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This Is One Heck Of A Great Bond ETF

Summary The Vanguard Long-Term Bond ETF does everything right. If investors could only hold one bond ETF, this one would be a very strong contender for that spot. The fund offers solid income, a low expense ratio, and negative correlation to most major equity classes. If you don’t like this ETF, tell me why, because I do not see a single weakness here. This is a great ETF. There are only a few ETFs that really catch my eye as I’m researching them. This is one that immediately stands out for being absolutely exceptional. It has pretty much everything an investor could want for a bond ETF. I’ve shown a strong preference for funds that I can trade without commissions from my Schwab account because it makes frequent rebalancing more appealing. I would love to see this fund show up on there, but I don’t expect Vanguard funds to show up on the Schwab list at any point. For investors that have access to free trading on Vanguard ETFs, look into using the Vanguard Long-Term Bond ETF (NYSEARCA: BLV ). This ETF comes with everything I want (except free trading) and nothing I don’t want. Let’s go through the fund. Expense Ratio The expense ratio is only .10%. That is beautiful. Just try to find a way to complain about a long term bond fund with over 2000 different holdings and an expense ratio of .10%. This is ideal. Characteristics The fund is offering a fairly respectable yield to maturity of 4.2%. In the last decade investors may have scoffed at the idea of 4.2%, but in the new normal this is great. Some investors may expect yields to increase, but I doubt the Federal Reserve can pull that rabbit out of the hat when other countries have lower rates. An increase in domestic rates would result in a surge of cash inflows to the U.S. as foreign investors would seek dollars to buy up the higher yielding treasury securities. The resulting appreciation of the dollar would slam domestic employment and contradict one of the two dual mandates of the Federal Reserve. Until we see some major changes in the world economy, 4.2% is a fairly reasonable yield. Types of Bonds The Vanguard Long-Term Bond ETF is structured precisely how I would want it to be structured. The holdings include some foreign exposure without a very large allocation and a mix between industrial bonds and treasury bonds. Despite a strong allocation to treasury securities, there are no Agency MBS or Commercial MBS. Investors wanting access to those securities can acquire them on leveraged basis at a substantial discount to book value by buying mREITs. I see no reason to pay book value, but I would like a long term bond ETF with a heavy emphasis on high quality debts. Credit Quality The holdings are all solid. This is investment grade debt with a significant portion being treasury debt. This is a very solid ETF to have in your portfolio if the market starts tanking. I put together a demonstration of the role BLV plays in a sample portfolio. 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 BLV offers a clear negative correlation with each asset except for short term TIPS (no surprise, high credit quality) and equity REITs. The equity REITs in IYR have a slight positive correlation with BLV which is caused at least in part by the fact that BLV is holding some high credit quality non-Agency debt. Since a substantial portion of the debt is still corporate in origin, it has a higher correlation with equity REITs than it would if it were pure treasuries. Despite that, the ETF still has a very clear negative correlation with other equity assets classes. Normally that kind of negative correlation requires midterm or longer treasury securities, but most of those funds have very limited yields. That isn’t any surprise either since the demand for extremely high quality debt (treasury securities) has pushed the yields to extremely low levels. By incorporating investment grade corporate debt the total portfolio for BLV is able to offer a respectable return so that the fund offers investors a material amount of income along with a negative correlation that results in total portfolio risk being materially reduced. This is what a bond fund should look like. Vanguard is known for high quality and low cost funds, but this fund is downright exceptional.

