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Summary The portfolio used by XLP isn’t optimized for the best possible performance. I love that the portfolio isn’t afraid to hold producers of addictive substances, but where is the BUD? The expense ratio is fairly solid at .15% and the yield isn’t too bad for an ETF used as a small allocation to overweight the sector. I’d like to see XLP increase the number of holdings within the ETF to reduce the concentrated risk of individual holdings. The low beta reflects a combination of mediocre correlation and low volatility which makes the fund a reasonable fit for a small allocation. 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 Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ). 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 XLP is .15%. I’d like to see a little lower on domestic equity but for a sector-specific ETF, this is still within reason. Yield The ETF is yielding 2.58%. That isn’t enough for a large position in a dividend growth investor’s portfolio, but it is not low enough to really damage the dividend performance of an investor’s portfolio if it is simply being used to create a slight overweight on the sector due to the lower volatility of this sector. Allocations by Industry The following chart breaks down the allocations by each sector: The heaviest exposures are to food and retailing of staples with beverages also coming in as a “very heavy weight”. All around, it should be clear that the goal of this portfolio is to focus on companies that sell products that will maintain strong demand even if the economy is not performing very well. Accordingly, these companies as a group are less volatile than the broader market. Top Holdings The following chart breaks down the top 10 holdings in the fund: After seeing the beverage sector coming at over 18% of the portfolio, I was expecting PepsiCo (NYSE: PEP ) to have a slightly higher weighting. There are a few other things that surprised me as well though. For instance, CVS Health Corporation (NYSE: CVS ) has a higher weighting than Wal-Mart (NYSE: WMT ). I would have expected Wal-Mart to get a slightly higher allocation. I also would have expected Target (NYSE: TGT ) to get at least a small exposure in the portfolio, but when I downloaded the entire list of holdings it was not present. For tobacco being just over 15% of the portfolio, how about some alcohol exposure? I would have expected Anheuser-Busch (NYSE: BUD ) to merit a place somewhere in the list since the goal is to have companies that can continue to make sales even if the market turns down. Perhaps I’m being cynical to think I’d like to own a large company that sells low-cost alcohol as part of a strategy for hedging against a weak economy which can often include high levels of unemployment. It may be cynical, but it is also prudent financial planning. Despite my rationale for including BUD, it is not listed in the portfolio either. The portfolio has a total of only 38 holdings which is also lower than I would expect for an ETF whose primary purpose is to lower the volatility of the portfolio. Building the Portfolio This hypothetical portfolio has a moderately 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 high-yield bonds. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since the volatility on equity can be so high. 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 REITs on the assumption that the hypothetical portfolio is not going to be tax exempt. Hopefully, investors will be keeping at least a material portion of their investment portfolio in tax-advantaged accounts. 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 PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEARCA: HYS ) for high yield shorter-term debt and iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) for longer-term treasury debt. TLT should be useful for the highly negative correlation it provides relative to the equity positions. HYS on the other hand is attempting to produce more current income with less duration risk by taking on some credit risk. XLP is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. iShares U.S. Utilities ETF (NYSEARCA: IDU ) is used to create a significant 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. iShares MSCI EAFE Small-Cap ETF (NYSEARCA: SCZ ) is used to provide some international diversification to the portfolio by giving it holdings in the foreign small-cap space. The core of the portfolio comes from simple exposure to the S&P 500 via SPDR S&P 500 Trust ETF (NYSEARCA: 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 – 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. 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 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 nice thing about XLP is that has a correlation of only .84 with the S&P 500 and .47 with high yield bonds. For an aggressive portfolio, a small allocation to XLP can provide a nice reduction in risk. The beta on the fund is only .65 which reflects the combination of moderate correlation to the market and lower total volatility as demonstrated by 12% annualized volatility when SPY had 15.5% annualized volatility. When it comes to the expense ratio and the statistical factors, I think XLP is doing a fairly good job. However, I can’t get past thinking that a portfolio that adds some exposure to other addictive substances like alcohol would be creating a more resilient base for the portfolio. At the same time, I’d like to see a slightly larger volume of holdings (perhaps around 70 rather than 38) to reduce the idiosyncratic risk from holding larger positions in individual companies. XLP is a decent ETF and it performs well in a portfolio. However, I think it could be optimized a little better. 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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