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TLT: Negative Beta Makes This Bond ETF Great For The Equity Heavy Portfolios

Summary TLT is a high-duration treasury ETF. The expense ratio of .15% is within reason and the yield of 2.66% is enough to generate a small amount of income. The main reason for holding a fund like TLT is to keep portfolios values steady when equity markets fall on fear. TLT has a negative correlation with most equity investments and a negative correlation with short term high yield bond funds. 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 iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ). 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 TLT is .15%, which is within reason for long term treasury ETFs. I’d love to see expense ratios dipping towards single digits, but this is still within reason. Yield The yield on the fund is 2.66%. This is lower than investors would expect from even a short term high yield fund, but it does provide some income in exchange for investors taking on the duration risk which can cause TLT to be fairly volatile. Maturity The maturity profile for TLT is fairly simple, as shown below. Over 98% of the portfolio is in treasury securities with a maturity of at least 20 years. Given the name of the ETF, that shouldn’t be a surprise. Similarly, the fund is pretty much exclusively treasury securities. No surprises in this category. 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 TLT and the PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEARCA: HYS ) for high yield shorter term debt and 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. The Consumer Staples Select Sector SPDR ETF (NYSEARCA: 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. The 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. The 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 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, the 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. When it comes down to it, TLT shines in a portfolio. In a vacuum, TLT would be a fairly poor investment due to its high volatility and mediocre yield. Being over 2.6% means the income is material, but for most investors that yield is not going to cover a large portion of their living expenses and unlike dividend growth funds this won’t be rapidly compounding unless the position is increasing in value from yields falling. The additional total return would be nice, but it would leave investors with even fewer options for trying to produce material amounts of income to support their lifestyle. By including TLT in a portfolio that is heavy on equities the risk/return profile is materially improved. A strong negative correlation with equity investments means TLT generally moves up when those investments are falling in value. The combined portfolio exhibits substantially less volatility than the domestic equity market. While high volatility for an individual holding can often be considered a bad thing, negative correlations with so many other investments completely reverses the impact. Look at the chart below to see how much higher the total risk profile of the portfolio would have been if the position in TLT had been placed in SPY instead: (click to enlarge) The date range used is the same, but the annualized volatility of the portfolio has increased from 9.4% to 13.7% because this portfolio lacks balancing effect of TLT using a negative correlation to keep portfolio values steady when investors are fleeing the equity market to buy up long term treasury securities. Conclusion TLT is offering most of the things I’m looking for in a long term bond fund. The fund has high volatility, but the low correlation with the market results in a beta of negative .55. When I’m looking for long term bond funds my first areas to consider are the expense ratio and whether the fund is eligible for free trading. Unfortunately, TLT does not fall on my list for free trading which is a significant problem since I want to be regularly rebalancing the positions which means much higher trading fees if the ETF is not eligible for free trading. Despite that one weakness, TLT does well on every other metric. It offers a solid negative beta and enough income to feel like it is in the portfolio for more than just the negative beta. This is a very respectable ETF for long term treasury exposure. 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: TLT has a negative correlation with most equity investments and a negative correlation with short term high yield bond funds

