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Weathering The Market Volatility Storm; Clear Skies On The Horizon For High Yield

By Darrin Smith, Portfolio Manager, Principal Global Fixed Income Since the beginning of June, high yield spreads have widened by over 150 basis points (bps). The energy sector is trading above 1,000 bps, blowing past the December wides. And although the rest of the high yield sectors have held up, no sector has been immune to market volatility. In light of recent market events, a good question to ask is: “Is this the beginning of a recession or just growth scares caused by a slow-down in China?” Our high yield team believes the latter, but in the current market environment, it’s not easy. But keep in mind, we’ve seen the growth scare before (remember the double-dip scare from 2011). High yield has traded off hard from May to August in recent years, so this mid-year volatility is nothing new. We expect volatility to continue into the first couple of weeks of September at the very least, but as current spreads approach 600 bps, we believe risk/reward is fairly attractive right now. Still, another good question is: “What role do the poor performing energy and metal sectors play in high yield’s ability to weather the volatility storm?” We understand the pain that’s been inflicted and will continue to be inflicted on the energy and metals sectors, but these sectors only represent 8.5% and 4.8%, respectively, of the total high yield index. We hear all the time about the headwinds in high yield being driven by the decline in energy prices, but this has mostly been an issue of oil supply rather than oil demand. For the rest of the sectors in high yield, $2 per gallon gasoline could provide a meaningful tailwind. Additionally, the underlying fundamentals of companies that are not in these sectors continue to be very robust (making the assumption this is just a growth scare and not the beginning of a recession). So where does this leave investors who are staring at a volatile market? Is there an end in sight? Our high yield team believes there will be volatility for at least another month given traditional poor performance of high yield during the late August/September timeframe and as we await further clarity surrounding the September Fed meeting. However, we do see spreads tightening from current levels heading into year end and into the first part of 2016. So, what are we doing in the interim in light of this forecast? Maintaining a Sector Focus: Our favorite sectors right now are finance, life insurance, leisure, automotive, and pharmaceuticals. For the most part, these sectors will benefit from reduced gasoline prices and are more tied to the consumer. The near-term default potential for these sectors is also very low. Establishing a Region Focus: We think European high yield offers value, as this segment has limited exposure to energy names and commodity weakness actually provides tailwinds for economic growth in the European high yield region. Examining our Sector Allocation: We are currently underweight energy. Nevertheless, we still have names that have been negatively impacted by the large sell-off in energy prices. We have not started buying back into the sector, but we are focusing on basins, balance sheets, and forward hedges (check out a previous post on this topic) that are in place for each company that we own. When we step back in, we will be adding to the higher-quality issues that have these positive characteristics. Evaluating our Credit-Rating Allocation: We are still overweight single-B’s, and we feel that our CCC’s have been rated incorrectly by rating agencies and should actually be rated higher. We will not call a bottom right now, but since the end of the financial crisis, the high yield market sells off during this timeframe every year. If our view is correct, and this is just a temporary growth scare, we believe the risk/reward is attractive right now, as long as you can withstand volatility over the next few weeks.

BIV: Excellent Diversification In A Single Bond ETF

Summary BIV offers investors exposure to both corporate bonds ranging from triple A to Baa and U.S. government debt. The inclusion of lower credit rating debts is allowing the ETF to offer more respectable yields. If investors wanted to get a large portion of their domestic bond exposure through a single ETF, BIV would be an extremely strong contender. I still prefer BIV in the context of a diversified portfolio, but it can eliminate the need for some other bond holdings. The Vanguard Intermediate-Term Bond Index ETF (NYSEARCA: BIV ) is a very interesting bond fund. As I’ve been searching for appealing bond funds, I’ve found some of my favorites are from Vanguard. Given my distaste for high expense ratios, it should be no surprise that the Vanguard products would be appealing. Quick Introduction The Vanguard Intermediate-Term Bond Index ETF is showing a yield to maturity of 2.7% and an average duration of 6.5 years. The yields are not high, but the duration is also not very long. All around, so far this seems fairly reasonable. If an investor wanted to use a single ETF for a large portion of their bond portfolio, this would be an option that could get it done without generating excessive amounts of risk. Credit Quality The following chart breaks down the credit quality of the issues being held in the portfolio. The lowest ratings are Baa, which is high enough that I’m not very concerned about the credit risk. However, the use of the lower rated