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Examining An ETF Strategy For Your U.S. Equity Exposure

Summary Reviewing several ETFs with exposure primarily to the U.S. equity space to see which combination will produce the highest risk-adjusted returns. I have used a mixture of large, mid, and small cap ETFs to get broad exposure to the U.S. stock market. Using fifteen years of historical data, I believe increasing exposure to a smaller-cap ETF will produce higher long-term risk-adjusted returns. With Christmas just around the corner, many investors begin their focus on asset allocation and reviewing their portfolios. It has been a turbulent year for global equities with many different macro events affecting returns throughout the world. With the recent economic news coming out of the U.S., specifically the Friday jobs report and the imminent rate hike from the Fed later in December, I’ve turned my focus onto the U.S. equity space to ensure my exposure to this market is balanced, poised for long-term growth, and well-diversified in terms of sectors. For the purposes of this article, I have narrowed down my selection of ETFs to include those that are simply focused on different market capitalizations within the U.S. equity space. That means I have eliminated funds that may be dividend-focused, value/growth focused, sector-specific, or other specialty funds. I’ve done this to keep my analysis simple and ensure I get as broad and diversified as possible. Once I narrowed it down my list, I had three broad categories – Large Cap, Mid Cap, and Small Cap – as defined by the fund companies themselves. Next, I wanted to focus on just a few from each category to see which performed better. For the Large Cap ETFs, I chose the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) and the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ). For the Mid Cap space, I chose the iShares Core S&P MidCap ETF (NYSEARCA: IJH ) as well as the SPDR S&P MidCap 400 ETF (NYSEARCA: MDY ). Finally, for the Small Caps I only had one fund that had enough historical data to do the simulation, so I chose the iShares Core S&P Small-Cap ETF (NYSEARCA: IJR ). Timing When I was narrowing down my list of ETFs, I wanted to ensure they have been active long enough to see some of the more significant events of the last decade and a half. That way, the results would capture the tech bubble, the financial crisis, as well as the bull markets that accompanied them. Since most of the iShares ETFs were launched in May 2000, I chose to begin my analysis on July 1, 2000. SPY data by YCharts Assumptions All the daily share price data was pulled from Yahoo! Finance and I used the adjusted close price for all of my analysis. In addition, I used the 3-month treasury bill rates from the Federal Reserve website for each calendar year to calculate excess returns and risk-adjusted returns. Finally, I pulled the most recent MER information for each fund from Yahoo! Finance as well and reduced each year’s gross returns by that percentage before calculated the excess return information. Analysis Below is the summary of each of the five funds performance over the 15 years of data. To make my analysis easier, I used the last trading day of each year to calculate the yearly portfolio return to compare against the risk-free rate. (click to enlarge) Sources: Yahoo! Finance, Federal Reserve website As can be seen above, the small cap fund IJR offers the highest risk-adjusted return profile of the five funds I analyzed. Furthermore, you should note that as you move from the large cap funds of SPY and DIA to the mid-caps and then small, both absolute and risk-adjusted returns become stronger. I found this to be quite interesting as typically smaller cap funds comparatively have higher risk profiles. Since I wouldn’t recommend having all your U.S. equity exposure in one fund, I calculated some hypothetical portfolios with different weights for each of the three categories. From the data above, I also was able to narrow down which fund to use for each category; DIA for the Large Cap, IJH for Mid Cap and IJR for Small Cap. I also used $10,000 as a starting investment for each portfolio. Portfolio #1 – One third (1/3) invested in each of the three funds Portfolio #2 – 50% invested in the small cap, 25% in the others Portfolio #3 – 50% invested in the large cap, 25% in the others I found it quite interesting, although not surprising, just how much stronger the performance was on portfolio #2, which had 50% invested in the small cap ETF and ultimately how it also offered the strongest Sharpe Ratio. Overall, portfolio #2 outperformed the “standard” portfolio #1 by over 4.3% and the large-cap focused #3 by almost 12%. I also wanted to look at the sector breakdown of each fund to see if there was a significant difference in the three portfolios based on how the funds would be split up. As you can see below, there is some variance in the sector breakdown of each fund as you move from the large to small caps as well as with each portfolios’ hypothetical breakdown, but there is nothing overly significant to note. Most of the funds keep a relatively similar balance in the sectors with the exception of Real Estate which has zero exposure in the DIA. Conclusion I’ve always been well aware of the fact that, over longer periods of time, small cap stocks will tend to outperform large caps. For the most part, I was always of the impression that this higher return came with higher risk. However, after doing this analysis and seeing the results I would be inclined to increase my overall U.S. equity exposure to smaller cap companies as I am looking to hold onto this portfolio for an extended period of time. This sort of analysis is something I will continue to do each year to ensure if there are significant changes in the performance and risk profile of each fund that I capture them and adjust my investments accordingly.