SCHF: My Portfolio Needs A Little More Of This Low Cost International ETF

Summary SCHF has excellent internal diversification and a low expense ratio. I’m holding SCHF already but I think I will add to the allocation. SCHF has only moderate correlations with domestic equities but shares their negative correlation with long term treasury ETFs. Holding SCHF as a major piece of the portfolio would be too risky, but it is great for being a small international 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 Schwab International Equity ETF (NYSEARCA: SCHF ). 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. Largest Holdings The diversification within SCHF isn’t too bad. By the 6th holding the allocations are less than 1% and there are over 1200 holdings in total. Put simply, SCHF is what I would look for as the centerpiece of an international allocation. The holdings are shown below: (click to enlarge) Expense Ratio The expense ratio on SCHF is only .08%. There is no way to complain about an expense ratio of .08% on international equity. Combined with it showing reasonable levels of volatility for an international equity investment in regression testing, I decided to use it as one of my international equity holdings. I’m already long SCHF, but there is a significant chance that I will be increasing my allocation since it is currently less than 2% of my portfolio. Building the Portfolio I put together a hypothetical portfolio using only ETFs that fall under the “free to trade” category for Charles Schwab accounts. My bias towards these ETFs is simple, I have my solo 401k there and recently moved my IRA accounts there as well. When I’m building a list of ETFs to consider I want to focus on things I can trade freely so that I can keep making small transactions to buy more when the market falls. Within the hypothetical portfolio there are no expense ratios higher than .18%. Just like trading costs, I want to be frugal with expense ratios. The portfolio is fairly aggressive. Only 30% of the total is allocated to bonds and I would consider that the weakest area in the portfolio. I’d like to see more bond options (with very low expense ratios) show up on the “One Source” list for free trading. (click to enlarge) A quick rundown of the portfolio The Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) is a dividend index. The Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) is a broad market index. The Schwab U.S. Large-Cap ETF (NYSEARCA: SCHX ) is focused on blended large cap exposure. The Schwab Emerging Markets ETF (NYSEARCA: SCHE ) is emerging market equity. The Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ) is developed small capitalization equity. The Schwab U.S. REIT ETF (NYSEARCA: SCHH ) is domestic equity REITs. The Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) is a remarkably complete bond fund. The SPDR Barclays Long Term Treasury ETF (NYSEARCA: TLO ) is a long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) is an extremely long term treasury ETF. Notice that the 3 international equity ETFs have only been weighted at 5% while the broad market index has been weighted at 25%. I find heavy exposure to international equity to bring more risk than expected returns so I try to keep my international exposure low. I prefer no more than 20% in international equity. Plenty of domestic companies already have enormous international operations so the benefit of international diversification is not as strong as it would be if the markets were isolated from each other. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. When TLO and ZROZ post negative risk contribution it is because the negative correlation to most of the equity holdings results in the long term treasury ETFs reducing the total portfolio risk. In my opinion, this is the best argument for including them in the portfolio. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). 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) Holding SCHF SCHF is still a fairly volatile equity investment so investors should be planning on balancing their portfolio occasionally to ensure that their allocations don’t drift too far away from the intended allocations. I’m thinking that I will want to add some SCHC to my portfolio as well to round out my international exposure. While SCHF is holding larger and more stable international investments the portfolio for SCHC is even more diversified and focusing on holding smaller companies. In designing a long term portfolio strategy I see mixing SCHF and SCHC as a solid way to enhance my portfolio exposure and ensure that I am allocating more of my money to whichever ETF is out of favor. You may notice from the chart that ZROZ is excellent for diversification with SCHF. The correlation comes in at a negative .47 which is great for the diversification benefits. I could use TLO instead because it is less volatile than ZROZ, but my intent is to bring in high volatility on the allocation that will have a negative correlation to almost everything else in my portfolio. It may sound like risk seeking behavior to intentionally pick the more volatile investment but the high volatility combined with the low correlation means I can use a smaller allocation within the portfolio to achieve the desired level of diversification. When it comes to the bond allocations, I’m focused on the diversification benefits more than on their ability to generate income. Realistically, bonds just don’t pay a reasonable interest rate in the current macroeconomic environment. The logical reason to hold the bond ETF is to provide some stability at the portfolio level and ZROZ is doing that very well. I think my portfolio would stand to benefit from having a little more SCHF in my strategy and adding some long duration bonds. Conclusion I don’t see anything to dislike about SCHF. The expense ratio is low and the holdings are highly diversified. The ETF adds diversification benefits to the standard domestic equity exposure and it still maintains a very negative correlation with the same bond funds that I would want to use for their negative correlation with domestic equities. Simply put SCHF just fits well within the portfolio. In my opinion, an allocation greater than 20% would be dangerous to the health of the portfolio, but for an allocation between 5% and 10%, I think SCHF looks very nice. Disclosure: I am/we are long SCHF, SCHB, SCHD, SCHH. (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.

Guggenheim Launches Equal-Weight Real Estate ETF

By DailyAlts Staff S&P Dow Jones Indices divides the U.S. stock market into ten sectors: Consumer-discretionary, consumer-staples, energy, financials, health care, industrials, materials, technology, telecommunications, and utilities. Real estate investment trusts (“REITs”) and other real estate-related stocks are currently included within the financial sector, but that will change next year , when S&P Dow Jones will break real estate out into an eleventh sub-sector of the S&P 500. Guggenheim Investments, which already has 14 equal-weight “smart beta” ETFs, is staking its claim on the new sector well in advance of its September 2016 debut with the launch of the Guggenheim S&P 500 Equal Weight Real Estate ETF (NYSEARCA: EWRE ). There are currently at least 33 real estate index funds on the market, but most – like the market-leading Vanguard REIT ETF (NYSEARCA: VNQ ) – are market cap-weighted. As a result, Simon Property Group (NYSE: SPG ), by far the U.S.’s largest REIT, dominates many of these other products. But within the Guggenheim S&P 500 Equal Weight Real Estate ETF, the nearly $60 billion SPG makes up just 1/25 of the fund’s holdings, which include the 25 S&P 500 stocks currently classified in the GICS real estate group, excluding mortgage REITs. The danger of market cap-weighted indexes and funds is that overvalued components are overweighted, and undervalued components are underweighted. The Guggenheim S&P 500 Equal Weight Real Estate ETF, by contrast, practices disciplined, systematic rebalancing to reallocate from outperforming to underperforming stocks, thereby potentially capitalizing on the mean-reverting characteristic of securities and ensuring that no single stock dominates the fund’s performance. This difference in weighting does result in both risk and return differences, and equal weighted funds end up having more exposure to stocks with small capitalizations, thus resulting in a small cap bias. How does this play out in performance terms? The following chart from the S&P Dow Jones website compares the equal and cap weighted REIT indices from S&P Dow Jones (see their website for additional disclosures): As of Aug. 31, 2015. All information for an index prior to its Launch Date is back-tested, based on the methodology that was in effect on the Launch Date. While the above comparison is not a pure apples to apples comparison (the S&P United States REIT Index is cap weighted, but includes REITS from all cap ranges, while the Equal Weight Index includes only REITS in the S&P 500 Index), the performance of the indices do bear out some differences over time. “The time-tested equal weight strategy can help long-term performance by reducing the bias towards the largest individual companies within a particular cap-weighted strategy,” said William Belden, Guggenheim’s Managing Director of Product Development, in a recent statement. “An equal-weight approach also may enhance portfolio diversification by reducing concentration risk often found in cap-weighted indices and provide a more balanced exposure across market capitalizations.” For more information, visit the fund’s webpage . Past performance is not necessarily indicative of future performance