credit securities is critical to allowing the ETF to establish a yield that is not horrible. This is a case of a fairly diversified portfolio in terms of credit ratings and it provides investors with an option for grabbing most of their domestic bond exposure within a single holding. Maturities I grabbed another chart to show the effective maturity on the securities: The maturity profile for the Vanguard Intermediate-Term Bond Index ETF shows that an investor looking for domestic bond exposure would be wise to focus on surrounding the ETF with very short durations or longer durations. The portfolio has great diversification across credit ratings but the maturities are heavily focused. A Hypothetical Portfolio I put together a very simple sample portfolio using Invest Spy. Due to some of the ETFs being newer the sample period is limited to a little over two years. (click to enlarge) This hypothetical portfolio is weighted to 60% equity and 40% bonds. To break that down the weights from the equity section are 30% total market index (NYSEARCA: VTI ), 10% equity REITs (NYSEARCA: VNQ ), 5% Utilities, 5% Consumer Staples (NYSEARCA: VDC ), 10% International Equity. The bond section is holding 10% in junk bonds (NYSEARCA: JNK ), 5% in extended duration treasuries (NYSEARCA: EDV ), 5% in emerging market government bonds (NASDAQ: VWOB ), 5% short term corporate debt (NASDAQ: VCSH ), 5% in short term government debt (NASDAQ: VGSH ), 5% in mortgage backed securities (NASDAQ: VMBS ), and 5% in intermediate-term corporate bonds . This portfolio won’t be perfect for hitting the efficient frontier, but it should beat the vast majority of real portfolios investors are using on a risk adjusted basis. If long term rates were higher I would have used a higher weighting for long duration bonds due to their exceptionally correlation to major equity classes. My disclosure already states it, but I’ll reiterate that I am long VTI and VNQ. Annualized Volatility When measuring risk adjusted returns for a portfolio the most efficient method is usually to use the Sharpe ratio. For that ratio we are taking the total return annualized return and subtracting the risk free rate. Then we divide the resulting number by the annualized volatility. The problem is that this metric is only really known after the fact. Predicting the level of returns in advance is problematic but correlations and relative volatility are more reliable over time than returns. Within the chart investors can see the annualized volatility of each holding as well as the resulting annualized volatility for the portfolio. While some holdings have higher annualized volatility scores, such as EDV, the ETF makes up for that by having negative correlation to a few of the equity holdings. As a result, the ETF only contributes .6% of the total risk in the portfolio. An Alternative Composition BIV is showing more annual volatility than VMBS, VGSH, and VCSH but it is also offering stronger yields. If an investor wanted to simplify the portfolio, they could raise the exposure to BIV and drop the exposures outside of EDV and VWOB. I prepared a second chart that demonstrates the same portfolio with BIV elevated to 20% of the portfolio and VMBS, VGSH, and VCSH eliminated. This portfolio would have significantly less short term exposure and no exposure to Mortgage-Backed Securities. (click to enlarge) This second portfolio is showing precisely what investors should expect. The annualized volatility increased slightly from 7.0% to 7.1%, but the total return over the period (about 26 months) increased from 19.8% to 20.1%. This bond allocation that relies more heavily on BIV is slightly more aggressive but it is also simpler to put in place. Correlation I want to dive a little deeper into the correlation statistics. The table below provides the correlation across each of those ETFs which should make it very quick to see which ones are work very well together. When a correlation is shown in the tan color it indicates a negative correlation which is very attractive for reaching the efficient frontier. You’ll notice that quite a few of the bond funds have negative correlations to VTI and the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Since VTI and SPY have a correlation ranging between 99% and 99.9% depending on the measurement period, it should not be surprising that those two funds have very similar correlations to other holdings. Here is the correlation table: (click to enlarge) BIV has a negative correlation to the market in general as demonstrated by the -.15 correlation to both VTI and SPY and virtually no correlation to foreign markets or consumer staples. On the other hand, it does show correlations to VNQ (which is REITs) and VPU (which is utilities) because those investments are both considered income investments. Conclusion BIV is one of the best options available for an investor that wants to reduce the number of tickers they need to follow. If an investor uses it to eliminate other short term bond funds they may see a slight increase in portfolio volatility as well as a slight increase in the expected returns on the portfolio. There are few bond funds that I think work well as such a large portion of the bond holdings within a portfolio, but BIV does it quite well. Since the holdings are limited to intermediate term domestic securities, it is still reasonable to maintain a small longer term allocation and an international allocation. Disclosure: I am/we are long VTI, VNQ. (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.