3 ETFs Covering The Defense Industry

Summary PPA offers the broadest, most diverse portfolio, extending its coverage to cybersecurity and communications, but at a cost. ITA offers the highest dividend yield, but also seems to lack the performance edge of the other funds. XAR has a small portfolio, and has the fewest assets of the three, but may have performance advantages. Given current world tensions, there is no wonder one of the major concerns in Washington, D.C. (particularly Republican legislators) is national defense; in particular, there is a great desire to increase military spending, with both parties seeking ways to add more funds to the defense budget, differing only on how much and how to account for it. 1 It seems like a good time to review one’s holdings in the area of defense, and it also seems that a good way to cast a wide net over this industry segment is with an ETF. There are currently three that focus on aerospace and defense (A&D): PowerShares Aerospace & Defense Portfolio ETF (NYSEARCA: PPA ) iShares U.S. Aerospace & Defense ETF (NYSEARCA: ITA ) SPDR S&P Aerospace & Defense ETF (NYSEARCA: XAR ) Comparison These funds are offered by three of the major ETF sources, and they show it. The smaller of the three – XAR – weighs in at more than $100 million in assets; it is also the youngest of the three (relatively speaking), having its inception in 2011. Blackrock (NYSE: BLK ) gives its iShares offering, ITA , typical heft with a $458 million in assets under management. PPA brings a NAV of nearly $230 million. XAR also has the lowest expense ratio (0.35%) of the three, with ITA next lowest (0.45%) and PPA coming in with a just-above-average ER of 0.66%. 2 In more practical terms, ITA has an expense margin (EM) of 74.83%, compared to XAR’s EM of 72.50% and PPA’s 58.78% EM. 3 The three funds overlap on 27 companies – something one would expect given the tight focus of the associated indices. Moreover, eight of those companies show up in the top-ten holdings of each of the funds: The Boeing Company (NYSE: BA ) Rockwell Collins Inc. (NYSE: COL ) General Dynamics Corporation (NYSE: GD ) Lockheed Martin Corporation (NYSE: LMT ) Northrop Grumman Corporation (NYSE: NOC ) Precision Castparts Corp. (NYSE: PCP ) Raytheon Company (NYSE: RTN ) United Technologies Corporation (NYSE: UTX ) Of the three funds, ITA and XAR are the most similar. Both are guided by similar indexes – that is, to the extent that the S&P index used by XAR and the Dow Jones index employed by ITA can be said to be “similar.” ITA has the larger portfolio – both in terms of number of holdings and assets – but in addition to the 27 companies they have in common with each other and with PPA , ITA and XAR overlap on an additional five holdings. In this respect, the two funds are almost identical. All three funds make their selections based on market cap , with ITA and XAR also introducing liquidity considerations. The funds are rebalanced quarterly. By way of contrasts, PPA and XAR each has an aspect with respect to which it differs from the others in the group. PPA defines A&D in broader terms than the other two funds, allowing it to define a larger universe of prospective holdings and resulting in a significantly larger number of holdings than either ITA and XAR . The broader concept of A&D adds companies in communications and cybersecurity to the mix; the portfolio is therefore more diverse and less focused than that of the fund’s competitors. While both PPA and ITA are cap-weighted funds, XAR is equal weighted. As I have written elsewhere, I do have a preference for equal-weighted funds; 4 research indicates that, over the long haul, such funds tend to outperform cap-weighted funds – indeed, they tend to be among the best-performing funds. The boost is due to the fact that equal-weighted funds put more emphasis on mid – and small – capped companies , which are more likely to see significant growths in share value than large-capped firms. At the same time, however, the greater exposure to small-capped holdings – in particular – adds an increased element of volatility . Performance All of the funds have enjoyed fairly consistent growth since their inceptions, as illustrated here: (click to enlarge) Of course, ITA and PPA both had to contend with the recession from 2007 – 2009, and ITA seems to have been particularly hard hit. All three funds have managed to more than double their share values. A direct comparison of performance on the basis of price is not easy, given the differences in share prices, but the following chart looks at the funds’ performance: (click to enlarge) All three funds seem to be following the same general trend, and it seems doubtful that PPA ‘s broader focus has made any significant improvement in performance (although it does perform somewhat better than the other two funds). For a more direct comparison of the three funds the following chart compares their performance since the inception of XAR : (click to enlarge) What I find interesting here is that both ITA and PPA are very close in performance, with PPA having a roughly 320bps edge over ITA (due to the larger number of holdings?). But note that XAR significantly outperforms the competition; it currently has a 1335bps lead over PPA , and that is down from its position at the beginning of 2015. 