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XLV: Getting Your Dose Of Pharmaceuticals And Biotechnology In A Single Source

Summary XLV is a Health Care ETF with the heaviest allocations going to Pharmaceuticals and Biotechnology. The returns figures look fairly volatile in a regression analysis which makes it substantially more difficult to diversify away the excess risk. The nice thing for shareholders is that they would be holding the very companies that are establishing the prices for the medicine they may consume. 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. One of the funds I am assessing is the Health Care Select Sect SPDR ETF (NYSEARCA: XLV ). 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 for Health Care Select Sect SPDR ETF is .15%, which isn’t too bad at all. I’d love to see the expense ratio go under .10%, but .15% is within reason and not too bad for giving investors exposure to the Health Care sector. Remember that the Biotechnology sector is also within the Health Care sector which makes it more volatile. Largest Holdings (click to enlarge) I don’t see anything to complain about here. The top holdings for the ETF almost perfectly mirror the index so investors should expect the portfolio to have very similar returns. Given the low expense ratio, a fairly passive indexing strategy is usually the result. I’m fine with that. Passive indexing is a solid strategy over the long term. Looking at the individual companies, I like seeing Johnson & Johnson (NYSE: JNJ ) at the top of the holdings. This is a strong dividend company that offers investors some stability. Their product lineup is diverse enough that they are largely protecting from minor shifts in the economy and positioned to benefit from an aging population requiring more medicine. Sector The largest weighting by sector is clearly the pharmaceuticals rather than biotechnology stocks. As a result of this sector diversification the fund is dramatically more stable than peers that are heavily invested in biotechnology companies. On the other hand, the returns for it have also been materially weaker. Building the Portfolio The sample portfolio I ran for this assessment is one that came out feeling a bit awkward. I’ve had some requests to include biotechnology ETFs and I decided it would be wise to also include a the related field of health care for a comparison. Since I wanted to create quite a bit of diversification, I put in 9 ETFs plus the S&P 500. The resulting portfolio is one that I think turned out to be too risky for most investors and certainly too risky for older investors. Despite that weakness, I opted to go with highlighting these ETFs in this manner because I think it is useful to show investors what it looks like when the allocations result in a suboptimal allocation. The weightings for each ETF in the portfolio are a simple 10% which results in 20% of the portfolio going to the combined Health Care and Biotechnology sectors. Outside of that we have one spot each for REITs, high yield bonds, TIPS, emerging market consumer staples, domestic consumer staples, foreign large capitalization firms, and long term bonds. The first thing I want to point out about these allocations are that for any older investor, running only 30% in bonds with 10% of that being high yield bonds is putting yourself in a fairly dangerous position. I will be highlighting the individual ETFs, but I would not endorse this portfolio as a whole. 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. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 10.00% 2.11% Health Care Select Sect SPDR ETF XLV 10.00% 1.40% SPDR Biotech ETF XBI 10.00% 1.54% iShares U.S. Real Estate ETF IYR 10.00% 3.83% PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB 10.00% 4.51% FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT 10.00% 0.16% EGShares Emerging Markets Consumer ETF ECON 10.00% 1.34% Fidelity MSCI Consumer Staples Index ETF FSTA 10.00% 2.99% iShares MSCI EAFE ETF EFA 10.00% 2.89% Vanguard Long-Term Bond ETF BLV 10.00% 4.02%   Portfolio 100.00% 2.48% The next chart shows the annualized volatility and beta of the portfolio since October of 2013. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. You can see immediately since this is a simple “equal weight” portfolio that XBI is by far the most risky ETF from the perspective of what it does to the portfolio’s volatility. You can also see that BLV has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in TDTT is also unique for having a risk contribution of almost nothing. Unfortunately, it also provides a weak yield and weak return with little opportunity for that to change unless yields on TIPS improve substantially. If that happened, it would create a significant loss before the position would start generating meaningful levels of income. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Health Care Select Sect SPDR ETF XLV Hedge Risk of Higher Costs SPDR Biotech ETF XBI Increase Expected Return iShares U.S. Real Estate ETF IYR Diversify Domestic Risk PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB Strong Yields on Bond Investments FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT Very Low Volatility EGShares Emerging Markets Consumer ETF ECON Enhance Foreign Exposure Fidelity MSCI Consumer Staples Index ETF FSTA Reduce Portfolio Risk iShares MSCI EAFE ETF EFA Enhance Foreign Exposure Vanguard Long-Term Bond ETF BLV Negative Correlation, Strong Yield Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. 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) Conclusion XLV is substantially less risky than the XBI. Since XBI is almost exclusively biotechnology companies, I’m not surprised that XLV is so much safer. Of course, it is still a fairly risky investment in its own right. The ETF has a beta higher than 1.00 so it will naturally be increasing the risk level on most traditional portfolios. The correlation with the S&P 500 stands at .88 which is high enough that it may be a concern. The bigger issue, in my opinion, is that XLV has a weaker negative correlation with the kind of long term bond holdings that investors would use to reduce portfolio volatility. In this case, that is demonstrated by having a negative correlation with BLV of only -.23 compared to -.29 for the S&P 500. I would treat XLV as a fairly aggressive allocation. If investors intend to bring their portfolio volatility significantly below the S&P 500, it will be more difficult if the allocations to XLV are significant. Despite the volatility, I do like the exposure within the portfolio. A heavy exposure to the pharmaceutical companies makes sense when an investor expects to be practically forced to buy their products in the future. While the portfolio has more volatility under modern portfolio theory, it does allow investors to benefit as shareholders if prices (and profits) from the pharmaceutical and biotechnology sector increase. 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: 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.

VWO: A Very Solid Emerging Market ETF, If You Don’t Mind China

Summary VWO offers some solid diversification among the companies and a low expense ratio. When investors look at diversification based on geography, the diversification is not as favorable. I’d like to see a lower allocation to China and stronger allocations to smaller emerging markets. When investors look at the correlation between VWO and major domestic indexes on a daily basis, the correlation looks very high. Over the long term, the high correlation breaks and there is a dramatic difference in returns even over periods of a few years. 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. One of the funds that I’m considering is the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ). 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 VWO is only .15%. Nice work Vanguard, this is another low cost index fund for effective diversification. Largest Holdings (click to enlarge) The holdings for VWO are fairly diversified with only 2 companies receiving an allocation higher than 2.1%. The one concern I have is that it seems like “China” keeps coming up in the top holdings. I checked the allocation by country to determine how large that exposure would be. Allocation by Country The allocation to China was 27.1% of the market. Since I’ve been a bear on China, I’m not really big on this allocation. I wasn’t bearish on China until their domestic equity market doubled. While the government in China is working hard to protect their equity valuations, I’d rather see the economy growing rapidly from people working and building both infrastructure and exports. I would prefer an emerging market portfolio with an international diversification that was closer to equal weights. It wouldn’t need to actually be equal weight, but less skewed than the current portfolio. Building the Portfolio This hypothetical portfolio has a moderately aggressive allocation for the middle aged investor. Only 25% of the total portfolio value is placed in bonds and a fifth of that bond allocation is given to high yield bonds. If the investor wants to treat an investment in an mREIT index as an investment in the underlying bonds that the individual mREITs hold, then the total bond allocation would be 35%. Given how substantially mREITs can deviate from book value, I’d rather consider the allocation as an equity position designed to create a very high yield. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since a major recession could still hit this pretty hard. If the investor wanted to modify the portfolio to be more appropriate for retirement, the first place to start would be increasing the bond exposure at the cost of equity. 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 equity REITs. An allocation is created for the mortgage REITs, which can offer some fairly nice diversification relative to the rest of the portfolio and they are a major source of yield in this hypothetical portfolio. 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. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 35.00% 2.06% Consumer Discretionary Select Sector SPDR ETF XLY 10.00% 1.36% First Trust Consumer Staples AlphaDEX ETF FXG 10.00% 1.60% Vanguard FTSE Emerging Markets ETF VWO 5.00% 3.17% First Trust Utilities AlphaDEX ETF FXU 5.00% 3.77% SPDR Barclays Capital Short Term High Yield Bond ETF SJNK 5.00% 5.45% PowerShares 1-30 Laddered Treasury Portfolio ETF PLW 20.00% 2.22% iShares Mortgage Real Estate Capped ETF REM 10.00% 14.45%   Portfolio 100.00% 3.53% The next chart shows the annualized volatility and beta of the portfolio since April of 2012. (click to enlarge) A quick rundown of the portfolio Using SJNK offers investors better yields from using short term exposure to credit sensitive debt. The yield on this is fairly nice and due to the short duration of the securities the volatility isn’t too bad. PLW on the other hand does have some material volatility, but a negative correlation to other investments allows it to reduce the total risk of the portfolio. FXG is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. FXU is used to create a small 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. VWO is simply there to provide more diversification from being an international equity portfolio. While giving investors exposure to emerging markets, it is also offering a very solid dividend yield that enhances the overall income level from the portfolio. XLY offers investors higher expected returns in a solid economy at the cost of higher risk. Using it as more than a small weighting would result in too much risk for the portfolio, but as a small weighting the diversification it offers relative to the core holding of SPY is eliminating most of the additional risk. REM is primarily there to offer a substantial increase in the dividend yield which is otherwise not very strong. The mREIT sector can be subject to some pretty harsh movements and dividends from mREITs should not be the core source of income for an investor. However, they can be used to enhance the level of dividend income while investors wait for their other equity investments to increase dividends over the coming decades. If you want a really quick version to refer back to, I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Consumer Discretionary Select Sector SPDR ETF XLY Enhance Expected Returned First Trust Consumer Staples AlphaDEX ETF FXG Reduce Beta of Portfolio Vanguard FTSE Emerging Markets ETF VWO Exposure to Foreign Markets First Trust Utilities AlphaDEX ETF FXU Enhance Dividends, Lower Portfolio Risk SPDR Barclays Capital Short Term High Yield Bond ETF SJNK Low Volatility with over 5% Yield PowerShares 1-30 Laddered Treasury Portfolio ETF PLW Negative Beta Reduces Portfolio Risk iShares Mortgage Real Estate Capped ETF REM Enhance Current Income 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. 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) Conclusion VWO is benefiting a great deal from having a fairly low correlation with several of the other assets in the portfolio. The highest correlation is with the S&P 500, but even the high level of correlation established here is a function of the very short term measurements being used to measure the correlation. When returns are measured over a longer time period the correlation decreases significantly. Over the sample period the S&P 500 is up by 52% and VWO is down by 12%. Simply put, short term correlations are resulting in significantly overstated correlations for VWO. In the same manner, I think the benefits of diversifying VWO with a long term treasury ETF are understated. When investors are in a period of panic, emerging markets will tend to go down while the risk free securities will be bid higher. If investors want to use a fund like VWO to grab some international diversification (with some heavy exposure to China), I would really for treasuries to be over-weight in the portfolio. The difficulty here is that long term rates are already fairly low so the maximum level of gains on a treasury allocation is limited. All around this is a good ETF, but I would prefer international options with less exposure to China. 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: 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.