Cheap Funds Dupe Investors – Q4 2015

Summary Comparison of AUM in funds with attractive holdings versus attractive costs. Distribution of ETFs and mutual funds by Predictive Rating and our two component ratings. Commentary on the shortcomings of traditional ETF and mutual fund research. Fund holdings affect fund performance more than fees or past performance. A cheap fund is not necessarily a good fund. A fund that has done well in the past is not likely to do well in the future ( e.g. 5-star kiss of death and active management has long history of underperformance ). Yet, traditional fund research focuses only on low fees and past performance. Our research on holdings enables investors to find funds with high quality holdings – AND – low fees. Investors are good at picking cheap funds. We want them to be better at picking funds with good stocks. Both are required to maximize success. We make this easy with our predictive fund ratings. A fund’s predictive rating is based on its holdings, its total costs, and how it ranks when compared to the rest of the 6700+ ETFs and mutual funds we cover. Figure 1 shows that 69% of fund assets are in ETFs and mutual funds with low costs but only 1% of assets are in ETFs and mutual funds with Attractive holdings. This discrepancy is astounding. Figure 1: Allocation of Fund Assets By Holdings Quality and By Costs Sources: New Constructs, LLC and company filings Two key shortcomings in the ETF and mutual fund industry cause this large discrepancy: A lack of research into the quality of holdings. A lack of high-quality holdings or good stocks. With about twice as many funds as stocks in the market, there simply are not enough good stocks to fill all the funds. These shortcomings are related. If investors had more insight into the quality of funds’ holdings, I think they would allocate a lot less money to funds with poor quality holdings. Many funds would cease to exist. Investors deserve research on the quality of stocks held by ETFs and mutual funds. Quality of holdings is the single most important factor in determining an ETF or mutual fund’s future performance. No matter how low the costs, if the ETF or mutual fund holds bad stocks, performance will be poor. Costs are easier to find but research on the quality of holdings is almost non-existent. Figure 2 shows investors are not putting enough money into ETFs and mutual funds with high-quality holdings. Only 94 out of 6706 (1% of assets) ETFs and mutual funds allocate a significant amount of value to quality holdings. 99% of assets are in funds that do not justify their costs and over charge investors for poor portfolio management. Figure 2: Distribution of ETFs & Mutual Funds (Count & Assets) By Portfolio Management Rating (click to enlarge) Source: New Constructs, LLC and company filings Figure 3 shows that investors successfully find low-cost funds. 69% of assets are held in ETFs and mutual funds that have Attractive-or-better rated total annual costs , our apples-to-apples measure of the all-in cost of investing in any given fund. Out of the 6706 ETFs and mutual funds we cover, 1524 (69% of assets) earn an Attractive-or-better Total Annual Costs rating. Clearly, ETF and mutual fund investors are smart shoppers when it comes to finding cheap investments. But cheap is not necessarily good. The PowerShares S&P SmallCap Utilities Portfolio ETF (NASDAQ: PSCU ) gets an overall predictive rating of Very Dangerous because no matter how low its fees (0.32%), we expect it to underperform because it holds too many Dangerous-or-worse rated stocks. Low fees cannot boost fund performance. Only good stocks can boost performance. Figure 3: Distribution of ETFs & Mutual Funds (Count & Assets) By Total Annual Costs Ratings (click to enlarge) Source: New Constructs, LLC and company filings Investors should allocate their capital to funds with both high-quality holdings and low costs because those are the funds that offer investors the best performance potential. But they do not. Not even close. Figure 4 shows that less than half (49%) of ETF and mutual fund assets are allocated to funds with low costs and high-quality holdings according to our Predictive Fund Ratings, which are based on the quality of holdings and the all-in costs to investors. Figure 4: Distribution of ETFs & Mutual Funds (Count & Assets) By Predictive Ratings (click to enlarge) Source: New Constructs, LLC and company filings Investors deserve forward-looking ETF and mutual fund research that assesses both costs and quality of holdings. For example, the PowerShares KBW Property & Casualty Insurance Portfolio ETF (NYSEARCA: KBWP ) has both low costs and quality holdings. Why is the most popular fund rating system based on backward-looking past performance? We do not know, but we do know that the