5 Since XAR has the smallest portfolio of the group, it is not size that counts; furthermore, the three funds overlap on a significant part of their holdings – particularly between XAR and ITA – making it less likely that the particular holdings of the funds is the cause of the difference in performance. I am drawn to the conclusion that XAR’s weighting scheme is the important factor in its performance. The following chart illustrates the funds’ performance year-to-date: (click to enlarge) What is interesting to note here is that while XAR was outperforming the other two funds for most of the year (so far), after the dramatic drops realized over the past summer XAR is actually performing at a lower level than the other two funds. This gives us a rather dramatic illustration of the downside to equal weighting. Assessment I am increasingly becoming a big fan of equal weighting. All things considered, I find XAR to be the best of these three funds. It has a trim portfolio – especially compared to PPA’s 53 holdings – and its equally weighted portfolio seems to have a marked edge over the more standard, cap-weighted portfolios offered by PPA and ITA . Someone wanting to cast a broader net over the defense industry might prefer the more open focus of PPA . That broader focus does come at a price, as PPA offers the lowest dividend yield of the three. This may be due to the fact that cybersecurity firms often do not pay dividends, but the just-under-$230-million NAV and seven million shares outstanding certainly don’t help here. I do not think that the difference in dividends between PPA and ITA outweighs the performance edge PPA seems to have, however. PPA does have a very high ER , and does seem to be more lightly traded than either ITA or XAR . For its part, ITA offers the typical BlackRock advantage: size . It is by far the largest ETF in terms of AUM. Its cap-weighted scheme, along with the assets it has to back that up, pretty much assure shareholders of regular dividends . The fact that it has only roughly 4.5 million shares outstanding (compared to PPA’s seven million) means the distributions are not going to be overly diluted. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from the Company’s Prospectus, Statement of Additional Information, and fact sheets. All tables, charts and graphs are produced by me using data acquired from pertinent documents; historical price data from Yahoo! Finance . Data from any other sources (if used) is cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. 1 On October 1, for instance, House Republicans approved a $612 billion defense authorization bill (” House passes sweeping defense policy bill ,” Reuters, October 1, 2015), a bill President Obama has promised to veto. The President seeks a more modest increase in spending, suggesting a base budget of $534 billion, with an additional $51 billion in “war funds” (” Defense chief says Obama likely to veto defense policy bill ,” Reuters, September 30, 2015). 2 Expenses have been averaging around 0.62%. ” ETF Fees Creep Higher ,” Rick Ferri, Forbes.com . According to Ferri, figures indicated that since the 1990s, ERs have been gradually increasing. 3 For those unfamiliar with my use of “expense margin,” this is what I consider to be the ETF’s equivalent of “operating margin”: it is the cost of the ETF’s doing business. To determine the EM divide the actual net income realized by the ETF by the ETF’s gross income. One could replace net income with total distributions to shareholders. Essentially, the idea is to determine how much of an ETF’s income is passed on to shareholders. I discuss the issue in detail in my article ” Ignore ETF Expense Ratios? Maybe. ” As a practical application, consider that while XAR has a lower ER than ITA, it actually distributes smaller proportion of its gross income than ITA does. Since XAR’s expenses are lower, one would suspect that it does not realize as much income (proportionately) as ITA. 4 ” Guggenheim s RSP: Equal Weight Or Dead Weight? ” 5 At XAR’s high point for this year (10 April), it was up 153% since inception; PPA was up 148.96% since its inception; ITA was up 141.27% from its starting point. More impressively, starting all three funds from XAR’s inception date through 10 April 2015, XAR was up 153.30%, PPA was up 124.49% and ITA was up 125.48%.

Recession-Testing Your Portfolio

This article originally appeared in the October issue of REP. Magazine and online at Wealthmanagement.com There is correlation between economic phases and sector performance. Which funds will best ride the wave ? If you subscribe to common wisdom, the late-summer market selloff must have you thinking about the potential for a true recessionary slide. After all, the stock market looked like it had topped out after a stunning six-year run. Many investors and pundits subscribe to the notion that the stock market is a leading indicator of the economy’s direction. True believers assume that certain market sectors will price in improvements some six to nine months before their fundamentals actually perk up. They use these signals to overweight favored industries while paring exposure to those segments most likely to falter. The trick to this rotation business is, of course, correctly identifying the market’s current state. How do you, after all, spot ascendant sectors? And which ones fare best-or worst-at different points in the economic cycle? The second question’s pretty easy to answer. The first not so much, but we’ll get to that in a minute. Research has shown pretty strong correlations between sector performance and economic phases. Sam Stovall, chief equity strategist at S&P Capital IQ Equity Research, famously mapped the relationship when he authored “The S&P Guide to Sector Investing” in 1995 (see chart). If Stovall et al are to be believed, we could confirm a market top if we found bullish signals in the sectors that outperform during contractions, i.e., consumer staples (non-cyclicals), health care, utilities, financials and consumer discretionary (cyclicals). So let’s get back to that first question. Just how do we spot sectors poised for liftoff? Fundamental analysis won’t avail us for a timing decision like this. Here, technical indicators and trend analysis work better. But what indicator? And what trend? It’s best to look at a mix of near-term and longer-term signals rather than relying upon a single marker. After all, sector performance is time-dependent: some industries will do better in the early phase of a recession, others in the midphase. You can then weight each indicator according to your confidence in its predictive power. There’s a wide range of indicators you can employ, but a half dozen or so seems ideal and nondilutive. Try these as examples: Point & Figure Price Objective: A point and figure chart, by its nature, filters out a lot of market noise, making longer-term price objectives easier to see. On the basis of its predictive strength, we’ll assign it a 25 percent weight. Seasonality: Sector performance does, to a certain extent, depend on the calendar. Looking back over the past five years, we can rank final-quarter performance for each sector and ascribe a 20 percent weight. Relative Performance: Plotting each sector’s 200-day performance against the broad market, represented by the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), measures changes in the degree of investor interest. Let’s make this a 15-percent factor. 20-Day Volatility: Here, we’re rating low volatility more favorably because gains are more likely to be retained in a stable price trajectory. We gauge changes in 20-day volatility over a 12 month period. This, like all the subsequent metrics, earns a 10 percent weight. Relative Strength: Each sector ETF’s price strength is measured against the entire universe of ETFs over the past 12 months. Momentum: This indicator measures each sector ETF’s 6-month price trend versus its 12-month trend. A higher rank is assigned when the longer-term trend exceeds the shorter-term. Percentage Price Oscillator: Another momentum indicator, PPO often signals trend changes before price tops and bottoms are formed. To create a model sector array, we can employ the wildly popular universe of State Street SPDR Select Sector ETFs as proxies. We’ll weight the ETFs’ indicators, ranking each ‘1’ through ‘9,’ with ‘1’ representing the highest rank and ‘9’ the lowest. (click to enlarge) Four Sectors Likely to Outperform the Market Putting the indicators together, the four sectors now likely to outperform the overall market are consumer staples, financials, consumer discretionary, and utilities-all signposts on the recessionary trail. With a case made for recession, we have to wonder if the SPDR Select Sector products are the best vehicles to use in a portfolio overweight. Maybe they are, but it’s worth looking around to see if there are better alternatives. There are a half-dozen ETFs focused on the large-cap consumer staples sector, including the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ). From a reward-to-risk standpoint (i.e., the Sharpe ratio), the category leader is the Guggenheim S&P Equal Weight Consumer Staples ETF (NYSEARCA: RHS ). RHS holds the same number of consumer staples stocks as the S&P 500 but, by equally weighting them, gives more heft to the smaller issues. That tilt’s given RHS a performance edge over the rest of the field while keeping a lid on volatility. The iShares U.S. Consumer Goods ETF (NYSEARCA: IYK ), sporting the category’s highest beta coefficient, lags the other five funds. There’s less dispersion in the returns of financial sector ETFs, but a clear standout is the First Trust Financials AlphaDEX ETF (NYSEARCA: FXO ). FXO is the only product that earned a better-than-breakeven Sharpe ratio over the past five years. It’s also the ETF most highly correlated with the S&P 500 proxy portfolio. Among volatile financial ETFs, high correlation is a good thing, a fact confirmed by the low r-squared coefficient and high beta of the bottom-scraping RevenueShares Financials Sector ETF (NYSEARCA: RWW ). RWW earns the distinction because its portfolio is revenue-weighted, tilting it toward larger-cap financial institutions. The iShares U.S. Consumer Services ETF (NYSEARCA: IYC ) earned the best risk-adjusted return in its category, owing largely to its low beta. The high-beta product, the First Trust Consumer Discretionary AlphaDEX ETF (NYSEARCA: FXD ), is the worst performer. FXD’s multifactor index methodology and tiered equal-weighting scheme yield a risky tilt to the portfolio which hasn’t paid off in outsized gains. Among utility sector ETFs, the Guggenheim S&P Equal Weight Utilities ETF (NYSEARCA: RYU ) earns the only 1+ Sharpe ratio. RYU owes its high return-to-risk tilt to its telecom allocation, which also accounts for the fund’s exceptionally high dividend yield. In the cellar is the PowerShares DWA Utilities Momentum Portfolio ETF (NYSEARCA: PUI ), a fund that weights its portfolio on the basis of its components’ price momentum. Over the past five years, momentum added volatility without a commensurate enhancement to returns. If you’re going to gird your portfolio for a recessionary turn using sector rotation, it’ll pay for you to consider lower-beta ETFs. State Street’s (NYSE: STT ) ETFs may be category-killers in terms of size, but they’re a fairly volatile lot. As a class, better risk-adjusted returns are earned by the Guggenheim set of equal-weighted portfolios. No one’s obliged to use a single purveyor, of course, but commission-free ETF trading offered by some brokerages acts as a sort of loyalty program. Staying loyal to portfolio performance may require some careful picking and choosing.