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VFINX/VBLTX Power-Up: Replace VFINX With UPRO Or SPXL

Summary I recently wrote about VFINX/VBLTX portfolios, and how to choose an asset allocation to maximize returns for the level of volatility you can tolerate. Swapping VFINX for a leveraged S&P 500 ETF makes the maximization game much more profitable. You can achieve a greater expected return for any particular level of volatility. You lose the benefit of completely free trades in a Vanguard account, but the improvement in expected returns is definitely worth it. Mathematically, using a leveraged version of VFINX allows you to increase your allocation to VBLTX, capturing a greater percentage of its alpha. I believe UPRO/VBLTX (or SPXL/VBLTX) can be an excellent core portfolio for many investors. VFINX and VBLTX In a recent article, I looked at the performance of various two-fund “stocks and bonds” portfolios comprised of Vanguard mutual funds. I paired the Vanguard 500 Index Fund Investor Shares (MUTF: VFINX ) with Vanguard bond funds of various durations, and found that the long-term bond fund, the Vanguard Long-Term Bond Index Fund (MUTF: VBLTX ), was generally the best choice in terms of maximizing expected returns for a particular level of volatility. Here is a slightly modified version of a graph from that article (curves for the other bond funds removed): (click to enlarge) To get you up to speed, the upper-right point on the curve shows that for a portfolio comprised of 100% VFINX, and 0% VBLTX, the mean and standard deviation of daily gains going back to 1994 are 0.042% and 1.192%, respectively. The next point, which represents 90% VFINX and 10% VBLTX, results in a slightly lower mean (0.041%) and considerably lower standard deviation (1.061%), making it arguably the better portfolio. You can see how mean and standard deviation vary as VFINX allocation increases in 10% increments all the way to 0% VFINX, 100% VBLTX. Notably, standard deviation is minimized for 25.8% VFINX, 74.2% VBLTX. So if you were a relatively conservative investor who wanted to take on no more than 75% of the S&P 500’s volatility, you would look at the second-from-the-right vertical line, and see that to maximize expected return you would need to be just below the 3rd data point from the right, or a VFINX allocation slightly below 80%. A nice aspect of a two-fund strategy based on Vanguard mutual funds is that trading costs are very low. The mutual funds have very low expense ratios and can be traded commission-free in a Vanguard account. 3x VFINX and VBLTX Something magical happens when you swap VFINX for a hypothetical 3x daily version of it: you get a drastically better expected returns for any given level of volatility. Take a look: (click to enlarge) (Note: Data points represent 10% allocation steps for VFINX/VBLTX, and 5% allocation steps for 3x VFINX/VBLTX. Also, daily gains for the hypothetical 3x VFINX fund were calculated by simply multiply VFINX gains by 3 and then subtracting a fixed value corresponding to a 1% annual expense ratio.) You can see that the blue curve offers drastically better mean returns than the red curve. For example, 90% VFINX/10% VBLTX (second point from the right on the red curve) has a standard deviation of 1.061% and a mean of 0.042%; 30% 3x VFINX/70% VBLTX (7th point from the bottom on the blue curve) has a very similar standard deviation of 1.064, with a much greater mean of 0.058%. In addition, with 3x VFINX/VBLTX you have the option of taking on more volatility than the S&P 500, and getting an excellent additional return. For example, if you can tolerate up to 50% more volatility than the S&P 500, you can achieve an 84.3% greater mean return (51.2% 3x VFINX/48.8% VBLTX: standard deviation 1.788%, mean 0.077%). CAGR vs. MDD I think the mean vs. SD plot best describes the performance of various VFINX/VBLTX portfolios. But CAGR vs. MDD is also very interesting, and highlights the huge improvement you get with 3x VFINX. (click to enlarge) You see drastically better raw returns for various maximum drawdowns with 3x VFINX/VBLTX compared to VFINX/VBLTX. One interesting special case, 35% 3x VFINX/65% VBLTX