks like when the allocations result in a suboptimal allocation. The weightings for each ETF in the portfolio are a simple 10% which results in 20% of the portfolio going to the combined Health Care and Biotechnology sectors. Outside of that we have one spot each for REITs, high yield bonds, TIPS, emerging market consumer staples, domestic consumer staples, foreign large capitalization firms, and long term bonds. The first thing I want to point out about these allocations are that for any older investor, running only 30% in bonds with 10% of that being high yield bonds is putting yourself in a fairly dangerous position. I will be highlighting the individual ETFs, but I would not endorse this portfolio as a whole. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 10.00% 2.11% Health Care Select Sect SPDR ETF XLV 10.00% 1.40% SPDR Biotech ETF XBI 10.00% 1.54% iShares U.S. Real Estate ETF IYR 10.00% 3.83% PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB 10.00% 4.51% FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT 10.00% 0.16% EGShares Emerging Markets Consumer ETF ECON 10.00% 1.34% Fidelity MSCI Consumer Staples Index ETF FSTA 10.00% 2.99% iShares MSCI EAFE ETF EFA 10.00% 2.89% Vanguard Long-Term Bond ETF BLV 10.00% 4.02% Portfolio 100.00% 2.48% The next chart shows the annualized volatility and beta of the portfolio since October of 2013. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. You can see immediately since this is a simple “equal weight” portfolio that XBI is by far the most risky ETF from the perspective of what it does to the portfolio’s volatility. You can also see that BLV has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in TDTT is also unique for having a risk contribution of almost nothing. Unfortunately, it also provides a weak yield and weak return with little opportunity for that to change unless yields on TIPS improve substantially. If that happened, it would create a significant loss before the position would start generating meaningful levels of income. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Health Care Select Sect SPDR ETF XLV Hedge Risk of Higher Costs SPDR Biotech ETF XBI Increase Expected Return iShares U.S. Real Estate ETF IYR Diversify Domestic Risk PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB Strong Yields on Bond Investments FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT Very Low Volatility EGShares Emerging Markets Consumer ETF ECON Enhance Foreign Exposure Fidelity MSCI Consumer Staples Index ETF FSTA Reduce Portfolio Risk iShares MSCI EAFE ETF EFA Enhance Foreign Exposure Vanguard Long-Term Bond ETF BLV Negative Correlation, Strong Yield Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. 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 XBI is an extremely aggressive allocation that easily brings in the heaviest level of risk in the portfolio. Despite being a major source of risk, the correlation with the S&P 500 is only .56% and the resulting beta is “only” 1.44 which is very good when you consider how volatile the ETF has been. The thing that may be even more interesting is what happens when investors run the regression over a longer period. When I extended the sample period back to February of 2006, the correlation goes up to .68 but the beta drops down to .91 because the ETF was dramatically less volatile in the earlier years. Lately the sector has been substantially more volatile. The strong performance of XBI also extends back quite a ways. Since February 2006 the ETF has returned over 400%. I also extended this sample by running another regression of returns on XBI against a long term government bond index. The negative correlation in that case came in at -.35 compared to the S&P 500 coming in at -.54. The risk that comes from the weaker negative correlation is that it makes it more difficult to really drive portfolio risk lower. However, for an investor that is willing to hold a portfolio that is already overweight on equities, it would seem perfectly reasonable to include XBI as an allocation. It is a highly aggressive allocation, but it has done very well. The one other interesting note that I would make in that regard is that it has shown a substantially higher correlation with international ETFs than with domestic equity. If you’re planning to run XBI as a large holding, you may want to consider reducing the international equity allocation.