2 New ETFs Track Cybersecurity Growth

Summary Since November 2014, two tactical ETFs tracking cybersecurity have been issued. CIBR offers a reasonable expense ratio and a portfolio of companies that have performed well over the past 5 years. HACK is widely traded and offers a NAV of more than $1 billion, although that comes at a price. Businesses involved in strategies, equipment and software designed to protect data and data networks are in great demand, and will continue to be for the foreseeable future. Hardly a month goes by without the announcement of a data breach, either in the business environment or in government. The risk to data security is not limited to the U.S., either – it is a global concern. It was just a matter of time before someone offered a tactical ETF that focused on companies involved in cybersecurity 1 – the term used to refer to the particular data risks inherent to information systems. There are now two such ETFs: PureFunds ISE Cyber Security ETF (NYSEARCA: HACK ) First Trust NASDAQ CEA Cybersecurity ETF (NASDAQ: CIBR ) In the following, I examine these two funds, comparing and contrasting their investment approaches. I will also provide an estimate of their growth potential over the coming year. HACK HACK is the older of the two funds by about 7 months. Its holdings, based on the index provided by International Securities Exchange, LLC (ISE), is divided between two sectors: Infrastructure Providers and Service Providers . Infrastructure Providers are companies that develop hardware and software for cybersecurity; Service Providers are companies the business models for which is “defined by its role in providing” cybersecurity services. 2 All holdings in the fund must meet the following criteria: 3 Cybersecurity activities are a key driver of the business; Must not be listed on an exchange in a country that employs restrictions on foreign capital investment; Must have a minimum market capitalization of $100 million; Must be liquid; 4 Must be an operating company (not a pass-through security). Weighting of the holdings is determined on two levels: sector exposure is determined by the aggregate market capitalization of the holdings in each sector, and companies within a sector are weighted equally. 5 Rebalancing and reconstitution are semi-annual, in June and December. 6 Dividends are expected to be distributed monthly, while capital gains will be paid annually. 7 CIBR CIBR has been on the market for just over one month, as of this writing. Its index is based on the Consumer Electronics Association ‘s (CEA) cybersecurity classification, which requires that companies satisfy one of the following: 8 Focus on developing technologies designed to protect computer and communications networks from attack and outside unauthorized use; Involvement in deploying cybersecurity technologies to government, businesses, financial institutions and other industries; Focus on protecting priority data from unauthorized external access and exploitation. A company is eligible to be a holding of the fund if it: 9 Is classified as a cybersecurity company according to CEA requirements; Is listed on an index-eligible global stock exchange; Has a worldwide capitalization of at least $250 million; Has a three-month daily average trading volume of at least $1 million; Has a minimum free float of 20% of outstanding shares available for public trading. (In the case of companies issuing more than one security, only one holding is permitted.) Weighting is determined by the holdings’ liquidity; liquidity is determined using the three-month average daily dollar trading volume for each company. The portfolio is rebalanced quarterly, in March, June, September and December; the portfolio is reconstituted , if needed, in March and September. 10 Dividends , if any, are to be paid quarterly; capital gains will be distributed annually. 11 A Word About Dividends I would not expect either fund to pay any dividends on the basis of income received by way of dividends from their holdings. Very few of the companies in either fund’s portfolio pay dividends (fewer than one-third, in fact), and both funds use up the dividend income in covering expenses. Of course, dividends are only one source of income for an ETF, other mony coming through capital gains and interest. 12 The Holdings One would expect there to be a significant overlap in the holdings of these funds, given their tight focus; in fact, 23 companies are common to both portfolios – just over two-thirds of each. Both funds are open to holdings purchased in foreign markets, and each fund currently has six such funds, overlapping in three. Despite the fact that HACK and CIBR utilize different weighting strategies, there are six companies common to the funds’ top-ten holdings: Palo Alto Networks, Inc. (NYSE: PANW ); Cisco Systems, Inc. (NASDAQ: CSCO ); Fortinet, Inc. (NASDAQ: FTNT ); Proofpoint, Inc. (NASDAQ: PFPT ); Imperva, Inc. (NYSE: IMPV ); and Trend Micro Inc. ( OTCPK:TMICY ). Performance One should not expect much in the way of reliable performance information from new ETFs, particularly one that is less than two months old. However, the following chart shows the two funds to be dancing to the same tune, as it were: The performance of the two funds has to be taken in the context of what has been a fairly disappointing 2015 – in particular, very poor conditions have prevailed since mid-July. 13 A dismal summer has seen HACK drop from a high of $33.60 (June 23) to a close of $27.17 (August 21) – a drop of 19.14%. CIBR has pretty much seen only the downside of the market. Portfolio Performance Since a new ETF, by definition, has no extended history, when considering the potential it might have, I believe it helps to take a look at its portfolio and see how that collection of holdings has performed historically. 