transparency into the quality of portfolio management provides cover for the ETF and mutual fund industry to continue to over charge investors for poor portfolio management. How else could they get away with selling so many Dangerous-or-worse rated ETFs and mutual funds? John Bogle is correct – investors should not pay high fees for active portfolio management. His index funds have provided investors with many low-cost alternatives to actively managed funds. However, by focusing entirely on costs, he overlooks the primary driver of fund performance: the stocks held by funds. Investors also need to beware certain Index Label Myths . Research on the quality of portfolio management of funds empowers investors to make better investment decisions. Investors should no longer pay for poor portfolio management. Disclosure: David Trainer and Blaine Skaggs receive no compensation to write about any specific stock, sector or theme.

4 Key Reasons To Consider Market Neutral Investing

Summary The Invesco Quantitative Strategies team believes one way to buffer the effects of market downturns, volatility and rising interest rates is to add market neutral equity strategies to traditional portfolios. The strategies may offer several potential benefits to investor portfolios, including diversification from traditional asset classes, ability to dampen volatility, cushion against equity market declines and boost from rising rates. We believe a market neutral equity strategy can be an excellent diversification tool that enables investors to pursue increased returns from assets that respond differently to changing markets. Low correlation, downside protection and rising rate performance among key benefits By Kenneth Masse, Client Portfolio Manager The market downturn and ensuing volatility in the third quarter of 2015 is a timely reminder about the benefits of diversifying your portfolio with investment strategies that are expected to exhibit little-to-no correlation with the broad equity and bond markets. Moreover, as the US enters the late innings of its current economic growth cycle, many professional and individual investors are expecting lower returns from equities going forward than they’ve enjoyed over the last few years. These lowered expectations are on top of concern about what will happen to investors’ bond holdings when today’s historically low interest rates eventually rise. The Invesco Quantitative Strategies team believes one potential way to buffer the effects of market downturns, volatility and rising interest rates is to add market neutral equity strategies to traditional portfolios, as they potentially offer a unique approach to generating return regardless of the general movements of the equity and bond markets. In this blog, I outline four of the top reasons to consider market neutral equity strategies: 1. They have very low levels of correlation to other asset classes One of the ways investors attempt to manage and mitigate risk is by combining strategies that differ within and across asset classes to help diversify their return pattern over time. Using this approach, investors’ wealth creation is not tied to the fortunes of just one or a few investment options. Since market neutral strategies typically seek to eliminate exposure to the broader market, these strategies have also delivered attractively low levels of correlation, not only to the equity markets, but to other broad asset classes as well. As shown in Figure 1, from January 1997 to August 2015, market neutral strategies had only a 0.18 correlation to equities and a 0.04 correlation to bonds. Market neutral also had low correlation to another popular asset class, commodities, as well as to other segments of the fixed income market, such as leveraged loans and high yield. As investors seek to diversify their holdings in order to lower overall volatility, we believe market neutral strategies should be considered as a way to achieve that goal. Sources: Invesco and StyleADVISOR. (January 1997 – August 2015) BarclayHedge Alternative Investment Database. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. 2. They may offer lower levels of total volatility Another way to potentially mitigate risk across an investment lineup is to include strategies that may offer lower levels of total volatility (variation in portfolio returns). Even if these strategies were perfectly correlated with other investments, their potentially lower total volatility profile could help lower the overall average volatility of the full lineup. Market neutral strategies also may be appealing to investors from this total volatility perspective, as their volatility has tended to be less than the broader equity markets, and in some cases, similar to broad fixed income indexes (see Figure 2). Furthermore, since market neutral returns are expected to be independent of the broader equity market, a spike in market-level volatility may not necessarily mean a spike in market neutral volatility. Sources: Invesco and StyleADVISOR. (January 1997 – August 2015). BarclayHedge Alternative Investment Database. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. 3. They have a history of attractive downside protection during extreme market stress Another often-cited potential benefit of market neutral is that the strategies may offer investors a way to mitigate severe losses during a sharp equity market sell-off. Because these strategies typically have beta exposure to the market that hovers around zero, a big drop (or surge) in equities should not influence the performance of the strategy. This contrasts sharply with traditional, benchmark-centric strategies, which typically have very high levels of market exposure and tend to vary similarly to the broader market. Sources: Invesco and StyleADVISOR. January 1997 – August 2015. BarclayHedge Alternative Investment Database. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. 4. They can provide an opportunity for higher returns in a rising interest rate environment. We believe an increase in the federal funds rate from the US Federal Reserve is inevitable; at this point it’s simply a matter of when and by how much. For market neutral equity strategies, a rise in interest rates – specifically short-term interest rates – can potentially provide a boost to returns. This occurs when market neutral equity strategies short a stock and receive proceeds from that sale. Those proceeds typically earn a rate of return tied to the prevailing short-term interest rate, such as the fed funds rate. When that rate increases, so does the interest earned by market neutral equity strategies on their short sale proceeds Key takeaway We believe a market neutral equity strategy is a valuable complement to a traditional portfolio of stocks and bonds, as well as an excellent diversification tool that enables investors to pursue increased returns from assets that respond differently to changing market conditions. Such characteristics may be important to today’s investors given the recent market downturn, volatility and expectation of rising interest rates. Important information Beta is a measure of risk representing how a security is expected to respond to general market movements. Correlation is the degree to which two investments have historically moved in relation to each other. Volatility measures the amount of fluctuation in the price of a security or portfolio over time. The S&P 500® Index is an unmanaged index considered representative of the US stock market. The S&P/LSTA US Leveraged Loan 100 Index is representative of the performance of the largest facilities in the leveraged loan market. The S&P GSCI Index is an unmanaged world production-weighted index composed of the principal physical commodities that are the subject of active, liquid futures markets. The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar-denominated, below-investment-grade corporate debt publicly issued in the US domestic market. BarclayHedge Alternative Investment Database is a computerized database that tracks and analyzes the performance of approximately 6800 hedge fund and managed futures investment programs worldwide. BarclayHedge has created and regularly updates 18 proprietary hedge fund indices and 10 managed futures indices. BarclayHedge indexes reflect performance of hedge funds, not of retail investment strategies, and are used for illustrative purposes only solely as points of reference in evaluating alternative investment strategies. Please note: BarclayHedge is not affiliated with Barclays Bank or any of its affiliated entities. Performance for funds included in the BarclayHedge indices is reported underlying fees in net of fees. About risk Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments. Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Most senior loans are made to corporations with below investment-grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may not be sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may be illiquid. Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods. Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested. Short sales may cause the fund to repurchase a security at a higher price, causing a loss. As there is no limit on how much the price of the security can increase, the fund’s exposure is unlimited. The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE All data provided by Invesco unless otherwise noted. Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. ©2015 Invesco Ltd. All rights reserved. Four key reasons to consider market neutral investing by Invesco Blog