PLW Is A Nicely Designed Treasury ETF

Summary PLW has a diversified ladder of maturities. The fund does a solid job of providing negative beta to reduce the volatility of the portfolio. Using longer maturity treasury securities offers better yields and a stronger negative beta because price movements are larger. The PowerShares 1-30 Laddered Treasury Portfolio ETF (NYSEARCA: PLW ) is an ETF with a fairly even distribution of maturities across the yield curve. It is an interesting ETF because most treasury ETFs are focused on a single duration range. As a treasury ETF that includes long maturities it shows a fiercely negative correlation with major equity indexes, but the individual volatility of the ETF is reduced compared to longer treasury ETFs because there is also a substantial allocation to the shorter parts of the yield curve. Expense Ratio The expense ratio on PLW is .25%. That isn’t too bad, but there are quite a few cheaper options out there if investors don’t mind having their holdings concentrated across certain maturities. For investors that want diversification across maturities, it may still be worth considering simply buying short, medium, and long term ETFs with lower expense ratios. There isn’t a great deal of “expertise” that goes into picking which bonds to hold in a treasury ETF. Most funds have a guideline establishing which part of the yield curve they will buy and it is really easy to decide which issuer to buy. There is no assessment of the credit rating of different companies or the impacts of the industries, this is simply buying up treasury ETFs and forwarding interest payments to shareholders. Maturity The diversification across the yield curve is clearly demonstrated here. This is far more diversified than most treasury ETFs, but I would favor replicating the portfolio with lower expense ratio funds. Characteristics The fund is showing an effective duration of 10.73 years, so investors should expect to see some material volatility when interest rates are shifting. The nice thing about that is the volatility tends to be headed in the opposite direction of the equity indexes. Perhaps I’m being a little strange, but I actually prefer longer durations on treasury ETFs because of the negative correlation with the market. When correlations are substantially negative, an increase in volatility for the individual ETF will often result in a decrease in volatility for the portfolio. That is, of course, assuming that the individual ETF is a fairly small portion of the total portfolio. For investors that want to go heavy on treasury securities and light on equity, the logic of going for longer duration and higher volatility falls apart. Building a Sample Portfolio This hypothetical portfolio has a moderately aggressive allocation for the middle aged investor. Only 25% of the total portfolio value is placed in bonds and a fifth of that bond allocation is given to high yield bonds. If the investor wants to treat an investment in an mREIT index as an investment in the underlying bonds that the individual mREITs hold, then the total bond allocation would be 35%. Given how substantially mREITs can deviate from book value, I’d rather consider the allocation as an equity position designed to create a very high yield. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since a major recession could still hit this pretty hard. If the investor wanted to modify the portfolio to be more appropriate for retirement, the first place to start would be increasing the bond exposure at the cost of equity. However, the diversification within the portfolio is fairly solid. Long term treasuries work nicely with major market indexes and I’ve designed this hypothetical portfolio without putting in the allocation I normally would for equity REITs. An allocation is created for the mortgage REITs, which can offer some fairly nice diversification relative to the rest of the portfolio and they are a major source of yield in this hypothetical portfolio. