Author Archives: Scalper1

A Seasonal Healthcare Portfolio Using VHT

Summary At the request of a reader, I modified my previous biotech portfolio to focus on healthcare. The result of applying the seasonal data of the healthcare industry was a portfolio that outperformed buy-and-hold strategies, both on VHT and SPY. This six-trades-per-year strategy produces improved performance and dividends with decreased risk. (click to enlarge) Another reader request for a modification of the seasonal biotech portfolio : In this case, Lisa wants to build a seasonal portfolio that can effectively invest in the Vanguard Health Care ETF (NYSEARCA: VHT ). I will help her develop such a strategy and back test it against a buy-and-hold strategy, as well as holding the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Why VHT and not XLV? Though I thought about using the Health Care Select Sect SPDR ETF (NYSEARCA: XLV ) instead of VHT, as it is immensely more popular than VHT as a tool to gain exposure to the health care industry, I decided that Lisa was right in her first choice of VHT. An important reason to use VHT in place of XLV is its dividend. In a seasonality based portfolio, we will be ditching the healthcare ETF at certain times to avoid the opportunity cost associated with the healthcare down season. However, both VHT and XLV pay out dividends. So, another downside arises: missing out on the dividend. VHT is the superior choice here because – as you will later see – we will always be holding VHT at the ex-dividend date, allowing us to gain all the dividends of VHT while not being forced to hold the ETF during underperforming seasons. VHT’s ex-dividend date for its annual dividend (XLV pays quarterly dividends; hence the problem) is usually in December, which is a good time for healthcare stocks. However, this year, the ex-dividend date was in late September. But this does not damage our strategy, as we will also be long on VHT in September. The Seasonality In my original strategy on the seasonal portfolio strategy for the iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ), we were long on IBB during November to January, long on utility stocks via the Energy Select Sector SPDR ETF (NYSEARCA: XLE ) from February to May, and stayed out of the market the rest of the year (sell in May), with the exception of holding gold during September, which is when gold tends to outperform. However, simply replacing IBB with VHT in this strategy is arbitrary. Hence, I looked into the seasonality of the health care sector. I found many academic studies on the subject in scholarly journals, most of which concluded the same thing: Health care does best in the fall and winter. A study performed by Equity Clock over the past 20 years produced the following image and the one you saw at the beginning of the article, which both generally sum up what the journals were telling us: stick with health care during fall and winter but drop it afterward. This leaves us with some clear modifications to our previous seasonal portfolio. The act of holding VHT from September to February changes our strategy in the following ways. We no longer need to hold gold, as VHT’s seasonality overlaps with gold. VHT’s seasonality slightly overlaps with XLE, reducing our exposure to XLE by one-third; we will still be in by the ex-dividend date. If we do not add anything to our strategy, we will only be holding two ETFs all year: VHT in the fall and winter; XLE in the spring. So what about the summer? Do we just stay out of the market? Jeroen Blokland, Seeking Alpha contributor, has already answered this question. The solution, according to Blokland, is to hold the iShares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ). This gives us a complete strategy: At February’s close: Sell VHT and Buy XLE A few days before April’s close (check IEF’s ex-dividend date for May): Sell XLE and Buy IEF At August’s close: Sell IEF and Buy VHT The Dividends Ignoring the performance of this strategy and looking at dividends alone, we see we gain exposure to all the dividends we can. A different strategy – for example one in which we buy XLE after March or VHT after September – could result in a drastically lower amount of dividends payouts. It is mere coincidence – and luck – that the strategy that should perform best also gives us full dividend exposure. VHT: Receive one annual dividend payout in September (or possibly December). XLE: Receive one quarterly dividend payout in March. IEF: Receive five monthly dividend payouts (we’ll be on the cusp ends of both May and September’s dividend payouts). And that’s in addition to the performance we can expect from the seasonality of these industries. Let’s now see how this strategy measures up: Results and Conclusion for Investors First, a notation issue: SPY_HOLD: Holding the SPY year-round VHT_HOLD: Holding the VHT year-round SECTOR: The strategy as outlined above The results: As you can see, the SECTOR strategy gives us the best risk vs. reward ratio. The strategy would have allowed us to reduce the downdraw resulting from the 2008 market crash while maintaining a level of growth exceeding both the SPY and the VHT alone. This portfolio has the highest Sharpe ratio – 0.78 – with the lowest max drawdown – -31.37%. In 2014, had you applied the three different portfolios with $100,000, the dividend payouts would have been (without reinvesting dividends): SPY_HOLD: $1832.01 VHT_HOLD: $1130.56 SECTOR: $487.24 (from XLE), $862.12 (from IEF), $1200.71 (from VHT) = $2550.07 Notice that the dividends we receive just from the VHT part of our portfolio exceed that of a VHT buy-and-hold strategy. This is because we are buying VHT with more than $100,000, as XLE and IEF grow our $100,000 into more capital to be used for the VHT purchase. Thus, we come out with more shares of VHT, equaling more dividends, even though we bought VHT later than buy-and-hold investors, whom we can assume bought the stock at a lower price. Overall, this strategy has three main advantages over the buy-and-hold strategies we looked at. First, it has improved cumulative performance. Second, it has the lowest max drawdowns. Third, it has the highest dividend payout. What’s the downside? I can think of two. First is the tax issue, which varies across individuals. If you’re playing this in an IRA, you can come out okay. The second is the increased commissions, as you’ll be making six trades per year, as opposed to one. In the end, you must decide whether the time invested in a seasonal strategy is appropriate for the increased gains and dividends. If you’re interested in seeing some tweaks to this strategy, ask me in the comments section or via mail. I’ll be rolling out my premium Seeking Alpha backtesting newsletter soon, in which I backtest your strategies. For example, if you want to see the above SECTOR strategy tested with different ETFs as the forerunners, just leave your ideas below.

