Summary ZROZ has very long duration treasury securities. The ETF has shown a very strong negative correlation with major market indexes. When used in a portfolio that is overweight on equity investments the result is a rapid reduction in portfolio volatility. The volatility on ZROZ would make it better for speculation than investment if the investor did not have a large equity allocation. The high volatility on the ETF is encouraging the very strong negative beta which makes it an incredible tool under modern portfolio theory. 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 PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ). 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 Call me cheap, frugal, or whatever other name you like. The simple fact is that I despise high expense ratios. The expense ratio on ZROZ is .15%. That is low enough for me to use it, but I’d really prefer to see something that was closer to single digits. In my experience, most ETFs and the vast majority of mutual funds have expense ratios way higher than I am comfortable paying. Compared to the rest of the market, ZROZ is doing just fine on controlling the expense ratio. The other useful for factor in analyzing total expenses is the cost of trading. Since ZROZ is on the “free to trade” list for Schwab clients, that makes it substantially more attractive for me. As you’ll see, I’m looking at ZROZ as a portfolio hedge since I’ve gone so heavily overweight on equity securities. Quick Numbers The average effective duration and maturity are incredible with scores over 25 years. (click to enlarge) The quick take on this extremely long duration treasury play should be that it makes sense for two kinds of people. One would be investors like me that go heavily overweight on equity positions and want then use modern portfolio theory to look for a way to reduce the volatility stemming from the heavy equity positions. The other group of people would be speculators that want to make bets on which way the interest rates will be moving. As you might guess, I’m going to focus on using the ETF for long term investors seeking to reduce volatility in the total value of the portfolio. Maturity The maturity breakdown for ZROZ is incredibly simple. Very long term treasury are not only the core of the portfolio, they are the entire portfolio. (click to enlarge) Building the Portfolio I put together a hypothetical portfolio using only ETF’s 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 International Equity ETF (NYSEARCA: SCHF ) is developed international equity. 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 moderately long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF 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) Why I like ZROZ The argument for a long term investor with a very long time horizon and a large margin of safety buying treasury securities when their yields are fairly mediocre is actually quite simple. It comes down to negative beta. Bond ETFs with extremely negative betas are able to provide substantial diversification benefits with even small allocations. I put together one more chart to demonstrate the impact of simply tossing ZROZ and TLO into a portfolio that is very overweight on SCHB. (click to enlarge) For an investor going overweight on equity exposure with 80% in a broad market index, ZROZ is providing a risk contribution to the total portfolio of minus 5.8% compared with TLO providing minus 3% when both are given a 10% allocation. The annualized volatility of the portfolio at 11.3% is dramatically lower than the annualized volatility of any of the individual holdings. Both TLO and ZROZ are reducing the portfolio volatility, but ZROZ is doing it more effectively because it has a stronger negative beta. That doesn’t mean TLO cannot accomplish the same goal, it simply takes a larger allocation to TLO to achieve it. The point of using ZROZ is to get the negative beta into the portfolio without having to use a large allocation. Given that treasury yields are fairly weak, I don’t see any other major reasons to use it. If yields were higher, I would certainly want to use a larger allocation because I would appreciate the expected income as well as the negative beta. On the other hand, if yields were fairly solid, say 5% to 6% on TLO, I would be much more inclined to allocate more of my portfolio to bonds and that would make it reasonable to use a combination of TLO and SCHZ rather than ZROZ. Conclusion ZROZ can be useful for speculators, but it also has a great purpose in the portfolio of a long term investor that simply wants to crank down the volatility of a portfolio that is already heavily overweight on equity securities. Since I am that kind of long term investor seeking to reduce the volatility in my portfolio, I see some benefits to using ZROZ for negative beta even when I find the yields fairly unattractive. Due to the very high volatility, investors using this strategy should either be using it inside a tax advantaged account so they can sell shares to fund rebalancing between the allocations or doing it with a constant inflow of new cash to the portfolio so they can rebalance without selling. As always, check with a tax consultant if you need help in that area. Disclosure: I am/we are long SCHB, SCHD, SCHF, 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.