has about the same MDD as VFINX (55.4% vs. 55.3%), but with a much greater CAGR (14.7% vs. 9.1%). Also noteworthy, the CAGR for 3x VFINX/VBLTX portfolios starts to decrease once the allocation to 3x VFINX reaches about 70%. How to Invest in 3x VFINX Vanguard does not offer a leveraged version of VFINX (or any leveraged funds for that matter), but there are several 3x daily S&P 500 ETFs to choose from. The ProShares UltraPro S&P 500 ETF (NYSEARCA: UPRO ) and the Direxion Daily S&P 500 Bull 3x Shares ETF (NYSEARCA: SPXL ) are two options. They both have expense ratios right around 1%, and both have done an excellent job tracking 3x daily S&P 500 gains over their 6-7 year lifetimes. I know some readers will take issue with the fact that my results are based on sort of “fake” data, as I just multiplied daily VFINX gains by 3 to simulate a leveraged version of the fund (or, equivalently, the performance of UPRO or SPXL before they were around). I wouldn’t worry about this too much. All signs indicate that daily leveraged ETFs like UPRO and SPXL have very minimal tracking error. Mathematical Basis Intuitively, the reason 3x VFINX/VBLTX provides better mean returns for a given level of volatility is that it allows for a greater allocation to the alpha-generating VBLTX. Suppose you can achieve a volatility of 1% with either 90% VFINX/10% VBLTX or 40% 3x VFINX/60% VBLTX. Which will have greater expected returns? The second, because it retains 40% of VBLTX’s alpha rather than only 10%. Now for a more mathematical approach (feel free to skip). Consider a VFINX/VBLTX portfolio where C represents the proportion allocated to VFINX, and (1-C) the allocation to VBLTX; and a 3x VFINX/VBLTX portfolio where D represents the proportion allocated to 3x VFINX, and (1-D) the allocation to VBLTX. Suppose we start at the top-right part of the first figure (i.e. C = D = 1) and decrease both C and D to the point where both portfolios have the same volatility. It is easy to see that D will be less than C, i.e. you will have to allocate less to 3x VFINX than to VFINX to achieve a certain portfolio volatility. So the two portfolios have the same volatility, and D < C. Let's compare their expected returns. Let X = daily VFINX return and Y = daily VBLTX return. The first portfolio's daily return, say Z 1 , is given by Z 1 = C X + (1-C) Y. The second portfolio's daily return, say Z 2 , is given by Z 2 = 3D X + (1-D) Y. How do Z 1 and Z 2 compare? Let's subtract their expected values, and see if we can figure out if the difference favors one or the other. E(Z 2 ) - E(Z 1 ) = [3D E(X) + (1-D) E(Y)] - [C E(X) + (1-C) E(Y)] = [3D - C] E(X) + [(1-D) - (1-C)] E(Y) We know E(X) and E(Y) are both positive (otherwise we wouldn't invest in stocks or bonds). The coefficient [(1-D) - (1-C)] is also positive since D < C. Thus the entire expression will be positive as long as 3D > C, or equivalently D is greater than one-third of C. I’m sure there’s some way to prove this is true under certain circumstances. But it’s good enough to just look at a plot of C and D vs. volatility, and observe that indeed 3D > C (i.e. dotted black line is above blue line), except at the very left side of the graph. (click to enlarge) Conclusions The more I think about leveraged ETFs, the more valuable I realize they are. Here, I show that you can drastically improve performance of a S&P 500/long-term bonds portfolio by simply replacing the S&P 500 fund with a 3x version. Whatever level of volatility you are willing to tolerate, you can achieve higher expected returns by simply using a leveraged S&P 500 fund. The reason is positive alpha. Using a leveraged stocks fund lets you achieve a particular level of volatility while allocating a greater percentage of your assets to an alpha-generating bond fund. More capital generating more alpha means greater returns. The results here are shown for VBLTX, but the main points should also hold for other long-term bond mutual funds or ETFs. Additionally, for those wary of investing in long-term bonds given that interest rates are about to rise, I would suggest considering a similar approach with a short or intermediate-term bond funds.