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 35.00% 2.06% Consumer Discretionary Select Sector SPDR ETF XLY 10.00% 1.36% First Trust Consumer Staples AlphaDEX ETF FXG 10.00% 1.60% Vanguard FTSE Emerging Markets ETF VWO 5.00% 3.17% First Trust Utilities AlphaDEX ETF FXU 5.00% 3.77% SPDR Barclays Capital Short Term High Yield Bond ETF SJNK 5.00% 5.45% PowerShares 1-30 Laddered Treasury Portfolio ETF PLW 20.00% 2.22% iShares Mortgage Real Estate Capped ETF REM 10.00% 14.45% Portfolio 100.00% 3.53% The next chart shows the annualized volatility and beta of the portfolio since April of 2012. (click to enlarge) A quick rundown of the portfolio Using SJNK offers investors better yields from using short term exposure to credit sensitive debt. The yield on this is fairly nice and due to the short duration of the securities the volatility isn’t too bad. PLW on the other hand does have some material volatility, but a negative correlation to other investments allows it to reduce the total risk of the portfolio. FXG is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. FXU is used to create a small utility allocation for the portfolio to give it a higher dividend yield and help it produce more income. I find the utility sector often has some desirable risk characteristics that make it worth at least considering for an overweight representation in a portfolio. VWO is simply there to provide more diversification from being an international equity portfolio. While giving investors exposure to emerging markets, it is also offering a very solid dividend yield that enhances the overall income level from the portfolio. XLY offers investors higher expected returns in a solid economy at the cost of higher risk. Using it as more than a small weighting would result in too much risk for the portfolio, but as a small weighting the diversification it offers relative to the core holding of SPY is eliminating most of the additional risk. REM is primarily there to offer a substantial increase in the dividend yield which is otherwise not very strong. The mREIT sector can be subject to some pretty harsh movements and dividends from mREITs should not be the core source of income for an investor. However, they can be used to enhance the level of dividend income while investors wait for their other equity investments to increase dividends over the coming decades. If you want a really quick version to refer back to, I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Consumer Discretionary Select Sector SPDR ETF XLY Enhance Expected Returned First Trust Consumer Staples AlphaDEX ETF FXG Reduce Beta of Portfolio Vanguard FTSE Emerging Markets ETF VWO Exposure to Foreign Markets First Trust Utilities AlphaDEX ETF FXU Enhance Dividends, Lower Portfolio Risk SPDR Barclays Capital Short Term High Yield Bond ETF SJNK Low Volatility with over 5% Yield PowerShares 1-30 Laddered Treasury Portfolio ETF PLW Negative Beta Reduces Portfolio Risk iShares Mortgage Real Estate Capped ETF REM Enhance Current Income Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. Despite TLT being fairly volatile and tying SPY for the second highest volatility in the portfolio, it actually produces a negative risk contribution because it has a negative correlation with most of the portfolio. It is important to recognize that the “risk” on an investment needs to be considered in the context of the entire portfolio. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of TLT’s heavy negative correlation, it receives a weighting of 20% and as the core of the portfolio SPY was weighted as 50%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. 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 PLW offers investors a fairly solid exposure to the treasury securities across the yield curve and will help equity heavy portfolios reach a substantially lower level of volatility. If an investor is willing to do the work, they may be able to replicate PLW at a lower cost by simply buying a few treasury ETFs that each offer exposure to a particular sector of the yield curve. Exposure to the shorter parts of the yield curve reduces the total volatility of PLW which makes sense for investors that are going heavy on bonds and light on equity, however the reduction in volatility can be counterproductive for investors that are going heavy on equity securities. Strong price movements on treasury ETFs can be desirable because of the negative correlation with the equity market.

The PowerShares S&P SmallCap Utilities Portfolio ETF – Simply Energetic

