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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.

Don’t Ride The Roller Coaster, Bet On It

With global markets (esp. EM) stumbling, the upcoming FOMC meeting, political instability worldwide, and weak US domestic data, it may be time to bet on an increase in volatility. September through December are going to be some of the most volatile months in the year. Several options for investors: ETFs/ETNs that track volatility, such as TVIX, VXX, UVXY, derivative strategies, or going bearish/long-term on stocks. What a summer it’s been and September is only half-way over. Just overnight (as of Sept. 14th, 2015), Asian markets dipped again on poor economic data, with the mainland Shanghai Composite (SHCOMP) ending on -2.67% (at one point, nearly falling under 3k) and the Nikkei Index falling under 18k at -1.63%. Unfortunately, for international investors, this is not news . With the stock market crash that started in June and the subsequent desperate attempts by the Chinese authorities to prevent the crisis from getting any worse, everyone can at least agree on one thing: the ‘Asian century’ is faltering (for the brief three decades that it lasted) and the annual 8% GDP growth figures are a thing of the past. And considering China’s is a pseudo-market system run by an aging regime that grew up out of the throes of Mao’s Great Leap Forward and Cultural Revolution, recent events should come as a surprise to no one. From the real estate sector to the financials sector, China has been one giant bubble bound to burst. Below is the SHCOMP 1yr with Jean-Paul Rodrigue’s ‘phases of a bubble’ superimposed. (Source: Bloomberg Business) As to be expected, capital investment has been pouring out of China as illustrated below. And China’s isn’t the only market international investors need to be worried about. All of the emerging markets, especially the BRICS, are going to be very volatile. Between Brazil’s immense debt and failing presidency or Russia’s falling ruble and dependence on oil , emerging markets are going to be in quite a lot of pain in the coming months, especially since central banks are running out of options as most have already exhausted their QE (quantitative easing) measures. (Source: JPMorgan) (Source: Reuters & NASDAQ) Speaking of central banks, on September 16th-17th, the Feds will finally meet, in what was probably one of the anticipated and over-analyzed FOMC meetings in recent times, to discuss the results of their votes on a Fed rate hike. As grossly aggrandized as the possibility of a rate hike has been, it is an important element to consider, especially since EM countries gobbled up so much dollar-denominated debt back when it was cheap. Not only that, but the private-sector credit to GDP gaps in EM countries is growing fast; China’s alone is off 25.4% from its long-term trend, the highest of any major country, with Turkey and Brazil following close behind with 16.6% and 15.7%, respectively, far above the recommended ratio of less than 10%. A rate hike, which the CME Group predicts is a 75% probability for the upcoming meeting, is going to add to the enormous strain that the financial sectors of these countries will face. All of these factors piling up seem to spell doom-and-gloom for the rest of the world, but what of the U.S.? Well, to the excitement of the Fed, employment data, which was a serious concern during the 2008 financial crisis, is looking more and more positive month after month. As of August, the official unemployment rate fell to 5.1%, with some officials celebrating the return to ‘full unemployment’ levels . However, despite all the jubilation, productivity and actual GDP growth is still lagging way behind. Macroeconomic expert Chris Varvares estimates that “capital-equipment, software and buildings-per worker has grown just 0.3% a year so far this decade, by far the worst in at least 40 years.” Thus, real wages are also stagnant, as the yearly change rate is still hovering around 0-2% . With less cash to spend and winter months approaching, American consumers are not going to be rushing to get in line for Wal-Mart’s Black Friday sales, they’re going to be running to the banks to deposit and save. Great news for the banks, but bad news for consumption which drives the American economy. So, with the general consensus being that emerging markets will suffer greatly in the short-term at least, and that American consumer confidence and demand will slow as well, what does that mean for the average investor? Volatility. To determine volatility is to simply measure the size of changes in a security’s value over time, e.g. a higher volatility means larger fluctuations in a stock’s price in a short timespan. Volatility means different things to different people, that is, central bankers, for example, work to keep volatility at a minimum as part of their Dual Mandate to keep the prices of goods and services stable. However, speculators willing to take the risks involved can profit greatly from volatility…in the same way someone betting at the horse races can profit greatly betting on a lame horse, if you have the magic of foresight and/or are very lucky. But in all seriousness, certain investors can benefit in taking a smart position in indices which track volatility. (Source: Bank of International Settlements) (Source: Yahoo Finance) One such index tracker is the VelocityShares Daily 2x VIX Short-Term ETN (NASDAQ: TVIX ) which tracks two times the daily performance of the S&P’s 500 VIX Short-Term Futures Index. The iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA: VXX ) and the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA: UVXY ) are more bearish options with lesser expense ratios (0.89% and 0.95% v.s. TVIX’s 1.65%) and there are even more options, such as inverse VIX ETFs (which are essentially the opposite, i.e. betting on stability). Now , before you get your contrarian pitchforks out, there are some points that I will concede. I think Dan Moskowitz of Investopedia puts it best – “the only way to win playing TVIX is by having impeccable timing.” Going long TVIX is a sure-fire way to lose money as common sense dictates high volatility is not a permanent condition. Even further, on the contrarian side of things, TVIX has depreciated 99.97% since its 2010 debut, 77.92% over the past year! Clearly, it is a very risky game to play, yes (but so is the lottery and that’s a multi-billion dollar industry). However , the timing is perfect now. With all the recent domestic political turmoil across the world, emerging markets crashing, and the Fed signaling a tightening of monetary policy, I cannot see, save for a miracle from the Feds, the markets getting by unscathed without a few twists and turns. And speculators would seem to agree with this. According to the CTFC (Commodity Futures Trading Commission), as of Sept. 1st, speculators achieved an all-time record of net long VIX futures contracts, with 32,239 contracts added, double the previous record set in early February and the largest ever bet on a rise in the VIX. This is very significant; even the contrarians who would immediately disregard it and go bullish on stocks in spite have to admit that. (Source: J. Lyons Fund Management Inc.) For the average investor out there (such as myself) staying long on stocks and bonds, sticking to ETFs, or cashing out may be some of the best options available to avoid getting strung along for the ride as the markets reel and spiral. But for you aspiring speculators, hedge fund managers, or simple millionaires, this might be a very profitable time to be betting on increased volatility. 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.