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XLP Has Numbers For Volatility And Correlation, But It Could Be Better

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.

The Stock Market’s Best Shot? A Fed Promise To Move Slower Than A Three-Toed Sloth

The U.S. economy is even more dependent on the consumer than it ought to be. And by extension, consumer credit as well as service-oriented business credit become more critical than they might otherwise be. And what affects credit more than the Federal Reserve? Until investors learn the what, when and why of Fed policy guidance, riskier assets will remain volatile. Consumers, as opposed to manufacturers, represent two-thirds of the U.S. economy. Indeed, Americans love to splurge. We buy sneakers, iPhones, home furnishings, real estate, cars, jewelry, concert tickets, and meals at our favorite restaurants. We even buy chew toys for our pets. Many of us, however, do not have enough cash saved up to acquire the things that we want when we want them. So we borrow. We satisfy our cravings through instruments of debt – credit cards, mortgages, “refis,” equity lines and school loans. Like consumers, there are scores of corporations that borrow more than they should and gorge when ultra-low interest rates beckon. How do companies do it? They issue low-yielding bonds to yield-seeking investors. Theoretically, companies can use the newfound dollars on research, development, marketing, equipment and human resources. In 2015, though, public corporations are spending an estimated 28% of their available cash on acquiring shares of their stock. That’s the highest percentage since 2007. Why do companies buy so much of their own stock in what the investing community calls “share buybacks?” Less stock in the marketplace limits supply, boosts the perception of profitability per share and artificially boosts buyer demand; prices tend to move higher. Stock prices rise in the early stages of accelerating corporate share buybacks. For instance, in the bull market of 2002-2007, public companies committed more and more of their total cash; the higher the prices moved, the less shares that corporate borrowed dollars could afford. As buybacks peaked in 2007, they rapidly descended during the 2008-2009 financial collapse. Now look at the current economic recovery since the 2nd quarter of 2009. Share buybacks have been on a strong upward trajectory, pushing stock market benchmarks to new heights. In fact, one of the big reasons that so many executives have been lobbying the U.S. Federal Reserve to hold off on hiking borrowing costs in September is because those costs would adversely impact the financing of stock buybacks at ultra-low bond yields. Are consumers and corporations the only groups that salivate over ultra-low interest rates? Hardly. The federal government debt is rapidly approaching $19 trillion. In particular, obligations have grown by approximately $8 trillion since the recovery’s inception – a pace that is more than twice as fast as the growth of the U.S. economy itself. That’s right. Uncle Sam is spending borrowed dollars at an alarming clip, guaranteeing that higher and higher percentages of total tax revenue will be used for debt servicing. (Recognize that nobody believes in the notion that debts could ever be paid back.) Why might this be troublesome at this particular moment? The Federal Reserve has wanted to hike borrowing costs as early as mid-September. And that means that Uncle Sam will likely be paying higher rates to service the interest charges on its treasury bonds very soon. What’s more, if the Federal Reserve hikes borrowing costs, consumers will have to pay more to service adjustable loans and mortgages; businesses will have to pay more to service the interest on corporate bonds. The probable result? The economy slows and possibly contracts such that Uncle Sam brings in less-than-anticipated tax revenue. Indeed, the Fed has been spooking markets with its desire to move toward “rate normalization.” If committee members spoke candidly about a more realistic intention – a plan to move no more than 1% off of the 0% anchor by the end of 2016 – there would be an end game that global investors could factor into decision making. Instead, there is fear that the Fed is misreading the tea leaves on the health of the U.S. economy as well as fear that the central bank would move to far in the wrong direction. Consider the manufacturing slowdown – the “less important” one-third of the U.S. economy. Does anyone doubt that U.S. manufacturing has suffered due to the global manufacturing slowdown and the outright recessions in places like Canada, Brazil and parts of the euro-zone? The recent jobs report by ADP confirms it. Of the 190,000 jobs created, 173,000 received the tag of “service-providing” whereas a meager 17,000 had been deemed “goods-producing.” Should we dismiss that oil giant Conoco Phillips is laying off 10% of its global workforce? What about critical metrics such as factory new orders and product shipments? The percentages for both are negative on a year-over-year basis. Global manufacturing woes did not just hit the investment markets in August; rather, the declines have been developing in key economic sectors since the fourth quarter of 2014. Every significant manufacturer-dependent sector in the exchange-traded investing world – iShares Dow Jones Transportations (NYSEARCA: IYT ), Industrials Select Sector SPDR (NYSEARCA: XLI ), Energy Select Sector SPDR (NYSEARCA: XLE ), Materials Select Sector SPDR (NYSEARCA: XLB ) – is down 10% or more year-to-date. It follows that the U.S. economy is even more dependent on the consumer than it ought to be. And by extension, consumer credit as well as service-oriented business credit become more critical than they might otherwise be. And what affects credit more than the Federal Reserve? Until investors learn the what, when and why of Fed policy guidance, riskier assets will remain volatile. Intra-day price swings of 300 points on the Dow? We should feel lucky if it remains that subdued. As regular readers already know, I began reducing client exposure to risk before the mid-August price plunge. We raised cash/cash equivalents in our accounts . Those levels are roughly 25% for moderate growth investors. The cash is there to reduce portfolio volatility, minimize depreciation in portfolios and provide opportunity to buy quality assets at lower prices. We also have 25% allocated to investment-grade income. Whereas moderate risk clients may typically have 65-75% in stocks, we gradually reduced that level to 50% across June and July. Our reasons for the tactical asset allocation shift? I presented them in ” A Market Top? 15 Warning Signs ” when the S&P 500 traded in and around the 2100 level. The 50% allocated to stock is spread across a variety of large-cap U.S. ETFs, including but not limited to, iShares S&P 100 (NYSEARCA: OEF ), Vanguard High Dividend Yield (NYSEARCA: VYM ), Health Care Select Sector SPDR (NYSEARCA: XLV ) and Vanguard Mid-Cap Value (NYSEARCA: VOE ). Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationships.