Summary Very Concise with some excellent defensive holdings. Low beta, good average cash flow and dividends. Also has the potential for capital appreciation. Recent events have put investors on the defensive against the increasing potential of a global economic contraction. It might be a good idea for the individual investor to channel funds towards defense, too. However, as it is with financial markets, the flight to safety will inevitably drive ‘defensive’ asset prices up and thus valuations beyond what is sensible. So how may the individual investor play defense without over paying? There just might be a solution. What drives utilities in the first place? The Housing market does, for one! Since new construction, either single family homes or multiple unit construction require utility services, particularly, gas, water, electricity and data , the recovering U.S. housing market has given a boost to the utility sector. According to the U.S. Department of Housing and Urban Development 883,000 units were complete in 2014 and the annualized 2015 rate, based on July data, will result in a seasonally adjust rate of 987,000. Further, it’s important to observe that utility service isn’t simply a ‘one-time-installation’. It is the unit dwelling, itself, generating revenue for the utility for decades, as long as it’s occupied. (click to enlarge) The PowerShares S&P SmallCap Utilities Portfolio ETF (NASDAQ: PSCU ) is a top performer in its ETF class. So straight away, it seems as though there’s uniqueness in the theme not found in other funds. Although uniqueness may be a winning quality in the arts and sciences, investors require more substance. So then, what makes this fund a good performer? According to Invesco : … The PowerShares S&P SmallCap Utilities Portfolio ((fund)) is based on the S&P SmallCap 600 ® Capped Utilities & Telecom Services Index … …companies are principally engaged in providing either energy, water or natural gas utilities, as well as services designed to promote or enhance the transmission of voice, data and video over various communications media, including wireline, wireless (terrestrial-based), satellite and cable … The interesting feature is that the fund meets its objective with only 20 holdings (as of mid-September). Before going into the individual holdings, it’s worth noting the subsector allocations. Data from Invesco With a mere 20 companies, it seems superfluous to analyze the ten heaviest weightings. It’s worth noting that 52.489% of the fund is concentrated in its top 7 holdings. Also, upon careful examination of the individual company businesses, there are few ‘pure-play’ utilities in the fund. For example, Piedmont Gas (NYSE: PNY ) is a ‘pure-play’ in natural gas, distribution pipeline and storage, including LNG. Piedmont is the heaviest weighted of the fund’s holdings at 9.964%, contributes a 3.47% dividend, has a P/E of 21.15, a price to book multiple of 2.14, price to cash flow of 10.74 and a high but sustainable payout ratio of almost 72%. American States Water (NYSE: AWR ) is more typical of the basic utility providers in the fund, distributing water through its pipeline network, which includes wells, reservoirs, and water treatment facilities. However, it also diversifies into electrical transmission infrastructure and a gas fueled electric generating plant. AWR provides a 2.26% dividend, with a P/E of 24.5, price to book of 3.10 times, price to cash flow of 14.16 times and a payout ratio of 52.49%. On the extreme end there’s Avista Corp (NYSE: AVA ) which comprises 4.54% of the fund’s total holdings. Although its primary business is to provide natural gas and electricity services , it also has real estate investments, provides venture capital and sheet metal fabrication for electrical enclosures, digital device parts, as well as parts for renewable energy systems and the medical industry, and lastly investments in mining. (According to Reuters, these ‘sub-segments’, “… do not form part of any reporting segment …”). Avista pays a 4.20% dividend, a P/E ratio of 17.57%, a price to book multiple of 1.29, a price to cash flow multiple of 7.69 and has a high but sustainable payout ratio of just over 72%. Piedmont, American States Water and Avista are in the top half of the fund’s weightings. Interestingly, all the telecoms are in the bottom half of the fund’s weightings. Only three of the 7 telecom holdings pay dividends. Top Half Holdings Type Weight