14 With this in mind, the following chart shows the performance of CIBR and HACK, starting from August 2, 2010: 15 (click to enlarge) Given the fact that the two portfolios overlap by about 66% of their holdings, it is no surprise that the two seem to march in lock step. However, by August 2012, CIBR begins to gradually outperform HACK, ultimately besting it by 2770bps. On an annual basis, CIBR has a CAGR of 20.75% compared to HACK’s 18.02%. There is no clear reason why the CIBR portfolio should so clearly beat HACK’s. The addition of two extra holdings should not be that much of a factor; both portfolios contain foreign equities; for sake of comparison, the standards set for CIBR’s portfolio seem marginally more stringent than the requirements established for HACK. If number of holdings is the difference, it shouldn’t be a factor to consider in choosing either fund. The indices the funds are based on are fluid in terms of content, and companies may either be added to or subtracted from the universe determined by their eligibility criteria. I should expect both indices to increase as security becomes a more pressing concern. Expectations Based on the five-year performance of their respective portfolios, the following chart shows one course these funds may track over the coming year: 16 (click to enlarge) Interestingly, the spreadsheet factored in a drop in value this month, and we are coming off one of the worse weeks the market has seen in quite a few years. In the long term, however, both funds are projected to do quite well, with CIBR expected to outperform HACK by a significant margin. 17 Assessment Both funds have a lot going for them. First Trust has a respectable history of offering responsible, quality, funds. PureFund ‘s HACK is simply huge – its NAV is currently ~ $1.36 billion , and trading volume has been significant. If there is any cautionary factor in HACK’s data, it would be its expense ratio; currently, its ER is listed at 0.75% – over the ~0.65% average for indexed funds, and well over the 0.60% ER for its competitor, CIBR. Given its NAV, an ER of that size is going to eat into income, leaving very little left for investors; not that CIBR is going to offer much in the way of dividends. Both funds are, and will continue to be, driven by developments in the cybersecurity market, and I do not see any reason to believe that market is going to drop off any time soon. If anything, as “cloud” storage becomes more and more prevalent one should expect to see increasing demand for continued research in, and development of, security solutions. The existence of an active – and persistent – hacking community will see to that. All in all, I perceive CIBR to be the better bet at this point, but the funds are too close to be able to say the choice is compelling. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from each Company’s Prospectus, Statement of Additional Information, and fact sheets. All tables, charts and graphs are produced by me using data acquired from pertinent documents; historical price data from The Wall Street Journal . Data from any other sources (if used) is cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. 1 Cybersecurity , in the broad sense, refers to “products (hardware/software) and services designed to protect computer hardware, software, networks and data from unauthorized access, vulnerabilities, attacks and other security breaches.” (HACK Prospectus , p. 2) HACK’s documentation refers to “cyber security,” (dividing the term into two words) while other sources use the single word. I endeavor to use the single word throughout. 2 HACK Prospectus , p. 2. 3 HACK Prospectus , p. 2. 4 This is not clarified in the Prospectus, but it is assumed to mean that the holdings must each be actively traded on the market. 5 HACK Prospectus , p. 2. 6 HACK Prospectus , p. 2. 7 HACK Prospectus , p. 13. 8 CIBR Prospectus , pp. 1-2. 9 CIBR Prospectus , p. 16. 10 CIBR Prospectus , p. 2. 11 CIBR Prospectus , p. 11. 12 My estimations of prospective dividends for new ETFs has been fairly good, so far, any difference between my calculation and the actual payments made being in the investors’ favor. 13 As I write this (Friday, August 21, 2015), the Dow has just finished the day down more than 500 points (-3.12%). 14 There are limitations to such a “backtest,” of course: it would be onerous, if not impossible, to apply a fund’s eligibility/selection criteria to the past – unless one has a lot of time and computing power, not to mention extensive access to databases. (This is why issuers of index-based ETFs pay out substantial amounts to license the indices their funds are based on.) Since not all companies currently in a portfolio have been in existence for extended period, matters of re-adjusting weightings becomes a substantial nuisance – except in the case of equal weighting. 15 Each portfolio was primed with a $25K “investment.” Each holding within the portfolio is weighted the same, throughout the trial, as it is currently weighted; in the case of companies entering the market later than August 2, the allocation they would have received is held in reserve until their entry into the portfolio. Portfolios were rebalanced and reconstituted quarterly. 16 The projection is based on the “forecast” function in Microsoft’s Excel which apparently bases its projections on an exponential trend line extrapolated from historical performance. 17 Note: these forecasts are generated by a spreadsheet, and are based on the historical performance of each fund’s portfolio holdings. This is not intended to reflect my own expectations of either fund. For my part – and as any responsible investor should realize – one cannot predict the future performance of any stock simply on the basis of past performance. At least, not with any degree of accuracy. The chart should be taken to reflect a potential tendency for future performance. 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.