Rate Hike Fears Rise, Time For Taper ETF?

The moment the China-induced stock market gyrations cooled a bit, the U.S. market started gaining ground. Meanwhile, the U.S. economy grew at 3.7% in Q2, which breezed past the initial reading of 2.3% growth and 0.6% expansion recorded in the seasonally weak Q1. Other data points including housing and job came on the stronger side at the home front. As a result, the bet on a September timeline of the Fed lift-off – which took a backseat in mid-August as global market rout took an upper hand – is back on the table on now. If this was not enough, Stanley Fischer who happens to be the Fed’s vice-Chairman flared up the rising rate worries even more. So, inflation was the main hindrance en route to Fed policy tightening as inflation is short of the Fed’s longer-term target on extremely muted energy prices. Also, the emerging Chinese market volatility prompted some to hope for a later-than-expected hike in rates. But, the Fed’s vice chairman expects inflation to inch up eventually. So waiting for a 2% inflation goal could be a pricey option. Though he added “we’ve got time to wait and see the incoming data and see what is going on now in the economy” before deciding on hiking rates, the jittery nerves ignited the rate hike bet all over again. There will be a set of data to be released and looked at before this historic decision is taken after nine long years, but the September lift-off timeline is now a possible option. This sent the yield on 10-year Treasury note to 2.20% (on September 2, 2015) from 2.01% recorded on August 24. In such a situation, the U.S. market will likely see a slump in the bond bull market next year and investors can make the most of it by shorting treasuries. Though the inverse U.S. Treasury space has only a handful of products, Barclays Inverse US Treasury Aggregate ETN (NASDAQ: TAPR ) could be an intriguing play for investors already preparing for the impending rate hike. TAPR in Focus The note provides investors a unique strategy to hedge against or benefit from the rising U.S. dollar interest rates by tracking the Barclays Inverse US Treasury Futures Aggregate Index. This benchmark employs a strategy, which follows the sum of the returns of the periodically rebalanced short positions in equal face values of each of the 2-year, 5-year, 10-year, long-bond and ultra-long U.S. Treasury futures contracts. If the price of each Treasury futures contract increases or decreases by 1% of its face value, the value of the index would decrease or increase by 5% over the same period. The ETN has about $22 million in net assets. It charges 43 bps in annual fees and trades in a light volume of about 5,000 shares per day on average, ensuring additional cost in the form of a wide bid/ask spread. The note added about 5.3% in last one month (as of September 2, 2015) thanks to the ascent of the benchmark treasury yield. Bottom Line TAPR offers investors positions against all five tenures on the U.S. Treasury futures curve and provides an interesting hedging strategy between short-term, intermediate-term and the long-term bonds. Investors should note that short-term bonds are less interest-rate sensitive and low yield in nature while long-term bonds act differently. Thus, focus on every part of the yield curve makes this product worthwhile. Original Post