USMV: It Lives Up To The Name, This Is One Durable Fund

By | September 18, 2015

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Summary USMV offers investors fairly low volatility and a low beta that make it easy to fit into a portfolio. The holdings start with a heavy position in telecommunications, but less than 5% of the portfolio is in the sector. The exposure to consumer staples, health care, and utilities look nice. Having seen USMV get hit by the absurd sell off on 8/24/2015, investors should avoid using stop loss orders. 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 iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ). 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 The expense ratio on USMV is .15%. It isn’t as cheap as many of the Schwab or Vanguard funds, but this is still well within reason for an investor trying to control the amount of their wealth that flows out to expense ratios each year. Largest Holdings The iShares MSCI USA Minimum Volatility ETF has a fairly diversified group of holdings. When I pulled the numbers nothing was over 1.7% of the portfolio. This internal diversification is great for reducing any idiosyncratic risk from concentrated positions. Looking through the portfolio investors may notice that there appears to be a bias towards companies that pay high dividends. Since those companies are rapidly returning money to shareholders, they have an easier time maintaining a solid valuation since their values are tied to dividends that are more predictable than future growth which may require more estimation. I’ve been fairly bearish on telecommunications since it became clear Sprint (NYSE: S ) intended to create a price war that I expected to drag down profits for AT&T (NYSE: T ) and Verizon (NYSE: VZ ). However, these are huge companies with a long track record, high dividend yield, and solid business model. I’m not completely sold on them, but with the level of diversification in the portfolio I don’t see it as a big problem. If they were combining to be 10 to 15% of the portfolio, I wouldn’t find USMV so attractive. Sectors The following chart breaks down the sector holdings for the fund. The first thing I was checking was for any other exposure to telecommunications. While there are two major telecommunications firms in the top 3 holdings, the total weight in the portfolio is only 4.23% which reassures me that the portfolio wouldn’t be heavily exposed to the price based competition in the telecommunication arena. On the other hand we do see some solid weights for healthcare, consumer staples, and utilities. These are three sectors that I expect to have very solid demand over the next decade. These sectors are simply very hard to replace. Even if we see substantial changes in the economy as technology changes, these sectors remain highly relevant due to the impacts of an aging population, a need for basic supplies, and a desire to keep our homes heated (or cooled). Building the Portfolio This hypothetical portfolio has a slightly aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to emerging market bonds. However, another 10% of the portfolio is given to preferred shares and 10% is given to a minimum volatility fund that has proven to be fairly stable. Within the bond portfolio, the portion of bonds that are not from emerging markets are high quality medium term treasury securities that show a negative correlation to most equity assets. The result is a portfolio that is substantially less volatile than what most investors would build for themselves. For a younger investor with a high risk tolerance this may be significantly more conservative than they would need. 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. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are the iShares J.P. Morgan USD Emerging Markets Bond ETF (EBM) for higher yielding debt from emerging markets and for medium term treasury debt. The iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) should be useful for the highly negative correlation it provides relative to the equity positions. EMB on the other hand is attempting to produce more current income with less duration risk by taking on some risk from investing in emerging markets. The iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) gives investors a respectable current yield in a period of very weak interest rates. The position in the iShares MSCI USA Minimum Volatility ETF offers investors substantially lower volatility with a beta of only .7 which makes the fund an excellent fit for many investors. It won’t climb as fast as the rest of the market, but it also does better at resisting drawdowns. It may not be “exciting”, but there are plenty of other areas to find “excitement” in life. Wondering if your retirement account is going to implode should not be a source of excitement. The position in the PowerShares Buyback Achievers Portfolio ETF (NYSEARCA: PKW ) makes the portfolio overweight on companies that are performing buybacks. The strategy has produced surprisingly solid returns over the sample period. I wouldn’t normally consider this as a necessary exposure for investors, but it seemed like an interesting one to include and with a very high correlation to the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and similar levels of volatility it has little impact on the numbers for the rest of the portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via SPY, though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard’s Vanguard S&P 500 ETF (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. 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 IEF’s heavy negative correlation, it receives a weighting of 20%. Since SPY is used as the core of the portfolio, it merits a weighting of 40%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500 . 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. Conclusion The USMV fund has a solid correlation to the S&P 500, coming in around 90%, but the low annualized volatility allows it to achieve a beta of only .69 which makes the required returns on the ETF substantially lower than the required returns on pure equity positions. While the performance of the portfolio trailed the S&P 500 and may regularly trail it, it is also more resilient to selling pressure. Perhaps there should be one caveat stated. During the panic on 8/24/2015 the ETF sold off dramatically and hit an absurd low of $26.41 before bouncing back to close at $39.25. The biggest message there is that investors seeking stability may want to look at USMV, but they shouldn’t be eager to put in stop losses. During the selling that impacted many stocks and ETFs, USMV was not immune to the sudden and absurd price drop. Simply using USMV as a large allocation should be enough to materially decrease portfolio risk. 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. 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. Scalper1 News

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