Shopping For High Dividend ETFs? Beware Volatility

This article originally appeared in the October issue of REP. Magazine and online at Wealthmanagement.com Yield-starved investors turn to high-dividend payers to squeeze out some cash flow, but how do you squeeze extra yield out of the market without blowing your risk budget? In today’s low-yield bond market, it’s no wonder income-oriented investors have looked to dividends for supplemental cash flows. In February 2011, ten-year Treasury notes were paying nearly two percentage points more than the S&P 500 dividend yield (see Chart 1). The yield premium has since plummeted and, at times, actually turned into a discount. Blue Chips Stalled The ten-year and blue-chip benchmarks are now pretty much stalled at a two percent yield, forcing many investors to cast about for better-paying opportunities. Especially enticing are high-dividend exchange-traded funds (“ETFs”), which offer cash flows nominally devoid of duration and interest rate risk. Seven have track records stretching back more than five years: The 100 stocks making up the iShares Select Dividend ETF (NYSEARCA: DVY ) are screened on the basis of dividend growth and sustainability. Utilities account for more than a third of the portfolio’s capitalization. Financials, mostly REITs, come in second. The 50-stock SPDR Dividend ETF (NYSEARCA: SDY ), which screens the S&P 1500 Composite Index for stocks with 20 years or more of consecutive dividend increases, maintains a narrower portfolio. Consequently, SDY skews heavily toward REITs. Vanguard avoids REITs entirely in its high-dividend product. The 400+ stocks populating the Vanguard High Dividend Yield ETF (NYSEARCA: VYM ) are more or less evenly weighted by sectors and tilt toward large caps. First Trust sponsors two veteran high-dividend ETFs. The larger, First Trust Value Line Dividend ETF (NYSEARCA: FVD ), is built with low-beta issues found with Value Line’s proprietary “safety rating” methodology. Not surprisingly, FVD gives over nearly a quarter of its real estate to utilities. The loose inclusion criteria of the WisdomTree High Dividend ETF (NYSEARCA: DHS ) accounts for its 900+ stock portfolio and its relatively modest sector bets. Still, financials are weighted more heavily than utilities. FVD’s stablemate, the First Trust Morningstar Dividend Leaders Index ETF (NYSEARCA: FDL ), is a 100-stock portfolio comprised of companies that have boosted their dividends over the past five years. REITs are specifically excluded. Accordingly, FDL tilts toward utilities. Rounding out the set is the PowerShares High Yield Equity Dividend Achievers Portfolio ETF (NYSEARCA: PEY ), a 50-stock portfolio of large caps selected on the basis of their ten-year dividend growth histories. Utilities figure heavily in the mix-more so, in fact, than in the other veteran funds. When interest rates sag, income-hungry investors may be tempted to chuck fixed-income exposure in favor of high-dividend funds. That’s a very risky move, however. Remember: These funds are equity products. Replacing all or part of a portfolio’s fixed-income allocation increases exposure to stock market volatility and can further concentrate risk in certain industry sectors. Choices, choices So how do you squeeze some extra yield out of the market without blowing your risk budget? The first step ought to be identifying the high-dividend funds that provide the greatest diversification. There’s a couple of ways to look at this problem. From Table 1, you can see that the First Trust FDL portfolio, in addition to offering the highest dividend yield, has the lowest r-squared and beta correlations versus the S&P 500. That makes FDL pretty different and pretty attractive. FDL, however, posts the worst Sharpe and Sortino ratios of the lot. Not a good thing. The Sharpe metric, remember, rates a fund’s risk-adjusted returns using total volatility. The Sortino ratio does the same thing but only uses downside deviation as the