PKW: Does It Outperform Because Of Strategy Or Sector Allocation?
Summary The PKW portfolio is built to take advantage of companies that are repurchasing shares. Over the last several years PKW has performed very well. The holdings are fairly concentrated but a focus on sectors with more buybacks could indicate less exposure to price based competition. My concern about the sector allocations is that they feel exposed to recessionary problems. If I was going to use PKW, I would want to include a heavy position in a long term treasury ETF to offset the risk in the portfolio. 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 PowerShares Buyback Achievers Portfolio ETF (NYSEARCA: PKW ). 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 the fund is arguably the largest drawback. At .68%, the expense ratio eats into the long term value that can be generated by the fund. If it continues to outperform the market that won’t be a problem, but that feels like a dangerous bet on the system continuing to work. If it does, then all economic theories based on efficient markets should be called into question. Largest Holdings The largest holdings represent very material portions of the ETF. The analysis of the portfolio is further complicated by the potential for substantial amounts of turnover within the ETF which may cause the holdings and sector allocations to change materially over time. When they change, the risk profile also changes. The ten largest holdings are included in the chart below: Heavy allocations to both Home Depot (NYSE: HD ) and Lowe’s (NYSE: LOW ) are interesting. If both companies are heavily committed to using their cash for buybacks rather than expanding competition against each other, it could be a favorable sign for both companies and help them see boosts in earnings. While I’ve been critical of industries that are destroying margins through excessive competition, seeing Lowe’s and Home Depot together seems like a positive sign. Of course, the companies will also be heavily influenced by other factors such as demand for their goods which will be tied to other factors in the economy. Sectors The sector allocation is heavily focused on consumer discretionary while staples are extremely low. Health care and utilities are also fairly light weight which leaves me concerned about how the portfolio would fair if the economy slipped substantially. I love how well the ETF has performed, but I’m wondering how much of that is a function of their methodology and how much is simply a measure of sector allocation during a period of low interest rates with expanding GDP and high corporate profits relative to total GDP. 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 (NYSEARCA: EMB ) for higher yielding debt from emerging markets and the i Shares 7-10 Year Treasury Bond ETF (NYSEARCA: IEF ) for medium term treasury debt. 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 position in the iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) 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 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 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 the 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’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 PKW has a high correlation to the S&P 500 and a similar level of volatility. When looking at the max drawdowns, it appears that during periods when the market shows fear the portfolio is more exposed to taking a hit. While I’m thoroughly impressed with the performance the ETF has shown, I am not buying into the theory that it will continue to outperform the market. I get the feeling that a really solid extended negative period for the market (rather than one week or so of free falling) could put a major dent into the portfolio. If I was going to build a portfolio with a large position in PKW, I would want to include a very material position in a long term treasury ETF for the negative correlation at -.42. The negative correlation would provide a better chance of gaining on the treasury ETF if fear or a recession took hold of the market and the underlying holdings began to suffer large setbacks. 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.