A Fork In The Road For XIV

Summary Investors are currently torn between fear mongering pundits and semi-positive economics. An update on the contango and backwardation strategy. The longest period of backwardation in over four years has ended, for now. It has been a very interesting couple of weeks in regards to contango and backwardation. Unlike most of my readers, I don’t get the real time view of the market since I am in the classroom all day. I get a few minutes to check at lunch and that sums up my daily view of the market until around 8pm. My preferred strategy here to profit from the increased volatility has been the contango and backwardation strategy. You can find a detailed description of that strategy, with back testing, here . I always find it fun to go back and read my past writings. When I first started writing for Seeking Alpha, I really wasn’t that great. I believe I had to edit my first article around five times before they agreed to publish it. That is life. Pick yourself up and try again. When I first introduced this strategy on Seeking Alpha, I pointed out that it would not win 100% of the time. Because we are using contango and backwardation as entry and exit points, the strategy becomes difficult when you have futures that consistently bouncing into and out of backwardation. There are two basic options to overcome this problem: Continue on with the strategy. Remember that this strategy will historically protect you from severe losses. Move away from the strategy by holding your position. If you have a long-term positive view for the market and the economy, then you may want to buy and hold a short position in volatility rather than continuing to trade into and out of positions. Before entering these trades you should be fully aware of your potential risks verses the reward. Moving Forward I have stated this previously and it is now being confirmed in the markets. The VIX Index and VIX Futures have moved away from their historically low range. In the short-term I would expect futures to begin trading more towards the historical mean. Take a look at the chart below: (click to enlarge) The VIX will move through cycles of higher and lower ranges of volatility. Historically when the VIX trades in the 10-13 range for an extended period of time, it is followed by a prolonged period where the median VIX will move to a 17-25 range. In periods of economic distress or turmoil that range can be much higher. Let’s look at the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ) as a basis for discussion here. We know that XIV is driven by the first and second month’s contract within the VIX futures. If the front month’s contract were to fall to 13 from here, that would represent a theoretical gain of around 30% considering all factors. However, if the front month contract were to fall to 17 than XIV would experience a theoretical gain of around 12%. In both cases you would have the added benefit of contango to compound your gains over time. This would make your actual gain larger than what I am reporting for illustration purposes. Over the long-term XIV needs healthy levels of contango to build value and cannot just depend on falling futures contracts. When assessing risk and reward you need to factor in a potential sea change in the median level of the VIX futures. As you can see below XIV is only off about 17% from six months ago despite experiencing a severe haircut. All of this is can be attributed to the wealth built from contango. See below: We have just experienced the longest period of backwardation in over four years: (click to enlarge) Other events that could affect XIV and volatility The Senate and House are currently debating the next potential government shutdown which is scheduled for the end of this month. This would provide a healthy dose of volatility and negatively impact XIV. The larger question here is, is this now how the United States government operates now? I have written past articles, which have been mainly brushed to the side, on government debt levels. I believe our debt is unsustainable with current levels of economic growth. Ultra low rates have helped our interest payments. I would be more optimistic about our government debt if we had respectable politicians who could put their personal agendas aside and come together to actually solve problems. Much of what I see is theater and kicking the can down the road. For example, the current solution to the government shutdown is to pass a measure to get us to December. Slow growth is now the new normal. This has been confirmed by The Fed and recently several CEOs have come on record as stating the same. The concern with slow economic growth and low inflation is that it doesn’t take much to turn the tide the other way. These are larger economic problems that require us to come together and create solutions that last longer than two months. Conclusion For now, the days of ultra-low volatility are gone but not forgotten. Like the business cycle it will always come back around. Whether that will be in a couple months or several years remains to be seen. I remain optimistic on the U.S. economy and hope that Washington has the will power to create long-term optimism through compromise. We need to help foster genuine sustainable growth. Bubbles create great opportunities for us volatility traders, but hurt real people. We may get into a longer period of contango this week that would again align your trading with the contango and backwardation strategy. However, if the market remains choppy we could be moving between the two often. You will have to make a personal decision on how you want to proceed with your investments. Follow me here on Seeking Alpha for regular volatility updates and news you can use. As always, feel free to leave your professional comments below. We always create some great discussions. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XIV over 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: The author reserves the right to trade into and out of any products mentioned here and generally will not post exact positions or trades in real time. The author does not give individual buy/sell advice.