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Summary XLV is a Health Care ETF with the heaviest allocations going to Pharmaceuticals and Biotechnology. The returns figures look fairly volatile in a regression analysis which makes it substantially more difficult to diversify away the excess risk. The nice thing for shareholders is that they would be holding the very companies that are establishing the prices for the medicine they may consume. 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. One of the funds I am assessing is the Health Care Select Sect SPDR ETF (NYSEARCA: XLV ). 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 for Health Care Select Sect SPDR ETF is .15%, which isn’t too bad at all. I’d love to see the expense ratio go under .10%, but .15% is within reason and not too bad for giving investors exposure to the Health Care sector. Remember that the Biotechnology sector is also within the Health Care sector which makes it more volatile. Largest Holdings (click to enlarge) I don’t see anything to complain about here. The top holdings for the ETF almost perfectly mirror the index so investors should expect the portfolio to have very similar returns. Given the low expense ratio, a fairly passive indexing strategy is usually the result. I’m fine with that. Passive indexing is a solid strategy over the long term. Looking at the individual companies, I like seeing Johnson & Johnson (NYSE: JNJ ) at the top of the holdings. This is a strong dividend company that offers investors some stability. Their product lineup is diverse enough that they are largely protecting from minor shifts in the economy and positioned to benefit from an aging population requiring more medicine. Sector The largest weighting by sector is clearly the pharmaceuticals rather than biotechnology stocks. As a result of this sector diversification the fund is dramatically more stable than peers that are heavily invested in biotechnology companies. On the other hand, the returns for it have also been materially weaker. Building the Portfolio The sample portfolio I ran for this assessment is one that came out feeling a bit awkward. I’ve had some requests to include biotechnology ETFs and I decided it would be wise to also include a the related field of health care for a comparison. Since I wanted to create quite a bit of diversification, I put in 9 ETFs plus the S&P 500. The resulting portfolio is one that I think turned out to be too risky for most investors and certainly too risky for older investors. Despite that weakness, I opted to go with highlighting these ETFs in this manner because I think it is useful to show investors what it looks like when the allocations result in a suboptimal allocation. The weightings for each ETF in the portfolio are a simple 10% which results in 20% of the portfolio going to the combined Health Care and Biotechnology sectors. Outside of that we have one spot each for REITs, high yield bonds, TIPS, emerging market consumer staples, domestic consumer staples, foreign large capitalization firms, and long term bonds. The first thing I want to point out about these allocations are that for any older investor, running only 30% in bonds with 10% of that being high yield bonds is putting yourself in a fairly dangerous position. I will be highlighting the individual ETFs, but I would not endorse this portfolio as a whole. 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. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 10.00% 2.11% Health Care Select Sect SPDR ETF XLV 10.00% 1.40% SPDR Biotech ETF XBI 10.00% 1.54% iShares U.S. Real Estate ETF IYR 10.00% 3.83% PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB 10.00% 4.51% FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT 10.00% 0.16% EGShares Emerging Markets Consumer ETF ECON 10.00% 1.34% Fidelity MSCI Consumer Staples Index ETF FSTA 10.00% 2.99% iShares MSCI EAFE ETF EFA 10.00% 2.89% Vanguard Long-Term Bond ETF BLV 10.00% 4.02% Portfolio 100.00% 2.48% The next chart shows the annualized volatility and beta of the portfolio since October of 2013. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. You can see immediately since this is a simple “equal weight” portfolio that XBI is by far the most risky ETF from the perspective of what it does to the portfolio’s volatility. You can also see that BLV has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in TDTT is also unique for having a risk contribution of almost nothing. Unfortunately, it also provides a weak yield and weak return with little opportunity for that to change unless yields on TIPS improve substantially. If that happened, it would create a significant loss before the position would start generating meaningful levels of income. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Health Care Select Sect SPDR ETF XLV Hedge Risk of Higher Costs SPDR Biotech ETF XBI Increase Expected Return iShares U.S. Real Estate ETF IYR Diversify Domestic Risk PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB Strong Yields on Bond Investments FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT Very Low Volatility EGShares Emerging Markets Consumer ETF ECON Enhance Foreign Exposure Fidelity MSCI Consumer Staples Index ETF FSTA Reduce Portfolio Risk iShares MSCI EAFE ETF EFA Enhance Foreign Exposure Vanguard Long-Term Bond ETF BLV Negative Correlation, Strong Yield Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. 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 XLV is substantially less risky than the XBI. Since XBI is almost exclusively biotechnology companies, I’m not surprised that XLV is so much safer. Of course, it is still a fairly risky investment in its own right. The ETF has a beta higher than 1.00 so it will naturally be increasing the risk level on most traditional portfolios. The correlation with the S&P 500 stands at .88 which is high enough that it may be a concern. The bigger issue, in my opinion, is that XLV has a weaker negative correlation with the kind of long term bond holdings that investors would use to reduce portfolio volatility. In this case, that is demonstrated by having a negative correlation with BLV of only -.23 compared to -.29 for the S&P 500. I would treat XLV as a fairly aggressive allocation. If investors intend to bring their portfolio volatility significantly below the S&P 500, it will be more difficult if the allocations to XLV are significant. Despite the volatility, I do like the exposure within the portfolio. A heavy exposure to the pharmaceutical companies makes sense when an investor expects to be practically forced to buy their products in the future. While the portfolio has more volatility under modern portfolio theory, it does allow investors to benefit as shareholders if prices (and profits) from the pharmaceutical and biotechnology sector increase. 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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