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ZROZ: One Of The Fastest Ways To Fix The Beta In Your Portfolio

Summary ZROZ has very long duration treasury securities. The ETF has shown a very strong negative correlation with major market indexes. When used in a portfolio that is overweight on equity investments the result is a rapid reduction in portfolio volatility. The volatility on ZROZ would make it better for speculation than investment if the investor did not have a large equity allocation. The high volatility on the ETF is encouraging the very strong negative beta which makes it an incredible tool under modern portfolio theory. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio Call me cheap, frugal, or whatever other name you like. The simple fact is that I despise high expense ratios. The expense ratio on ZROZ is .15%. That is low enough for me to use it, but I’d really prefer to see something that was closer to single digits. In my experience, most ETFs and the vast majority of mutual funds have expense ratios way higher than I am comfortable paying. Compared to the rest of the market, ZROZ is doing just fine on controlling the expense ratio. The other useful for factor in analyzing total expenses is the cost of trading. Since ZROZ is on the “free to trade” list for Schwab clients, that makes it substantially more attractive for me. As you’ll see, I’m looking at ZROZ as a portfolio hedge since I’ve gone so heavily overweight on equity securities. Quick Numbers The average effective duration and maturity are incredible with scores over 25 years. (click to enlarge) The quick take on this extremely long duration treasury play should be that it makes sense for two kinds of people. One would be investors like me that go heavily overweight on equity positions and want then use modern portfolio theory to look for a way to reduce the volatility stemming from the heavy equity positions. The other group of people would be speculators that want to make bets on which way the interest rates will be moving. As you might guess, I’m going to focus on using the ETF for long term investors seeking to reduce volatility in the total value of the portfolio. Maturity The maturity breakdown for ZROZ is incredibly simple. Very long term treasury are not only the core of the portfolio, they are the entire portfolio. (click to enlarge) Building the Portfolio I put together a hypothetical portfolio using only ETF’s 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. The SPDR Barclays Long Term Treasury ETF (NYSEARCA: TLO ) is a moderately long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF 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) Why I like ZROZ The argument for a long term investor with a very long time horizon and a large margin of safety buying treasury securities when their yields are fairly mediocre is actually quite simple. It comes down to negative beta. Bond ETFs with extremely negative betas are able to provide substantial diversification benefits with even small allocations. I put together one more chart to demonstrate the impact of simply tossing ZROZ and TLO into a portfolio that is very overweight on SCHB. (click to enlarge) For an investor going overweight on equity exposure with 80% in a broad market index, ZROZ is providing a risk contribution to the total portfolio of minus 5.8% compared with TLO providing minus 3% when both are given a 10% allocation. The annualized volatility of the portfolio at 11.3% is dramatically lower than the annualized volatility of any of the individual holdings. Both TLO and ZROZ are reducing the portfolio volatility, but ZROZ is doing it more effectively because it has a stronger negative beta. That doesn’t mean TLO cannot accomplish the same goal, it simply takes a larger allocation to TLO to achieve it. The point of using ZROZ is to get the negative beta into the portfolio without having to use a large allocation. Given that treasury yields are fairly weak, I don’t see any other major reasons to use it. If yields were higher, I would certainly want to use a larger allocation because I would appreciate the expected income as well as the negative beta. On the other hand, if yields were fairly solid, say 5% to 6% on TLO, I would be much more inclined to allocate more of my portfolio to bonds and that would make it reasonable to use a combination of TLO and SCHZ rather than ZROZ. Conclusion ZROZ can be useful for speculators, but it also has a great purpose in the portfolio of a long term investor that simply wants to crank down the volatility of a portfolio that is already heavily overweight on equity securities. Since I am that kind of long term investor seeking to reduce the volatility in my portfolio, I see some benefits to using ZROZ for negative beta even when I find the yields fairly unattractive. Due to the very high volatility, investors using this strategy should either be using it inside a tax advantaged account so they can sell shares to fund rebalancing between the allocations or doing it with a constant inflow of new cash to the portfolio so they can rebalance without selling. As always, check with a tax consultant if you need help in that area. 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.

