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Summary The Vanguard Short-Term Government Bond Index ETF is an intelligent holding within a portfolio, especially when the equity market is hot. The ETF has low volatility and low correlation with other important investments. The credit quality is excellent and the expense ratio is reasonable. The big weakness is a very weak yield. The fund is relatively similar to simply holding cash within the account. Within a diversified portfolio almost all of the risk (volatility) attributed to VGSH is eliminated. The Vanguard Short-Term Government Bond Index ETF (NASDAQ: VGSH ) is a very solid choice for investors trying to limit volatility in an equity market that has been trading at fairly high levels over the summer. By many fundamental measures, such as P/E, the equity market is feeling expensive enough that investors may want to consider increasing their bond exposure. Unfortunately, the yields on debt have been very low, contributing to higher valuations in the equity market. For investors wanting to see their portfolio risk reduced, VGSH is a great tool to get there. Duration The following chart breaks down the duration of the funds. Holdings are all less than 3 years and usually more than 1 year. Again, this is a solid choice. It shouldn’t be surprising that such short-term debt is unlikely to have any meaningful volatility since this is high quality government debt and the short duration limits any volatility from shifts in the yield curve. Of course, there is one major weakness, which is the fund having a yield of .56%. That is a pretty severe weakness for the ETF, but it is a cost of acquiring such low volatility. Some investors may point out that they might as well just deposit their cash in the bank. If the investor has that as an option, that is a fine choice. However, if the investor is working with funds in retirement accounts, that may not be an option. If the account is a 401k and the exposure needs to be accomplished through mutual funds, VGSH also trades as a mutual fund under the ticker (MUTF: VSBSX ). A Hypothetical Portfolio I put together a very simple sample portfolio using Invest Spy. Due to some of the ETFs being newer, the sample period is limited to a little over two years. (click to enlarge) This hypothetical portfolio is weighted to 60% equity and 40% bonds. To break that down, the weights from the equity section are 30% total market index (NYSEARCA: VTI ), 10% equity REITs (NYSEARCA: VNQ ), 5% Utilities, 5% Consumer Staples (NYSEARCA: VDC ), 10% International Equity. The bond section is holding 10% in junk bonds (NYSEARCA: JNK ), 5% in extended duration treasuries (NYSEARCA: EDV ), 5% in emerging market government bonds (NASDAQ: VWOB ), 5% short term corporate debt (NASDAQ: VCSH ), 5% in short term government debt , 5% in mortgage backed securities (NASDAQ: VMBS ), and 5% in intermediate-term corporate bonds (NYSEARCA: BIV ). This portfolio won’t be perfect for hitting the efficient frontier, but it should beat the vast majority of real portfolios investors are using on a risk-adjusted basis. If long-term rates were higher, I would have used a higher weighting for long duration bonds due to their exceptional correlation to major equity classes. My disclosure already states it, but I’ll reiterate that I am long VTI and VNQ. Annualized Volatility When measuring risk-adjusted returns for a portfolio, the most efficient method is usually to use the Sharpe ratio. For that ratio, we are taking the total return annualized return and subtracting the risk free rate. Then we divide the resulting number by the annualized volatility. The problem is that this metric is only really known after the fact. Predicting the level of returns in advance is problematic, but correlations and relative volatility are more reliable over time than returns. Within the chart investors can see the annualized volatility of each holding as well as the resulting annualized volatility for the portfolio. While some holdings have higher annualized volatility scores, such as EDV, the ETF makes up for that by having negative correlation to a few of the equity holdings. As a result, the ETF only contributes .6% of the total risk in the portfolio. VGSH has an annualized volatility of .9%, which is extremely low. Once we adjust for correlation, the risk contribution to the portfolio is only .1% of the total. That means VGSH fits extremely well in this kind of hypothetical portfolio. This is fairly similar to using cash as part of the portfolio value except the returns over time here should be positive. I wouldn’t bother using VGSH outside of a retirement account, but it is a fine holding to use within the retirement account if the investor is concerned about the high valuations in the market. Correlation I want to dive a little deeper into the correlation statistics. The table below provides the correlation across each of those ETFs, which should make it very quick to see which ones are work very well together. When a correlation is shown in the tan color, it indicates a negative correlation which is very attractive for reaching the efficient frontier. You’ll notice that quite a few of the bond funds have negative correlations to VTI and the S&P 500 (NYSEARCA: SPY ). Since VTI and SPY have a correlation ranging between 99% and 99.9%, depending on the measurement period, it should not be surprising that those two funds have very similar correlations to other holdings. Here is the correlation table: (click to enlarge) Conclusion The expected returns on VGSH will regularly be weak when yields are already very low. On the other hand, with high valuations throughout the equity market, there is a solid argument for keeping part of the portfolio protected from the fluctuations in equity valuations. Disclosure: I am/we are long VTI,VNQ. (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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