representation of risk. If preservation of capital is paramount, a high-dividend fund sporting the best Sharpe and Sortino ratios ought to be a top pick. That makes the PowerShares PEY fund a standout. The next problem is the allocation issue. Just how much of the high-dividend fund do you add to your portfolio? And, where do you carve out room for it? Here, a little backtesting offers clues. Suppose you’re keen on dampening risk as much as possible while keeping your commitment to a high-dividend product at 20 percent of your capital. Let’s look back at the last five years to see how PEY might have performed. Classic 60/40 Portfolio Our benchmark will be a classic “60/40” portfolio: 60 percent stocks, represented by the SPDR S&P 500 ETF (NYSEARCA: SPY ), and 40 percent bonds, proxied by the iShares Core Aggregate Bond ETF (NYSEARCA: AGG ). Taking a 20 percent PEY carve-out from the bond side (a “60/20/20” allocation) produces a significantly higher average annual return than the benchmark but yields an inferior Sortino ratio. Splitting the PEY carve-out equally from the equity and bond sides (a “48/32/20” mix) improves both nominal and risk-adjusted returns but ticks up volatility. The sweet spot’s found by carving out a PEY allocation from the classic portfolio’s equity side (a “40/40/20” exposure). There’s a minimal impact on the portfolio’s average annual return but a significant reduction in volatility and, therefore, realized risk. Both risk ratios, especially the Sortino metric, are dramatically improved at the cost of just 10 basis points in annualized returns. High div/low vol packages Some newer high-dividend ETFs attempt to entice risk-averse investors by branding themselves as “low-volatility” portfolios. The oldest of these, launched in 2012, is the PowerShares S&P 500 High Dividend Portfolio ETF (NYSEARCA: SPHD ). SPHD’s index methodology screens the S&P 500 for 50 of the blue-chip benchmark’s highest-paying and least-volatile components, tilting the portfolio heavily toward utilities, consumer staples and financials. At last look, SPHD paid out a 3.5 percent dividend. It’s no surprise that SPHD is highly correlated to its parent index. Movements in the S&P 500 explain 77 percent of SPHD’s variance. SPHD’s beta, at .76, makes the fund a middling competitor to the veteran high-dividend products. Using SPHD in a “40/40/20” portfolio pares 50 basis points off the return earned by a classic “60/40” portfolio and an equal amount from the portfolio’s volatility. The significant improvement in the portfolio’s Sortino ratio bespeaks SPHD’s defensive sector concentration. SPHD isn’t the only ETF claiming low-vol street cred. The Global X SuperDividend US ETF (NYSEARCA: DIV ) is another 50-stock portfolio that screens stocks for low volatility, but its universe includes MLPs and REITs. Thus, the fund’s high-dividend yield is north of seven percent. The fund’s equal-weighting scheme magnifies the energy and financial sectors’ influence, which perhaps explains why a portfolio including DIV has Sharpe and Sortino ratios worse than a classic “60/40” mix. As with anything, it pays to look beyond the advertising for real evidence. Volatility is relative. Investors will soon have another exchange-traded high-div/low-vol option. Legg Mason recently filed a registration statement for an ETF based on the QS Low Volatility High Dividend Index, a proprietary benchmark that culls 3,000 domestic stocks for sustainable dividends as well as low earnings and price volatility. The Legg Mason Low Volatility High Dividend ETF is expected to be listed on Nasdaq, but no ticker symbol has yet been assigned. What’s clear from this exercise is that dividends come at a cost. Each high-dividend fund is constructed differently, and each presents a unique combination of risks and rewards. The highest-yielding product may not be the best addition to your portfolio. It’s often better to accept a more modest cash flow than risk hard-earned capital.