Market Cap (billions) Yield P/E Beta Payout Ratio Piedmont Gas, Storage 9.964% $3.123 3.47% 21.15 0.47 71.98% UIL Holdings (NYSE: UIL ) Electric and Gas 8.986% $2.719 3.60% 23.23 0.47 41.37% Southwest Gas (NYSE: SWX ) Gas, Construction 8.621% $2.607 2.92% 18.85 0.63 52.90% Northwestern Corp (NYSE: NWE ) Electricity and Natural Gas 7.906% $2.391 3.78% 15.05 0.52 73.30% New Jersey Resources (NYSE: NJR ) Gas and renewables 7.866% $2.379 3.45% 15.72 0.57 50.23% Consolidated Communications (NASDAQ: CNSL ) Network, Video, Voice, Data, Landline 4.59% $1.005 7.79% N/A 0.74 N/A American States Water Water, Electric infrastructure 4.556% $1.475 2.26% 24.49 0.56 52.49% South Jersey Industries (NYSE: SJI ) Gas and Electric 4.554% $1.636 4.21% 15.23 0.73 62.93% Northwest Natural Gas (NYSE: NWN ) Gas and Electric 4.544% $1.217 4.18% 24.14 0.30 49.89% Avista Corp Electric, Gas, RE, Venture funds, metal manufacturing 4.54% $1.957 4.20% 17.57 0.57 72.29% All Tabled Data From Reuters, YaHoo! and PowerShares The lower half weightings of the fund contains those Telecommunications Services. Lumos (NASDAQ: LMOS ) , 1.42% of total holdings contributes a 4.66% dividend yield to the fund. Lumos provides mainly fiber optic infrastructure for voice, data, IP service and also provides wireless. The company as a low P/E of just over 13 times, a price to book of 2.7 times, price to cash flow of 4.14 and a low payout ratio of 32.61%. Generally, it focuses on the fiber optic backbone and related services. On the other hand Atlantic Tele-Network (NASDAQ: ATNI ) , at 4.06% of the fund, is a holding company providing land-line, wireless telephony, data, DSL and provides electricity through solar power generation. Further, Atlantic Tele-Network services the Caisos, Turks, Aruba, Guyana and the U.S. Virgin Islands. ATNI does not contribute a dividend to the fund. The company has a P/E of 35.21, price to book of 1.74 times and price to cash flow of 11.68. It has revenues of about $353.57 million with 8.5% year over year revenue growth. Bottom Half Holdings Type Weight Market Cap (billions) Yield P/E Beta Payout Ratio Laclede Group (NYSE: LG ) Gas 4.537% $2.252 3.54% 16.03 0.36 42.55% El Paso Electric (NYSE: EE ) Electric, Renewables 4.493% $1.431 3.33% 17.61 0.32 56.51% Allete (NYSE: ALE ) Water, Electric, Renewables, Coal 4.422% $2.360 4.18% 16.10 0.74 61.20% Atlantic Tele-Network Wireless, Wired, Broadband, International and Domestic 4.061% $1.202 1.75% 35.21 0.96 55.37% 8×8 (NASDAQ: EGHT ) Telecom, Telephony, Video Cnfrc 3.813% $0.739 0.00% 536.29 0.41 0.00% Cincinnati Bell (NYSE: CBB ) Telecom, VOIP, Wireless 3.71% $0.719 0.00% 5.96 1.17 0.00% Iridium (NASDAQ: IRDM ) Satellite, global communications 2.851% $0.651 0.00% 11.82 0.87 0.00% General Communications (NASDAQ: GNCMA ) Wireless and Landline Tel 2.748% $0.694 0.00% N/A 1.31 0.00% Spok Holdings (NASDAQ: SPOK ) Enterprise Communication Solutions 1.817% $0.352 3.05% 19.15 0.70 58.57% Lumos Networks Fiber optics, VOIP 1.42% $0.276 4.66% 13.93 0.01 32.61% All Tabled Data From Reuters, Yahoo! and PowerShares Only four of the 20 holdings do not pay a dividend, yet the average yield of the dividend paying companies is just over 3.00% and has an average payout ratio of 41.70%. The average market capitalization is indeed in the ‘small-cap’ range at $1.559 billion and the fund has low volatility with an average beta of 0.62 and the shares are marginable With the exception of 2015, the fund’s share price has had respectable, steady returns. The fund’s P/E is 19.99, has 400,000 shares outstanding and has a low trading volume. Lastly, the fund is currently trading at a discount to its NAV and the 0.29% total expense ratio is well below the ETF industry average of 0.44%. The point of the matter is that PSCU is concise with some pretty smart picks, has a good dividend yield, is mainly in a defensive sector, yet has potential for capital appreciation through its telecommunication service holdings, yet is a relatively lightly traded fund. Period YTD 1-Year 3-Year 5-Year Inception 4/7/2010 Share Price -6.34% 2.25% 9.96% 12.56% 10.67% All Tabled Data From Reuters, YaHoo! and PowerShares It seems to be the type of defensive investment that will perform reasonably well in both good and bad economic cycles and in particular a fund that may serve as a long term holding.