VTWNX: This Is A Great Option For The Investor Nearing Retirement

Summary The Vanguard Target Retirement 2020 Fund has a simple construction and a low expense ratio. Despite being a very simple portfolio, they have covered exposure to most of the important asset classes to reach the efficient frontier. I would like a very slight modification to increase the allocation to higher credit quality bonds at the expense of lower quality bonds. This is quite simply one of the best constructed portfolios I’ve seen for a worker nearing retirement. Lately I have been doing some research on target date retirement funds. Despite the concept of a target date retirement fund being fairly simple, the investment options appear to vary quite dramatically in quality. Some of the funds have dramatically more complex holdings consisting with a high volume of various funds while others use only a few funds and yet achieve excellent diversification. My goal is help investors recognize which funds are the most useful tools for planning for retirement. In this article I’m focusing on the Vanguard Target Retirement 2020 Fund Inv (MUTF: VTWNX ). What do funds like VTWNX do? They establish a portfolio based on a hypothetical start to retirement period. The portfolios are generally going to be designed under Modern Portfolio Theory so the goal is to maximize the expected return relative to the amount of risk the portfolio takes on. As investors are approaching retirement it is assumed that their risk tolerance will be decreasing and thus the holdings of the fund should become more conservative over time. That won’t be the case for every investor, but it is a reasonable starting place for creating a retirement option when each investor cannot be surveyed about their own unique risk tolerances. Therefore, the holdings of VTWNX should be more aggressive now than they would be 3 years from now, but at all points we would expect the fund to be more conservative than a fund designed for investors that are expected to retire 5 years later. What Must Investors Know? The most important things to know about the funds are the expenses and either the individual holdings or the volatility of the portfolio as a whole. Regardless of the planned retirement date, high expense ratios are a problem. Depending on the individual, they may wish to modify their portfolio to be more or less aggressive than the holdings of VTWNX. Expense Ratio The expense ratio of Vanguard Target Retirement 2020 Fund Inv is .16%. That is higher than some of the underlying funds, but overall this is a very reasonable expense ratio for a fund that is creating an exceptionally efficient portfolio for investors and rebalancing it over time to reflect a reduced risk tolerance as investors get closer to retirement. In short, this is a very solid value for investors that don’t want to be constantly actively management their portfolio. This is the kind of portfolio I would want my wife to use if I died prematurely. That is a ringing endorsement of Vanguard’s high quality target date funds. Holdings / Composition The following chart demonstrates the holdings of the Vanguard Target Retirement 2020 Fund: This is a fairly simple portfolio. Only five total tickers are included so the fund can gradually be shifted to more conservative allocations by making small decreases in equity weightings and increases in bond weightings. The funds included are the kind of funds you would expect from Vanguard. The top 4 which carry almost all of the value are extremely diversified funds. The Vanguard Total Stock Market Index Fund is also available as an ETF under the ticker VTI . I have a significant position in VTI because it carries an extremely low expense ratio and offers excellent diversification across the U.S. economy. Volatility An investor may choose to use VTWNX in an employer sponsored account (if their employer has it on the approved list) while creating their own portfolio in separate accounts. Since I can’t predict what investors will choose to combine with the fund, I analyze it as being an entire portfolio. Since the fund includes domestic and international exposure to both equity and bonds, that seems like a fair way to analyze it. (click to enlarge) When we look at the volatility on VTWNX, it is dramatically lower than the volatility on SPY. That shouldn’t be surprising since the portfolio has some large bond positions. Over the last five years it has significantly underperformed SPY, but that should be expected given the much lower beta and volatility of the fund. Investors should expect this fund to retain dramatically more value in a bear market and to fall behind in a prolonged bull market. Opinions I find this to be a very solid fund, but if I could make two adjustments it would be to slightly increase the amount of domestic equity at the expense of international equity and to increase the percentage of long term government debt by adding a small position in the Vanguard Long-Term Government Bond Index Fund (MUTF: VLGSX ). The long term government bonds have a negative correlation to equity markets and a high level of volatility. Due to the strong negative correlation they make the resulting portfolio less volatile than it would be without them. The ideal allocation would be fairly small, but I would prefer to a small inclusion of that (say 5%, maybe as high as 10%) at the cost of total bond index funds that will hold more corporate debt. Corporate debt can be a great investment, but because it is has more credit sensitivity the diversification benefits are weaker. This inclusion would be expected to drop the annualized volatility a little further. Conclusion VTWNX is a great mutual fund for investors looking for a simple “set it and forget it” option for their employer sponsored retirement accounts. It is ideally designed for investors planning to retire around 2020, but can also be used by younger employees with lower risk tolerances or older workers with higher risk tolerances. Disclosure: I am/we are long VTI. (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.