Valuation Dashboard: Consumer Discretionary – November 2015

Summary 4 key factors are reported across industries in the Consumer Discretionary sector. They give a valuation status of industries relative to their history. They give a reference for picking stocks at a reasonable value. This article is part of a series giving a valuation dashboard by sector of companies in the S&P 500 index (NYSEARCA: SPY ). I follow up a certain number of fundamental factors for every sector, and compare them to historical averages. This article is going down at industry level in the GICS classification. It covers Consumer Discretionary. The choice of the fundamental ratios has been justified here and here . You can find in this article numbers that may be useful in a top-down approach. There is no analysis of individual stocks. A link to a list of individual stocks to consider is provided at the end. Methodology Four industry factors calculated by portfolio123 are extracted from the database: Price/Earnings (P/E), Price to sales (P/S), Price to free cash flow (P/FCF), Return on Equity (ROE). They are compared with their own historical averages “Avg”. The difference is measured in percentage for valuation ratios and in absolute for ROE, and named “D-xxx” if xxx is the factor’s name (for example D-P/E for price/earnings). The industry factors are proprietary data from the platform. The calculation aims at eliminating extreme values and size biases, which is necessary when going out of a large cap universe. These factors are not representative of capital-weighted indices. They are useful as reference values for picking stocks in an industry, not for ETF investors. Industry valuation table on 11/2/2015 The next table reports the 4 industry factors. For each factor, the next “Avg” column gives its average between January 1999 and October 2015, taken as an arbitrary reference of fair valuation. The next “D-xxx” column is the difference as explained above. So there are 3 columns for each ratio. P/E Avg D- P/E P/S Avg D- P/S P/FCF Avg D- P/FCF ROE Avg D-ROE Auto Components 18.17 15.33 -18.53% 0.8 0.62 -29.03% 45.52 21.23 -114.41% 10.44 3.9 6.54 Automobiles 14.35 17.67 18.79% 1.02 1.06 3.77% 16.58 21.97 24.53% 15.1 0.21 14.89 Household Durables 19.24 15.46 -24.45% 0.89 0.59 -50.85% 31.14 16.33 -90.69% 9.04 5.3 3.74 Leisure Equip.&Products 23.65 17.82 -32.72% 1.2 0.84 -42.86% 35.83 22.05 -62.49% 9.54 2.63 6.91 Textile,Apparel,Luxury 17.6 16.34 -7.71% 1.07 0.71 -50.70% 27.43 17.23 -59.20% 12.15 7 5.15 Hotels, Restaurants, Leisure 28.5 21.67 -31.52% 1.43 1.04 -37.50% 30.66 24.18 -26.80% 8.96 4.51 4.45 Div. Consumer Services* 26.05 21.49 -21.22% 1.41 1.4 -0.71% 15.58 18.64 16.42% 1.08 11.35 -10.27 Media 21.57 23.31 7.46% 1.81 1.55 -16.77% 22.28 19.9 -11.96% 3.44 -3.45 6.89 Distributors 19.47 14.32 -35.96% 1.76 0.48 -266.67% 36.08 16.28 -121.62% 10.24 3.18 7.06 Internet&Catalog Retail 30.77 37.37 17.66% 1.35 1.8 25.00% 24.02 32.11 25.19% 4.31 -14.7 19.01 Multiline Retail 20.3 19.41 -4.59% 0.5 0.48 -4.17% 25.27 26.81 5.74% 7.1 10.44 -3.34 Specialty Retail 19.9 17.95 -10.86% 0.6 0.56 -7.14% 25.05 21.87 -14.54% 11.78 9.85 1.93 *Averages since 2005 Valuation The following charts give an idea of the current status of industries relative to their historical average. In all cases, the higher the better. Price/Earnings: Price/Sales: Price/Free Cash Flow: Quality Relative Momentum The next chart compares the price action of the SPDR Select Sector ETF (NYSEARCA: XLY ) with SPY. (click to enlarge) Conclusion The Consumer Discretionary sector has widely outperformed the broad market in the last 6 months. It hit a new all-time high last week. Automobiles (the group of car and motorcycle manufacturers) and Internet & Catalog Retail look the most interesting industries now: they are underpriced relative to historical averages for the 3 valuations factors, and quality is above historical averages. However, there may be quality stocks at a reasonable price in any industry. To check them out, you can compare individual fundamental factors to the industry factors provided in the table. As an example, a list of stocks in Consumer Discretionary beating their industry factors is provided on this page . If you want to stay informed of my updates on this topic and other articles, click the “Follow” tab at the top of this article.