VSCSX: High Quality Short Term Corporate Debt May Be On Sale In December

Summary The Vanguard Short-Term Corporate Bond Index mutual fund is everything I would hope for in a short-term corporate debt exposure. The mutual fund has low volatility and low correlation with other important investments. The Federal Reserve may push up yields and put high quality bond funds on sale in December. The Vanguard Short-Term Corporate Bond Index Admiral Shares (MUTF: VSCSX ) is simply a great fund. I wish I could start more articles out with comments that are this positive. This fund is simply great. The yields are severely limited since this is short term debt with respectable credit quality, but the ETF on the whole is just exceptional when it comes to being part of an effective portfolio. Duration The following chart breaks down the duration of the funds. Holdings are almost all less than 5 years and usually more than 1 year. Again, this is a solid choice. If an investor wants to load up on even shorter term bonds, there are funds designed specifically for that. It is difficult to find a useful yield level on those ultra-short bonds so this is a reasonable portfolio composition. Credit The following chart shows the credit quality breakdown. When it comes to a corporate bond fund there are two ways that I like to see the weightings. Either I would want a junk bond fund or I would want one with a credit breakdown similar to this. Personally, favor combining a fund like this with quite a few other bond funds to create a more complex group of bond holdings. Sector The following chart breaks down the sector allocation: This sector allocation may seem absurd if an investor looks at numbers without reading the names. The names of the sectors indicate that rather than breaking down the market into all the corporate sectors, Vanguard is containing several other bond sectors that are not relevant to corporate debt. It wouldn’t make sense for this fund to have an allocation to foreign debt issues or MBS. Portfolio Usage When the mutual fund is placed within the context of a portfolio that is heavy on U.S. equities it looks like an intelligent way to reduce the overall risk of the portfolio. When it comes to generating alpha, I’ve often told investors that the secret to reaching alpha is to focus on reducing risk. (click to enlarge) Most other investors are already focused on trying to maximize their returns and many will take on more risk than they can handle. Focusing on risk reduction reduces the incentives for an investor to sell off after a big loss and makes it easier to generate alpha relative to the S&P 500 because it is easier to reduce risk through superior diversification. In this case we can see that the return on the fund was fairly weak over the last several years, but the annualized volatility has also been fairly low. When consider that the total risk contribution to the portfolio is negative due to the fund having a negative correlation with the S&P 500, the impact on risk adjusted returns is much more favorable than it would have appeared at first. These bonds do take on some credit risk as corporate debt, but the fund is not holding junk bonds so the credit risk is not material enough to outweigh the impact of a small amount of duration risk. As a result, investors end up with a negative correlation between this fund and most domestic equity funds. One Risk Factor The biggest risk factor for this portfolio right now is the potential for share prices to drop if the Federal Reserve is able to raise rates in December. I’m treating an increase in rates as a buying opportunity for any rate sensitive asset. That could mean bond funds, equity REITs, mREITs, or utilities. Regardless, I’d like to have a little cash available this December to see if the Federal Reserve is able to push some of the investments I want into the bargain bin. Another Use Investors that want to keep a fairly short amount of duration exposure in their portfolio while maintaining higher yield may consider this bond fund as part of an automatic allocation strategy within retirement portfolios. The yields aren’t going to be incredible, but for an investor that is feeling particularly risk averse this is a fairly nice fund. Since volatility is fairly low, it isn’t likely to move up or down very far, but it does offer some gains over time while making the portfolio less risky. Conclusion This mutual fund offers high quality corporate debt that will offer superior yields to treasuries but it still has a negative correlation with equity securities. The return is severely limited by short duration and high credit quality combining to create very low yields on the bonds, but it still makes sense for investors looking for some less volatile investments. If the Federal Reserve moves to raise rates it could put this fund on sale for a bit in December which would create a nice buying opportunity.